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

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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
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