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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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:

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

Hewlett-Packard's TIE = EBIT / Interest Expense
= $10,940M / $467M
= 23.43

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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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 calculate 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
= 7.26%

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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Evaluate Operating Performance: Net Operating Profit After Taxes

Although I'm partial towards the use of Operating Cash Flow (OCF) as a primary basis for performance measurement, investors should nonetheless be familiar with Net Operating Profit After Taxes (NOPAT). NOPAT is completely derived from the income statement, subjecting itself to the usual non-cash adjustments dictated by GAAP. However, NOPAT is useful because, as the name implies, it is strictly a measure of operating performance.

Calculation of NOPAT is relatively straightforward, you're simply multiplying Income From Operations Before Taxes by the corporation's effective tax rate. To calculate the tax rate, divide income tax expense by net income before taxes(NIBT); make sure you place NIBT, also known as Pretax Income in the denominator, and not Operating Income. Once you've determined the total taxes owed, you just subtract it from Operating Income to arrive at NOPAT. The two step process is delineated below:

Tax Rate = Net Income Before Taxes / Income Tax Expense
Net Operating Profit After Taxes = Income From Operations Before Taxes X (1-Tax Rate)

*Note that a company's annual reports and 10-Q's will not always show a neatly constructed income statement that spoon feeds you the Operating Income, Pretax Income, and Income Tax Expense lines. GAAP doesn't require the income statement to be constructed in any special sort of way, thus you may have to occasionally deploy some common sense. Nearly all of the time however, websites like Yahoo!Finance and (if you have a subscription) S&P's NetAdvantage will go ahead and break out the necessary line items. The point is, pay attention.

I'll use Hewlett-Packard Company (HPQ) to illustrate an example calculation of NOPAT:
HPQ NOPAT - Year Ended October 31st 2009
Tax Rate = $2144M / $10,473M
= 20.47%

Net Operating Profit After Taxes = $10,802M X (1-.2047)
= $10,802M X 0.7952
=$8,590M

Hewlett-Packard's NOPAT of $8590M compares with net income of $8329M for fiscal year 2008; at only 3% less than NOPAT, 2008 net income is indicative of only a modest amount of interest expense for the year ($329M). The disparity between NOPAT and net income isn't always so minimal, as can be seen in the chart below:
General Electric (GE)'s large disparity between NOPAT and net income is an obvious first observation to make. The primary driver of this phenomenon is the $26,209M worth of interest expense incurred by the company during 2008. The second result of such a massive interest expense is that GE's 2008 effective tax rate was only 5.3% (interest is deductible). The relationship between these two variables will change based upon the industry, and circumstances specific to the company.

*long GE
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Earnings Quality Analysis: Operating Cash Flow to Net Income

In my intro to fundamental analysis, I focused on discrediting the P/E ratio as a viable means of gauging the relative value of a stock. The premise behind my campaign of disparagement was that net income, or the "E", is influenced by so many non-cash adjustments as to render its predictive value useless. In general, you could say that my complaints revolve around the concept of "earnings quality" (or lack thereof in many circumstances). Although earnings can consist of both cash and non-cash adjustments, I think we can all agree that earnings based on an increase in a company's cash position are of a higher quality than those which are not. Luckily, there's a useful ratio we can deploy against the income statement to determine the quality of a firm's reported earnings: Operating Cash Flow (CFFO) to Net Income

As the name implies, the ratio is calculated by dividing a company's operating cash flow by it's net income. Operating cash flow is an item found on the Statement of Cash Flows, and is often labeled "Cash Flows Provided by Operating Activities", or "Cash From Operating Activities". Basically, business activities are all placed in one of three categories: Operating, Investing, and Financing. Operating activities are the actions a company takes pursuant to its normal, or core business activities. For instance, a PC company like Hewlett-Packard (HPQ) sells computers and printers as it's core operating activity; if HP sold a piece of land it owned, that cash increase would not appear as cash provided by operating activities. Once you've located your CFFO number, move over to the income statement and find net income. Make sure you use the after tax figure. Divide the two, and there you have your ratio.

Example: Hewlett-Packard (HPQ), 2008 fiscal year totals
Operating Cash Flow: $14,591M
Net Income: $8329M
CFFO to Net Income = $14591M / $8329M = 1.75

The following chart should put HP's 1.75 CFFO to Net Income ratio in perspective; it shows that same ratio for HP and 6 other large tech firms.When a company's CFFO to net income ratio rises above 1, it is indicative of a strong ability to fund it's activities through generation of operating cash flow. In other words, a higher ratio means that the firm's earnings are of a higher quality. Both Apple (AAPL) and Intel (INTC) were able to generate cash from operations that was nearly twice reported earnings. Dell (DELL) however, actually generated less cash from operations than it reported in net income. If I were an investor in Dell, I would probably keep an eye on this ratio in order to determine whether it was a chronic issue at the company. A CFFO to net income ratio which remains below 1 for an extended period of time could be an indication that the company will need to raise money to fund its operations.

Next installment: Free Cash Flow: The Alternate Bottom Line

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