By: Edward Walsh and Frank Walsh
"I have always thought the actions of men the best interpreters of their thoughts." ~ John Locke
While understanding corporate behavior is more of an art than a science, an organization’s actions and the motivations behind those actions offer unique insight into predicting future behavior. At Pantheon Integrated Solutions, we have pioneered a paradigm of analysis that looks to understand corporate behavior by analyzing the incentive structure underlying their actions in a novel way. In this article, we set forth Pantheon’s financial analysis framework – Corporate Objective Insight (COIN) - and explain how the COIN framework can help give context to the actions of companies in the defense industry. With this deeper understanding of how the defense industry is currently under unprecedented pressure as a result of previous monetary policy-based decisions and the COVID-19 pandemic, we outline the implications for a program manager and specify applications for a program office.
The truth underlying John Locke’s axiom about the importance of a man’s actions sentiment extends beyond political philosophy and is applicable to human action more broadly. To better understand the objectives of an individual or an organization, which really is just a group of individuals acting in a rational manner, it is important to focus on actions – more specifically, the intent-revealing actions.
What are the intent-revealing actions to analyze? As Jack Welch popularized in the 1980s, “cash is king.” To understand corporate behavior, we should look beyond the Income Statement and emphasize the Balance Sheet, keeping a close eye on cash flows. That information tells the story of cash in motion, and that story is key to understanding what a corporation’s objectives are and provides key insight into future behavior.
The Pantheon’s Financial Analysis Framework – Corporate Objective Insight (COIN)
At a fundamental level, the current business environment incentivizes free cash flow. Put simply, it is in everyone’s interest to pursue strategies that focus on cash flow. Corporations seek to maximize free cash flow because that allows them to return value to shareholders via increased dividends and share repurchases. Investors want to maximize free cash flow because companies that have emphasized share repurchases have traditionally outperformed the broader S&P 500. Executives likewise want free cash flow because their remuneration is heavily dependent on boosting free cash flow – either directly or indirectly (indirect examples include Return on Invested Capital objectives that provides incentive to reduce capital expenditures, earnings per share that encourage using cash to repurchase stock, etc.). With this alignment of incentives, it is no wonder that actors will consistently pursue the easiest way to maximize free cash flow.
Although the income statement is extremely important, over reliance on revenue and earnings can obfuscate the financial health of a company. For example, a defense company that has gone an acquisition spree, a practice that has been the norm over the past decade as capital has become cheaper, can record a goodwill impairment charge on its balance sheet. Given the size of recent acquisitions in the defense space, an impairment can significantly reduce earnings – even to the point of showing overall losses. However, since the impairment is a non-cash expense, it does not directly impact a company’s liquidity.
From our experience, greater emphasis needs to be placed on understanding how companies are working to manage free cash flow. The best tool for this is the Cash Flow Statement because that gives the story of cash in motion. Conceptually, the COIN framework approaches this issue in the following way:
First, the COIN framework identifies a company’s strategy, both by looking at public statements (e.g., earnings presentations, annual reports, investor presentations, etc.) and the company’s past decisions regarding cash deployment.
Second, channeling Locke’s axiom, the COIN framework looks at a how the company is spending its money and not just what it says it intends to do. The Cash Flow Statement is critical in this regard, analyzing each line item, both in terms of absolute and in relative terms. Is a company investing in capital expenditures to maintain operations, increase capacity, and/or improve productivity to drive future growth and subsequently higher margins? Or is the company expending cash to acquire growth? What is the company’s relative contribution to investing in its own operations and acquisitions versus returning cash to shareholders via share repurchases and increasing dividends? Based on the aforementioned step, a company may note the desire to push into high-end technology markets that require Research and Development (R&D) investment – these expenses are on the Income Statement and should also be analyzed to project future behavior. Finally, what is the source of this cash? Is it based on earnings the business generates or is it derived from raising debt?
Third, understanding the source of the cash used to execute corporate objectives matters. Depending on the source of the cash, a company could have less available cash from retained earnings or increased debt levels. Tracking debt maturity levels and the corresponding interest expense provides further insight into future claims on cash.
Fourth, connecting the dots from corporate objectives through to the use of cash and then to the impact on debt, interest expense, and cash balances, paints a picture as to the company’s liquidity status and, more broadly, the overall health of a balance sheet. Traditional liquidity ratios over time include the current ratio (current assets to current liabilities), quick ratio (current assets less inventory to current liabilities), and cash ratio. Solvency ratios include interest coverage, fixed charge coverage, and debt to capital ratio. Although all ratios are valuable, there are times when certain variables are more insightful. For example, when firms with heavy exposure to the commercial aerospace were hit, inventory was not moving and less beneficial in supporting liquidity needs.
Finally, there is a feedback loop. The health and status of the balance sheet influences corporate objectives going forward. If there is a build up of cash over time, then it is likely that investors will demand share repurchases and/or increase dividends. The COIN framework can forecast these strategies based on past behavior and a board’s approval in terms of the amount of shares that can be purchased and over what time period. Companies may be incentivized to stay within investment grade status or desire to go from speculative status to investment grade – thus, it may strive to refinance debt or plow retained earnings to retire debt to improve EBITDA-to-Debt levels.
A Brewing Storm: The Current Corporate Financial Landscape
Since the 2008 Financial Crisis (also referred to as the Great Recession), companies have been incentivized to return cash to shareholders because of the structure of compensation plans and strong market demand. Loose monetary policy encourages this strategy because it made money and debt relatively cheap. Following the Crisis, the Federal Reserve increased its own balance sheet in order to substantially reduce the costs of borrowing money. At the same time, two factors were pushing companies to return money to investors: (1) executive compensation was increasingly tied to financial metrics that corresponded to stock price, and (2) the stock markets consistently rewarded securities that returned value back to shareholders.
Thus, the stage was set for a massive expansion of corporate debt. Executives earned more when they immediately returned value to shareholders, and the easiest way to do that was to give large dividends and repurchase shares. Both of these steps increased the value of shareholders’ stock positions. To finance the dividends and stock repurchases, companies turned to the cheap debt they could obtain as a result of the Federal Reserve’s loose monetary policy.
With this incentive structure, corporate debt has soared over the past several years. As long as corporate growth continued unabated, companies were able to continue return value to investors while still servicing their debt. This approach, however, led to a fundamental balance sheet risk because of the increasing amounts of debt. The premise behind this approach was that profits and revenues would not be suddenly disturbed.
Balance Sheet Ascendency: Growing Importance of Liquidity and Solvency
COVID-19 shattered the assumptions of uninterrupted prosperity, leading to a dramatic reduction in revenue and cash. Figure 2, below, illustrates how companies began to face a “debt wall” even prior to COVID and how that “wall” threatened to crumble under the economic pressures. The bill for the debt that had financed high dividends and stock buybacks had come due, and but companies were now receiving lower revenue as a result of the pandemic. Cash management and liquidity became the immediate concern - with the possibility that illiquidity risk could turn into a risk of insolvency.
Ultimately, extraordinary efforts made by the Federal Reserve in late March, including the direct purchase of investment grade corporate bonds and the exchange traded funds that hold them, mitigated the widespread illiquidity risk. Yields came down, and the spreads between investment grade and high yield shrank as well. Industry thus avoided the immediate crisis, but the risk still remains.
The key variable for the financial health going forward, is not the nominal interest rates but the rate of change in interest rates. If inflation concerns and economic growth lead to higher corporate rates over time, an increase of even 200 basis points, some economists estimate, may result in a significant insolvency event. The nominal interest rates would not be high relative to the past, but given the amount of corporate debt, this modest increase may translate in the doubling or tripling the cost to service debt, and that would pose a significant risk to the financial health throughout the industrial base.
COIN framework can offer insight into how companies are navigating the illiquidity risk.As discussed in the next section, the COIN framework reveals that different parts of the defense industry will be able to weather the storm differently.This perspective can help program managers in their approach to working with industry.
Application to the Department of Defense
All companies in the defense industry are not created equal, and some are better equipped to handle illiquidity issues. Specifically, major defense companies have secured lines of credit and their balance sheets are large enough that it seems that they are able to access capital markets, meaning that they likely have adequate access to liquidity to maintain operations if there are future exogenous shocks. On the other hand, smaller companies throughout the industrial base will likely have a harder time to access capital compared to the major primes. Put another way, interest rates are only part of the story; access to that credit is the other half of how rates translate into corporate behavior.
Moreover, even though interest rates are currently low, future rate increases do pose a financial risk to companies. Professionals in the filed need to monitor when debt is set to mature and the interest coverage ratios. Given the current low rates, even incremental changes in rates can signify a large percentage increase in interest expenses – which would lead to reemergence of liquidity risk posing a threat of insolvency for certain vendors.
Another aspect to analyzing industry behavior depends on whether the company is a prime or sub-prime contractor. Figure 3 illustrates the appropriate approach for prime contractors with better access to credit.
Below, Figure 4 illustrates the paradigm for smaller, sub-tier vendors.The reality is that these firms are simply less capable of weathering exogenous shocks.
Cash retains its throne, and its subjects continue to serve its mandates. Consequently, cash flow serves as the best lighthouse to guide program managers and the broader DoD community in understanding corporate objectives. This insight can lead to discrete actions and help to strategically align objectives to ensure the best outcomes for industry and government alike.