Joy Global (JOY) Module 11: Adjusting Accounting Information

1. Joy Global (JOY) Module 11: Adjusting Accounting Information Thomas Maguire 4/6/2014

2. Joy Global Background • Manufactures and services mining equipment • Focus on: Coal, Copper, Iron Ore, Oil Sands, and Gold • Revenue split between • Surface Mining Equipment • Underground Mining Machinery

3. Introduction • In Module 10, we analyzed and included additional sources of info included in footnotes and management’s discussion and analysis • Allowed us to revise and improve our identification of NEA and EPAT • Understanding effects of accounting choices • Reported numbers are the result of a set of accounting methods that were chosen by management • Had another set of accounting methods been chosen by management we would have different numbers • In this module we will look at potential adjustments to address particular accounting methods and valuation relevant issues in regards to these methods

4. Effects of Accounting Method Choices on Valuation Models • What happens when we make a choice between two different accounting methods? • Shift reported income between two periods– total income is not changed over the total life of the company • We are examining what period the revenues/expenses are reported • Choice of depreciation effect analyzed previously • Method does not affect computed valuation • Accounting method choice will not affect value!

5. How does this affect our Valuation? • In our previous examples (finite life project) we had known payoffs and a finite life • It appears as if the depreciation method choice had no effect on valuation • However, in an exercise where we are using past accounting data as the basis for forecasting, income shifting or different accounting method choices can convolute our projections • Reduction in comparability or the appurtenance of comparability when it is not there

6. How does this affect our Valuation? • We may be looking at inappropriate data to forecast enterprise profitability, also affected: • Forecasted sales growth, EPM and EATO because they are based on past sales growth, EPAT, and NEA • Analysis of industry competitors may also be distorted • Want to make sure our projections are as precise as possible!

7. How does this affect our Valuation? • We now will look at four separate adjustments that may affect realized EPAT and NEA: • Inventory Method • Operating Leases • Special-Purpose Entities • Share-Based Compensation • If these adjustments are not made, there is a lack of comparability and forecasts may be imprecise

8. Inventory Method • If two companies use different inventory costing methods, we may not be able to accurately compare their reported financial statements • Comparability is especially effected when LIFO is used • Problem is compounded if the companies hold large amounts of inventory in which prices have moved significantly • To compare the companies with different inventory costing methods we need to adjust the LIFO numbers to their FIFO equivalents or vice versa

9. Inventory Method • A LIFO to FIFO adjustment is not difficult • If the company chooses to use the LIFO method for inventory costing, they must also provide a LIFO adjustment • This amount allows us to calculate the value of inventory as if the company had reported under the FIFO method • This adjustment should be considered even if all the companies being compared report under LIFO method0– LIFO to LIFO not necessarily apples to apples: • The magnitude of the LIFO adjustment relates to how long the company has used LIFO • Rising costs- more recent adopted would have a much higher cost

10. Inventory Method • Need to adjust the balance sheet and income statement using the company’s disclosure relating to LIFO reserve • Must be a “net of tax” adjustment because the company would be forced to report to the IRS under FIFO had they used FIFO inventory for financial reporting purposes • Creating “as-if” FIFO numbers for the companies • Working to improve our understanding of reported results and in turn improve our forecasts and eventual valuation

11. Inventory Method: Joy Global • This inventory adjustment does not pertain to Joy Global’s 2013 financial statements: • Footnote 2- Significant Accounting Policies, Inventories: • “Inventories are carried at the lower of cost or market using the first-in, first-out method for all inventories.” • We would want to make sure that all companies used for industry analysis have been adjusted properly to assure comparability

12. Operating Leases • Use of operating leases is the most common off-balance sheet financing employed b companies • Financing transaction not on the balance sheet • Neither the liability or the related asset has been recorded • Accounting standards require detailed footnote disclosures of operating leases, however: • Some managers believe keeping the assets and liabilities off the balance sheet improves the market’s perception of performance and financial health • Implies managers believe market is somewhat inefficient • Research shows informed investors adjust balance sheet to include these items

13. Operating Leases • Lease transactions affect: • Both sides of the balance sheet: • Long-term assets • Long-term liabilities • Income statement • Lease expense buried in SG&A • Two acceptable approaches under GAAP for reporting leases • Capital Lease Method • Operating Lease Method

14. Operating Leases • Capital Lease Method- lease asset and liability recorded on balance sheet • Lease asset is depreciated like all long-term assets • Reduces EPAT • Lease liability amortized like debt, separated into interest expense and principal repayment • Financing liability • Operating Lease Method- neither the enterprise lease asset nor financing lease liability is reported on balance sheet • Lease payments recorded as rent expense (SG&A)– reduces EPAT of company

15. Operating Leases • Four financial reporting consequences of operating leases for lessee: • Lease asset not reported on balance sheet • EATO higher because reported NEA is lower and revenues are not affected • Lease liability is not reported on balance sheet • Financial leverage ratios are improved- wouldn’t affect enterprise value calculation but would impact adjustment from enterprise to equity value • Return on NEA is inflated without adjustment • Reported rent expense for operating lease less than depreciation and interest expense for capital lease • Net income higher in early years of lease • EPAT lower because only depreciation expense is an enterprise expense for capital lease

16. Operating Leases • Use of operating leases varies by industry • Airline industry notorious for use of operating leases • GAAP requires disclosure of expected future payments for leases • Use these disclosures to form better estimates of NEA and EPAT • “As-if” the operating leases had instead been capital leases

17. Capitalizing Operating Leases • Capitalization of operating leases is a four step process: • Determine the discount rate • Compute the present value of future lease payments • Adjust the balance sheet to include the PV on both asset and liability side • Adjust the income statement to include depreciation and interest instead of rent expense • Capitalization on pre tax interest rate and adjustment to EPAT on an after-tax basis

18. Capitalizing Operating Leases • Step 1: Determine the discount rate • Three approaches to determine appropriate discount rate • If capital leases are disclosed in addition to operating leases: impute implicit rate of return on those capital leases • Rate that yields the PV computed by the company on the given capital leases • Use the rate that corresponds to the company’s credit rating • Employ the cost of debt capital

19. Capitalizing Operating Leases • Joy Global Step 1: Determine the discount rate • No capital leases to impute implicit rate of return • No recent borrowings • Last issue was 10/6/2011 • Use rate computed for cost of debt– 4.93% • BBB, so high rate makes sense!

20. Capitalizing Operating Leases • Joy Global Step 2: Future Lease Payments

21. Capitalizing Operating Leases Joy Global Step 2: Present Value of Future Lease Payments

22. Capitalizing Operating Leases • Joy Global Step 3: • Now that we have the PV of the future lease payments, $108.2, we adjust NEA upward by that amount to include this additional asset that is now capitalized • Enterprise liabilities however is not adjusted • This was a choice in financing • Financing liabilities increased by $108.2

23. Capitalizing Operating Leases • Joy Global Step 4: Adjust income statement to include depreciation and interest instead of rent expense • Operating lease payment included in SG&A in 2013: • $47.9 million • We reverse this amount out of EPAAT • Calculating additional depreciation • Unrecorded obligation of $108.2 would yield interest expense at 4.93% of $5.33

24. Capitalizing Operating Leases • Payment of $47.9 million removed from SG&A reclassified: • $5.33 Interest Expense • $42.6 Depreciation Expense • After Tax Effect: • Using effective tax rate of 32%, • Net after tax effect is increase to EPAT of $7.04 • 2013 revenue was $5,000

25. Special-Purpose Entities • Special-Purpose Entities (SPEs) allow companies to structure projects or transactions with a number of financial benefits, have a long rooted history in finance: • Sponsoring companies often form subsidiary capitalized only with equity • Bankruptcy remote entity • If the parent becomes bankrupt, no one has claims to SPEs assets • Not parent or creditors • SPEs often set up to assist in securitization • Subsidiary purchases assets from sponsoring company and sells them to securitization trust– the SPE • SPE purchases assets using borrowed funds

26. Special-Purpose Entities • Benefits of SPEs: • Direct economic benefits to parent • Speed up receipt of company’s operating cash flows and mitigating risk • Indirect economic benefit to parent- financial reporting benefits and alternatives • Removing assets and corresponding debt from the balance sheet • Improve asset turnover and financial leverage ratio • Most common forms of SPE use: • Asset securitization • Ford motor company example • Real estate financing

27. Special-Purpose Entities • SPEs must be consolidated by whichever company has the power to direct the activities of the SPE and the right to receive its benefits • SEC registrants, balance sheet and income statement of SPE reported together with the parent • With the previously discussed Ford example, securitization process would be fully reflected in the financial statements • Companies are required to have comprehensive disclosures relating to the magnitude of the assets securitized and effects on access to credit markets

28. Special-Purpose Entities • Even though these SPEs are fully reflected in financial statements, they provide a lower-cost financing source to companies • Reduce credit risk for lenders • Will continue to be part of the financial reporting process as long as this is the case • If an SPE financing source was in danger of continuing, this would be a serious concern in which a large amount of business was generated through the entity • Another concern would be if credit markets no longer favored SPE structure

29. Special-Purpose Entities • SPEs do not affect EPAT and NEA • Need to consider: • Cost of debt capital & • Liquidity

30. Share-Based Compensation • Employee Stock Options (ESOs) are used by companies to compensate employees and better align employee interest with that of the shareholder’s • Attempting to limit principal-agent problem • Companies differing use of ESOs creates a lack of comparability unless an adjustment is made to EPAT and NEA • Consider the case where one company chooses to only ESO compensation and another uses only cash!!!

31. Share-Based Compensation • ASC 718-10-25-2 applies to stock options granted after 2005: • Requires companies to expense fair value of options at grant date • Recognize equivalent increase in stockholder’s equity (APIC) • Reflecting the transfer of enterprise value to employees- reduction in what is available to other stakeholders • Use of grant date to measure expense omits changes in value of stock9optiosn between the grant and exercise date • Changes in value prior to exercise are additional compensation earned by employee and should be considered

32. Share-Based Compensation • Use disclosures to estimate the expense between grant date and exercise date • 7 step process to capture ESO liability • Compute the value of options exercisable at beginning of year using beginning of year share price • Compute the value of options exercisable at beginning of year using end of year share price • Estimate the value of ESOs exercised during the current year using an estimate of the average share price over the year

33. Share-Based Compensation • Estimate the value of ESOs cancelled during the current year using an estimate of the average share price over the year • Compute the value of options exercisable at end of year using end of year share price • Compute an estimate of additional share-based compensation from information computed above • Adjust NFL, CSE, EPAT, and FEAT using information computed above

34. Share-Based Compensation • In addition to the information below, we need to know the beginning and ending share price: • Beginning: $61.55 • Ending: $58.09

35. Share-Based Compensation • Joy Global Step 1: Compute the value of options exercisable at beginning of year using beginning of year share price • The beginning share price was $61.55 which is $21.86 greater than the exercise price of $39.69 for the 1,009,916 exercisable options • Beginning ESO overhang of: • $22,076,764 • (61.55-39.69)*1,009,916

36. Share-Based Compensation • Joy Global Step 2: Compute the value of options exercisable at the beginning of year using end of year share price • The share price at the end of year was $58.09 which is $18.40 greater than the exercise price of $39.69 for the 1,009,916 exercisable options • This yields a value of: • $18,582,454 • (58.09-39.69)*1,009,916

37. Share-Based Compensation • Joy Global Step 3: Estimate the value of ESOs exercised during the current year using the average share price • The beginning and ending share price yield an average share price of: $59.82 • This average share price is $33.18 greater than the average exercise price of $26.64 for the 160,276 exercised options • This yields an estimated value for exercised options of: • $5,317,958 • ($59.82-$33.18)*160,276

38. Share-Based Compensation • Joy Global Step 4: Estimate the value of ESOs cancelled during the current year using the average share price • The average share price was $59.82 which is $13.24 less than the average exercise price of $73.06 for the 144,094 cancelled options • This yields an estimated value of: • -$1,907,805 • ($59.82-$73.06)*144,094

39. Share-Based Compensation • Joy Global Step 5: Compute the value of options exercisable at end of year using end of year share price: • The ending share price was $58.09 which $5.42 is greater than the exercise price of $52.67 for the 1,255,551 exercisable options. • This yields an ending ESO overhang of: • $8,977,190 • (58.09-52.67)*1,255,551

40. Share-Based Compensation • Joy Global Step 6: Compute estimate of additional share-based compensation from information computed above:

41. Share-Based Compensation • Joy Global Step 7: Adjust NFL, CSE, EPAT, and FEAT using the information above • Increase NFL by (5): $8,977,190 • Decreases CSE by (5): $8,977,190 • (Increase) decrease EPAT by (6): $(6,195,112) • Increase (decrease) FEAT by (2)-(1)-(3)-(4): $(6,904,462)

42. Share-Based Compensation • With the adjustments listed above, we are now capturing estimates of compensation owed by the firm as a result of ESOs • Incorporating items that would be excluded under GAAP • Better comparability • Not income shifting as previously discussed but an “ommision”

43. Questions? Thank You!