Archive for the 'Common Size Analysis' Category

The 3-Stage DuPont Model

Return on equity is one of the most significant financial ratios. Not only does it describe how well management is making use of the funds it has been entrusted with, but it also sets the limits of sustainable growth. Analysts at DuPont created a system to analyze the components of ROE to better understand how the return is being generated.

The basic formula for ROE is net income divided by shareholders equity. This, in turn, can be recast into two components – the return on assets and the impact of leverage.

(Net income/Shareholders equity) = (Net income)/(Total Assets) X (Total assets)/(Shareholders equity).

ROA can also be expressed as a function of profit margin and asset turnover: (Net income)/(Total assets) = (Net income)/Sales X Sales/(Total assets) and thus ROE = (Net income)/Sales X Sales/(Total assets) X (Total assets)/(Shareholders equity).

Posted on 19th September 2007
Under: Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

How Lessors Report Operating Leases

When a lease is classified as an operating lease, the related assets and liabilities are kept off of the lessee’s balance sheet. Logically, this means that they remain on the lessor’s balance sheet. The lessor’s balance sheet will show the asset, and depreciation of the asset will be counted as an expense on the income statement and reduce the carrying value of the asset.

The lessor will record lease revenue as the lease payments are received.

Posted on 12th August 2007
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Adjusting Net Income for Currency Translation

Global Payments is a leading payment processing and consumer money transfer company. The risk factors section of their 10-K notes the following:

We are exposed to foreign currency risks because of our significant card processing operations in Canada, the Czech Republic, and those in the Asia-Pacific region, as well as our significant electronic money transfer operations in the U.S. and Europe.

We have significant operations in Canada which are denominated in Canadian dollars. In addition, we have significant operations in the Asia-Pacific region, the Czech Republic and Spain. We are subject to the risk that currency exchange rates between these regions and the United States will fluctuate, potentially resulting in a loss of some of our revenue and earnings when such amounts are exchanged into U.S. dollars.

We also have significant money transfer operations in the U.S. and Europe which subject us to foreign currency exchange risks as our customers deposit funds in the local currencies of the originating countries where our branches are located, and we typically deliver funds denominated in the home country currencies to each of our settlement locations.

Global Payments’ revenue and net income for the three years ending May 31, 2007 are summarized below.

Global Payments revenue and net income

However, turning to the statement of shareholder equity we see that there were significant other components of “total comprehensive income.”

Global Payments Comprehensive Income

The most significant adjustment is the foreign currency translation adjustment, which results from the net assets of foreign subsidiaries being translated into dollars at current exchange rates. Since the amount is positive in all periods, if the subsidiaries have positive net assets the amount reflects strengthening foreign currencies (a weaker dollar.) The adjustment does not flow through the income statement unless the gains or losses are realized. However, it does reflect the underlying economic position and investors may also want to adjust the statements for better comparison to firms that translate foreign operations using the temporal method.

All one needs to do is replace net income with total comprehensive income.

comprehensivemargin.jpg

Since the currency adjustments were positive in all three years, profit margin based on comprehensive income were higher in all three years. Had foreign currencies weakened against the dollar, margins would have been reduced. In addition, the profit margins were much more volatile when based on comprehensive income – rising 440 basis points in 2006 rather than 200, then falling by 290 basis points in 2007 rather than 30.

Furthermore, net income growth patterns are markedly different from the growth in comprehensive income. Net income grew at double digit rates in both 2006 and 2007. Comprehensive income, however, rose faster in 2006 and actually declined in 2007.

Posted on 10th August 2007
Under: Accounting, Adjusting Reported Financial Statements, Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis | No Comments »

Analyzing Debt Disclosures

The balance sheet typically includes all debt maturing in more than 12 months as a single line item. However, additional disclosures can be found throughout the firm’s financial reports. As an example, we examine the recently filed Gerber Scientific 10K.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s primary ongoing cash requirements, both in the short and long-term, will be to fund operating and capital expenditures, product development, acquisitions, expansion in China, pension plan funding and debt service. The primary sources of liquidity are internally generated cash flows from operations and available borrowings under the Company’s credit facility. These sources of liquidity are subject to all of the risks of the Company’s business and could be adversely affected by, among other factors, a decrease in demand for the Company’s products, charges that may be required because of changes in market conditions or other costs of doing business, delayed product introductions, or adverse changes to the Company’s availability of funds.

The Company believes that its cash on hand, cash flows from operations and borrowings expected to be available under the Company’s revolving credit facility will enable the Company to meet its ongoing cash requirements. As of April 30, 2007, the Company had $20.5 million available for borrowing under its revolving credit facility based on its borrowing base.

The following table shows information about the Company’s capitalization as of the dates indicated:


In thousands except ratio amounts

April 30,
2007

April 30,
2006

Cash and cash equivalents

$ 8,052

$ 14,145

Total debt

$ 33,376

$ 37,120

Net debt (total debt less cash and cash equivalents)

$ 25,324

$ 22,975

Shareholders’ equity

$144,481

$125,616

Total capital (net debt plus shareholders’ equity)

$169,805

$148,591

Net debt-to-total capital ratio

14.9%

15.5%

Cash Flows

The following table summarizes the Company’s consolidated cash flows by major activity.

 

For the Fiscal Years Ended April 30,

In thousands

2007

2006

2005

Cash flows provided by operating activities

$ 272

$24,646

$ 17,607

Cash flows used for investing activities

$(5,901)

$ (7,266)

$ (4,907)

Cash flows provided by (used for) financing activities

$ 117

$ (8,288)

$(13,373)

Cash Flows from Operating Activities – The $24.4 million decrease in cash flows from operations in fiscal 2007, as compared with fiscal 2006, was primarily driven by increased accounts receivable and inventory as well as lower accounts payable. The increase in accounts receivable was primarily related to elevated sales volume during the Company’s fourth quarter as compared with the same period in fiscal 2006. As revenue continues to increase, the Company expects that its accounts receivable balances will similarly increase.

Analysis: Considering that data, an investor would be pleased by the reduction in debt and improved solvency ratios, but concerned by the steep drop in cash from operations. It would be prudent to monitor the receivables, in particular, to confirm management’s explanation that the rise was due to timing (in which case they should decline relative to sales as the receivables are collected) or due to collection problems (in which case they would not.)

Long-term Debt - The Company’s primary source of debt is a $50.0 million asset-based revolving line of credit with a group of banking institutions, which matures in 2008. The Company also has a term loan that is payable in monthly installments through 2010 and $6.0 million of industrial development bonds that mature in 2014.

The Company was in compliance with its financial covenants as of April 30, 2007. The Company’s future compliance with its covenants will depend primarily on its success in growing the business and generating operating cash flows. Future compliance with the financial covenants may be adversely affected by various economic, financial and industry factors. Noncompliance with the covenants would constitute an event of default under the credit facility, allowing the lenders to accelerate repayment of any outstanding borrowings. In the event of potential failure by the Company to continue to be in compliance with any covenants, the Company would seek to negotiate amendments to the applicable covenants or obtain compliance waivers from its lenders.

The Company entered into a third amendment to its credit facility with Citizens Bank of Massachusetts and Sovereign Bank (the “Third Amendment”) during May 2007. The Third Amendment provides for a line of credit available in the form of term loans with a maximum aggregate amount of $10.0 million for permitted acquisitions. Principal amounts outstanding under the Third Amendment are payable in 30 equal installments. The Third Amendment provides that borrowings accrue interest, payable monthly, at an annual rate equal to the specified London Interbank Offer Rate (”LIBOR”) plus 175 basis points or the designated prime rate at the Company’s option. In addition, a fee of 25 basis points is incurred on the difference between $10.0 million and the average daily principal amount outstanding under the Third Amendment. Term loan borrowings may be made through October 31, 2008 so long as the aggregate principal amount of outstanding term loans does not exceed $10.0 million.

OFF-BALANCE SHEET ARRANGEMENTS

The Company’s participation in financing arrangements to assist customers in obtaining leases with third parties constitute the only off-balance sheet arrangements as defined in Item 303(a)(4) of the SEC’s Regulation S-K. The Company has agreements with major financial services institutions to assist purchasers of its equipment. These leases typically have terms ranging from three to five years. As of April 30, 2007, the amount of lease receivables financed under these agreements between the external financial services institutions and the lessees was $16.8 million. The Company’s net exposure related to recourse provisions under these agreements was approximately $5.6 million.  The equipment sold generally collateralizes the lease receivables.  In the event of default by the lessee, the Company has liability to the financial services institution under recourse provisions once the institution repossesses the equipment from the lessee and returns it to the Company. The Company then can resell the equipment, the proceeds of which are expected to substantially cover a majority of the liability to the financial services institution. As of April 30, 2007 and 2006, the Company recorded undiscounted accruals for the expected losses under recourse provisions of $0.4 million and $0.6 million, respectively.

CONTRACTUAL CASH OBLIGATIONS AND COMMITMENTS

As of April 30, 2007, the Company had the following contractual cash obligations and commercial commitments (including restructuring related commitments):

 

Payments Due by Period


In thousands


Total

Less Than
1 Year


1-3 Years


3-5 Years

More than
5 Years

Long-term debt obligations

$  31,836

$     233

$25,467

$     136

$  6,000

Lease obligations

65,075

9,047

14,678

12,655

28,695

Inventory and other purchase obligations

13,371

11,102

2,269

— 

— 

Qualified and non-qualified pension funding

4,388

4,388

— 

— 

— 

    Total

$114,670

$24,770

$42,414

$12,791

$34,695

Analysis: Investors should watch for the credit line expiration date and any signs that it might not be renewed (it most likely will be.) If not there could be difficulties repaying it, particularly if the cash from operations remains depressed.  The company also has significant other contractual financial commitments due during that time.

Note 8.  Borrowings

The Company’s outstanding debt is comprised of the following:

April 30,

In thousands

Effective rate(s)

2007 

2006 

Short-term lines of credit

5.10 – 6.75%

$  1,540 

$       51 

Revolvers

7.07%

25,000 

30,000 

Term loans

7.36 – 8.25%

836 

1,069 

Industrial development bonds

3.89%

6,000 

6,000 

33,376 

37,120 

   Less portion due within one year

(1,773)

(284)

      Total long-term debt

$31,603 

$36,836 

All of the Company’s outstanding debt was at variable interest rates as of April 30, 2007. As the underlying interest rates are believed to represent market rates, the carrying amounts are considered to approximate fair value.

Credit Facility - The Company has a credit facility (the “Credit Facility”) with Citizens Bank of Massachusetts, the Export-Import Bank of the United States (”Ex-Im”) and Sovereign Bank. The Credit Facility consists of a $50.0 million asset-based revolving line of credit (the “Revolver”) that includes a $13.0 million working capital loan guarantee from Ex-Im. The Credit Facility also includes a $1.2 million term loan (the “Term Loan”) and a $6.5 million standby letter of credit. The Revolver matures on October 31, 2008. The Term Loan requires 60 equal monthly principal payments that began in December 2005 and matures in November 2010. Weighted average interest rates of the Company’s primary credit facility, inclusive of deferred debt issue costs amortized, were 9.5 percent in the fiscal year ended April 30, 2007, 11.0 percent in the fiscal year ended April 30, 2006 and 13.5 percent in the fiscal year ended April 30, 2005.

The Credit Facility obligations are collateralized by selected assets of the Company in the United States and its subsidiaries in the United Kingdom and Canada, including inventory, accounts receivable, and real estate and leasehold improvements. The Credit Facility obligations are also collateralized by the capital stock of certain subsidiaries of the Company.

Under the Revolver, the Company can terminate its commitment at any time, subject to a prepayment fee. If the Company were to terminate its commitment by October 31, 2007, the fee would be 2.0 percent of the outstanding balance, and if it were to terminate its commitment between November 1, 2007 and October 31, 2008, the fee would be 1.0 percent of the outstanding balance. The Company may permanently reduce the Revolver commitment by up to $10.0 million without any prepayment fee.

Revolver borrowings are subject to a borrowing base formula based upon eligible accounts receivable and eligible inventory. The Company must maintain a minimum availability of $1.0 million. Interest on obligations under the Revolver is charged, at the option of the Company, at the London Interbank Offered Rate (”LIBOR”) plus 1.75 percent, or at the lender’s prime rate. As of April 30, 2007, the Company had $20.5 million available for borrowing on the Revolver based on its borrowing base.

The Company is required to pay an annual commitment fee on a monthly basis of 0.25 percent of the daily difference between the total commitment amount of the Revolver and the aggregate outstanding principal amount of the loans under the Revolver.

Interest on obligations under the Term Loan is charged, at the option of the Company, at LIBOR plus 2.0 percent, or at the lender’s prime rate.

The Company is required to maintain certain financial covenants, including leverage and debt service coverage ratios. The agreement also includes limitations on additional indebtedness and liens, investments, legal entity restructurings, changes in control and restrictions on dividend payments. The Company was in compliance with all of the covenants under its financing arrangements as of April 30, 2007.

In May 2007, the Company amended its Credit Facility to include term loans for acquisitions. See Note 19.

Industrial Development Bonds - The Company has outstanding $6.0 million of Variable Rate Demand Industrial Development Bonds (”Industrial Development Bonds”). The interest rate is adjusted to market rates on a weekly basis. During the fiscal years ended April 30, 2007 and 2006, the weighted average interest rate was 3.6 percent and 2.7 percent, respectively. The Industrial Development Bonds are collateralized by certain property, plant and equipment and mature in 2014.

The demand feature of the Industrial Development Bonds is supported by a letter of credit from a major United States commercial bank. The letter of credit, which expires in September 2007, automatically renews on an annual basis through an evergreen clause and carries a fee of 1.75 percent of the face amount. Advances under the letter of credit become a note payable on demand at the bank’s prime interest rate. The bank providing the letter of credit has a mortgage and security interest in certain property. There were no outstanding amounts under this letter of credit as of April 30, 2007 or 2006.

Short-term Lines of Credit - The Company had short-term bank lines of credit with several international banks of approximately $4.8 million as of April 30, 2007.

Analysis:  This final section did not present any additional issues. Overall, Gerber Scientific has been reducing its debt load dramatically and will likely extend its credit facilities before they expire. Investors will want to closely monitor cash from operations, and particularly accounts receivable, to either confirm management’s evaluation or for signs that something less benign is the cause.

Posted on 16th July 2007
Under: Accounting, Adjusting Reported Financial Statements, Common Size Analysis, Financial Statement Analysis, Fixed income investments, Fundamental Analysis, Investing in Stocks, Investing in bonds, Security Selection | No Comments »

How Lessors Report Capital Leases Classified as Sales-Type Leases

Capital leases are treated by the lessee as though the asset was purchased and financed by the seller. For the lessor, however, the accounting treatment depends on whether the lease is classified as direct financing or as a sales-type lease.

If the present value of future lease payments is greater than the asset’s cost the lease is treated as a sale of the asset. The asset value is recorded as revenue at lease inception, and the asset cost is recorded as cost of goods sold. The lessor will also report interest income on the lease payments as received.

As with a direct-financing type lease, the value of the asset is replaced by a lease receivable of equal value on the balance sheet.

Posted on 13th July 2007
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Earnings Measures and Stock Return Momentum

One explanation for stock price momentum is that investors react slowly to changing circumstances. In the May/June 2007 Financial Analysts Journal Ilya Figelman studies the interaction between earnings measures and past stock returns.

Large-cap companies with high ROE but poor recent stock returns significantly underperform the market and companies with poor stock returns but low ROE. Figelman suggests that the poor recent returns for such companies results from some investors recognizing that profitability has peaked for such firms, while the continued underperformance suggests that it has not been efficiently priced by all investors.

Companies with poor past returns and poor earnings quality (high accruals) significantly underperform both the market and those companies with poor past stock returns and high earnings quality. Therefore, investors also appear to react slowly to earnings manipulation.

Posted on 7th July 2007
Under: Accounting, Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Investment Returns, Ratio Analysis, Security Selection, Valuation | No Comments »

Comparative Ratio Analysis for Gerdau SA and Nucor

This section presents ratio analysis of Brazilian steelmaker Gerdau SA and U.S. steel producer Nucor. The reported numbers of these firms cannot be compared directly due to differences in size and currencies. Therefore, it is important to create ratios for each. Investors should also consider differences in accounting standards internationally when interpreting the ratios. Further, a time series analysis of each firm ratios calculated for three to five years in order to identify trends. Since many ratios require average balance sheet data, six years of data are required to compute five years of ratios. Since financial statements only contain data for two years of the balance sheet, it is necessary to either collect prior annual reports or use a data service such as Bloomberg, Baseline or Compustat. The tables below provide summary financial data from Zacks Research Wizard and the company financial statements for Gerdau and Nucor, respectively. Commercial databases almost always aggregate financial statement data into common categories. For example two or three income statement line items may be aggregated into one expense category. This can improve comparability between firms but can also result in a loss of information. The analyst must consider this when interpreting ratios.

gerdaufinancialinfo.jpg

nucorfinancialinfo.jpg

In the following sections we examine selected ratios from the activity, liquidity, solvency and profitability categories to assess the relative performance and financial position of Gerdau and Nucor.

Activity Ratios

Recall that the activity ratios provide indicators of efficient operations. The inventory turnover ratios for Motorola (MOT) and Nokia (NOK) for 2001, using the average inventory, are as the follows:

inventoryturnover.jpg

Computed directly from this ratio is the measure of days in inventory:

dsi.jpg

It appears that Nucor is much more efficient at managing inventory. In 2006, Nucor’s inventory on hand averaged only 33.7 days versus 84.1 for Gerdau. Nucor also seems to be improving its days inventory (though lumpily) over the five-year period, while Gerdau’s has remained fairly steady. In 2006 Gerdau wrote off some inventory, causing the turnover ratios to appear better than they otherwise would have. Nucor accounts for inventory using the last-in, first-out (LIFO) method. In a period of generally rising prices this tends to inflate COGS (higher-priced recent purchases are recorded as the cost) and reduce inventory (which consists of “older,” lower-priced product.) Both aspects of LIFO accounting tend to increase turnover and reduce days inventory. Therefore, further analysis would be needed to determine whether Nucor’s ratios reflect greater efficiency or are simply accounting artifacts.

Accounts receivable turnover and days receivable indicate how these firms manage the collection of credit sales. A weakness in these two ratios as computed using financial statement data is that companies typically do not disclose credit sales separately from cash sales. Since neither Gerdau nor Nucor indicate credit sales separately, the turnover calculation is presented using total sales revenues, equivalent to assuming that all sales are made on credit .

Accounts receivable turnover:

accountsreceivableturnover.jpg

Days sales outstanding:

dayssalesoutstanding.jpg

Once again, Nucor appears to be doing a better job than Gerdau. Nucor requires on average 25.6 days to collect receivables while Gerdau is taking 31.8 days. Both companies have been improving their collections over the last five years.

To examine the overall efficiency of the two firms we can consider the total asset turnover ratio:

assetturnover.jpg

Gerdau is generating $1.00 of revenues for every $1.00 invested in assets. Gerdau’s ratio was rather stable over the last five years. Nucor’s ratio, on the other hand, is much higher and improved dramatically during the five year period. Specifically, there was a large increase in efficiency reported in 2004. According to the MD&A section of the 2004 annual report, “Net sales for 2004 increased 82% to $11.38 billion, compared with $6.27 billion in 2003. The average sales price per ton increased 66% from $359 in 2003 to $595 in 2004, while total shipments to outside customers increased 9%.” Given that steel is a commodity, it is curious that Gerdau did not see a similar efficiency boost. It is possible that steel tariffs imposed by the U.S. in March 2002 were having an ongoing effect. A November 10, 2003 article in USA Today notes that Nucor was a strong supporter of the tariff, suggesting it did indeed benefit:

Steel producers and unions are demanding that Bush resist the WTO. “The steel industry is a test case for problems facing all sectors of U.S. manufacturing,” said Daniel DiMicco, CEO of Charlotte-based Nucor (NUE), the USA’s largest steel producer. “All of America is watching.”

Liquidity ratios

Examination of the short-term liquidity of each company is presented in the current ratios and the quick ratios for each company.

Current ratio:

currentratio.jpg

Quick Ratio:

quickratio.jpg

Both companies have generally been increasing their liquidity over the last several years, though Gerdau’s deteriorated somewhat in 2006. Nucor has consistently been more financially liquid than its peer.

Solvency Ratios

To examine the relative solvency of Gerdau and Nucor we can look at the proportion of liabilities on the balance sheet.

Debt-to-assets ratio (using total liabilities):

debttoassets1.jpg

Debt to capital:

debttocapital.jpg

Both companies have been consistently reducing leverage. Care must be taken in interpreting solvency ratios. On one hand a high level of leverage indicates a low level of solvency; however, as pointed out earlier, leverage can be beneficial if the company borrows at a rate lower than it can earn on the proceeds in its business. Given that interest rates were low and declining during the 2002-2006 period, the reduction in leverage is somewhat curious.

Profitability Ratios

Here we examine the ability of Gerdau and Nucor to generate profits based upon the level of assets and equity invested in the companies.

Return on assets:

returnonassets.jpg

Return on equity:

returnonequity.jpg

Return on assets measures the return generated based upon total assets invested in the firm. Both companies began with very low returns on capital and ended the period with very high returns. Such wide fluctuations are common in cyclical industries such as steel.

To further examine the trend in ROE we can look at a decomposition of ROE:

gerdaudupont.jpg

From 2002 to 2006, the increase in Gerdau’s ROE was primarily due to an improvement in operating margin and lower tax rates. This was offset by a lower leverage.

nucordupont.jpg

In the case of Nucor, operating margins were by far the most significant ROE driver.

Update: This post was featured in the Carnival of Investing.

Posted on 4th June 2007
Under: Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Common Size Comparison of Total SA and Exxon Mobil

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
xomtotcrosssectionalcommonsizeincomestatement.jpg

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
industryfinancialdata.jpg

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.

Posted on 7th May 2007
Under: Accounting, Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Common Size Analysis of Exxon Mobil

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
exxonhorizontalcommonsizeincomestatement.jpg

Exhibit 2: Vertical Common Size Income Statement
exxonverticalcommonsizeincomestatement.jpg

Exhibit 3: Horizontal Common Size Balance Sheet
exxonhorizontalcommonsizebalancesheet.jpg

Exhibit 4: Vertical Common Size Balance Sheet
exxonverticalcommonsizebalancesheet.jpg

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.

Posted on 7th May 2007
Under: Accounting, Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Common Size Analysis of Total SA

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
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Exhibit 2: Vertical Common Size Income Statement
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Exhibit 3: Horizontal Common Size Balance Sheet

totalhorizontalcommonsizebalancesheet.jpg

Exhibit 4: Vertical Common Size Balance Sheet

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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.

Posted on 6th May 2007
Under: Accounting, Adjusting Reported Financial Statements, Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | 1 Comment »