10/14/2018 1 Impact of Free Cash Flow on Firm Performance During Market Contractions: Evidence from U.S. Defense Industry Lane Cohee, Palm Beach Atlantic University Ron Piccolo, University of Central Florida Halil Kiymaz, Rollins College Impact of Free Cash Flow on Firm Performance During Market Contractions: Evidence from U.S. Defense Industry Relevance of the Study Contracting markets represent a “crucible” by which firm leadership may be measured Source: https://www.frbatlanta.org/cqer/research/chauvet_real_time_analysis.aspx On average, 80% of public corporations do not return to pre- recessionary performance levels within 3 years of emerging from a recession and 17% of them actually fail (Gulati et al., 2010) Why U.S. Defense Industry? • We use the U.S. defense industry for this analysis for two primary reasons. – 2011 to 2016 budgetary reduction represents a recent and very significant industry contraction – Defense industry has a highly cyclical and measurable set of budgetary appropriations that lends itself well to analyses of recessionary environments (Anand and Singh, 1997; Anand, 2004).
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Impact of Free Cash Flow on Firm Performance During Market Contractions:
Evidence from U.S. Defense Industry
Lane Cohee, Palm Beach Atlantic UniversityRon Piccolo, University of Central FloridaHalil Kiymaz, Rollins College
Impact of Free Cash Flow on Firm Performance During Market Contractions:
Evidence from U.S. Defense Industry
Relevance of the Study
Contracting markets represent a “crucible” by which firm leadership may be measured
On average, 80% of public corporations do not return to pre-recessionary performance levels within 3 years of emerging from a recession and 17% of them actually fail (Gulati et al., 2010)
Why U.S. Defense Industry?
• We use the U.S. defense industry for this analysis for two primary reasons. – 2011 to 2016 budgetary reduction represents a recent
and very significant industry contraction
– Defense industry has a highly cyclical and measurable set of budgetary appropriations that lends itself well to analyses of recessionary environments (Anand and Singh, 1997; Anand, 2004).
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Analyzing the US Defense Industry
Study Window
What can firms do during contracting market?
Asset Deployment Strategies in Contracting Markets
–Retrenchment (defensive or prevention strategies)
–Investment (offensive or promotion strategies)
–“Ambidextrous” or combined variations of retrenchment and investment strategies
Literature Review
Retrenchment StrategiesCategory Strategy Literature Sources
Operating/Capital Expense
Labor force and salary reductions
R&D, IT, marketing, and training reductions
Capital expenditure reductions
Couto et al. (2001), Geroski and Gregg (1993), Geroski and Gregg (1997), Kitching et al. (2009), Robbins and Pearce II (1992)
Financial/Capital Structure
Working capital/inventory reductions
Cash flow acceleration through management of payables/receivables
Increase shareholder dividends
Reduce debt position
Barrett (1990), Banjeri et al. (2009), Bethel and Liebeskind (1993), Bowman and Singh (1993), Couto et al. (2001)
Portfolio Management
Divestiture of non-core firm segments or operations
Plant closures and consolidations
Asset conversions or disposal
Contract out functions or services
Bethel and Liebeskind (1993), Bowman and Singh (1993), Couto et al. (2001), Geroski and Gregg (1993), Kitching et al. (2009)
Literature Review
Investment StrategiesCategory Strategy Literature Sources
Operating/Capital Expense
R&D and productivity investments
Capital expenditure growth
Marketing and advertising investments
Employee training investments
New product development
Brenner (2008), Chastain(2003), Nickell et al. (2013), Roberts (2003), Esteve-Perez and MañezCastillejo (2006), Pearce II and Michael (2006)
Market and Price Positioning
Expanded products and services
Adapted pricing strategies to gain market share or margin
Banjeri et al. (2009), Chou and Chen (2002), Clifford (1977), Köksal and Özgül (2007), Quelcand Jocz (2009)
by cash flow required for capital expenditures. (FCF/shares outstanding)
Dividend Payout Firm earnings returned to shareholders in terms of cash or stock (dividend/shares outstanding)
Investment Measure of firm investment in R&D and capital. Consistent with Hsiao and Li, 2012 and 2013) (Capital Expenditure deflated by (PPE))
Core Consolidation Measure of firms’ combining multiple existing segments or acquiring businesses related to the firm’s core industry (the percentage of transaction value to firm market valuation)
Variable DefinitionDiversification Measure of the amount in which the firm engages in
acquiring businesses unrelated to its core industry. (the percentage of transaction value to firm market valuation)
Divestiture Measure of the amount of asset disposal e.g., business sales or plant closures associated with eliminating redundant or unprofitable business units. (the percentage of transaction value to firm market valuation)
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Literature Review
Measures of Firm Performance
• The literature provides a clear path to decomposing and triangulating on the dimensions and variables necessary to perform firm comparisons
• This path follows three discrete steps– Assessment of financial and non-financial performance constructs
– Assessment of dimensions representing financial performance
– Assessment of various financial performance indicators or variables within each financial dimension
Literature Review Summary
Financial and Non-Financial Constructs• Venkatraman and Ramanujam’s seminal work distinguishes between
financial and non-financial constructs when performing firm performance measurement
• Meta-analysis of the literature indicates a strong continued tendency toward the use of financial measures– Central to a firm's overall system of goals and perceived as more objectively
quantifiable
• Research indicates positive correlation between financial and non-financial constructs
• Particularly when triangulating using a number of financial performance dimensions, a financial performance construct may be used to represent overall firm performance
Which Financial Measures?
Financial Performance Dimensions
Note: Several researchers further separate the accounting dimension into liquidity and profitability dimensions, highlighting the distinction between an organization’s ability to meet financial obligations based on cash flows and the ability to generate earnings (Murphy et al., 1996; Murphy, Trailer, and Hill, 1996; Richard et al., 2009).
Dimension Measure Literature Sources
Accounting Historical performance using standard accounting data. Includes profitability and liquidity variables.
Hamann et al. (2013), Richard et al. (2009), Murphy et al. (1996), Rowe and Marrow (1999), Fryxell and Barton (1990)
Market Based Future looking performance variables reflecting shareholder return.
Hamann et al. (2013), Richard et al. (2009), Murphy et al. (1996), Rowe and Marrow (1999), Fryxell and Barton (1990)
Mixed Measures Hybrid ratios incorporating both accounting and financial market measures.
Hamann et al. (2013), Richard et al. (2009)
Growth Sales, employee and asset expansion variables.
Hamann et al. (2013), Murphy et al. (1996)
Data and Methodology
Two sources of data
• Financial performance indicators collected from the FactSet financial database– FCF, Dividends, Investment, ROA, CFROA, TSR, Tobin’s q,
Assets Growth
• M&A and divestiture information documented in quarterly/annual corporate investor reports and industry reports
Each data source compiled for 26 quarters between Q2 2010 and Q3 2016 – corresponds to recessionary
window
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Table 1. Firms with Highest Percentage of Defense to Total Revenue (2015) GROUP 1
FirmDefense Revenue
(billions)Total Revenue
(billions)Percent
Raytheon (NYSE: RTN) 21.6 23.2 93.1
Lockheed Martin (NYSE: LMT) 40.6 46.1 88.1
L‐3 Communications (NYSE: LLL) 8.7 10.5 82.9
Northrop Grumman (NYSE: NOC) 17.6 23.5 74.9
General Dynamics (NYSE: GD) 31.5 19.1 60.6
Table 2. Firms with Lowest Percentage of Defense to Total Revenue (2015) GROUP 2
FirmDefense Revenue
(billions)Total Revenue
(billions)Percent
Boeing (NYSE: BA) 30.3 96.1 31.5
Textron (NYSE: TXT) 4.2 13.4 31.3
United Technologies (NYSE: UTX) 6.8 56.5 12.0
Honeywell (NYSE: HON) 4.7 38.6 12.2
General Electric (NYSE: GE) 3.7 115.9 3.2
Methodology
iShares U.S. Aerospace&Defense ETF
A weighted avergecomputed for each group (next slide)
Table 4. Corporate Performance Indicators
Dimension Indicator Definition
Profitability Return on Assets (ROA) Ratio of net operating profit to average total assets
Liquidity Cash flow Return on Assets Ratio of cash flow from operations to average total assets
Market Based Total Shareholder Return Ratio of annual stock price change (including dividends) to opening stock price
Mixed Measures Tobin’s q Ratio of market value of firm’s assets to their replacement cost (where book value is often a proxy)
Growth Assets Growth Percentage change of assets from start to end‐of‐period
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Hypotheses
H1: During a market contraction, increased free cash flow is positively associated with firm performance
H2: When firms are not exposed to a contracting market, increased capital investment is more positively associated with firm performance than increased free cash flow.
Data Approach• First, calculated arithmetic means for each variable
– This was performed for each group
• Second, performed time-based adjustments of select IVs– Investment IV - adjusted 1 yr. to account for return on capital
investment period– M&A-related IVs - applied four quarter moving average to account
for realization of integration/synergy effects
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Example:FCF IV for Group 1
Data Approach
• Third, calculated Cumulative Performance DV by– Normalizing each contributing DV and summing the normalized values, using
– This was performed for each
group
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Example for Group 1
Summary of Analyzed Data
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Independent Variables...
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Moderator and Control Variables
Dependent Variables
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Example for Group 1
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Test for Multicollinearity
• Calculated VIFs from standard regression to assess multicollinearity amongst IVs
• No high VIF levels
• Moderate VIF levels for Group 2 FCF and Dividend variables
• Mitigated via variable isolation in stepwise regression models
Test for Heteroscedasticity
• Utilized the Glejser Test methodology
No statistical significance (p < .05) indicates hypothesis of homoscedasticity may be accepted
Correlation Analysis Correlation Analysis
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Standard Regression Stepwise Regression
Stepwise Regression Investment vs. Cum Performance
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Key Findings
The impact of free cash on firm performance is distinctly higher amongst firms operating in the recessionary environment.
The impact of capital investment over increased free cash flow is distinctly higher amongst firms that are less exposed to the recessionary environment.
A conversion of free cash flow to increased capital investment during the latter phase of the recession appears to yield optimal firm performance.
