Analyzing Performance and Competitive Position

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Chapter 8
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• Analyzing Performance and Competitive Position

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Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in three steps
Analyze ROIC and Economic Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate Credit Health and Financial
Structure Assess the companys liquidity and
evaluate its capital structure in order to
determine whether the company has the financial
resources to conduct business and make short- and
long-term investments.
Slides 2-10
Slides 11-19
Slides 20-25
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Using ROIC to Compare Operating Performance

• To measure historical operating performance,
  compute ROIC by comparing NOPLAT to invested
  capital

Home Depot and Lowe's Return on Invested Capital

• The ROIC at Home Depot outpaced Lowes by
  approximately five percentage points during the
  early 2000s. This gap disappeared in 2005, when
  Home Depot began acquiring other companies.

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ROIC With or Without Goodwill?

• Compute ROIC both with and without goodwill and
  acquired intangibles, because each ratio analyzes
  different things.
• To measure aggregate value creation for the
  companys shareholders, measure ROIC with
  goodwill.
• ROIC excluding goodwill measures the underlying
  operating performance of the company and its
  businesses and is used to compare performance
  against peers and to analyze trends.

CVS Caremark Return on Invested Capital
Note This presentation sometimes shortens
goodwill and acquired intangibles to goodwill.
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Understanding Value Creation Decomposing ROIC

• in 2008, Home Depots ROIC (8.0) lagged Lowes
  ROIC (8.9) by approximately one percentage
  point.
• But what is driving this drop in performance?
• Can these losses be recovered?
• To better understand ROIC, we can decompose the
  ratio as follows

Profit Margin
Capital Efficiency

• As the formula demonstrates, a companys ROIC is
  driven by its ability to (1) maximize
  profitability, (2) optimize capital efficiency,
  or (3) minimize taxes.

This equation can be organized into a tree
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Understanding Value Creation Decomposing ROIC

• From a margin perspective, Home Depots operating
  margin was 6.8 percent versus 8.3 percent for
  Lowes. The lower operating margin is primarily
  attributable to higher selling, general, and
  administrative (SGA ) expense.
• According to press reports, the rise in SGA
  reflects the cost of additional floor personnel
  to improve the customer experience. Whether this
  translates to higher sales through better service
  in the future is a key to the companys valuation.

Home Depot and Lowe's ROIC Tree, 2008
Gross margin
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Understanding Value Creation Line Item Analysis

• To complete a thorough analysis, each tree branch
  should examined separately over time and across
  competitors.
• For operating current assets and liabilities, we
  can convert each line item into days, using the
  following formula

Home Depot and Lowe's Operating Current Assets
in Days
Inventories have risen slightly at Lowes from
85 to 94 days.
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Understanding Value Creation Nonfinancial Metrics

• In an external analysis, ratios are often
  confined to financial performance.
• If you are working inside a company, however, or
  if the company releases operating data, you
  should link operating drivers directly to return
  on invested capital. For instance, how can we
  use data about employees and miles flown for
  airlines?

Financial and Operating Statistics across U.S.
Airlines, 2008
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Nonfinancial Metrics Building an Equation

• To better understand labor expenses, we
  disaggregate labor expenses to revenue using the
  following equation

How much labor cost is incurred per available
seat-mile (ASM) flown?
Labor Expenses
Labor Expenses
Total Employees
ASMs Flown



Revenue
Total Employees
ASMs Flown
Revenue
Cost Structure

Productivity

Price
Average Salary per
Productivity of Each Full-Time
Miles Needed to
Full-Time
Employee ( Employees to Fly One
Be Flown to
Billion Available Seat-Miles)
Generate 1
Employee

• Note how each terms denominator cancels the next
  terms numerator, leaving us with the original
  ratio.

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Nonfinancial Metrics Analyzing the Data

• Discount carriers have higher labor cost per
  dollar of revenue, when compared to network
  carriers. But this statistic is misleading. The
  difference is caused by higher prices, not higher
  labor costs.
• The average labor cost per ASM1 for discount
  airlines equals 10.6 cents, versus 14.4 cents for
  network carriers.

Operational Drivers of Labor Expenses to
Revenues, 2008
100 -
11
Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in three steps
Analyze ROIC and Economic Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate Credit Health and Financial
Structure Assess the companys liquidity and
evaluate its capital structure in order to
determine whether the company has the financial
resources to conduct business and make short- and
long-term investments.
Slides 2-10
Slides 11-19
Slides 20-25
12
Analyzing Revenue Growth

• The value of a company is driven by return on
  invested capital, the weighted average cost of
  capital, and growth. The ability to grow cash
  flows over the long term depends on a companys
  ability to grow its revenues organically.
• Calculating revenue growth directly from the
  income statement will suffice for most companies.
  The year-to-year revenue growth numbers sometimes
  can be misleading, however. The three prime
  culprits affecting revenue growth are
• Currency changes. Foreign revenues must be
  consolidated into domestic financial statements.
  If foreign currencies are rising in value
  relative to the companys home currency, this
  translation, at better rates, will lead to higher
  revenue.
• Mergers and acquisitions. When one company
  purchases another, the bidding company may not
  restate historical financial statements. This
  will bias one-year growth rates upward.
• Changes in accounting policies. When a company
  change its revenue recognition policies,
  comparing year-to-year revenues can be misleading.

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Organic Growth vs. Reported Growth

• Compass (based in the United Kingdom) and Sodexo
  (based in France) are global providers of canteen
  services in businesses, schools, and sporting
  venues.
• In 2008, total revenues at Compass grew by 11.4
  percent, and revenues at Sodexo grew by 1.7
  percent. The difference in growth rates appears
  dramatic but is driven primarily by changes in
  currency values (pounds sterling versus euros),
  not by organic revenue growth.

Compass and Sodexo Revenue Growth Analysis
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Analyzing Revenue Growth Currency Changes

• The exhibit below reports the revenue breakout by
  geography for Compass and Sodexo.
• The companies have similar geographic mixes, with
  roughly 40 percent of revenues coming from North
  America. Since each company translates U.S.
  dollars into a different currency, exchange rates
  will affect each company quite differently.

Compass and Sodexo Effect of Currencies on
Revenue Growth
Compass translates U.S. dollars from its North
American business into British pounds. Given the
weakening of the pound against the U.S. dollar
(2.04 per pound in 2007 versus 1.78 per pound
in 2008), Compass reported an increase in
revenues of 5.1 percent attributable to the
weakening pound.
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Analyzing Revenue Growth Currency Changes

• Companies with extensive foreign business will
  report revenues using both current and constant
  exchange rates (CER).
• For instance, IBM reported a year-to-year revenue
  change of 9.8 percent in 2003, but a year-to-year
  constant currency change of only 2.8 percent.

IBM 2003 Annual Report, Page 51
Had currencies remained at their prior-year
levels, IBM revenue would have been 83.5
billion, rather than the 89.1 billion reported.
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Analyzing Revenue Growth MA

• Stripping the effect of acquisitions from
  reported revenues is difficult. Unless an
  acquisition is deemed material by the companys
  accountants, company filings do not need to
  detail or even report the acquisition.
• For larger acquisitions, a company will report
  pro forma statements that recast historical
  financials as though the acquisition were
  completed at the beginning of the fiscal year.
  Revenue growth then should be calculated using
  the pro forma revenue numbers
• If the target company publicly reports its own
  financial data, you can construct pro forma
  statements manually by combining revenue of the
  acquirer and the target for the prior year. But
  beware The bidder will include partial-year
  revenues from the target for the period after the
  acquisition is completed.

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Analyzing Revenue Growth MA

• Consider the hypothetical purchase of a target
  company in the seventh month of year 3.
• Both the parent company and the target are
  growing organically at 10 percent per year.
  Consolidated revenue growth, however, is reported
  at 22.8 percent in year 3 and 18.2 percent in
  year 4.
• To create an internally consistent comparison for
  years 3 and 4, adjust the prior years
  consolidated revenues to match the current years
  composition.

Effect of Acquisitions on Revenue Growth
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Analyzing Revenue Growth Accounting Changes

• Each year the Financial Accounting Standards
  Board (U.S.) and International Accounting
  Standards Board (Europe) make recommendations
  concerning the financial treatment of certain
  business transactions.
• Consider EITF 01-14 from the Financial Accounting
  Standards Board, which concerns reimbursable
  expenses.
• Prior to 2002, U.S. companies accounted for
  reimbursable expenses by ignoring the expense
  entirely. Starting in 2003, U.S. companies can
  recognize the reimbursement as revenue and the
  outlay as an expense.
• This new revenue will artificially increase
  year-to-year comparisons.

Total System Services, Annual Report, page F-7
Reimbursable Expenses As a result of the
Financial Accounting Standards Boards (FASBs)
Emerging Issues Task Force 01-14 (EITF 01-14),
formerly known as Staff Announcement Topic D-103,
Income Statement Characterization of
Reimbursements Received for Out-of-Pocket
Expenses Incurred, the Company has included
reimbursements received for out-of-pocket
expenses as revenue. Historically, TSYS had not
reflected such reimbursements in its consolidated
statements of income.
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Understanding Value Creation Decomposing Growth

• Once revenues have been disaggregated, analyze
  revenue growth from an operational perspective.
  The most standard decomposition is

Home Depot and Lowes Revenue Growth Analysis,
2008

• Growth trees can be built using advanced versions
  of the decomposition formula presented above.
• How is Home Depot driving revenue growth?

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Evaluating Historical Performance
To analyze a companys historical performance, we
proceed in three steps
Analyze ROIC and Economic Profit Return on
invested capital (ROIC) measures the economic
performance of a companys core business. ROIC
is independent of financial structure and can be
disaggregated into measures examining
profitability and capital efficiency. Analyze
Revenue Growth Break down revenue growth into its
four components organic revenue growth, currency
effects, acquisitions, and accounting
changes. Evaluate Credit Health and Financial
Structure Assess the companys liquidity and
evaluate its capital structure in order to
determine whether the company has the financial
resources to conduct business and make short- and
long-term investments.
Slides 2-10
Slides 11-19
Slides 20-25
21
Credit Health and Capital Structure

• In the final step of historical analysis, focus
  on how the company has financed its operations.
  Ask
• How is the company financed? That is, what
  proportion of invested capital (IC) comes from
  creditors versus equity holders?
• Is this capital structure sustainable?
• Can the company survive an industry downturn?
• To assess the aggressiveness of a companys
  capital structure, examine
• Liquiditythe ability to meet short-term
  obligations. We measure liquidity by examining
  the interest coverage ratio.
• Leveragethe ability to meet long-term
  obligations. Leverage is measured by computing
  the market-based debt-to-value ratio.

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Credit Health and Capital StructureLiquidity

• The interest coverage ratio measures a companys
  ability to meet short-term obligations
• EBITDA/interest measures the ability to meet
  short-term financial commitments using profits,
  as well as depreciation dollars earmarked for
  replacement capital.
• EBITA/interest measures the ability to pay
  interest without having to cut expenditures
  intended to replace depreciating equipment.

Home Depot Measuring Interest Coverage
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Credit Health and Capital StructureLiquidity

• EBITDA interest coverage (times interest earned)
  is the most widely used ratio for large companies
  with access to public capital markets.

• Although interest coverage is the primary driver
  of a companys rating, it is not the only driver.
  Other drivers include capital intensity, debt to
  value, among others.

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Credit Health and Capital StructureLeverage

• To better understand the power (and danger) of
  leverage, consider the relationship between
  return on equity (ROE) and ROIC.

• The use of leverage magnifies the effect of
  operating performance.
• The higher the leverage ratio (IC/E), the greater
  the risk.
• Specifically, with a high leverage ratio (a very
  steep line), the smallest change in operating
  performance can lead to enormous changes in ROE.

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Median Leverage Ratios Across Industries

• To place the companys current capital structure
  in the proper context, compare its capital
  structure with those of similar companies.
• Industries with heavy fixed investment in
  tangible assets tend to have higher debt levels.
• High-growth industries, especially those with
  intangible investments, tend to use very little
  debt.

Median Debt to Value by Industry1
Note Market value of debt proxied by book
value. Enterprise value proxied by book value of
debt plus market value of equity.
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Closing Thoughts

• Understanding a companys past is essential for
  forecasting its future. Through historical
  analysis, we can test a firms ability to create
  value
• over time by analyzing trends in operating and
  financial metrics, and
• as compared to other companies within the firms
  industry.
• When analyzing historical performance, keep the
  following in mind
• Look back as far as possible (at least 10 years).
  Long-term horizons will allow you to evaluate
  company and industry trends and whether
  short-term trends will likely be permanent.
• Disaggregate value drivers, both ROIC and revenue
  growth, as far back as possible. If possible,
  link operational performance measures with each
  key value driver.
• Identify the source when there are radical
  changes in performance. Determine whether the
  change is temporary or permanent, or merely an
  accounting effect.