Wednesday, March 27, 2013

How Should We Look at The Relationship Between Operating Cash Flows and Operating Earnings

Operating Cash Flows and Operating Income are two metrics that every serious investor should spend some time on when conducting investment analysis because they provide very useful information on recurring earnings and cash flows from the normal business operations.

Furthermore, the relationship between Operating Cash Flow (adjusted for non-recurring and non-operating items) and Operating Income is important because it can be indicative of a company's earnings quality and financial health. Usually those two metrics should move in same direction and any inconsistencies may suggest accounting problems. However, there may be valid reasons for the divergence of Operating Cash Flow and Operating Income. As I search for authoritative guidance on this topic, I found Chapter Eight of the book Creative Cash Flow Reporting by Charles Mulford and Eugene Comiskey extremely helpful.

Here are my summaries and notes:

"Reported operating cash flow can be much larger than operating income for capital intensive businesses. A capital intensive company need to invest heavily in Property, Plant and Equipment and these expenditures are included in the investing cash flows whereas the related depreciation is added back to operating cash flows. In addition, through the use of accelerated depreciation for tax purposes, deferred taxes liabilities are often recorded, which reduce net income, but not operating cash flow."

Notes: For capital intensive industries such as airlines and utilities, subtract capital expenditures from the reported operating cash flows to get "normalized operating cash flows." Even though GAAP classifies capital expenditures as investing cash flows, for capital intensive businesses, capital expenditures are in reality cash flows to maintain normal business operations and hence, operating in nature.

"Seasonal factors can also validate the temporary divergence between Operating Cash Flow and Operating Income. In anticipating stronger sales (such as holiday season), companies often build up inventory, which lead to lower Operating Cash Flow. As sales build later, earnings increase and inventory acquired earlier is liquidated. The net result is that operating cash flows can grow at a faster pace than operating income."

Notes: This is certainly true for retailers. Using Macy's as an example, here is the quarterly information for inventory, change in inventory and operating cash flows:

We can tell that there is a surge in inventory and a dramatic decline in operating cash flows in every third quarter and a decline in inventory and improvement in operating cash flow in every fourth quarter. The implication is that when we analyze quarterly financial information for retailers such as Macy's and JC Penney, we have to consider seasonal factors that are inherent to the business.

"An important but often ignored valid factor that drives the divergence between Operating Cash Flow and Operating Income is business cycle development, especially for those cyclical companies. As companies and industries go through cyclical changes, the relationship between earnings and operating cash flow also change. During a recession, a cyclical company will experience a decline in revenue and operating income. Net losses may ensue. However, the company may also reduce inventory accordingly, resulting in improvement in operating cash flow. As the recovery goes, cash flow may decline as inventory levels are brought up back to the pre-recession levels whereas earnings are improving. Gradually, as the business moves beyond the effects of business-cycle changes on its operations, more stable relationship between earnings and operating cash flows should return."

Notes: Again, let's use Macy's to illustrate this point. Below is selected Macy's financial information from 2006 to 2012:

Even though Macy's operating income and net income deteriorated materially from 2006 to 2009, the drop in operating cash flow was not as dramatic. However, this divergence between operating cash flow and operating income is expected and therefore, not to be interpreted as red flags.

"Investors also often misunderstand the effect of business life cycle has on the relationship between Operating Cash Flow and Operating Income. A company's earnings and operating cash flows have certain characteristic relationships that depend on the stage of the life cycle in which it operates."

Notes: Business cycle development is certainly a factor that is often obliterated by investors. Here is the summary of the earnings and cash flow characteristics of each phase in the cycle.
  • Start up phase (2003-2004): A start up firm usually experiences net losses as it spends on SG&A and not generating enough revenues. It may consume even more operating cash flow as early sales result in increase in A/R and as inventories are accumulated. 
  • Early Growth Phase (2005-2006): Revenue continues to grow and earnings may turn positive. However, continued increase in A/R and inventory may cause the company to report negative Operating Cash Flow. In the transition between start-up and growth, earnings often turn positive before Operating Cash Flow. 
  • Established Growth Phase (2007-2012): As the company continues to grow, the growth rate of A/R and inventory should gradually lag the growth rate of earnings and Operating Cash Flow should turn positive. Moreover, as depreciation continues to grow, lowering operating income without lowering Operating Cash, Operating Cash Flow should eventually exceed Operating Income. A company may operate in the growth stage of its life cycle for an extended period. During that period, the stable relationship between Operating Cash Flow and Operating Income should persist. 
  • Late Growth Phase and Maturity Phase: As revenue growth slows or even declines, the company may still report operating income. Restructuring events are likely to happen. However, when the company begins taking significant NON-CASH restructuring charges, the spread between Operating Cash Flow and Operating Income will increase. It would not be surprising to see the company continue generating positive Operating Cash Flow. Only if the company were to remain unprofitable and enter an extended period of decline would it run the risk of beginning to consume cash from operations. 
  • Decline Phase: A company in decline may report losses but provide ample amounts of operating cash flow as investments in working capital accumulated during earlier periods of growth are liquidated. However, as the decline continues, positive cash flows will likely turn negative. 

After considering the above factors, if a company's Operating Cash Flow is not consistent with the Operating Income, its earnings quality may very well be questionable. At this point, the prudent investor should adjust the reported cash flows from operations for non-recurring and non-operating items and adjust operating earnings for non-recurring and non-operating items as well. If there is still a significant divergence between the adjusted Operating Cash Flow and Operating Income after considering all the above factors, the investor should further analyze the reason for the divergence, extrapolate the implications and proceed with caution.

National Oilwell Varco -Stock Analysis Qualitative

1. Business Description (from google finance):

National Oilwell Varco, Inc. is a provider of equipment and components used in oil and gas drilling and production operations, oilfield services, and supply chain integration services to the upstream oil and gas industry. The Company operates through three segments. Its Rig Technology segment designs, manufactures, sells and services complete systems for the drilling, completion, and servicing of oil and gas wells. Its Petroleum Services & Supplies segment provides a variety of consumable goods and services used to drill, complete, remediate and workover oil and gas wells and service drill pipe, tubing, casing, flowlines and other oilfield tubular goods. Its Distribution & Transmission segment provides maintenance, repair and operating supplies and spare parts to drill site and production locations worldwide. 

2. How Does NOV Make Money? 


Rig Technology Segment: This segment designs, manufactures, sells and services complete system for the drilling, completion, and servicing of oil and gas wells. This segment offers a comprehensive line of highly-engineered equipment that automates complex well construction and management operations. Products include  topdrive, mud pump, pressure pumping equipment, drilling rig monitor, drawworks, pipe histering systems, workover rigs, land rig packages, blowout preventers, cranes, coiled tubing, wireline tubing. etc. 

Petroleum Services and Supplies: This segment provides a range of support equipment, spare parts, consumables and services. It sells and provides a variety of tubular services, composite tubing, and coiled tubing, inspection and reclamation services for drill pipe, casing, production tubing, suck rods and line pipe at drilling and workover rig locations. This segment also provides product and services that are used in the course of drilling oil and gas wells. The NOV Downhole business sells and rents bits, drilling motors and specialized downhole tools that are incorporated into the drill stem during drilling corporations. Furthermore, this segment offers solids control and waste management, and Coring Solutions (which enables the extraction of actual rock samples from a drilled well bore and allow geologists to examine the formations at the surface. 

Distribution and Transmission: The Distribution Services business unit provides supply chain management services to drilling contractors and exploration and production companies. It also stocks and sells a large line of oilfield products including consumable maintenance, repair and operating supplies, valves, fittings and other parts that are needed throughout the drilling, completion and production process.  NOV RigStore provides the installation, staffing and management of supply stores on offshore drilling rigs. 

The Transmission business unit supplies products and services used in the construction of water pipelines, lining and wind towers, progressing cavity pumps, grinders, filters, screens and a variety of artificial lift equipment. 


Raw Materials:Steel, other commodities and energy costs. 

Marketing costs.

Research and Development costs.

Engineering and Manufacturing costs. 

SG&A costs. 

3. How does the Company grow?

NOV grows both by organic growth and acquisition. Capital expenditure has been between 1.9% to 3.5% of revenues. Acquisition costs of $1 billion, 556 million and 573 million during 2011, 2010 and 2009. 

4. Moat: 

i. One-stop-shop. The firm supplies nearly all of the equipment needed for a land rig and much of the downhole equipment and consumables (which are being consumed at a greater rate than in the past) as well. 

ii. Scale and rig equipment dominance, particularly in deep-water rigs. NOV's equipment is on 90% of the world's rigs. 

iii. Premium products. 

Offshore drillers, it has the best and only source of rig equipment and the deep-water technology needed for new rigs to economically drill far more complex and deeper wells. 

iv.Diversified revenue stream

5.  3Cs:

(i) Customers: 

  • Rig Technology: Drilling contractors, who provide the equipment, people and expertise to drill the wells, which can be either offshore or onshore. Such as Transocean and Diamond Offshore. Other customers include rig fabricators, well servicing companies, pressure pumping companies, national oil companies, major and independent oil and gas companies, supply stores, and pipe-running service providers. 
  • Petroleum Services: Major and independent oil and gas companies, national oil companies, drilling and workover contractors, oilfield equipment and product distributors and manufacturers, oilfield service companies, steel mills, and other industrial companies. 
  • Distribution Services: Major and independent oil and gas companies, national oil companies, drilling contractors, well services companies. 
  • Transmission Services: Local, state and federal agencies, developers and general contractors. 
  • Samsung Heavy Industries account for 12% of NOV's revenue. 
(ii) Cost structure: Fixed costs vs varying costs: Low operating leverage implies low fixed costs compared to various costs. (iii) Competitors: 
  • Rig Technologies: Access Oil Tools;Aker Solutions AS; American Block; Cavins Oil Tools; Tesco Corporation; Vanoil; Huntings Ltd;
  • Petroleum Services :Schlumberger; Baker Hughes; Halliburton; Weatherfold International; Shaw Cor Ltd; EDO Corporation; Patterson Tubular Services; Vallourec & Mannesmann; and Precision Tube (a division of Tenaris). 
  • Distribution: WESCO International Inc;KS Energy Limited; Apex Distributions; CE Franklin; Wilson Supply ( a division of Schlumberger). 
  • Transmission: Northwestern Pipe Company and a number of regional competitors. 
6. The selling process: 
  • Rig Technology: Direct sales force and distribution service centers. 
  • Petroleum Services: Direct sales force and through commissioned representatives. 
  • Transmission and Distribution: NOV's own network of distribution service centers. 
7. Pricing Power:

Strong pricing power as disclosed by the Company: The Company has generally been successful in its effort to mitigate the financial impact of higher raw materials costs on its operations by applying surcharges to and adjusting prices on the products it sells. 

8. What’s the impact of govt regulations in the business and what’s the risk involved here?

The Business is subject to numerous federal, state and local laws, regulations and policies governing environmental protection, zoning and other mattes. The adoption of climate change legislation or regulations restricting emissions of greenhouse gases could increase its operating costs or reduce demands for NOV's products. 

9.What’s the spread of business between international and USA operations and the impact of foreign currency on earnings?

For 2011, 56% of the revenue NOV generated are international. NOV's foreign operations include Canada, Europe, Middle East, Africa, and Southeast Asia, Latin America. 

10. Important data to watch:

  • West Texas Intermediate Crude
  • Natural Gas Price
  • Rig Counts. 

11. Does the balance sheet have a large amount of goodwill and intangibles?

As of 12/31/2011, goodwill totals $6.151 billion and intangibles totals $4.073 billion and total asset is $25.515 billion. Goodwill and intangibles represent 40% of total assets, which is not a small number. NOV is subject to future goodwill and intangibles impairment. 

12. Are there any quality issues with its products?

2010 Warranty Accrual: $52 million. Actual warranty amounts: $45 million
2011 Warranty Accrual: $40 million. Actual warranty amounts: $47 million

Warranty expense is very minor compared to sales (less than 1%). 

Tuesday, March 26, 2013

JC Penney - Maximum Pessimism?

If you go to Yahoo Finance and search for headlines of J.C. Penney (JCP), chances are you will not see many positive headlines. In fact, you probably don't even need to go to Yahoo Finance — the popular media and Wall Street analysts have been nothing but negative about the outlook for J.C. Penney. Below are a few quotes:

"An analyst at BMO Capital Markets downgraded JCP from marketperform to underperform, and said at this rate the company may go bankrupt next year. The company's stock is now at less than 40% of its 52-week high, which was a year ago tomorrow."

"J.C. Penney has been a train wreck whose comeback always seems just around the next earnings corner, but investors are beginning to doubt that CEO Ron Johnson can weave the same magic that he did at Apple." — CNBC

"J.C. Penney is doing everything short of walking into your living room and executing short trades for you. They're screaming from rooftops in their last annual filing that things aren't going as planned. The stock chart looks like a slalom route for the '98 Nagano men's Olympic downhill team." — Motley Fool

"The company is stuck on a mezozoic era branding problem, and has failed to make massive, paradigm shifting changes to their business. They are not focusing enough on online sales and younger generations, all the while seriously burning through cash." — Seeking Alpha

Further evidences of pessimism include a 42% short interest in J.C. Penney's stock and only one "buy" rating from analysts covering J.C. Penney. So the pessimism is obvious, but the question is, does this represent "rational herding" (i.e. JCP is a value trap) or does this represent a buying-at-maximum-pessimism opportunity? There are a few apparent and seemingly compelling arguments for being bearish on JCP:

1. The turnaround has not been working. Sales are down 25% year over year and 31% for the most recent quarter. The loss is even more horrendous and profit margin is deteriorating. 

2. J.C. Penny has been losing old customers and not been able to attract enough new customers. The pricing strategy in 2012 isolated itself from its loyal old customers and they may never come back. 

3. A major insider (Varnado) has lost faith in J.C. Penney by dumping 40% of its shares. 

4. J.C. Penney will be burning cash at an accelerated rate and may not exist in a few years. 

5. Sales will most likely continue to go down unless Johnson is fired.

6. The Martha Stewart Store may not work out. 

7. The shops are not enough to save J.C. Penney. 

8. J.C. Penney's new executives are not even living in Texas. They are not involved enough in the day-to-day operation. 

I think these are all valid points, but I do have a few questions to the investors who share the above bearish view:

1. Are the bad news reflected in JC Penney's stock price?

2. Does the other side of the trade-namely the buyers of JC Penneys' stock, know about those negative views? 

3. Are you subject to the availability bias, the confirmation bias, the endowment bias and the social proof bias?

4. Have you done a thorough research (not just visiting stores) and come up with risk/reward analysis?

5. Did Ron Johnson and the Penney Board ever say the turnaround will be done in 2013 and did he mention that sales and profits will be down for a while? 

If you read "Celebration of Fools" by Bill Hare, you will find out that the problem with J.C. Penney did not start with Ron Johnson. Early problems with J.C. Penney emerged at the late years when Bill Howell was still Penney's CEO. Bill Howell was not known for any particular stellar accomplishment, unlike the previous Penney's CEOs. He was charismatic politically with an executive image. He always chose his publicized appearance with great care, favoring prestige events like serving on a While House Blue ribbon panel. He started paying a lot of attention to Wall Street and under his reign, J.C. Penny became overly bureaucratic. Jim Osterreicher, the CEO after Bill Howell, was unable to make important decisions until last minutes and not communicating what he wanted exactly. Osterreicher also made bad acquisitions such as Eckerd. Neither Allen Questrom nor Mike Ullman made things better for J.C. Penney. Mike Ullman initiated massive off-mall stores investments which proved to be unsuccessful. 

Continued struggle since the 1990s made it clear that J.C. Penney needed a change, to quote Mil Batten, J.C. Penney's legendary CEO, "Change, of course, is the only constant, the future never assured. So to not plan for change and not invest in the future would be crazy, no matter what Wall Street says." This is why I believe Bill Ackman brought in Ron Johnson. J.C. Penney needed a change, and not a small one. 

The changes Johnson made have been discouraging so far, to say the best. However, there is some hope. First, Johnson made a few big mistakes, but he had realized that he screwed up and he had taken steps to correct those mistakes. Admitting mistakes and learning from them is not the easiest thing in the world. Second, J.C. Penney only installed a very small portion of shops so far. The result of Joe Fresh and the like is still to be seen, but it is hard to imagine those shops will do worse than their current lineups. Third, one reason sales and margins were down dramatically last year is that Johnson's team got rid of a lot of old obsolete inventories. Inventories went down by $600 million during 2012 and most likely the majority of them were sold below cost. This is unlikely to happen in 2013. Therefore, I expect at least better margins for 2013. 

One of my favorite and most respected writers and investors on GuruFocus, The Science of Hitting, has done a masterful job of analyzing J.C. Penney from a consumer's perspective. His article is a good read (at least for the sake of disconfirming evidence) for JCP bears. 

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As far as valuation is concerned, I calculated for the liquidation value and came up with a range of $13 to $16, assuming a 33% discount on inventory at lower cost or market as shown on the balance sheet, and if you mark up 40% of J.C. Penney's property value by 50% (Penney owns a little more than 40% of the approximately 1,100 stores). There are other assumptions regarding other assets such as deferred taxes assets but they are not material. I think Whitney Tilson and Bill Ackman have also calculated the down side risk for J.C. Penney as well. The point is, at less than $15 per share, the market has pretty much priced in the worst for J.C. Penney, and it looks that at this point the risk/reward ratio favors the long side of the stock. Of course I could be very wrong about JC Penney but if that's the case, I will be grateful for the learning oppportunity. 

I also want to share with you the stories of a few most recent notorious value traps:
52-Week Low:1.63
Current Price as of 3/26/2013: 3.30 

52-Week Low:11.35 
Current Price as of 3/26/2013:23.64

52-Week Low:6.22  
Current Price as of 3/26/2013:14.46

52-Week Low:11.43
Current Price as of 3/26/2013:27.60

52-Week Low:1.90
Current Price as of 3/26/2013: 3.36

Let me end with one of my favorite quotes: 

"The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell." — Sir John Templeton 

With that, I welcome any criticism and further discussion. 

Disclosure: Long JCP and long JCP Call Options