Cash Flow Insufficient to Fund Share Repurchases January 28, Summary:

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1 Cash Flow Insufficient to Fund Share Repurchases January 28, 2005 Summary: CFRA cautions that the free cash flows (defined as cash from operations less capital expenditures dividends) of certain companies are not sufficient to fund share buybacks. We believe negative cash flow after share repurchases on a trailing twelvemonth basis four consecutive quarters warrants concern further investigation. Some companies, such as WMT, BUD, WON, DST, AZO, are increasing their balance sheet leverage using debt to fund share repurchases. o $0.03 of the $0.05 of BUD s EPS growth in the September 2004 quarter was attributable to share repurchases. o $0.02 of the $0.08 of WMT s EPS growth in the October 2004 quarter was attributable to share repurchases. A Company may have a stock repurchase program in place to offset the dilution from employee stock option exercises. While the amount of cash d solely to offset dilution is difficult to estimate we believe this is an excellent proxy the true cash cost of stock option compensation expense. We believe the current low interest rate environment provides the opportunity to utilize debt financing as a means of boosting EPS growth in situations where the decrease in shares outsting will offset incremental interest expense. At this point you may be wondering why we would be cautioning you regarding what appears to be a smart reallocation of capital from a more expensive source to a cheaper source. Our concern stems from the fact that this source of EPS growth does not appear sustainable. The increased leverage ratios on a company s balance sheet rising interest rate environment are likely to increase debt costs. Additionally, any increase in the current market price of the companies shares which may occur as a result of the increased dem the stock (from the Company) as well as higher EPS (from the buyback) will increase the amount of debt that must be raised to get the same amount of accretion causing a contraction in the return on investment. In certain instances a company may have a stock repurchase program in place to offset the dilution from employee stock option exercises. While the amount of cash d solely to offset dilution is difficult to estimate we believe this is an excellent proxy the true cash cost of stock option compensation expense. 2005, Rockville Pike, Suite 640, Rockville, MD, 20852; Phone: (301) ; ALL RIGHTS RESERVED. This research report may not be reproduced, stored in a retrieval system, or transmitted, in whole or in part, in any m or any means, without the prior written permission of CFRA. The inmation in this report was based on sources believed to be reliable accurate, principally consisting of required filings submitted the Company to the Securities Exchange Commission; but no warranty can be made. No data or statement is or should be construed to be a recommendation the purchase, retention, or sale of the securities of the company mentioned. Printed Jerry Strawser. 1

2 We surveyed companies in the S&P 500 as well as the S&P Midcap 1 Index to identify those companies that had: 1. Negative free cash flow after share repurchases on a trailing-twelve month basis the past four quarters. 2. Net share repurchases as a of cash in the most recent quarter. 3. An increase in net debt levels on a year over year basis in the most recent quarter or a decrease in cash. Of the 900 companies included in the screen 15 met the above noted criteria, of the 15 we are particularly concerned the trends at WMT, BUD, IMN AZO. See Tables 1a 1b. Please review our individual reports on AZO further inmation. WMT had the largest shortfall in the most recent twelve-month period at $4.9 billion. Interestingly while WMT s cash from operations (CFFO) has only grown 3% on a basis at October 31, 2004 capital expenditures, dividends share repurchases have each grown 24%, 36% 57% respectively. Additionally, in each period going back to October 2002, except the period ended July 31, 2003 WMT has not generated enough cash to cover both dividends share repurchases prior to any asset sales. Additionally the sluggish 3% growth in CFFO compares to 14% growth in net income is of further concern. Conversely on a basis the period ended October 31, 2003 CFFO grew 23% versus 17% growth in net income. The share repurchases resulted in a 2.4% decrease in shares outsting that contributed $0.02 to EPS growth of $0.08 in the October 2004 quarter. The offset of stock options does not appear to be a significant component of WMT s share repurchase program. CSCO has d $1.8 billion of cash after share buybacks in the most recent twelve-month period. We estimate that of the 156 million shares repurchased in the October 2004 quarter 12 million were purchases to offset share dilution. Thus we estimate that approximately $231 million of cash d in the quarter share repurchases is in fact a cash expense of its option program. We further estimate that had this been expensed in the period CSCO s pretax income would have been 12% lower in the October 2004 period FDC had a shortfall in its most recent period at $1.6 billion. This appears to be due to a significant acceleration of its share repurchase program. FDC s shares outsting have increased due to the issuance of shares acquisitions. CFRA included in CAT s cash flow changes in finance receivables cash generated from the securitization of such receivables, which are included in the Company s investing cash flows in its financial statements. Nonetheless, CAT generated negative $3.7 billion in cash flow in the period ended September 30, 2004 after dividends share repurchases. The shortfall appears to be driven a decline in CFFO, increasing capital expenditures, a 50% spike in the of cash financing receivables while securitization of such receivables has declined. Additionally, CAT began repurchasing shares in the December 2003 quarter. We are concerned that absent an acceleration in operating cash flows CAT s share repurchase activity will decline. BUD s net debt has increased $1.2 billion or 17% in the past year due to a combination of borrowings share repurchases acquisitions. In fact BUD has not generated positive cash flow after share repurchases since June Furthermore, this does not take into account debt raised acquisitions. During the past twelve months the weighted average share count decreased 3.7% in the September 2004 quarter the reduction in share count accounted $0.03 of BUD s $0.05 of reported earnings growth. Printed Jerry Strawser. 2

3 IMN s free cash flow has turned negative yet they have begun buying back shares with cash on h. Absent a turnaround of the recent CFFO declines we do not view the repurchase program as sustainable. OSI has not generated free cash flow after share repurchases since June of The primary reasons appear to be an increase in capital spending. Printed Jerry Strawser. 3

4 Table 1a: Trailing Twelve Month Free Cash Flow (), Net Stock Repurchases Cash after Stock Repurchases (CASR) AZO (815) (938) (1,084) (390) (485) (497) 260 BUD 1,185 1,405 1,297 1,293 1,269 (1,503) (1,807) (1,870) (318) (403) (573) 975 CAT (3,133) (3,288) (2,392) (1,694) (592) (409) (429) (248) (3,542) (3,717) (2,640) (5,236) COMS (177) (193) (191) (168) (83) (126) (64) (50) (294) CSCO 7,060 6,508 5,888 4,679 4,378 (7,823) (7,288) (6,361) (763) (780) (473) 3,916 DST (1,008) (1,097) (1,126) (843) (968) (975) (735) FDC 1,850 1,559 1,714 1,547 1,531 (2,642) (2,276) (1,628) (792) (717) IMN (3) (28) (21) (23) 13 (8) (14) (5) (11) (42) (26) (34) ISIL (61) (42) (26) 31 (10) (17) 36 LUV (632) (267) (326) (246) (136) (125) (878) (403) (451) (811) OSI (1) (99) (100) (102) (79) (36) (37) (41) SEPR (193) (141) (117) (109) (61) (254) (102) (105) (101) VC (277) (44) (317) (540) (223) (11) (11) (5) (288) (55) (322) (828) WMT 1,416 1,302 1,521 4,119 3,798 (7,107) (6,173) (5,046) (5,691) (4,871) (3,525) (1,572) WON (181) (173) (171) (66) (62) (71) 37 the Center Printed Analysis Jerry (CFRA) Strawser. 4

5 Table 1b: Change in Diluted Weighted Average Shares Outsting () (Mils.) Q3, 9/03 YOY Change % Change YOY Change % Change AZO 1,825 1, % (9.7) (11%) BUD 8,272 7,075 1,197 17% (23.7) (3%) CAT 22,273 18,727 3,546 19% (3.1) (1%) COMS % CSCO , ,110.0 (337.0) (5%) DST 1, % (31.2) (27%) FDC 3,966 3, % % IMN (0.6) (2%) ISIL % LUV 1,846 1, % (20.0) (2%) OSI % (1.5) (2%) SEPR 1, % % VC 2,015 1, % (0.4) (0%) WMT 33,643 27,751 5,892 21% 4, ,372.0 (123.0) (3%) WON % (5.6) (6%) the Center Printed Analysis Jerry (CFRA) Strawser. 5