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Analyzing Performance and Competitive Position in 3 Steps

Learn how to evaluate a company's historical performance by analyzing ROIC, revenue growth, credit health, and financial structure. Understand the drivers of ROIC and perform line item analysis. Includes nonfinancial metrics and operating data.

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Analyzing Performance and Competitive Position in 3 Steps

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  1. Chapter 8 Instructors: Please do not post raw PowerPoint files on public website. Thank you! Analyzing Performance and Competitive Position

  2. Evaluating Historical Performance Step 1 Step 2 Step 3 To analyze a company’s historical performance, we proceed in threesteps: • Analyze ROIC and Economic Profit • Return on invested capital (ROIC) measures the economic performance of a company’s 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 company’s 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

  3. 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 Lowe’s by approximately five percentage points during the early 2000s. This gap disappeared in 2005, when Home Depot began acquiring other companies.

  4. 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 company’s 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.

  5. Understanding Value Creation: Decomposing ROIC • in 2008, Home Depot’s ROIC (8.0%) lagged Lowe’s 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 company’s 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 …

  6. Understanding Value Creation: Decomposing ROIC percent Home Depot 33.7 Lowe's 34.2 Operating margin 1 SG&A /revenues Home Depot 6.8 Home Depot 24.4 Pretax ROIC Lowe's 8.3 Lowe's 22.8 Depreciation/ revenues Home Depot 13.3 ROIC without goodwill Home Depot 2.5 Lowe's 14.6 Home Depot 8.3 Lowe's 3.2 ROIC with goodwill Operating cash tax rate Lowe's 9.1 Operating working Home Depot 8.0 Home Depot 37.4 Revenues / invested capital capital/revenues Premium over book capital 4.9 Home Depot Lowe's 8.9 Lowe's 37.5 Home Depot 1.95 Home Depot 3.5 4.0 Lowe's Lowe's Lowe's 1.77 Lowe's 2.7 Fixed assets/revenues 46.4 Home Depot 52.5 Lowe's 1 • Implicit interest expense related to capitalized operating leases has been removed from selling, general, and administrative (SG&A) expense. • From a margin perspective, Home Depot’s operating margin was 6.8 percent versus 8.3 percent for Lowe’s. The lower operating margin is primarily attributable to higher selling, general, and administrative (SG&A ) expense. • According to press reports, the rise in SG&A 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 company’s valuation. Home Depot and Lowe's: ROIC Tree, 2008 Gross margin

  7. 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 Lowe’s: from 85to 94 days.

  8. 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

  9. 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 term’s denominator cancels the next term’s numerator, leaving us with the original ratio.

  10. Nonfinancial Metrics: Analyzing the Data percent Aircraft fuel/revenues Labor expenses/employee2 Network 36.2 1 Labor expenses/ASM Network 82.9 3.4 Network Discount 40.1 Discount 75.6 Operating margin 2.5 Discount Labor expenses/revenues Network −3.8 Millions of ASMs/employee Network 23.5 1 Revenues/ASM Discount −2.9 Network 2.5 Discount 23.1 Network 14.4 Discount 3.1 Discount 10.6 Other costs/revenues Network 44.1 Discount 39.6 1 Available seat-miles (ASMs) are the standard unit of measure for the U.S. airline industry. Labor expense and revenue ratios are measured in cents per mile. 2 Labor expenses per employee are measured in $ thousands. • 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 Step 2 Step 3 Step 1 To analyze a company’s historical performance, we proceed in threesteps: • Analyze ROIC and Economic Profit • Return on invested capital (ROIC) measures the economic performance of a company’s 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 company’s 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 company’s 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 company’s 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.

  13. 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

  14. 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.

  15. 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.

  16. Analyzing Revenue Growth: M&A • Stripping the effect of acquisitions from reported revenues is difficult. Unless an acquisition is deemed material by the company’s 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.

  17. Analyzing Revenue Growth: M&A $ million Year Revenue by company 1 2 3 4 5 Parent company 100.0 110.0 121.0 133.1 146.4 Target company 20.0 22.0 24.2 26.6 29.3 Consolidated revenues 110.0 Revenue from parent 100.0 121.0 133.1 146.4 Revenue from target 14.1 26.6 29.3 1 Consolidated revenues 100.0 110.0 135.1 159.7 175.7 Growth rates (percent) Consolidated revenue growth 10.0 22.8 18.2 10.0 Organic growth 10.0 10.0 10.0 10.0 1 Only consolidated revenues are reported in a company's annual report. • 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 year’s consolidated revenues to match the current year’s composition. Effect of Acquisitions on Revenue Growth

  18. 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 Board’s (FASB’s) 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.

  19. Understanding Value Creation: Decomposing Growth percent Square feet/store Home Depot −0.5 Transactions/store Home Depot −6.5 Lowe's 0.0 Revenues/store Lowe's −4.4 Transactions/square foot Home Depot −9.5 Revenues Home Depot −6.0 Dollars/transaction Home Depot −7.9 Lowe's −7.1 Home Depot −3.3 Lowe's −4.4 Lowe's −0.1 Number of stores Lowe's −2.8 Home Depot 1.8 Lowe's 7.5 • Once revenues have been disaggregated, analyze revenue growth from an operational perspective. The most standard decomposition is: Home Depot and Lowe’s: 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?

  20. Evaluating Historical Performance Step 2 Step 3 Step 1 To analyze a company’s historical performance, we proceed in threesteps: • Analyze ROIC and Economic Profit • Return on invested capital (ROIC) measures the economic performance of a company’s 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 company’s 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 company’s capital structure, examine: • Liquidity—the ability to meet short-term obligations. We measure liquidity by examining the interest coverage ratio. • Leverage—the ability to meet long-term obligations. Leverage is measured by computing the market-based debt-to-value ratio.

  22. Credit Health and Capital Structure—Liquidity $ million 2006 2007 2008 EBITA 9,790 7,251 4,359 EBITDA 11,435 8,944 6,144 1 EBITDAR 12,393 9,768 6,990 Interest 392 696 624 Rental expense 958 824 846 Interest plus rental expense 1,350 1,520 1,470 Coverage ratios EBITA/interest 25.0 10.4 7.0 EBITDA/interest 29.2 12.9 9.8 EBITDAR/interest plus rental expense 9.2 6.4 4.8 1 Earnings before interest, taxes, depreciation, amortization, and rental expense. • The interest coverage ratio measures a company’s ability to meet short-term obligations: • EBITDA/interestmeasures the ability to meet short-term financial commitments using profits, as well as depreciation dollars earmarked for replacement capital. • EBITA/interestmeasures the ability to pay interest without having to cut expenditures intended to replace depreciating equipment. Home Depot: Measuring Interest Coverage

  23. Credit Health and Capital Structure—Liquidity Yield to Maturity 1 Interest Coverage Ratio by Ratings Class, 2009 Three - Year (2005 − 2007) Medians 9.44 9.10 26.5 7.07 22.2 6.19 19.8 6.09 5.33 17.2 17.0 5.05 4.83 16.2 4.75 4.68 4.44 4.20 3.31 10.5 AAA AA+ AA AA − A+ A A − BBB+ BBB BBB − BB+ BB AAA AA A BBB BB B CCC 1 Monthly average of yields. • 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 company’s rating, it is not the only driver. Other drivers include capital intensity, debt to value, among others.

  24. Credit Health and Capital Structure—Leverage Effect of Financial Leverage on Operating Returns 2.0x 25% 15% 1.0x 5% − 25% − 15% − 5% 5% 15% 25% 5% − Return on Equity − 15% − 25% Operating Profit/Invested Capital (ROIC) • 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.

  25. Median Leverage Ratios Across Industries percent 2003 2008 Internet 0.1 63.1 Software 0.0 58.5 Health care equipment 3.8 36.8 Beverages 29.1 29.5 Household products 13.0 24.0 Tobacco 26.0 21.1 Chemicals 24.0 17.2 Gas utilities 41.7 9.7 Paper and forest … 42.2 4.1 Airlines 33.2 0.2 1 S&P 1500 classified by GICS industry. Debt to value measured using market values. • To place the company’s 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.

  26. Closing Thoughts • Understanding a company’s past is essential for forecasting its future. Through historical analysis, we can test a firm’s ability to create value… • over time by analyzing trends in operating and financial metrics, and • as compared to other companies within the firm’s 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 sourcewhen there are radical changes in performance. Determine whether the change is temporary or permanent, or merely an accounting effect.

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