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Analyzing Performance and Competitive Position

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Title: Analyzing Performance and Competitive Position


1
Chapter 8
Instructors Please do not post raw PowerPoint
files on public website. Thank you!
  • Analyzing Performance and Competitive Position

2
Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in three steps
Analyze ROIC and Economic Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate Credit Health and Financial
Structure Assess the companys liquidity and
evaluate its capital structure in order to
determine whether the company has the financial
resources to conduct business and make short- and
long-term investments.
Slides 2-10
Slides 11-19
Slides 20-25
3
Using ROIC to Compare Operating Performance
  • To measure historical operating performance,
    compute ROIC by comparing NOPLAT to invested
    capital

Home Depot and Lowe's Return on Invested Capital
  • The ROIC at Home Depot outpaced Lowes by
    approximately five percentage points during the
    early 2000s. This gap disappeared in 2005, when
    Home Depot began acquiring other companies.

4
ROIC With or Without Goodwill?
  • Compute ROIC both with and without goodwill and
    acquired intangibles, because each ratio analyzes
    different things.
  • To measure aggregate value creation for the
    companys shareholders, measure ROIC with
    goodwill.
  • ROIC excluding goodwill measures the underlying
    operating performance of the company and its
    businesses and is used to compare performance
    against peers and to analyze trends.

CVS Caremark Return on Invested Capital
Note This presentation sometimes shortens
goodwill and acquired intangibles to goodwill.
5
Understanding Value Creation Decomposing ROIC
  • in 2008, Home Depots ROIC (8.0) lagged Lowes
    ROIC (8.9) by approximately one percentage
    point.
  • But what is driving this drop in performance?
  • Can these losses be recovered?
  • To better understand ROIC, we can decompose the
    ratio as follows

Profit Margin
Capital Efficiency
  • As the formula demonstrates, a companys ROIC is
    driven by its ability to (1) maximize
    profitability, (2) optimize capital efficiency,
    or (3) minimize taxes.

This equation can be organized into a tree
6
Understanding Value Creation Decomposing ROIC
  • From a margin perspective, Home Depots operating
    margin was 6.8 percent versus 8.3 percent for
    Lowes. The lower operating margin is primarily
    attributable to higher selling, general, and
    administrative (SGA ) expense.
  • According to press reports, the rise in SGA
    reflects the cost of additional floor personnel
    to improve the customer experience. Whether this
    translates to higher sales through better service
    in the future is a key to the companys valuation.

Home Depot and Lowe's ROIC Tree, 2008
Gross margin
7
Understanding Value Creation Line Item Analysis
  • To complete a thorough analysis, each tree branch
    should examined separately over time and across
    competitors.
  • For operating current assets and liabilities, we
    can convert each line item into days, using the
    following formula

Home Depot and Lowe's Operating Current Assets
in Days
Inventories have risen slightly at Lowes from
85 to 94 days.
8
Understanding Value Creation Nonfinancial Metrics
  • In an external analysis, ratios are often
    confined to financial performance.
  • If you are working inside a company, however, or
    if the company releases operating data, you
    should link operating drivers directly to return
    on invested capital. For instance, how can we
    use data about employees and miles flown for
    airlines?

Financial and Operating Statistics across U.S.
Airlines, 2008
9
Nonfinancial Metrics Building an Equation
  • To better understand labor expenses, we
    disaggregate labor expenses to revenue using the
    following equation

How much labor cost is incurred per available
seat-mile (ASM) flown?
Labor Expenses
Labor Expenses
Total Employees
ASMs Flown



Revenue
Total Employees
ASMs Flown
Revenue
Cost Structure

Productivity

Price
Average Salary per
Productivity of Each Full-Time
Miles Needed to
Full-Time
Employee ( Employees to Fly One
Be Flown to
Billion Available Seat-Miles)
Generate 1
Employee
  • Note how each terms denominator cancels the next
    terms numerator, leaving us with the original
    ratio.

10
Nonfinancial Metrics Analyzing the Data
  • Discount carriers have higher labor cost per
    dollar of revenue, when compared to network
    carriers. But this statistic is misleading. The
    difference is caused by higher prices, not higher
    labor costs.
  • The average labor cost per ASM1 for discount
    airlines equals 10.6 cents, versus 14.4 cents for
    network carriers.

Operational Drivers of Labor Expenses to
Revenues, 2008
100 -
11
Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in three steps
Analyze ROIC and Economic Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate Credit Health and Financial
Structure Assess the companys liquidity and
evaluate its capital structure in order to
determine whether the company has the financial
resources to conduct business and make short- and
long-term investments.
Slides 2-10
Slides 11-19
Slides 20-25
12
Analyzing Revenue Growth
  • The value of a company is driven by return on
    invested capital, the weighted average cost of
    capital, and growth. The ability to grow cash
    flows over the long term depends on a companys
    ability to grow its revenues organically.
  • Calculating revenue growth directly from the
    income statement will suffice for most companies.
    The year-to-year revenue growth numbers sometimes
    can be misleading, however. The three prime
    culprits affecting revenue growth are
  • Currency changes. Foreign revenues must be
    consolidated into domestic financial statements.
    If foreign currencies are rising in value
    relative to the companys home currency, this
    translation, at better rates, will lead to higher
    revenue.
  • Mergers and acquisitions. When one company
    purchases another, the bidding company may not
    restate historical financial statements. This
    will bias one-year growth rates upward.
  • Changes in accounting policies. When a company
    change its revenue recognition policies,
    comparing year-to-year revenues can be misleading.

13
Organic Growth vs. Reported Growth
  • Compass (based in the United Kingdom) and Sodexo
    (based in France) are global providers of canteen
    services in businesses, schools, and sporting
    venues.
  • In 2008, total revenues at Compass grew by 11.4
    percent, and revenues at Sodexo grew by 1.7
    percent. The difference in growth rates appears
    dramatic but is driven primarily by changes in
    currency values (pounds sterling versus euros),
    not by organic revenue growth.

Compass and Sodexo Revenue Growth Analysis
14
Analyzing Revenue Growth Currency Changes
  • The exhibit below reports the revenue breakout by
    geography for Compass and Sodexo.
  • The companies have similar geographic mixes, with
    roughly 40 percent of revenues coming from North
    America. Since each company translates U.S.
    dollars into a different currency, exchange rates
    will affect each company quite differently.

Compass and Sodexo Effect of Currencies on
Revenue Growth
Compass translates U.S. dollars from its North
American business into British pounds. Given the
weakening of the pound against the U.S. dollar
(2.04 per pound in 2007 versus 1.78 per pound
in 2008), Compass reported an increase in
revenues of 5.1 percent attributable to the
weakening pound.
15
Analyzing Revenue Growth Currency Changes
  • Companies with extensive foreign business will
    report revenues using both current and constant
    exchange rates (CER).
  • For instance, IBM reported a year-to-year revenue
    change of 9.8 percent in 2003, but a year-to-year
    constant currency change of only 2.8 percent.

IBM 2003 Annual Report, Page 51
Had currencies remained at their prior-year
levels, IBM revenue would have been 83.5
billion, rather than the 89.1 billion reported.
16
Analyzing Revenue Growth MA
  • Stripping the effect of acquisitions from
    reported revenues is difficult. Unless an
    acquisition is deemed material by the companys
    accountants, company filings do not need to
    detail or even report the acquisition.
  • For larger acquisitions, a company will report
    pro forma statements that recast historical
    financials as though the acquisition were
    completed at the beginning of the fiscal year.
    Revenue growth then should be calculated using
    the pro forma revenue numbers
  • If the target company publicly reports its own
    financial data, you can construct pro forma
    statements manually by combining revenue of the
    acquirer and the target for the prior year. But
    beware The bidder will include partial-year
    revenues from the target for the period after the
    acquisition is completed.

17
Analyzing Revenue Growth MA
  • Consider the hypothetical purchase of a target
    company in the seventh month of year 3.
  • Both the parent company and the target are
    growing organically at 10 percent per year.
    Consolidated revenue growth, however, is reported
    at 22.8 percent in year 3 and 18.2 percent in
    year 4.
  • To create an internally consistent comparison for
    years 3 and 4, adjust the prior years
    consolidated revenues to match the current years
    composition.

Effect of Acquisitions on Revenue Growth
18
Analyzing Revenue Growth Accounting Changes
  • Each year the Financial Accounting Standards
    Board (U.S.) and International Accounting
    Standards Board (Europe) make recommendations
    concerning the financial treatment of certain
    business transactions.
  • Consider EITF 01-14 from the Financial Accounting
    Standards Board, which concerns reimbursable
    expenses.
  • Prior to 2002, U.S. companies accounted for
    reimbursable expenses by ignoring the expense
    entirely. Starting in 2003, U.S. companies can
    recognize the reimbursement as revenue and the
    outlay as an expense.
  • This new revenue will artificially increase
    year-to-year comparisons.

Total System Services, Annual Report, page F-7
Reimbursable Expenses As a result of the
Financial Accounting Standards Boards (FASBs)
Emerging Issues Task Force 01-14 (EITF 01-14),
formerly known as Staff Announcement Topic D-103,
Income Statement Characterization of
Reimbursements Received for Out-of-Pocket
Expenses Incurred, the Company has included
reimbursements received for out-of-pocket
expenses as revenue. Historically, TSYS had not
reflected such reimbursements in its consolidated
statements of income.
19
Understanding Value Creation Decomposing Growth
  • Once revenues have been disaggregated, analyze
    revenue growth from an operational perspective.
    The most standard decomposition is

Home Depot and Lowes Revenue Growth Analysis,
2008
  • Growth trees can be built using advanced versions
    of the decomposition formula presented above.
  • How is Home Depot driving revenue growth?

20
Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in three steps
Analyze ROIC and Economic Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate Credit Health and Financial
Structure Assess the companys liquidity and
evaluate its capital structure in order to
determine whether the company has the financial
resources to conduct business and make short- and
long-term investments.
Slides 2-10
Slides 11-19
Slides 20-25
21
Credit Health and Capital Structure
  • In the final step of historical analysis, focus
    on how the company has financed its operations.
    Ask
  • How is the company financed? That is, what
    proportion of invested capital (IC) comes from
    creditors versus equity holders?
  • Is this capital structure sustainable?
  • Can the company survive an industry downturn?
  • To assess the aggressiveness of a companys
    capital structure, examine
  • Liquiditythe ability to meet short-term
    obligations. We measure liquidity by examining
    the interest coverage ratio.
  • Leveragethe ability to meet long-term
    obligations. Leverage is measured by computing
    the market-based debt-to-value ratio.

22
Credit Health and Capital StructureLiquidity
  • The interest coverage ratio measures a companys
    ability to meet short-term obligations
  • EBITDA/interest measures the ability to meet
    short-term financial commitments using profits,
    as well as depreciation dollars earmarked for
    replacement capital.
  • EBITA/interest measures the ability to pay
    interest without having to cut expenditures
    intended to replace depreciating equipment.

Home Depot Measuring Interest Coverage
23
Credit Health and Capital StructureLiquidity
  • EBITDA interest coverage (times interest earned)
    is the most widely used ratio for large companies
    with access to public capital markets.
  • Although interest coverage is the primary driver
    of a companys rating, it is not the only driver.
    Other drivers include capital intensity, debt to
    value, among others.

24
Credit Health and Capital StructureLeverage
  • To better understand the power (and danger) of
    leverage, consider the relationship between
    return on equity (ROE) and ROIC.
  • The use of leverage magnifies the effect of
    operating performance.
  • The higher the leverage ratio (IC/E), the greater
    the risk.
  • Specifically, with a high leverage ratio (a very
    steep line), the smallest change in operating
    performance can lead to enormous changes in ROE.

25
Median Leverage Ratios Across Industries
  • To place the companys current capital structure
    in the proper context, compare its capital
    structure with those of similar companies.
  • Industries with heavy fixed investment in
    tangible assets tend to have higher debt levels.
  • High-growth industries, especially those with
    intangible investments, tend to use very little
    debt.

Median Debt to Value by Industry1
Note Market value of debt proxied by book
value. Enterprise value proxied by book value of
debt plus market value of equity.
26
Closing Thoughts
  • Understanding a companys past is essential for
    forecasting its future. Through historical
    analysis, we can test a firms ability to create
    value
  • over time by analyzing trends in operating and
    financial metrics, and
  • as compared to other companies within the firms
    industry.
  • When analyzing historical performance, keep the
    following in mind
  • Look back as far as possible (at least 10 years).
    Long-term horizons will allow you to evaluate
    company and industry trends and whether
    short-term trends will likely be permanent.
  • Disaggregate value drivers, both ROIC and revenue
    growth, as far back as possible. If possible,
    link operational performance measures with each
    key value driver.
  • Identify the source when there are radical
    changes in performance. Determine whether the
    change is temporary or permanent, or merely an
    accounting effect.
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