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Citigroup, Inc. and American International Group, Inc. have two very disparate views on the realizability of their deferred tax assets. Important to each company’s decision is the assessed availability or lack of tax-planning strategies needed to generate future taxable income. Yet, notwithstanding the importance of such strategies to these firms and others generally, little is known about them. Further, we find that companies are often not forthcoming in their disclosures of what tax-planning strategies are available to them and how they might be used. Investors and analysts could use this information in assessing the likelihood of future taxable income and the need for a valuation allowance against reported deferred tax assets.

In this research report we look closely at tax-planning strategies and the details, or lack thereof, provided by firms in describing them. From a sample of 34 firms drawn from recent filings with the SEC, we identify and categorize tax-planning strategies currently being used. We find that investment-related tax-planning strategies, e.g., selling appreciated securities or switching tax-exempt securities to taxable ones are the most common strategy in use, comprising 47% of our sample. Planned sales of other assets comprise 16% and transactions related to sale and leaseback transactions and other income-acceleration transactions constitute 13% of the sample. Five percent of the sample each employ a permanent reinvestment of foreign subsidiary earnings or capitalizing R&D costs for tax purposes. The remaining sample firms use a host of other miscellaneous practices, including the purchase of replacement properties, the merging of subsidiaries, or the shifting of entities to lower tax-rate jurisdictions. Given the general lack of disclosures observed, the FASB may wish to consider requiring more disclosure of tax-planning strategies by reporting firms.


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Quarter 2, 2011
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

4.63% (Jun. 2012)

Recent High

7.18% (Mar. 2010)

Median free cash margin declined for the fifth straight twelve-month reporting period off of its March 2010 high of 7.18%. The metric now stands at 4.63% for the twelve months ended June 2011, down from 5.20% in the March 2011 period. Continuing recent trends, companies are increasing investments in inventory and fixed assets, the net effect of which is reduce free cash margin. Inventory days increased to 24.00 days in the June 2011 reporting period from 23.14 days in March 2011. Capital expenditures as a percent of revenue also increased, to 3.16% in the June period from 3.01% in March.

While free cash margin continued it decline, some bright spots began to appear during the June 2011 reporting period. Both median revenues and free cash flow increased. Median revenues increased 14.9% in the twelve months ending June 2011 to $633.57 million from $551.41 million in the twelve months ending March 2011. Median free cash flow grew 4.25% to $21.72 million in June from $20.71 million in March.

During the June 2011 reporting period only 3 of the 44 industries in the sample, Shipbuilding and Railroad Equipment, Defense, and Precious Metals, reported increasing free cash margin. There were 19 industries with declines in free cash margin and 22 industries with a stable free cash margin. The individual companies examined in this report are: Marine Products Corp (MPX), Coeur D Alene Mines Corp. (CDE), Deckers Outdoor Corp. (DECK), Under Armour Inc (UA) and Chesapeake Energy Corp. (CHK).


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An Effective Antidote to Hedge Accounting

Natural hedges offer a low-cost and often no-cost alternative to the costs and restatement risks associated with hedge accounting.  In this report we look at the use of natural hedges to reduce the balance sheet risk and earnings volatility associated with foreign currency exposure. Our objective is to clarify terminology and identify how natural hedges are being used in practice.

Using a sample of disclosures from 70 companies we find that many firms are using pure natural hedges, a simple by-product of a firm’s operations, to address foreign currency risk.  However, derivatives that are not designated as accounting hedges, referred to here as quasi-natural hedges, are also frequently used.  Often, especially for large multinationals, a consolidated or entity-wide approach is used in offsetting foreign currency risk.  In evaluating how hedges are being used in practice we noted that a majority of firms are using natural or quasi-natural hedges to offset foreign currency revenues and expenses, foreign currency assets and liabilities or foreign currency receivables and payables.

With the results provided in this report, financial managers and CFOs as well as outside investors will gain insight into how firms are using natural hedges to limit earnings volatility while avoiding the costs and risks associated with hedge accounting.   Also, evidence on how firms are using natural hedges to reduce the need for hedge accounting should provide helpful input to the FASB.


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Quarter 1, 2011
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

5.20% (Mar. 2012)

Recent High

7.18% (Mar. 2010)

Median free cash margin declined for the fourth straight quarter off of its March 2010 high of 7.18%. The metric now stands at 5.20% for the twelve months ended March 2011, down from 5.56% in the December 2010 reporting period. Pushing free cash margin lower were increased investments in inventory and fixed assets.  Inventory days increased to 50.76 days in the March 2011 reporting period from 49.63 days in December 2010, while capital expenditures as a percent of revenue increased to 3.01% in the March period from 2.90% in December. Continuing recent trends, companies are continuing to increase investments in their businesses, through the net effect is to crimp free cash flow.

Revenue growth was meager in the twelve months ending March 2011, growing a scant 0.56% from the twelve months ended December 2010, though profitability, as measured by operating cushion (operating profit before depreciation and amortization), improved.

During the March 2011 reporting period, only 2 of the 44 industries in the sample, utilities and defense, reported improved free cash margin from the same period in 2010. There were 17 industries with declines in free cash margin and 25 industries with a stable free cash margin. The individual companies with free cash margin trends examined in this report are Scana Corp (SCG), Wisconsin Energy Corp (WEC), Borg Warner Inc (BWA), International Paper Co (IP) and Johnson Controls Inc (JCI).


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Updated through Q4 2010

Following the market swoon of 2008 and 2009, equity prices have enjoyed a significant rebound. Investors are understandably interested in where stocks are headed next. An interesting long-term perspective on the subject can be gained by examining the extent to which Nominal Gross Domestic Product has explained the movement of share prices, in particular, the Dow Jones Industrial Average, over time. In this report, we look at the relationship between the two metrics since 1916, updated with data through the fourth quarter, 2010. Barring any unforeseen shocks, we find strong historical precedent for the Dow to be trading in the vicinity of 15,000 in 2011.


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Why Sell for Less than Fair Value?

Generally accepted accounting principles do not specifically address the cash flow classification of premiums on company-owned life insurance policies. Our review of annual financial statement filings with the SEC indicates that many firms are classifying those premiums as an operating use of cash. An operating designation is afforded those premiums even when they serve to increase the cash surrender value of the underlying policies. Such treatment appears to be contrary to the spirit, if not the letter, of GAAP. Moreover, when premiums are paid, it unduly lowers operating cash flow and free cash flow, and could lead to lower assessments of corporate financial health and valuation. Similarly, operating cash flow and free cash flow may be overstated when policy proceeds are classified as operating cash flow.

We were able to identify firms who employ an investing classification for life insurance premiums that increase cash surrender values. Such a classification could be characterized as a best-practices approach.

The objective of this research report is to raise the awareness of corporate managers, analysts, and investors to the diversity in practice we are witnessing in the classification of life insurance premiums for the purpose of bringing more consistency to practice. Our hope is that regulators such as the FASB, possibly through the Emerging Issues Task Force, will consider it a worthwhile issue to address.


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Quarter 3, 2010
Free Cash Margin Index:
Recession Lows

2.43%, 3.96% (Mar. 2001, Dec. 2008)

Current

4.41% (Sep. 2011)

Recent High

7.18% (Mar. 2010)

For the twelve months ending with the third quarter of 2010, median free cash margin continued to decline off of the March 2010 high of 7.18%, falling to 6.18% from 6.71% in the second quarter of 2010. However, the decline in free cash margin notwithstanding, using data dating to March 2000, the metric still remains high by historical standards. While operating cushion, driven by an increase in gross margin, improved during the third quarter reporting period and the cash cycle remained relatively unchanged, it was an increase in capital expenditures that was behind the decline in free cash margin. As a percentage of revenue, median capital expenditures increased to 2.77% from 2.65% in the second quarter.

During the third quarter reporting period, of the forty-four industries examined, three industries saw improved free cash margin from the same period in 2009, while twenty industries saw free cash margin decline. Twenty-one industries reported free cash margin that remained relatively unchanged. Individual companies with free cash margin trends that are examined in this report are Arch Coal (ACI), Cal Maine Foods (CALM), Boston Scientific (BSX), Worthington Industries (WOR) and MDC Holdings (MDC). 


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Cash Flow Trends and Their Fundamental Drivers:Comprehensive Review (Quarter 1, 2012)

FREE CASH MARGIN INDEX: