Share repurchases

CAN CASH FLOW CONTINUE TO SUPPORT SOARING SHARE REPURCHASES? January 30, 2015 Will Becker [email protected]

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Despite a broad trading slowdown, companies are continuing to repurchase their own shares at the briskest clip since the financial crisis and helping to fuel the stock market rally. According to research firm Birinyi Associates, 740 firms had authorized repurchase programs through August of last year, the most since 2008. Meanwhile, in terms of participation, FactSet showed that 374 companies (or 75% of the S&P 500 index) repurchased shares in 3Q14, spending $143.4 billion for the quarter, marking a year-over-year increase of 16%. On a trailing 12-month basis through 9/30/14, companies spent $567.2 billion on share repurchases, a year-over-year increase of 27%.

What is interesting is that this growth in buybacks comes as overall stock-market volume has fallen, helping magnify the impact of repurchases. According to WSJ (9/15/14), in mid-August, about 25% of non-electronic trades executed at Goldman Sachs Group, excluding the high-frequency trading (HFT) that has come to dominate the market, involved companies buying back shares. That is more than twice the long-run trend, according to a person familiar with the matter. Meanwhile, companies with the largest buyback programs by dollar value have outperformed the broader market by 20% since 2008, according to an analysis by Barclays PLC. Jonathan Glionna, head of US equity strategy at Barclays, said,

"There are a couple of reasons why companies do buybacks. One is that it seems to work; it makes stocks go up."

However, this explained direct causality is hardly scientific and we would argue that even recent history shows this is a very flawed way of thinking. On a basic level, a company creates value when it is buying back shares below their intrinsic value. Conversely, it destroys value when it buys back shares above their intrinsic value. Unfortunately, management rarely views share repurchases under these terms, instead looking at them almost as a default option when companies have strong cash flow but can’t find suitable capital investments. Of course, companies typically have more difficulty finding good investments when asset prices are high and returns on investment are low. With a dearth of internal projects meeting the cost of capital, too many companies turn to buybacks. Yet,

it's precisely these periods when one can almost be assured that stock prices are over-inflated, as well. In essence, companies are merely exchanging one form of malinvestment (capital expenditures) for another (repurchases). Thus, managements seem to follow the herd-mentality when it comes to buybacks as the activity is largely ignored when interest in the stock market is low and stock prices are at or near their companies’ intrinsic values. Cash is held dearly by management and inactivity reigns despite attractive asset prices. Meanwhile, share repurchases peak at the height of bull markets when intrinsic values are sky-high. Cash is considered trash and management feels it has to do something with it. We note that repurchases recently bottomed at the heart of the financial crisis when stocks were their cheapest, and are now accelerating six years later after the S&P 500 has more than tripled. Does this seem to be a smart allocation of cash or are we seeing another massive round of malinvestment? When companies repurchase their own shares, they decrease the number of outstanding stock available, which theoretically increases the stock value. Many investors consider this to be the most tax efficient method of returning cash to shareholders, since there is no tax on repurchasing shares. Remember, the highest tax on qualified dividend income is 15% for the top income tax bracket. When companies earn money, they pay taxes on it. When companies pay dividends, dividends are taxed again at the individual level. However, these investors seem to forget that the holders of stock who sold to the company end up paying a capital gains tax on their profit. While not all shareholders sell their shares to companies that are repurchasing their own stock, the ones that do could end up with a higher tax bill at the end of the day, especially if they were longer-term buy-and-hold investors. The current long-term capital gains rate is 20% for high-income investors. On top of that, households making more than $200,000 may also be subject to a 3.8% Medicare surtax on some of their investment income. That makes for a current top rate of 23.8%. Meanwhile, in his 1/20/15 State of the Union speech, President Obama called for raising the cap gains tax rate on households making over $500,000 to 28%. Additionally, shareholders must realize that when a company spends large amounts of money on share repurchases when it could be paying higher dividends instead, the company’s management is limiting the shareholders’ control and increasing theirs. Shareholders are essentially relying on management’s ability to judge whether it’s an appropriate time to repurchase shares, whereas when shareholders are paid a dividend they have complete control over that choice. Thus, we prefer the flexibility of dividends for shareholders since it allows them to direct their flow of income to where they think the best investment opportunities are at any given time. Share repurchases simply lack that flexibility. Next, in theory, share repurchases should equate to lower share counts, which should then inflate earnings per share (EPS). However, we see a large number of companies that

http://www.dividendgrowthinvestor.com/2009/06/dividends-and-stock-buybacks-in-news.html

Can Cash Flow Continue To Support Soaring Share Repurchases? Behind The Numbers Will Becker January 30, 2015

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use share repurchases as a clever way to offset shareholder dilution from exercised stock options from management. We are always wary of companies that make large share repurchases yet fail to reduce their share count due to new issuance of stock to redeem employee stock options. In fact, despite the elevated levels of repurchases, one could argue that lower share count has barely helped EPS growth lately. According to research by Standard & Poor’s, Compustat, and JP Morgan Asset Management, EPS for the S&P 500 companies advanced by 22% year-over-year for 4Q13, yet lower share count only accounted for 0.1% of this increase:

To make matters even worse, since buybacks are typically initiated in good times when stock prices are high, these corporations end up purchasing their own stock at inflated prices, only to have many of these same shares then redeemed by management as compensation committees increasingly hand out these perks in good times. So what happens to heavy share-repurchasing companies when the bad times hit? General Electric (GE) showed in 2008 how quickly repurchases can go wrong. According to The Dividend Growth Investor (6/23/09), In 2007, the company spent $12.319 billion buying back stock, which reduced the share count from 10,394 million to 10,218 million, or a decrease of 176 million shares. This comes out to $70/share, whereas the high and low prices of GE stock in 2007 were $42.15 and $34.50, respectively. This sure tells us that the company gave out at least one hundred million shares through option exercises. Facing a liquidity crunch in 2008, the company was forced to sell $12 billion worth of stock at $22.25/share, much lower than the price it had paid for buybacks over the past 4 years. Back in February 2009, the company cut its dividend as well in order to conserve cash. Thus, GE insiders got filthy rich in 2007-08, while the same GE shareholders that held the stock through the financial crisis quickly found themselves holding diluted shares of a company that held more debt, a cut dividend and a heavily depressed share price. Lastly, we are perhaps most concerned with companies that are willing to take on large amounts of debt to repurchase shares. With the 10-year Treasury yield heading back down to approximately 1.8% off its 3% range back in late 2013, more companies are now able to justify bond-backed share repurchases these days. Even companies with low dividend yields may find bond-backed repos hard to turn down. Meanwhile, there are likely few bankers that will discourage an S&P 500 company - a super safe credit - to take on more debt

in the interest of appeasing their shareholders through repurchases, perhaps even when interest rates are heading up. In Reuters (9/6/13), Jim Turner, head of debt capital markets at BNP Paribas, said,

"When rates go up, any kind of debt financing becomes less attractive, but on a historical basis rates are still very low. If a company has debt capacity at its current ratings, and it makes sense from a capital optimization point of view, share repurchases with bond proceeds still make good sense."

However, once again, we point to the GE example above as a prime example of what can go wrong when shareholders rely on repurchases to drive higher stock prices. Meanwhile, high debt can only potentially compound the problem, as it gives the company less financial flexibility in an economic downturn to make necessary capital expenditures, maintain a dividend, or cover other cash commitments to help the company recover. In short, when it comes to repurchases, we believe financial discipline must be strictly maintained. Not surprisingly, with the U.S. stock market probing record levels, share buybacks are expected to continue at a brisk pace in 2015. According to CNBC (11/11/14), an analysis by Goldman Sachs expects repurchases to increase by 18% to $707 billion in 2015. Goldman strategist David Kosten wrote,

"Since the start of (the fourth quarter), a sector-neutral basket of 50 stocks with the highest buyback yields has outpaced the S&P 500. From a strategic perspective, buybacks have been the largest source of overall U.S. equity demand in recent years."

Yet, what is interesting is that Goldman projects only modest growth in capital expenditures for S&P 500 companies in 2015. Though the current annualized pace for CapEx—at about $2.1 trillion, according to the latest Bureau of Economic Analysis figures—outpaces the aggregate total for buybacks, the buyback pace is well ahead. After increasing by 9.7% year-over-year in 2Q14, the pace of the CapEx increase slowed to 5.5% in 3Q14. Goldman expects declining oil prices will sap CapEx activity at energy firms, resulting in just a 6% gain for 2015 even as nonfinancial companies sit on nearly $1.9 trillion in cash. However, for this exercise, we are going to challenge Goldman’s expectation that the S&P 500 can boost share repurchases by 18% in 2015. Frankly, we believe free cash flow for many of these companies could soon encounter a number of headwinds, thereby making it more difficult for them to expand their buyback programs. For some, the biggest hurdle that may pressure cash flow is restructurings. While most on Wall Street view restructurings as one-time events that largely deal with realigning businesses, reducing asset values and thereby lowering future depreciation, many of these charges were taken years ago and are still consuming cash. When companies shut down a business and layoff a number of employees, they are then required to make severance payments, cover healthcare and life insurance costs, and contribute to pension plans. As we addressed in our 10/31/14 Pensions Must Account For Longevity Risk report, the Society of Actuaries (SOA) updated their mortality estimates for the first time in 14 years, showing life expectancies for 65-year-old Americans is up more than two years. This rising longevity risk will be recognized in the form of higher pension contributions for many companies. Additionally, companies must pay to break leases or cancel outstanding purchase orders or

http://seekingalpha.com/article/118708-share-buybacks-and-dividends-the-missing-fine-print

http://seekingalpha.com/article/118708-share-buybacks-and-dividends-the-missing-fine-print

http://www.cnbc.com/id/102173955

http://www.bea.gov/newsreleases/national/gdp/2014/txt/gdp3q14_adv.txt


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distribution agreements as part of these restructurings. Thus, these are big cash costs that can squeeze cash flow for a number of restructuring companies and force some of them to cut back on their share repurchases and/or other cash commitments. We screened the S&P 500 index, excluding Financials, and looked for companies that have recently made large share repurchases and taken a string of sizeable restructuring charges. In particular, we focused on those charges in which a significant amount of it was taken in cash, thereby pressuring operating cash flow. For example, while a company’s first restructuring may have been a $200 million charge with only about $55 million of that in cash, they may now be taking $500 million charges and $300 million is cash. Additionally, we screened for companies that have already drawn down their working capital so that source of cash is now gone. Finally, we looked at capital expenditures to see which companies have already slashed this spending to free cash and will likely have to ramp it back up to grow business and maintain existing capital. These are the companies that would seem to be in the most jeopardy of having to reduce their share repurchase activity going forward. We focused on the following four companies: Cisco Systems – CSCO

CSCO has recently undertaken two large restructuring plans – the Fiscal 2011 Plan and the Fiscal 2014 Plan – to realign businesses, consolidate excess facilities and sell manufacturing operations. Cash payments for restructurings have been heading much higher.

Still, CSCO’s operations have not improved with declining margins and negative sales growth leading to lower earnings.

To boost cash, CSCO recently benefited from working capital improvements and CapEx remains fairly flat. However, the company recently initiated its first dividend program, which continues to ramp up.

Share repurchases nearly doubled over the last twelve months ended 10/25/14, leading to a large adjusted free cash flow deficit for the period.

CSCO continues to pay its executives heavily in stock, thereby minimizing share count reduction.

Although CSCO’s balance sheet remains fairly solid, debt jumped noticeably over the last year.

General Mills – GIS

GIS has been a regular restructurer and has two big plans – Project Catalyst and Project Century – currently in progress.

Yet, margins have been steadily falling for years, while sales fell year-over-year for last twelve months ended 11/23/14.

Excluding working capital adjustments, operating cash flow declined over the last twelve months ended 11/23/14. Meanwhile, with CapEx heading higher, dividend coverage tightened noticeably over this period.

With share repurchases jumping, GIS has now reported an adjusted free cash flow deficit over each of the last two twelve-month periods ended November.

GIS continues to dole out stock for compensation and appears willing to take on debt to boost its share repurchase program.

The company’s net debt-to-EBITDA ratio was at 3.16 at 11/23/14.

Coca-Cola – KO KO has recently been involved in a number of

productivity, integration and restructuring initiatives. Cash restructuring charges have been large lately.

Since acquiring the North American bottling operations of Coca-Cola Enterprises in October 2010, margins have improved slightly, but recent sales growth has been negative.

Excluding working capital adjustments, operating cash flow has remained fairly flat over the last three years. Meanwhile, CapEx spending remains at lower levels while dividend coverage has tightened.

Share repurchases remain at elevated levels and KO has reported adjusted free cash flow deficits over the last four twelve-month periods ended September.

KO continues to pay its executive very handsomely in stock, causing share count to decline minimally despite heavy buybacks.

KO’s debt levels have more than tripled over the last four years and the company’s balance sheet is no longer solid.

Philip Morris International – PM

PM has recorded a number of separation program and contract termination charges. Cash charges have ballooned lately.

Yet, margins are well-below 2010 levels and sales growth has been negative essentially over the last two years.

Excluding working capital adjustments, operating cash flow declined by 7% year-over-year for the twelve months ended 9/30/14.

Meanwhile, with CapEx and dividends heading steadily higher, free cash flow continues to shrink noticeably.

With large share repurchases, PM has reported adjusted free cash flow deficits in four of the last five twelve-month periods ended September.

PM’s balance sheet has taken a sizeable hit, as total debt has nearly doubled over the last four years and the shareholders’ equity balance is now negative.

Can Cash Flow Continue To Support Soaring Share Repurchases? Behind The Numbers

Will Becker January 30, 2015

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Ticker Short Name TTM NI TTM NI

(-4) %chg Shares Shares

(-4) %chg Repos Repos

(-4) %chg Res Res(-4) TTM CPX

TTM CPX(-4) %chg W/C Adj Adj FCF

THC Tenet Healthcare 84 219 -62% 98 99 -1% -100 -400 -75% 148 45 -1,027 -546 88% -1,659 -404 MOS Mosaic Co 843 1,621 -48% 373 426 -12% -2,508 - #DIV/0! 67 - -1,030 -1,624 -37% 317 -1,518 LLY Eli Lilly & Co 2,987 4,646 -36% 1,113 1,127 -1% -1,000 -1,919 -48% 72 226 -1,038 -939 11% 441 601 DD Du Pont (Ei) 3,612 5,154 -30% 906 926 -2% -2,000 -1,000 100% 114 99 -1,970 -1,877 5% -1,314 -1,947 SPLS Staples Inc 637 856 -26% 640 654 -2% -220 -393 -44% 126 241 -368 -350 5% -39 245 BRCM Broadcom Corp 937 1,169 -20% 592 568 4% -420 -627 -33% 159 13 -270 -227 19% 33 718 FLIR FLIR Systems 187 226 -18% 141 142 -1% -149 -218 -32% 41 1 -56 -56 0% 23 55 ADBE Adobe Sys Inc 332 373 -11% 497 496 0% -774 -1,100 -30% 20 26 -148 -188 -21% 396 365 LH Laboratory Cp 576 643 -11% 85 88 -3% -480 -901 -47% 19 39 -217 -204 6% -36 77 ADT ADT Corp 370 413 -10% 174 209 -17% -1,384 -1,241 12% 17 23 -742 -651 14% N/A -739 ADI Analog Devices 604 670 -10% 311 311 0% -356 -64 454% 37 30 -178 -123 45% N/A -117 STX Seagate Technology 1,731 1,907 -9% 327 359 -9% -1,913 -1,197 60% 28 5 -570 -684 -17% -284 -567 XRX Xerox Corp 1,300 1,419 -8% 1,142 1,231 -7% -1,297 -561 131% 149 151 -370 -358 3% -463 194 WDC Western Digital 1,855 2,018 -8% 234 236 -1% -889 -774 15% 45 112 -652 -706 -8% -48 1,128 HOT Starwood Hotels 531 575 -8% 180 193 -6% -1,106 -417 165% 24 -2 -489 -348 41% 235 -1,437 CAH Cardinal Health 1,286 1,384 -7% 334 341 -2% -983 -307 220% 40 77 -259 -195 33% -47 -37 CSCO Cisco Systems 9,402 10,021 -6% 5,109 5,351 -5% -8,603 -4,488 92% 499 283 -1,245 -1,210 3% 1,208 -1,491 IP International Paper 1,061 1,122 -5% 423 446 -5% -1,333 -220 506% 427 135 -1,400 -1,141 23% -246 -368 GIS General Mills 1,700 1,778 -4% 597 626 -5% -1,850 -1,430 29% 229 11 -710 -621 14% -108 -1,162 NLSN Nielsen Nv 443 464 -4% 381 378 1% -97 - #DIV/0! 99 91 -147 -139 6% -20 431 DNB Dun & Bradstreet 286 299 -4% 36 38 -6% -287 -626 -54% 15 17 -13 -11 15% -4 -53 SNDK Sandisk Corp 1,172 1,212 -3% 221 225 -2% -1,341 -1,590 -16% 33 - -233 -213 9% 44 -110 EMC EMC Corp 3,019 3,118 -3% 2,035 2,058 -1% -2,990 -3,141 -5% 188 - -963 -969 -1% 1,011 1,679 ORCL Oracle Corp 11,539 11,914 -3% 4,398 4,506 -2% -8,099 -10,750 -25% 195 184 -727 -578 26% -111 4,298 MSFT Microsoft Corp 22,539 23,232 -3% 8,255 8,346 -1% -8,016 -5,916 35% 1,267 - -5,536 -4,885 13% 2,620 9,558 PM Philip Morris Intl 8,490 8,725 -3% 1,556 1,606 -3% -4,497 -6,483 -31% 315 41 -1,183 -1,158 2% -722 -2,964 CTXS Citrix Systems 371 378 -2% 164 187 -13% -1,851 -232 696% 17 - -152 -162 -7% 114 -1,117 SYMC Symantec Corp 1,162 1,184 -2% 690 696 -1% -500 -575 -13% 115 272 -341 -286 19% -280 -12 KO Coca-Cola Co 9,213 9,372 -2% 4,375 4,416 -1% -3,903 -4,832 -19% 301 473 -2,543 -2,434 4% -781 -792 CSC Computer Science 644 654 -1% 140 148 -5% -829 -534 55% 57 201 -433 -368 18% N/A 183 MRK Merck & Co 10,310 10,384 -1% 2,861 2,927 -2% -6,279 -7,472 -16% 1,229 1,335 -1,256 -1,897 -34% 650 -776 PBI Pitney Bowes Inc 402 405 -1% 201 202 0% -50 - #DIV/0! 53 54 -155 -152 2% 120 153 RL Ralph Lauren 753 747 1% 88 90 -3% -629 -411 53% 22 11 -352 -374 -6% -110 -174 MDT Medtronic Inc 3,937 3,887 1% 984 998 -1% -2,120 -2,216 -4% 90 190 -410 -442 -7% 233 475 HPQ Hewlett-Packard 7,145 6,938 3% 1,839 1,908 -4% -2,728 -1,532 78% 1,619 990 -3,853 -3,199 20% 4,079 4,568 SIAL Sigma-Aldrich 510 494 3% 119 120 -1% -116 -140 -17% 27 11 -114 -100 14% -31 302 GLW Corning Inc 1,966 1,899 4% 1,282 1,447 -11% -3,375 -581 481% 122 133 -1,077 -1,208 -11% 18 -150 ADP Automatic Data 1,488 1,425 4% 482 482 0% -463 -756 -39% 15 - -207 -179 16% 358 546 DAL Delta Air Lines 2,833 2,699 5% N/A 851 N/A -757 -250 203% 716 402 -2,541 -2,568 -1% N/A 1,971 EMN Eastman Chemical 1,033 982 5% 148 154 -4% -535 -113 373% 129 107 -577 -480 20% -52 132 HSY Hershey Co 860 817 5% 221 224 -1% -543 -319 70% 26 30 -323 -273 18% -166 -344 NWL Newell Rubbermaid 557 528 6% 271 287 -6% -643 -143 348% 57 116 -154 -133 16% -64 -327 STJ St Jude Medical 1,148 1,085 6% 286 289 -1% -700 -1,301 -46% 337 305 -190 -263 -28% 98 -59 COV Covidien Plc 1,948 1,837 6% 454 450 1% -109 -1,763 -94% 86 154 -352 -427 -18% -494 1,185 TWX Time Warner Inc 3,903 3,650 7% 842 909 -7% -5,586 -3,879 44% 513 220 -603 -513 18% -7,964 -3,736 M Macy's Inc 1,601 1,493 7% 345 368 -6% -1,799 -1,607 12% 88 5 -709 -615 15% -279 -407 YHOO Yahoo! Inc 1,498 1,389 8% 979 1,013 -3% -2,782 -4,565 -39% 78 73 -413 -379 9% 196 -2,061 TYC Tyco International 939 870 8% 427 463 -8% -1,833 -300 511% 48 122 -288 -270 7% -23 -1,520 CFN CareFusion Corp 511 472 8% 236 231 2% -566 -514 10% 51 27 -96 -84 14% 70 17 SYK Stryker Corp 1,727 1,583 9% 378 378 0% -165 -252 -35% 26 66 -228 -188 21% 598 940 WM Waste Management 1,106 1,011 9% 458 469 -2% -839 - #DIV/0! 74 29 -1,228 -1,202 2% -5 -262 McCormick-N/V 448 408 10% 129 132 -2% -264 -126 109% 27 - -124 -102 21% -43 -64


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Ticker Short Name TTM NI TTM NI

(-4) %chg Shares Shares

(-4) %chg Repos Repos

(-4) %chg Res Res(-4) TTM CPX

TTM CPX(-4) %chg W/C Adj Adj FCF

TWC Time Warner Cable 2,082 1,887 10% 280 283 -1% -1,212 -2,419 -50% 225 98 -4,006 -3,275 22% 591 94 CBS CBS Corp-B 2,014 1,822 11% 520 601 -13% -3,151 -2,162 46% 26 - -245 -214 14% N/A -2,841 MDLZ Mondelez Inter-A 2,951 2,643 12% 1,680 1,754 -4% -3,127 -793 294% 423 204 -1,723 -1,409 22% 1,119 551 DLPH Delphi Automotive 1,492 1,313 14% 297 308 -4% -766 -456 68% 174 249 -836 -654 28% 43 31 JCI Johnson Controls 2,225 1,954 14% 657 664 -1% -650 -1,549 -58% 324 957 -1,134 -1,351 -16% 864 166 WHR Whirlpool Corp 863 755 14% 78 79 -1% -235 -140 68% 157 203 -683 -517 32% -429 -239 PKI PerkinElmer Inc 264 228 16% 113 112 1% -39 -127 -69% 24 28 -30 -50 -40% -90 156 TEL TE Connectivity 1,582 1,367 16% 408 412 -1% -578 -844 -32% 59 311 -673 -615 9% -279 389 CTAS Cintas Corp 375 323 16% 117 120 -2% -270 -221 22% 26 - -182 -174 4% 102 133 KRFT Kraft Foods Group 1,744 1,481 18% 590 596 -1% -473 - #DIV/0! 7 138 -509 -532 -4% -840 -432 IPG Interpublic Group 419 354 18% 418 416 0% -349 -685 -49% 61 - -176 -162 9% -101 -37 NTAP NetApp Inc 775 656 18% 313 342 -8% -1,600 -1,242 29% 39 50 -223 -282 -21% 114 -680 INTC Intel Corp 11,786 9,942 19% 4,769 4,967 -4% -11,106 -2,440 355% 295 240 -10,105 -10,711 -6% 69 -4,863 XYL Xylem Inc 351 296 19% 182 185 -1% -161 -53 204% 18 40 -113 -122 -7% 22 47 WY Weyerhaeuser Co 744 627 19% 525 583 -10% -123 - #DIV/0! 417 14 -385 -245 57% -171 40 BLL Ball Corp 562 461 22% 138 145 -5% -475 -494 -4% 8 148 -319 -408 -22% 256 170 JNPR Juniper Networks 485 393 23% 438 505 -13% -2,007 -583 244% 175 32 -191 -275 -31% -18 -1,335 DISCA Discovery Comm-A 1,307 1,050 24% 560 705 -21% -1,413 -1,203 17% 24 13 -124 -100 24% 46 -289 CPB Campbell Soup Co 958 763 26% 313 314 0% -147 -138 7% 34 50 -357 -347 3% -111 150 ECL Ecolab Inc 1,300 1,029 26% 300 301 0% -420 -245 71% 44 186 -690 -604 14% -227 332 AGN Allergan Inc 1,763 1,385 27% 298 297 0% -836 -835 0% 209 5 -264 -144 84% -97 552 TXN Texas Instrument 2,716 2,034 34% 1,056 1,095 -3% -2,867 -2,734 5% 38 112 -367 -401 -8% -51 -708 DOW Dow Chemical Co 3,514 2,577 36% 1,179 1,213 -3% -3,273 -134 2343% -22 986 -3,350 -2,427 38% -270 -2,617 SEE Sealed Air Corp 346 253 37% 212 196 8% -137 -5 2942% 44 94 -128 -107 20% -763 -503 GT Goodyear Tire 830 599 39% 275 247 11% -97 - #DIV/0! 97 149 -1,068 -1,073 0% 60 -945 BSX Boston Scientific 914 610 50% 1,326 1,339 -1% -350 -375 -7% 83 98 -264 -223 18% N/A 1,022 ADM Archer-Daniels 2,027 1,171 73% 646 658 -2% -708 -95 645% 31 - -859 -1,022 -16% 2,871 2,619 LUV Southwest Air 1,397 805 74% 679 700 -3% -955 -541 77% 48 - -1,807 -1,446 25% 377 -1

CAN CASH FLOW CONTINUE TO SUPPORT SOARING SHARE REPURCHASES? Behind The Numbers Will Becker January 30, 2015

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CISCO SYSTEMS Cisco Systems (CSCO) is a leading designer, manufacturer and seller of Internet Protocol (IP) based networking products and services related to the communications and information technology industry worldwide. In recent years, CSCO has announced several restructuring plans and taken heavy charges to restructure and realign its businesses. According to its 7/26/14 10-K,

In August 2013, the Company announced a workforce reduction plan that would impact up to 4,000 employees, or 5% of the Company’s global workforce. In connection with this restructuring action, the Company incurred charges of $418 million during fiscal 2014 (included as part of the charges discussed below). The Company has completed the Fiscal 2014 restructuring and does not expect any remaining charges related to this action. The Fiscal 2011 Plans consist primarily of the realignment and restructuring of the Company’s business announced in July 2011 and of certain consumer product lines as announced during April 2011. The Company completed the Fiscal 2011 Plans at the end of fiscal 2013. The Company incurred cumulative charges of approximately $1.1 billion in connection with these plans. As part of the Fiscal 2011 Plans, other charges incurred during fiscal 2012 were primarily for the consolidation of excess facilities, as well as an incremental charge related to the sale of the Company’s Juarez, Mexico manufacturing operations, which sale was completed in the first quarter of fiscal 2012.

The following table summarizes the activities related to the restructuring and other charges pursuant to the Company’s Fiscal 2014 Plan and the Fiscal 2011 Plans related to the realignment and restructuring of the Company’s business (in millions):

Restructuring Breakouts – Fiscal 2011 and 2014 Plans

(in $mil)

FY11 Plans

Voluntary

Retirement

Employee

Severance

Other

Liability, 7/11 17 234 11

FY12 charges - 299 54

Estimate change related to

FY11 charges

-

(49)

-

Cash payments (17) (401) (18)

Non-cash items - - (20)

Liability, 7/12 - 83 27

FY13 gross charges - 111 (6)

Cash payments - (173) (11)


Liability, 7/13 - 21 7

FY14 gross charges - - -

Cash payments - (19) (3)

Non-cash items - (2) (1)

Liability, 7/14 - - 3

FY14 Plan

Employee

Severance

Other Total

Liability, 7/11 - - 262

FY12 charges - - 353

Estimate change related to

FY11 charges

-

-

(49)

Cash payments - - (436)


Liability, 7/12 - - 110

FY13 gross charges - - 105

Cash payments - - (184)


Liability, 7/13 - - 28

FY14 gross charges 366 52 418

Cash payments (326) (4) (352)

Non-cash items - (22) (25)

Liability, 7/14 40 26 69

Thus, as one can see, CSCO has taken some large restructurings in recent fiscal years and cash payments have not been small. Meanwhile, CSCO plans more heavy restructuring as the most recent 10-K disclosed its Fiscal 2015 Plan,

In August 2014 the Company announced a restructuring plan that will impact up to 6,000 employees, representing approximately 8% of its global workforce. The Company expects to take action under this plan beginning in the first quarter of fiscal 2015. The Company currently estimates that it will recognize pre-tax charges in an amount not expected to exceed $700 million, consisting of severance and other one-time termination benefits and other associated costs. These charges are primarily cash-based. The Company expects that approximately $250 million to $350 million of these charges will be recognized during the first quarter of fiscal 2015, with the remaining amount to be recognized during the rest of fiscal 2015.

In connection with the Fiscal 2015 Plan, CSCO incurred cumulative charges of $318 million for its fiscal first quarter ended 10/25/14, with cash payments in the form of employee severance taking up nearly half of this charge: Restructuring Breakout – Fiscal 2014 and Prior Plans (in $mil)

Fiscal 2014 & Prior

Plans

Fiscal 2015 Plan

Employee

Severance

Other

Employee

Severance

Other Total

Liability, 7/14 40 29 - - 69

FY15 gross

charges

-

-

322

(4)

318

Cash

payments

(13)

-

(142)

-

(155)

Non-cash

items

-

(4)

-

4

-

Liability,

10/14

27

25

180

-

232

Meanwhile, with CSCO estimating it will recognize pre-tax charges of up to $700 million for the Fiscal 2015 Plan, we can expect further large restructuring charges to take place over the remaining quarters of FY15. So how has CSCO


7

responded operationally from its recent heavy restructurings? Frankly, not well:

Recent Operating Performance

LTM-10/25 FY14 FY13 FY12 FY11

Sales growth (3.1%) (3.0%) 5.5% 6.6% 7.9%

Gross margin 58.5% 58.9% 60.6% 61.2% 61.4%

EBITDA margin 24.7% 25.0% 27.9% 27.5% 23.5%

Next, let’s take a look at CSCO’s adjusted free cash flow (after covering share repurchases and dividends) over the last five twelve-month periods ended October:

Adjusted Free Cash Flow (in $mil)

Twelve Months

Ended:

10/14

10/13

10/12

10/11

10/10

OCF before W/C

impact

10,966

13,422

10,902

8,806

10,161

Working capital

impact

1,208

(344)

721

1,939

191

Reported OCF 12,174 13,078 11,623 10,745 10,352

CapEx 1,245 1,210 1,126 1,113 1,174

FCF 10,929 11,868 10,497 9,632 9,178

Dividend 3,817 3,480 1,923 980 -

% FCF paid in

dividends

34.9%

29.3%

18.3%

10.2%

0.0%

Share repurchases 8,603 4,488 3,062 6,076 8,696

Surplus/(Shortfall) (1,491) 3,900 5,512 2,576 482

Acquisitions 726 4,301 5,249 235 5,348

# of shares

outstanding

5109

5351

5311

5371

5577

% Growth -4.5% 0.8% -1.1% -3.7% #DIV/0!

As one can see, CSCO reported an adjusted free cash flow deficit of nearly $1.5 billion for the last twelve months ended 10/25/14. This is its first deficit in many years and what is even more concerning is the fact that working capital improvements helped boost operating cash flow by approximately $1.2 billion over this same twelve-month period. Additionally, this large deficit occurred despite the fact that capital expenditures only increased by roughly $35 million, or 3%, year-over-year for the twelve months ended 10/25/14. Although CSCO continues to invest in the Cloud, capital expenditures have stayed in a very tight range over the last five years and the company did not project CapEx for FY15. Another cash commitment that has been eating into CSCO’s cash flow lately is dividends. Although CSCO only initiated its first dividend program roughly four years ago, the company has continued to steadily increase its dividend, which took up approximately $3.8 billion in cash over the last twelve months ended 10/25/14. Still, dividend coverage is solid, as the dividend only took up about 35% of free cash flow over the last twelve months. However, we are particularly focused on CSCO’s share repurchase program, which has been a heavy user of cash over the last five twelve-month periods. For the twelve months ended 10/25/14, share repurchases nearly doubled year-over-year to more than $8.6 billion. This is the highest level of repurchases at CSCO in essentially four years. Not

surprisingly due to these upped repurchases, CSCO’s share count has been coming down in recent years. In fact, the table above shows that CSCO’s shares outstanding as of 10/25/14 fell by nearly 5% year-over-year. Meanwhile, considering that CSCO’s adjusted net income over this twelve-month period fell by approximately 6% to $9.4 billion from $10.0 billion for the same year-ago period, the company was able to essentially keep its adjusted EPS fairly flat year-over-year and beat Bloomberg’s recent consensus EPS expectations, as the following table shows:

Bloomberg’s Adjusted EPS Expectations

Quarter 10/14 7/14 4/14 1/14 10/13

Reported EPS $0.44 $0.44 $0.42 $0.36 $0.42

Bloomberg comp adj

EPS

$0.54

$0.55

$0.51

$0.47

$0.53

Bloomberg estimated

EPS

$0.525

$0.528

$0.477

$0.458

$0.505

Bloomberg surprise % +2.9% +4.2% +6.9% +2.6% +5.0%

Diluted wtd avg shares 5,156 5,172 5,180 5,327 5,430

With CSCO reporting an adjusted free cash flow deficit of approximately $1.5 billion over the last twelve months ended 10/25/14, it is not surprising that CSCO’s balance sheet has taken a hit over the last year, as the following table shows:

Capital Structure (in $mil)

10/14 10/13 10/12 10/11 10/10

Cash 4,387 5,254 4,773 4,747 3,796

Long Term Debt 19,615 12,947 16,272 16,264 12,214

Short Term Debt 1,357 3,279 55 589 3,064

Debt/EBITDA 1.80 1.22 1.25 1.67 1.32

Net Debt/EBITDA 1.42 0.82 0.88 1.20 0.99

As one can see, CSCO’s total debt jumped by 22% year-over-year to nearly $21 billion over the last twelve months ended 10/25/14, while cash levels declined by about 17% year-over-year to $4.4 billion over the same 12-month period. While CSCO’s current net debt-to-EBITDA ratio of 1.42 is hardly concerning, it is still at the highest level in many years. Still, to keep its share count from rising, CSCO must continue to do some level of share repurchases as the company continues to pay its officers heavily in stock. The following table shows the dilutive impact from stock options and restricted stock units over the last three fiscal years:

Share Dilution (in mil)

7/14 7/13 7/12

Weighted-average shares – basic 5,234 5,329 5,370

Effect of dilutive potential common

shares

47

51

34

Weighted-average shares – diluted 5,281 5,380 5,404

Antidilutive employee share-based

awards, excluded

254

407

591

Total shared-based compensation

expense

$1,348

$1,120

$1,401

Meanwhile, as of 7/26/14, the total compensation cost


8

related to unvested share-based awards not yet recognized was $2.4 billion, which is expected to be recognized over approximately 2.3 years on a weighted-average basis. In summary, CSCO is a tech company that has recently been taking on larger cash restructurings, shrinking in size and taking on debt, while spending its cash heavily on severance packages, as well as share repurchases to help accommodate rising executive pay. This is obviously not a healthy development for CSCO shareholders. GENERAL MILLS General Mills (GIS) is a global food company and supplies branded and unbranded food products to foodservice and commercial baking industries. The company has taken on a number of restructuring projects in recent fiscal years to deliver cash savings and/or reduced depreciation. These activities result in asset write-offs, exit charges including severance, contract termination fees, and decommissioning and other costs. Each restructuring action normally takes one to two years to complete. According to its 5/25/14 10-K,

In fiscal 2012, we recorded a $100.6 million restructuring charge related to a productivity and cost savings plan approved in the fourth quarter of fiscal 2012. The plan was designed to improve organizational effectiveness and focus on key growth strategies, and included organizational changes to strengthen business alignment and actions to accelerate administrative efficiencies across all of our operating segments and support functions. In connection with this initiative, we eliminated approximately 850 positions globally. The restructuring charge consisted of $87.6 million of employee severance expense and a non-cash charge of $13.0 million related to the write-off of certain long-lived assets in our U.S. Retail segment. All of our operating segments and support functions were affected by these actions including $69.9 million related to our U.S. Retail segment, $12.2 million related to our Convenience Stores and Foodservice segment, $9.5 million related to our International segment, and $9.0 million related to our administrative functions.

The following table summarizes the activities related to the restructuring and other charges pursuant to the company’s Fiscal 2012 plan related to the realignment and restructuring of the company’s business (in millions):

Restructuring Breakout (in $mil)

Severance Contract

Termination

Other Exit

Costs

Total

Reserve, 5/11 1.7 5.5 - 7.2

2012 charges 82.4 - - 82.4

Utilized in 2012 (1.0) (2.8) 0.1 (3.7)

Reserve, 5/12 83.1 2.7 0.1 85.9

2013 charges 10.6 - - 10.6

Utilized in 2013 (74.2) (2.7) (0.1) (77.0)

Reserve, 5/13 19.5 - - 19.5

2014 charges 6.4 - - 6.4

Utilized in 2014 (22.4) - - (22.4)

Reserve, 5/14 3.5 - - 3.5

For FY14, FY13 and FY12, GIS paid $22.4 million, $79.9 million and $3.8 million, respectively, in cash related to restructuring actions taken in fiscal 2012 and previous years. Meanwhile, through the first six months ended 11/23/14, GIS initiated several new restructuring projects as the most recent 10-Q detailed,

During the second quarter of fiscal 2015, we approved Project Catalyst, a restructuring plan to increase organizational effectiveness and reduce overhead expense. In connection with this project, we expect to eliminate approximately 700 to 800 positions primarily in the United States. We expect to incur approximately $160 million of net expenses relating to these actions of which approximately $123 million will be cash. We expect these actions to be largely completed by the end of fiscal 2015. Project Century is a review of our North American manufacturing and distribution network to streamline operations and identify potential capacity reductions which we expect to complete by the end of fiscal 2017. During the second quarter of fiscal 2015, we approved a restructuring plan to consolidate yogurt manufacturing capacity and exit our Methuen, MA facility in our U.S. Retail and Convenience Stores and Foodservice supply chains as part of Project Century. This action will affect approximately 250 positions. We expect to incur approximately $65 million of net expenses relating to this action of which approximately $17 million will be cash. We expect this action to be completed by the end of fiscal 2016. Also as part of Project Century, during the second quarter of fiscal 2015, we approved a restructuring plan to eliminate excess cereal and dry mix capacity and exit our Lodi, CA facility in our U.S. Retail supply chain. This action will affect approximately 430 positions. We expect to incur approximately $123 million of net expenses relating to this action of which approximately $24 million will be cash. We expect this action to be completed by the end of fiscal 2016. During the first quarter of fiscal 2015, we approved a plan to combine certain Yoplait and General Mills operational facilities within our International segment to increase efficiencies and reduce costs. This action will affect approximately 240 positions. We expect to incur approximately $15 million of net expenses relating to this action of which approximately $14 million will be cash. We expect this action to be completed in fiscal 2016.

The roll forward of GIS’ restructuring and other exit cost reserves, included in other current liabilities, is as follows:

Restructuring Breakout (in $mil)

Severance Contract

Termination

Other Exit

Costs

Total

Reserve, 5/14 3.5 - - 3.5

2015 charges 168.2 0.7 0.1 169.0

Utilized in 2015 (4.0) - - (4.0)

Reserve, 11/14 167.7 0.7 0.1 168.5


9

During the six-month period ended 11/23/14, GIS paid $10.5 million in cash related to restructuring actions. GIS could spend another $112.5 million in cash over the second half of FY15 to complete its Project Catalyst restructuring plan, as well as millions of dollars more in cash to help cover its Project Century plan. Let’s take a look at how GIS has performed operationally in recent years since taking these large restructurings:


LTM-11/25 FY14 FY13 FY12* FY11

Sales growth (2.5%) 0.8% 6.7% 11.9% 1.7%

Gross margin 34.3% 35.6% 36.1% 36.3% 40.0%

EBITDA margin 17.3% 19.8% 19.4% 18.6% 21.8%

* GIS acquired Yoplait International in July 2011.

As one can see, GIS’ recent operating results are hardly encouraging. Next, let’s take a look at GIS’ adjusted free cash flow (after covering share repurchases and dividends) over the last five twelve-month periods ended November:


Twelve Months

Ended:

11/14

11/13

11/12

11/11

11/10

OCF before W/C

impact

2,503

2,549

2,234

2,095

2,118

Working capital

impact

(108)

69

334

601

(324)

Reported OCF 2,395 2,618 2,568 2,696 1,794

CapEx 710 621 675 632 677

FCF 1,685 1,997 1,893 2,064 1,117

Dividend 997 923 835 763 697

% FCF paid in

dividends

59.2%

46.2%

44.1%

37.0%

62.4%

Share repurchases 1,850 1,430 581 411 1,420

Surplus/(Shortfall) (1,162) (355) 476 891 (1,000)

Acquisitions 822 46 1,002 1,023 0

# of shares

outstanding

597

626

646

645

641

% Growth -4.7% -3.0% 0.2% 0.7% #DIV/0!

Looking at the cash flow numbers, GIS posted an adjusted free cash flow deficit of nearly $1.2 billion for the last twelve months ended 11/23/14. This is the company’s second consecutive deficit over the last two 12-month periods ended November and third over the last five periods. Granted, this most recent large deficit was exacerbated by a $108 million working capital drain. Additionally, capital expenditures jumped by 14% year-over-year to $710 million over the last twelve months ended 11/25/14 largely due to incremental spending related to North America supply chain actions. Management projects capital spending will reach $750 million for FY15. Additionally, dividends are cutting into GIS’ cash flow more, as the company has continued to steadily increase its dividend over at least the last four years which absorbed approximately $1.0 billion in cash over the last twelve months ended 11/23/14.

Still, these incremental cash drains from working capital, capital expenditures and dividends over the last twelve months ended 11/23/14 only combined for about $271 million, while GIS reported an adjusted free cash flow deficit of nearly $1.2 billion. Clearly, the biggest problem is that GIS’ share repurchase program has recently become a huge user of cash. For the twelve months ended 11/23/14, share repurchases increased year-over-year by 29% to $1.85 billion, which is the highest level of repurchases at GIS for a 12-month period ever. As a result of these heavy repurchases, GIS’ share count has been falling noticeably in recent years. The table above shows that GIS’ shares outstanding as of 11/23/14 fell by nearly 5% year-over-year. Meanwhile, considering that GIS’ adjusted net income over this twelve-month period fell by approximately 4% to $1.70 billion from $1.78 billion for the same year-ago period, the company was able to keep its adjusted EPS somewhat level year-over-year and beat Bloomberg’s consensus EPS expectations for 2Q15 ended 11/23/14, as the following table shows:


Quarter 11/14 8/14 5/14 2/14 11/13

Reported EPS $0.847 $0.605 $0.588 $0.618 $0.82

Bloomberg comp adj

EPS

$0.80

$0.61

$0.67

$0.62

$0.83

Bloomberg estimated

EPS

$0.762

$0.686

$0.719

$0.615

$0.874

Bloomberg surprise % +5.0% -11.1% -6.8% +0.8% -5.0%

Diluted wtd avg shares 618.4 645.7 665.6 666.7 664.8

Thus, with GIS posting an adjusted free cash flow deficit of approximately $1.2 billion over the last twelve months ended 11/23/14, it is not surprising that the company’s balance sheet has taken a hit over the last year, as the following table shows:


11/14 11/13 11/12 11/11 11/10

Cash 895 774 735 509 566

Long Term Debt 7,713 6,741 5,572 5,248 5,864

Short Term Debt 2,822 1,904 2,761 2,581 1,182

Debt/EBITDA 3.46 2.51 2.47 2.56 2.29

Net Debt/EBITDA 3.16 2.28 2.25 2.40 2.11

As one can see, GIS’ total debt jumped by 22% year-over-year to approximately $10.5 billion over the last twelve months ended 11/23/14, while cash levels increased slightly. As a result, GIS’ current net debt-to-EBITDA ratio is now at 3.16 as of 11/23/14, compared to just 2.28 a year ago. This is the highest level in many years for GIS and its debt level is becoming a bigger concern. Meanwhile, to keep its share count from rising, GIS must continue to do some level of share repurchases as the company continues to pay its officers heavily in stock. The following table shows the dilutive impact from stock options and restricted stock units over the last three fiscal years:


10


5/14 5/13 5/12

Weighted-average shares – basic 628.6 648.6 648.1

Incremental share effect from:

Stock options 12.3 12.0 13.9

Restricted stock, restricted stock units,

and other

4.8

5.0

4.7

Weighted-average shares – diluted 645.7 665.6 666.7

Anti-dilutive stock options and restricted

stock units, excluded

1.7

0.6

5.8


expense

$107.0

$128.9

$124.3

Thus, average diluted shares outstanding decreased by 20 million in FY14 from FY13 due primarily to the repurchase of 36 million shares, partially offset by the issuance of 7 million shares related to stock compensation plans. Meanwhile, as of 5/25/14, unrecognized compensation expense related to non-vested stock options and restricted stock units was $117.2 million. This expense will be recognized over 17 months, on average. To summarize, GIS is a packaged food company with a history of restructurings that has recently taken on several large restructuring projects. Not only does it appear that GIS will be laying off more employees and spending cash on more severance packages, but it will likely continue to take on even more debt as it repurchases shares to boost EPS growth as well as to help accommodate generous executive pay. This is certainly not a development that GIS shareholders should continue to endorse. COCA-COLA The Coca-Cola Company (KO) manufactures, markets, and distributes soft drink concentrates and syrups. The company also distributes and markets juice and juice-drink products. KO distributes its products to retailers and wholesalers in the United States and internationally. Throughout the years, KO has been involved in a number of productivity, integration and restructuring initiatives. According to its 2013 10-K,

In February 2012, the Company announced a four-year productivity and reinvestment program which will further enable our efforts to strengthen our brands and reinvest our resources to drive long-term profitable growth. This program will be focused on the following initiatives: global supply chain optimization; global marketing and innovation effectiveness; operating expense leverage and operational excellence; data and information technology systems standardization; and further integration of CCE's former North America business. The Company incurred total pretax expenses of $764 million related to this program since the plan commenced. These expenses were recorded in the line item other operating charges in our consolidated statement of income. Refer to Note 19 for the impact these charges had on our operating segments. Outside services reported in the table below primarily relate to expenses in connection with legal,

outplacement and consulting activities. Other direct costs reported in the table below include, among other items, internal and external costs associated with the development, communication, administration and implementation of these initiatives; accelerated depreciation on certain fixed assets; contract termination fees; and relocation costs.

The following table summarizes the balance of accrued expenses related to these productivity and reinvestment initiatives and the changes in the accrued amounts since the commencement of the plan:

Productivity and Reinvestment Breakout (in $mil)

Severance

Pay and

Benefits

Outside

Services

Other

Direct

Costs

Total

2012

Costs incurred 21 61 188 270

Payments (8) (55) (167) (230)

Noncash and

exchange

(1)

-

(13)

(14)

Balance, 12/12 12 6 8 26

2013


Payments (113) (59) (209) (381)

Noncash and

exchange

1

-

(28)

(27)

Balance, 12/13 88 6 18 112

Additionally, in 2008, KO began an integration initiative related to the 18 German bottling and distribution operations acquired in 2007. KO incurred charges of $15 million and $52 million related to these other restructuring initiatives during 2012 and 2011, respectively. These other restructuring initiatives were outside the scope of the productivity and reinvestment, productivity and integration initiatives discussed above and were related to individually insignificant activities throughout many of KO’s business units. These charges were recorded in the line item other operating charges. Meanwhile, KO expanded its productivity and reinvestment program in 2014, as the 3Q14 10-Q noted,

In February 2014, the Company announced that we are expanding our productivity and reinvestment program to drive an incremental $1 billion in productivity by 2016 that will primarily be redirected into increased media investments. Our incremental productivity goal consists of two relatively equal components. First, we will expand savings through global supply chain optimization, data and information technology systems standardization, and resource and cost reallocation. These savings will be reinvested in global brand-building initiatives, with an emphasis on increased media spending. Second, we will increase the effectiveness of our marketing investments by transforming our marketing and commercial model to redeploy resources into more consumer-facing marketing investments to accelerate growth.

As of September 26, 2014, the Company has incurred total pretax expenses of $1,023 million related to our


11

productivity and reinvestment program since the plan commenced.

The following table summarizes the balance of accrued expenses related to these productivity and reinvestment initiatives and the changes in the accrued amounts as of and for the nine months ended 9/26/14: Severance

Pay and

Benefits

Outside

Services

Other

Direct

Costs

Total

Balance, 12/13 88 6 18 112


Payments (77) (55) (162) (294)

Noncash and

exchange

(1)

-

(23)

(24)

Balance, 9/14 36 3 14 53

Meanwhile, KO incurred expenses of $34 million and $142 million related to the bottling and distribution initiative during the three and nine months ended 9/26/14, respectively, and has incurred total pretax expenses of $769 million related to this initiative since it commenced. These charges were recorded in the line item other operating charges in our condensed consolidated statements of income and impacted the Bottling Investments operating segment. The expenses recorded in connection with these integration activities have been primarily due to involuntary terminations. KO had $124 million and $127 million accrued related to these integration costs as of 9/26/14 and 12/31/13, respectively. To summarize, just focusing on the 2012 and 2014 productivity and reinvestment initiatives, KO has made cash payments of $294 million, $381 million and $230 million, respectively, for the nine months ended 9/26/14, 2013, and 2012, respectively. Thus, these sizeable cash payments appear to be trending even higher over the last few years and are putting additional strain on KO’s operating cash flow. So just how well has KO performed operationally in recent years since taking these large restructurings:


LTM-9/14 2013 2012 2011* 2010

Sales growth (2.3%) (2.4%) 3.2% 32.5% 13.3%

Gross margin 61.3% 60.7% 60.3% 60.9% 63.9%

EBITDA margin 26.8% 26.0% 26.6% 26.1% 28.2%

* KO acquired the North American bottling operations of Coca-Cola

Enterprises in October 2010.

While one can see some slight margin improvement in recent quarters, KO’s recent operating results are hardly inspiring. Next, let’s take a look at KO’s adjusted free cash flow (after covering share repurchases and dividends) over the last five twelve-month periods ended September:


Twelve Months

Ended:

9/14

9/13

9/12

9/11

9/10

CFO before W/C

impact

11,590

11,407

11,570

10,706

9,406

Working capital

impact

(781)

(890)

(1,059)

(1,598)

(266)

Cash from ops 10,809 10,517 10,511 9,108 9,140

CapEx 2,543 2,434 2,976 2,795 1,929

Free cash flow 8,266 8,083 7,535 6,313 7,211

Dividend 5,155 4,785 4,445 3,193 3,984

% FCF paid in

dividends

62.4%

59.2%

59.0%

50.6%

55.2%


Surplus/(Shortfall) (792) (1,534) (1,434) (3,446) 1,712

Acquisitions 370 695 1,833 1,023 1,812

# of shares

outstanding

4375 4416 4486 4542 4630

% Growth -0.9% -1.6% -1.2% -1.9% #DIV/0!

Looking at cash flow, KO posted an adjusted free cash flow deficit of nearly $800 million for the last twelve months ended 9/26/14. Ominously, this marks the company’s fourth consecutive deficit over the last four 12-month periods ended September. Granted, adjusted free cash flow would have come in about break-even over the last twelve months if not for a $781 million drain from working capital adjustments. Additionally, capital expenditures increased by 4% year-over-year to more than $2.5 billion over the last twelve months ended 9/26/14 due to investments in new cooler placements, route-to-market enhancements, brand and packaging innovation. Still, management projects capital spending will finish around $2.5 billion for all of 2014, which will be the third consecutive year in which CapEx will have declined from $2.92 billion in 2011. Meanwhile, dividends continue to absorb more of KO’s cash flow, as the company has been steadily increasing its dividend in recent years and took up approximately $5.2 billion in cash over the last twelve months ended 9/26/14. Dividends have taken up more of free cash flow over the last two years, accounting for roughly 62% of free cash flow over the last twelve months ended 9/26/14. Still, we are most concerned about KO’s massive share repurchase program, which has continued to drive adjusted free cash flow deficits over the last four 12-month periods ended September. For the twelve months ended 9/26/14, share repurchases declined year-over-year by 19%, but still came in at a large $3.9 billion. Meanwhile, despite heavy repurchases over the last four years, KO’s share count has not fallen much. The table above shows that KO’s shares outstanding as of 9/26/14 fell by just 1% year-over-year. However, considering that KO’s adjusted net income over this same twelve-month period fell by 2% to approximately $9.2 billion from $9.4 billion for the year-ago period, the company was able to keep its adjusted EPS essentially flat year-over-year and beat Bloomberg’s consensus EPS expectations for 3Q14, as the following table shows:


12


Quarter 9/14 6/14 3/14 12/13 9/13

Reported EPS $0.525 $0.618 $0.408 $0.421 $0.50

Bloomberg comp adj EPS $0.53 $0.64 $0.44 $0.46 $0.53

Bloomberg estimated EPS $0.527 $0.633 $0.441 $0.463 $0.533

Bloomberg surprise % +0.6% +1.1% -0.2% -0.7% +0.2%


Thus, with KO posting steady adjusted free cash flow deficits over the last four twelve-month periods ended September, it is not surprising that the company’s balance sheet has steadily deteriorated over this same period, as the following table shows:


9/14 9/13 9/12 9/11 9/10

Cash 11,084 11,118 9,615 12,682 10,509

Long Term Debt 20,111 14,173 16,181 13,708 4,456

Short Term Debt 21,699 22,034 16,549 15,480 8,937

Debt/EBITDA 3.38 2.95 2.61 2.58 1.30

Net Debt/EBITDA 2.48 2.05 1.84 1.46 0.28

Looking at these numbers, it is pretty shocking to see that KO’s total debt has more than tripled in just four years, while cash levels have remained essentially flat. As a result, KO’s current net debt-to-EBITDA ratio is now at 2.48 as of 9/26/14, compared to just 0.28 four years ago. This ratio is easily at record levels for KO and the company’s once-pristine balance sheet is simply no longer. Meanwhile, to keep its share count from rising, KO must continue to do some level of share repurchases as the company continues to pay its officers heavily in stock. The following table shows the dilutive impact from stock options and restricted stock units over the last three years:


12/13 12/12 12/11

Average shares outstanding 4,434 4,504 4,568

Effect of dilutive securities 75 80 78

Average shares outstanding assuming

dilution

4,509

4,584

4,646

Anti-dilutive stock option awards,

excluded

28

34

32


expense

$227

$259

$354

Thus, KO’s number of shares outstanding decreased by roughly 67 million in 2013 from 2012 due primarily to the repurchase of 121 million shares, partially offset by the issuance of 54 million shares related to stock compensation plans. Meanwhile, as of 12/31/13, KO had $416 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under its plans. This cost is expected to be recognized over a weighted-average period of 1.8 years as stock-based compensation expense. Last March, David Winters, CEO of Wintergreen Advisors, heavily criticized KO’s pay plan for its executives that would transfer roughly $13 billion to management over the next

four years. Winters urged Warren Buffett, whose Berkshire-Hathaway (BRK/A) is KO’s largest shareholder with about a 9% interest, to vote against the plan. However, while Buffett called the plan “excessive” in a 4/23/14 interview with CNBC, Buffet noted that Berkshire abstained from voting against it because he didn’t want to express disapproval of the company’s management. Buffett gave the pathetic excuse that he had never heard anyone speak out against a compensation committee’s plan in 55 years of serving on boards, saying,

“Taking them on is a little like belching at the dinner table. You can’t do it too often.”

Mr. Buffett, please enjoy being the largest shareholder of a company that is not growing, is continually restructuring, is becoming less profitable, is reducing capital investment, and is taking on more and more debt so as to keep its executives grossly over-compensated. PHILIP MORRIS INTERNATIONAL Spun off from Altria Group (MO) in March 2008, Philip Morris International (PM), through its subsidiaries, affiliates and their licensees, produces, sells, distributes, and markets a wide range of branded cigarettes and tobacco products in markets outside of the United States of America. The Company's portfolio comprises both international and local brands. Over the years, PM has recorded a number of separation program and contract termination charges. According to PM’s 2013 10-K,

Separation Programs: PMI recorded pre-tax separation program charges of $51 million, $42 million and $63 million for the years ended December 31, 2013, 2012 and 2011, respectively. The 2013 pre-tax separation program charges primarily related to the restructuring of global and regional functions based in Switzerland and Australia. The 2012 pretax separation program charges primarily related to severance costs associated with factory restructurings. The 2011 pre-tax separation program charges primarily related to severance costs for factory and R&D restructurings.

Contract Termination Charges: During 2013, PMI recorded exit costs of $258 million related to the termination of distribution agreements in Eastern Europe, Middle East & Africa (due to a new business model in Egypt) and Asia. During 2012, PMI recorded exit costs of $13 million related to the termination of distribution agreements in Asia. During 2011, PMI recorded exit costs of $12 million related to the termination of a distribution agreement in Eastern Europe, Middle East & Africa.


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The movement in exit cost liabilities for PM was as follows:

Exit Cost Breakout (in $mil)

Balance, 12/11 28

Charges 55

Cash spent (57)

Currency/other (6)

Balance, 12/12 20

Charges 309

Cash spent (21)

Currency/other -

Balance, 12/13 308

Charges 370

Cash spent (263)

Currency/other (48)

Balance, 9/14 367

As one can see, cash payments from these restructurings have increased noticeably just over the last nine months ended 9/30/14. These higher payments have certainly put additional pressure PM’s operating cash flow lately. Meanwhile, let’s see how PM has performed operationally in recent years since taking these large restructurings:


LTM-9/14 2013 2012 2011 2010

Sales growth (3.1%) (0.5%) 0.9% 14.3% 8.7%

Gross margin 65.7% 66.7% 66.9% 65.7% 64.3%

EBITDA margin 43.6% 46.1% 47.0% 46.1% 44.6%

As one can see, PM’s margins have remained fairly flat over the last few years, while sales growth has been negative for about the last two years. Next, let’s take a look at PM’s adjusted free cash flow (after covering share repurchases and dividends) over the last five twelve-month periods ended September:


Twelve Months

Ended:

9/14

9/13

9/12

9/11

9/10

CFO before W/C

impact

9,427

10,157

9,756

9,726

7,951

Working capital

impact

(722)

(692)

(1,024)

1,423

1,370

Cash from ops 8,705 9,465 8,732 11,149 9,321

CapEx 1,183 1,158 1,048 798 715

Free cash flow 7,522 8,307 7,684 10,351 8,606

Dividend 5,989 5,633 5,320 4,610 4,369

% FCF paid in

dividends

79.6%

67.8%

69.2%

44.5%

50.8%


Surplus/(Shortfall) (2,964) (3,809) (3,198) 207 (993)

Acquisitions 0 0 0 121 36

# of shares

outstanding

1556

1606

1676

1740

1818

% Growth -3.1% -4.2% -3.7% -4.3% #DIV/0!

Excluding working capital adjustments, PM’s operating cash flow declined by 7% year-over-year for the twelve

months ended 9/30/14. This decline in cash flow was blamed largely on a currency hit. Meanwhile, PM posted an adjusted free cash flow deficit of nearly $3 billion for the last twelve months ended 9/30/14. Ominously, this marks the company’s fourth deficit over the last five 12-month periods ended September. Even excluding the roughly $722 million drain from working capital adjustments, adjusted free cash flow would have come in down over $2.2 billion for the last twelve months. Additionally, capital expenditures increased by 2% year-over-year to about $1.2 billion over the last twelve months ended 9/30/14. Meanwhile, management projects capital spending will continue to pick up in 2H14 due to the commercialization of Reduced-Risk Product, roll out of Marlboro Red 2.0 and some underlying cost related to the optimizations of its manufacturing footprint. Meanwhile, dividends continue to absorb more of PM’s cash flow, as the company has been steadily increasing its dividend in recent years and took up approximately $6.0 billion in cash over the last twelve months ended 9/30/14. Dividends have taken up noticeably more of free cash flow in recent years, accounting for roughly 80% of free cash flow over the last twelve months ended 9/30/14. Once again for this exercise, we are most concerned about PM’s massive share repurchase program, which has continued to drive huge adjusted free cash flow deficits over the last three 12-month periods ended September. For the twelve months ended 9/30/14, share repurchases declined year-over-year by 31%, but still came in at a large $4.5 billion. Share buyback activity is expected to slow slightly in 4Q14, as PM targets total repurchases at $4 billion for 2014. For 2015, repurchases are projected to come down even further to the $2 billion to $3 billion range. Meanwhile, despite heavy repurchases over the last four years, PM’s share count has only declined moderately. The table above shows that PM’s shares outstanding as of 9/30/14 fell by just 3.1% year-over-year. However, considering that PM’s adjusted net income over this same twelve-month period fell by 3% to approximately $8.5 billion from $8.7 billion for the year-ago period, the company was able to keep its adjusted EPS nearly flat year-over-year and handily beat Bloomberg’s consensus EPS expectations for 3Q14, as well as for the prior four quarters, as the following table shows:


Quarter 9/14 6/14 3/14 12/13 9/13

Reported EPS $1.378 $1.413 $1.191 $1.347 $1.441

Bloomberg comp adj EPS $1.39 $1.41 $1.19 $1.37 $1.44

Bloomberg estimated EPS $1.334 $1.243 $1.163 $1.367 $1.433

Bloomberg surprise % 4.2% 13.4% 2.3% 0.2% 0.5%


With PM posting steady adjusted free cash flow deficits over the last three twelve-month periods ended September, it is not surprising that the company’s balance sheet has taken a sizeable hit over this same period, as the following table shows:


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9/14 9/13 9/12 9/11 9/10

Cash 2,043 3,382 4,817 3,391 3,507

Long Term Debt 25,395 21,877 17,520 12,870 13,595

Short Term Debt 3,448 4,923 4,916 4,889 3,852

Debt/EBITDA 2.18 1.86 1.55 1.26 1.48

Net Debt/EBITDA 2.02 1.62 1.22 1.02 1.18

Shareholders’ Equity (8,677) (5,908) 116 3,654 6,122

Looking at these numbers, PM’s total debt has nearly doubled in just four years, while cash levels have dropped to historically-low levels. As a result, PM’s current net debt-to-EBITDA ratio is now at 2.02 as of 9/30/14, compared to just 1.18 four years ago. This ratio is easily at record levels for PM since the spin-off. Meanwhile, with its heavy restructurings, it is hard not to notice that PM’s total liabilities outweigh total assets now, as the company has reported negative shareholders’ equity for roughly two years now. In just four years, PM’s equity balance has gone from approximately $6.1 billion at 9/30/10 to a negative $8.7 billion at 9/3014. Thus, PM’s once healthy balance sheet is now under noticeable strain. Meanwhile, although PM continues to grant restricted stock and deferred stock awards, the company’s share count from assumed conversions has not been materially impacted. Without this dilutive impact that we have seen from prior company examples, there is less pressure on PM to repurchase shares. To summarize, PM is a leading tobacco company that was only spun off seven years ago yet already has a history of restructurings. Not only does it appear that PM will continue to restructure operations as it tries to regain earnings growth, but it could take on even more debt as it repurchases shares to bolster EPS.


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Jeffery B. Middleswart (214) 378-4186

Bill E. Whiteside, CFA (682) 224-5715

William N. Becker (636) 821-1319

Jeffrey N. Dalton (214) 378-4176

Rob Peebles, CFA (214) 378-4183

JR Riddlehoover, CPA (817) 447-7067

Documents

Share repurchases