Financial Education

In addition to comparing a single company’s performance over time, common size analysis can be a useful way to compare the performance of two or more companies with each other. However, this is not as easy as it may seem. For one thing, not all companies use the same reporting categories. Even if similar expense categories are used, one company may classify certain costs in a different category. For example, some companies include some or all of their depreciation expense within cost of sales, while others separate it out as a line item.

Exhibit 1 presents a side-by-side comparison of Total SA and and Exxon Mobil vertical common-size income statement data for 2006. Notice that Total reports higher “other operating expenses” than Exxon’s “production and manufacturing expenses” when measured as a percentage of sales. However, Total shows no category for “selling, general and administrative expense,” which it appears to include within that “other operating expenses” line along with production and manufacturing expense. To compare the performance, the investor must add Exxon’s production expenses (8.1%) to SG&A expenses (3.9%) to arrive at a category similar to Total’s “other operating expense.” On this basis, Exxon Mobil spent 12.0% on the category while Total spent 12.7%.

Exhibit 1: Cross Sectional Common Size Income Statement for Total SA and Exxon Mobil

Other issues include differences in accounting methods. We discussed the fact that beginning in 2006 Exxon Mobil must record the full estimated amount of its pension shortfall, whereas before it was only required to recognize a portion of it. Under International Accounting Standards, Total still reports just a portion of the expense, so the two are no longer comparable on that basis.

Companies can also employ different business models. We earlier compared the fixed cost structure of Landstar and Arkansas Best. Because of their different business models, the cost structures may also differ. Landstar pays its drivers a percentage of the revenue from each load, whereas Arkansas Best pays drivers per mile driven. Arkansas Best may be able to reduce driver pay, while for Landstar the pay varies with revenue and is therefore something they would want to maximize in absolute dollar terms.

For these reasons, investors should have a solid understanding of any differences in accounting methods between companies being compared. Additionally, it is usually preferable to compare more broad based common-size data rather than line-by-line comparisons. Generally speaking, operating margin, pre-tax margin and net profit margin are more comparable between firms than, for example, gross margin or SG&A expenses.

In the case of Total SA and Exxon Mobil, Exxon appears to have higher operating margins – primarily due to lower purchases of crude inventory as a percentage of sales. Given its larger size, it is probably able to produce more of its own requirements. Other operating items appear relatively evenly matched, once some categorization adjustments are made.

Exxon also has lower sales-based taxes and more “other income.” While the taxes are a fair issue, it is probably not fair to judge management performance on the basis of non-operational items. However, regardless of the sources Exxon Mobil clearly appears to return a higher percentage of sales to its shareholders.

We can also compare both companies to industry data. For example, Yahoo! Finance reports key industry financial ratios, with the data provided by Hemscott Americas. Here is a selection of the industry data they provided for the Major Integrated Oil & Gas Industry recently.

Exhibit 2: Industry Financial Data

The net profit margin given for Exxon Mobil and Total SA are similar to those we calculated, despite being made on the basis of the most recent quarter rather than the full year 2006. We can easily see that Exxon’s net margin was higher than the 10.3% industry average, while Total’s was lower.

We can also compare the debt to equity ratios of the firms and industry using this data. We find that Total SA has more debt than average, while Exxon has less. Finally, we can compare return on equity (see Chapter 6), which combines net income (an income statement item) with total equity (a balance sheet item.) Although both companies have higher returns on equity than the industry average, Exxon’s is the better of the two.

Overall it appears that Exxon Mobil is using its resources more effectively than Total.

Below we provide common-size income statement and balance sheets for ExxonMobil. Under U.S. GAAP, Exxon provides three years of income statement data and two years of balance sheet data.

Exhibit 1: Horizontal Common Size Income Statement

Exhibit 2: Vertical Common Size Income Statement

Exhibit 3: Horizontal Common Size Balance Sheet

Exhibit 4: Vertical Common Size Balance Sheet

Initial Assessment
For the most recent year, 2006, Exxon Mobil’s revenues (sales) rose just 1.8% (Exhibit 1) while total assets rose a larger but still modest 5.1% (Exhibit 3). This indicates a modest deterioration in operating efficiency.

Income Statement
ExxonMobil’s horizontal common-size income statement is presented in Exhibit 1. The vertical common-size income statement is presented in Exhibit 2. Revenue grew 23.2% in 2005 but cumulatively grew just a little more. Surprisingly, management’s discussion and analysis (MD&A), makes no comments regarding the significant revenue growth in 2005. However, given the similarity to the growth rate experienced that year by Total SA, it seems likely to have had the same underlying cause: higher oil prices. This is supported by the increase in the cost of crude oil and product purchases (Exxon purchases some of the oil used in its upstream operations) which rose substantially in 2005 but declined slightly in 2006.

Nearly all of ExxonMobil’s other operating expenses rose at a slower rate than sales. Only crude oil and production and manufacturing expenses rose at a faster rate. Selling, general and administrative expense was virtually a fixed cost, as was exploration expense. Given the large increase in oil prices the lack of new exploration is somewhat surprising. Typically one would expect the higher profits to attract capital (which in turn would increase supply and help control the prices.) The largest oil company is spending little incremental capital to find additional supply, which could suggest that the high prices will persist.

Because the costs in aggregate rose at a slower rate than sales, the net profit margin for ExxonMobil increased steadily from 8.7% in 2004 to 10.1% in 2005 and 10.8% in 2006.

Balance Sheet
Exxon Mobil’s horizontal common-size balance sheet is presented in Exhibit 3. The vertical common-size income statement is presented in Exhibit 4. The financial statements present only two years of balance sheet data, which is the norm. Investors would have to search prior year documents to compare longer-term trends.

For 2006, total assets increased by 5.1%, which is somewhat more than the 1.8% growth in revenue. Overall the company made slightly less efficient use of its assets in 2006.

Assets
Cash and cash equivalents were reduced by 1.5% during the year. Although the company generated more than $49 billion in cash from operations, it used nearly $30 billion to repurchase shares, $7 billion for dividends and $15 billion to invest in equipment. Restricted cash was generally unchanged. As a percentage of total assets, the combined restricted and unrestricted cash fell from 16.0% to 15.0%.

Notes and accounts receivable increased 5.3%, in line with total assets but at a faster rate than the sales that resulted in the receivable. When receivables grow faster than sales it could indicate that the company is having trouble collecting from customers, is offering more lenient credit terms, or simply that more of the sales took place later in the accounting period. Each of those can sometimes be innocuous and can sometimes indicate deteriorating earnings quality. It is up to investors to smoke out the underlying cause and evaluate whether it is significant.

Inventories rose 14.4% for crude inventory and 18.1% for materials and supplies, both of which are considerably faster than either sales or assets. As is the case with accounts receivable, inventories are often tied to the level of sales. Large increases in inventory at a retailer would typically be cause for concern – namely that the company chose poor-selling merchandise. However, since Exxon’s inventory is primarily a commodity, there isn’t that issue to contend with. Even if sales slow down, the inventory will remain valuable. In fact, if oil prices rise the inventory will increase in value, and the larger dollar value of inventory likely consists at least in part of the same quantity of oil marked to a higher value.

Prepaid expenses were close to unchanged, and total current assets rose 3.3% – almost exactly in the middle between the growth in sales and the growth in assets.

Investments and advances rose 12.8% and finished 2006 at 10.6% of assets, up from 9.9% in 2005. Property, plant and equipment rose at a slower rate, but still faster than either sales or assets. The lack of new exploration noted above has not prevented the company from investing more in existing fields or other operations. Other assets declined year/year.

Liabilities
Notes and loans payable declined 3.9% in 2006 as maturing long-term debt was repaid and replaced with debt of longer maturities.

Accounts payable increased 8.2%, which was faster than assets and sales but in line with the growth in inventories. If inventories were purchased late in the year it could result in higher accounts payable for any inventory purchased on credit. As a percentage of assets, accounts payable represent 17.8%, compared to 17.3% the preceding year.

Income taxes payable fell 4.6%, and in aggregate current liabilities grew at approximately the same rate as total assets.

Turning to long-term liabilities, long-term debt and the portion of earnings owed to minority investors grew a bit faster than total assets, while deferred tax liabilities declined. The most significant change related to postretirement benefit reserves, which increased 36.3% year/year and represented 6.4% of total assets in 2006 compared with just 4.9% in 2005.

The reason for the significant pension obligation increase in 2006 was primarily a change in accounting principles. As the company explains in its 10K:

Effective December 31, 2006, Exxon Mobil Corporation implemented FASB Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (FAS 158), which requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through other nonowner changes in equity. In 2006, the amounts recorded in other nonowner changes in equity for net actuarial losses and prior service costs are required by FAS 158. For 2005, FASB Statement No. 87, “Employers’ Accounting for Pensions,” required an employer to recognize a liability in its statement of financial position that was at least equal to the unfunded accumulated benefit obligation for defined benefit pension plans.

The plans themselves did not change, merely the way they are recognized on the financial statements. In 2005, Exxon did not have to recognize its entire shortfall (the difference between the current value what it is expected to pay out in future benefits and the assets available to cover the expenses) on the balance sheet. In 2006 and future years it must.

Largely due to the difference in reported pension obligations, total liabilities grew as a percentage of total assets from 46.6% to 48.0%. In aggregate, all other liabilities declined relative to assets.

Stockholders’ Equity
In 2006 Exxon Mobil issued new stock, increasing its common equity by $309 million. This amount most likely reflected changes resulting from stock based compensation. The company repurchased $28 billion worth of stock for the treasury account.

The significant share buyback negated most of the other contributions to shareholder equity, resulting in a modest 2.4% increase for total shareholder equity. As a percentage of assets, shareholder equity declined to 52.0% from 53.4%. Still, it represents the largest source of capital for the firm.

Anecdotally, magazine cover stories have been purported contrarian indicators. Most famous, perhaps, is the Business Week “The Death of Equities” cover just before the long bull run of the 1980’s and 1990’s. However, the long-term stock price impact following cover story headlines from major business publications had never been studied academically.

In the March/April 2007 Financial Analysts Journal, Arnold, Earl and North take the issue head on. They collect 20 years of headlines from Business Week, Fortune and Forbes and classify them as positive, negative or neutral. Their statistical tests indicate that positive cover stories typically signal the end of superior performance and that negative headlines typically signal the end of poor performance. However, the evidence does not strongly suggest significant reversal or momentum when factors such as company size are also considered.

Total’s common-size statements are presented below. The first step in conducting a common-size analysis is to review both the common-size income statements and common-size balance sheets to look for changes and trends that warrant further review. Once the trends are identified, explanations should be sought. Management’s discussion of financial performance and the financial statement footnotes are good starting points, provided the reader maintains a healthy skepticism of management’s explanations. These internal perspectives should be balanced by external sources such as industry reports, economic data, peer company financial statements and news reports. We present a common-size analysis of Total below including an initial assessment, income statement analysis and balance sheet analysis.

Exhibit 1: Horizontal Common Size Income Statement

Exhibit 2: Vertical Common Size Income Statement


Exhibit 3: Horizontal Common Size Balance Sheet


Exhibit 4: Vertical Common Size Balance Sheet

Initial Assessment

Total’s horizontal common-size income statement is presented in Exhibit 1. Revenues grew 22.8% in 2005 and 39.2% cumulatively between 2004 and 2006. Total’s horizontal common-size balance sheet is presented in Exhibit 3. Total assets increased by 22.3% in 2005 and declined slightly in 2006 for a cumulative increase of 21.3%. Assets grew at about the same rate as sales in 2005, but fewer assets produced a higher level of sales in 2006, indicating that Total used its assets more efficiently that year.

In Total’s Form 20-F filed with the U.S. Securities and Exchange Commission, management notes that the “average oil market environment in 2006 was marked by higher oil prices, with the average Brent oil price increasing 19% to $65.10/b from $54.50/b in 2005.” They further disclose that “Oil and gas production in 2006 was 2,356 kboe/d compared to 2,489 kboe/d in 2005, a decrease of 5% due principally to the impacts of the price effect (1) (-2%), shutdowns of production in the Niger Delta area because of security issues (-2%) and changes in the Group’s perimeter (-1%). Excluding these items, the positive impact of new field start-ups was offset by normal production declines at mature fields and shutdowns in the North Sea.” This explains the apparent productivity increase: rather than producing more petroleum with fewer assets the company produced less. However, due to higher oil prices the revenue from the production more than offset the decline in quantity. By comparing output rather than revenue we see that output declined 5% and assets declined less than 1%. By this measure, efficiency actually decreased rather than increased. Since management has control over production but not commodity prices, this may be a more appropriate measure.

Income Statement

An examination of Total’s vertical common-size income statement, presented as Exhibit 2, shows that the while the company was profitable the entire time net profit margin declined steadily from 9.5% in 2004 to 9.2%in 2005 and just 7.9% in 2006. Investors will want to know if this trend is more likely to continue or to reverse. To do this we analyze the components of the income statement.

Excise taxes declined steadily throughout the period, which increased net revenue available to the company. Whatever caused the decline in profit margin had to overcome this positive effect. Purchases offer a partial explanation. Rising crude oil prices hurt operating margins for the refining and retail businesses. However, while this expense grew substantially faster than sales during the three years (48.8% compared to net revenue growth of 39.2%) it does not account for the entire decline in net margins. In fact, Figure 5-1 shows that operating income as a percentage of sales increased in 2005 and the decline in 2006 still left the income from operations higher than it was in 2004. Instead, we see that the decline in net profitability was due to non-operating items: specifically “other income” and an increase in income taxes.

Turning to the 20-F for information, we learn that the biggest reason for the decline was a one-time gain recognized in 2004: “The gains (losses) on sales of assets included a pre-tax dilution gain on the Sanofi-Aventis merger of 2,969 M € in 2004.” Without the gain in 2004, other income would only have been 0.1% of sales, and the apparent decline in margins would not have occurred.

With regard to income tax, the effective tax rate has been rising relative to pre-tax income, with the major factor being the difference between French tax rates and foreign tax rates. In particular, “The Venezuelan government has modified the initial agreement for the Sincor project several times. In May, 2006, the organic law on hydrocarbons was amended with immediate effect to establish a new extraction tax, calculated on the same basis as for royalties and bringing the overall tax rate to 33.33%. In September, 2006, the corporate income tax was modified to increase the rate on oil activities (excluding natural gas) to 50%. This new tax rate will come into effect in 2007.”

Some expenses can be crucial to a company’s future success. For example, pharmaceutical companies rely heavily on research and development. Improved margins due to lower R&D spending may actually be bad news. For oil companies, the equivalent of R&D is exploration costs – expenses related to trying to find new sources of oil. Total’s exploration costs were fairly stable as a percentage of revenue.

Another industry-specific expense is depletion, which is the counterpart to exploration and the equivalent of depreciation for fixed assets. When new oil discoveries are made an estimate of the total available oil is added to assets. The depletion charge represents the amount used up each year from the resources.

For forecasting future net margins, we would probably want to use the more recent years as a guideline. Tax rate increases should be considered permanent, and the 2004 net gain appears to have been a one-time event.

Balance Sheet

Note that Total presents its balance sheet with long-term assets and liabilities above current assets and liabilities. This presentation is fairly common outside the United States.

Remember that revenues grew 22.8% in 2005 and 39.2% cumulatively between 2004 and 2006. Total assets increased by 22.3% in 2005 and declined slightly in 2006 for a cumulative increase of 21.3%. When reviewing common-size balance sheets, particular attention should be paid to individual items that are not in line with this trend.

Assets

Beginning with long-term assets, intangible assets rose faster than sales or total assets while tangible assets (property, plant and equipment) grew slower. By their nature intangible assets are difficult to value, and subjective judgment is involved. Investors should always investigate the composition of intangible assets. Looking at Note 10 in Total’s 20-F we find that the increase in 2005 was mostly due to acquired mineral rights. Assuming the valuation was performed appropriately this is a valid asset. In 2006 acquisitions of other companies resulted in the change. Rapidly growing intangible assets and slow-growing property and equipment indicates the company may be pursuing a “buy versus build” strategy. In aggregate, long-term tangible and intangible assets amounted to 43.9% of total assets in 2004, 42.3% in 2005 and 43.1% in 2006 – a fairly constant proportion. Equity and other investments also stayed fairly consistent as a percentage of assets.

Hedging instruments of non-current financial debt declined as a percentage of assets. However, looking further down the balance sheet we see that the non-current debt increased in both absolute and percentage terms. It is possible that the company reduced the amount of overall hedges, or that the hedges declined in value (which would normally be offset by a similar change in the fair value of the hedged liability.) The discussion in the 20-F reveals losses is limited to the change between 2005 and 2006, so it is necessary to refer to the 2005 20-F to learn about the large decline between 2004 and 2005. In doing so, we find that currency and interest rate swaps lost value. Currency and interest rate movements were of a favorable direction, so any currency and interest rate hedges were unfavorable. Although the amount of debt changed year/year it is possible to gauge the overall impact by comparing debt maturing in specific years. For example, in 2004 Total had $2,241 million of bonds issued that mature in 2008. In 2005, the amount of 2008 maturities was similar at $2,256. However, the fair value of interest and currency swaps on the 2008 maturities had fallen from $398 million to $117 million. Similar declines were seen across other maturity dates.

From 2005 to 2006 there was a decline in “other non-current financial assets.” Note 14 of the 20-F explains that the company used up some deferred tax assets during the year. As discussed in Chapter 3, deferred tax assets represent differences between earnings reported to shareholders and earnings reported to the tax authorities. Assets arise when book earnings are lower than tax earnings, frequently because of tax loss carry-forwards. As the company earns money in future periods it can use these carry-forwards to offset current period taxes. By contrast, deferred tax liabilities arise when the company’s reported book earnings are higher than reported tax earnings. This can be caused by use of accelerated depreciation for tax purposes, for example, and represents a tax payment that has been recognized in the income statement but not yet paid. Looking further down the balance sheet, we see that deferred tax liabilities grew in both years, though at a slower rate than either sales or total assets. As a result, they declined as a percentage of assets from 7.2% in 2004 to 6.8% in 2006. In aggregate, non-current assets declined from 62.0% of total assets in 2004 to 59.3% in 2006.

Turning to current assets, both inventories and accounts receivable grew faster than sales or assets in 2005, but declined in 2006. Over the entire two-year period inventories grew faster than total assets but slower than sales. Since sales are made directly from inventory and often result in accounts receivable, the comparison to sales indicates that working capital was efficiently managed in 2006.

Prepaid expenses and other current assets rose faster than assets and in line with sales for the entire period. Investors frequently devote special attention to the “other” category because changes there sometimes indicate earnings management since such assets arise when more earnings appear on the income statement than are collected in cash. Here the 20-F doesn’t help, as Note 16 provides a table breaking the category down further but the drivers of the change remain classified as “other.”
Cash and equivalents declined considerably. Half of the decline in 2006 was due to currency issues. Current financial assets were up sharply over the two years, which also contributed to the cash decline. According to the 20-F, “Certain financial instruments hedge against risks related to the equity of foreign subsidiaries whose functional currency is not the euro (mainly the U.S. dollar). They qualify as “net investment hedges”. Changes in fair value are recorded in shareholders’ equity. The fair value of these instruments is recorded under “Current financial assets” or “Other current financial liabilities”.” Given that the latter category declined considerably, favorable changes in the value of such hedges would seem to be a likely explanation for both shifts.

Liabilities

Total’s long-term liabilities grew just 7.1% in 2005 and declined in 2006. As a percentage of total assets they fell from 18.8% to 15.6%. The main driver of the overall decline was a reduced liability for employee benefits. Looking at Note 18 in the 20F, we find that the expected future obligation has been reduced by approximately €900 million between 2005 and 2006. Specifically, the reduction was due to actuarial gains and losses, which reduced the reported obligation by €1.15 billion but merely reflect actuarial estimates. In addition, currency translation adjustments reduced the expected future liability by €900 million. Investors might want to ignore these adjustments or make their own adjustments to reflect their arbitrary and possibly unsustainable nature. Without these two adjustments the liability would have increased rather than decreased. Non-current debt increased 25.6% cumulatively, which was faster than the growth in total assets but slower than the growth in sales.

Short-term borrowings increased substantially, particularly in 2006. This resulted from a larger portion of the non-current debt coming due in 2007.

Accounts payable ballooned in 2005 but were reduced in 2006 such that cumulative growth was in line with the growth in sales and assets. The large increase in 2005 could have been resulted from an unusually large amount of purchases late in the year. Other current liabilities grew at a slower rate than sales or assets in both periods.