Tuesday, December 29, 2009

Health Insurers and the Medical Loss Ratio

As Washington continues to micro-manage various industries via royal decree, it is becoming increasingly evident that Congress is afflicted by some combination of the following conditions:
  1. Ignorance of industry specific business models
  2. An inability to read financial statements
  3. Willful disregard of #'s 1 and 2
  4. Delusions of grandeur
Now, I will readily admit that the near collapse of the financial system is evidence in and of itself that the pre-crisis regulatory framework was flawed. However, the solution to ineffective regulation is not the passing of more ineffective regulation. In other words, Congress seems to assume that capitalism's regulatory guard rails simply weren't strong enough, as opposed to questioning whether those rails were even in the proper location.

The latest Congressional foray into the ineffective regulation of business is contained within H.R. 3962 (the Health Care bill). Apparently, the likes of Harry Reid and Maxine Waters have secretly been working towards a masters degree in actuarial statistics, and have subsequently determined that the health insurance industry can make coverage more affordable by throwing all actuarial assumptions out the window. This strange brand of ill-informed meddling has culminated in Section 102 of H.R. 3962, in the form of a mandate that health insurer's medical loss ratio never dip below 85%. The medical loss ratio is calculated as medical benefits paid divided by premiums received. Now, all questions regarding the ability of Congress to properly determine a reasonable medical loss ratio aside, I'll turn to an analysis of where this ratio has trended over time. Below is a chart comparing the medical loss ratio's of United HealthCare (UNH), Aetna (AET), Wellpoint (WLP), Humana (HUM) and Coventry Health Care (CVH). Data is based on the 9 most recently reported quarterly results for the above mentioned firms:

The evidence above would suggest that the health insurance industry's major players are already operating at a medical loss ratio of between 80-85%. So why make a point of regulating this metric? I certainly don't purport to know the absolute truth on this one, but one could theorize that Congress intends to start at 85%, and slowly creep up into the 90's. Nevertheless, we can assume that these firms will need to take steps towards putting themselves comfortably within the 85% medical loss ratio mandate. The most likely compliance scenario will involve management's assessment of operating expenses. A little "trimming the fat" analysis if you will. To get an idea of where operating expenses stand relative to premiums at these large firms, I've prepared the analysis below.

As you can see above, medical costs and operating expenses combined have come close to - or in most cases exceeded - premiums received by the major health insurance companies. Therefore, health insurance firms are not able to turn a profit from premium revenue alone. Profitability, it seems, is achieved by two other sources of revenue: fees and investment income. Because investment income is unreliable in many circumstances, and the premiums charged to individuals will henceforth be regulated in arbitrary fashion, I can only see two ways that health insurers will respond:
  1. Reduce operating expense via layoffs and off-shoring where possible
  2. Increasing fees that Congress didn't remember to regulate
If I could make a recommendation to the industry, it would be to arbitrarily "invent" new fees. Maybe introduce another stage to the application process that would require payment of additional fees. To introduce a little bit of irony to the situation, the industry could pretend that it now faces burdensome ratio compliance costs, and must assess a few cents worth of compliance fee upon every claim. Remember: Focus on the Fees.

*no positions
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Wednesday, December 23, 2009

3COM Corporation: Poised to Profitably Emerge From Downturn

Although some companies in the technology sector - especially those firms that benefit from semiconductor demand - appear to be pulling out of the recession, 3COM Corp's (COMS) fiscal second quarter results show that even tech is experiencing a rocky and uneven recovery. Although net income for the period rose 55% from a year ago to $20M , today's report indicates that extraordinary items played an over sized role in the bottom line growth. 3COM, a firm that recently agreed to be acquired by Hewlett-Packard (HPQ), might appear to be suffering from performance declines:

 What I'd point out though, is that from 2004 to the beginning of the recession in December 2007, 3COM fairly consistently operated in the red. Sales appear to have reached a plateau mid-2006. However, one could argue that 3COM is in the midst of a turnaround that has occurred during and despite the global recession. Evidence exists that 3COM has significantly reduced its cost structure and improved efficiency. For example, gross profit margins have consistently improved since 2004:

Furthermore, the company appears to have become substantially more liquid - as measured by a ratio of cash to current liabilities - since the onset of the recession:

It remains to be seen just how HP will choose to integrate 3COM's operations into the existing organization; however, it appears that 3COM is well positioned for strong earnings growth in the coming quarters. With the resources of HP behind it, I look for the Company to successfully secure new sources of revenue, and to continue to streamline operations.

*no positions in any securities mentioned in this article
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Monday, December 21, 2009

XTO Energy: Liquidity and Solvency Analysis

Anyone who has been even remotely cognizant of financial market events over the past week should be aware that Exxon (XOM) has agreed to purchase XTO Energy (XTO) in an all stock deal worth $31B (or $41B, depending upon whether you choose to categorize debt assumption as a direct cost to Exxon). At first glance, the deal looks like a pure-play home run bet on the natural gas industry. After all, XTO's revenue has risen from less than $400M in 1999, to over $8B over the trailing twelve month period. Net Income has risen from $46M to $2B over the same time period. 

The question though, is whether XTO has managed to achieve this level of growth with a debt level that is manageable in the long term. I'll begin an attempt to answer this question by looking at XTO's debt maturity profile, as stated in its most recent 10-Q. All figures are in $MM:
 The schedule above lets us know that XTO has several billion dollars worth of debt maturing in the next 6 years; however, it may be more instructive to observe just how this debt has affected the firm's balance sheet. To do so, I prepared a 10 year look at XTO's debt to equity ratio:

The trend displayed by the chart above is encouraging; XTO's debt-to-equity ratio has declined throughout the past decade, and the company is now financed by roughly a 1 to 1 mixture of debt and equity. Yet another way of examining XTO's use of leverage is to take a look at its Times Interest Earned (TIE) ratio, which measures EBIT as a multiple of interest expense:
In 2006, XTO's TIE ratio peaked at just over 14X, meaning that the company reported earnings before interest and taxes that could have covered its annual interest expense 14 times. That multiple has since decreased to ~6X, as interest has comprised an ever larger share of XTO's EBIT. A possible explanation for this trend lies in TIE's numerator: EBIT. A rapidly growing company like XTO will have large amounts of depletion expense that will adversely affect EBIT, but not cash flow. To see whether this idea holds water, I'll look at operating cash flow as a multiple of interest expense:

Once again, we see this measure trending downwards. Obviously, 3 data points doesn't create an irreversible trend. However, its worth noting from a standpoint of how XTO's financial performance is likely to affect Exxon in the coming years. Of course, Exxon may be able to refinance XTO's debt at a far lower weighted average cost of capital.

Next, I think that XTO's liquidity should be examined using the current and quick ratio's:
Although you'd generally like to see both of these ratios at a level above 1, its worth noting that over the past decade, XTO's current and quick ratios have stayed within a relatively stable band (1.4-0.8). If you look at XTO's balance sheet, you'll notice a relatively large current asset labeled "Derivative Fair Value". According to XTO management, these derivatives are cash flow hedges used to protect the company from major price swings in the natural gas market. Ultimately, the hedges should be viewed as a prudent move that allows XTO to focus on the acquisition, exploitation etc of new properties, and ignore short term noise in the price of natural gas. 

In the end, XTO has to be considered a pretty remarkable growth story. There's clearly a strong performance oriented culture at the company that has allowed it to expand as rapidly as it has. My feeling is that post-merger, Exxon would do best by allowing the XTO culture to remain in place, at least in its core business operations. Exxon's true contribution to the marriage will be in the economies of scale created by the combined venture; perhaps XOM should handle the financing and hedging activities that XTO requires, and simply place some guard rails on the acquisition strategy. XTO is definitely structured for growth; the problem is, it needs to be managed properly, and with manageable levels of debt.
My last comment on the XOM-XTO merger is it represents the potential for a brilliant strategy. Exxon has poured too much money into share buybacks over the past decade, probably because hostile foreign government run oil companies have kept Exxon from exploiting their natural resources. The XTO purchase though, could provide a useful outlet for XOM's excess cash. If XTO's acquisitions can be funded through Exxon's internally generated cash flow, and the debt agglomeration trend can be halted, then Exxon could wind up being the largest owner of natural gas property in the country - and the US has plenty of natural gas.

*no positions

Sphere: Related Content

Saturday, December 12, 2009

Basic Principles of Revenue Recognition

Common sense would indicate to most people that the issue of revenue recognition shouldn't even be an issue; after all, a sale has either occurred or it hasn't right? The problem is, due to the multitude and variety of transactions that occur in the modern economy, it isn't always clear when a firm may record a given sales dollar. For instance, when several pieces of software are sold in a bundle, and a right of return exists for any of the individual bundled components, then at what point can the company reasonable assert that the sale is final? To look for guidance on this issue, we have to consult with dual sets of regulatory guidance, originating from the FASB and SEC.

The FASB guidelines for revenue recognition involve two primary criteria, both of which must be met in order for the sale to be legitimate and reportable as revenue:
  1. The revenue must be realized or realizable
  2. The revenue must be earned; that is, the company has performed it's duties under the terms of the sales agreement.
The general picture here is that the FASB has developed a relatively straightforward, common sense set of criteria for assessing when a sale...is a sale. The company must both have the cash - or be reasonably sure that it can collect the cash - and has actually delivered its product or service. The guidance doesn't stop there though; the SEC, via Staff Accounting Bulletin (SAB) 101, has issued four additional pieces of guidance in clarification of the principles of revenue recognition: 
  1. Persuasive evidence that a sales agreement/arrangement exists must be present. The SEC appears to believe that this principle is very important in relation to arrangements that customarily require a written sales agreement between the buyer and seller, specifically as it relates to the timing of product delivery and execution of a sales agreement. If product delivery and sales agreement execution fall in different fiscal periods, revenue can only be recognized in the later accounting period (during which both have been completed).
  2. Delivery has occurred or services have been rendered. The SEC seems to be interested in the passage of title and assumption of risks associated with the delivered product. A consignment store may have received delivery of a product, but it hasn't assumed title, or any of the risk associated with owning the product. As such, revenue can not be recognized until the consignment product has been paid for.
  3. The seller's price to the buyer is fixed or determinable. The SEC's primary focus with regards to this rule has to do with "side agreements" that may have attached themselves to the primary sales arrangement. Sometimes, the practical effect of these side agreements is to transform a sale into a demonstration period or otherwise incomplete sale. In such cases, the associated revenues may not be recognized. The SEC further explains that when the right of return is structured so that the dollar value of returnable product declines according to a fixed schedule over time, the associated revenue must be recognized according to that schedule.
  4. Collectibility is reasonably assured. This requirement is not explicitly addressed in SAB 101, however the general principles outlined in the bulletin can be applied towards its understanding. If the transaction is customary, historic data indicates a reasonable expectation of collectibility, and no external factors which might affect the transaction have significantly changed, then we can probably infer that the requirement has been satisfied. There are some obvious factors that could hinder the assurance of collectibility, such as bankruptcy proceedings or major litigation.
Because the SEC has issued these guidelines, they must be followed in addition to the FASB/GAAP requirements. As business practices evolve, its likely that the issue of revenue recognition will continue to be clarified and revised accordingly. Nevertheless, investors should be aware that not all revenue is created equally, and is subject to restatement, especially during times of economic turmoil. Sphere: Related Content

Sunday, December 6, 2009

Financial Statement Effects of Intercorporate Investments

For a wide variety of reasons, one company will often make an equity investment in another company. We could be simply talking about the parking of excess capital, or there could be strategic reasons such as a bid to gain control of a supplier or other important segment of the supply chain. These investments show up on corporate financial statements in a variety of ways, depending largely upon the size of the investment, and the ability of the investor to control the investee.

In terms of a relatively insignificant, non-controlling (<20%) stake in another firms equity, the financial statement effect will depend largely upon whether management classifies the investment as Available-for-Sale (AFS), or Trading (T) . The difference here really comes down to the intent of management; if management considers the investment a "buy and hold" kind of scenario, and generally won't sell unless the price is right, the investment is AFS. Securities classified as Trading are acquired with the intent to sell in a short period of time. This difference is extremely important due to the way GAAP requires companies to report unrealized gains (losses) from investments in the income statement. Market value changes of AFS securities flow to the Accumulated Other Comprehensive Income (AOCI) section of stockholders equity. Current period income and retained earnings are not affected. Market value fluctuations in Trading securities on the other hand, are counted as investment income (or loss) on the income statement, as well as an increase (decrease) of retained earnings. Dividends received in conjunction with both classifications are treated as other income on the current period income statement. Lastly, in both instances, these marketable securities are reported on the balance sheet at fair market value (FMV).

When the equity investment is such that the investor is able to exert significant control (between 20% and 50% stake) over the investee firm, the rules change just a bit.  Accountants refer to the financial statement treatment of these investments as the Equity Method. First of all, market value fluctuations affect neither the income statement or balance sheet. Dividends received are treated as a reduction in the investment basis. Additionally, the investor recognizes investment income - and concomitant increase in retained earnings - from its stake that is proportional to the stake held in the investee.For example:

On February 2nd, Company A purchases $2,000,000, or a 40% stake, in the equity securities of Company B. Let's say this corresponds to 400,000 of Company B's 1,000,000 outstanding shares. On March 31st, Company B pays a $1/share dividend to all common shareholders. On December 31st, Company B reports $5,000,000 of net income. The accounting for these events, from Company A's perspective, is as follows:

Investment in Company B                      $2,000,000
              Cash                                                                           $2,000,000

Cash                                                         $400,000
               Investment in Company B                                 $400,000

Investment in Company B                         $2,000,000
               Investment Income                                             $2,000,000

At the end of the year, Company A will report it's investment in Company on its balance sheet at $3,600,000 ($2,000,000 - $400,000 + $2,000,000)

Given that investments in marketable securities comprise a significant portion of most firm's balance sheets, and can have a significant impact on stockholders equity and retained earnings, its important to monitor them. You should read up on the footnotes associated with these investments, and monitor the way management changes its AFS or T classifications over time. Also, be wary of the income related to unrealized gains on trading securities; financial market volatility can significantly impact these numbers between each reporting period. Sphere: Related Content

Wednesday, December 2, 2009

Will Earnings Eventually Support the Stock Market Rally?

Since closing at 676.53 on March 9th, 2009, the S&P has rallied some 63.7% to its current level of ~1108. Some market pundits attribute this meteoric rise to the Fed's unprecedented market intervention(s), which has created massive amounts of liquidity. Other skeptics call it another round of irrational exuberance; a short-lived bull market within a cyclical (or secular?) bear market. Still others say this rally is for real, that the equity markets typically look 6-9 months into the future, and that only the fools are still on the sidelines.

Granted, stocks have become relatively non-cheap, at least in terms of the multiples of reported earnings which they're trading. The real question behind this debate however, is "Whether corporate earnings will catch up to, and eventually support, the current stock market's trading range". Before I attempt to answer that question, I'd like to first frame the argument in terms of the psychological basis from which each side is attempting to further its argument.

The first point I need to make is that this economy IS recovering. However, the rising tide is not lifting all boats. I wouldn't want to be D.R Horton right now, but I wouldn't mind being Intel. Most of all, I would not want to be a small business; they have effectively been denied access to nearly all sources of credit, they aren't large enough to throw their weight around with suppliers, and oh yea, health insurance premiums are about to go up. Given this set of facts, its easy to see why nearly every small business owner in this country is quite pessimistic at this moment. Furthermore, small businesses don't use - or even understand for that matter - GAAP accounting. Their focus is on cash in v. cash out, i.e small business income statements are usually just two lines: sales and costs. Therefore, profit boosting concepts like LIFO liquidations and unrealized gains on trading securities are somewhat foreign, effectively obfuscating their perception of recent corporate profit increases. Psychologically, they are mad; the government bailed out big business and didn't throw them a crumb. Watching the stock market rise on a daily basis simply angers many small business owners.

On the flip side, big business reacted quickly and viciously to the Great Recession; they laid people off in the thousands and shuttered profitable plants/mills just to achieve higher asset utilization rates. The result was the temporary occurrence of costly restructuring charges. The largest of these are probably behind us though, meaning that bottom lines will be juiced in the coming quarters. The next advantage available to big business is global scale; there may be little US based sales growth in the months ahead, but developing markets continue to grow. Given this set of facts, many large corporations that operate in a handful of industries have reason to be cautiously optimistic.

Don't think for a minute that the current stock market bulls v bears argument isn't completely driven by this psychological and economic dichotomy. Bulls typically cite the earnings cycle, proposing that the following sequence of events will lead to an earnings - and an economic - rebound:
  1. Corporation's cut costs
  2. Productivity Increases
  3. Profits begin to increase
  4. Inventories are replenished
  5. Capital Expenditures are made
  6. Hiring resumes
  7. Consumption rebounds
In contrast, the bears are either in denial that corporate profits will increase, or (the more sophisticated ones) would say that once inventories are replenished, firms will hold onto cash and the capital expenditures will never materialize. From my perspective, the resumption of hiring looks to be the major impediment to a recovery. When hiring does resume, it will be at the largest, healthiest multi-national corporations. Furthermore, those hired first will the most educated and most able to add value to the firm. Housing and construction may never return to pre-recession employment (absolute) numbers, and manufacturing jobs will continue to be lost to a combination of technology and China. This doesn't bode well for the consumer as a whole, whom I expect to behave anemically for another 3-7 years.

That all being said, the answer to the title to of this post is something to the effect of "some of them". It's up to individual investors to figure out which firms have the global scale and management capacity to go out and find (take?) new sources of revenue, whether it be via acquisitions or expansion into new markets. Beware of dead business models.  Sphere: Related Content

Tuesday, December 1, 2009

Components of RNOA: Margin and Turnover

Previously, I touched on the importance of Return on Net Operating Assets (RNOA), specifically with respect to my view that it's foolish to examine a firm's ROE without an idea as to the relative contributions of operating and nonoperating returns. I'd like to examine RNOA a bit further, and place some emphasis on it's dual components of margin and turnover. Just to refresh, the original formula for Operating Return is:

RNOA = Net Operating Profit After Taxes / Average Net Operating Assets

In order to illustrate the margin and turnover components, I'll create a new, equivalent equation:

RNOA = (Net Operating Profit Margin / Sales)  X (Sales / Net Operating Asset Turnover)


RNOA = Net Operating Profit Margin (NOPM)  X  Net Operating Asset Turnover (NOAT)

Truthfully, I don't blame you if this still doesn't make a whole lot of sense. So, let's look at this using some real numbers from the largest employer in the world/retail titan..WalMart (WMT).

Above I've included every part of an equation necessary to understand RNOA's components of NOPM and NOAT. Keep in mind that WalMart's RNOA was originally calculated using NOPAT/RNOA, or $15,637/$109,987 to yield 14.22%. To calculate Net Operating Profit Margin (NOPM) I took NOPAT of $15,637 and divided it by 2009 revenue of $401,244. The resulting 3.9% seems rather feeble for such a monster like WalMart; it means that for every dollar of sales revenue, WalMart is only earning 3.9 cents of after tax operating profit. Remember though that the margin is somewhat useless in the absence of turnover figures. To calculate Net Operating Asset Turnover (NOAT), I took 2009 revenue of $401,244 (millions by the way, crazy right) and divided it by Average Net Operating Assets of $109,987. The resulting NOAT is 3.65. Now multiply 3.9 (NOPM) by 3.65 (NOAT); the result should look familiar - 14.2%. Walmart's figures highlight an important concerning the relationship between margins and asset turnover. A high margin firm won't necessarily earn healthy returns for shareholders; it all depends on the turnover they are able to achieve given that level of margin.

I included WalMart's 20.63% ROE just to illustrate that the company is earning a very healthy operating return component of 69% (14.22RNOA / 20.63ROE). Interestingly, the company doesn't highlight this ratio in its financial presentations. Rather, they use a modified return on investment (ROI) formula that takes operating income as its starting point, and adds back in some non-cash adjustments for depreciation and amortization to arrive at the numerator. In the denominator, WalMart creates an average operating assets figure, similar to NOA except that operating liabilities are not netted out of the equation. Although investors should keep an eye on these metrics that are recommended by management, don't forget that they are non-GAAP and are probably suggested for a reason.

*no positions
Sphere: Related Content

Monday, November 30, 2009

Beyond ROE: Return on Net Operating Assets (RNOA)

Many investors rely on Return-on-Equity (ROE) to gauge a firm's ability to generate profit from each dollar of equity; a somewhat fundamental determination when assessing the attractiveness of owning a piece of that equity. The problem is, ROE is calculated as net income divided by average stockholders equity, meaning that you have no idea the extent to which leverage played a role in the returns generated for shareholders. In the aftermath of the credit bubble, it should be apparent that not all returns are created equally. For instance, had you been an investor in Merrill Lynch around say, 2006, you may have been lulled into complacency by the firms ridiculous returns-on-equity; oblivious unfortunately to the fact that MER's performance was merely the result of massive amounts of leverage. Fortunately, through calculation of a firm's Return on Net Operating Assets (RNOA), we can isolate the portion of ROE attributable to the operations of the business (the portion that matters).

The general concept behind RNOA is that ROE= Operating Return + Nonoperating Return. As I've said, investors should focus on the operating portion of return, which is calculated as follows:
Operating Return (RNOA) = Net Operating Profit After Taxes (NOPAT) / Average Net Operating Assets (NOA)

The calculation of RNOA requires you be able to differentiate between the operating, and nonoperating items on both the balance sheet and income statement. This should be somewhat easier to do with the income statement, just because although GAAP doesn't require it, most companies will break out their operating results on their financial statements. Management tends to be judged based on the firms operating results, so this shouldn't be surprising. I'll refer to Dell's most recent full year results to illustrate the RNOA calculation.

Step 1: Calculate NOPAT
For FY '09, Dell logged pretax income of $3324M, and income tax expense of $846M, resulting in an effective tax rate of 25.45% (846/3324). Dell posted operating income of $3190M; therefore, applying the 25.45% tax rate, we can state that Dell's NOPAT is $2378M ($3190 X (1-.2545) ). 

Step 2: Calculate average net operating assets (NOA)
First of all, Net Operating Assets =  Operating Assets - Operating Liabilities. The components of each category are listed below.
Operating Assets
Cash/Cash Equivalents
Accounts Receivable
Prepaid expenses
Other Current Assets
Property, plant and equipment (net)
Capitalized lease assets
Natural Resources
Equity method investments (unless unrelated to the core business)
Goodwill and other intangible assets
Deferred income tax assets (current and long term portions)

Other long term assets

Operating Liabilities
Accounts Payable
Accrued Liabilities
Deferred income tax liabilities (current and long term portions)

Pension and other post-employment obligations

Dell's 2009 and 2008 NOA are $6488M and $7501M, respectively. The average of these two numbers is $6995M. Therefore:

= $2378 / $6995

This compares with a 2009 ROE of:
ROE= Net Income / Avg Stockholders Equity
= $2478M / $4003M

A conclusion which can be drawn from these results is that only 55% of Dell's ROE (34/61.9) is attributable to operations. I'd generally like to see a higher ratio of operating to nonoperating return; however, Dell's 34% RNOA is substantially higher than the 10% average RNOA for publicly traded companies. A further examination into Dell reveals that it's debt-to-equity ratio (total liabilities divided by total stockholders equity) is 5.2, meaning that for every dollar of equity, dell has $5.20 worth of debt. This high debt to equity ratio partially explains the juiced ROE number, and should probably be monitored by investors.

*no positions
Sphere: Related Content

Friday, November 27, 2009

Vertical Analysis of Financial Statements: Coca-Cola v Pepsi

Due to the complexity of corporate financial statements, the prospect of deciphering meaningful insight can be a daunting task. Furthermore, the ratios deployed by professional analysts are numerous, effectively creating a thousand piece jigsaw puzzle whose composition perpetually and frequently fluctuates. Luckily, for those of you who lack either the time or mental stamina to perform calculations such as the disaggregation of the components of return on net operating assets (RNOA), a relatively effective process exists known as Vertical Analysis. The premise of Vertical Analysis is to create common-size financial statements, where all balance sheet and income statement items are converted into percentage terms for purposes of comparison.Using vertical analysis, comparisons can be made between firms regardless of size. This approach is especially useful when determining the relative financial health of competing firms within the same industry. Financial metrics display a large degree of variability across industries; however, within a given industry, competitors should be fairly aligned in terms of funding sources (debt v equity), liquidity, asset turnovers etc. Below is a vertical analysis I prepared using the FY '08 balance sheets from Pepsico (PEP) and Coca-Cola (KO).
Vertical Analysis of Financial Statements - Pepsi v Coke

From here, it's fairly easy to scan through Coke and Pepsi's relative balance sheet percentages(page 2 of pdf) , making some fairly useful generalizations. The first thing I noticed from this comparison is that Pepsi and Coca-Cola have a nearly identical composition of current v long term assets (30/70). However, Cash/Cash Equivalents represents 11.7% of Coke's assets, but only 5.7% of Pepsi's. It appears that Pepsi makes up the difference in it's proportion of (net) receivables to assets (13% v 7.6%); this could just be a timing issue, but it could also mean that Pepsi has become more aggressive in terms of the conditions by which it will offer credit to customers. The next observation I'd make has to do with differences between the two company's capital structures. Pepsi's debt/equity split percentage is 66.2/33.8, whereas Coca-Cola's capital structure is comprised of 49.5% debt and 50.5% equity. Interestingly though, Pepsi's short term debt only represents 1% of the right side of the balance sheet, whereas Coca-Cola comes in at 16.1%. This could just be an indication that Coke relies more heavily on commercial paper to fund it's short term operations; it could also mean that Coke has a significant amount of long term debt coming due in the months ahead. Coca-Cola's 2008 10-K should contain footnote disclosures describing the nature of these short term obligations. In this sense, the vertical analysis above serves as an informative starting point from which to diagnose any potential issues the firm might have down the road. Additionally, vertical analysis can expedite the analysis process by narrowing down which footnotes you, as an investor, should be concerned with.

*no positions  Sphere: Related Content

Friday, November 20, 2009

Fed Flushes $1.7B Worth of Taxpayer Funds Down the Toilet

Last week, under the cover of darkness and in an extraordinary show of Government incompetence, the FDIC seized United Commercial Bank. The problem is that Mingsheng, a Chinese bank, had already approached the Fed about a potential acquisition of UCB. Mingsheng, which had already invested $129M into UCB, was presumably trying to salvage some portion of it's investment. Unfortunately, Mingsheng's application was destined to whither away on a bureaucrats desk, as various branches of the federal government bumbled about in an attempt to resolve the problems at UCB - oblivious it seems to the cost effective solution right before their eyes. They (Mingsheng) were not the only investors though; last year the Treasury injected $298M into UCB as part of the now infamous TARP program. Furthermore, the FDIC estimates that the UCB failure will cost it's Deposit Insurance Fund $1.4B. The DCF is theoretically funded through premia leveled on the banking industry; however, we all know that this cost gets passed onto consumers in the form of higher overdraft, ATM, inactivity etc. fees. Therefore, the Treasury/Fed/FDIC - acting in disorganized concert - managed to flush $1.7B worth of taxpayer money down the toilet.

This is truly an embarrassment. Sphere: Related Content

Wednesday, November 18, 2009

Diluted EPS and the Capital Structure

Although the financial media's reporting centers almost entirely on a corporation's reported basic earnings-per-share (EPS), most analysts have historically paid attention to a different line on the income statement: Diluted Earnings per Share. Diluted EPS takes into account the potential dilutive effect that would ensue if holders of the firms preferred stock and bonds were to convert their stake into common equity. This possibility theoretically exists whenever investors purchases securities that include a conversion option. Usually there is some sort of market based trigger point, but ultimately those details will be contained on the face of the preferred stock certificate, or in the bond covenants. For the sake of simplicity, let's say that Company X earned $1000 in a given quarter, and there are 1000 shares outstanding, resulting in quarterly Basic EPS of $1/share. However, let's assume that Company X has also financed itself via 500 shares of convertible preferred stock which give holders the right to convert each preferred share into 2 shares of common equity. Assuming that all preferred holders exercised that option, Company X would record 2000 outstanding shares of common stock, and would only have earned 50 cents/share for the same quarter. This hypothetical example is rather extreme for the purposes of making a point; below is a chart showing Basic v Diluted EPS during the most recently reported quarter for 7 large firms:
Corporations must disclose both basic and diluted EPS on the income statement, however the actual calculation is below for those who must know:

Diluted EPS = (Net Income - Preferred Dividends) / (Weighted Average # of Common Shares Outstanding + Additional Shares Due to Dilutive Securities)

Arithmetically, we can see that the dilutive effect increases the denominator, reducing the amount of net income available to each shareholder. In many firms with simple capital structures, the basic and diluted EPS numbers will be identical. However, firms that utilize more complex financing instruments generally have more potential for dilutive equity conversions.

Going forward, I would expect Diluted EPS to continue to gain significance, especially with regards to analysis of financial corporations. As banks struggle to refinance trillions of dollars worth of debt, the use of convertible options should become more popular for a couple of reasons. First, a conversion option represents value to the investor and additional capital for the borrower. Second, if the conversion option is tied to a regulatory trigger like TCE ratios, then the borrower is essentially selling an automatic equity boosting instrument for times of market distress. If things play out like I anticipate regarding convertible debt, the gap between basic and diluted EPS will grow further. Equity investors need to monitor these developments to insure that they are not diluted into oblivion.

*no positions
Sphere: Related Content

Friday, November 13, 2009

Contingent Convertible Bond Ruminations

The latest idea to revolve around the task of inoculating the global financial system involves a financial instrument known as the contingent convertible bond. Overall, I'm somewhat pleased that the discussions surrounding financial reform have begun to deviate from the bonus-recipient-witch hunt mentality which has dominated the Obama Administration's rhetoric to date. Furthermore, it's encouraging to see the private sector begin to formulate it's own prescriptions; opposed to of course government solutions which amount to nothing more than throwing (other people's) cash at the situation, appointing czars of every shape and form, and hoping the problem solves itself.

Contingent convertibles are a nifty bit of financial innovation (isn't that supposed to be synonymous with evil and destructive?) that takes regular convertible bonds and adds a twist. The process would play out something like this:
  1. Investors give cash to banks, and in return, they receive contingent convertible bonds.
  2. Investors receive regular coupon payments, just like with any other bond.
  3. If and only if the bank's capital ratio falls below a certain threshold determined by the bond contract, the instrument will convert into equity.
Part of the draw for contingent convertibles is that the conversion clause is not based upon observable market prices. In that sense, even the most concerted efforts by short-sellers can not trigger the conversion. Conceptually, assuming these instruments comprised a significant enough portion of global banks' capital structures, they would act as automatic stabilizers during periods of economic distress, bolstering banks' capital ratios without the need for TARP-like government interventions. As an aside, will widespread use of contingent convertibles be evidence of the Europeanization of financial markets? We all know how much the Europeans love their automatic stabilizers.

To briefly play devil's advocate, I could see the establishment of contingent convertibles causing a wholesale shift in the way bank stocks are valued. Capital ratios would be monitored very closely in order to develop a probability of equity conversion; this could cause bank stocks to prematurely fall in anticipation of a massive equity dilution. I could also see bank stocks' losing all of their appeal in terms of a dividend investment. That might not be an issue now, what with 1 cent dividends imposed by the Treasury; however, I have to assume that by say 2015, banks will once again be paying healthy dividends. The problem is from the banks standpoint, the debt to equity conversion will amount to the elimination of a contractual obligation to make semi-annual interest payments, and replace it with the extremely optional payment of a dividend. If I were investing in a bank's contingent convertibles from a current income perspective, I would prefer that the potential conversion be structured so that I received some class of preferential stock whereby a dividend comparable to the coupon rate was guaranteed. Nevertheless, the discussions surrounding contingent convertibles is a net positive in my book; we'll just have to wait and see if this new "movement" has the legs necessary to become a widespread reality.
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Thursday, November 12, 2009

Analyzing Leases On and Off the Balance Sheet

In the midst of the criticism that's been leveled towards financial innovation of all shapes and sizes, one form of financial instrument in particular has managed to travel under the radar: leases. Although leases have never been accused of wreaking financial destruction, they do serve as a convenient means of off-balance sheet financing.

The first thing to know about leases as they pertain to financial statements is that there are two main categories: Operating Leases and Capital Leases. The closer a lease is to an actual purchase agreement, the more likely it is that the lease should be classified as Capital. There are however four conditions which, if any are met, automatically render the agreement a Capital Lease. They are:
  1. The lease agreement contains a provision whereby, at the end of the lease term, title to the leased asset is transferred from the lessor to the lessee.
  2. The lease agreement provides the lessee an option to purchase the leased asset at bargain terms (like $1 for instance)
  3. The term of the lease agreement constitutes a period of time which is greater than or equal to 75% of the leased assets useful/economic life.
  4. The present value of all scheduled lease payments is greater than or equal to 90% of the fair market value of the leased asset.
At this point, you're probably questioning why it really matters whether accountants refer to the lease as Operating or Capital. Simply put, a Capital Lease must come onto the balance sheet via a debit to Leased Asset and a credit to Lease Liability. The amount recorded on the balance sheet is the present value of all future lease payments. Operating Leases on the other hand are not capitalized, and only appear to external stakeholders in the form of footnote disclosures in regulatory filings. The accounting for Operating Leases is relatively straightforward however; lease payments simply flow to the income statement and are recorded as Rent Expense. Capital Leases though, have interest and principle components that must be amortized over the lease term just like a debt instrument. Below is an amortization schedule for an asset of FMV $70,000 , a lease term of 6 years and $15,000 annual payments. Using the Internal Rate of Return (IRR) function on Excel, I'm able to discover that the lease contains an implied interest rate of 7.69%.
As I mentioned above, the leased asset must be depreciated over time. Below is the depreciation table for the same example.
The table above brings me to the next point: expenses under a Capital Lease are front-loaded, whereas an Operating Lease maintains consistency. In years 1-6 in the above example, the total expense for an Operating Lease would be $15,000/year. Keep in mind that my prior point isn't applicable to the cash flow statement; I'm only discussing income statement implications. From a cash flow standpoint, the interest portion of Capital Leases is classified as a Financing Activity, and the principal re-payment is considered an Operating Activity. Under Operating Leases, the entire rent expense is classified as an Operating Activity. In this sense, Capital Leases will result in higher cash flow from operations than a similar Operating Lease.

The final nuance that's important to grasp is that Operating Leases can distort certain leverage related financial ratios such as debt to equity and return on assets (ROA). The distorting effect can range from very minimal to materially drastic, especially in the case of businesses like airlines who lease the majority of their assets. Nevertheless, leases should be reason alone to spend some time examining the footnote disclosures found in your subject firm's financial statements.

*no positions
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Wednesday, November 11, 2009

Corporate Inventory Analysis and Costing Methods

For Home Depot (HD) and many other corporations, inventory represents one of the single largest items on the balance sheet. For 2008, inventory represented 25.9% of Home Depot's total assets. Furthermore, inventory turns over many times throughout the course of the year, feeding into the firm's income statement through cost of goods sold (COGS). In order to understand inventories, you first need to be aware of the three major inventory costing methods.

When the concept of inventory costing methods was first presented to me, I wasn't sure what exactly there was to talk about; if a company buys a widget for cost X, it would make sense that upon the sale of that widget, X dollars would flow to cost of goods sold. Furthermore, if you had to place a value on your inventory in it's entirety, it would make the most sense to simply report the sum of the cost of all items in inventory. Unfortunately, the accountant powers- that- be didn't design inventory costing in such a straightforward manner. As a corporation, you basically have three choices in terms of inventory costing: first-in-first-out (FIFO), last-in-first-out (LIFO), and average cost. In FIFO, the oldest price stored in inventory is assigned to cost of goods sold. With FIFO, the most recently recorded price is attached to the good and flows to COGS. Average cost, as the name implies, assigns the average cost of the inventory item. During inflationary times, the FIFO costing method is the most profit-advantageous because yesterday's cost is being booked as today's expense. The opposite would of course apply during times of falling prices. Because of the profit implications, the IRS requires corporations to remain consistent with their costing method. From what I've been told, the IRS will allow you to switch methods - but only once. Below is a quick example showing how different inventory costing methods can result in completely different COGS (and subsequently gross profit margins) - for the same transaction.
In this simplified example, I'm assuming that Company A is purchasing hammers from the manufacturer/distributor, holding them in inventory, and subsequently selling them at its retail locations. I'm also assuming some severe inflation in the hammer supply industry, but it was done to help clarify the point. As is evident though, FIFO leads to significantly lower cost of goods sold, gross profit margins, and ultimately net income. You should check the footnotes that accompany the firm's financial statements to determine which method is being used. This is important due to a profit-boosting phenomenon known as LIFO Liquidations, which usually occurs during times like now when corporations are allowing their inventories to dwindle lower and lower without replacement. The result is that new sales begin to cut through years of (assumedly lower) price layers, lowering COGS and boosting net income. This could result in a temporary profit windfall, however it's unlikely to repeat itself, and should almost be considered an extraordinary aspect of income (in my humble opinion).

Now that you have a cursory grasp of inventory costing, I'll move on to two ratios that will help to assess a given company's inventory situation: Inventory Turnover and Average Inventory Days Outstanding.

Inventory Turnover measures the number of times that a firm's inventory has "turned over" during the year. It's calculated as follows:

Inventory Turnover = Cost of Goods Sold / ( (Starting Inventory + Ending Inventory) / 2 )
Home Depot's Inventory Turnover
= $47,298M / ( ( $10,673M + $11,731M) / 2 )
= $47,298M / ($22,404M / 2)
= $47,298M / $11,202M
= 4.22

The implication here is that Home Depot's inventory turned over 4.22 times during its 2008 fiscal year.

Some sources provide a several step process for determining the next ratio, Average Inventory Days Outstanding. The shortcut though is to just 365 and divide it by Inventory Turnover. For Home Depot:

Average Inventory Days Outstanding = 365 / (Inventory Turnover)
=365 / 4.22

This means that, during 2008, the average item spent 86.49 days in Home Depot's inventory. This ratio should be compared across several years to determine trends in the firm's inventory. As an example, during 2007, Home Depot's average inventory days outstanding was 87.25. This means that Home Depot actually improved its turnover from 2007 to 2008, which is contrary to what I would expect during a recession. This year-over-year comparison is probably most indicative of efficient inventory controls at the company. My expectation though is that when Home Depot reports fiscal 2009 results (towards the beginning of February 2010) we'll be able to observe an increase in the average inventory days outstanding. I may be wrong though, and HD could have conceivably scaled down its inventory to meet sales demand in an efficient manner that will allow it to remain consistent with its ~86 day turnover rate. It's items like these that should allow investors to discern between market leaders and laggards coming out of this recession (and into the new normal?)

*no positions

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Tuesday, November 10, 2009

Liquidity Analysis Part 2: Current Ratio and Quick Ratio

In the first installment of my liquidity analysis discussion, I covered Net Working Capital; which is defined as Current Assets minus Current Liabilities. There are two additional ratios that should be a part of investor's liquidity analysis: the current ratio and the quick ratio. Both the current and the quick ratio are calculated entirely from the "current" section of the balance sheet. To refresh, current assets are cash, short term investments, receivables, inventory, or any other asset that the company expects will be converted to cash within a year or less. Current liabilities are accounts payable, expenses that accrue on a regular basis like wages, short term notes, and the portion of long term debt due within a year or less. The "due in one year or less" is a consistent theme which applies to current liabilites. To illustrate this distinction, I've included Intel Corporation's (INTC) consolidated balance sheet (2006-8) below:
Although not entirely scientific, I like to think of current assets and current liabilities as the corporation's revolving door; these portions of the balance sheet are turning over constantly between reporting periods. In contrast, non-current assets like buildings and machinery are relatively immutable, as are the portions of debt which mature many years down the road. In that sense, a corporation could own every parcel of land on the east coast, but without the liquidity contained in current assets, might conceivably be unable to pay it's bills or service it's debt. The previous example, although extreme, underscores the importance of applying both of the following ratios during your analysis of financial statements.

Current Ratio
The Current Ratio is simply current assets divided by current liabilities. The point is basically to measure how many times the firm's current assets can cover it's current liabilities. I'll use the figures from Intel's 2008 balance sheet to calculate it's current ratio.

Intel's Current Ratio = Current Assets / Current Liabilities
= $19,871M / $7818M
= 2.54

Generally, a current ratio above 1 is indicative of a strong current liquidity position. At 2.54, Intel appears to have more than sufficient liquidity necessary to cover it's payables and other short term debts coming due within the year.

Quick Ratio
I think of the quick ratio as a more precise glimpse into the firm's liquidity position. It basically measures whether the corporation could, if needed, quickly pay down all of it's current liabilities. The calculation here is Cash/Cash Equivalents divided by Current Liabilities. Below is a calculation of Intel's quick ratio for 2008:

Intel's Quick Ratio = Cash and Cash Equivalents / Current Liabilities
= $6512M / $7818M
= 0.83

To verbalize Intel's quick ratio, I'd say that Intel has 83% of the cash necessary to fund it's current liabilities. This is actually a relatively healthy quick ratio, and isn't expected to be greater than 1. Furthermore, if you look at the rest of Intel's current assets, you'll see $5331M worth of Short Term Investments. As Intel cashes out these investments over the subsequent twelve months, it will have substantially more cash than necessary to meet it's short term liquidity needs.

*Note: many analysts will include marketable securities and accounts receivable in the numerator of the quick ratio, the theory being that these items could be liquidated quickly. You may want to look at both calculations; however, I don't like assuming that a company can just go out and factor it's receivables on the market without taking a substantial hit.

As usual, it's important to monitor how these ratios change over time, as it will illustrate whether the firm is becoming more - or less - liquid with the passage of time. In the current environment, it should be obvious which way you'd like to see these measures trending.

*no positions
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Friday, November 6, 2009

Liquidity Analysis Part 1: Net Working Capital

The term liquidity can be interpreted in various ways, depending of course upon the specific circumstances. In corporate financial accounting, liquidity refers to the firm's ability to pay its debts when they are due. The importance of possessing that ability should be self evident, as should the ability to evaluate a firm's liquidity position.

The first measure that you should be able to calculate is Net Working Capital:

Net Working Capital = Current Assets - Current Liabilities
Intel's 2008 Net Working Capital = $19,871M - $7818M
= $12,053M

In order to properly grasp the concept of Net Working Capital, you should be familiar with the two balance sheet accounts used to calculate it; Current Assets and Current Liabilities. Current Assets are basically those assets which are not necessarily long term in nature. It includes cash and cash equivalents, accounts receivable, and inventory held by the firm for sale. You should know however, that items like prepaid rent and prepaid insurance for the next 12 months also fall under Current Assets. Current Liabilities are short term notes payable, accounts payable, and the portion of long ter
m debt that is due within the year. That being said, it should be evident that the prepaid rent portion of Current Assets wouldn't satisfy the cash obligation portions of Current Liabilities. The point is, investors need to dig in a little bit to determine the actual quality of a firm's net working capital. Also, it can be instructive to compare a firm's changes in net working capital over time. The chart below serves that purpose for Intel Corporation (INTC):
From the chart above, I'm not sure whether any discernible trend can be declared. Most likely, Intel was making use of it's cash for investments/acquisitions from 2003-2006, thus lowering it's net working capital. Intel is not a highly leveraged corporation - relatively speaking - though, so I wouldn't be too concerned with these fluctuations. If however, we observed that net working capital was declining, and over the same period the firm's debt-to-equity ratio was rising, it might be wise to pause and examine just why this was occurring.

*no positions
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Thursday, November 5, 2009

Depreciation and Financial Statements

The formal definition of depreciation is the systematic allocation of the cost of an asset, as an expense, over a period of time. If I were able to provide a definition for depreciation, it would be " a non-cash expense on the income statement, recorded in order to display the theoretical consumption of an asset's useful life". Before I get started, it's important to understand the distinction between depreciation recorded on a firm's financial statements, and the depreciation expense used by a corporation to determine it's federal income tax liability. Basically, there are two separate books that can show different depreciation expense for the same asset, in the same year. The depreciation schedule that a corporation must follow on it's tax returns is known as the Modified Accelerated Cost Recovery System (MACRS). If you want to read about MACRS, you can refer to IRS Publication 946; I will be covering depreciation strictly from the financial statement standpoint.

The two concepts you need to initially understand about depreciation are "Useful Life" and "Residual Value". An asset's useful life is the period of time that the asset will provide an actual economic benefit to the company; although an excavator could in theory still be alive after 50 years, the company might know from experience that an average excavator can only usefully serve its purpose for 15 years; therefore, useful life = 15 years. Residual value is also called salvage value, and its basically an estimate of what the asset could be sold for (as scrap usually) after it has served the duration of it's useful life.

There are basically three accepted depreciation methods that corporations use to convey information on financial statements: straight line, double declining balance, and units of production. To determine the annual depreciation expense for an asset using the straight line method, you simply plug your numbers into the following formula:
Annual Depreciation Expense = (Cost of Asset - Residual Value) / Useful Life.
Let's say a corporation purchases a truck for $110,000, estimates a $10,000 residual value and 10 years worth of useful life for the truck. A depreciable base of $100,000 (cost-residual value), divided by 10 years (useful life) yields an annual depreciation expense of $10,000. Unless the firm ever determines that the truck's useful life or residual value has changed materially, this $10,000/year will remain constant for each of the subsequent 10 years.

To determine the annual depreciation expense under the double declining balance method, you first need to determine the annual rate of depreciation by plugging your information into the following formula:

Rate of Annual Depreciation = (100% / Useful Life) X 2
Using the same truck example from above, we'd calculate (100% / 10 years) X 2 = 20%. Step 2 involves plugging your depreciation rate into the following formula:
Year 1 Depreciation Expense = (Cost of Asset - Residual Value) X Annual Depreciation Rate
= ($110,000 - $10,000) X 20%
That $20,000 shows up as depreciation expense in Year 1 on the income statement, and also appears in a contra asset account on the balance sheet known as "Accumulated Depreciation". The calculation for depreciation expense in Year 2 is as follows:
Year 2 Depreciation Expense = (Cost of Asset - Accumulated Depreciation - Residual Value) X Depreciation Rate
=($110,000 - $20,000 - $10,000) X 20%
Once again, $16,000 flows to the income statement as an expense, and is added to Accumulated Depreciation, resulting in a new balance of $36,000 at the end of Year 2. What should be evident is that the double declining balance method results in a front-loading of an asset's depreciation towards the beginning of it's useful life. By the end of the asset's useful life however - in this case Year 10, both methods will have all of the asset's value except for the residual value.

The units of production methods is, in my opinion at least, the most effective/honest/straightforward method of depreciation. Unfortunately, it only works when the asset has a useful life that can be represented in terms of a unit of measurement. For instance, using the truck example again, let's say that the company estimates the truck will provide 200,000 miles worth of service. Operating off an identical depreciable base of $100,000, the company could state that each mile amounts to 50 cents worth of depreciation for the truck. Thus, if the trucks trip log showed 50,000 miles of service for the year, the formula for annual depreciation using the units of production method is as follows:
Annual Depreciation Expense = ( Units of Useful Life / (Asset Cost - Residual) ) X Units consumed
= ( 200,000 / ($110,000 - $10,000) ) X 50,000
= $25,000

The only other depreciation caveat to be aware of at this point is that sometimes management adjusts it's estimates regarding the asset's useful life and salvage value. Luckily, these estimate changes are applied to the depreciation schedule prospectively; that is, you simply readjust the schedule for the new variables based upon the already accumulated depreciation and original cost.

Practically speaking, you can use your knowledge of the accumulated depreciation balance sheet account to gauge the relative age of the firm's long term operating assets. Simply divide Accumulated Depreciation by the amount of long term assets to determine a depreciation percentage. If your answer is in the 10-20% range, the firms assets are relatively new, and so on. Older assets on the balance sheet could be a sign that the company will have to ramp up it's capital expenditures in the coming years.

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Wednesday, November 4, 2009

Bond Pricing 101

If you're going to learn how to effectively interpret corporate financial statements, it's a good idea to possess at least a cursory understanding of the pricing of long-term non-operating liabilities - also known as bonds.

o start off, you need to know that bond pricing involves two separate interest rates, the Coupon Rate and the Market Rate. The coupon rate, also known as the contract or stated rate, is the interest rate listed in the bond contract, and is used to compute the amount of the cash interest payments that are due periodically from the issuer. The market rate is the interest rate demanded by investors, and is usually referred to as the bond's "yield".

Next, you need to think of a bond in terms of the two distinct cash flows involved; the bond pays periodic, usually semiannual interest payments (interest annuity), as well as the lump sum principal amount (face value) which is returned at maturity.

Moving on, the next distinction which needs to be made is that the price of the bond varies depending upon the relationship between the coupon and the yield. If the two are the same, the bond is priced at what is known as "par". If the market rate is greater than the coupon rate, the bond will be priced at a discount; conversely, if the coupon rate exceeds the market rate, the bond is priced at a premium. I'll start with pricing a bond at par; it's a much simpler process, for reasons I'll touch on a bit later. The assumptions used in this example of pricing a bond at face value are as follows: Face amount of $800,000, annual coupon rate of 6%, semi-annual interest payments, and a 5 year maturity. The first step involves calculating the interest payment, the formula for which is:
est Payment = Face Value X Annual Coupon Rate X Payment Period (time)
= $800,000 X 6% X 6/12
= $24,000
Next you need to calculate the present value of both sets of cash flows. Instead of going into detail on the present value calculation, I'll just direct you to the PV() function in Excel. Present value is built on the concept that $24,000 today is worth less to the investor than $24,000 in three years, simply due to the time value of money. In the current example, it's easy to ascertain that the sum of the bonds interest payments over the five year period is $240,000 ($24,000 X 5 (years) X 2 (payments per year). However, the present value of those five years worth of payments is only $204,724.87. Along th
ose same lines, the present value of (the lump sum principal payment of) $800,000 is only $595,275.13. Now, we sum the present value of the bonds future cash flows:

Present Value of Cash Flows = $595,275.13 + $204,724.87 = $800,000

Well then, this all looks pretty simple: the present value of a par priced bond's future cash flows is in fact the face value of the bond. For bonds sold at a premium or a discount however, the equation shakes up a little differently. For a discount example, let's assume that all of the variables are identical to the par example above, except that the market is demanding an 8% yield. The calculation of
the cash interest payment still uses the coupon rate, so we arrive at an identical $24,000 semi-annual interest obligation for the issuer. The curve ball arrives when calculating the present value of the bond's future cash flows; these cash flows must be discounted using the bond's yield rate of 8%. Therefore, the present value of the discount bond's interest payments is $194,661.50, and the principal payment's present value is $540,451.34. Add them together, and you arrive at $735,112.83. What this means is that the bond issuer will receive $735,112.83 in cash from investors, but will still be required to make $24,000 interest payments (that were calculated using a face value of $800,000). The difference of $64,887.17 (discount balance) shows up on the balance sheet as a contra-liability account which reduces bonds payable in line with the amount of cash actually received by the issuer. The discount balance is then amortized over the life of the bond, and falls into the income statement as successively higher amounts of interest expense (although not an actual cash outlay). The amortization table for this example is below:

As you can see above, the bond discount amount feeds - in entirety - into the income statement throughout the 10 periods, until it is no more. A bond sold at a premium works in the exact inverse way; a premium balance is created on the balance sheet which effectively reduces the issuer's interest expense - by the premium amount - over the life of the bond. Obviously, the issuer would prefer to sell bonds at a premium. Despite the interest expense reduction, a premium usually means that the market judges the firm to be more credit worthy than implied by the coupon rate. Nevertheless, it's important to comb through a corporation's filings to determine the amounts and associated maturities of it's bond liabilities, and be able to understand the income statement ramifications.

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Tuesday, November 3, 2009

Times Interest Earned and Credit Risk Analysis

When determining an individual's qualifications for taking out a mortgage of a certain amount, the ideal situation involves the bank/mortgage broker/real estate agent calculating a simple ratio based upon payments/obligations to income. Where p=mortgage payment, r=other recurring payments, and i=gross monthly income, the ideal situation dictates that (p+r)/i should be less than or equal to 36%. A corporation's creditworthiness is inherently a more complex determination, although today's concept is - from a logical standpoint - similar in nature to the mortgage brokers "back of the napkin" recurring obligations to income ratio.

Times Interest Earned (TIE) is essentially a measure of how many times a firm's interest expense is covered by it's earnings before interest and taxes (EBIT). Depending upon whether the company specifically reports EBIT in it's income statement, you may have to do some simple math to arrive at the ratio's correct numerator. For instance, you may only be provided with the firm's pretax earnings; in this case, just add interest expense in order to arrive at the EBIT figure. Below is the formula, along with Hewlett-Packard's calculation as an example:

mes Interest Earned (TIE)= Earnings Before Interest & Taxes / Interest Expense

Hewlett-Packard's TIE = EBIT / Interest Expense
= $10,940M / $467M
= 2

This rather impressive example means that, for FY 2008, Hewlett-Packard earned 23.43 times it's interest expense before taxes. That number is not so high for many other firms, as can be seen in the chart below:

As usual, it's most instructive to compare these figures across industries, and over time. Below is a graph showing Comcast Corporation's (CMCSA) TIE calculation for FY's 2004-2008:
In general, we can say that the latter part of this decade has been good for Comcast, as it's TIE ratio increased from 2X to 2.5X. If the company was incurring additional long term debt during the time period of 2004-2008, we can assume that these were prudent borrowings which allowed Comcast to grow earnings at a greater rate than it's increase in debt service. A five year TIE chart, similar to the one above, should be a part of any investors credit risk analysis.

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Monday, November 2, 2009

Intro to Credit Risk Analysis: Debt-to-Equity Ratio

If recent financial market events have taught us anything, it's that a) leverage can work both ways, and b) when leverage works against an individual/corporation/investment entity, the results can be fairly disastrous. Although the pair of statements above are essentially commonly held knowledge, the behavior exhibited by market participants throughout the past 20 years was nothing if not a blatant disregard for this reality. Moving forward, it will be more prudent than ever for investors to perform a sober assessment of a corporation's use of leverage.

At the heart of credit risk analysis is a corporation's solvency, or in other words, it's ability to function as a going concern, capable of avoiding financial distress. The cornerstone of evaluating
solvency is the Debt-to-Equity Ratio, which as the name implies, looks at a firms absolute debt level in terms of a multiple of total stockholders' equity. Both parts of the equation can be found on the balance sheet, and are plugged in as follows:

Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity

Verizon's (VZ) Debt-to-Equity Ratio is calculated as follows:
Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity
= $160,646M / $41,706M
= 3.85

In other words, for every dollar of Shareholders' Equity, Verizon holds $3.85 worth of debt. This ratio will obviously fluctuate greatly based upon the industry, and the composition of the firm's funding sources, i.e. relative breakdown of debt v equity funding. The chart below compares Verizon with seven other large firms from a debt-to-equity ratio standpoint:
Clearly, the debt-to-equity ratio needs to be examined from within the context of the individual firm and industry as a whole. For instance, there are two reasons why I wouldn't be alarmed at Verizon's high ratio of debt funding. First, it's subscriber based business provides relatively stable and predictable cash flows; a distinction that translates into ample access to the bond market. Secondly, a major portion of Verizon's borrowing activity over the past couple of years has been geared towards investment in it;s FiOs network. I haven't assessed that product from a consumer standpoint, but feel certain that Verizon will be able to leverage it's market leadership position into a substantial FiOs subscriber base.

Step 2 in the credit risk analysis process is determining the firms ability to cover interest payments from internally generated cash. That ratio will be addressed in a future article.

*no positions
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Monday, October 26, 2009

Focus on Operating Efficiency: Net Operating Profit Margin

In a previous installment, I covered a measure of after-tax operating profitability known as NOPAT (Net Operating Profit After Taxes). NOPAT serves as a relevant indicator of a firm's ability to operate efficiently, as it strips away many transitory, one-time items from the picture, focusing only on the firm's core business profitability. From an analytical perspective however, NOPAT may be more significant as a numerator of a ratio than as a stand alone measure. One of the most important such metrics is the Net Operating Profit Margin (NOPM).

Calculating the Net Operating Profit Margin is very easy, assuming however that you can properly ca
lculate a firm's Net Operating Profit After Taxes. See this post if you need a refresher on NOPAT. Anyways, below is the formula:

Net Operating Profit Margin = NOPAT / Sales Revenue

Hewlett-Packard (HPQ) FY 2008 NOPM Calculation

Net Operating Profit Margin = NOPAT / Sales Revenue
= $8591M / $118,364M

To verbalize HP's NOPM of 7.26%, we would say that for every dollar of sales, HP was able to generate 7.26 cents worth of after-tax operating profit. For many companies, operating profit margin may be a more concise measure of performance than the commonly cited Gross Profit Margin. Several small business owners I know are proud of what they perceive to be an impressive gross profit margin at their business. I usually dismiss such talk, as any fool can go out and sell cheaply manufactured products to generate a healthy looking gross profit margin. To pass the NOPM test though, you must be able to operate the organization efficiently and effectively.
Because net operating profit margins vary greatly across industries, it's most productive to compare NOPM's across competing organization's within an industry. Below is a focus on HP and it's primary tech industry competitors from a NOPM perspective.

Clearly, industry leaders like IBM and Apple tend to have very healthy net operating profit margins. There's a little bit of "chicken or the egg" dilemma inherent to that observation; i.e. larger industry leaders are better able to exert their will down the supply chain and operate more efficiently.

Although NOPM is only one element that should be considered when evaluating a company's/stock's relative investment attractiveness, it is nonetheless a very insightful indicator of the profitability of a company's operations.The most important analysis that should be performed as a companion to the NOPM calculation is an evaluation of a firm's leverage. NOPM strips out interest expense, effectively looking at the firm from a non-levered position.I'll get into that portion of analysis later via an examination of the debt-to-equity ratio.

*no positions
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