Tuesday, July 03, 2007

Value Creation or Destruction-As Simple as (1), (2), (3)- Finding the Value Direction!

As some of you know, I write a monthly post for Marketthoughts.com, an excellent service that is published by Henry To, a fellow CFA. I recommend Henry’s service very highly. I should mention Bill and his many contributions to Henry's service and forum. I play a rather minor, very modest role with a once a month post...a sideshow to the real thing.

Here is an excerpt from my piece published on June 21. I think it may help some of my readers understand what goes into value creation as well as what prompts some corporate activists to rattle their swords.

As a timely example of the value creation / destruction debate, I have selected Angelica, a NYSE listed company as an example that is currently undergoing pressure from an institutional holder, Pirate Capital .

In it, I review some basic tenets of creating a discounted cash flow model by using free cash flow. It strikes me that so often, terms like DCF and FCF just get tossed out to blog audiences without going through an explanation of just what they mean. These are not high fallutin terms. Understanding the creation of value can really be just as simple as (1), (2), (3)

A little review of finance to begin. From first principles we recognize that the value of any company is a function of the Present Value of future cash flows, a Buffett principle if ever there was one, and certainly the basis of most EVA® (Economic Value Added) Theory and corporate finance.


Operating Income (1)

Less: Taxes

= EBIT after Taxes

Plus: Depreciation and Amortization

Less: Capital Expenditures (2)

Less: Changes in Working Capital (3)

= Unlevered Free Cash Flow

The main drivers of free cash flow are as simple as (1), (2), (3), essentially operating margins, the intensity of capital expenditures, and the investment in working capital. These factors work together to provide the valuation of the entire firm. The valuation of the equity of the firm is simply the value of the firm less the value of the debt. Much like a house may be valued for a certain price, the equity is simply the value of the house less the value of the mortgage.

Discounting these future free cash flows back to the present depends on the cost of capital, a cost which moves directly with the cost of borrowed money. Needless to say, the sell-off in government bonds over the last few weeks suggests that a higher discount rate is needed to reflect the cost of money. That in itself is disturbing, but there is more.

As you can see from my calculation of unlevered free cash flow, the combination of downward pressure on operating margins, increased capital expenditure needs, and increased working capital needs put downward pressure on valuation.

A recent Wall Street Journal article of June 19, 2007 (subscription needed) highlights “Companies Fall Behind in Cash Management.” The article suggests that large US companies are stalling in their working capital management and becoming inefficient. As the article indicates:

“Reducing working-capital needs can lead to significant improvements in a company's overall cash flow. And strong cash flow can boost a company's return on assets -- a measure of a company's ability to generate profit and earnings growth through the use of its assets and investment. Reductions in working capital over the past several years have helped buoy stock-market valuations.”

The survey of working capital utilization trends is compiled by a consulting firm, Hackett Group- REL and is published in CFO magazine. Their most recent published survey was last year, compiling year-end 2005 results and showing that for the fourth year in a row, working capital management had improved. Not so this year. Though the results have yet to be published, the WSJ article suggests that inefficiencies are creeping into the system.

I thought it would be useful to pinpoint all three elements of free cash flow generation in order to screen some companies where all three factors were deteriorating i.e. operating margins were falling, working capital intensity was increasing, and capex was increasing. I applied my screening to S&P 1500, the composite of the S&P 500, the S&P mid-cap 400, and the S&P Small cap 600. Only non-financial companies were considered.

S&P 1500 Screen

This is not a list of short candidates necessarily. Many of these companies, despite the one year deterioration in operating margins or the increasing investment, the market may be mis-pricing some of these names, in either direction. In fact, check the disclaimer…I, my family, or clients may own some of these stocks because in my opinion, they represent value. But in aggregate, there’s a lot here that could go wrong here. The aggregate price to free cash flow based on trailing twelve months numbers is 69.2 times representing a free cash flow yield of only 1.45%. At an average 48.51 times operating cash flow (NOT earnings but operating cash flow), there is a lot to be consider.

Exercises like this represent only an opening salvo in your analysis. A more complete understanding of the working capital dynamics and competitive industry dynamics will tell you a lot more about the reasons that valuation should be under pressure. The deterioration could represent a short term phenomenon reflecting a recent acquisition, or it could suggest something more difficult and deep-rooted.

Finally, the appropriate discount rate used to discount these cash flows must be chosen carefully. I am modeling companies based on a base case of 6% government bond yields plus a risk premium that is determined by the volatility of the cash flow stream and the quality of the balance sheet. Is 6% too high a base case? Better safe than sorry.

And that is my bottom-line here. I am still finding companies that are worth buying (at least I hope so!) But the “wall of worry” that many people are willing to clamber has a lot of chasms in it. The “animal spirits” certainly seem to be there in spades when we look at the Blackstone IPO which reportedly was six to ten times over-subscribed despite the great uncertainty about the firm’s taxation and pro-forma compensation assumptions. As one observer cites, “If you have enough orders there's no point in waiting.” Since that time, another alternative asset manager has filed to go public. Och-Ziff Capital Management Group filed its proposed IPO yesterday hoping to raise $2 billion. The decision to pursue an IPO infers that the proposed tax changes Congress suggested last month for hedge and private equity funds may not deter more of them from going public.

Bill Gross at Pimco may well be onto something as far as seeing a 25 year bull market in bonds drawing to an end. The effect on the cost of capital is obvious.

The (1), (2), (3) of corporate finance is incredibly important in deciphering the “value direction” of a business. When those three factors turn south, you should recognize that management is destroying value rather than creating it.

Great investors develop a sense of the value building or value destroying behaviors of businesses or as I call it, the value direction. The work of corporate activists often relates to changing the capital intensity (both working capital and fixed capital) of a business. As well, corporate activists will work to change the cost of capital usually by increasing the amount of debt on a balance sheet. The cost of debt is reduced by the tax deductibility of interest payments. Consequently, lowering the cost of capital by increasing debt will increase the value of the firm (so long as the debt is manageable.)

Angelica Corp (AGL) is a case in point.

An activist investor, Pirate Capital LLC sent a letter to Angelica Corp.'s board Monday, July 1st encouraging it to explore all strategic alternatives, including the sale of Angelica, according to a regulatory filing Monday.

In its letter, signed by Manager Thomas Hudson Jr., Pirate Capital wrote: "For the past several years, Angelica's management has failed to improve its operating results, and in fact its net income has declined precipitously... We believe this failure has significantly hampered value generation for shareholders. ...

"Specifically, we, as a substantial holder of Angelica stock, demand that the company engage a nationally recognized investment banking firm to explore all strategic alternatives to increase shareholder value, including, but not limited to, the sale of the company, sales of assets, or another extraordinary transaction, and that the board of directors publicly identify the investment banking firm and its mandate."

Let’s have a look at Angelica’s cash flow drivers:

Angelica Cash Flow Drivers Spreadsheet

Sustainable free cash flow has been negative in 3 of the last five years, and down substantially from levels attained in 2002. (row 23 of the spreadsheet) The compound annual growth rate of revenues over the ten year period has been -1.34%. The compound annual growth rate of operating profit has been -12.7%. (rows 7 and 8 of the spreadsheet)

Gross margins in 2007 were up slightly from 2006 levels but are about half of what they were just five years ago. Fortunately, SG&A expenses have also dropped off significantly. The operating cushion (essentially operating margins without depreciation and amortization expense) is at the worst level in ten years. (rows 28, 29, and 31)

Moving onto working capital intensity, there has in fact been considerable improvement in working capital management. Working capital to revenues has trended down from levels of low to mid 30% ten years ago to current levels of 12% of revenues…an all time low. (row 40) Most of this benefit has occurred through better inventory management (row 35)

However, fixed capital investment tells a different story. Capex to revenues is at an all time high of 9.2%. The last few years have been fairly intensive capex years especially when compared to the years prior to 2003 when capex was generally about 2% of revenues. (row 55)

Capex does not appear to have been especially productive with returns on invested capital for the last few years looking like this:

Jan 2007 1.60 %

2006 1.00

2005 4.70

2004 5.30

2003 6.70

2002 3.20

2001 2.90

2000 2.10

A company only creates value when its return on invested capital exceeds its cost of capital. Clearly, the company does not appear to have earned any reasonable return over its cost of capital for some years.

What is the remedy here? It appears that interest coverage is okay at 2.88 times EBITDA to interest. However, there are also rent payments and cash taxes. Taking these into account provides coverage of about 1.9 times (cash taxes + interest + rents) I am not sure that one could safely add much incremental leverage to reduce costs of capital.

There is an old adage in the business…the best way to get yourself out of a hole is to stop digging. I have no idea where the capex is going but at least the numbers tell me it isn’t demonstrating any profitability as of yet. It appears at least from an initial examination to be a program that is not working. Beyond that, perhaps some additional cost efficiencies can be garnered to improve operating profitability. Who knows? Maybe there are some additional efficiencies that can be garnered from working capital management beyond what has already been achieved.

In my opinion, the three most important steps an investor can take in understanding what it is he or she owns is incorporated in the technique I have shown. The old basic (1), (2), (3) will provide a lot of information about what direction value is heading and whether management is adding or subtracting.

Disclaimer: I, my family, and clients do not have a current position in Angelica Corporation. There are numerous securities mentioned in the screen that is part of this post. Relating to that, I, my family, or clients have a current long or short position in Amgen, Becton Dickinson, Bed Bath and Beyond, Chattem, Compuware, Fiserv, Foot Locker, Furniture Brands, Global Payments, Jones Apparel, Lexmark, Mentor, Merck, Pharmaceutical Product Development, Southwest Airlines, TTM Technologies, and Yahoo.


At 4:59 PM, Blogger micks said...

Thanks for good write up
Keep it up

At 6:16 PM, Blogger Andy Kern said...

This is one of the best and most educated blog postings I have read in some time. I appreciate your work.

At 9:54 AM, Blogger Jason said...

Rick - nice work sir.

By the way, what is your position in Amgen? I see that in your disclaimer.

At 8:45 AM, Blogger Rick said...

I appreciate the kind commentary from all of you!

I, my family, or clients have a long position in AMGN currently.

At 11:10 AM, Blogger George said...

Hi Rick,

"Value Creation or Destruction-As Simple as 1, 2, 3" was ranked in the top 10 Value Investing News articles of 2007. Congrats! See http://www.fatpitchfinancials.com/730/top-10-value-investing-stories-of-2007/ for details. Feel free to brag about this acheivement with your readers.


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