Saturday, September 28, 2013

Mergers Hurt Credit Rating

Standard & Poor's recently analyzed 101 mergers and acquisitions worth more than $5 billion since 2000 and found that these mergers and acquisitions can hurt credit ratings. In fact, 53 of the 101 transactions resulted in a credit rating that dropped at least one notch. Twenty one of the transactions resulted in no credit change and 27 resulted in a higher credit rating. The risks cited by S&P in the downgrades include weaker pro forma credit measures, reduced free cash flows, and increased business risk for the combined firm. It appears that many acquirers are borrowing too much in paying for acquisitions, at least according to S&P.

Tuesday, September 24, 2013

Notes Payable: Operating Or Financing Cash Flows?

A common question posed to us is the treatment of notes payable. Are notes payable part of total debt, or is it something else? You should note that there is an unavoidable inconsistency in dealing with notes payable and cash flow from assets. The same thing occurs when calculate EFN. In both contexts, NWC is essentially treated as an asset, which means that notes payable have been netted out (treated as a contra-asset). On the other hand, interest paid shows up in cash flow to creditors, but not repayments of note principal (which show up in the change in NWC). Interestingly, a similar inconsistency shows up in the standard statement of cash flows, where interest paid is treated as an operating cost.

Some argue that it would be more consistent to define net operating working capital (NOWC), which is just NWC with notes payable left out.

In our view, this issue runs much deeper. First, notes payable are operating liabilities for many businesses. Any company, such as a car dealer, that uses bank borrowing to floor plan inventory is using notes as operating liabilities. In this case, the interest paid actually is an operating cost. Very commonly, companies with seasonal sales use revolvers (a form of notes payable) to crank up inventory. Same story. Making matters more complicated, accounts payable is the single most important form of business financing (not just operating financing) for small businesses. The distinction between accounts payable and notes payable is pretty artificial in these cases. Both are debts, just different creditors. However, long-term secured debt maturing in the current year is clearly not an operating flow.

But wait, there is more.

Large corporations are increasingly holding huge amounts of cash, far more than needed for operations. This excess cash is properly viewed as a short-term investment portfolio. If we are trying to be very rigorous in our definitions of operating assets and liabilities, then we have to somehow separate out the operating cash (this is why we subtract cash in calculating enterprise value, but that’s also wrong because some of the cash is needed for operations).

So, in light of all this, we made the decision to follow common business practice and call NWC the difference between current assets and current liabilities. The cash flow to shareholders comes out correctly, EFN comes out correctly, and in capital budgeting, none of these issues exist. As you go out in the world and use what we have taught you, you may run into these issues. Hopefully, for your company, you should have more information available which will allow you to separate cash and notes payable into separate operating and financing cash flows.

Trading At The Speed Of Light

What do the speed of light and stock trading have to do with each other? Actually, quite a lot. On September 18th, the Federal Reserve made an announcement that it would not scale back its support of the economy, an unexpected announcement. This type of news should move the market as a whole, and indeed it did. Looking at the chart below, taken from Yahoo! Finance, what time do you think the announcement was made public?

If you guessed 2 PM, you are correct. This chart shows that the announcement was a systematic event since the entire stock market moved, as well as the efficiency of the market in rapidly reflecting the new information.

However, several large trades made in Chicago are now under investigation. As you can read in the article, the Federal Reserve went to great lengths to ensure that the information was released to the market at exactly 2PM. Even with the Fed's safeguards, over $600 million dollars worth of assets traded in Chicago, all within 3 milliseconds after 2PM. Unfortunately, because of the physics related to the sped of light, it would have taken 7 milliseconds for the news to reach Chicago. In this case, it appears that someone in Chicago received the information early.

Thursday, September 19, 2013

Rising Interest Rates Good For Ford?

People generally believe that rising interest rates are bad for corporations. After all, an increase in interest rates results in higher borrowing costs. However, Ford recently stated that an increase in interest rates may actually benefit the company. The reason has to do with Ford's pension liabilities. In order to calculate the present value of future pension benefits, a company must discount the future cash flows. As you know by now, a higher interest rate results in a lower present value. Since the discount rate used to calculate the present value of pension liabilities is based on a market rate, rising interest rates will result in a lower present value for these liabilities. When examining how any factor will affect a corporation, it is important to examine all of the side effects, not just one particular effect. Of course, one effect not mentioned in the article is that higher interest rates may negatively affect consumers willingness to borrow, reducing auto sales in general.

Wednesday, September 18, 2013

A Long-Term View On Interest Rates

In the textbook, we show a chart of long-term interest rates. For a slightly longer view of interest rates, Louise Yamada shows interest rates back to 1790. A difference in the textbook figure and the figure provided by Yamada is that the interest rates in the textbook, taken from Jeremy Seigel's Stocks for the Long Run, is that Seigel uses government bonds while Yamada uses corporate bonds. What may also be of interest to you is that Yamada discusses interest rates in terms of a technical analyst. She notes that interest rates have peaks and bottoms, bases, and states that a reversal is in order.

Monday, September 16, 2013

The Equity Risk Premium In Emerging Markets

Back for his second appearance as our guest blogger is Dr. Aswath Damodaran from the Stern School at NYU. Dr. Damodaran is a noted expert on valuation and publishes his own blog, Musings on Markets.  Here, he discusses the equity risk premium in emerging markets, a shortened version of his more detailed post. If you are interested in more on the U.S equity, check out Dr. Damodaran’s updated article on the U.S. equity risk premium.

As you have figured out from the textbook, estimating the U.S equity risk premium (ERP) is not a simple task. Things get even more complicated when we are attempting to estimate the ERP in emerging markets. In a recent discussion, Dr. Damodaran examines the factors that affect the ERP in emerging markets. The first factor is the sovereign credit rating and credit default spreads. A country with a higher probability of default on sovereign debt is more risky, and therefore would have a higher ERP as financial instability in the government would extend to the private market as well. Next is the country risk score, which measures economic, political, and legal risks in the country. Finally, the volatility of the individual country’s equity market as measured by standard deviation impacts the ERP. Using this method, Guinea, Sudan, Somolia, and Zimbabwe share the highest ERP, at 22.25 percent. In contrast, the ERP for the U.S is 5.75 percent.  

Acquisition Divestiture

In an acquisition, it is not uncommon for the acquiring firm to buy more than it is willing to acquire, either because the acquirer does not want all of the target assets, or regulators force the combined company to sell off part of its assets. Glencore announced that it was selling Dakota Growers Pasta Company (DGPC) for $370 million. Glencore had acquired DPGC in December 2012 when it purchased Viterra for $6.1 billion. Since the acquisition, Glencore has sold off several Viterra assets including some Viterra farm retail outlets, and parts of Viterra to Agrium Inc., and Richardson International Ltd. If an acquisition includes plans for the partial divestiture of target firm, be sure to include those cash flows in your analysis.

Friday, September 13, 2013

Lehman Bankruptcy Costs Rise

If Lehman Brothers hadn't already filed for bankruptcy in 2008, the company's bankruptcy costs may have forced the company to file for bankruptcy anyway. Five years after the bankruptcy filing, the costs of the Lehman bankruptcy have risen to $2.2 billion, almost three times as large as the next most expensive bankruptcy, which was Enron at $793 million. Consulting firm Alvarez & Marshall has billed $657 million in the bankruptcy, and law firm Weil, Gotschal & Manges has billed $484 million. Given that there is still about $32 billion to distribute to creditors, the cost of Lehman's bankruptcy is still rising.

Twitter Tweets IPO

Twitter tweeted that the company had filed its S-1 registration documents with the SEC, the first public step toward an IPO. Twitter's filing is somewhat unique in that it is confidential. Under the JOBS Act, an "emerging growth company" can file a confidential S-1 if revenues are less than $1 billion. The S-1 does not have to be released publicly until 21 days prior to the IPO. Private sales of Twitter stock lead to a valuation of about $10 billion on the company.

Thursday, September 12, 2013

Executive Pay Matches Performance

According to a recent study by Equilar and The Wall Street Journal, executive pay seems to becoming more aligned with performance. Examining the period from 2008 to 2010, CEOs received bigger than expected rewards when the company's performance exceeded expectations, but when the company's performance did not meet expectations, CEOs lost much of their potential pay. One pay-for-performance deal we particularly liked was that given to Macy's CEO Terry Lundgren in 2009. Mr Lundgren was given 666,666 shares of restricted stock. In order to receive any shares, Macy's stock had to outperform five of ten large retailer's stock over the next three years. To receive all of the restricted stock, Macy's stock had to outperform at least seven of the ten retailers. In the end, Mr. Lundgren received $22.5 million, far more than the projected $2.4 million, as Macy's stock nearly quadrupled over the next three years and outperformed seven of the selected companies. We like that Mr. Lundgren's restricted stock was tied to the company outperforming and not just the result of a general market increase.

Wednesday, September 11, 2013

Verizon's Record Bond Sale

Verizon Communications Inc., announced that it is planning to sell $45 to $49 billion worth of bonds as early as tomorrow.  Verizon's offering is almost three times as large as Apple's $17 billion bond sale in April. The various bonds in the issue will carry maturities of three to 30 years, have have both fixed and floating rate bonds, and be issued in U.S. dollars, euros, British pounds, and possibly Japanese yen. The bond issue is intended to finance part of purchase of Vodafone's 45 percent stake in Verizon Wireless.

Tuesday, September 10, 2013

SEOs Rise

As with IPOs, SEOs tend to be issued cyclically, usually when the stock market is doing well. Given this, it is not surprising that nearly $3 billion in SEOs have been announced recently. For example, Armstrong World Industries announce a $520 million SEO, Enbridge Energy Management announced a $240 million SEO, and Stratys Ltd. announced a $400 million SEO, or about 10 percent of the company's current market value. Given the relative strength of the stock market in the recent past, it would not be surprising to see more SEOs soon.

The Dow Changes

So how did the stock market do today? Although a seemingly simple question, most people refer to a  stock market index to answer that question. Today, the Dow Jones Industrial Average (DJIA), one of the oldest stock market indices in the U.S., announced that it would change its components.  As of next Friday, Alcoa, Hewlett-Packard, and Bank of America will be dropped from the DJIA and Nike, Visa, and Goldman Sachs will be added to the index.

Monday, September 9, 2013

Aligning Shareholder And Manangement Interests

The use of options to better align management and shareholder interests has come under fire since management can often receive huge sums when the options are sold. Recently, it appears that the use of stock options as a management bonus is decreasing while the use of restricted stock is increasing. Restricted stock are shares of stock that are transferable only when certain restrictions have been met. These restrictions are often EPS targets, stock price increases, or tenure at the company. Shareholders appear to be favoring restricted stock because it allows for employees to benefit from stock price increases, but limits the potential gains.

Tuesday, September 3, 2013

Microsoft's Vertical Acquisition Of Nokia

The acquisition of a cell phone manufacturer by a software company would not have been seen as a vertical acquisition 10 years ago, but Microsoft's recently announced acquisition of Nokia is exactly that. For the past several years, Nokia has been the only major cell phone manufacturer to use the Windows Mobile OS. Given Nokia's recent problems, it is possible that the company would be going out of business soon, or just as bad for Microsoft, changing to the Android OS. In fact, the deal calls for €1.5 billion in immediate financing, a unique clause for an acquisition, a possible indication of financial problems at Nokia. Either way, Microsoft now has a captive cell phone manufacturer for its OS.