FCF To Debt: Unscrubbed Data Creates Misleading Credit Ratings

fcf-to-debt:-unscrubbed-data-creates-misleading-credit-ratings

NEW YORK – FEBRUARY 23: A trader works on the floor of the New York Stock Exchange as a chart shows … [+] the downward track of the S&P 500 Index during afternoon trading February 23, 2009 in New York City. Stocks tumbled to their lowest close in 12 years with the Dow Jones closing down 3.41 percent to 7114.78 (Photo by Mario Tama/Getty Images)

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To demonstrate the difference my firm’s proprietary Adjusted Fundamental data makes, I am writing a series of reports that compare my firm’s Credit Ratings to legacy firms’ ratings. This first report compares the “Adjusted” Free Cash Flow (FCF) to Debt ratio to the “Traditional” ratio based on unscrubbed financial data. FCF to Debt is one of the 5 ratios that drives my firm’s Credit Ratings.

No Bias, More Coverage, and Better Analytics: A New Paradigm for Credit Ratings

For too long, legacy providers, e.g. Moody’s, S&P, and Fitch, have dominated the credit ratings industry. Controversy surrounding these providers’ conflicts of interest during the Financial Crisis is well documented, yet conflicts of interest persist because these firms get paid so much by the companies they rate. My Firm’s Credit Ratings are free of conflicts of interest and also offer:

  • more coverage: ~2,700 companies vs. ~1,500 for S&P
  • more frequent updates: my firm updates all ~2,700 of its credit ratings quarterly while S&P updates ratings for ~400 companies per year

This report will show how FCF to Debt ratings for 54% of S&P 500 companies are misleading because they rely on unscrubbed data.

I will also detail the differences that better data makes at the aggregate[1], i.e. S&P 500[2], level and the individual company level (see Appendix) so readers can easily quantify the differences in data.

Unscrubbed FCF Is Highly Overstated for the S&P 500

I use 3-year average FCF as the numerator for the FCF to Debt ratio. Figure 1 shows the difference between Traditional 3-Year Average FCF and my Adjusted 3-Year Average FCF since 2016. Over the TTM, Traditional 3-Year Average FCF is overstated by $689 billion, or 51% of the Traditional 3-Year Average FCF.

Figure 1: Traditional Vs. Adjusted 3-Year Average FCF for S&P 500

Traditional Vs. Adjusted 3-Year Average FCF for S&P 500

New Constructs, LLC

Unscrubbed Total Debt Is Understated for the S&P 500

I use total debt as the denominator for the FCF to Debt ratio. Adjusted Total Debt provides a more complete view of the fair value of a firm’s total short-term, long-term, and off-balance sheet debt. Over the trailing twelve months (TTM), Traditional Total Debt is understated by $595 billion, or 7% of Traditional Total Debt.

Figure 2: Traditional Vs. Adjusted FCF to Debt for S&P 500

Traditional Vs. Adjusted FCF to Debt for S&P 500

New Constructs, LLC

Inflated Numerators + Deflated Denominators = Overstated Ratios

Better inputs yield better outputs. After reviewing Figures 1 and 2, I am not surprised to see in Figure 3 how much higher the Traditional FCF to Debt ratio is compared to the Adjusted version. In the TTM, the Traditional FCF to Debt ratio is more than twice the Adjusted FCF to Debt ratio.

Figure 3: Traditional Vs. Adjusted FCF to Debt Ratio for S&P 500

Traditional Vs. Adjusted FCF to Debt Ratio for S&P 500

New Constructs, LLC

The Five Most Under/Overstated FCF to Debt Ratios in the S&P 500

Given the large difference I see in the results at the aggregate level, I am not surprised to see very large differences at the individual company level. Figure 4 lists ten S&P 500 companies with most understated and overstated FCF to Debt ratios, by total difference over the TTM.

Note: I detail the data and disclosures that drive the differences in Traditional versus Adjusted FCF and Debt for Monolithic Power Systems’ (MPWR) and T. Rowe Price Group’s (TROW) in the Appendix to this report. 

Figure 4: Select Companies with Under/Overstated FCF to Debt: TTM

Select Companies with Under/Overstated FCF to Debt

New Constructs, LLC

Ratings Based on Traditional Ratios Are Misleading

Not surprisingly, these large differences between Traditional and Adjusted ratios drive large differences in the Credit Ratings I derive for FCF to Debt.

Figure 5 shows how my firm’s Credit Ratings align with legacy firms’ ratings systems and the percentage of Traditional FCF to Debt ratings that are different from ratings based on Adjusted ratios for companies in the S&P 500. Overall, 54% of the Traditional FCF to Debt ratings are different from the Adjusted FCF to Debt rating because they rely on unscrubbed data.

Figure 5: S&P 500[3]: Percent of Traditional FCF to Debt Ratings that Are Misleading

Percent of Traditional FCF to Debt Ratings that Are Misleading

New Constructs, LLC

Figure 6 provides more details on the number of companies whose Traditional FCF to Debt ratings are different from the rating based on Adjusted FCF to Debt ratios.

For example, 48 out of 123 (39%) companies that earn a Very Attractive FCF to Debt rating based on the Traditional ratio earn a different rating based on the Adjusted ratio.

Figure 6: S&P 500[4]: Number of Misleading Traditional FCF to Debt Ratings

Number of Misleading Traditional FCF to Debt Ratings

New Constructs, LLC

I dedicate the Appendix of this report to showing readers exactly how the Adjusted values for FCF and total debt are different than the unscrubbed versions.

Disclosure: David Trainer, Kyle Guske II, Alex Sword, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.

Appendix: Auditing the Differences in Traditional Vs. Adjusted Values

This Appendix will show exactly how the Adjusted values for FCF and debt differ from the Traditional versions for two companies Monolithic Power Systems and T. Rowe Price.

Monolithic Power Systems: The Difference in Traditional Vs. Adjusted Values

Figure 7 shows the differences between the two components of the FCF to Debt ratio, 3-year average FCF and total debt for Monolithic Power Systems (MPWR). The difference between Monolithic Power Systems’ Traditional 3-Year Average FCF and Adjusted 3-Year Average FCF is -$108 million, or 499% of Traditional 3-Year Average FCF. The difference between Traditional Total Debt and Adjusted Total Debt is $2 million, or 46% of Traditional Total Debt.

Figure 7: Monolithic Power Systems: Traditional Vs. Adjusted FCF to Debt Components

Monolithic Power Systems: Traditional Vs. Adjusted FCF to Debt Components

New Constructs, LLC

Reconciling Monolithic Power Systems’ Traditional and Adjusted 3-Year Average FCF

The primary driver of Monolithic Power Systems’ understated FCF to Debt ratio is understated 3-year average FCF. Figure 8 shows the firm’s Traditional and Adjusted 3-Year Average FCF have diverged since 2016.

Figure 8: Monolithic Power Systems: Traditional Vs. Adjusted 3-Year Average FCF: 2016-TTM

Monolithic Power Systems: Traditional Vs. Adjusted 3-Year Average FCF

New Constructs, LLC

The differences between Traditional 3-Year Average FCF and Adjusted 3-Year Average FCF are driven by the differences between:

  1. NOPAT and EBIT after tax
  2. change in net working capital vs. change in adjusted net working capital, and
  3. the change in adjusted fixed assets[5] vs. depreciation and amortization – CAPEX.

For Monolithic Power Systems, those differences are:

  • The difference between NOPAT and EBIT after tax is $0.
  • The difference between change in net working capital and adjusted net working capital is $112 million.
  • The difference between change in adjusted fixed assets vs. depreciation and amortization – CAPEX is -$96 million.

Figure 9 reconciles Monolithic Power Systems’ Traditional 3-Year Average FCF and Adjusted 3-Year Average FCF and details each of the differences listed above.

Figure 9: Monolithic Power Systems: 3-Year Average Adjusted Vs. Traditional FCF Detailed Comparison[6][7]

Monolithic Power Systems: 3-Year Average Adjusted Vs. Traditional FCF Detailed Comparison

New Constructs, LLC

Reconciling Monolithic Power Systems’ Traditional and Adjusted Total Debt

Figure 10 compares Monolithic Power Systems’ Traditional Debt and Adjusted Debt since 2016. The difference over the TTM between the reported net present value (NPV) of operating lease liability of $5.4 million and the adjusted NPV of operating lease liability of $7.9 million drives the -$2.5 million difference between Monolithic Power Systems’ Traditional and Adjusted Total Debt.

Figure 10: Monolithic Power Systems: Traditional Vs. Adjusted Total Debt: 2016-TTM

Monolithic Power Systems: Traditional Vs. Adjusted Total Debt

New Constructs, LLC

Monolithic Power Systems’ FCF to Debt Ratio Is Understated

With understated 3-year FCF and total debt, Monolithic Power Systems FCF to Debt ratio has the largest difference between Traditional and Adjusted of all companies in the S&P 500. Per Figure 11, Monolithic Power Systems’ FCF to Debt has been largely understated since 2017.

Figure 11: Monolithic Power Systems: Traditional Vs. Adjusted FCF to Debt Ratio: 2016-TTM

Monolithic Power Systems: Traditional Vs. Adjusted FCF to Debt Ratio

New Constructs, LLC

T. Rowe Price: The Difference in Traditional Vs. Adjusted Values

Figure 12 shows the difference between T. Rowe Price’s Traditional 3-Year Average FCF and Adjusted 3-Year Average FCF is $190 million, or 12% of Traditional 3-Year Average FCF. The difference between Traditional Total Debt and Adjusted Total Debt is -$3 million, or just -2% of Traditional Total Debt.

Figure 12: T. Rowe Price: Traditional Vs. Adjusted FCF to Debt Components

T. Rowe Price: Traditional Vs. Adjusted FCF to Debt Components

New Constructs, LLC

Reconciling T. Rowe Price’s Traditional and Adjusted 3-Year Average FCF

Nearly all the difference between T. Rowe Price’s Traditional and Adjusted FCF to Debt ratio is driven by the difference between its Traditional 3-Year Average FCF and Adjusted 3-Year Average FCF, which is illustrated in Figure 13.

Figure 13: T. Rowe Price: Traditional Vs. Adjusted 3-Year Average FCF: 2016-TTM

T. Rowe Price: Traditional Vs. Adjusted 3-Year Average FCF

New Constructs, LLC

The following is a summary of the differences when calculating T. Rowe Price’s TTM Adjusted 3-Year Average FCF:

  • The difference between NOPAT and EBIT after tax is -$5 million.
  • The difference between change in net working capital and adjusted net working capital is $0.
  • The difference between change in adjusted fixed assets[8] vs. depreciation and amortization – CAPEX is -$232 million.

Figure 14 reconciles T. Rowe Price’s Traditional 3-Year Average FCF and Adjusted 3-Year Average FCF and details each of the differences listed above.

Figure 14: T. Rowe Price: 3-Year Average Adjusted Vs. Traditional FCF Detailed Comparison[9][10]

T. Rowe Price: 3-Year Average Adjusted Vs. Traditional FCF Detailed Comparison

New Constructs, LLC

Reconciling T. Rowe Price’s Traditional and Adjusted Total Debt

Figure 15 shows T. Rowe Price’s Traditional Debt and Adjusted Debt since 2016. The difference over the TTM between T. Rowe Price’s reported NPV of operating lease liability of $146 million and the adjusted NPV of operating lease liability of $149 million drives the -$3 million difference between its Traditional and Adjusted Total Debt.

Figure 15: T. Rowe Price: Traditional Vs. Adjusted Total Debt: 2016-TTM

T. Rowe Price: Traditional Vs. Adjusted Total Debt

New Constructs, LLC

T. Rowe Price’s FCF to Debt Ratio Is Overstated

T. Rowe Price’s Traditional FCF to Debt ratio rose from 10.5 in 2020 to 11.1 TTM, while its Adjusted FCF to Debt ratio fell from 9.9 to 9.6 over the same time. Per Figure 16, T. Rowe Price’s Traditional FCF to Debt ratio has been overstated since 2016.

Figure 16: T. Rowe Price: Traditional Vs. Adjusted FCF to Debt Ratio: 2016-TTM

T. Rowe Price: Traditional Vs. Adjusted FCF to Debt Ratio

New Constructs, LLC

[1] I calculate the S&P 500 Traditional and Adjusted 3-Year Average FCF by aggregating the results for all current members of the S&P 500.

[2] In this analysis, I use the 494 companies for which I have data back to 2016 and are currently in the S&P 500.

[3] Due to a lack of a sufficient number of available filings to calculate a Traditional FCF to Debt ratio over the TTM, I exclude Amcor Plc (AMCR), Carrier Global Corp (CARR), and Otis Worldwide Corp (OTIS) from this analysis.

[4] Due to a lack of a sufficient number of available filings to calculate a Traditional FCF to Debt ratio over the TTM, I exclude Amcor Plc (AMCR), Carrier Global Corp (CARR), and Otis Worldwide Corp (OTIS) from this analysis.

[5] The Adjusted FCF used in my firm’s Credit Ratings accounts for the impact of acquisitions on the firm’s fixed assets. Over the TTM, however, Monolithic Power Systems’ 3-year average Adjusted FCF equals its 3-year average Adjusted FCF excluding acquisitions.

[6] I calculate the Cash Operating Taxes applied to Reported EBIT and NOPBT using the same cash operating tax rate.

[7] Fixed assets include Net Property, Plant, and Equipment, Goodwill, net, Net Other Intangibles, Long-term Restricted Cash, and Other Fixed Assets.

[8] The Adjusted FCF used in my firm’s Credit Ratings accounts for the impact of acquisitions on the firm’s fixed assets. Over the TTM, T. Rowe Price’s 3-year average Adjusted FCF of $1,431 million is equal to its 3-year average Adjusted FCF excluding acquisitions.

[9] I calculate the Cash Operating Taxes applied to Reported EBIT and NOPBT using the same cash operating tax rate.

[10] Fixed assets include Net Property, Plant, and Equipment, Goodwill, net, Net Other Intangibles, Unconsolidated Subsidiary Assets, and Other Fixed Assets.

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