Valuation Spreadsheet for Johnson and Johnson

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timer Asked: Jul 5th, 2018
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Question description

Please submit the valuation Excel spreadsheet for Johnson and Johnson. The attached valuation spreadsheet (ValuationModels.xls) has yellow highlighted cells on two worksheets (FCFF Valuation and Earnings Growth Models) which need to be filled with the Johnson and Johnson data.

Attached is a sample valuation worksheet (ValuationModels.xls), document on how to compute the Weighted Average Cost of Capital (WACC.pdf) and the class textbook for reference (businessanalysis-valuation3rd-ed-62402.pdf).



Computing the Weighted Average Cost of Capital WACC is the weighted average cost of capital i.e., a weighted average of the cost of debt (rd) and the cost of equity (re) given a firms current financing mix (i.e., the value of its debt [vd] and the value of its equity [ve]) . The WACC is thus equal to the sum, of the product of the cost of debt and the proportion of capital that comes from debt, and the product of the cost of equity and the proportion of capital that comes from equity: WACC = rd * vd / (vd + ve) + re * ve / (vd + ve) Total equity financing is the sum of the values of debt capital (vd) and equity capital (ve). Since debt capital is put on the balance sheet at its present value, we need only find the company’s longterm debt (plus any current portion of long term debt) to determine V d. The value of equity is more problematic, if we use book-value (equity from the balance sheet were understating the value of equity substantially. If we use market capitalization (the product of the price per-share of common stock and the number of shares of common stock outstanding), were including price in a model were using to determine price. Unfortunately, that’s the best we can do, so market cap is our proxy for ve. The cost of debt (rd) is also determinable in a straight-forward fashion. The firm’s notes will list the various debt owed, and the cost (interest rates) of each. Often the company will distill these numbers into a weighted average for you. If it doesn’t, you can compute it yourself. e.g., lets say Zulu Company has the following debt issues outstanding: Amount Rate $2,000,000,000 8% bonds $8,000,000,000 9% bonds The total LT debt is $10 billion, 20% at 5% and 80% at 6%. The weighted average of these interest rates are .2*.08 + .8*.09 = .016+.072 = .088 or 8.8% = rd If, however, the company operates in an environment where interest expense is deductible for tax purposes, then we must also adjust the cost of debt for the tax shield on interest to determine rd. For example, if the company has an effective tax rate (tax expense/earnings before taxes) of 40%, then the real interest rate (the percentage we want to use as rd in our calculations) is .088 x (1- tax rate) = .088 x (1-.4) = .088 x .6 = .0528 or 5.28% Okay, weve got rd, vd, and ve. All we need is re, or the cost of equity capital. Well get re from the capital asset pricing model, where: re = rf + β(rm-rf), and rf is the risk free rate, b is beta or systematic risk, and rm is the average return to the equity markets. Our proxies for these variables are as follows: rf = rate of interest paid on 30 year US treasury securities; β is the regression coefficient derived when changes in a particular company’s common stock price are regressed on a measure of changes in market prices (e.g., the S&P 500 index). Usually, β is computed over 1 year of trading days (240 observations), and it can be found (rather than computed) in various published sources; rm is the market rate of return, so the difference between rm and rf is often referred to as the risk premium. Historically, the risk premium has averaged between 7% and 8%. We can now approximate re using the CAPM, by setting re = 30year US Treasury Bond rate + β(.075). If, for example, the rate currently paid on 30-year US Treasury Bonds is 5.4% and the companys beta is 1.2, the estimate of re would be: re = .054 + 1.2(.075) = .054 + .09 = .144 or 14.4% Now we have all the parts necessary to compute the WACC!
11 chapter A F r am e w o rk fo r Bu sin e ss An alysis an d Valu at i on U sin g Fin an c ial S t at e me n t s T 1 Framework he purpose of this chapter is to outline a comprehensive framework for financial statement analysis. Because financial statements provide the most widely available data on public corporations’ economic activities, investors and other stakeholders rely on financial reports to assess the plans and performance of firms and corporate managers. A variety of questions can be addressed by business analysis using financial statements, as shown in the following examples: • A security analyst may be interested in asking: “How well is the firm I am following performing? Did the firm meet my performance expectations? If not, why not? What is the value of the firm’s stock given my assessment of the firm’s current and future performance?” • A loan officer may need to ask: “What is the credit risk involved in lending a certain amount of money to this firm? How well is the firm managing its liquidity and solvency? What is the firm’s business risk? What is the additional risk created by the firm’s financing and dividend policies?” • A management consultant might ask: “What is the structure of the industry in which the firm is operating? What are the strategies pursued by various players in the industry? What is the relative performance of different firms in the industry?” • A corporate manager may ask: “Is my firm properly valued by investors? Is our investor communication program adequate to facilitate this process?” • A corporate manager could ask: “Is this firm a potential takeover target? How much value can be added if we acquire this firm? How can we finance the acquisition?” • An independent auditor would want to ask: “Are the accounting policies and accrual estimates in this company’s financial statements consistent with my understanding of this business and its recent performance? Do these financial reports communicate the current status and significant risks of the business?” Financial statement analysis is a valuable activity when managers have complete information on a firm’s strategies and a variety of institutional factors make it unlikely that they fully disclose this information. In this setting, outside analysts attempt to create “inside information” from analyzing financial statement data, thereby gaining valuable insights about the firm’s current performance and future prospects. To understand the contribution that financial statement analysis can make, it is important to understand the role of financial reporting in the functioning of capital markets 1-1 1 2 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Analysis and Valuation Using Financial Statements and the institutional forces that shape financial statements. Therefore, we present first a brief description of these forces; then we discuss the steps that an analyst must perform to extract information from financial statements and provide valuable forecasts. THE ROLE OF FINANCIAL REPORTING IN CAPITAL MARKETS A critical challenge for any economy is the allocation of savings to investment opportunities. Economies that do this well can exploit new business ideas to spur innovation and create jobs and wealth at a rapid pace. In contrast, economies that manage this process poorly dissipate their wealth and fail to support business opportunities. In the twentieth century, we have seen two distinct models for channeling savings into business investments. Communist and socialist market economies have used central planning and government agencies to pool national savings and to direct investments in business enterprises. The failure of this model is evident from the fact that most of these economies have abandoned it in favor of the second model—the market model. In almost all countries in the world today, capital markets play an important role in channeling financial resources from savers to business enterprises that need capital. Figure 1-1 provides a schematic representation of how capital markets typically work. Savings in any economy are widely distributed among households. There are usually many new entrepreneurs and existing companies that would like to attract these savings to fund their business ideas. While both savers and entrepreneurs would like to do business with each other, matching savings to business investment opportunities is complicated for at least two reasons. First, entrepreneurs typically have better information than savers on the value of business investment opportunities. Second, communication by entrepreneurs to investors is not completely credible because investors know entrepreneurs have an incentive to inflate the value of their ideas. Figure 1-1 Capital Markets Savings Financial Intermediaries Information Intermediaries Business Ideas 1-2 A Framework for Business Analysis and Valuation Using Financial Statements 1-3 Part 1 Framework These information and incentive problems lead to what economists call the “lemons” problem, which can potentially break down the functioning of the capital market.1 It works like this. Consider a situation where half the business ideas are “good” and the other half are “bad.” If investors cannot distinguish between the two types of business ideas, entrepreneurs with “bad” ideas will try to claim that their ideas are as valuable as the “good” ideas. Realizing this possibility, investors value both good and bad ideas at an average level. Unfortunately, this penalizes good ideas, and entrepreneurs with good ideas find the terms on which they can get financing to be unattractive. As these entrepreneurs leave the capital market, the proportion of bad ideas in the market increases. Over time, bad ideas “crowd out” good ideas, and investors lose confidence in this market. The emergence of intermediaries can prevent such a market breakdown. Intermediaries are like a car mechanic who provides an independent certification of a used car’s quality to help a buyer and seller agree on a price. There are two types of intermediaries in the capital markets. Financial intermediaries, such as venture capital firms, banks, mutual funds, and insurance companies, focus on aggregating funds from individual investors and analyzing different investment alternatives to make investment decisions. Information intermediaries, such as auditors, financial analysts, bond-rating agencies, and the financial press, focus on providing information to investors (and to financial intermediaries who represent them) on the quality of various business investment opportunities. Both these types of intermediaries add value by helping investors distinguish “good” investment opportunities from the “bad” ones. Financial reporting plays a critical role in the functioning of both the information intermediaries and financial intermediaries. Information intermediaries add value by either enhancing the credibility of financial reports (as auditors do), or by analyzing the information in the financial statements (as analysts and the rating agencies do). Financial intermediaries rely on the information in the financial statements, and supplement this information with other sources of information, to analyze investment opportunities. In the following section, we discuss key aspects of the financial reporting system design that enable it to play effectively this vital role in the functioning of the capital markets. FROM BUSINESS ACTIVITIES TO FINANCIAL STATEMENTS Corporate managers are responsible for acquiring physical and financial resources from the firm’s environment and using them to create value for the firm’s investors. Value is created when the firm earns a return on its investment in excess of the cost of capital. Managers formulate business strategies to achieve this goal, and they implement them through business activities. A firm’s business activities are influenced by its economic environment and its own business strategy. The economic environment includes the firm’s industry, its input and output markets, and the regulations under which the firm operates. The firm’s business strategy determines how the firm positions itself in its environment to achieve a competitive advantage. 3 4 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Analysis and Valuation Using Financial Statements As shown in Figure 1-2, a firm’s financial statements summarize the economic consequences of its business activities. The firm’s business activities in any time period are too numerous to be reported individually to outsiders. Further, some of the activities undertaken by the firm are proprietary in nature, and disclosing these activities in detail could be a detriment to the firm’s competitive position. The firm’s accounting system provides a mechanism through which business activities are selected, measured, and aggregated into financial statement data. Intermediaries using financial statement data to do business analysis have to be aware that financial reports are influenced both by the firm’s business activities and by its Figure 1-2 From Business Activities to Financial Statements Business Environment Labor markets Capital markets Product markets: Suppliers Customers Competitors Business regulations Business Strategy Business Activities Operating activities Investment activities Financing activities Accounting Environment Capital market structure Contracting and governance Accounting conventions and regulations Tax and financial accounting linkages Third-party auditing Legal system for accounting disputes Scope of business: Degree of diversification Type of diversification Competitive positioning: Cost leadership Differentiation Key success factors and risks Accounting Strategy Accounting System Measure and report economic consequences of business activities. Financial Statements Managers’ superior information on business activities Estimation errors Distortions from managers’ accounting choices Choice of accounting policies Choice of accounting estimates Choice of reporting format Choice of supplementary disclosures 1-4 A Framework for Business Analysis and Valuation Using Financial Statements 1-5 Part 1 Framework accounting system. A key aspect of financial statement analysis, therefore, involves understanding the influence of the accounting system on the quality of the financial statement data being used in the analysis. The institutional features of accounting systems discussed below determine the extent of that influence. Accounting System Feature 1: Accrual Accounting One of the fundamental features of corporate financial reports is that they are prepared using accrual rather than cash accounting. Unlike cash accounting, accrual accounting distinguishes between the recording of costs and benefits associated with economic activities and the actual payment and receipt of cash. Net income is the primary periodic performance index under accrual accounting. To compute net income, the effects of economic transactions are recorded on the basis of expected, not necessarily actual, cash receipts and payments. Expected cash receipts from the delivery of products or services are recognized as revenues, and expected cash outflows associated with these revenues are recognized as expenses. The need for accrual accounting arises from investors’ demand for financial reports on a periodic basis. Because firms undertake economic transactions on a continual basis, the arbitrary closing of accounting books at the end of a reporting period leads to a fundamental measurement problem. Since cash accounting does not report the full economic consequence of the transactions undertaken in a given period, accrual accounting is designed to provide more complete information on a firm’s periodic performance. Accounting System Feature 2: Accounting Standards and Auditing The use of accrual accounting lies at the center of many important complexities in corporate financial reporting. Because accrual accounting deals with expectations of future cash consequences of current events, it is subjective and relies on a variety of assumptions. Who should be charged with the primary responsibility of making these assumptions? A firm’s managers are entrusted with the task of making the appropriate estimates and assumptions to prepare the financial statements because they have intimate knowledge of their firm’s business. The accounting discretion granted to managers is potentially valuable because it allows them to reflect inside information in reported financial statements. However, since investors view profits as a measure of managers’ performance, managers have incentives to use their accounting discretion to distort reported profits by making biased assumptions. Further, the use of accounting numbers in contracts between the firm and outsiders provides another motivation for management manipulation of accounting numbers. Income management distorts financial accounting data, making them less valuable to external users of financial statements. Therefore, the delegation of financial reporting decisions to corporate managers has both costs and benefits. 5 6 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Analysis and Valuation Using Financial Statements A number of accounting conventions have evolved to ensure that managers use their accounting flexibility to summarize their knowledge of the firm’s business activities, and not to disguise reality for self-serving purposes. For example, the measurability and conservatism conventions are accounting responses to concerns about distortions from managers’ potentially optimistic bias. Both these conventions attempt to limit managers’ optimistic bias by imposing their own pessimistic bias. Accounting standards (Generally Accepted Accounting Principles), promulgated by the Financial Accounting Standards Board (FASB) and similar standard-setting bodies in other countries, also limit potential distortions that managers can introduce into reported numbers. Uniform accounting standards attempt to reduce managers’ ability to record similar economic transactions in dissimilar ways, either over time or across firms. Increased uniformity from accounting standards, however, comes at the expense of reduced flexibility for managers to reflect genuine business differences in their firm’s financial statements. Rigid accounting standards work best for economic transactions whose accounting treatment is not predicated on managers’ proprietary information. However, when there is significant business judgment involved in assessing a transaction’s economic consequences, rigid standards which prevent managers from using their superior business knowledge would be dysfunctional. Further, if accounting standards are too rigid, they may induce managers to expend economic resources to restructure business transactions to achieve a desired accounting result. Auditing, broadly defined as a verification of the integrity of the reported financial statements by someone other than the preparer, ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable. Therefore, auditing improves the quality of accounting data. Third-party auditing may also reduce the quality of financial reporting because it constrains the kind of accounting rules and conventions that evolve over time. For example, the FASB considers the views of auditors in the standard-setting process. Auditors are likely to argue against accounting standards producing numbers that are difficult to audit, even if the proposed rules produce relevant information for investors. The legal environment in which accounting disputes between managers, auditors, and investors are adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and resulting penalties have the beneficial effect of improving the accuracy of disclosure. However, the potential for a significant legal liability might also discourage managers and auditors from supporting accounting proposals requiring risky forecasts, such as forward-looking disclosures. Accounting System Feature 3: Managers’ Reporting Strategy Because the mechanisms that limit managers’ ability to distort accounting data add noise, it is not optimal to use accounting regulation to eliminate managerial flexibility completely. Therefore, real-world accounting systems leave considerable room for managers to influence financial statement data. A firm’s reporting strategy, that is, the 1-6 A Framework for Business Analysis and Valuation Using Financial Statements 1-7 Part 1 Framework manner in which managers use their accounting discretion, has an important influence on the firm’s financial statements. Corporate managers can choose accounting and disclosure policies that make it more or less difficult for external users of financial reports to understand the true economic picture of their businesses. Accounting rules often provide a broad set of alternatives from which managers can choose. Further, managers are entrusted with making a range of estimates in implementing these accounting policies. Accounting regulations usually prescribe minimum disclosure requirements, but they do not restrict managers from voluntarily providing additional disclosures. A superior disclosure strategy will enable managers to communicate the underlying business reality to outside investors. One important constraint on a firm’s disclosure strategy is the competitive dynamics in product markets. Disclosure of proprietary information about business strategies and their expected economic consequences may hurt the firm’s competitive position. Subject to this constraint, managers can use financial statements to provide information useful to investors in assessing their firm’s true economic performance. Managers can also use financial reporting strategies to manipulate investors’ perceptions. Using the discretion granted to them, managers can make it difficult for investors to identify poor performance on a timely basis. For example, managers can choose accounting policies and estimates to provide an optimistic assessment of the firm’s true performance. They can also make it costly for investors to understand the true performance by controlling the extent of information that is disclosed voluntarily. The extent to which financial statements are informative about the underlying business reality varies across firms—and across time for a given firm. This variation in accounting quality provides both an important opportunity and a challenge in doing business analysis. The process through which analysts can separate noise from information in financial statements, and gain valuable business insights from financial statement analysis, is discussed next. FROM FINANCIAL STATEMENTS TO BUSINESS ANALYSIS Because managers’ insider knowledge is a source both of value and distortion in accounting data, it is difficult for outside users of financial statements to separate true information from distortion and noise. Not being able to undo accounting distortions completely, investors “discount” a firm’s reported accounting performance. In doing so, they make a probabilistic assessment of the extent to which a firm’s reported numbers reflect economic reality. As a result, investors can have only an imprecise assessment of an individual firm’s performance. Financial and information intermediaries can add value by improving investors’ understanding of a firm’s current performance and its future prospects. Effective financial statement analysis is valuable because it attempts to get at managers’ inside information from public financial statement data. Because intermediaries do not have direct or complete access to this information, they rely on their knowledge of the 7 8 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Analysis and Valuation Using Financial Statements firm’s industry and its competitive strategies to interpret financial statements. Successful intermediaries have at least as good an understanding of the industry economics as do the firm’s managers, and a reasonably good understanding of the firm’s competitive strategy. Although outside analysts have an information disadvantage relative to the firm’s managers, they are more objective in evaluating the economic consequences of the firm’s investment and operating decisions. Figure 1-3 provides a schematic overview of how business intermediaries use financial statements to accomplish four key steps: (1) business strategy analysis, (2) accounting analysis, (3) financial analysis, and (4) prospective analysis. Figure 1-3 Analysis Using Financial Statements Financial Statements Business Application Context Managers’ superior information on business activities Noise from estimation errors Distortions from managers’ accounting choices Credit analysis Securities analysis Mergers and acquisitions analysis Debt/Dividend analysis Corporate communication strategy analysis General business analysis Other Public Data Industry and firm data Outside financial statements ANALYSIS TOOLS Business Strategy Analysis Generate performance expectations through industry analysis and competitive strategy analysis. Accounting Analysis Financial Analysis Evaluate accounting quality by assessing accounting policies and estimates. Evaluate performance using ratios and cash flow analysis. Prospective Analysis Make forecasts and value business. 1-8 A Framework for Business Analysis and Valuation Using Financial Statements 1-9 Part 1 Framework Analysis Step 1: Business Strategy Analysis The purpose of business strategy analysis is to identify key profit drivers and business risks, and to assess the company’s profit potential at a qualitative level. Business strategy analysis involves analyzing a firm’s industry and its strategy to create a sustainable competitive advantage. This qualitative analysis is an essential first step because it enables the analyst to frame the subsequent accounting and financial analysis better. For example, identifying the key success factors and key business risks allows the identification of key accounting policies. Assessment of a firm’s competitive strategy facilitates evaluating whether current profitability is sustainable. Finally, business analysis enables the analyst to make sound assumptions in forecasting a firm’s future performance. Analysis Step 2: Accounting Analysis The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures the underlying business reality. By identifying places where there is accounting flexibility, and by evaluating the appropriateness of the firm’s accounting policies and estimates, analysts can assess the degree of distortion in a firm’s accounting numbers. Another important step in accounting analysis is to “undo” any accounting distortions by recasting a firm’s accounting numbers to create unbiased accounting data. Sound accounting analysis improves the reliability of conclusions from financial analysis, the next step in financial statement analysis. Analysis Step 3: Financial Analysis The goal of financial analysis is to use financial data to evaluate the current and past performance of a firm and to assess its sustainability. There are two important skills related to financial analysis. First, the analysis should be systematic and efficient. Second, the analysis should allow the analyst to use financial data to explore business issues. Ratio analysis and cash flow analysis are the two most commonly used financial tools. Ratio analysis focuses on evaluating a firm’s product market performance and financial policies; cash flow analysis focuses on a firm’s liquidity and financial flexibility. Analysis Step 4: Prospective Analysis Prospective analysis, which focuses on forecasting a firm’s future, is the final step in business analysis. Two commonly used techniques in prospective analysis are financial statement forecasting and valuation. Both these tools allow the synthesis of the insights from business analysis, accounting analysis, and financial analysis in order to make predictions about a firm’s future. 9 10 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Analysis and Valuation Using Financial Statements While the value of a firm is a function of its future cash flow performance, it is also possible to assess a firm’s value based on the firm’s current book value of equity, and its future return on equity (ROE) and growth. Strategy analysis, accounting analysis, and financial analysis, the first three steps in the framework discussed here, provide an excellent foundation for estimating a firm’s intrinsic value. Strategy analysis, in addition to enabling sound accounting and financial analysis, also helps in assessing potential changes in a firm’s competitive advantage and their implications for the firm’s future ROE and growth. Accounting analysis provides an unbiased estimate of a firm’s current book value and ROE. Financial analysis allows you to gain an in-depth understanding of what drives the firm’s current ROE. The predictions from a sound business analysis are useful to a variety of parties and can be applied in various contexts. The exact nature of the analysis will depend on the context. The contexts that we will examine include securities analysis, credit evaluation, mergers and acquisitions, evaluation of debt and dividend policies, and assessing corporate communication strategies. The four analytical steps described above are useful in each of these contexts. Appropriate use of these tools, however, requires a familiarity with the economic theories and institutional factors relevant to the context. SUMMARY Financial statements provide the most widely available data on public corporations’ economic activities; investors and other stakeholders rely on them to assess the plans and performance of firms and corporate managers. Accrual accounting data in financial statements are noisy, and unsophisticated investors can assess firms’ performance only imprecisely. Financial analysts who understand managers’ disclosure strategies have an opportunity to create inside information from public data, and they play a valuable role in enabling outside parties to evaluate a firm’s current and prospective performance. This chapter has outlined the framework for business analysis with financial statements, using the four key steps: business strategy analysis, accounting analysis, financial analysis, and prospective analysis. The remaining chapters in this book describe these steps in greater detail and discuss how they can be used in a variety of business contexts. DISCUSSION QUESTIONS 1. John, who has just completed his first finance course, is unsure whether he should take a course in business analysis and valuation using financial statements, since he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to John when financial analysis can add value, even if capital markets are efficient. 2. Accounting statements rarely report financial performance without error. List three types of errors that can arise in financial reporting. 1-10 A Framework for Business Analysis and Valuation Using Financial Statements 1-11 Part 1 Framework 3. Joe Smith argues that “learning how to do business analysis and valuation using financial statements is not very useful, unless you are interested in becoming a financial analyst.” Comment. 4. Four steps for business analysis are discussed in the chapter (strategy analysis, accounting analysis, financial analysis, and prospective analysis). As a financial analyst, explain why each of these steps is a critical part of your job, and how they relate to one another. NOTE 1. G. Akerolf, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics (August 1970): 488–500. 11 Korea Stock Exchange 1998 I 1 Framework 1 A Framework for Business Valuation Using Financial Statements n July 1998 Hong In-Kie, Chairman and CEO of the Korea Stock Exchange, was pondering on how best to attract a significant amount of long-term capital into the Korean stock market. Mr. Hong, a graduate of Harvard Business School AMP 85, avid mountain climber, church leader, and accomplished tenor, was aware that there were stiff challenges ahead. At the pinnacle of a successful career as a bureaucrat and as ex-president of a large conglomerate in one of the world’s most dynamic economies, he had a unique birds-eye view of Korean society and the economy. During the past 30 years, the Korean economy had grown at 8.6 percent annually. At the end of 1996, South Korea became the eleventh largest economy in the world and a member of the Organization for Economic Cooperation and Development (OECD). Used to hosannas as a worldwide leader in areas as diverse as shipbuilding, construction, semiconductors, and automobiles, Korea found itself in the unenviable position of having practically depleted its foreign exchange reserves by November of 1997, and having had to seek assistance from the International Monetary Fund (IMF). As a result of the economic crisis, the Korea Composite Stock Price Index (KOSPI) closed at 376.31 by the end of 1997, down 42.2 percent from the closing index of 651.22 in 1996 (see Exhibit 1 for selected economic data). Mr. Hong described the current situation as follows: “It is like a movie unfolding every day, and we are all watching and on stage at the same time. Events are occurring so fast that the headlines in the evening version of the paper and the morning version of the same paper are often substantially different.” Mr. Hong was convinced that finding a way to spur the development of the stock market was a crucial part of the change needed to shepherd Korea out of its current economic predicament. KOREAN ECONOMIC SYSTEM Prior to the 1997 economic crisis, the Korean economy was viewed by many, both inside and outside the country, as a dramatic success story. While there were many facets to the export-oriented economic strategy of Korea, two features stood out: a bank-centered financial system that financed the rapid industrial growth, and the chaebol system that created globally competitive enterprises. ......................................................................................................................... Professors James Jinho Chang (The Wharton School), Tarun Khanna, and Krishna Palepu prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright  1998 by the President and Fellows of Harvard College. Harvard Business School case 9-199-033. Note: All references in this case to the country of Korea mean South Korea. 12 A Framework for Business Analysis and Valuation Using Financial Statements 1-13 Part 1 Framework Korea Stock Exchange 1998 Bank-Centered Financial System Unlike the U.S. and the U.K. economies’ reliance on the stock market, the Korean economy relied heavily on the banking system for channeling savings to industrial investments. In this respect, Korea followed the example of Germany and Japan in the development of its financial system. Many commentators, both in Korea and abroad, believed that the bank-centered financial system facilitated long-term investments, largely due to the close relationships between industrial enterprises and financiers. Because stock market investors typically had no long-term relationship with the firms that they invested in, the U.S.-style stock market system was alleged to lead to “myopic management.” Even though Korean banks operated in the private sector, the national government had significant influence on the banking industry. Through ownership and the appointment of bank directors, the Korean government could influence banks’ lending decisions to further its economic development plans. For example, in the 1970s government policies favored the development of heavy industries, such as construction, machinery, and shipbuilding. The government encouraged companies to expand business in these industries and provided favorable capital related to that expansion through banks. Business Groups The Korean economy was dominated by multibusiness organizations known as chaebols. The largest chaebols, such as Samsung, Daewoo, Hyundai, LG, and the SK Group, operated in a wide variety of industries such as construction, shipbuilding, automobiles, consumer electronics, computing, telecommunication, and financial services. The 30 largest chaebols accounted for 51.8 percent of the total industrial output of Korea in 1996. The top four chaebols, Hyundai, Samsung, LG, and Daewoo, accounted for 31.2 percent of the total industrial output of Korea in 1996. Historically, government policy favored the growth of chaebols. These policies included granting industrial licenses, distributing foreign borrowings, and providing favored access to bank financing.1 The promotion of chaebols was seen by the Korean government as a way to create domestic industry that could compete in global markets. Indeed, Korean chaebols played a very critical role in the export-led growth of the Korean economy. By 1996 the top seven trading companies of chaebols accounted for 47.7 percent of Korea’s total exports.2 The chaebol organizational structure conferred several advantages in the early growth stage of the Korean economy by enabling entrepreneurs to overcome the problem of underdeveloped product, labor, and financial markets. At this stage, many of the institutions ......................................................................................................................... 1. In the early 1970s, the interest rate on foreign borrowing was 5–6 percent, whereas the interest rate on domestic bank debt was 25–30 percent. The interest rate for nonbank borrowing was higher than that from banks. The privilege of using foreign borrowing and bank loans significantly contributed to the accumulation of the chaebols’ wealth. 2. The top seven trading companies are Hyundai, Samsung, LG, Daewoo, SK, Ssangyong, and Hyosung. 13 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Valuation Using Financial Statements that underpin the functioning of advanced markets were either missing or underdeveloped in Korea. In advanced markets, intermediary institutions and legal structures address potential information and incentive problems. These institutions permit individual entrepreneurs to raise capital, access management talent, and earn customer acceptance, and they require all parties to play by the same rules. Entrepreneurs and investors can be sure of the stable legal environment in advanced markets to protect property rights, giving entrepreneurs the confidence that they will reap the fruits of their entrepreneurial activity. In this context found in advanced markets, it is less likely that the entrepreneur will benefit significantly by being associated with a large corporate entity. Hence, the costs of business diversification are likely to exceed any potential benefits. In an emerging market like Korea, in contrast, there were a variety of market failures, caused by information and incentive problems. For example, the financial markets were characterized by a lack of adequate disclosure and weak corporate governance and control. Intermediaries such as financial analysts, mutual funds, investment bankers, venture capitalists, and the financial press were either absent or not fully evolved. Finally, securities regulations were generally weak, and their enforcement was uncertain. Similar problems abounded in product markets and labor markets, once again because of the absence of intermediaries. The absence of intermediary institutions made it costly for individual entrepreneurs to acquire necessary inputs like finance, technology, and management talent. Market and legal imperfections also made it costly to establish quality brand images in product markets, and to establish contractual relationships with joint venture partners. As a result, an enterprise could often be more profitably pursued as part of a large diversified business group, a chaebol, which acted as an intermediary between individual entrepreneurs and imperfect markets. Affiliates of chaebols also enjoyed preferential access to financing from domestic banks because of their strong connections with bankers and government officials. In addition, established companies in a chaebol often provided cross-guarantees on loans to new affiliates, making it easier for new ventures to raise financing from domestic and foreign lenders. Korean chaebols such as Samsung and Daewoo were also able to use their size and scope to invest in world-class brand names. These brand names enabled new companies promoted by these leading chaebols, even in unrelated fields, to gain instant credibility in export markets and with technology partners. Chaebols were the preferred employers for students graduating from prestigious Korean universities. Because of their size and scope, chaebols could offer job security in an economy with no safety nets. Further, chaebols such as Samsung and the SK Group made extensive investment in the training and development of their employees, in effect creating their own “business schools.” Due to their size, they could hire professors from top business schools around the world to lead their in-house training programs. Because Korea did not have many world-class business schools, the in-house “business schools” of chaebols were in a unique position to develop management talent. 1-14 Korea Stock Exchange 1998 14 A Framework for Business Analysis and Valuation Using Financial Statements Korea Stock Exchange 1998 1-15 Part 1 Framework As a result of the above advantages, chaebols were uniquely positioned to launch new ventures in the Korean economy. Chaebols relied extensively on domestic and foreign debt to finance their rapid growth. Reliance on domestic debt arose as a result of the bank-centered nature of the financial system. Further, with a view to keep the control of Korean businesses in Korean hands, government policy restricted foreign direct investment in Korean chaebols. While foreign investors could invest through the stock market, banks and other financial institutions were a more significant channel through which foreign money was invested in Korean companies.3 One of the key characteristics of a chaebol is family ownership and cross-holding. In 1995 the average family ownership in the top 30 chaebols was 10.6 percent and the average ownership through cross-holding equity ownership among member firms was 32.8 percent. Cross-holdings increased the founder family’s control on large business groups.4 Traditionally, the voting rights of institutional investors, such as securities firms and insurance companies, were limited by the law and minority shareholders were not active.5 As a result, the founder or founder’s family could effectively control the business group with relatively small direct ownership, and family members took top management positions.6 By 1996, prior to the economic crisis, the median debt-to-equity ratio of the top 30 Korean chaebols stood at 420 percent (see Exhibit 2). While each company in a chaebol borrowed money independently, bankers often demanded and received cross-guarantees from the other firms in the chaebol. Since Korean financial accounting rules did not require the disclosure of these cross-guarantees, it was difficult for outsiders to assess the true debt commitments of a given Korean company. The “IMF Crisis” The Korean economic crisis in 1997 was part of a broader Asian financial crisis that first started in Thailand, when the baht weakened as foreign investors lost confidence in the Thai economy. Amid the Asian currency crisis, foreign financial institutions, concerned about potential financial distress for Korean firms, started calling in their loans rapidly. Foreign portfolio investors also began to sell their investments and repatriate the sales proceeds for fear of the depreciation of the Korean won.7 ......................................................................................................................... 3. The details of the institutional investor market in Korea can be found in “The growing financial market importance of institutional investors: the case of Korea,” by Yu-Kyung Kim, OECD Proceedings: Institutional Investors in the New Financial Landscape, 1998. 4. Suppose that a family owns 20 percent of Company A and manages it, and Company A has a controlling ownership of Companies B and C, which in turn own 20 percent each of Company A. Through these cross-holdings, the founder’s family can effectively own 60 percent of Company A, and control B and C as well. 5. Under these regulations, institutional investors were restricted to so called “shadow voting,” which essentially meant that they voted with the management. After the recent crisis, this practice was abolished. 6. In 1995, among the top 30 chaebols, only one, KIA Motors, had a CEO who was not related to the founder’s family. 7. 1997 Fact Book published by Korea Stock Exchange. 15 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Valuation Using Financial Statements The outflow of foreign portfolio investment funds continued for four consecutive months, from August to November, bringing Korea close to depleting its foreign exchange reserves. On November 21 the Korean government requested the IMF’s assistance to avoid a potential default on its obligations. After frenzied negotiations, the IMF agreed to provide Korea with U.S.$55 billion or more in a bailout package. Exhibit 3 shows the chronology of events surrounding the crisis; the rapid change in the value of Korean won during 1997 and 1998 is shown in Exhibit 4. The Search for Causes Many observers, both inside and outside Korea, were stunned by the rapid change of investor sentiment. The darling of foreign investors and economists until then, Korea found itself in the middle of an economic crisis that threatened to wipe out the fruits of hard work of a whole generation. As a sense of gloom enveloped the country, a heated debate focused on the search for the root causes of the crisis. The nexus of the banking system and the chaebols, once viewed as the means to rapid economic growth, came under increased attack. Influential policy makers, including those at the IMF, believed that the chaebols, with their close connections to politicians and government officials, could get loans without much resistance from banks. As a result, the vaunted “relationship financing” model, meant to facilitate long-term investments, was now viewed more as facilitating “crony capitalism.” A consensus began to emerge that, with easy access to financing, a lack of supervision by banks, and the government’s emphasis on job creation, chaebols focused excessively on growth and expansion and ignored profitability. On December 19, 1997, in the middle of the serious economic crisis, Kim Dae-Jung won the election as president of South Korea. Soon after entering office, President Kim noted that big business groups, together with government officials in power in the past, must take responsibility for having brought the economy to near collapse. He proclaimed that it was the collusion between the government and business, the government’s control of finance, and widespread corruption that had battered the economy. Kim said, “Unless chaebols implement reform, they would face the recall of existing debts or the suspension of fresh credit. Only profitable enterprises and exporting companies will be regarded as ‘patriotic’ firms eligible for government supports.” 8 The IMF Program As a condition for IMF bailout loans, receiving countries must adhere to the economic programs prescribed by the IMF. Michel Camdessus, IMF managing director, stated: “The program comprises strengthened fiscal and monetary policies, far-reaching financial reforms and further liberalization of trade and capital flows, as well as improvement ......................................................................................................................... 8. Lee Chang-sup, “Kim rules out new currency crisis, Korea Times , September 28, 1998. 1-16 Korea Stock Exchange 1998 16 A Framework for Business Analysis and Valuation Using Financial Statements Korea Stock Exchange 1998 1-17 Part 1 Framework in the structure and governance of Korean corporations.” The IMF’s program for Korea was heavily influenced by the conclusion that it was time for Korea to significantly restructure its financial and industrial sectors (see Exhibit 5 for details of the IMF-supported program of economic reform). Some Koreans were positive about the IMF program because they felt that it could serve as an opportunity to sharpen Korea’s international competitiveness, even though it was to be carried out by the force of outsiders. There were, however, others who expressed concern that the rapid changes proposed under the program were not only unrealistic but could lead to significant layoffs and social instability. In fact, the common reference to the economic crisis as the “IMF crisis” reflected the ambivalence in the Korean reaction to both the causes and the remedies being debated. ECONOMIC RESTRUCTURING 9 To implement the IMF program and to restore international confidence in Korea, the newly elected government of President Kim Dae-Jung began to pursue aggressively financial sector reforms and a total restructuring of chaebols. To this end, the Financial Supervisory Commission (FSC) was established on April 1, 1998, under the Prime Minister’s jurisdiction to supervise all financial institutions including banks, securities firms, and insurance companies. The restructuring process of the financial industry and the corporate sector was administrated by the FSC. The FSC pursued a strategy of sequential restructuring, beginning with banks and accelerating corporate sector restructuring through bank reform. Bank Restructuring The FSC requested twelve banks that fell short of the 8 percent capital adequacy ratio (as of December 1997) set by the Bank for International Settlement (BIS) to submit rehabilitation plans. Bank appraisal committees and accounting firms assessed the size of nonperforming loans through asset due diligence reviews and made full provision and write-offs based on the actual size of nonperforming loans. Based on this review, the FSC conditionally approved the bailout of seven banks and ordered the closure of five nonviable banks. Conditionally approved banks were asked to submit implementation plans which included changes in management, cost reductions, and recapitalization plans such as mergers, joint ventures, or rights issues. The five banks which were classified as nonviable were to be acquired by healthy banks. To protect acquiring banks from spilled-over problem loans, several measures were taken: only good assets would be sold with a six-month put option; government ......................................................................................................................... 9. This section is based on reports published by the Ministry of Finance and Economy (MOFE) and the Financial Supervisory Commission (FSC) in Korea. 17 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Valuation Using Financial Statements would inject fresh capital to enhance the acquiring bank’s capital adequacy to pre-acquisition level; the acquiring bank’s bad assets would be purchased by Korea Asset Management Corporation, funded by public resources; and deposit guarantees would be honored until the completion of all restructuring in order to prevent any bank runs. One example of bank restructuring was a merger between Commercial Bank of Korea and the Hanil Bank. On July 31, 1998, following the guidelines of the FSC, the two banks announced a one-to-one merger. The newly merged bank proposed that in order for it to succeed, the following actions would be taken: (1) an accountable management system through drastic management improvement; (2) early resolution of nonperforming loans through injection from public resources; and (3) capital injection from international investors.10 A key issue in the normalization of the Korean financial sector was to develop a plan to clear nonperforming loans. At the end of March 1998, the nonperforming loans of financial institutions were estimated to be about 120 trillion won, which is about 23.3 percent of Korean financial institutions’ entire credit portfolio. The Korean government estimated that the total market value of the nonperforming loans would be equal to 50 percent of their book value. The realized losses borne by financial institutions were therefore estimated to be approximately 60 trillion won. To finance these losses, the Korean government planned to raise 50 trillion won through government bonds. From this amount, 41 trillion won would be used to purchase nonperforming loans and to recapitalize the affected financial institutions; the remaining nine trillion won would be reserved for the potential new demand for increased deposit protection. The government expected financial institutions to issue new equity worth twenty trillion won, which accounted for as much as one-third of total current capitalization in the Korean stock market. Corporate Restructuring In the short term, the Korean government’s focus with respect to corporate restructuring was to shut down nonviable enterprises, and to improve the financial condition of the rest. In the long term, the objective was to improve the management and governance of the corporate sector in general, and of the chaebols in particular. To achieve these objectives, the FSC delineated five principles of corporate restructuring: (1) improving the financial structure, (2) eliminating the practice of mutual guarantees of loans among affiliated firms, (3) focusing on “core” business sectors, (4) increasing transparency, and (5) improving corporate governance (e.g., increasing major shareholders’ and management’s accountability). In order to direct the restructuring process, the FSC classified all Korean companies into three categories. Companies classified as “viable” would receive full support from ......................................................................................................................... 10. Joint press conference upon announcement of merger between the Commercial Bank of Korea and the Hanil Bank. 1-18 Korea Stock Exchange 1998 18 A Framework for Business Analysis and Valuation Using Financial Statements Korea Stock Exchange 1998 1-19 Part 1 Framework financial institutions; those that were classified as “subject to exit” would be sold off or shut down on a timely basis; and those that were classified as “subject to restructuring” would benefit from proactive support toward restructuring from financial institutions. In June 1998, 55 corporations, which represented 17 percent of the total number of corporations subject to the assessment, were classified as nonviable and ordered to exit. Of these 55 corporations, twenty were affiliated companies of the top five chaebols (Hyundai, Samsung, LG, Daewoo, and SK), and 32 were affiliates of the top 6 to 64 business groups. One of the senior officials at FSC stated: “To reduce excessive reliance on debt financing, the government set a target for reducing Korean companies’ debt to equity (D/E) ratio from the current level of approximately 500 percent to a level of 200 percent by the end of 1999. To meet this requirement, Korean companies had to raise more equity or sell off some of their assets.” Korean chaebols were directed by the FSC to formulate restructuring plans with a view to identifying core businesses on which they would focus, and to close down or divest the rest. To improve transparency and governance of individual companies in a chaebol, new guidelines curtailed the role of the central corporate office, and prohibited cross-guarantees. The top five chaebols were cajoled into the so-called “Big Deal” swaps of business units in order to boost national competitiveness by cutting out some domestic competition. To expedite the pace of corporate restructuring, government submitted the legislative articles, such as allowing tax benefits to restructuring, simplifying the mergers and acquisitions process, and permitting corporate spin-offs/carve-outs, to the coming session of the National Assembly. Attracting Foreign Capital Recognizing the importance of foreign capital for the successful restructuring of Korean banks and chaebols, President Kim Dae-Jung proclaimed his intention to make South Korea a haven for foreign investors. Foreign investors were essential in several ways. First, since all major Korean companies were looking to sell assets and raise new capital, the only viable buyers were foreigner investors. Second, foreign investors brought with them world-class management and governance practices to Korea. To attract foreign capital, the government proposed several new policies. Under the new policy, foreign firms were allowed to freely establish mutual funds in Korea. At the same time, restrictions on foreign investors were also reduced. Earlier, foreign investors needed the approval of the board of directors of a company to buy more than ten percent of its outstanding shares. On May 25, 1998, under the new rules, the ten percent limit was completely abolished. The government also granted special privileges to domestic companies that attracted foreign investment or sold their assets to foreigners. While these moves were somewhat effective in increasing foreign investors’ interest in Korea, several hurdles remained. Deals for foreign direct investment could not be consummated because of widespread disagreement in valuation estimates of Korean sellers 19 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Valuation Using Financial Statements and foreign buyers. These valuation difficulties were exacerbated by the poor quality of accounting information. Further, foreign buyers were uncertain about the ease with which they could lay off employees. Despite the recent agreement between government, industry, and labor unions to cooperate in the restructuring process, the possibility of widespread lay-offs, especially by foreign owners, could be received with hostility. The popular sentiment towards foreign direct investment was also ambiguous. On the one hand, the Korean government undertook a process of educating Koreans that attracting international investors was critical to economic rebuilding. On the other hand, there was a popular feeling against foreign investment, partly due to the 40-year Japanese rule of the country that ended in 1945. As a result, while many American franchises such as McDonald’s and KFC have prospered in Korea, symbolic gestures against foreign investment abounded. When Microsoft attempted to buy a Korean word processing software company in financial distress, there was a fund-raising campaign to save the company and keep it in Korean hands. Even though the amount of foreign investment involved in this deal was only about U.S.$20 million, it was symbolic. Foreign investors were also wary of the risks involved in investing in Korean companies through the stock market. Even in advanced capital markets, investing in stocks involves taking additional risks relative to investment in bonds or bank deposits. Unlike debt holders, shareholders are not promised a fixed payoff. Finally, when insiders have a controlling stake, they can take actions that are potentially harmful to the minority shareholders. In advanced markets, these potential risks faced by public shareholders are mitigated through a variety of mechanisms such as credible financial reporting, minority shareholder protection laws, the threat of hostile takeovers, scrutiny by an aggressive analyst community, and the supervision of management by an independent board of directors. In Korea as of early 1998, many of these institutional mechanisms that protect shareholders and reduce their risks were either absent, underdeveloped, or poorly enforced. Relative to international standards, accounting rules and disclosure regulations were lax; there was a widespread belief that external auditors were either unwilling or unable to exercise independence; it was rare for shareholders to sue corporate managers or auditors successfully; boards were viewed as being too close to corporate managers; there was no effective threat of a hostile takeover or a proxy fight to replace a company’s management; and the financial analysts themselves often worked for brokerage houses owned by large chaebols. The net result of these institutional voids was a perception among investors, both domestic and foreign, that investing in Korean stocks was very risky. DEVELOPING THE CAPITAL MARKETS As Chairman and CEO of the Korea Stock Exchange, Hong In-Kie was committed to leading the development of the Korean capital markets to a truly world-class level. He believed that the long-term prosperity of Korea depended critically on the success of this initiative. 1-20 Korea Stock Exchange 1998 20 A Framework for Business Analysis and Valuation Using Financial Statements Korea Stock Exchange 1998 1-21 Part 1 Framework Traditionally, the stock market played a relatively small role in the Korean financial system. The first significant boost to the Korean stock market came in 1976 when the Securities and Exchange Law underwent extensive revision. The main objective of the amendment was to ensure more effective supervision of the securities industry and to reinforce investor protection. Throughout the latter half of the 1970s, the Korean securities market experienced an unprecedented rush of public offerings. The number of listed corporations, which stood at only 66 in 1972, jumped to 356 by the end of 1978. At the end of 1997, the number of listed companies was 776. During the period from 1972 to 1997, the traded value of listed stocks jumped more than two thousandfold from 71 billion won to 162.3 trillion won and the total market capitalization increased from 246 billion won to 71 trillion won (see Exhibit 6 and Exhibit 7). Even though the absolute amount of both the traded value of stocks and market capitalization has increased over time, the relative magnitude of market capitalization to GDP declined in recent years. In 1994 and 1995, the market value to GDP ratio was greater than 40 percent, but it declined to 30 percent in 1996 and to 17 percent in 1997 (see Exhibit 8). The significance of equity as a source of financing also decreased over the last decade: The proportion of financing from the stock market relative to all sources of external financing declined from 23 percent in 1989 to 7.87 percent in 1997 (see Exhibit 9 and Exhibit 10). The KOSPI composite index (100 as of January 4, 1980) rose from 532 on January 1, 1988, to 1007 on April 1, 1989. Many small investors were counting capital gains in excess of 100 percent in a little over a year. However, this 1988–89 upturn in the Korea Stock Exchange was not sustainable. The composite index has since dived and climbed like a roller coaster. On August 21, 1992, the composite index bottomed out at 460. Many small investors became seriously disillusioned with the stock market in 1992, blaming the government for their losses. Indeed, for political reasons the government had repeatedly intervened to prop up share prices by infusing large inflows of cash from various stabilization funds. Hardly anyone approached the market from a long-term perspective of focusing on the fundamental financial soundness of the company, managerial acumen, or on dividend performance.11 Recent Developments After Mr. Hong became the CEO of the stock exchange in 1993, he initiated several efforts to modernize it. In 1996 the stock exchange moved to a new skyscraper with a fully computerized trading floor and a strict computerized surveillance system to monitor trading activity. Under Mr. Hong’s leadership, the Korea Stock Exchange introduced derivative products for the first time—KOSPI 200 stock index futures contracts in May 1996, and KOSPI 200 stock index option contracts in July 1997. While Mr. Hong was proud of these innovations, and the investments in improving the physical infrastructure ......................................................................................................................... 11. James M. West, “Korea Stock Exchange,” Korea Herald, August 30, 1998. 21 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Valuation Using Financial Statements of the exchange, he was aware that the exchange would not become truly world-class without significantly more support of institutional infrastructure. Mr. Hong noted with satisfaction some recent developments in this direction. Recognizing the fact that lack of transparency was one of the weaknesses that contributed to the current crisis, the Korean government proposed major changes in accounting rules. New regulations required the 30 largest conglomerates to prepare certified financial statements which would cover all the affiliated companies on a combined basis beginning in the 1999 fiscal year. The objective of this requirement was to improve the transparency of large conglomerates. There was also a move to make a fundamental change in Korean Generally Accepted Accounting Principles by adopting the more stringent International Accounting Standards. There was also a change in the process through which accounting standards were set. Earlier, the Korea Securities and Exchange Commissions (KSEC) used to set accounting standards. When a new accounting standard was proposed, the KSEC would form a temporary board to review that standard. Board members included auditors, accounting professors, and government officials. Starting in April 1998, the KSEC became a part of the Financial Supervisory Board, and the FSC took over the supervision of accounting standard setting. To improve shareholder rights, the Korean government took a number of steps. For example, in April 1998, to improve minority shareholders’ rights, the current requirement of 1 percent ownership to bring suits against management was eased to 0.05 percent; the requirement of 1 percent ownership to request the dismissal of a director or an auditor for an illegal act was relaxed to 0.5 percent; the minimum share-ownership required to examine corporate books was reduced from 3 percent to 1 percent. New regulations also attempted to ease restrictions that had previously made hostile takeovers of Korean companies very difficult. Earlier, a company or an individual could not acquire more than 25 percent of the outstanding shares of another company unless an open tender offer to purchase more than 50 percent of the outstanding shares was made. However, in February 1998, this provision was abolished. Also, restrictions on institutional investors’ voting rights were eliminated. Public shareholders were also becoming more vocal in demanding management accountability. In May 1998, for the first time, foreign shareholders were beginning to have a voice in the management of Korean companies. The New York-based hedge fund Tiger Management, with the coalition of other foreign funds, staged a successful revolt at SK Telecom, the country’s leading cellular phone operator. These outsider shareholders forced the phone company to stop subsidizing its sister companies in the SK Group. SK Telecom, for instance, backed a $50 million loan to its sibling SK Securities, which recently suffered heavy losses in derivatives trading. To guard against such maneuvers in the future, minority shareholders demanded—and got—three outside directors on the board of SK Telecom and an independent auditor.12, 13 ......................................................................................................................... 12. Louis Kraar, “Korea’s comeback . . . Don’t expect a miracle,” Forbes , May 25, 1998, p.120. 13. Starting in 1999, all Korea Stock Exchange listed firms are required to have at least 25 percent of their board members be outside directors. 1-22 Korea Stock Exchange 1998 22 A Framework for Business Analysis and Valuation Using Financial Statements Korea Stock Exchange 1998 1-23 Part 1 Framework Management accountability was also being championed by nongovernmental organizations such as The People’s Solidarity for Participatory Democracy (PSPD). The organization was founded in September, 1994, and headed by Professor Chang Ha-sung at Korea University. In July 1998 PSPD successfully won a legal judgment against the management of the Korea First Bank for failure to exercise due diligence in its lending to a failed company, Hanbo Steel. The court order required four former top managers of Korea First Bank to pay about U.S.$30 million with their personal wealth to the bank (not to the plaintiffs) to make up for the losses caused by their negligence. The Korean press hailed it as the first case where plaintiffs won in a suit against management based on the failure to perform due diligence. Future Challenges Mr. Hong was convinced that a lot of progress had been made in the past few months. There was evidence that foreign investors were beginning to come back. Korea was also winning praise from the IMF for following closely its prescriptions. However, he was also aware that much more needed to be done. Although the new accounting regulations were aimed at improving the quality of information available to investors to monitor corporate managers, there was much skepticism about the rules that had been mandated. The editor of a major Korean newspaper commented, “It’s fine for the government and the international investors to demand transparency. However, it’s important to realize that the different facets of Korean society are closely tied together—the government, business, and the banks. The entire system will have to be made transparent, not just a part of it.” Mr. Hong also noted that without effective auditing, financial reports were unlikely to be viewed by investors as reliable. One of the senior partners at a Big Five accounting firm in the United States echoed this sentiment: “Foreign investors know that the quality of audits in Korea is suspect; they will not be satisfied unless the financial statements of their Korean companies are signed by reputable international accounting firms.” The recent victory of minority shareholders represented the coming of major changes in Korean financial markets. However, this development was viewed with mixed feelings by several observers. Given the average Korean citizen’s lack of sophistication about financial markets, there was a concern that minority shareholder rights would be pushed forward without adequate attention paid to minority shareholder responsibilities. Would the prospect of shareholder lawsuits and second-guessing management decisions by courts hamper the restructuring process? There was also a debate in Korea and other emerging markets on the appropriate speed of opening capital markets to foreign investors, given the experience of the past few months. One of the major concerns was the instability of the stock market due to speculative hot money. There was a concern that rapid outflow would significantly damage not only the stock market but also the foreign exchange rate. In order to prevent this, many emerging countries imposed regulations on foreign investment and intervened in their stock markets. 23 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Valuation Using Financial Statements Mr. Hong believed that full liberalization of the stock market was the fundamental solution. He stated, “Government regulations, as in the case of Malaysia, or government interventions in the stock market, as in the case of Hong Kong, do not guarantee the long-term development of a stock market. While in the rest of the world the acronym PKO may stand for Peace Keeping Operation, the same term in Asian securities markets is known as Price Keeping Operation, a derogatory term for intervention by the government. As the underlying philosophy of the government is based on democracy and a market economy, stock market participants must not rely on government to implement artificial market-boosting measures. In the short term, the stock market may have difficulty in breaking out of the doldrums, but as the market finds itself free from any sort of intervention, it will grow into a more independent, transparent, predictable, accountable, and self-sustaining market. Korea is following closely the IMF prescription toward a fully open market. The earlier we can get to the open market, the better.” However, he wondered whether Korea had the institutional infrastructure necessary to support an open stock market. As he pondered over these issues, Mr. Hong knew that the stakes were high. A senior editor of one of Korea’s leading newspapers summed up the situation: “The newly elected President asked for a year to resolve matters. It has been six months already. If things don’t improve, Korean people may not remain patient much longer.” Due to the efforts made by government and business, there was a sign of increase in the foreign investment in Korean stocks (see Exhibit 11). However, the level has not met Mr. Hong’s expectation. Mr. Hong wondered which of several possible directions the Korean stock market should pursue to attract foreign investment. QUESTIONS 1. What are the merits and demerits of a stock versus a bank system of financing? 2. To prevent another bad loan problem in the future, what changes should be made in South Korean banks? 3. Is it a good idea for South Korea to rely more on the stock market as a source of corporate finance? Is it a good idea from the perspective of the chaebols? 4. How long do you think it will take South Korea to develop a vibrant stock market? What are the impediments? Are the changes contemplated adequate for the development of a vibrant stock market? What other steps would you recommend? 1-24 Korea Stock Exchange 1998 24 A Framework for Business Analysis and Valuation Using Financial Statements 1-25 Part 1 Framework EXHIBIT 1 Selected Economic Indicators for South Korea 1995 1996 1997 1998 (estimate) Korea Stock Exchange 1998 ........................................................................................................................................... Korea Composite Stock Price Index (year-end) 882.94 651.22 376.31 Real GDP growth (percent change) 8.8 5.5 –0.4 –4.0 to –5.5 Consumer prices (percent change) 7.4 4.8 7.7 10.0 Central government balance (% of GDP) 3.0 2.4 –0.9 –2.4 82.6 90.5 91.8 89.7 External debt (billion US$) ........................................................................................................................................... Source: International Monetary Fund. 25 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Valuation Using Financial Statements 1-26 EXHIBIT 2 Top 30 Chaebols,a 1996 Financial Data (amounts in billion won) Assets Owners’ Equity Debt-to-Equity Return on Equity ..................................................................................................................................... 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Halla Dong-Ah Doosan Daelim Hansol Hyosung Dongkuk Steel Jinro Kolon Kohap Dongbu Tongyang Haitai New Core Anam Hanil Keopyung Miwon Shinho 52,821 50,705 37,068 34,197 22,743 15,802 13,907 14,121 10,592 7,753 7,399 6,627 6,289 6,369 5,849 4,214 4,131 3,698 3,826 3,840 3,653 3,423 2,631 3,398 2,796 2,638 2,599 2,296 2,233 2,139 9,842 13,809 8,302 7,817 4,703 3,102 2,118 2,289 1,244 2,654 1,281 306 1,383 808 1,118 1,075 879 1,161 99 919 529 946 646 448 211 456 384 513 432 362 437% 267% 346% 337% 384% 409% 557% 517% 751% 192% 478% 2066% 355% 688% 423% 292% 370% 219% 3765% 318% 591% 262% 307% 658% 1225% 479% 577% 348% 417% 491% 5.69% 1.71% 5.64% 5.90% 12.73% –1.90% –10.49% –4.70% –11.01% 5.34% –0.58% 12.89% 4.64% –23.33% 6.35% 1.10% 7.16% 4.75% –169.06% 4.80% 7.34% 3.00% 0.05% 5.89% 15.99% 10.22% –40.00% –0.04% –7.42% –2.93% Mean Median 11,325 5,032 2,328 1,011 617% 420% –5.01% 3.82% ..................................................................................................................................... a. Excluding financial and insurance industries Source: Korea Fair Trade Commissions. Korea Stock Exchange 1998 26 A Framework for Business Analysis and Valuation Using Financial Statements 1-27 Part 1 Framework EXHIBIT 3 Chronological Highlights of the Korean Economic Crisis Date Events Korea Stock Exchange 1998 ................................................................................................................................................... August 20, 1997 The IMF approves a US$4 billion stand-by credit for Thailand, and releases a disbursement of US$1.6 billion. October 8, 1997 The IMF announces support for Indonesia’s intention to seek support from the IMF and other multilateral institutions. November 21, 1997 The IMF welcomes Korea’s request for IMF assistance. December 4, 1997 The IMF approves a US$21 billion stand-by credit for Korea, and releases a disbursement of US$5.6 billion. December 11, 1997 Korean government increases the foreigners’ stock ownership ceiling from 26% to 50% (which later changed to 100%). December 12, 1997 Korean government allows foreigners to invest in short-term financial instruments in domestic market. December 31, 1997 The Korea Composite Stock Price Index closes the year at 376.31, down 42.2% from the closing index of 651.22 in 1996. Total market capitalization is reduced to about 71 trillion won. April 1, 1998 Financial Supervisory Commission (FSC) is established to supervise all financial institutions, including banks, securities firms, and insurance companies. April 9, 1998 The Foreign Exchange Equalization Bonds of US$4 billion are issued successfully and the Korean government shifts its focus from escaping the currency crisis to financial and corporate sector restructuring. May 25, 1998 The ceiling on foreigners’ stock investment is abolished, fully liberalizing the Korean stock market to foreign investors. June 10, 1998 President Kim Dae-Jung delivers address at the U.S. Chamber of Commerce in Washington, D.C. He promises that Korea will become one of the best countries for international investors to freely and safely do business. Foreign Investment Promotion Act is designed to make Korea hospitable to foreign investors by providing financial concessions and administrative support. June 18, 1998 The Financial Supervisory Committee (FSC) classified 55 corporations as financially nonviable and ordered them to liquidate. June 29, 1998 Financial Supervisory Committee (FSC) orders 5 banks to shut down their operation and merge with other banks. FSC requests 7 banks, classified as conditional approval, to submit restructuring implementation plans. July 24, 1998 Minority shareholders win, for the first time in history, against bank management for their failure to exercise due diligence. July 31, 1998 Two conditionally approved banks, the Commercial Bank of Korea and the Hanil Bank, announce one-to-one merger. ................................................................................................................................................... 27 A Framework for Business Analysis and Valuation Using Financial Statements A Framework for Business Valuation Using Financial Statements 1-28 EXHIBIT 4 Bilateral U.S. Dollar–Korean Won Exchange Rate 110 Korea Stock Exchange 1998 100 Won per Dollar 90 80 70 60 50 Source: Bank of Korea. Aug 98 Jun 98 Apr 98 Feb 98 Dec 97 Oct 97 Aug 97 Jun 97 Apr 97 40 Feb 97 28 A Framework for Business Analysis and Valuation Using Financial Statements 1-29 Part 1 Framework EXHIBIT 5 IMF-Supported Program of Economic Reform for South Korea Korea Stock Exchange 1998 ............................................................................................................................................... Financial sector restructuring Comprehensive financial sector restructuring that introduced a clear and firm exit policy for financial institutions, strong market and supervisory discipline, and independence for the central bank. Abolishment of regulations prohibiting a foreigner from becoming a director of a commercial bank. Requirement that all merchant banks meet their capital adequacy ratios. Transparency and corporate sector restructuring Efforts to dismantle the nontransparent and inefficient ties among the government, banks, and businesses, including measures to upgrade accounting, auditing, and disclosure standards. Requirement that corporate financial statements be published every half year, on a consolidated basis, and certified by external auditors according to the international accounting standards. Submission of legislation fully liberalizing hostile takeovers of Korean corporations by domestic companies and foreigners. Amendment of the Bankruptcy Law to accelerate the corporate bankruptcy procedure. Phase-out of the system of cross-guarantees within conglomerates. Foreign investment Full liberalization measures to open up the Korean money, bond, and equity markets to capital inflows, and to liberalize foreign direct investment. Permission for foreign banks’ securities companies to establish subsidiaries in Korea. Labor market reform Amendment of layoff-related laws which facilitate the redeployment of labor. Increase in the government’s financial support for the unemployed. Expansion in the number of companies whose employees are eligible for unemployment insurance, and raising the minimum unemployment subsidy. Trade policy Trade liberalization measures, including setting a timetable in line with WTO commitments to eliminate trade-related subsidies and the import diversification program, as well as streamlining and improving transparency of import certification procedures. ............................................................................................................................................... Source: Adapted from reports published by Financial Supervisory Commissions. 29 A Framework for Business Analysis and Valuation Using Financial Statements 1-30 A Framework for Business Valuation Using Financial Statements EXHIBIT 6 Ten-year history of Korea Composite Stock Price Index (KOSPI) 1200 Korea Stock Exchange 1998 1000 KOSPI 800 600 400 200 0 86 87 88 89 90 91 92 93 94 95 96 97 Source: Fact Book published by Korea Stock Exchange. EXHIBIT 7 Stock Trading Value 250,000 200,000 Billion Won 30 150,000 100,000 50,000 0 71 73 75 77 79 Source: Fact Book published by Korea Stock Exchange. 81 83 85 87 89 91 93 95 97 A Framework for Business Analysis and Valuation Using Financial Statements 1-31 Part 1 Framework Market Capitalization/GDP Korea Stock Exchange 1998 EXHIBIT 8 Market Value to GDP Ratios 0 .5 0 0 .4 0 0 .3 0 0 .2 0 0 .1 0 0 .0 0 92 93 94 95 96 97 Source: Fact Book published by Korea Stock Exchange. EXHIBIT 9 Financing of Korean Corporations (in billion won) Through Financial Institutions Through Capital Markets .......................................... ................................................ Bank Non-Bank CP Stock Bonds Foreigna Othersb Total .............................................................................................................................................................. 1989 5,698 7,963 5,131 8,310 4,932 –185 4,292 36,140 1990 7,995 11,477 1,902 5,987 10,931 3,247 6,517 48,056 1991 11,487 12,686 –2,211 5,555 14,065 2,501 8,002 52,085 1992 8,313 11,599 4,183 7,177 6,616 2,527 9,737 50,152 1993 8,440 11,718 9,017 8,619 9,218 –1,298 9,857 55,571 1994 18,367 20,981 4,405 13,198 13,568 4,037 10,423 84,978 1995 14,991 16,884 16,096 14,445 14,958 5,568 11,656 94,597 1996 18,571 18,424 20,691 13,342 20,265 12,063 13,542 116,899 1997 15,116 28,399 4,773 8,974 27,422 7,162 22,127 113,973 .............................................................................................................................................................. a. Foreign implies funds borrowed from overseas capital markets. b. Others include letters of credit, loans from government, reserve for retirement allowances, etc. Source: Bank of Korea. 31 A Framework for Business Analysis and Valuation Using Financial Statements 1-32 A Framework for Business Valuation Using Financial Statements Through Financial Institutions Through Bond/CP Markets Through Stock Markets Foreign Others Total ................................................................................................................................................... 1989 37.80% 27.84% 22.99% –0.51% 11.87% 100.00% 1990 40.52% 26.70% 12.46% 6.76% 13.56% 100.00% 1991 46.41% 22.76% 10.66% 4.80% 15.36% 100.00% 1992 39.70% 21.53% 14.31% 5.04% 19.42% 100.00% 1993 36.27% 32.81% 15.51% –2.34% 17.74% 100.00% 1994 46.30% 21.15% 15.53% 4.75% 12.27% 100.00% 1995 33.69% 32.83% 15.27% 5.89% 12.32% 100.00% 1996 31.65% 35.04% 11.41% 10.32% 11.58% 100.00% 1997 38.18% 28.25% 7.87% 6.28% 19.41% 100.00% ................................................................................................................................................... Source: Bank of Korea. EXHIBIT 11 Foreign Investment in Korean Stock 22 20 18 16 14 12 Source: Korea Stock Exchange. Jul 98 Apr 98 Jan 98 Oct 97 Jul 97 Apr 97 Jan 97 Oct 96 Jul 96 Apr 96 Jan 96 10 Korea Stock Exchange 1998 EXHIBIT 10 Financing of Korean Corporations (in percent) U.S.$ Billions 32 22 S t r a t egy A n alysis chapter S Business Analysis 2 and Valuation Tools trategy analysis is an important starting point for the analysis of financial statements. Strategy analysis allows the analyst to probe the economics of the firm at a qualitative level so that the subsequent accounting and financial analysis is grounded in business reality. Strategy analysis also allows the identification of the firm’s profit drivers and key risks. This, in turn, enables the analyst to assess the sustainability of the firm’s current performance and make realistic forecasts of future performance. A firm’s value is determined by its ability to earn a return on its capital in excess of the cost of capital. What determines whether or not a firm is able to accomplish this goal? While a firm’s cost of capital is determined by the capital markets, its profit potential is determined by its own strategic choices: (1) the choice of an industry or a set of industries in which the firm operates (industry choice), (2) the manner in which the firm intends to compete with other firms in its chosen industry or industries (competitive positioning), and (3) the way in which the firm expects to create and exploit synergies across the range of businesses in which it operates (corporate strategy). Strategy analysis, therefore, involves industry analysis, competitive strategy analysis, and corporate strategy analysis.1 In this chapter, we will briefly discuss these three steps and use the personal computer industry and Amazon.com, respectively, to illustrate the application of the steps. INDUSTRY ANALYSIS In analyzing a firm’s profit potential, an analyst has to first assess the profit potential of each of the industries in which the firm is competing, because the profitability of various industries differs systematically and predictably over time. For example, the ratio of earnings before interest and taxes to the book value of assets for all U.S. companies between 1981 and 1997 was 8.8 percent. However, the average returns varied widely across specific industries: for the bakery products industry, the profitability ratio was 43 percentage points greater than the population average, and 23 percentage points less than the population average for the silver ore mining industry.2 What causes these profitability differences? There is a vast body of research in industrial organization on the influence of industry structure on profitability.3 Relying on this research, strategy literature suggests that the average profitability of an industry is influenced by the “five forces” shown in Figure 2-1.4 According to this framework, the intensity of competition determines the potential for creating abnormal profits by the firms in an industry. Whether or not the potential profits are kept by the industry is determined by the relative bargaining power of the 2-1 33 34 Strategy Analysis Strategy Analysis Figure 2-1 Industry Structure and Profitability DEGREE OF ACTUAL AND POTENTIAL COMPETITION Rivalry Among Existing Firms Industry growth Concentration Differentiation Switching costs Scale/Learning economies Fixed-Variable costs Excess capacity Exit barriers Threat of New Entrants Threat of Substitute Products Scale economies First mover advantage Distribution access Relationships Legal barriers Relative price and performance Buyers’ willingness to switch INDUSTRY PROFITABILITY BARGAINING POWER IN INPUT AND OUTPUT MARKETS Bargaining Power of Buyers Bargaining Power of Suppliers Switching costs Differentiation Importance of product for cost and quality Number of buyers Volume per buyer Switching costs Differentiation Importance of product for cost and quality Number of suppliers Volume per supplier firms in the industry and their customers and suppliers. We will discuss each of these industry profit drivers in more detail below. DEGREE OF ACTUAL AND POTENTIAL COMPETITION At the most basic level, the profits in an industry are a function of the maximum price that customers are willing to pay for the industry’s product or service. One of the key 2-2 Strategy Analysis 2-3 Part 2 Business Analysis and Valuation Tools determinants of the price is the degree to which there is competition among suppliers of the same or similar products. At one extreme, if there is a state of perfect competition in the industry, micro-economic theory predicts that prices will be equal to marginal cost, and there will be few opportunities to earn supernormal profits. At the other extreme, if the industry is dominated by a single firm, there will be potential to earn monopoly profits. In reality, the degree of competition in most industries is somewhere in between perfect competition and monopoly. There are three potential sources of competition in an industry: (1) rivalry between existing firms, (2) threat of entry of new firms, and (3) threat of substitute products or services. We will discuss each of these competitive forces in the following paragraphs. Competitive Force 1: Rivalry Among Existing Firms In most industries, the average level of profitability is primarily influenced by the nature of rivalry among existing firms in the industry. In some industries, firms compete aggressively, pushing prices close to (and sometimes below) the marginal cost. In other industries, firms do not compete aggressively on price. Instead, they find ways to coordinate their pricing, or compete on nonprice dimensions, such as innovation or brand image. Several factors determine the intensity of competition between existing players in an industry: INDUSTRY GROWTH RATE. If an industry is growing very rapidly, incumbent firms need not grab market share from each other to grow. In contrast, in stagnant industries, the only way existing firms can grow is by taking share away from the other players. In this situation, one can expect price wars among firms in the industry. CONCENTRATION AND BALANCE OF COMPETITORS. The number of firms in an industry and their relative sizes determine the degree of concentration in an industry.5 The degree of concentration influences the extent to which firms in an industry can coordinate their pricing and other competitive moves. For example, if there is one dominant firm in an industry (such as IBM in the mainframe computer industry in the 1970s), it can set and enforce the rules of competition. Similarly, if there are only two or three equal-sized players (such as Coke and Pepsi in the U.S. soft-drink industry), they can implicitly cooperate with each other to avoid destructive price competition. If an industry is fragmented, price competition is likely to be severe. DEGREE OF DIFFERENTIATION AND SWITCHING COSTS. The extent to which firms in an industry can avoid head-on competition depends on the extent to which they can differentiate their products and services. If the products in an industry are very similar, customers are ready to switch from one competitor to another purely on the basis of price. Switching costs also determine customers’ propensity to move from one product to another. When switching costs are low, there is a greater incentive for firms in an industry to engage in price competition. 35 36 Strategy Analysis Strategy Analysis SCALE/LEARNING ECONOMIES AND THE RATIO OF FIXED TO VARIABLE COSTS. If there is a steep learning curve or there are other types of scale economies in an industry, size becomes an important factor for firms in the industry. In such situations, there are incentives to engage in aggressive competition for market share. Similarly, if the ratio of fixed to variable costs is high, firms have an incentive to reduce prices to utilize installed capacity. The airline industry, where price wars are quite common, is an example of this type of situation. EXCESS CAPACITY AND EXIT BARRIERS. If capacity in an industry is larger than customer demand, there is a strong incentive for firms to cut prices to fill capacity. The problem of excess capacity is likely to be exacerbated if there are significant barriers for firms to exit the industry. Exit barriers are high when the assets are specialized, or if there are regulations which make exit costly. Competitive Force 2: Threat of New Entrants The potential for earning abnormal profits will attract new entrants to an industry. The very threat of new firms entering an industry potentially constrains the pricing of existing firms within it. Therefore, the ease with which new firms can enter an industry is a key determinant of its profitability. Several factors determine the height of barriers to entry in an industry: ECONOMIES OF SCALE. When there are large economies of scale, new entrants face the choice of having either to invest in a large capacity which might not be utilized right away, or to enter with less than the optimum capacity. Either way, new entrants will at least initially suffer from a cost disadvantage in competing with existing firms. Economies of scale might arise from large investments in research and development (the pharmaceutical or jet engine industries), in brand advertising (soft-drink industry), or in physical plant and equipment (telecommunications industry). FIRST MOVER ADVANTAGE. Early entrants in an industry may deter future en- trants if there are first mover advantages. For example, first movers might be able to set industry standards, or enter into exclusive arrangements with suppliers of cheap raw materials. They may also acquire scarce government licenses to operate in regulated industries. Finally, if there are learning economies, early firms will have an absolute cost advantage over new entrants. First mover advantages are also likely to be large when there are significant switching costs for customers once they start using existing products. For example, switching costs faced by the users of Microsoft’s DOS operating system make it difficult for software companies to market a new operating system. ACCESS TO CHANNELS OF DISTRIBUTION AND RELATIONSHIPS. Limited ca- pacity in the existing distribution channels and high costs of developing new channels 2-4 Strategy Analysis 2-5 Part 2 Business Analysis and Valuation Tools can act as powerful barriers to entry. For example, a new entrant into the domestic auto industry in the U.S. is likely to face formidable barriers because of the difficulty of developing a dealer network. Similarly, new consumer goods manufacturers find it difficult to obtain supermarket shelf space for their products. Existing relationships between firms and customers in an industry also make it difficult for new firms to enter an industry. Industry examples of this include auditing, investment banking, and advertising. LEGAL BARRIERS. There are many industries in which legal barriers, such as patents and copyrights in research-intensive industries, limit entry. Similarly, licensing regulations limit entry into taxi services, medical services, broadcasting, and telecommunications industries. Competitive Force 3: Threat of Substitute Products The third dimension of competition in an industry is the threat of substitute products or services. Relevant substitutes are not necessarily those that have the same form as the existing products, but those that perform the same function. For example, airlines and car rental services might be substitutes for each other when it comes to travel over short distances. Similarly, plastic bottles and metal cans substitute for each other as packaging in the beverage industry. In some cases, threat of substitution comes not from customers’ switching to another product but from utilizing technologies that allow them to do without, or use less of, the existing products. For example, energy-conserving technologies allow customers to reduce their consumption of electricity and fossil fuels. The threat of substitutes depends on the relative price and performance of the competing products or services, and on customers’ willingness to substitute. Customers’ perception of whether two products are substitutes depends to some extent on whether they perform the same function for a similar price. If two products perform an identical function, then it would be difficult for them to differ from each other in price. However, customers’ willingness to switch is often the critical factor in making this competitive dynamic work. For example, even when tap water and bottled water serve the same function, many customers may be unwilling to substitute the former for the latter, enabling bottlers to charge a price premium. Similarly, designer label clothing commands a price premium even if it is not superior in terms of basic functionality, because customers place a value on the image offered by designer labels. RELATIVE BARGAINING POWER IN INPUT AND OUTPUT MARKETS While the degree of competition in an industry determines whether or not there is potential to earn abnormal profits, the actual profits are influenced by the industry’s bargaining power with its suppliers and customers. On the input side, firms enter into 37 38 Strategy Analysis Strategy Analysis transactions with suppliers of labor, raw materials and components, and finances. On the output side, firms either sell directly to the final customers, or enter into contracts with intermediaries in the distribution chain. In all these transactions, the relative economic power of the two sides is important to the overall profitability of the industry firms. Competitive Force 4: Bargaining Power of Buyers Two factors determine the power of buyers: price sensitivity and relative bargaining power. Price sensitivity determines the extent to which buyers care to bargain on price; relative bargaining power determines the extent to which they will succeed in forcing the price down.6 PRICE SENSITIVITY. Buyers are more price sensitive when the product is undifferentiated and there are few switching costs. The sensitivity of buyers to price also depends on the importance of the product to their own cost structure. When the product represents a large fraction of the buyers’ cost (for example, the packaging material for soft-drink producers), the buyer is likely to expend the resources necessary to shop for a lower cost alternative. In contrast, if the product is a small fraction of the buyers’ cost (for example, windshield wipers for automobile manufacturers), it may not pay to expend resources to search for lower-cost alternatives. Further, the importance of the product to the buyers’ product quality also determines whether or not price becomes the most important determinant of the buying decision. RELATIVE BARGAINING POWER. Even if buyers are price sensitive, they may not be able to achieve low prices unless they have a strong bargaining position. Relative bargaining power in a transaction depends, ultimately, on the cost to each party of not doing business with the other party. The buyers’ bargaining power is determined by the number of buyers relative to the number of suppliers, volume of purchases by a single buyer, number of alternative products available to the buyer, buyers’ costs of switching from one product to another, and the threat of backward integration by the buyers. For example, in the automobile industry, car manufacturers have considerable power over component manufacturers because auto companies are large buyers, with several alternative suppliers to choose from, and switching costs are relatively low. In contrast, in the personal computer industry, computer makers have low bargaining power relative to the operating system software producers because of high switching costs. Competitive Force 5: Bargaining Power of Suppliers The analysis of the relative power of suppliers is a mirror image of the analysis of the buyer’s power in an industry. Suppliers are powerful when there are only a few companies and there are few substitutes available to their customers. For example, in the soft- 2-6 Strategy Analysis 2-7 Part 2 Business Analysis and Valuation Tools drink industry, Coke and Pepsi are very powerful relative to the bottlers. In contrast, metal can suppliers to the soft drink industry are not very powerful because of intense competition among can producers and the threat of substitution of cans by plastic bottles. Suppliers also have a lot of power over buyers when the suppliers’ product or service is critical to buyers’ business. For example, airline pilots have a strong bargaining power in the airline industry. Suppliers also tend to be powerful when they pose a credible threat of forward integration. For example, IBM is powerful relative to mainframe computer leasing companies because of IBM’s unique position as a mainframe supplier, and its own presence in the computer leasing business. APPLYING INDUSTRY ANALYSIS: THE PERSONAL COMPUTER INDUSTRY Let us consider the above concepts of industry analysis in the context of the personal computer (PC) industry.7 The industry began in 1981 when IBM announced its PC with Intel’s microprocessor and Microsoft’s DOS operating system. In 1997 the U.S. had an installed base of 100 million personal computers. The shipments in 1997 alone totaled 30 million units, up 21 percent from 1996. Despite this spectacular growth, however, the industry in 1998 was characterized by low profitability. Even the largest companies in the industry, such as IBM, Compaq, Dell, and Apple, reported poor performance in the early 1990s and were forced to undergo internal restructuring. What accounted for this low profitability? What was the computer industry’s future profit potential? COMPETITION IN THE PERSONAL COMPUTER INDUSTRY. The competition was very intense for a number of reasons: • The industry was fragmented, with many firms producing virtually identical products. Even though the computer market became more concentrated in the 1990s, with the top five vendors controlling close to 60 percent of the market, competition was intense, leading to routine price cuts on a monthly basis. • Component costs accounted for more than 60 percent of total hardware costs of a personal computer, and volume purchases of components reduced these costs. Therefore, there was intense competition for market share among competing manufacturers. • Products produced by different firms in the industry were virtually identical, and there were few opportunities to differentiate the products. While brand name and service were dimensions that customers valued in the early years of the industry, they became less important as PC buyers became more informed about the technology. • Switching costs across different brands of personal computers were relatively low because a vast majority of the personal computers used Intel microprocessors and Microsoft Windows operating systems. 39 40 Strategy Analysis Strategy Analysis • Access to distribution was not a significant barrier, as demonstrated by Dell Computers, which distributed its computers by direct mail through the 1980s and introduced Internet-based sales in the mid-1990s. The advent of computer superstores like CompUSA also mitigated this constraint, since these stores were willing to carry several brands. • Since virtually all the components needed to produce a personal computer were available for purchase, there were very few barriers to entering the industry. In fact, Michael Dell started Dell Computer Company in the early 1980s by assembling PCs in his University of Texas dormitory room. • Apple’s Macintosh computers offered competition as a substitute product. Workstations produced by Sun and other vendors were also potential substitutes at the higher end of the personal computer market. THE POWER OF SUPPLIERS AND BUYERS. Suppliers and buyers had significant power over firms in the industry for these reasons: • Key hardware and software components for personal computers were controlled by firms with virtual monopoly. Intel dominated the microprocessor production for the personal computer industry, and Microsoft controlled the operating system market with its DOS and Windows operating systems. • Buyers gained more power during the ten years from 1983 to 1993. Corporate buyers, who represented a significant portion of the customer base, were highly price sensitive since the expenditure on PCs represented a significant cost to their operations. Further, as they became knowledgeable about personal computer technology, customers were less influenced by brand name in their purchase decision. Buyers increasingly viewed PCs as commodities, and used price as the most important consideration in their buying decision. As a result of the intense rivalry and low barriers to entry in the personal computer industry, there was severe price competition among different manufacturers. Further, there was tremendous pressure on firms to spend large sums of money to introduce new products rapidly, maintain high quality, and provide excellent customer support. Both these factors led to a low profit potential in the industry. The power of suppliers and buyers reduced the profit potential further. Thus, while the personal computer industry represented a technologically dynamic industry, its profit potential was poor. There were few indications of change in the basic structure of the personal computer industry, and there was little likelihood of viable competition emerging to challenge the domination of Microsoft and Intel in the input markets. Attempts by industry leaders like IBM to create alternative proprietary technologies have not succeeded. As a result, the profitability of the PC industry may not improve significantly any time in the near future. LIMITATIONS OF INDUSTRY ANALYSIS. A potential limitation of the industry analysis framework discussed in this chapter is the assumption that industries have clear 2-8 Strategy Analysis 2-9 Part 2 Business Analysis and Valuation Tools boundaries. In reality, it is often not easy to clearly demarcate industry boundaries. For example, in analyzing Dell’s industry, should one focus on the IBM-compatible personal computer industry or the personal computer industry as a whole? Should one include workstations in the industry definition? Should one consider only the domestic manufacturers of personal computers, or also manufacturers abroad? Inappropriate industry definition will result in incomplete analysis and inaccurate forecasts. COMPETITIVE STRATEGY ANALYSIS The profitability of a firm is influenced not only by its industry structure but also by the strategic choices it makes in positioning itself in the industry. While there are many ways to characterize a firm’s business strategy, as Figure 2-2 shows, there are two generic competitive strategies: (1) cost leadership and (2) differentiation.8 Both these strategies can potentially allow a firm to build a sustainable competitive advantage. Figure 2-2 Strategies for Creating Competitive Advantage Cost Leadership Differentiation Supply same product or service at a lower cost. Supply a unique product or service at a cost lower than the price premium customers will pay. Economies of scale and scope Efficient production Simpler product designs Lower input costs Low-cost distribution Little research and development or brand advertising Tight cost control system Superior product quality Superior product variety Superior customer service More flexible delivery Investment in brand image Investment in research and development Control system focus on creativity and innovation Competitive Advantage • Match between firm’s core competencies and key success factors to execute strategy • Match between firm’s value chain and activities required to execute strategy • Sustainability of competitive advantage 41 42 Strategy Analysis Strategy Analysis Strategy researchers have traditionally viewed cost leadership and differentiation as mutually exclusive strategies. Firms that straddle the two strategies are considered to be “stuck in the middle” and are expected to earn low profitability.9 These firms run the risk of not being able to attract price conscious customers because their costs are too high; they are also unable to provide adequate differentiation to attract premium price customers.10 SOURCES OF COMPETITIVE ADVANTAGE Cost leadership enables a firm to supply the same product or service offered by its competitors at a lower cost. Differentiation strategy involves providing a product or service that is distinct in some important respect valued by the customer. For example, in retailing, Nordstrom has succeeded on the basis of differentiation by emphasizing exceptionally high customer service. In contrast, Filene’s Basement Stores is a discount retailer competing purely on a low-cost basis. Competitive Strategy 1: Cost Leadership Cost leadership is often the clearest way to achieve competitive advantage. In industries where the basic product or service is a commodity, cost leadership might be the only way to achieve superior performance. There are many ways to achieve cost leadership, including economies of scale and scope, economies of learning, efficient production, simpler product design, lower input costs, and efficient organizational processes. If a firm can achieve cost leadership, then it will be able to earn above-average profitability by merely charging the same price as its rivals. Conversely, a cost leader can force its competitors to cut prices and accept lower returns, or to exit the industry. Firms that achieve cost leadership focus on tight cost controls. They make investments in efficient scale plants, focus on product designs that reduce manufacturing costs, minimize overhead costs, make little investment in risky research and development, and avoid serving marginal customers. They have organizational structures and control systems that focus on cost control. Competitive Strategy 2: Differentiation A firm following the differentiation strategy seeks to be unique in its industry along some dimension that is highly valued by customers. For differentiation to be successful, the firm has to accomplish three things. First, it needs to identify one or more attributes of a product or service that customers value. Second, it has to position itself to meet the chosen customer need in a unique manner. Finally, the firm has to achieve differentiation at a cost that is lower than the price the customer is willing to pay for the differentiated product or service. 2-10 Strategy Analysis 2-11 Part 2 Business Analysis and Valuation Tools Drivers of differentiation include providing superior intrinsic value via product quality, product variety, bundled services, or delivery timing. Differentiation can also be achieved by investing in signals of value, such as brand image, product appearance, or reputation. Differentiated strategies require investments in research and development, engineering skills, and marketing capabilities. The organizational structures and control systems in firms with differentiation strategies need to foster creativity and innovation. While successful firms choose between cost leadership and differentiation, they cannot completely ignore the dimension on which they are not primarily competing. Firms that target differentiation still need to focus on costs, so that the differentiation can be achieved at an acceptable cost. Similarly, cost leaders cannot compete unless they achieve at least a minimum level on key dimensions on which competitors might differentiate, such as quality and service. ACHIEVING AND SUSTAINING COMPETITIVE ADVANTAGE The choice of competitive strategy does not automatically lead to the achievement of competitive advantage. To achieve competitive advantage, the firm has to have the capabilities needed to implement and sustain the chosen strategy. Both cost leadership and differentiation strategy require that the firm make the necessary commitments to acquire the core competencies needed, and structure its value chain in an appropriate way. Core competencies are the economic assets that the firm possesses, whereas the value chain is the set of activities that the firm performs to convert inputs into outputs. The uniqueness of a firm’s core competencies and its value chain and the extent to which it is difficult for competitors to imitate them determines the sustainability of a firm’s competitive advantage.11 To evaluate whether or not a firm is likely to achieve its intended competitive advantage, the analyst should ask the following questions: • What are the key success factors and risks associated with the firm’s chosen competitive strategy? • Does the firm currently have the resources and capabilities to deal with the key success factors and risks? • Has the firm made irreversible commitments to bridge the gap between its current capabilities and the requirements to achieve its competitive advantage? • Has the firm structured its activities (such as research and development, design, manufacturing, marketing and distribution, and support activities) in a way that is consistent with its competitive strategy? • Is the company’s competitive advantage sustainable? Are there any barriers that make imitation of the firm’s strategy difficult? • Are there any potential changes in the firm’s industry structure (such as new technologies, foreign competition, changes in regulation, changes in customer requirements) that might dissipate the firm’s competitive advantage? Is the company flexible enough to address these changes? 43 44 Strategy Analysis Strategy Analysis APPLYING COMPETITIVE STRATEGY ANALYSIS Let us consider the concepts of competitive strategy analysis in the context of Dell Computer Corporation. In 1998 Round Rock, Texas-based Dell Computer was the fourth largest computer maker, behind IBM, Hewlett-Packard, and Compaq. The company, founded by Michael Dell in his University of Texas dorm room, started selling “IBM clone” personal computers in 1984. From the beginning, Dell sold its machines directly to end users, rather than through retail outlets, at a significantly lower price than its competitors. After rapid growth and some management hiccups, Dell firmly established itself in the personal computer industry by following a low cost strategy. By 1998 Dell achieved $18 billion in revenues and $1.5 billion in net income. Dell’s growth rates over the previous three years were extraordinary: 51 percent growth in revenues, and 78 percent growth in net income. Dell’s stellar performance made it one of the most profitable personal computer makers in a highly competitive industry. How did Dell achieve such performance? Dell’s superior performance was based on a low-cost competitive strategy that consisted of the following key elements: • Direct selling. Dell sold most of its computers directly to its customers, thus saving on retail markups. As computer users become sophisticated, and as computers become standardized on the Windows-Intel platform, the value of distribution through retailers declines. Dell was the first company to capitalize on this trend. In 1996 Dell began selling computers through its Internet web site. By 1999 the company was generating several million dollars of sales per day through the Internet. • Made-to-order manufacturing. Dell developed a system of flexible manufacturing that allowed the company to assemble and ship computers very quickly, usually within five days of receiving an order. This allowed the company to avoid large inventories of parts and assembled computers. Low inventories allowed Dell to save working capital costs; it also reduced costly write-offs of obsolete inventories, a significant risk in the fast-changing computer industry. • Third-party service. Dell used two low-cost approaches to after-sales service: telephone-based service and third-party maintenance service. Dell had several hundred technical support representatives accessible to the customers by phone any time of the day. Using a comprehensive electronic maintenance system, the service representatives could diagnose and help the customer to resolve problems in the vast majority of cases. In the rare case where on-site maintenance was required, Dell used third-party maintenance contracts with office equipment companies such as Xerox. Through this service strategy, Dell was able to avoid investing in an expensive field service network without compromising on service quality. • Low accounts receivable. Dell was able to reduce its accounts receivable days to an industry minimum by encouraging its customers to pay by credit card at the time of the purchase, or through electronic payment immediately after the purchase. 2-12 Strategy Analysis 2-13 Part 2 Business Analysis and Valuation Tools • Focused investment in R&D. Dell recognized that most of the basic innovations in the personal computer industry were led by the component suppliers and software producers. For example, Intel and Microsoft, two key suppliers, invested billions of dollars in developing new generation processors and software, respectively. Dell’s innovations were primarily in creating a low-cost, high-velocity organization that can respond quickly to these changes. By focusing its R&D innovations, Dell was able to minimize these costs and get high return on its investments. As a result of the above strategy, Dell achieved a significant cost advantage over its competitors in the personal computer industry. This advantage resulted in a consistent pattern of rapid growth, increasing market share, and very high profitability in an industry that is characterized by rapid technological changes, significant supplier and buyer power, and intense competition. Further, because the strategy involved activities that are highly interrelated and involved continuous organizational innovations, Dell’s business model was difficult to replicate, making Dell’s competitive advantage sustainable. In fact, Dell’s success inspired several of its competitors, including Compaq and IBM, to attempt to replicate parts of its strategy. However, no competitor to date has been able to replicate Dell’s business model. The extraordinarily high earnings and book value multiples at which Dell’s stock has been trading in recent years is evidence that investors are betting that Dell’s competitive advantage and its superior profit performance is likely to be sustained for the foreseeable future. CORPORATE STRATEGY ANALYSIS So far in this chapter, we have focused on the strategies at the individual business level. While some companies focus on only one business, many companies operate in multiple businesses. For example, the average number of business segments operated by the top 500 U.S. companies in 1992 is eleven industries.12 In recent years, there has been an attempt by U.S. companies to reduce the diversity of their operations and focus on a relatively few “core” businesses. However, multibusiness organizations continue to dominate the economic activity in most countries in the world. When analyzing a multibusiness organization, an analyst has to not only evaluate the industries and strategies of the individual business units but also the economic consequences—either positive or negative—of managing all the different businesses under one corporate umbrella. For example, General Electric has been very successful in creating significant value by managing a highly diversified set of businesses ranging from aircraft engines to light bulbs, but Sears has not been very successful in managing retailing together with financial services. Sources of Value Creation at the Corporate Level Economists and strategy researchers have identified several factors that influence an organization’s ability to create value through a broad corporate scope. Economic theory 45 46 Strategy Analysis Strategy Analysis suggests that the optimal activity scope of a firm depends on the relative transaction cost of performing a set of activities inside the firm versus using the market mechanism.13 Transaction cost economics implies that the multiproduct firm is an efficient choice of organizational form when coordination among independent, focused firms is costly due to market transaction costs. Transaction costs can arise out of several sources. They may arise if the production process involves specialized assets, such as human capital skills, proprietary technology, or other organizational know-how that is not easily available in the marketplace. Transaction costs also may arise from market imperfections such as information and incentive problems. If buyers and sellers cannot solve these problems through standard mechanisms such as enforceable contracts, it will be costly to conduct transactions through market mechanisms. For example, as discussed in Chapter 1, public capital markets may not work well when there are significant information and incentive problems, making it difficult for entrepreneurs to raise capital from investors. Similarly, if buyers cannot ascertain the quality of products being sold because of lack of information, or cannot enforce warranties because of poor legal infrastructure, entrepreneurs will find it difficult to break into new markets. Finally, if employers cannot assess the quality of applicants for new positions, they will have to rely more on internal promotions, rather than external recruiting, to fill higher positions in an organization. Emerging economies often suffer from these types of transaction costs because of poorly developed intermediation infrastructure.14 Even in many advanced economies, examples of high transaction costs can be found. For example, in many countries other than the U.S., the venture capital industry is not highly developed, making it costly for new businesses in high technology industries to attract financing. Even in the U.S., transaction costs may vary across economic sectors. For example, until recently electronic commerce was hampered by consumer concerns regarding the security of credit card information sent over the Internet. Transactions inside an organization may be less costly than market-based transactions for several reasons. First, communication costs inside an organization are reduced because confidentiality can be protected and credibility can be assured through internal mechanisms. Second, the headquarters office can play a critical role in reducing costs of enforcing agreements between organizational subunits. Third, organizational subunits can share valuable nontradable assets (such as organizational skills, systems, and processes) or nondivisible assets (such as brand names, distribution channels, and reputation). There are also forces that increase transaction costs inside organizations. Top management of an organization may lack the specialized information and skills necessary to manage businesses across several different industries. This lack of expertise reduces the possibility of realizing economies of scope in reality, even when there is potential for such economies. This problem can be remedied by creating a decentralized organization, hiring specialist managers to run each business unit, and providing them with proper incentives. However, decentralization will also potentially decrease goal congruence among subunit managers, making it difficult to realize economies of scope. 2-14 Strategy Analysis 2-15 Part 2 Business Analysis and Valuation Tools Whether or not a multibusiness organization creates more value than a comparable collection of focused firms is, therefore, context dependent.15 Analysts should ask the following questions to assess whether or not an organization’s corporate strategy has the potential to create value: • Are there significant imperfections in the product, labor, or financial markets in the industries (or countries) in which a company is operating? Is it likely that transaction costs in these markets are higher than the costs of similar activities inside a well managed organization? • Does the organization have special resources such as brand names, proprietary know-how, access to scarce distribution channels, and special organizational processes that have the potential to create economies of scope? • Is there a good fit between the company’s specialized resources and the portfolio of businesses in which the company is operating? • Does the company allocate decision rights between the headquarters office and the business units optimally to realize all the potential economies of scope? • Does the company have internal measurement, information, and incentive systems to reduce agency costs and increase coordination across business units? Empirical evidence suggests that creating value through a multibusiness corporate strategy is hard in practice. Several researchers have documented that diversified U.S. companies trade at a discount in the stock market relative to a comparable portfolio of focused companies.16 Studies also show that acquisitions of one company by another, especially when the two are in unrelated businesses, often fail to create value for the acquiring companies.17 Finally, there is considerable evidence that value is created when multibusiness companies increase corporate focus through divisional spinoffs and asset sales.18 There are several potential explanations for the above diversification discount. First, managers’ decisions to diversify and expand are frequently driven by a desire to maximize the size of their organization rather than to maximize shareholder value. Second, diversified companies suffer from agency problems leading to suboptimal investment decisions and poor operating performance. Third, capital markets find it difficult to monitor and value multibusiness organizations because of inadequate disclosure about the performance of individual business segments. In summary, while companies can theoretically create value through innovative corporate strategies, there are many ways in which this potential fails to get realized in practice. Therefore, it pays to be skeptical when evaluating companies’ corporate strategies. Applying Corporate Strategy Analysis Let us apply the concepts of corporate strategy analysis to Amazon.com, a pioneer in electronic commerce. Amazon started operations as an online bookseller in 1995 and 47 48 Strategy Analysis Strategy Analysis went public in 1997 with a market capitalization of $561 million dollars. The company grew rapidly and began to pose a serious threat to the dominance of leading traditional booksellers like Barnes & Noble. Investors rewarded Amazon by increasing its market capitalization to a remarkable $36 billion dollars by April 1999. Flush with his success in online book-selling, Jeff Bezos, the founder and chief executive officer of Amazon, moved the company into many other areas of electronic commerce. Amazon claimed that its brand, its loyal customer base, and its ability to execute electronic commerce were valuable assets that can be exploited in a number of other online business areas. Beginning in 1998, through a series of acquisitions, Amazon expanded into online selling of CDs, videos, gifts, pharmaceutical drugs, pet supplies, and groceries. In April 1999, Amazon announced plans to diversify into the online auction business by acquiring LiveBid.com. Bezos explained, “We are not a book company. We’re not a music company. We’re not a video company. We’re not an auctions company. We’re a customer company.”19 Amazon’s rapid expansion attracted controversy among the investment community. Some analysts argued that Amazon could create value through its broad corporate focus because of the following reasons: • Amazon has established a valuable brand name on the Internet. Given that electronic commerce is a relatively new phenomenon, customers are likely to rely on well known brands to reduce the risk of a bad shopping experience. Amazon’s expansion strategy is sensible because it exploits this valuable resource. • Amazon has been able to acquire critical expertise in flawless execution of electronic retailing. This is a general competency that can be exploited in many areas of electronic retailing. • Amazon has been able to create a tremendous amount of loyalty among its customers through superior marketing and execution. As a result, a very high proportion of Amazon’s sales comes from repeat purchases by its customers. Amazon’s strategy exploits this valuable customer base. There were also some skeptics who believed that Amazon was expanding too rapidly, and that its diversification beyond book retailing was likely to fail. These skeptics questioned the value of Amazon’s brand name. They argued that traditional retailers, such as Barnes & Noble, Wal-Mart, and CVS, who are boosting their online efforts, also have valuable brand names, execution capabilities, and customer loyalty. Therefore, these companies are likely to offer formidable competition to Amazon’s individual business lines. Amazon’s critics also pointed out that expanding rapidly into so many different areas is likely to confuse customers, dilute Amazon’s brand value, and increase the chance of poor execution. Commenting on the fact that Amazon is losing money in all of its businesses while it is expanding rapidly, Barron’s business weekly stated, “Increasingly, Amazon’s strategy is looking like the dim-bulb businessman who loses money on every sale but tries to make it up by making more sales.”20 2-16 Strategy Analysis 2-17 Part 2 Business Analysis and Valuation Tools Investor concerns about Amazon’s corporate strategy began to affect its share price, which dropped from a high of $221 dollars in April 1999 to $118 dollars by the end of May 1999. Still, at a total market capitalization of about $19 billion dollars, many investors are betting that Amazon’s corporate strategy is likely to yield rich dividends in the future. SUMMARY Strategy analysis is an important starting point for the analysis of financial statements because it allows the analyst to probe the economics of the firm at a qualitative level. Strategy analysis also allows the identification of the firm’s profit drivers and key risks, enabling the analyst to assess the sustainability of the firm’s performance and make realistic forecasts of future performance. Whether or not a firm is able to earn a return on its capital in excess of its cost of capital is determined by its own strategic choices: (1) the choice of an industry or a set of industries in which the firm operates (industry choice), (2) the manner in which the firm intends to compete with other firms in its chosen industry or industries (competitive positioning), and (3) the way in which the firm expects to create and exploit synergies across the range of businesses in which it operates (corporate strategy). Strategy analysis involves analyzing all three choices. Industry analysis consists of identifying the economic factors which drive the industry profitability. In general, an industry’s average profit potential is influenced by the degree of rivalry among existing competitors, the ease with which new firms can enter the industry, the availability of substitute products, the power of buyers, and the power of suppliers. To perform industry analysis, the analyst has to assess the current strength of each of these forces in an industry and make forecasts of any likely future changes. Competitive strategy analysis involves identifying the basis on which the firm intends to compete in its industry. In general, there are two potential strategies that could provide a firm with a competitive advantage: cost leadership and differentiation. Cost leadership involves offering the same product or service that other firms offer at a lower cost. Differentiation involves satisfying a chosen dimension of customer need better than the competition, at an incremental cost that is less than the price premium that customers are willing to pay. To perform strategy analysis, the analyst has to identify the firm’s intended strategy, assess whether or not the firm possesses the competencies required to execute the strategy, and recognize the key risks that the firm has to guard against. The analyst also has to evaluate the sustainability of the firm’s strategy. Corporate strategy analysis involves examining whether a company is able to create value by being in multiple businesses at the same time. A well-crafted corporate strategy reduces costs or increases revenues from running several businesses in one firm relative 49 50 Strategy Analysis Strategy Analysis to operating the same businesses independently and transacting with each other in the marketplace. These cost savings or revenue increases come from specialized resources that the firm has to exploit synergies across these businesses. For these resources to be valuable, they must be nontradable, not easily imitated by competition, and nondivisible. Even when a firm has such resources, it can create value through a multibusiness organization only when it is managed so that the information and agency costs inside the organization are smaller than the market transaction costs. The insights gained from strategy analysis can be useful in performing the remainder of the financial statement analysis. In accounting analysis, the analyst can examine whether a firm’s accounting policies and estimates are consistent with its stated strategy. For example, a firm’s choice of functional currency in accounting for its international operations should be consistent with the level of integration between domestic and international operations that the business strategy calls for. Similarly, a firm that mainly sells housing to low-income customers should have higher bad debts expenses. Strategy analysis is also useful in guiding financial analysis. For example, in a crosssectional analysis the analyst should expect firms with cost leadership strategy to have lower gross margins and higher asset turnover than firms that follow differentiated strategies. In a time series analysis, the analyst should closely monitor any increases in expense ratios and asset turnover ratios for low-cost firms, and any decreases in investments critical to differentiation for firms that follow differentiation strategy. Business strategy analysis also helps in prospective analysis and valuation. First, it allows the analyst to assess whether, and for how long, differences between the firm’s performance and its industry (or industries) performance are likely to persist. Second, strategy analysis facilitates forecasting investment outlays the firm has to make to maintain its competitive advantage. DISCUSSION QUESTIONS 1. Judith, an accounting major, states, “Strategy analysis seems to be an unnecessary detour in doing financial statement analysis. Why can’t we just get straight to the accounting issues?” Explain to Judith why she might be wrong? 2. What are the critical drivers of industry profitability? 3. One of the fastest growing industries in the last twenty years is the memory chip industry, which supplies memory chips for personal computers and other electronic devices. Yet the average profitability for this industry has been very low. Using the industry analysis framework, list all the potential factors that might explain this apparent contradiction. 2-18 Strategy Analysis 2-19 Part 2 Business Analysis and Valuation Tools 4. Rate the pharmaceutical and lumber industries as high, medium, or low on the following dimensions of industry structure: Pharmaceutical Industry Lumber Industry Rivalry Threat of new entrants Threat of substitute products Bargaining power of buyers Bargaining power of suppliers Given your ratings, which industry would you expect to earn the highest returns? 5. Joe Smith argues, “Your analysis of the five forces that affect industry profitability is incomplete. For example, in the banking industry, I can think of at least three other factors that are also important; namely, government regulation, demographic trends, and cultural factors.” His classmate Jane Brown disagrees and says, “These three factors are important only to the extent that they influence one of the five forces.” Explain how, if at all, the three factors discussed by Joe affect the five forces in the banking industry. 6. Coca-Cola and Pepsi are both very profitable soft drinks. Inputs for these products include sugar, bottles/cans, and soft drink syrup. Coca-Cola and Pepsi produce the syrup themselves and purchase the other inputs. They then enter into exclusive contracts with independent bottlers to produce their products. Use the five forces framework and your knowledge of the soft drink industry to explain how Coca-Cola and Pepsi are able to retain most of the profits in this industry. 7. In the early 1980s, United, Delta, and American Airlines each started frequent flier programs as a way to differentiate themselves in response to excess capacity in the industry. Many industry analysts, however, believe that this move had only mixed success. Use the competitive advantage concepts to explain why. 8. What are the ways that a firm can use to create barriers to entry to deter competition in its business? What factors determine whether these barriers are likely to be enduring? 9. Explain why you agree or disagree with each of the following statements: a. It’s better to be a differentiator than a cost leader, since you can then charge premium prices. b. It’s more profitable to be in a high technology than a low technology industry. c. The reason why industries with large investments have high barriers to entry is because it is costly to raise capital. 10. There are very few companies that are able to be both cost leaders and differentiators. Why? Can you think of a company that has been successful at both? 11. Many consultants are advising diversified companies in emerging markets, such as India, Korea, Mexico, and Turkey, to adopt corporate strategies proven to be of val- 51 52 Strategy Analysis Strategy Analysis ue in advanced economies, like the U.S. and the U.K. What are the pros and cons of this advice? NOTES 1. The discussion presented here is intended to provide a basic background in strategy analysis. For a more complete discussion of the strategy concepts, see, for example, Contemporary Strategy Analysis by Robert M. Grant (Cambridge, MA: Blackwell Publishers, 1991); Economics of Strategy by David Besanko, David Dranove, and Mark Shanley (New York: John Wiley & Sons, 1996); Strategy and the Business Landscape by Pankaj Ghemawat (Reading, MA: Addison Wesley Longman, 1999); and Corporate Strategy: Resources and the Scope of the Firm by David J. Collis and Cynthia Montgomery (Burr Ridge, IL: Irwin/McGraw-Hill, 1997). 2. These data are taken from “Do Competitors Perform Better When They Pursue Different Strategies?” by Anita M. McGahan (Boston: Harvard Business School, working paper, May 12, 1999). 3. For a summary of this research, see Industrial Market Structure and Economic Performance, second edition, by F. M. Scherer (Chicago: Rand McNally College Publishing Co., 1980). 4. See Competitive Strategy by Michael E. Porter (New York: The Free Press, 1980). 5. The four-firm concentration ratio is a commonly used measure of industry concentration; it refers to the market share of the four largest firms in an industry. 6. While the discussion here uses the buyer to connote industrial buyers, the same concepts also apply to buyers of consumer products. Throughout this chapter, we use the terms buyers and customers interchangeably. 7. The data on Dell and the personal computer (PC) industry discussed here and elsewhere in this chapter is drawn from “Dell Computer Corporation” by Das Narayandas and V. Kasturi Rangan (Boston: Harvard Business School Publishing Division, 9-596-058) and “Dell Online” by V. Kasturi Rangan and Marie Bell (Boston: Harvard Business School Publishing Division, 9-598116). 8. For a more detailed discussion of these two sources of competitive advantage, see Michael E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: The Free Press, 1985). 9. Ibid. 10. In recent years, one of the strategic challenges faced by corporations is having to deal with competitors who achieve differentiation with low cost. For example, Japanese auto manufacturers have successfully demonstrated that there is no necessary trade-off between quality and cost. Similarly, in recent years several highly successful retailers like Wal-Mart and Home Depot have been able to combine high quality, high service, and low prices. These examples suggest that combining low cost and differentiation strategies is possible when a firm introduces a significant technical or business innovation. However, such cost advantage and differentiation will be sustainable only if there are significant barriers to imitation by competitors. 11. See Competing for the Future by Gary Hammel and C. K. Prahalad (Boston: Harvard Business School Press, 1994) for a more detailed discussion of the concept of core competencies and their critical role in corporate strategy. 12. Cynthia Montgomery, “Corporate Diversification,” Journal of Economic Perspectives, Summer 1994. 2-20 Strategy Analysis 2-21 Part 2 Business Analysis and Valuation Tools 13. The following works are seminal to the transaction cost economics: “The Nature of the Firm” by Ronald Coase, Economica 4, 1937: 386–405; “Markets and Hierarchies: Analysis and Antitrust Implications” by Oliver Williamson (New York: The Free Press, 1975); “Toward an Economic Theory of the Multi-product Firm” by David Teece, Journal of Economic Behavior and Organization 3, 1982: 39–63. 14. For a more complete discussion of these issues, see “Building Institutional Infrastructure in Emerging Markets” by Krishna Palepu and Tarun Khanna, Brown Journal of World Affairs, Winter/Spring 1998, and “Why Focused Strategies May Be Wrong for Emerging Markets,” by Tarun Khanna and Krishna Palepu, Harvard Business Review, July/August, 1997. 15. For an empirical study which illustrates this point, see “Is Group Affiliation Profitable in Emerging Markets? An Analysis of Diversified Indian Business Groups,” by Tarun Khanna and Krishna Palepu, Journal of Finance, forthcoming. 16. See “Tobin’s q, diversification, and firm performance” by Larry Lang and Rene Stulz, Journal of Political Economy 102: 1248–1280, and “Diversification’s Effect on Firm Value” by Phillip Berger and Eli Ofek, Journal of Financial Economics 37: 39–65. 17. See “Which Takeovers are Profitable: Strategic or Financial?” by Paul Healy, Krishna Palepu, and Richard Ruback, Sloan Management Review, 1996. 18. See “Effects of Recontracting on Shareholder Wealth: The Case of Voluntary Spinoffs” by Katherine Schipper and Abbie Smith, Journal of Financial Economics 12: 437–467; “Asset Sales, Firm Performance, and the Agency Costs of Managerial Discretion” by L. Lang, A. Poulsen, and R. Stulz, Journal of Financial Economics 37: 3–37. 19. “eBay vs. Amazon.com,” Business Week, May 31, 1999. 20. “Amazon.Bomb” by Jacqueline Doherty, Barron’s, May 31, 1999. 53 America Online, Inc. W Business Analysis 2 and Valuation Tools 2 Strategy Analysis America Online hen it comes to technology companies, the stock market’s current mania, it’s hard to top America Online, Inc. Technology stocks are hot, up about 50 percent on average this year, but AOL is positively scalding, up about 135 percent. In fact, AOL’s stock has soared more than 2,000 percent from its initial public offering, in 1992. The Vienna-based company has 35 times the customers and 20 times the revenue it had five years ago. It’s the nation’s biggest on-line company and is building a recognized brand. But look closely and you see that AOL is as much about accounting technology as it is about computer technology. So make sure you understand the numbers before rushing out to buy AOL, which is valued at about $4 billion. The above report written by Allan Sloan appeared on October 24, 1995, in Newsweek’s business section.1 COMPANY BACKGROUND Founded in Vienna, VA, America Online, Inc. (AOL) was a leader in the development of a new mass medium that encompassed online services, the Internet, multimedia, and other interactive technologies. Through its America Online service the company offered members a broad range of features including real-time talk, electronic mail, electronic magazines and newspapers, online classes and shopping, and Internet access. In addition to its online service, AOL’s business had expanded during 1995 to include access software for the Internet, production and distribution of original content, interactive marketing and transactions capabilities, and networks to support the transmission of data. AOL generated revenues principally from consumers through membership fees, as well as from content providers and merchandisers through advertising, commissions on merchandise sales and other transactions, and from other businesses through the sale of network and production services. Through continued investment in the growth of its existing online service, the pursuit of related business opportunities, its ability to provide ......................................................................................................................... This case was prepared by Professors Krishna Palepu and Amy Hutton as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright  1997 by the President and Fellows of Harvard College. Harvard Business School case 9-196-13. 1. “Look Beyond the High-Tech Accounting To Measure America Online’s Market Risk,” Allan Sloan, Newsweek, October 24, 1995. 54 Strategy Analysis America Online 2-23 Part 2 Business Analysis and Valuation Tools a full range of interactive services, and its technological flexibility, the company positioned itself to lead the development of the evolving mass medium for interactive services. Stephen Case and James Kimsey founded America Online’s predecessor, Quantum Computer Services, in 1985. Quantum offered its Q-Link service for Commodore computers. In 1989, the service was extended to Apple computers. The company changed its name to America Online in 1991 and went public in 1992. That same year, AOL licensed its on-line technology to Apple for use in eWorld and NewtonMail services for which AOL continues to receive a usage-based royalty. In 1993, the company expanded its market with a Windows version of its software and began developing a version for palmtop computer. In 1994, AOL’s subscription base surpassed those of CompuServe and Prodigy, two rival online service providers, making AOL the number one consumer online service in the United States. By the end of October 1995, AOL had a subscriber base of more than four million members. AOL’s Products The broad range of features offered by the America Online service was designed to meet the varied needs of its four million members. A key feature of the online service was the ease with which members with related interests could communicate through real-time conferences, e-mail, and bulletin boards. Members used the interactive communications facilities to share information and ideas, exchange advice, and socialize. It was America Online’s goal to continue developing and adding new sources of information and content in support of these member activities. The range of features offered by America Online included the following: • Online Community. In addition to its e-mail service, AOL promoted real-time online communications by scheduling conferences and discussions on specific topics, offering interactive areas that served as “meeting rooms” for members to participate in lively interactive discussions with other members, and providing public bulletin boards on which members could share information and opinions on subjects of general or specialized interest. • Computing. AOL provided its members access to tens of thousands of public domain and “shareware” software programs, to online help from 300 hardware and software developers, and to online computer shopping and online computer magazines such as MacWorld, PC World, and Computer Life. • Education and References. AOL’s online educational services allowed adults and children to learn without leaving their homes. AOL contracted with professional instructors to teach real-time interactive classes in subjects of both general academic interest and adult education (such as creative writing and gourmet cooking). Regular tutoring sessions were offered in English, biology, and math. Education and reference services included the Library of Congress, College Board, CNN, Smithsonian, Consumer Reports, and Compton’s Encyclopedia. 55 Strategy Analysis Strategy Analysis • News and Personal Finance. AOL offered a broad range of information services, including domestic and international news, weather, sports, stock market prices, and personalized portfolio tracking. Members could search news wires for stories of interest, access mutual fund information through Fidelity Online and Morningstar, and execute brokered trades online through PC Financial Network. Subscribers had access to over 70 newspapers, periodicals, and wire services, including The New York Times, Chicago Tribune, San Jose Mercury News, Time, Scientific American, Investors Business Daily, and Reuters. • Travel and Shopping. AOL members also had access to travel and shopping reference materials and transaction services. Subscribers could send customized greeting cards through Hallmark Corporation, send flowers through 1-800-Flowers, shop for CDs and tapes online at Tower Records, book vacation packages with Preview Vacations, and access account data and travel information and services with American ExpressNet. Additionally, AOL had introduced its own interactive shopping service, 2Market, which featured goods and services from numerous catalogs and retailers. • Entertainment and Children’s Programming. AOL provided various clubs and forums for games and sports, multi-player games, and other related content for both adults and children. Specialized content was provided by such organizations as MusicSpace, the Games Channel, Disney Adventures, Comedy Clubs, Nintendo Power Source, Kids Only, Hollywood Online, Warner-Reprise Records, American Association for Retired Persons, MTV, Cooking Club, Environment Club, and Baby Boomers’ Forum. Customer Acquisition and Retention AOL’s biggest expenditure was the cost of attracting new subscribers. AOL aggressively marketed its online service using both independent marketing efforts, such as direct mail packets with AOL software disks and television and print advertising featuring a toll-free telephone number for ordering the AOL software, as well as co-marketing efforts with computer magazine publishers and personal computer hardware and software producers. These companies bundled the AOL software with their computer products, facilitating easy trial use by their customers. With the AOL software in hand, the customer needed only a personal computer, a telephone line, and a computer modem to gain access to AOL’s online service. Accompanying each program disk was a unique registration number and password that could be used to generate a new AOL account. Customers could activate their accounts by providing AOL with their credit card account number. The first ten hours of access by this new account were free, after which AOL automatically billed the customer’s credit card account the standard monthly rate until the customer canceled the AOL account. These types of promotions were expensive, costing more than $40 per new subscriber in 1994. Thus, to retain these new subscribers and increase customer loyalty and satis- 2-24 America Online 56 Strategy Analysis America Online 2-25 Part 2 Business Analysis and Valuation Tools faction, AOL invested in specialized retention programs including regularly scheduled online events and conferences, online promotions of upcoming events and new features, and the regular addition of new content, services, and software programs. AOL’s goal was to maximize customer subscription life. Critical to customer retention and usage rates was the content available on AOL. To build and create unique content America Online participated in numerous joint ventures. During 1995 its alliances grew to include American Express, ABC, Reuters, Shoppers Express, Business Week, Fidelity, Vanguard, and the National Education Association. Also important to AOL were the newest stars of cyberspace, special-interest sites created by entrepreneurs such as Tom and David Gardner, who created Motley Fool and Follywood, two of the most popular sites offered on America Online. These hot special-interest sites kept customers on line, running up metered time and revenues. Traditionally, AOL had kept 80 percent or more of the revenues generated by these sites and had demanded exclusive contracts with the entrepreneurs creating them. However, content providers now had the option of setting up sites on the Internet World Wide Web. While they could not yet collect fees from Web browsers, this new distribution channel was changing the balance of power between AOL and its content providers.2 Compared to its competitors, AOL’s rate structure was the easiest for consumers to understand and anticipate. A monthly fee of $9.95 provided access to all of America Online’s services for up to five hours each month. Each additional hour was $2.95 and no additional downloading fees were charged. CompuServe and Prodigy offered the same standard pricing but charged additional fees for premium services and downloading. Microsoft Network (MSN), the newest entrant into the online services industry, offered a standard monthly plan of up to three hours for $4.95, with each additional hour costing $2.50. Content providers on MSN also applied charges to customers based on usage rates. The additional fees charged by AOL’s competitors made it more difficult for their customers to anticipate their monthly spending. Strategy for Future Growth Through a tapestry of alliances and subsidiaries AOL’s goal was to establish a central and defining leadership position in the worldwide market for interactive services. Toward this end, AOL had signed new strategic partnerships with American Express, Business Week Online, and NTN Communications; shipped the 2Market CD-ROM shopping service with an online connection; and completed its acquisitions of Internet software developers BookLink Technologies, Inc., NaviSoft, Inc., and Internet backbone developer Advanced Network & Services (ANS). These deals, along with AOL’s growing membership base, its enhanced look and feel, and its ability to program content to appeal to users, uniquely positioned America Online to lead the development of the new interactive services industry. In implementing its strategy, AOL pursued a number of initiatives: ......................................................................................................................... 2. “On-Line Stars Hear Siren Calls to Free Agency,” Steven Lohr, New York Times , November 25, 1995. 57 Strategy Analysis Strategy Analysis • Invest in Growth of Existing Service. America Online planned to continue to invest in the rapid growth of its existing online service. AOL believed it could attract and retain new members by expanding the range of content and services it offers, continuing to improve the engaging multimedia context of its service and building a sense of community online. At the same time, by offering access to a large, growing, and demographically attractive audience, together with software tools and services to develop content and programming for that audience, AOL believed it would continue to appeal to content and service providers. • Exploit New Business Opportunities. AOL intended to leverage its technology, management skills, and content packaging skills to identify and exploit new business opportunities, such as electronic commerce, entry into international markets, and the “consumerization” of the Internet with its highly graphical interface software and its World Wide Web browser, which used high-speed compression technology to improve access speed and graphic display performance. • Provide a Full Range of Interactive Services. Through acquisitions and internal development, AOL had assembled content development, distribution capabilities, access software, and its own communications network to become a full service, vertically integrated provider of interactive services. As a result, AOL believed it was well positioned to influence the evolution of the interactive services market. • Maintain Technological Flexibility. AOL recognized the need to provide its services over a diverse set of platforms. Its software worked on different types of personal computers and operating systems (including Macintosh, Windows 3.xx and Windows 95) and supported a variety of different media, including online services, the Internet, and CD-ROM. AOL intended to adapt its products and services as new technologies become available. While AOL currently generated revenues largely from membership fees, AOL’s management believed that these initiatives would allow the company to increase the proportion of its revenues generated from other sources, such as advertising fees, commissions on merchandise sales to consumers, and revenues from the sale of production and network services to other enterprises. INDUSTRY COMPETITION AND OUTLOOK The online consumer services industry represented $1.1 billion in revenues in 1994 and was expected to grow by 30 percent to $1.4 billion in 1995. Eleven million customers subscribed to commercial online services worldwide and this number was expected to explode in the next five years. Industry leaders America Online, CompuServe, and Prodigy served about 8.5 million of the existing subscribers (4.0 million, 2.8 million, and 1.6 million, respectively). This oligopoly had very successfully acted as middlemen between thousands of content providers and millions of customers. They were the publishers, closely controlling the product and paying content providers, the writers, only 2-26 America Online 58 Strategy Analysis 2-27 Part 2 Business Analysis and Valuation Tools modest royalties. However, with the advent of the Internet World Wide Web and the entrance of Microsoft Network, content providers now had alternative distribution channels which offered greater control over their products and potentially higher revenues. Forbes discussed this topic in its August 28, 1995 issue: America Online Until recently the only way to reach cyberspace browsers was through one of the big three on-line services, America Online, CompuServe and Prodigy. That oligopoly is set to fade fast, and it’s not just Microsoft that threatens. It’s the whole Internet, the pulsating, undisciplined and rapidly expanding network of World Wide Web computers that contain public data bases.3 While the big three acted as publishers, Microsoft had decided to act more like a bookstore, one in which every author (content provider) was his/her own publisher. Customers of MSN paid $4.95 per month for up to three hours (each additional hour was $2.50). Then, each content provider charged whatever it wanted for its material, so much per hour, per page, or per picture. Microsoft kept a 30 percent commission out of the provider’s fee and passed along the rest to the content provider. In addition to offering content providers a larger share of the revenues, MSN also offered content providers greater control over their own products. In contrast to the standardized screen displays and icons of the big three, MSN permitted content providers to use any font and format they wished. Thus, while Microsoft still acted as a middleman, it played a very limited and passive role in determining content and fees charged for that content. Beyond Microsoft lurked the vast potential of the Internet World Wide Web, where the middleman’s role was shrunk still further. On the Internet, everyone with a computer was his/her own publisher. Customers would sign up for an Internet on-ramp service, of the sort offered by PST, Netcom, or MCI. Once on the net, the subscriber used browsing software like Netscape or Spyglass to roam the world’s databases. While it remained difficult for self-publishers on the Internet to collect fees from browsers who read their pages, that was expected to change quickly as banks, Microsoft, and other intermediaries worked on systems to provide on-line currency. Many content providers were beginning to take advantage of these alternative distribution channels. For example, Wired magazine, unwilling to settle for just 20 percent of the revenues from subscribers spending time on its pages on AOL, created HotWired on the Internet. Andrew Anker, chief technologist at Wired, believed that HotWired would soon be more lucrative than the America Online venture and he noted that on the Internet his firm had greater control of its own product. General Electric’s NBC decided to switch from AOL to Microsoft Network. “While we had many users visiting us on America Online, we weren’t making much revenue,” explained Martin Yudkovitz, a senior vice-president at NBC.4 With the migration of proprietary services and content to Web sites, the unique offerings of the big three services were declining. However, the online services were still bet......................................................................................................................... 3. “Who Needs the Middleman?,” Nikhil Hutheesing, Forbes , August 28, 1995. 4. Ibid. 59 Strategy Analysis Strategy Analysis ter for interactive communications with full-fledged message boards and live chat. The Web, on the other hand, was mainly a publication environment for reading. The question remained, what would be the role of online service providers in the future? Would they become just another Internet access provider with their own look and browsers or could they continue to offer something unique to users? Some analysts were projecting that the U.S. online services market would grow 30– 35 percent annually through the year 2000, and that the Internet market would grow even faster. These analysts expected America Online to retain about a 20 percent market share.5 On the other hand, Forrester Research of Cambridge, Mass., predicted that the big three, America Online, CompuServe, and Prodigy, would continue to add subscribers only through 1997. After that, Forrester predicted, it would be all downhill for the big three.6 AOL’S RECENT PERFORMANCE For the fourth quarter ended June 30, 1995, America Online announced that its earnings were $0.16, excluding $0.01 merger expenses and $0.02 amortization of goodwill. This was a significant improvement over 1994’s fourth-quarter earnings, $0.02, and above analysts’ estimate, $0.14. Service revenues surged to $139 million, versus analysts’ estimate of $132 million, and total revenues rose to $152 million versus $40.4 in the fourth quarter of 1994. For the fiscal year ended June 30, 1995, AOL reported a loss of $33.6 million on revenues of $394 million compared with a profit of $2.5 million on revenues of $116 million a year earlier. New charges recorded for the first time in 1995 included $50.3 million for acquired R&D, $1.7 million amortization of goodwill, and $2.2 million in merger expenses. (See Exhibit 3, America Online’s 1995 Abridged Annual Report.) New subscriber momentum continued to be strong, increasing 233 percent year-overyear and adding 691,000 new net subscribers during the fourth quarter. All major metrics used by analysts to evaluate AOL’s franchise and gauge the “health” of its rapidly growing subscriber base also improved during the quarter: projected retention rates rose to 41 months from 39 months; paid usage grew to 2.93 hours from 2.73, and projected lifetime revenues per subscriber increased to $714 from $667. (See Exhibit 2 for the history of America Online’s User Metrics.) However, analysts were projecting lower gross margins in the future as subscribers continued to transition to higher-speed access and as AOL introduced a heavy-usage pricing plan in response to Microsoft’s lower per-hour pricing. On November 8, 1995, America Online announced its results for the first quarter of fiscal 1996 ended September 30, 1995. Even though revenues rose to $197.9 million from $56 million a year earlier, America Online reported a loss of $10.3 million com......................................................................................................................... 5. “America Online, Inc. — Company Report,” A. Pooley, The Chicago Corporation, April 18, 1995. 6. Op. cit., Forbes , August 28, 1995. 2-28 America Online 60 Strategy Analysis America Online 2-29 Part 2 Business Analysis and Valuation Tools pared with a profit of $1.5 million a year earlier. America Online took a $16.9 million charge to reflect research and development taking place at Ubique, a company it acquired on September 21, 1995, as well as to pay off other recently acquired assets. It took another charge of $1.7 million for amortization of goodwill. These charges were partially offset by AOL’s decision to increase the period over which it amortized subscriber acquisition costs. Effective July 1, 1995, these costs would be amortized over 24 months rather than 12–18 months. The effect of the change in accounting estimates for the three months ended September 30, 1995, was to decrease the reported loss by $1.95 million. AOL also announced that it added 711,000 subscribers in the first quarter of 1996, bringing its total subscriber base to four million.7 America Online’s stock price had been on the move since the company’s initial public offering (IPO) in March 1992. The stock price appreciated from the IPO price of $2.90 to $7.31, $14.63, and $28.00 at calendar year end 1992, 1993, and 1994, respectively. At its current price of $81.63 (dated November 8, 1995), the company’s market value was around $4.0 billion. (See Exhibit 1 for the stock price history of America Online, its equity beta, and additional market-based data.) THE CONTROVERSY SURROUNDING AOL America Online’s stock was one of the most controversial of this period. Some analysts promoted the stock’s potential for price appreciation, while others recommended selling the shares short to profit from a decline in price. Bulls saw America Online as part of a revolution in communication, like cellular phones and cable television in the early days. They considered AOL’s graphical interface software, its high-speed Web browser, and Mr. Case’s marketing genius (subscribership had quadrupled to over four million in a little over a year) to be major competitive advantages. Bears, on the other hand, anticipating new entrants competing in the online services industry and a migration of subscribers to the Internet, questioned whether AOL would continue to experience high growth in its subscriber base or be able to retain existing subscribers. Shortsellers had sold around seven million America Online shares, betting that the stock’s price would not go up forever. Shortsellers pointed to the recent hedging activities by Apple Computer to lock in profits on its 5.7 percent stake as an indication that AOL’s stock was overvalued. Adding fuel to the shortsellers’ fire, corporate insiders at AOL had sold some of their shareholdings. Between March 9 and March 15 of 1995, seventeen insiders sold approximately 200,000 shares, including the company founders, President Steven Case (25,000 shares for $2.1 million) and Chairman James Kimsey (40,000 shares for $3.3 million).8 ......................................................................................................................... 7. “America Online Posts $10.3 Million Loss But Says Revenue Rose 250% in Quarter,” The Washington Post, Nov. 8, 1995. 8. As of August 15, 1995 all executive officers and directors as a group continued to own 3,729,547 shares, Steven Case owned 1,036,790 shares and James Kimsey owned 679,616 shares. 61 Strategy Analysis Strategy Analysis Adding to the controversy, some analysts labeled AOL’s accounting “aggressive.” AOL amortized its software development costs over five years, a long time in the fastchanging, uncertain online services industry, and AOL capitalized subscriber acquisition costs when its number one competitor, CompuServe, did not. Furthermore, effective July 1, 1995, AOL extended the amortization period for its subscriber acquisition costs from about 15 months to 24 months. Given the uncertainties surrounding AOL’s subscriber retention rates and revenue growth as competition emerged in the young industry, analysts questioned the wisdom of AOL’s accounting decisions. The big risk AOL faced was that eventually customers could switch on-line services as frequently as they now move among long-distance carriers. While America Online expensed the free trial expenses (i.e., those charges incurred from the ten free hours given away in the initial month), it capitalized the marketing costs associated with acquiring a customer including direct mail, advertising, start-up kits, and bundling costs. As indicated in its annual report, prior to July 1, 1995, the capitalization had occurred on two schedules depending on the acquisition method. Costs for subscribers acquired through direct marketing programs were amortized over a 12month period. Costs for subscribers acquired through co-marketing efforts with personal computer producers and magazine publishers were amortized over an 18-month period, as these bundling campaigns had historically shown a longer response time. However, effective July 1, 1995, AOL increased the period over which it amortized subscriber acquisition costs to 24 months for both acquisition methods. Defending AOL’s accounting choices, Lennert Leader, the Chief Financial Officer of America Online, Inc., said that the company was following standard accounting procedures in matching the timing of expenses with the period over which the revenues would be received. He argued that the company’s marketing and software development expenses produced customer accounts that last a long time. Thus, he said, it was appropriate to write off the costs over a period of years, even though AOL had spent the cash.9 However, some analysts raised red flags about AOL’s accounting choices. As noted in the October 24, 1995 Newsweek article: One of AOL’s hidden assets is the brilliant accounting decision it made to treat its marketing and research and development costs as capital items rather than expenses. . . . AOL charges R&D expenses over a five-year period, a very long time in the online biz. In July, AOL began charging off marketing expenses over two years, up from about 15 months. Why change to 24 months from 15? Leader said it’s because the average life of an AOL account has climbed to 41 months from 25 months in 1992. How many AOL customers have been around for 41 months? Almost none, as Leader concedes. That’s understandable, considering that AOL has added virtually all its ......................................................................................................................... 9. Op. cit., Newsweek, October 24, 1995. 2-30 America Online 62 Strategy Analysis 2-31 Part 2 Business Analysis and Valuation Tools customers in the past 36 months. Leader says the 41-month average live number comes from projections. Of course, it will take years to find out if he’s right. . . .10 America Online Analysts were also concerned about AOL’s cash flow situation and the signal sent by the timing of its latest equity offering. The Newsweek article continued: Accounting is terribly important to AOL. The better the numbers look, the more Wall Street loves it and the easier AOL can sell new shares to raise cash to pay its bills. . . . On October 10 [AOL] raised about $100 million by selling new shares. AOL sold the stock even though its shares had fallen to $58.37 from about $72 in September, when the sale plans were announced. Most companies would have delayed the offering, waiting for the price to snap back. AOL didn’t, prompting cynics to think the company really needed the money. . . . Some analysts believed that AOL issued shares when its stock price was low because the company needed the cash immediately. Others argued that AOL was building a war chest needed because deep-pocketed rivals such as Microsoft were about to start an online price war and because increasingly information providers were going directly to the Internet, rather than using middlemen such as AOL. Some analysts interpreted CompuServe’s recent adoption of more aggressive accounting techniques as a sign that it too was readying for war. Beginning the first quarter of fiscal 1996, CompuServe would capitalize direct response advertising costs associated with customer acquisition activity.11 While AOL’s stock price rebounded to $81.63 by November 8, 1995, there were many questions concerning AOL’s future. How would the demand for AOL’s services be affected by the entry of Microsoft Network and the growth of Internet? Would AOL’s accounting choices stand the test of time? What if AOL’s subscription growth rates slowed or subscriber renewal rates fell? Did AOL have the financial flexibility to face these competitive pressures and accounting risks? ......................................................................................................................... 10. Op. cit., Newsweek, October 24, 1995. 11. Op. cit., Newsweek, October 24, 1995. 63 Sep-92 Dec-92 Mar-93 Jun-93 Sep-93 Sep-94 Dec-94 Mar-95 Jun-95 NASDAQ Composite Sep-95 Strategy Analysis America Online Sources: Datastream International, Standard and Poor’s Compustat, and the Wall Street Journal. 1.4 7.02 5.35 6.26 Dec-93 Mar-94 Jun-94 AOL Stock Price (indexed) Additional market-based data: America Online’s equity beta Moody’s AAA corporate debt in November 1995 (%) Treasury bills rate in November 1995 (%) Government 30-year treasury rates in November 1995 (%) Mar-92 Jun-92 0 500 1000 1500 2000 2500 EXHIBIT 1 Stock Price History for America Online, Inc. Indexed Price 64 Strategy Analysis 2-32 Dec-93 Mar-94 Jun-94 Sep-94 Dec-94 Mar-95 Jun-95 30 $443 Projected average months’ retention Projected average lifetime revenue $496 3% 1% 32+ 2.1 $496 32 2 4% $551 34 2.27 5% $612 36 2.46 6% $667 39 2.73 9% $714 41 2.93 Source: Alex Brown & Sons, Inc., August 24, 1995. ........................................................................................................................................................................................... Internet usage (% time) 1.85 Paid usage (hours) ........................................................................................................................................................................................... 2-33 EXHIBIT 2 America Online, Inc. User Metrics to June 30, 1995 America Online Strategy Analysis Part 2 Business Analysis and Valuation Tools 65 Strategy Analysis Strategy Analysis 2-34 EXHIBIT 3 America Online 1995 Abridged Annual Report REPORT OF INDEPENDENT AUDITORS Board of Directors and Stockholders America Online, Inc. We have audited the accompanying consolidated balance sheets of America Online, Inc., as of June 30, 1995 and 1994, and the related consolidated statements of operations, changes in stockholders’ equity and cash flows for each of the three years in the period ended June 30, 1995. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of America Online, Inc. at June 30, 1995 and 1994, and the consolidated results of their operations and their cash flows for each of the three years in the period ended June 30, 1995, in conformity with generally accepted accounting principles. As discussed in Note 9 to the consolidated financial statements, in fiscal 1994 the Company changed its method of accounting for income taxes. As discussed in Note 2 to the consolidated financial statements, in fiscal 1995 the Company changed its method of accounting for short-term investments in certain debt and equity securities. Ernst & Young LLP Vienna, Virginia August 25, 1995 America Online 66 Strategy Analysis 2-35 Part 2 Business Analysis and Valuation Tools SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA (In Thousands, Except Per Share Data) Year Ended June 30, .................................................................................................. 1995 1994 1993 1992 1991 America Online .................................................................................................................................................. Statements of Operations Data: Online service revenues Other revenues Total Revenues Income (loss) from operations Income (loss) before extraordinary items Net income (loss) (1) Income (loss) per common share: Income (loss) before extraordinary item Net income (loss) Weighted average shares outstanding $358,498 35,792 394,290 (19,294) $100,993 14,729 115,722 4,608 $38,462 13,522 51,984 1,925 $26,226 12,527 38,753 3,685 $19,515 10,646 30,161 1,341 (33,647) (33,647) 2,550 2,550 399 1,532 2,344 3,768 1,100 1,761 $ (0.99) $ (0.99) $ 0.07 $ 0.07 $ 0.01 $ 0.05 $ 0.10 $ 0.17 $ 0.06 $ 0.09 33,986 34,208 29,286 22,828 19,304 .................................................................................................................................................. As of June 30, .................................................................................................. 1995 1994 1993 1992 1991 .................................................................................................................................................. Balance Sheet Data: Working capital (deficiency) Total assets Total debt Stockholders’ equity (deficiency) Other data (at fiscal year end): Subscribers $ (456) 406,464 21,810 $47,890 154,584 9,302 $10,498 39,279 2,959 $12,363 31,144 2,672 $ (966) 11,534 1,865 217,944 98,297 23,785 21,611 (8,623) 3,005 903 303 182 131 .................................................................................................................................................. (1) Net loss in the fiscal year ended June 30, 1995, includes charges of $50.3 million for acquired research and development and $2.2 million for merger expenses. See Note 3 of the Notes to Consolidated Financial Statements. 67 Strategy Analysis Strategy Analysis 2-36 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS Overview The Company has experienced a significant increase in revenues over the past three fiscal years. The higher revenues have been principally produced by increases in the Company’s subscriber base resulting from growth of the online services market, the introduction of a Windows version of America Online in the middle of fiscal 1993, which greatly increased the available market for the Company’s service, as well as the expansion of its services and content. Additionally, revenues have increased as the average monthly revenue per subscriber has risen steadily during the past three years, primarily as a result of an increase in the average monthly paid hours of use per subscriber. The Company’s online service revenues are generated primarily from subscribers paying a monthly member’s fee and hourly charges based on usage in excess of the number of hours of usage provided as part of the monthly fee. Through December 31, 1994, the Company’s standard monthly membership fee, which includes five hours of service, was $9.95, with a $3.50 hourly fee for usage in excess of five hours per month. Effective January 1, 1995, the hourly fee for usage in excess of five hours per month decreased from $3.50 to $2.95, while the monthly membership fee remained unchanged at $9.95. The Company’s other revenues are generated primarily from providing new media and interactive marketing services, data network services, and multimedia and CD-ROM production services. Additionally, the Company generates revenues related to online transactions and advertising, as well as development and licensing fees. In fiscal 1995 the Company acquired RCC, NaviSoft, BookLink, ANS, WAIS, Medior and Global Network Navigator, Inc. Additionally, in August 1995, the Company entered into an agreement to acquire Ubique. For additional information relating to these acquisitions, refer to Notes 3 and 13 of the Notes to Consolidated Financial Statements. The online services market is highly competitive. The Company believes that existing competitors, which include, among others, CompuServe, Prodigy and MSN, are likely to enhance their service offerings. In addition, new competitors have announced plans to enter the online services market, resulting in greater competition for the Company. The competitive environment could require new pricing programs and increased spending on marketing, content procurement and product development; limit the Company’s opportunities to enter into and/ or renew agreements with content providers and distribution partners; limit the Company’s ability to grow its subscriber base; and result in increased attrition in the Company’s subscriber base. Any of the foregoing events could result in an increase in costs as a percentage of revenues, and may have a material adverse effect on the Company’s financial condition and operating results. During September 1995, the Company modified the components of subscriber acquisition costs deferred and will be expensing certain subscriber acquisition cost as incurred, effective July 1, 1995. All costs capitalized before this change will continue to be amortized. The effect of this change for the year ended June 30, 1995 (including the amortization of amounts capitalized as of June 30, 1994) would have been to increase marketing costs by approximately $8 million. This change will have a greater impact on the Company’s marketing costs in fiscal 1996, as the Company expects to significantly increase subscriber acquisition activity, including those subscriber acquisition expenditures which the Company will be expensing as incurred. In addition, effective July 1, 1995, the Company changed the period over which it amortizes subscriber acquisition cost from twelve and eighteen months to twenty-four months. Based on the Company’s historical average customer life experience, the change in amortization period is being made to more appropriately match subscriber acquisition costs with associated online service revenues. The effect of this change in accounting estimate for the year ended June 30, 1995 would have been to America Online 68 Strategy Analysis 2-37 Part 2 Business Analysis and Valuation Tools decrease the amount of the amortization of subscriber acquisition costs by approximately $27 million. While this change will thereby positively impact operating margins, the Company expects that any such positive impact will be partially offset by increased investments in marketing and other business activities during fiscal 1996 and the decision, effective July 1, 1995, to expense certain subscriber acquisition costs as incurred. America Online Results of Operations Fiscal 1995 Compared to Fiscal 1994 Online Service Revenues. For fiscal 1995, online service revenues increased from $100,993,000 to $358,498,000, or 255%, over fiscal 1994. This increase was primarily attributable to a 289% increase in revenues from IBM-compatible subscribers and a 196% increase in revenues from Macintosh subscribers as a result of a 273% increase in the number of IBM-compatible subscribers and a 143% increase in the number of Macintosh subscribers. The percentage increase in online service revenues in fiscal 1995 was greater than the percentage increase in subscribers principally due to an increase in the average monthly online service revenue per subscriber, which increased from $15.00 in fiscal 1994 to $17.10 in fiscal 1995. Other Revenues. Other revenues, consisting principally of new media and interactive marketing services, data network services, multimedia and CDROM production services, and development and licensing fees, increased from $14,729,000 in fiscal 1994 to $35,792,000 in fiscal 1995. This increase was primarily attributable to data network revenues and multimedia and CD-ROM production service revenues from companies acquired during fiscal 1995. Cost of Revenues. Cost of revenues includes network-related costs, consisting primarily of data and voice communication costs, costs associated with operating the data center and providing customer support, royalties paid to information and service providers and other expenses related to marketing and production services. For fiscal 1995, cost of revenues increased from $69,043,000 to $229,724,000, or 233%, over fiscal 1994, and decreased as a percentage of total revenues from 59.7% to 58.3%. The increase in cost of revenues was primarily attributable to an increase in data communication costs, customer support costs and royalties paid to information and service providers. Data communication costs increased primarily as a result of the larger customer base and more usage by customers. Customer support costs, which include personnel and telephone costs associated with providing customer support, were higher as a result of the larger customer base and a large number of new subscriber registrations. Royalties paid to information and service providers increased as a result of a larger customer base and more usage and the Company’s addition of more service content to broaden the appeal of the America Online service. The decrease in cost of revenues as a percentage of total revenues is primarily attributable to a decrease in expenses related to marketing services and personnel related costs as a percentage of total revenues, partially offset by an increase in data communication costs as a percentage of total revenues, primarily resulting from an increase in higher baud speed usage at a higher variable rate as well as lower hourly pricing for online service revenue which became effective January 1, 1995. Marketing. Marketing expenses include the costs to acquire and retain subscribers and other general marketing expenses. Subscriber acquisition costs are deferred and charged to operations over a twelve or eighteen month period, using the straightline method, beginning the month after such costs are incurred. For additional information regarding the accounting for deferred subscriber acquisition costs, refer to Note 2 of the Notes to Consolidated Financial Statements. For fiscal 1995, marketing expenses increased from $23,548,000 to $77,064,000, or 227%, over fiscal 1994, and decreased as a percentage of total revenues from 20.3% to 19.5%. The increase in marketing expenses was primarily due to an increase in the number and size of marketing programs to expand the Company’s subscriber base. The decrease in marketing expenses as a percentage of total revenues is primarily attributable to a decrease as a percentage of total revenues in personnel related costs. 69 Strategy Analysis Strategy Analysis Product Development. Product development costs include research and development expenses, other product development costs and the amortization of software costs. For fiscal 1995, product development expenses increased from $4,961,000 to $12,842,000, or 159%, over fiscal 1994, and decreased as a percentage of total revenues from 4.3% to 3.3%. The increase in product development costs was primarily attributable to an increase in personnel costs related to an increase in the number of technical employees. The decrease in product development costs as a percentage of total revenues was principally a result of the substantial growth in revenues, which more than offset the additional product development costs. Product development costs, before capitalization and amortization, increased by 126% in fiscal 1995. General and Administrative. Fiscal 1995 general and administrative costs increased from $13,562,000 to $41,966,000, or 209%, over fiscal 1994, and decreased as a percentage of total revenues from 11.7% to 10.6%. The increase in general and administrative expenses was principally attributable to higher office and personnel expenses related to an increase in the number of employees. The decrease in general and administrative costs as a percentage of total revenues was a result of the substantial growth in revenues, which more than offset the additional general and administrative costs, combined with the semi-variable nature of many of the general and administrative costs. Acquired Research and Development. Acquired research and development costs, totaling $50,335,000, relate to in-process research and development purchased pursuant to the Company’s acquisition of two early-stage Internet technology companies, BookLink and NaviSoft. The purchased research and development relating to the BookLink and NaviSoft acquisitions was the foundation of the development of the Company’s Internet related products. Amortization of Goodwill. Amortization of goodwill relates to the Company’s acquisition of ANS, which resulted in approximately $44 million in goodwill. The goodwill related to the ANS acquisition is being amortized on a straight-line basis over a ten-year period. 2-38 Other Income. Other income consists primarily of investment and rental income net of interest expense. For fiscal 1995, other income increased from $1,774,000 to $3,023,000. This increase was primarily attributable to an increase in interest income generated by higher levels of cash available for investment, partially offset by a decrease in rental income and an increase in interest expense. Merger Expenses. Non-recurring merger expenses totaling $2,207,000 were recognized in fiscal 1995 in connection with the mergers of the Company with RCC, WAIS and Medior. Provisions for Income Taxes. The provision for income taxes was $3,832,000 and $15,169,000 in fiscal year 1994 and fiscal 1995, respectively. For additional information regarding income taxes, refer to Note 9 of the Notes to Consolidated Financial Statements. Net Loss. The net loss in fiscal 1995 totaled $33,647,000. The net loss in fiscal 1995 included charges of $50,335,000 for acquired research and development and $2,207,000 for merger expenses. Liquidity and Capital Resources The Company has financed its operations through cash generated from operations, sale of its common stock and funding by third parties for certain product development activities. Net cash provided by operating activities was $2,205,000, $1,884,000 and $15,891,000 for fiscal 1993, fiscal 1994 and fiscal 1995, respectively. Included in operating activities were expenditures for deferred subscriber acquisition costs of $10,685,000, $37,424,000 and $111,761,000 in fiscal 1993, fiscal 1994 and fiscal 1995, respectively. Net cash used in investing activities was $8,915,000, $41,870,000 and $85,725,000 in fiscal 1993, fiscal 1994 and fiscal 1995, respectively. Investing activities included $20,523,000 in fiscal 1995 related to business acquisitions, substantially all of which were related to the acquisition of ANS. In December 1993 the Company completed a public stock offering of 4,000,000 shares of common stock which generated net cash proceeds of approximately $62.7 million. America Online 70 Strategy Analysis 2-39 Part 2 Business Analysis and Valuation Tools America Online In April 1995 the company entered into a joint venture with Bertelsmann to offer interactive online services in Europe. In connection with the agreement, the Company received approximately $54 million through the sale of approximately 5% of its common stock to Bertelsmann. The Company leases the majority of its equipment under noncancelable operating leases, and as part of its network portfolio strategy is building AOLnet, its data communications network. The buildout of this network requires a substantial investment in telecommunication equipment, which the Company plans to finance principally though leasing. In addition, the Company has guaranteed minimum commitments under certain data and voice communication agreements. The Company’s future lease commitments and guaranteed minimums are discussed in Note 6 of the Notes to Consolidated Financial Statements. The Company uses its working capital to finance ongoing operations and to fund marketing and content programs and the development of its products and services. The Company plans to continue to invest aggressively in acquisition marketing and content programs to expand its subscriber base, as well as in computing and support infrastructure. Additionally, the Company expects to use a portion of its cash for the acquisition and subsequent funding of technologies, products or businesses complementary to the Company’s current business. Apart from its agreement to acquire Ubique, as discussed below, the Company has no agreements or understandings to acquire any businesses. The Company anticipates that available cash and cash provided by operating activities will be sufficient to fund its operations for the next fiscal year. Various legal proceedings have arisen against the Company in the ordinary course of business. In the opinion of management, these proceedings will not have a material effect on the financial position of the Company. The Company believes that inflation has not had a material effect on its results of operations. On August 23, 1995, the Company entered into a stock purchase agreement to purchase Ubique, an Israeli company. The Company has agreed to pay approximately $15 million ($1.5 million in cash and $13.5 million in common stock) in the transaction, which is to be accounted for as a purchase. Subject to the results of an in-process valuation, a substantial portion of the purchase price may be allocated to in-process research and development and charged to the Company’s operations in the first quarter of fiscal 1996. 71 Strategy Analysis 2-40 Strategy Analysis CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in Thousands, Except Per Share Data) Year ended June 30, .......................................................... 1995 1994 1993 ...................................................................................................................................... Revenues: Online service revenues Other revenues Total revenues Costs and expenses: Cost of revenues Marketing Product development General and administrative Acquired research and development Amortization of goodwill Total costs and expenses Income (loss) from operations Other income, net Merger expenses Income (loss) before provision for income taxes and extraordinary item Provision for income taxes Income (loss) before extraordinary item Extraordinary item—tax benefit arising from net operating loss carryforward Net income (loss) Earnings (loss) per share: Income (loss) before extraordinary item Net income (loss) Weighted average shares outstanding $358,498 35,792 394,290 $100,993 14,729 115,722 $ 38,462 13,522 51,984 229,724 77,064 12,842 41,966 50,335 1,653 413,584 (19,294) 3,023 (2,207) 69,043 23,548 4,961 13,562 — — 111,114 4,608 1,774 — 28,820 9,745 2,913 8,581 — — 50,059 1,925 371 — (18,478) (15,169) (33,647) 6,382 (3,832) 2,550 2,296 (1,897) 399 — $ (33,647) — 2,550 1,133 $ 1,532 $ 0.07 $ 0.07 34,208 $ 0.01 $ 0.05 29,286 $ (0.99) $ (0.99) 33,986 $ ...................................................................................................................................... See accompanying notes. America Online 72 Strategy Analysis 2-41 Part 2 Business Analysis and Valuation Tools CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in Thousands) Year ended June 30, .............................................................. 1995 1994 1993 America Online ................................................................................................................................................... Cash flows from operating activities: Net income (loss) Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Amortization of subscriber acquisition costs Loss/(Gain) on sale of property and equipment Charge for acquired research and development Changes in assets and liabilities: Trade accounts receivable Other receivables Prepaid expenses and other current assets Deferred subscriber acquisition costs Other assets Trade accounts payable Accrued personnel costs Other accrued expenses and liabilities Deferred revenue Deferred income taxes Deferred rent Total adjustments Net cash provided by operating activities Cash flows from investing activities: Short-term investments Purchase of property and equipment Product development costs Sale of property and equipment Purchase costs of acquired businesses Net cash used in investing activities Cash flows from financing activities: Proceeds from issuance of common stock, net Principal and accrued interest payments on line of credit and long-term debt Proceeds from line of credit and issuance of long-term debt Tax benefit from stock option exercises Principal payments under capital lease obligations $ (33,647) $ 2,550 $ 1,532 11,136 60,924 37 50,335 2,965 17,922 5 — 1,957 7,038 (39) — (14,373) (9,057) (19,641) (111,761) (8,432) 60,824 1,846 5,703 7,190 14,763 44 49,538 15,891 (4,266) (681) (2,867) (37,424) (2,519) 10,204 367 9,526 2,322 3,832 (52) (666) 1,884 (936) (966) (1,494) (10,685) (89) 2,119 336 1,492 1,381 759 (200) 673 2,205 5,380 (57,751) (13,011) 180 (20,523) (85,725) (18,947) (17,886) (5,132) 95 — (41,870) (5,105) (2,041) (1,831) 62 — (8,915) 61,253 67,372 609 (3,298) (7,716) (6,924) 13,741 — (375) 14,200 — (142) 7,181 6 (112) 73 Strategy Analysis 2-42 Strategy Analysis CONSOLIDATED STATEMENT OF CASH FLOWS (continued) Year ended June 30, .............................................................. 1995 1994 1993 ................................................................................................................................................... Net cash provided by financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental cash flow information Cash paid during the period for: Interest Income taxes 71,321 1,487 43,891 $ 45,378 73,714 33,728 10,163 $ 43,891 1,067 — 575 — 760 (5,950) 16,113 $ 10,163 193 15 ................................................................................................................................................... See accompanying notes. CONSOLIDATED BALANCE SHEETS (Amounts in Thousands, Except Per Share Data) June 30, .................................... 1995 1994 ...................................................................................................................................... ASSETS Current assets: Cash and cash equivalents Short-term investments Trade accounts receivable Other receivables Prepaid expenses and other current assets Total current assets Property and equipment at cost, net Other assets: Product development costs, net Deferred subscriber acquisition costs, net License rights, net Other assets Deferred income taxes Goodwill, net $ 45,378 18,672 32,176 11,103 25,527 132,856 70,466 $ 43,891 24,052 8,547 2,036 5,753 84,279 20,306 18,914 77,229 5,537 11,479 35,627 54,356 $406,464 7,912 26,392 53 2,800 12,842 — $154,584 (continued) America Online 74 Strategy Analysis 2-43 Part 2 Business Analysis and Valuation Tools CONSOLIDATED BALANCE SHEETS (continued) June 30, .................................... 1995 1994 America Online ...................................................................................................................................... LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Trade accounts payable Accrued personnel costs Other accrued expenses and liabilities Deferred revenue Line of credit Current portion of long-term debt and capital lease obligations Total current liabilities Long-term liabilities: Notes payable Capital lease obligations Deferred income taxes Deferred rent Total liabilities Stockholders’ equity: Preferred stock, $.01 par value; 5,000,000 shares authorized, none issued Common stock, $.01 par value; 100,000,000 shares authorized, 37,554,849 and 30,771,212 shares issued and outstanding at June 30, 1995 and 1994, respectively Additional paid-in capital Accumulated deficit Total stockholders’ equity $ 84,639 2,829 23,509 20,021 484 1,830 133,312 $ 15,642 896 13,076 4,488 1,690 597 36,389 17,369 2,127 35,627 85 188,520 5,836 1,179 12,842 41 56,287 — — 375 251,539 (33,970) 217,944 $406,464 308 98,836 (847) 98,297 $154,584 ...................................................................................................................................... See accompanying notes. 75 Strategy Analysis Strategy Analysis 2-44 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization is not material to the financial statements of the Company. America Online, Inc. (“the Company”) was incorporated in the State of Delaware in May 1985. The Company, based in Vienna, Virginia, is a leading provider of online services, offering its subscribers a wide variety of services, including e-mail, online conferences, entertainment, software, computing support, interactive magazines and newspapers, and online classes, as well as easy and affordable access to services of the Internet. In addition, the Company is a provider of data network services, new media and interactive marketing services, and multimedia and CD-ROM production services. Revenue and cost recognition – Online service revenue is recognized over the period services are provided. Other revenue, consisting principally of marketing, data network and multimedia production services, as well as development and royalty revenues, are recognized as services are rendered. Deferred revenue consists principally of third-party development funding not yet recognized and monthly subscription fees billed in advance. 2. Summary of Significant Accounting Policies Principles of Consolidation – The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated. Investments in affiliates owned twenty percent or more and corporate joint ventures are accounted for under the equity method. Other securities in companies owned less than twenty percent are accounted for under the cost method. Business Combinations – Business combinations which have been accounted for under the purchase method of accounting include the results of operations of the acquired business from the date of acquisition. Net assets of the companies acquired are recorded at their fair value to the Company at the date of acquisition. Other business combinations have been accounted for under the pooling of interests method of accounting. In such cases, the assets, liabilities, and stockholders’ equity of the acquired entities were combined with the Company’s respective accounts at recorded values. Prior period financial statements have been restated to give effect to the merger unless the effect of the business combination Property and equipment – Property and equipment are depreciated or amortized using the straight-line method over the estimated useful life of the asset, which ranges from 5 to 40 years, or over the life of the lease. Property and equipment under capital leases are stated at the lower of the present value of minimum lease payments at the beginning of the lease term or fair value at inception of the lease. Deferred subscriber acquisition costs – Subscriber acquisition costs are deferred and charged to operations over a twelve or eighteen month period (straight-line method) beginning the month after such costs are incurred. These costs, which relate directly to subscriber solicitations, principally include printing, production and shipping of starter kits and the costs of obtaining qualified prospects by various targeted direct marketing programs (i.e., direct marketing response cards, mailing lists) and from third parties, and are recorded separately from ordinary operating expenses. No indirect costs are included in subscriber acquisition costs. To date, all subscriber acquisition costs have been incurred for the solicitation of specific identifiable prospects. Costs incurred for other than those targeted at specific identifiable prospects for the Company’s services, and general marketing, are expensed as incurred. The Company’s services are sold on a monthly subscription basis. Subscriber acquisition costs incurred to obtain new subscribers are recoverable from revenues generated by such subscribers within a short period of time after such costs are incurred. America Online 76 Strategy Analysis America Online 2-45 Part 2 Business Analysis and Valuation Tools Effective July 1, 1992, the Company changed, from twelve months to eighteen months, the period over which it amortizes the costs of deferred subscriber acquisition costs relating to marketing activities in which the Company’s starter kit is bundled and distributed by a third-party marketing company. The change in accounting estimate was made to more accurately match revenues and expenses. Based on the Company’s experience and the distribution channels used in such marketing activities, there is a greater time lag between the time the Company incurs the cost for the starter kits and the time the starter kits begin to generate new customers than with direct marketing activities. Also, the period over which new subscribers (and related revenues) are generated is longer than that experienced with the use of traditional independent, direct marketing activities. The effect of this change in accounting estimate for the year ended June 30, 1993 was to increase income before extraordinary item and net income by $264,000 ($.01 per share). In the first quarter of fiscal 1995 the Company adopted the provisions of Statement of Position (“SOP”) 93-7, “Reporting on Advertising Costs,” which provides guidance on financial reporting on advertising costs. The adoption of SOP 93-7 had no effect on the Company’s financial position or results of operations. Product development costs – The Company capitalizes cost incurred for the production of computer software used in the sale of its services. Costs capitalized include direct labor and related overhead for software produced by the Company and the costs of software purchased from third parties. All costs in the software development process which are classified as research and development are expensed as incurred until technological feasibility has been established. Once technological feasibility has been established, such costs are capitalized until the software is commercially available. To the extent the Company retains the rights to software development funded by third parties, such costs are capitalized in accordance with the Company’s normal accounting policies. Amortization is provided on a product-by-product basis, using the greater of the straight-line method or current year revenue as a percent of total revenue estimates for the related software product not to exceed five years, commencing the month after the date of product release. Product development costs consist of the following: Year ended June 30, 1995 1994 (in thousands) Balance, beginning of year Cost capitalized Cost amortized Balance, end of year $ 7,912 13,011 (2,009) $18,914 $3,915 5,132 (1,135) $7,912 The accumulated amortization of product development costs related to the production of computer software totaled $7,894,000, and $5,885,000 at June 30, 1995 and 1994, respectively. Included in product development costs are research and development costs totaling $3,856,000, $2,126,000, and $1,130,000 and other product development costs totaling $6,977,000, $1,050,000 and $579,000 in the years ended June 30, 1995, 1994 and 1993, respectively. License rights – The cost of acquired license rights is amortized using the straight-line method over the term of the agreement for such license rights, ranging from one to three years. Goodwill – Goodwill consists of the excess of cost over the fair value of net assets acquired and certain other intangible assets relating to purchase transactions. Goodwilll and intangible assets are amortized over periods ranging from 5–10 years. Operating lease costs – Rent expense for operating leases is recognized on a straight-line basis over the lease term. The difference between rent expense incurred and rental payments is charged or credited to deferred rent. Cash, cash equivalents and short-term investments – The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. In fiscal 1995, the Company adopted Statement of Financial 77 Strategy Analysis 2-46 Strategy Analysis Accounting Standards No. 115 (”SFAS 115”), “Accounting for Certain Investments in Debt and Equity Securities.” The adoption was not material to the Company’s financial position or results of operations. The Company has classified all debt and equity securities as available-for-sale. Available-forsale securities are carried at fair value, with unrealized gains and losses reported as a separate component of stockholders’ equity. Realized gains and losses and declines in value judged to be otherthan-temporary on available-for-sale securities are included in other income. Available-for-sale securities at June 30, 1995, consisted of U.S. Treasury Bills and other obligations of U.S. Government agencies totaling $7,579,000 and U.S. corporate debt obligations totaling $11,093,000. At June 20, 1995, the estimated fair value of these securities approximated cost. Net income (loss) per common share – Net income (loss) per share is calculated by dividing income (loss) before extraordinary item and net income (loss) by the weighted average number of common and, when dilutive, common equivalent shares outstanding during the period. Reclassification – Certain amounts in prior years’ consolidated financial statements have been reclassified to conform to the current year presentation. 3. Business Combination Pooling Transactions On August 19, 1994, Redgate Communications Corporation (“RCC”) was merged with and into a subsidiary of the Company. The Company exchanged 1,789,300 shares of common stock for all of the outstanding common and preferred stock and warrants of RCC. Additionally, 401,148 shares of the Company’s common stock were reserved for outstanding stock options issued by RCC and assumed by the Company. The merger was accounted for under the pooling of interests method of accounting, and accordingly, the accompanying consolidated financial statements have been restated for all periods prior to the acquisition to include the financial position, results of operations and cash flows of RCC. Effective August 1994, RCC’s fiscal year-end has been changed from December 31 to June 30 to conform to the Company’s fiscal year-end. Revenues and net earnings (loss) for the individual entities are as follows: Three months ended September 30, 1994 Year ended June 30, 1994 1993 (unaudited) (in thousands) Total revenues: AOL RCC Less intercompany sales Net income (loss): AOL RCC Merger expenses $50,783 3,813 (173) $104,410 11,312 — $40,019 11,965 — $54,423 $115,722 $51,984 $ 3,018 (42) (1,710) $ 6,210 (3,660) — $ 4,210 (2,678) — $ 1,266 $ 2,550 $ 1,532 America Online 78 Strategy Analysis 2-47 Part 2 Business Analysis and Valuation Tools America Online In connection with the merger of the Company and RCC, merger expenses of $1,710,000 were recognized during 1995. Year ended June 30, 1995 1994 (in thousands except per share data) During fiscal 1995, Medior, Inc. and Wide Area Information Servers, Inc. were merged into subsidiaries of the Company. The Company issued 1,082,019 shares of its common stock in the transactions. The transactions were accounted for under the pooling of interests method of accounting. Prior year financial statements have not been restated for the transactions because the effect would not be material to the operations of the Company. Revenues Income (loss) from operations Pro forma income (loss) Pro forma income (loss) per share Purchase Transactions Property and equipment consist of the following: During fiscal 1995, the Company acquired NaviSoft, Inc. (“NaviSoft”), BookLink Technologies, Inc. (“BookLink”), Advanced Network & Services, Inc. (“ANS”) and Global Network Navigator, Inc., in transactions accounted for under the purchase method of accounting. The Company paid a total of $97,669,000, of which $75,697,000 was in stock and $21,972,000 was in cash for the acquisitions. Of the aggregate purchase price, approximately $50,335,000 was allocated to in-process research and development and $55,314,000 was allocated to goodwill and other intangible assets. The following unaudited pro forma information relating to the BookLink and ANS acquisitions is not necessarily an indication of the combined results that would have occurred had the acquisitions taken place at the beginning of the period, nor is necessarily an indication of the results that may occur in the future. Pro forma information for NaviSoft and Global Network Navigator, Inc. is immaterial to the operations of the consolidated entity. The amount of the aggregate purchase price allocated to in-process research and development for both the NaviSoft and BookLink acquisitions has been excluded from the pro forma information as it is a non-recurring item. $410,147 $135,785 23,117 (5,465) 11,205 (4,694) $ 0.25 $ (0.16) 4. Property and Equipment June 30, 1995 1994 (in thousands) Computer equipment Furniture and fixtures Buildings Land Building improvements Property under capital leases Leasehold improvements Less accumulated depreciation and amortization Net property and equipment $49,167 4,992 13,800 6,075 6,284 $12,418 1,398 5,648 2,052 1,343 8,486 3,059 2,686 306 91,863 25,851 (21,397) ( 5,545) $70,466 $20,306 5. License Rights License rights consist of the following: June 30, 1995 1994 (in thousands ) License rights Less accumulated amortization $ 7,484 $ 954 (1,947) $ 5,537 $ (901) 53 79 Strategy Analysis 2-48 Strategy Analysis 6. Commitments and Contingencies The Company leases equipment under several long-term capital and operating leases. Future minimum payments under capital leases and noncancelable operating leases with initial terms of one year or more consist of the following: Capital Leases Operating Leases (in thousands) Year ending June 30, 1996 1997 1998 1999 2000 Thereafter Total minimum lease payments Less amount representing interest Present value of net minimum capital lease payments, including current portion of $1,415 The Company’s rental expense under operating leases in the years ended June 30, 1995, 1994 and 1993 totaled approximately $10,001,000, $2,889,000, and $2,155,000, respectively. Communication networks – The Company has guaranteed monthly usage levels of data and voice communications with one of its vendors. The remaining commitments are $113,400,000, $59,000,000, $9,000,000 and $6,750,000 for the years ending June 30, 1996, 1997, 1998 and 1999, respectively. The related expense for the years ended June 30, 1995, 1994 and 1993 was $138,793,000, $40,315,000 and $11,226,000, respectively. Contingencies – Various legal proceedings have arisen against the Company in the ordinary course of business. In the opinion of management, these proceedings will not have a material effect on the financial position of the Company. $1,654 1,236 641 310 103 — $20,997 21,264 19,450 8,711 3,511 2,636 3,944 $76,569 America Online 80 (402) $3,542 amounts borrowed to finance the purchases of two office buildings. The notes are collateralized by the respective properties. The notes have a variable interest rate equal to 105 basis points above the 30 day London Interbank Offered Rate and a fixed interest rate of 8.48% per annum at June 30, 1995. Aggregate maturities of notes payable for the years ended June 30, 1996, 1997, 1998, 1999, 2000 and thereafter are $415,000, $429,000, $445,000, $462,000, $480,000 and $15,553,000, respectively. 8. Other Income The following table summarizes the components of other income: Year ended June 30, 1995 1994 1993 (in thousands) 7. Notes Payable Notes payable at June 30, 1995 totaled approximately $18 million and consist primarily of Interest income Interest expense Other $3,920 (1,054) 157 $1,646 (575) 703 $572 (172) (29) $3,023 $1,774 $371 Strategy Analysis 2-49 Part 2 Business Analysis and Valuation Tools 9. Income Taxes The provision for income taxes is attributable to: Deferred income taxes arise because of differences in the treatment of income and expense items for financial reporting and income tax purposes, primarily relating to deferred subscriber acquisition and product development costs. As of June 30, 1995, the Company has net operating loss carryforwards of approximately $109 1993 million for tax purposes which will be available, subject to certain annual limitations, to offset future tax$1,897 able income. If not used, these loss carryforwards will expire between 2001 and 2010. To the extent that net operating loss carryforwards, when realized, relate to stock option deductions, the resulting bene(1,133) fits will be credited to stockholders’ equity. Year ended June 30, 1995 1994 America Online (in thousands) Income before extraordinary item Tax benefit arising from net operating loss carryforward $15,169 $3,832 — — $15,169 $3,832 $ 764 $ — 15,169 $ — 3,832 $ 765 759 $15,169 $3,832 $ 764 The Company’s income tax provision was computed on the federal statutory rate and the average state statutory rates, net of the related federal benefit. The provision for income taxes differs from the amount computed by applying the statutory federal income tax rate to income before provision for income taxes and extraordinary item. The sources and tax effects of the differences are as follows: Effective July 1, 1993 the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, “Accounting for Income Taxes.” As permitted under the new rules, prior years’ financial statements have not been restated. Current Deferred Year ended June 30, 1995 1994 1993 (in thousands) Income tax at the federal statutory rate of 34% State income tax, net of federal benefit Losses relating to RCC Nondeductible merger expenses Nondeductible charge for purchased research and development Loss, for which no tax benefit was derived Other $ (6,283) $2,170 $ 781 1,597 403 200 — 1,259 916 750 — — 17,114 — — 1,632 359 — — — — $15,169 $3,832 $1,897 No increase to net income resulted from the cumulative effect of adopting Statement No. 109 as of July 1, 1993. The deferred tax asset increased by approximately $5,965,000 as a result of the adoption. Similarly, the deferred tax liability, stockholders’ equity and the valuation allowance increased by approximately $3,173,000, $759,000 and $2,033,000, respectively. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax liabilities and assets are as follows: 81 Strategy Analysis 2-50 Strategy Analysis 13. Subsequent Event Year ended June 30, 1995 1994 (in thousands) Deferred tax liabilities: Capitalized software costs Deferred member acquisition costs $ 7,008 $ 2,962 28,619 9,880 Net deferred tax liabilities Deferred tax assets: Net operating loss carryforwards $35,627 $12,842 $39,000 $17,510 Total deferred tax assets Valuation allowance for deferred assets 39,000 17,510 Net deferred tax assets $35,627 (3,373) (4,668) On August 23, 1995, the Company entered into a stock purchase agreement to purchase Ubique, Ltd., an Israeli company. The Company has agreed to pay approximately $15 million ($1.5 million in cash and $13.5 million in common stock) in the transaction, which is to be accounted for under the purchase method of accounting. Subject to the results of an in-process valuation, a substantial portion of the purchase price may be allocated to inprocess research and development and charged to the Company’s operations in the first quarter of fiscal 1996. $12,842 QUARTERLY INFORMATION (unaudited) September 30 Quarter Ended December 31 March 31 June 30 Total $138,916 12,939 $358,498 35,792 1995a Fiscal Online service revenues Other revenues $69,712 6,683 $99,814 9,290 76,395 (35,258) (38,730) $ (0.20) 109,104 233 (2,587) $ ( 0.07) 151,855 11,108 6,189 $ 0.13 $14,299 4,780 $20,292 4,239 $28,853 2,836 $37,549 2,874 $100,993 14,729 Total revenues 19,079 24,531 31,689 40,423 115,722 Income from operations Net income Net income per shareb 531 303 $ 0.01 520 70 $ — 1,931 1,272 $ 0.03 1,626 905 $ 0.02 4,608 2,550 $ 0.07 Total revenues Income (loss) from operations Net income (loss) Net income (loss) per share b Fiscal 1994 Online service revenues Other revenues $50,056 6,880 56,936 4,623 1,481 $ 0.04 394,290 (19,294) (33,647) $ (0.99) a. Historical financial information for amounts previously reported in fiscal 1995 has been adjusted to account for pooling of interest transactions. b. The sum of per-share earnings (loss) does not equal earnings (loss) per share for the year due to equivalent share calculations which are impacted by the Company’s loss in 1995 and by fluctuations in the Company’s common stock market prices. America Online 82 33 O v e r v ie w o f Ac c o u n t in g An alysis chapter T Business Analysis and 2Valuation Tools he purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business reality.1 By identifying places where there is accounting flexibility, and by evaluating the appropriateness of the firm’s accounting policies and estimates, analysts can assess the degree of distortion in a firm’s accounting numbers. Another important skill is recasting a firm’s accounting numbers using cash flow and footnote information to “undo” any accounting distortions. Sound accounting analysis improves the reliability of conclusions from financial analysis, the next step in financial statement analysis. THE INSTITUTIONAL FRAMEWORK FOR FINANCIAL REPORTING There is typically a separation between ownership and management in public corporations. Financial statements serve as the vehicle through which owners keep track of their firms’ financial situation. On a periodic basis, firms typically produce three financial reports : (1) an income statement that describes the operating performance during a time period, (2) a balance sheet that states the firm’s assets and how they are financed, and (3) a cash flow statement (or in some countries, a funds flow statement) that summarizes the cash flows of the firm. These statements are accompanied by several footnotes and a message and narrative discussion written by the management. To evaluate effectively the quality of a firm’s financial statement data, the analyst needs to first understand the basic features of financial reporting and the institutional framework that governs them, as discussed in the following sections. Building Blocks of Accrual Accounting One of the fundamental features of corporate financial reports is that they are prepared using accrual rather than cash accounting. Unlike cash accounting, accrual accounting distinguishes between the recording of costs and benefits associated with economic activities and the actual payment and receipt of cash. Net income is the primary periodic performance index under accrual accounting. To compute net income, the effects of economic transactions are recorded on the basis of expected, not necessarily actual, cash receipts and payments. Expected cash receipts from the delivery of products or services are recognized as revenues, and expected cash outflows associated with these revenues are recognized as expenses. 3-1 83 84 Overview of Accounting Analysis Overview of Accounting Analysis While there are many rules and conventions that govern a firm’s preparation of financial statements, there are only a few conceptual building blocks that form the foundation of accrual accounting. The principles that define a firm’s assets, liabilities, equities, revenues, and expenses are as follows2: • Assets are economic resources owned by a firm that (a) are likely to produce future economic benefits and (b) are measurable with a reasonable degree of certainty. • Liabilities are economic obligations of a firm arising from benefits received in the past that are (a) required to be met with a reasonable degree of certainty and (b) at a reasonably well-defined time in the future. • Equity is the difference between a firm’s net assets and its liabilities. The definitions of assets, liabilities, and equity lead to the fundamental relationship that governs a firm’s balance sheet: Assets = Liabilities + Equity While the balance sheet is a summary at one point in time, the income statement summarizes a firm’s revenues and expenses and its gains and losses arising from changes in assets and liabilities in accord with the following definitions: • Revenues are economic resources earned during a time period. Revenue recognition is governed by the realization principle, which proposes that revenues should be recognized when (a) the firm has provided all, or substantially all, the goods or services to be delivered to the customer and (b) the customer has paid cash or is expected to pay cash with a reasonable degree of certainty. • Expenses are economic resources used up in a time period. Expense recognition is governed by the matching and the conservatism principles. Under these principles, expenses are (a) costs directly associated with revenues recognized in the same period, or (b) costs associated with benefits that are consumed in this time period, or (c) resources whose future benefits are not reasonably certain. • Profit is the difference between a firm’s revenues and expenses in a time period.3 Chapters 4 through 7 discuss the key isues to consider for analyzing accounting policies and estimates reflected in the financial statements. The chapters present each financial statement account type (assets, liabilities, equity, revenues, and expenses) separately to reflect the way that analysts typically approach financial statements. Obviously, however, there are close links between these types of accounts; these are noted where appropriate. Delegation of Reporting to Management While the basic definitions of the elements of a firm’s financial statements are simple, their application in practice often involves complex judgments. For example, how should revenues be recognized when a firm sells land to customers and also provides customer financing? If revenue is recognized before cash is collected, how should 3-2 Overview of Accounting Analysis 3-3 Part 2 Business Analysis and Valuation Tools potential defaults be estimated? Are the outlays associated with research and development activities, whose payoffs are uncertain, assets or expenses when incurred? Do frequent flyer reward programs create accounting liabilities for airline companies? If so, when and at what value? Because corporate managers have intimate knowledge of their firms’ businesses, they are entrusted with the primary task of making the appropriate judgments in portraying myriad business transactions using the basic accrual accounting framework. The accounting discretion granted to managers is potentially valuable because it allows them to reflect inside information in reported financial statements. However, since investors view profits as a measure of managers’ performance, managers have an incentive to use their accounting discretion to distort reported profits by making biased assumptions. Further, the use of accounting numbers in contracts between the firm and outsiders provides a motivation for management manipulation of accounting numbers. Earnings management distorts financial accounting data, making them less valuable to external users of financial statements. Therefore, the delegation of financial reporting decisions to managers has both costs and benefits. Accounting rules and auditing are mechanisms designed to reduce the cost and preserve the benefit of delegating financial reporting to corporate managers. Generally Accepted Accounting Principles Given that it is difficult for outside investors to determine whether managers have used their accounting flexibility to signal their proprietary information or merely to disguise reality, a number of accounting conventions have evolved to mitigate the problem. Accounting conventions and standards promulgated by the standard-setting bodies limit potential distortions that managers can introduce into reported accounting numbers. In the United States, the Securities and Exchange Commission (SEC) has the legal authority to set accounting standards. The SEC typically relies on private sector accounting bodies to undertake this task. Since 1973 accounting standards in the United States have been set by the Financial Accounting Standards Board (FASB). There are similar private sector or public sector accounting standard-setting bodies in many other countries. In addition, the International Accounting Standards Committee (IASC) has been attempting to set worldwide accounting standards, though IASC’s pronouncements are not legally binding as of now. Uniform accounting standards attempt to reduce managers’ ability to record similar economic transactions in dissimilar ways either over time or across firms. Thus they create a uniform accounting language and increase the credibility of financial statements by limiting a firm’s ability to distort them. Increased uniformity from accounting standards, however, comes at the expense of reduced flexibility for managers to reflect genuine business differences in a firm’s accounting decisions. Rigid accounting standards work best for economic transactions whose accounting treatment is not predicated on managers’ proprietary information. However, when there is a significant business judgment 85 86 Overview of Accounting Analysis Overview of Accounting Analysis involved in assessing a transaction’s economic consequences, rigid standards are likely to be dysfunctional, because they prevent managers from using their superior business knowledge. Further, if accounting standards are too rigid, they may induce managers to expend economic resources to restructure business transactions to achieve a desired accounting result. External Auditing Broadly defined as a verification of the integrity of the reported financial statements by someone other than the preparer, external auditing ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable. In the U.S., all listed companies are required to have their financial statements audited by an independent public accountant. The standards and procedures to be followed by independent auditors are set by the American Institute of Certified Public Accountants (AICPA). These standards are known as Generally Accepted Auditing Standards (GAAS). While auditors issue an opinion on published financial statements, it is important to remember that the primary responsibility for the statements still rests with corporate managers. Auditing improves the quality and credibility of accounting data by limiting a firm’s ability to distort financial statements to suit its own purposes. However, third-party auditing may also reduce the quality of financial reporting because it constrains the kind of accounting rules and conventions that evolve over time. For example, the FASB considers the views of auditors in the standard-setting process. Auditors are likely to argue against accounting standards that produce numbers which are difficult to audit, even if the proposed rules produce relevant information for investors. Legal Liability The legal environment in which accounting disputes between managers, auditors, and investors are adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and resulting penalties have the beneficial effect of improving the accuracy of disclosure. However, the potential for a significant legal liability might also discourage managers and auditors from supporting accounting proposals requiring risky forecasts, such as forward looking disclosures. This type of concern is often expressed by the auditing community in the U.S. Limitations of Accounting Analysis Because the mechanisms that limit managers’ ability to distort accounting data themselves add noise, it is not optimal to use accounting regulation to eliminate managerial flexibility completely. Therefore, real-world accounting systems leave considerable room for managers to influence financial statement data. The net result is that information in corporate financial reports is noisy and biased, even in the presence of accounting 3-4 Overview of Accounting Analysis 3-5 Part 2 Business Analysis and Valuation Tools regulation and external auditing.4 The objective of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business reality and to “undo” any accounting distortions. When potential distortions are large, accounting analysis can add considerable value.5 Factors Influencing Accounting Quality There are three potential sources of noise and bias in accounting data: (1) the noise and bias introduced by rigidity in accounting rules, (2) random forecast errors, and (3) systematic reporting choices made by corporate managers to achieve specific objectives. Each of these factors is discussed below. ACCOUNTING RULES. Accounting rules introduce noise and bias because it is often difficult to restrict management discretion without reducing the information content of accounting data. For example, the Statement of Financial Accounting Standards No. 2 issued by the FASB requires firms to expense research outlays when they are incurred. Clearly, some research expenditures have future value while others do not. However, because SFAS No. 2 does not allow firms to distinguish between the two types of expenditures, it leads to a systematic distortion of reported accounting numbers. Broadly speaking, the degree of distortion introduced by accounting standards depends on how well uniform accounting standards capture the nature of a firm’s transactions. FORECAST ERRORS. Another source of noise in accounting data arises from pure forecast error, because managers cannot predict future consequences of current transactions perfectly. For example, when a firm sells products on credit, accrual accounting requires managers to make a judgment on the probability of collecting payments from customers. If payments are deemed “reasonably certain,” the firm treats the transactions as sales, creating accounts receivable on its balance sheet. Managers then make an estimate of the proportion of receivables that will not be collected. Because managers do not have perfect foresight, actual defaults are likely to be different from estimated customer defaults, leading to a forecast error. The extent of errors in managers’ accounting forecasts depends on a variety of factors, including the complexity of the business transactions, the predictability of the firm’s environment, and unforeseen economy-wide changes. MANAGERS’ ACCOUNTING CHOICES. Corporate managers also introduce noise and bias into accounting data through their own accounting decisions. Managers have a variety of incentives to exercise their accounting discretion to achieve certain objectives, leading to systematic influences on their firms’ reporting6: • Accounting-based debt covenants. Managers may make accounting decisions to meet certain contractual obligations in their debt covenants. For example, firms’ lending agreements with banks and other debt holders require them to meet cove- 87 88 Overview of Accounting Analysis Overview of Accounting Analysis • • • • • • • nants related to interest coverage, working capital ratios, and net worth, all defined in terms of accounting numbers. Violation of these constraints may be costly because it allows lenders to demand immediate payment of their loans. Managers of firms close to violating debt covenants have an incentive to select accounting policies and estimates to reduce the probability of covenant violation. The debt covenant motivation for managers’ accounting decisions has been analyzed by a number of accounting researchers.7 Management compensation. Another motivation for managers’ accounting choice comes from the fact that their compensation and job security are often tied to reported profits. For example, many top managers receive bonus compensation if they exceed certain prespecified profit targets. This provides motivation for managers to choose accounting policies and estimates to maximize their expected compensation.8 Corporate control contests. In corporate control contests, including hostile takeovers and proxy fights, competing management groups attempt to win over the firm’s shareholders. Accounting numbers are used extensively in debating managers’ performance in these contests. Therefore, managers may make accounting decisions to influence investor perceptions in corporate control contests.9 Tax considerations. Managers may also make reporting choices to trade off between financial reporting and tax considerations. For example, U.S. firms are required to use LIFO inventory accounting for shareholder reporting in order to use it for tax reporting. Under LIFO, when prices are rising, firms report lower profits, thereby reducing tax payments. Some firms may forgo the tax reduction in order to report higher profits in their financial statements.10 Regulatory considerations. Since accounting numbers are used by regulators in a variety of contexts, managers of some firms may make accounting decisions to influence regulatory outcomes. Examples of regulatory situations where accounting numbers are used include antitrust actions, import tariffs to protect domestic industries, and tax policies.11 Capital market considerations. Managers may make accounting decisions to influence the perceptions of capital markets. When there are information asymmetries between managers and outsiders, this strategy may succeed in influencing investor perceptions, at least temporarily.12 Stakeholder considerations. Managers may also make accounting decisions to influence the perception of important stakeholders in the firm. For example, since labor unions can use healthy profits as a basis for demanding wage increases, managers may make accounting decisions to decrease income when they are facing union contract negotiations. In countries like Germany, where labor unions are strong, these considerations appear to play an important role in firms’ accounting policy. Other important stakeholders that firms may wish to influence through their financial reports include suppliers and customers. Competitive considerations. The dynamics of competition in an industry might also influence a firm’s reporting choices. For example, a firm’s segment disclosure 3-6 Overview of Accounting Analysis 3-7 Part 2 Business Analysis and Valuation Tools decisions may be influenced by its concern that disaggregated disclosure may help competitors in their business decisions. Similarly, firms may not disclose data on their margins by product line for fear of giving away proprietary information. Finally, firms may discourage new entrants by making income-decreasing accounting choices. In addition to accounting policy choices and estimates, the level of disclosure is also an important determinant of a firm’s accounting quality. Corporate managers can choose disclosure policies that make it more or less costly for external users of financial reports to understand the true economic picture of their businesses. Accounting regulations usually prescribe minimum disclosure requirements, but they do not restrict managers from voluntarily providing additional disclosures. Managers can use various parts of the financial reports, including the Letter to the Shareholders, Management Discussion and Analysis, and footnotes, to describe the company’s strategy, its accounting policies, and its current performance. There is wide variation across firms in how managers use their disclosure flexibility.13 DOING ACCOUNTING ANALYSIS In this section we will discuss a series of steps that an analyst can follow to evaluate a firm’s accounting quality. In the subsequent five chapters, these concepts are illustrated for the analysis of assets, liabilities and equity, revenues, expenses, and business entity accounting. Step 1: Identify Key Accounting Policies As discussed in the chapter on business strategy analysis, a firm’s industry characteristics and its own competitive strategy determine its key success factors and risks. One of the goals of financial statement analysis is to evaluate how well these success factors and risks are being managed by the firm. In accounting analysis, therefore, the analyst should identify and evaluate the policies and the estimates the firm uses to measure its critical factors and risks. For example, one of the key success factors in the leasing business is to make accurate forecasts of residual values of the leased equipment at the end of the lease terms. For a firm in the equipment leasing industry, therefore, one of the most important accounting policies is the way residual values are recorded. Residual values influence the company’s reported profits and its asset base. If residual values are overestimated, the firm runs the risk of having to take large write-offs in the future. Key success factors in the banking industry include interest and credit risk management; in the retail industry, inventory management is a key success factor; and for a manufacturer competing on product quality and innovation, research and development and 89 90 Overview of Accounting Analysis Overview of Accounting Analysis product defects after the sale are key areas of concern. In each of these cases, the analyst has to identify the accounting measures the firm uses to capture these business constructs, the policies that determine how the measures are implemented, and the key estimates embedded in these policies. For example, the accounting measure a bank uses to capture credit risk is its loan loss reserves, and the accounting measure that captures product quality for a manufacturer is its warranty expenses and reserves. Step 2: Assess Accounting Flexibility Not all firms have equal flexibility in choosing their key accounting policies and estimates. Some firms’ accounting choice is severely constrained by accounting standards and conventions. For example, even though research and development is a key success factor for biotechnology companies, managers have no accounting discretion in reporting on this activity. Similarly, even though marketing and brand building are key to the success of consumer goods firms, they are required to expense all their marketing outlays. In contrast, managing credit risk is one of the critical success factors for banks, and bank managers have the freedom to estimate expected defaults on their loans. Similarly, software developers have the flexibility to decide at what points in their development cycles the outlays can be capitalized. If managers have little flexibility in choosing accounting policies and estimates related to their key success factors (as in the case of biotechnology firms), accounting data are likely to be less informative for understanding the firm’s economics. In contrast, if managers have considerable flexibility in choosing the policies and estimates (as in the case of software developers), accounting numbers have the potential to be informative, depending upon how managers exercise this flexibility. Regardless of the degree of accounting flexibility a firm’s managers have in measuring their key success factors and risks, they will have some flexibility with respect to several other accounting policies. For example, all firms have to make choices with respect to depreciation policy (straight-line or accelerated methods), inventory accounting policy (LIFO, FIFO, or Average Cost), policy for amortizing goodwill (write-off over forty years or less), and policies regarding the estimation of pension and other post-employment benefits (expected return on plan assets, discount rate for liabilities, and rate of increase in wages and health care costs). Since all these policy choices can have a significant impact on the reported performance of a firm, they offer an opportunity for the firm to manage its reported numbers. Step 3: Evaluate Accounting Strategy When managers have accounting flexibility, they can use it either to communicate their firm’s economic situation or to hide true performance. Some of the strategy questions one could ask in examining how managers exercise their accounting flexibility include the following: 3-8 Overview of Accounting Analysis 3-9 Part 2 Business Analysis and Valuation Tools • How do the firm’s accounting policies compare to the norms in the industry? If they are dissimilar, is it because the firm’s competitive strategy is unique? For example, consider a firm that reports a lower warranty allowance than the industry average. One explanation is that the firm competes on the basis of high quality and has invested considerable resources to reduce the rate of product failure. An alternative explanation is that the firm is merely understating its warranty liabilities. • Does management face strong incentives to use accounting discretion for earnings management? For example, is the firm close to violating bond covenants? Or, are the managers having difficulty meeting accounting-based bonus targets? Does management own significant stock? Is the firm in the middle of a proxy fight or union negotiations? Managers may also make accounting decisions to reduce tax payments, or to influence the perceptions of the firm’s competitors. • Has the firm changed any of its policies or estimates? What is the justification? What is the impact of these changes? For example, if warranty expenses decreased, is it because the firm made significant investments to improve quality? • Have the company’s policies and estimates been realistic in the past? For example, firms may overstate their revenues and understate their expenses during the year by manipulating quarterly reports, which are not subject to a full-blown external audit. However, the auditing process at the end of the fiscal year forces such companies to make large fourth-quarter adjustments, providing an opportunity for the analyst to assess the quality of the firm’s interim reporting. Similarly, firms that expense acquisition goodwill too slowly will be forced to take a large write-off later. A history of write-offs may be, therefore, a sign of prior earnings management. • Does the firm structure any significant business transactions so that it can achieve certain accounting objectives? For example, leasing firms can alter lease terms (the length of the lease or the bargain purchase option at the end of the lease term) so that the transactions qualify as sales-type leases for the lessors. Firms may structure a takeover transaction (equity financing rather than debt financing) so that they can use the pooling of interests method rather than the purchase method of accounting. Finally, a firm can alter the way it finances (coupon rate and the terms of conversion for a convertible bond issue) so that its reported earnings per share is not diluted. Such behavior may suggest that the firm’s managers are willing to expend economic resources merely to achieve an accounting objective. Step 4: Evaluate the Quality of Disclosure Managers can make it more or less easy for an analyst to assess the firm’s accounting quality and to use its financial statements to understand business reality. While accounting rules require a certain amount of minimum disclosure, managers have considerable choice in the matter. Disclosure quality, therefore, is an important dimension of a firm’s accounting quality. In assessing a firm’s disclosure quality, an analyst could ask the following questions: 91 92 Overview of Accounting Analysis Overview of Accounting Analysis • Does the company provide adequate disclosures to assess the firm’s business strategy and its economic consequences? For example, some firms use the Letter to the Shareholders in their annual report to clearly lay out the firm’s industry conditions, its competitive position, and management’s plans for the future. Others use the Letter to puff up the firm’s financial performance and gloss over any competitive difficulties the firm might be facing. • Do the footnotes adequately explain the key accounting policies and assumptions and their logic? For example, if a firm’s revenue and expense recognition policies differ from industry norms, the firm can explain its choices in a footnote. Similarly, when there are significant changes in a firm’s policies, footnotes can be used to disclose the reasons. • Does the firm adequately explain its current performance? The Management Discussion and Analysis section of the firm’s annual report provides an opportunity to help analysts understand the reasons behind the firm’s performance changes. Some firms use this section to link financial performance to business conditions. For example, if profit margins went down in a period, was it because of price competition or because of increases in manufacturing costs? If the selling and general administrative expenses went up, was it because the firm is investing in a differentiation strategy, or because unproductive overhead expenses were creeping up? • If accounting rules and conventions restrict the firm from measuring its key success factors appropriately, does the firm provide adequate additional disclosure to help outsiders understand how these factors are being managed? For example, if a firm invests in product quality and customer service, accounting rules do not allow the management to capitalize these outlays, even when the future benefits are certain. The firm’s Management Discussion and Analysis can be used to highlight how these outlays are being managed and their performance consequences. For example, the firm can disclose physical indexes of defect rates and customer satisfaction so that outsiders can assess the progress being made in these areas and the future cash flow consequences of these actions. • If a firm is in multiple business segments, what is the quality of segment disclosure? Some firms provide excellent discussion of their performance by product segments and geographic segments. Others lump many different businesses into one broad segment. The level of competition in an industry and management’s willingness to share desegregated performance data influence a firm’s quality of segment disclosure. • How forthcoming is the management with respect to bad news? A firm’s disclosure quality is most clearly revealed by the way management deals with bad news. Does it adequately explain the reasons for poor performance? Does the company clearly articulate its strategy, if any, to address the company’s performance problems? • How good is the firm’s investor relations program? Does the firm provide fact books with detailed data on the firm’s business and performance? Is the management accessible to analysts? 3-10 Overview of Accounting Analysis 3-11 Part 2 Business Analysis and Valuation Tools Step 5: Identify Potential Red Flags In addition to the above analysis, a common approach to accounting quality analysis is to look for “red flags” pointing to questionable accounting quality. These indicators suggest that the analyst should examine certain items more closely or gather more information on them. Some common red flags are: • Unexplained changes in accounting, especially when performance is poor. This may suggest that managers are using their accounting discretion to “dress up” their financial statements.14 • Unexplained transactions that boost profits. For example, firms might undertake balance sheet transactions, such as asset sales or debt for equity swaps, to realize gains in periods when operating performance is poor.15 • Unusual increases in accounts receivable in relation to sales increases. This may suggest that the company might be relaxing its credit policies or artificially loading up its distribution channels to record revenues during the current period. If credit policies are relaxed unduly, the firm may face receivable write-offs in the subsequent periods as a result of customer defaults. If the firm accelerates shipments to the distribution channels, it may either face product returns or reduced shipments in the subsequent periods. • Unusual increases in inventories in relation to sales increases. If the inventory build-up is due to an increase in finished goods inventory, it could be a sign that the demand for the firm’s products is slowing down, suggesting that the firm may be forced to cut prices (and hence earn lower margins) or write down its inventory. A build-up in work-in-progress inventory tends to be good news on average, probably signaling that managers expect an increase in sales. If the build-up is in raw materials, it could suggest manufacturing or procurement inefficiencies, leading to an increase in cost of goods sold (and hence lower margins).16 • An increasing gap between a firm’s reported income and its cash flow from operating activities. While it is legitimate for accrual accounting numbers to differ from cash flows, there is usually a steady relationship between the two if the company’s accounting policies remain the same. Therefore, any change in the relationship between reported profits and operating cash flows might indicate subtle changes in the firm’s accrual estimates. For example, a firm undertaking large construction contracts might use the percentage-of-completion method to record revenues. While earnings and operating cash flows are likely to differ for such a firm, they should bear a steady relationship to each other. Now suppose the firm increases revenues in a period through an aggressive application of the percentage-of-completion method. Then its earnings will go up, but its cash flow remains unaffected. This change in the firm’s accounting quality will be manifested by a change in the relationship between the firm’s earnings and cash flows. • An increasing gap between a firm’s reported income and its tax income. Once again, it is quite legitimate for a firm to follow different accounting policies for fi- 93 94 Overview of Accounting Analysis Overview of Accounting Analysis • • • • • nancial reporting and tax accounting, as long as the tax law allows it.17 However, the relationship between a firm’s book and tax accounting is likely to remain constant over time, unless there are significant changes in tax rules or accounting standards. Thus, an increasing gap between a firm’s reported income and its tax income may indicate that the firm’s financial reporting to shareholders has become more aggressive. As an example, consider that warranty expenses are estimated on an accrual basis for financial reporting, but are recorded on a cash basis for tax reporting. Unless there is a big change in the firm’s product quality, these two numbers bear a consistent relationship to each other. Therefore, a change in this relationship can be an indication either that the product quality is changing significantly or that financial reporting estimates are changing. A tendency to use financing mechanisms like research and development partnerships and the sale of receivables with recourse. While these arrangements may have a sound business logic, they can also provide management with an opportunity to understate the firm’s liabilities and/or overstate its assets.18 Unexpected large asset write-offs. This may suggest that management is slow to incorporate changing business circumstances into its accounting estimates. Asset write-offs may also be a result of unexpected changes in business circumstances.19 Large fourth-quarter adjustments. A firm’s annual reports are audited by the external auditors, but its interim financial statements are usually only reviewed. If a firm’s management is reluctant to make appropriate accounting estimates (such as provisions for uncollectable receivables) in its interim statements, it could be forced to make adjustments at the end of the year as a result of pressure from its external auditors. A consistent pattern of fourth-quarter adjustments, therefore, may indicate an aggressive management orientation towards interim reporting.20 Qualified audit opinions or changes in independent auditors that are not well justified. These may indicate a firm’s aggressive attitude or a tendency to “opinion shop.” Related-party transactions or transactions between related entities. These transactions may lack the objectivity of the marketplace, and managers’ accounting estimates related to these transactions are likely to be more subjective and potentially self-serving. While the preceding list provides a number of red flags for potentially poor accounting quality, it is important to do further analysis before reaching final conclusions. Each of the red flags has multiple interpretations; some interpretations are based on sound business reasons, and others indicate questionable accounting. It is, therefore, best to use the red flag analysis as a starting point for further probing, not as an end point in itself.21 Step 6: Undo Accounting Distortions If the accounting analysis suggests that the firm’s reported numbers are misleading, analysts should attempt to restate the reported numbers to reduce the distortion to the 3-12 Overview of Accounting Analysis 3-13 Part 2 Business Analysis and Valuation Tools extent possible. It is, of course, virtually impossible to undo all the distortion using outside information alone. However, some progress can be made in this direction by using the cash flow statement and the financial statement footnotes. A firm’s cash flow statement provides a reconciliation of its performance based on accrual accounting and cash accounting. If the analyst is unsure of the quality of the firm’s accrual accounting, the cash flow statement provides an alternative benchmark of its performance. The cash flow statement also provides information on how individual line items in the income statement diverge from the underlying cash flows. For example, if an analyst is concerned that the firm is aggressively capitalizing certain costs that should be expensed, the information in the cash flow statement provides a basis to make the necessary adjustment. Financial statement footnotes also provide a lot of information that is potentially useful in restating reported accounting numbers. For example, when a firm changes its accounting policies, it provides a footnote indicating the effect of that change if it is material. Similarly, some firms provide information on the details of accrual estimates such as the allowance for bad debts. The tax footnote usually provides information on the differences between a firm’s accounting policies for shareholder reporting and tax reporting. Since tax reporting is often more conservative than shareholder reporting, the information in the tax footnote can be used to estimate what the earnings reported to shareholders would be under more conservative policies. ACCOUNTING ANALYSIS PITFALLS There are several potential pitfalls in accounting analysis that an analyst should avoid. First, it is important to remember that from an analyst’s perspective, conservative accounting is not the same as “good” accounting. Financial analysts are interested in evaluating how well a firm’s accounting captures business reality in an unbiased manner, and conservative accounting can be as misleading as aggressive accounting in this respect. Further, conservative accounting often provides managers with opportunities for “income smoothing.” Income smoothing may prevent analysts from recognizing poor performance in a timely fashion. A second potential mistake is to confuse unusual accounting with questionable accounting. While unusual accounting choices might make a firm’s performance difficult to compare with other firms’ performance, such an accounting choice might be justified if the company’s business is unusual. For example, firms that follow differentiated strategies or firms that structure their business in an innovative manner to take advantage of particular market situations may make unusual accounting choices to properly reflect their business. Therefore, it is important to evaluate a company’s accounting choices in the context of its business strategy. Another potential pitfall in accounting analysis arises when an analyst attributes all changes in a firm’s accounting policies and accruals to earnings management motives.22 Accounting changes might be merely reflecting changed business circumstances. For 95 96 Overview of Accounting Analysis Overview of Accounting Analysis example, as already discussed, a firm that shows unusual increases in its inventory might be preparing for a new product introduction. Similarly, unusual increases in receivables might merely be due to changes in a firm’s sales strategy. Unusual decreases in the allowance for uncollectable receivables might be reflecting a firm’s changed customer focus. It is therefore important for an analyst to consider all possible explanations for accounting changes and investigate them using the qualitative information available in a firm’s financial statements. VALUE OF ACCOUNTING DATA AND ACCOUNTING ANALYSIS What is the value of accounting information and accounting analysis? Given the incentives and opportunities for managers to affect their firms’ reported accounting numbers, some have argued that accounting data and accounting analysis are not likely to be useful for investors. Researchers have examined the value of accounting by estimating the return that could be earned by an investor with perfect earnings foresight one year prior to an earnings announcement.23 The findings show that by buying stocks of firms with increased earnings and selling stocks of firms with decreased earnings each year, a hypothetical investor could earn an average portfolio return of 37.5 percent in the period 1954 to 1996. This is equivalent to 44 percent of the return that could have been earned if the investor had perfect foresight of the stock price itself for one year, and bought stocks with increased prices and sold stocks whose price decreased. Perfect foresight of ROE permits the investor to earn an even higher rate of return, 43 percent, than perfect earnings foresight. This is equivalent to 50 percent of the return that could be earned with perfect stock price foresight. In contrast, cash flow data appear to be considerably less valuable than earnings or ROE information. Perfect foresight of cash flows from operations would permit the hypothetical investor to earn an average annual return of only 9 percent, equivalent to 11 percent of the return that could be earned with perfect foresight of stock prices. Overall, this research suggests that the institutional arrangements and conventions created to mitigate potential misuse of accounting by managers are effective in providing assurance to investors. The research indicates that investors do not view earnings management as so pervasive as to make earnings data unreliable. A number of research studies have examined whether superior accounting analysis is a valuable activity. By and large, this evidence indicates that there are opportunities for superior analysts to earn positive stock returns. Research findings indicate that companies criticized in the financial press for misleading financial reporting subsequently suffered an average stock price drop of 8 percent.24 Firms where managers appeared to inflate reported earnings prior to an equity issue and subsequently reported poor earnings performance had more negative stock performance after the offer than firms with no apparent earnings management.25 Finally, firms subject to SEC investigation for earnings management showed an average stock price decline of 9 percent when the earnings 3-14 Overview of Accounting Analysis 3-15 Part 2 Business Analysis and Valuation Tools management was first announced and continued to have poor stock performance for up to two years.26 These findings imply that analysts who are able to identify firms with misleading accounting are able to create value for investors. The findings also indicate that the stock market ultimately sees through earnings management. For all of these cases, earnings management is eventually uncovered and the stock price responds negatively to evidence that firms have inflated prior earnings through misleading accounting. SUMMARY In summary, accounting analysis is an important step in the process of analyzing corporate financial reports. The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures the underlying business reality. Sound accounting analysis improves the reliability of conclusions from financial analysis, the next step in financial statement analysis. There are six key steps in accounting analysis. The analyst begins by identifying the key accounting policies and estimates, given the firm’s industry and its business strategy. The second step is to evaluate the degree of flexibility available to managers, given the accounting rules and conventions. Next, the analyst has to evaluate how managers exercise their accounting flexibility and the likely motivations behind managers’ accounting strategy. The fourth step involves assessing the depth and quality of a firm’s disclosures. The analyst should next identify any red flags needing further investigation. The final accounting analysis step is to restate accounting numbers to remove any noise and bias introduced by the accounting rules and management decisions. The subsequent five chapters apply these concepts to the analysis of assets, liabilities and equity, revenues, expenses, and business entity accounting. DISCUSSION QUESTIONS 1. A finance student states, “I don’t understand why anyone pays any attention to accounting earnings numbers, given that a ‘clean’ number like cash from operations is readily available.” Do you agree? Why or why not? 2. Fred argues, “The standards that I like most are the ones that eliminate all management discretion in reporting—that way I get uniform numbers across all companies and don’t have to worry about doing accounting analysis.” Do you agree? Why or why not? 3. Bill Simon says, “We should get rid of the FASB and SEC, since free market forces will make sure that companies report reliable information.” Do you agree? Why or why not? 4. Many firms recognize revenues at the point of shipment. This provides an incentive to accelerate revenues by shipping goods at the end of the quarter. Consider two com- 97 98 Overview of Accounting Analysis Overview of Accounting Analysis panies, one of which ships its product evenly throughout the quarter, and the second of which ships all its products in the last two weeks of the quarter. Each company’s customers pay thirty days after receiving shipment. How can you distinguish these companies, using accounting ratios? 5. a. If management reports truthfully, what economic events are likely to prompt the following accounting changes? • Increase in the estimated life of depreciable assets • Decrease in the uncollectibles allowance as a percentage of gross receivables • Recognition of revenues at the point of delivery, rather than at the point cash is received • Capitalization of a higher proportion of software R&D costs b. What features of accounting, if any, would make it costly for dishonest managers to make the same changes without any corresponding economic changes? 6. The conservatism principle arises because of concerns about management’s incentives to overstate the firm’s performance. Joe Banks argues, “We could get rid of conservatism and make accounting numbers more useful if we delegated financial reporting to independent auditors rather than to corporate managers.” Do you agree? Why or why not? 7. A fund manager states, “I refuse to buy any company that makes a voluntary accounting change, since it’s certainly the case that its management is trying to hide bad news.” Can you think of any alternative interpretation? NOTES 1. Accounting analysis is sometimes also called quality of earnings analysis. We prefer to use the term accounting analysis, since we are discussing a broader concept than merely a firm’s earnings quality. 2. These definitions paraphrase those of the Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 6, “Elements of Financial Statements” (1985). Our intent is to present the definitions at a conceptual, not technical, level. For more complete discussion of these and related concepts, see the FASB’s Statements of Financial Accounting Concepts. 3. Strictly speaking, the comprehensive net income of a firm also includes gains and losses from increases and decreases in equity from nonoperating activities or extraordinary items. 4. Thus, although accrual accounting is theoretically superior to cash accounting in measuring a firm’s periodic performance, the distortions it introduces can make accounting data less valuable to users. If these distortions are large enough, current cash flows may measure a firm’s periodic performance better than accounting profits. The relative usefulness of cash flows and accounting profits in measuring performance, therefore, varies from firm to firm. For empirical evidence on this issue, see “Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals” by Patricia M. Dechow, Journal of Accounting and Economics 18, 1994. 5. For example, Abraham Brilloff wrote a series of accounting analyses of public companies in Barron’s over several years. On average, the stock prices of the analyzed companies changed by about 8 percent on the day these articles were published, indicating the potential value of 3-16 Overview of Accounting Analysis 3-17 Part 2 Business Analysis and Valuation Tools performing such analysis. For a more complete discussion of this evidence, see “Brilloff and the Capital Market: Further Evidence” by George Foster, Stanford University, working paper, 1985. 6. For a complete discussion of these motivations, see Positive Accounting Theory by Ross L. Watts and Jerold L. Zimmerman (Englewood Cliffs, NJ: Prentice-Hall, 1986). 7. The most convincing evidence supporting the covenant hypothesis is reported in a study of the accounting decisions by firms in financial distress: “Debt-covenant violations and managers’ accounting responses,” Amy Patricia Sweeney, Journal of Accounting and Economics 17, 1994. 8. Studies that examine the bonus hypothesis report evidence supporting the view that managers’ accounting decisions are influenced by compensation considerations. See, for example, “The effect of bonus schemes on accounting decisions,” Paul M. Healy, Journal of Accounting and Economics 12, 1985; R. Holthausen, D. Larcker, and R. Sloan, 1995, “Annual Bonus Schemes and the Manipulation of Earnings,” Journal of Accounting and Economics 19: 29–74; and Flora Guidry, Andrew Leone, and Steve Rock, 1998, “Earnings-Based Bonus Plans and Earnings Management by Business Unit Managers,” Journal of Accounting and Economics, forthcoming. 9. “Managerial competition, information costs, and corporate governance: The use of accounting performance measures in proxy contests,” Linda DeAngelo, Journal of Accounting and Economics 10, 1988. 10. The trade-off between taxes and financial reporting in the context of managers’ accounting decisions is discussed in detail in Taxes and Business Strategy by Myron Scholes and Mark Wolfson (Englewood Cliffs, NJ: Prentice-Hall, 1992). Many empirical studies have examined firms’ LIFO/FIFO choices. 11. Several researchers have documented that firms affected by such situations have a motivation to influence regulators’ perceptions through accounting decisions. For example, J. Jones documents that firms seeking import protections make income-decreasing accounting decisions in “Earnings management during import relief investigations,” Journal of Accounting Research 29, 1991. A number of studies find that banks that are close to minimum capital requirements overstate loan loss provisions, understate loan write-offs, and recognize abnormal realized gains on securities portfolios (see S. Moyer, 1990, “Capital Adequacy Ratio Regulations and Accounting Choices in Commercial Banks,” Journal of Accounting and Economics 12: 123–154; M. Scholes, G. P. Wilson, and M. Wolfson, 1990, “Tax Planning, Regulatory Capital Planning, and Financial Reporting Strategy for Commercial Banks,” Review of Financial Studies 3: 625–650; A. Beatty, S. Chamberlain, and J. Magliolo, 1995, “Managing Financial Reports of Commercial Banks: The Influence of Taxes, Regulatory Capital and Earnings,” Journal of Accounting Research 33, No. 2: 231–261; and J. Collins, D. Shackelford, and J. Wahlen, 1995, “Bank Differences in the Coordination of Regulatory Capital, Earnings and Taxes,” Journal of Accounting Research 33, No. 2: 263–291). Finally, Petroni finds that financially weak property-casualty insurers that risk regulatory attention understate claim loss reserves: K. R. Petroni, 1992, “Optimistic Reporting in the Property Casualty Insurance Industry,” Journal of Accounting and Economics 15: 485–508. 12. “The effect of firms’ financial disclosure strategies on stock prices,” Paul Healy and Krishna Palepu, Accounting Horizons 7, 1993. For a summary of the empirical evidence, see P. Healy and J. Wahlen, “Earnings Management,” (Harvard Business School, working paper, 1999). 13. Financial analysts pay close attention to managers’ disclosure strategies; the Financial Analysts’ Federation publishes annually a report evaluating them in U.S. firms. For a discussion of these ratings, see “Cross-sectional Determinants of Analysts’ Ratings of Corporate Disclosures” by Mark Lang and Russ Lundholm, Journal of Accounting Research 31, Autumn 1993: 246–271. 14. For a detailed analysis of a company that made such changes, see “Anatomy of an Account- 99 100 Overview of Accounting Analysis Overview of Accounting Analysis ing Change” by Krishna Palepu in Accounting & Management: Field Study Perspectives, edited by William J. Bruns, Jr. and Robert S. Kaplan (Boston: Harvard Business School Press, 1987). 15. An example of this type of behavior is documented by John Hand in his study, “Did Firms Undertake Debt-Equity Swaps for an Accounting Paper Profit or True Financial Gain?,” The Accounting Review 64, October 1989. 16. For an empirical analysis of inventory build-ups, see “Do Inventory Disclosures Predict Sales and Earnings?” by Victor Bernard and James Noel, Journal of Accounting, Auditing, and Finance, Fall 1991. 17. This is true by and large in the United States and in several other countries. However, in some countries, such as Germany and Japan, tax accounting and financial reporting are closely tied together, and this particular red flag is not very meaningful. 18. For research on accounting and economic incentives in the formation of R&D partnerships, see “Motives for Forming Research and Development Financing Organizations” by Anne Beatty, Philip G. Berger, and Joseph Magliolo, Journal of Accounting & Economics 19, 1995. 19. For an empirical examination of asset write-offs, see “Write-offs as Accounting Procedures to Manage Perceptions” by John A. Elliott and Wayne H. Shaw, Journal of Accounting Research, Supplement, 1988. 20. Richard R. Mendenhall and William D. Nichols report evidence consistent with the hypothesis that managers take advantage of their discretion to postpone reporting bad news until the fourth quarter. See “Bad News and Differential Market Reactions to Announcements of EarlierQuarter versus Fourth-Quarter Earnings,” Journal of Accounting Research, Supplement, 1988. 21. This type of analysis is presented in the context of provisions for bad debts by Maureen McNichols and G. Peter Wilson in their study, “Evidence of Earnings Management from the Provisions for Bad Debts,” Journal of Accounting Research, Supplement, 1988. 22. This point has been made by several accounting researchers. For a summary of research on earnings management, see “Earnings Management” by Katherine Schipper, Accounting Horizons, December 1989: 91–102. 23. See James Chang, 1998, “The Decline in Value Relevance of Earnings and Book Values,” Unpublished dissertation, Harvard University. Similar evidence is reported by J. Francis and K. Schipper, 1998, “Have Financial Statements Lost Their Relevance?,” working paper, University of Chicago; and W. E. Collins, E. Maydew, and I. Weiss, 1997, “Changes in the Value-Relevance of Earnings and Book Value over the Past Forty Years, Journal of Accounting and Economics 24: 39–67. 24. See G. Foster, 1979, “Briloff and the Capital Market,” Journal of Accounting Research 17 (Spring): 262–274. 25. See S. H. Teoh, I. Welch, and T. J. Wong, 1998a, “Earnings Management and the LongRun Market Performance of Initial Public Offerings,” Journal of Finance 53, No. 6, December 1998: 1935–1974; S. H. Teoh, I. Welch, and T. J. Wong, 1998b, “Earnings Management and the Post-Issue Underperformance of Seasoned Equity Offerings,” Journal of Financial Economics 50, No. 1, October 1998: 63–99; and S. H. Teoh, T. J. Wong, and G. Rao, 1998, “Incentives and Opportunities for Earnings Management in Initial Public Offerings,” Review of Accounting Studies, forthcoming. 26. See Patricia Dechow, Richard G. Sloan, and Amy P. Sweeney, 1996, “Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC,” Contemporary Accounting Research 13, No. 1: 1–36; and M. D. Beneish, 1997, “Detecting GAAP Violation: Implications for Assessing Earnings Management among Firms with Extreme Financial Performance,” Journal of Accounting and Public Policy 16: 271–309. 3-18 Harnischfeger Corporation I n February 1985, Peter Roberts, the research director of Exeter Group, a small Boston-based investment advisory service specializing in turnaround stocks, was reviewing the 1984 annual report of Harnischfeger Corporation (Exhibit 4). His attention was drawn by the $1.28 per share net profit Harnischfeger reported for 1984. He knew that barely three years earlier the company had faced a severe financial crisis. Harnischfeger had defaulted on its debt and stopped dividend payments after reporting a hefty $7.64 per share net loss in fiscal 1982. The company’s poor performance continued in 1983, leading to a net loss of $3.49 per share. Roberts was intrigued by Harnischfeger’s rapid turnaround and wondered whether he should recommend purchase of the company’s stock (see Exhibit 3 for selected data on Harnischfeger’s stock). COMPANY BUSINESS AND PRODUCTS Business Analysis 2 and Valuation Tools 3 Overview of Accounting Analysis Harnischfeger Corporation was a machinery company based in Milwaukee, Wisconsin. The company had originally been started as a partnership in 1884 and was incorporated in Wisconsin in 1910 under the name Pawling and Harnischfeger. Its name was changed to the present one in 1924. The company went public in 1929 and was listed on the New York Stock Exchange. The company’s two major segments were the P&H Heavy Equipment Group, consisting of the Construction Equipment and the Mining and Electrical Equipment divisions, and the Industrial Technologies Group, consisting of the Material Handling Equipment and the Harnischfeger Engineers divisions. The sales mix of the company in 1983 consisted of: Construction Equipment 32 percent; Mining and Electrical Equipment 33 percent, Material Handling Equipment 29 percent, and Harnischfeger Engineers 6 percent. Harnischfeger was a leading producer of construction equipment. Its products, bearing the widely recognized brand name P&H, included hydraulic cranes and lattice boom cranes. These were used in bridge and highway construction and for cargo and other material handling applications. Harnischfeger had market shares of about 20 percent in hydraulic cranes and about 30 percent in lattice boom cranes. In the 1980s the construction equipment industry in general was experiencing declining margins. ......................................................................................................................... Professor Krishna Palepu prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1985 by the President and Fellows of Harvard College. Harvard Business School case 9-186-160. 101 Overview of Accounting Analysis Overview of Accounting Analysis Electric mining shovels and excavators constituted the principal products of the Mining and Electrical Equipment Division of Harnischfeger. The company had a dominant share of the mining machinery market. The company’s products were used in coal, copper, and iron mining. A significant part of the division’s sales were from the sale of spare parts. Because of its large market share and the lucrative spare parts sales, the division was traditionally very profitable. Most of the company’s future mining product sales were expected to occur outside the United States, principally in developing countries. The Material Handling Equipment Division of Harnischfeger was the fourth largest supplier of automated material handling equipment, with a 9 percent market share. The division’s products included overhead cranes, portal cranes, hoists, monorails, and components and parts. The demand for this equipment was expected to grow in the coming years as an increasing number of manufacturing firms emphasized cost reduction programs. Harnischfeger believed that the material handling equipment business would be a major source of its future growth. Harnischfeger Engineers was an engineering services division engaged in design, custom software development, and project management for factory and distribution automation projects. The division engineered and installed complete automated material handling systems for a wide variety of applications on a fee basis. The company expected such automated storage and retrieval systems to play an increasingly important role in the “factory of the future.” Harnischfeger had a number of subsidiaries, affiliated companies, and licensees in a number of countries. Export and foreign sales constituted more than 50 percent of the total revenues of the company. FINANCIAL DIFFICULTIES OF 1982 The machinery industry experienced a period of explosive growth during the 1970s. Harnischfeger expanded rapidly during this period, growing from $205 million in revenues in 1973 to $644 million in 1980. To fund this growth, the company relied increasingly on debt financing, and the firm’s debt/equity ratio rose from 0.88 in 1973 to 1.26 in 1980. The worldwide recession in the early 1980s caused a significant drop in demand for the company’s products starting in 1981 and culminated in a series of events that shook the financial stability of Harnischfeger. Reduced sales and the high interest payments resulted in poor profit performance leading to a reported loss in 1982 of $77 million. The management of Harnischfeger commented on its financial difficulties: There is a persistent weakness in the basic industries, both in the United States and overseas, which have been large, traditional markets for P&H products. Energy-related projects, which had been a major source of business of our Construction Equipment Division, have slowed significantly in the last year as a result of lower oil demand and subsequent price decline, not only in the U.S. but throughout the world. Lack of demand for such basic minerals as iron ore, copper and 3-20 Harnischfeger Corporation 102 Overview of Accounting Analysis 3-21 Part 2 Business Analysis and Valuation Tools Harnischfeger Corporation bauxite have decreased worldwide mining activity, causing reduced sales for mining equipment, although coal mining remains relatively strong worldwide. Difficult economic conditions have caused many of our normal customers to cut capital expenditures dramatically, especially in such depressed sectors as the steel industry, which has always been a major source of sales for all P&H products. The significant operating losses recorded in 1982 and the credit losses experienced by its finance subsidiary caused Harnischfeger to default on certain covenants of its loan agreements. The most restrictive provisions of the company’s loan agreements required it to maintain a minimum working capital of $175 million, consolidated net worth of $180 million, and a ratio of current assets to current liabilities of 1.75. On October 31, 1982, the company’s working capital (after reclassification of about $115 million longterm debt as a current liability) was $29.3 million, the consolidated net worth was $142.2 million, and the ratio of current assets to current liabilities was 1.12. Harnischfeger Credit Corporation, an unconsolidated finance subsidiary, also defaulted on certain covenants of its loan agreements, largely due to significant credit losses relating to the financing of construction equipment sold to a large distributor. As a result of these covenant violations, the company’s long-term debt of $124.3 million became due on demand, the unused portion of the bank revolving credit line of $25.0 million became unavailable, and the unused short-term bank credit lines of $12.0 million were canceled. In addition, the $25.1 million debt of Harnischfeger Credit Corporation also became immediately due. The company was forced to stop paying dividends and began negotiations with its lenders to restructure its debt to permit operations to continue. Price Waterhouse, the company’s audit firm, qualified its audit opinion on Harnischfeger’s 1982 annual report with respect to the outcome of the company’s negotiations with its lenders. CORPORATE RECOVERY PLAN Harnischfeger responded to the financial crisis facing the firm by developing a corporate recovery plan. The plan consisted of four elements: (1) changes in the top management, (2) cost reductions to lower the break-even point, (3) reorientation of the company’s business, and (4) debt restructuring and recapitalization. The actions taken in each of these four areas are described below. To deal effectively with the financial crisis, Henry Harnischfeger, then Chairman and Chief Executive Officer of the company, created the position of Chief Operating Officer. After an extensive search, the position was offered in August 1982 to William Goessel, who had considerable experience in the machinery industry. Another addition to the management team was Jeffrey Grade, who joined the company in 1983 as Senior Vice President of Finance and Administration and Chief Financial Officer. Grade’s appointment was necessitated by the early retirement of the previous Vice President of Finance in 1982. The engineering, manufacturing, and marketing functions were also restructured to streamline the company’s operations (see Exhibits 1 and 2 for additional information on Harnischfeger’s current management). 103 Overview of Accounting Analysis Overview of Accounting Analysis To deal with the short-term liquidity squeeze, the company initiated a number of cost reduction measures. These included (1) reducing the workforce from 6,900 to 3,800; (2) eliminating management bonuses and reducing benefits and freezing wages of salaried and hourly employees; (3) liquidating excess inventories and stretching payments to creditors; and (4) permanent closure of the construction equipment plant at Escanaba, Michigan. These and other related measures improved the company’s cash position and helped to reduce the rate of loss during fiscal 1983. Concurrent with the above cost reduction measures, the new management made some strategic decisions to reorient Harnischfeger’s business. First, the company entered into a long-term agreement with Kobe Steel, Ltd., of Japan. Under this agreement, Kobe agreed to supply Harnischfeger’s requirements for construction cranes for sale in the United States as Harnischfeger phased out its own manufacture of cranes. This step was expected to significantly reduce the manufacturing costs of Harnischfeger’s construction equipment, enabling it to compete effectively in the domestic market. Second, the company decided to emphasize the high technology part of its business by targeting for future growth the material handling equipment and systems business. To facilitate this strategy, the Industrial Technologies Group was created. As part of the reorientation, the company stated that it would develop and acquire new products, technology, and equipment and would expand its abilities to provide computer-integrated solutions to handling, storing, and retrieval in areas hitherto not pursued—industries such as distribution warehousing, food, pharmaceuticals, and aerospace. While Harnischfeger was implementing its turnaround strategy, it was engaged at the same time in complex and difficult negotiations with its bankers. On January 6, 1984, the company entered into agreements with its lenders to restructure its debt obligations into three-year term loans secured by fixed as well as other assets, with a one-year extension option. This agreement required, among other things, specified minimum levels of cash and unpledged receivables, working capital, and net worth. The company reported a net loss of $35 million in 1983, down from the $77 million loss the year before. Based on the above developments during the year, in the 1983 annual report the management expressed confidence that the company would return to profitability soon: We approach our second century with optimism, knowing that the negative events of the last three years are behind us, and with a firm belief that positive achievements will be recorded in 1984. By the time the corporation celebrates its 100th birthday on December 1, we are confident it will be operating profitably and attaining new levels of market strength and leadership. During 1984 the company reported profits during each of the four quarters, ending the year with a pre-tax operating profit of $5.7 million, and a net income after tax and extraordinary credits of $15 million (see Exhibit 4). It also raised substantial new capital through a public offering of debentures and common stock. Net proceeds from the offering, which totaled $150 million, were used to pay off all of the company’s restruc- 3-22 Harnischfeger Corporation 104 Overview of Accounting Analysis 3-23 Part 2 Business Analysis and Valuation Tools tured debt. In the 1984 annual report the management commented on the company’s performance as follows: ... Harnischfeger Corporation 1984 was the Corporation’s Centennial year and we marked the occasion by rededicating ourselves to excellence through market leadership, customer service and improved operating performance and profitability. We look back with pride. We move ahead with confidence and optimism. Our major markets have never been more competitive; however, we will strive to take advantage of any and all opportunities for growth and to attain satisfactory profitability. Collectively, we will do what has to be done to ensure that the future will be rewarding to all who have a part in our success. QUESTIONS 1. Identify all the accounting policy changes and accounting estimates that Harnischfeger made during 1984. Estimate, as accurately as possible, the effect of these on the company’s 1984 reported profits. 2. What do you think are the motives of Harnischfeger’s management in making the changes in its financial reporting policies? Do you think investors will see through these changes? 3. Assess the company’s future prospects, given your insights from questions 1 and 2 and the information in the case about the company’s turnaround strategy. 105 Director Since Current Term Shares Owned Chairman, Chief Executive Officer, and Director of Kohler Company, manufacturer of plumbing and specialty products, engines, and generators, since 1972; President since 1974. Age 44. Executive Vice Chairman and Director of Kobe Steel, Ltd., a Japanese manufacturer of steel and steel products, industrial machinery, construction equipment, aluminum, copper and alloy products, and welding equipment and consumables. Age 63. President and Chief Operating Officer of the Corporation since 1982. Executive Vice President of Beloit Corporation from 1978 to 1982. Director, Goulds Pumps, Inc. Age 56. Chairman of the Board and Chief Executive Officer of the Corporation since 1970; President from 1959 to 1982. Director, First Wisconsin Corporation and First Wisconsin National Bank of Milwaukee. Age 60. Partner in Kirkland & Ellis, attorneys, since 1959. Age 56. Herbert V. Kohler, Jr. Taisuke Mori William W. Goessel Henry Harnischfeger Karl F. Nygren 1964 1945 1986 1986 1986 1985 1981 1982 1985 1985 1973 1981 continued 2,000 611,362 15,000 None 700 100 Overview of Accounting Analysis Harnischfeger Corporation Chairman of the Board and Chief Executive Officer of United States Gypsum Company, manufacturer of building materials and products used in industrial processes, since 1983; Vice Chairman from 1981 to 1983; President and Chief Operating Officer from 1971 to 1981. Director, American National Bank and Trust Company of Chicago, Walter E. Heller International Corporation, W. W. Grainger, Inc., and UNR Industries, Inc. Age 64. Edward W. Duffy ................................................................................................................................................................................. EXHIBIT 1 Harnischfeger Corporation Board of Directions in 1984 106 Overview of Accounting Analysis 3-24 Shares Owned Senior Vice President/Finance and Administration and Chief Financial Officer of the Corporation since August 1, 1983. Vice President Corporate Finance of IC Industries from 1981 to 1983; Assistant Vice President from 1976 to 1981. Age 40. President, Chief Operating Officer, and Director of Rexnord, Inc., a major manufacturer of industrial components and machinery, since 1978. Director, Johnson Controls, Inc., Marine Corporation, and Marine Bank, N.A. Age 56. Director of Foster Wheeler Corporation since 1971; Chairman of the Board from 1981 to 1982; President and Chief Executive Officer from 1978 to 1981. Director, Belco Pollution Control Corporation, International General Industries, Inc., and Banker’s Life Insurance Co. Age 59. Jeffrey T. Grade Donald Taylor Frank A. Lee 1987 1987 1987 1987 1979 1983 1979 1983 None 100 3,750 500 ................................................................................................................................................................................. Senior lecturer, Graduate School of Business, University of Chicago. Director, IC Industries, Inc., Stone Container Corporation, UNR Industries, Inc., American National Bank and Trust Company of Chicago, and Walter E. Heller International Corporation. Age 67. John P. Gallagher ................................................................................................................................................................................. Current Term 3-25 Director Since Harnischfeger Corporation Overview of Accounting Analysis Part 2 Business Analysis and Valuation Tools 107 Overview of Accounting Analysis 3-26 Overview of Accounting Analysis EXHIBIT 2 Executive Compensation, Harnischfeger Corporation The following table sets forth all cash compensation paid to each of the Corporation’s five most highly compensated executive officers and to all executive officers as a group for services rendered to the Corporation and its subsidiaries during fiscal 1984. Cash Compensation ...................................................................................................................................... Henry Harnischfeger Chairman of the Board and Chief Executive Officer William W. Goessel President and Chief Operating Officer 280,000 C. P. Cousland Senior Vice President and group executive, P&H Heavy Equipment 210,000 Jeffrey T. Grade Senior Vice President-Finance and Administration and Chief Financial Officer 205,336 Douglas E. Holt President, Harnischfeger Engineers, Inc. 152,839 All persons who were executive officers during the fiscal year as a group (14 persons) $ 364,004 2,159,066 ...................................................................................................................................... 1985 EXECUTIVE INCENTIVE PLAN In December 1984, the board of directors established an Executive Incentive Plan for fiscal 1985 which provides an incentive compensation opportunity of 40% of annual salary for 11 senior executive officers only if the Corporation reaches a specific net after-tax profit objective; it provides an additional incentive compensation of up to 40% of annual salary for seven of those officers if the corporation exceeds the objective. The Plan covers the chairman, president, senior vice presidents; president, Harnischfeger Engineers, Inc.; vice president, P&H World Services; vice president; Material Handling Equipment; and secretary. Awards made in fiscal year 1984 are included in the compensation table above. Harnischfeger Corporation 108 Low Close High Low Close 9 1/8 10 6/8 11 11 2/8 11 5/8 8 6/8 8 7/8 10 10 1/8 10 7/8 9 10 5/8 10 4/8 11 11 2/8 186.4 188.2 191.9 199.7 201.8 181.8 182.2 186.9 191.3 198.6 182.2 182.8 191.3 198.6 200.0 February 1985 10.0 10.5% 8.4% 11.4% 12.0% 10.9 11.3 ........................................................................................................ Median P/E ratio of Dow Jones Industrials Median P/E ratio of Value Line stocks Median P/E ratio of machinery industry (construction and mining equipment) Prime rate 91-day Treasury bill rate 30-year Treasury bond yield Moody’s Aaa corporate bond yield ........................................................................................................ B. MARKET DATA Harnischfeger’s stock beta = 0.95 (Value Line estimate) ............................................................................................................................................................................ January 4, 1985 January 11, 1985 January 18, 1985 January 25, 1985 February 1, 1985 ............................................................................................................................................................................ High S&P 400 Industrials Index ................................................................. Harnischfeger’s Stock Price ................................................................ 3-27 A. STOCK PRICES EXHIBIT 3 Harnischfeger Corporation, Selected Stock Price and Market Data Harnischfeger Corporation Overview of Accounting Analysis Part 2 Business Analysis and Valuation Tools 109 Overview of Accounting Analysis Overview of Accounting Analysis 3-28 EXHIBIT 4 Harnischfeger Corporation 1984 Annual Report (abridged) TO OUR SHAREHOLDERS The Corporation recorded gains in each quarter during fiscal 1984, returning to profitability despite the continued depressed demand and intense price competition in the world markets it serves. For the year ended October 31, net income was $15,176,000 or $1.28 per common share, which included $11,005,000 or 93¢ per share from the cumulative effect of a change in depreciation accounting. In 1983, the Corporation reported a loss of $34,630,000 or $3.49 per share. Sales for 1984 improved 24% over the preceding year, rising to $398.7 million from $321 million a year ago. New orders totaled $451 million, a $101 million increase over 1983. We entered fiscal 1985 with a backlog of $193 million, which compared to $141 million a year earlier. ALL DIVISIONS IMPROVED All product divisions recorded sales and operating improvements during 1984. Mining equipment was the strongest performer with sales up over 60%, including major orders from Turkey and the People’s Republic of China. During the year we began the implementation of the training, engineering and manufacturing license agreement concluded in November, 1983 with the People’s Republic of China, which offers the Corporation long-term potential in modernizing and mechanizing this vast and rapidly developing mining market. Sales of material handling equipment and systems were up 10% for the year and the increasingly stronger bookings recorded during the latter part of the year are continuing into the first quarter of 1985. Sales on construction equipment products showed some signs of selective improvement. In the fourth quarter, bookings more than doubled from the very depressed levels in the same period a year ago, although the current level is still far below what is needed to achieve acceptable operating results for this product line. FINANCIAL STABILITY RESTORED In April, the financial stability of the Corporation was improved through a public offering of 2.15 million shares of common stock, $50 million of 15% notes due April 15, 1994, and $100 million of 12% subordinated debentures due April 15, 2004, with two million common stock purchase warrants. Net proceeds from the offering totaled $149 million, to which we added an additional $23 million in cash, enabling us to pay off all of our long-term debt. As a result of the refinancing, the Corporation gained permanent long-term capital with minimal annual cash flow requirements to service it. We now have the financial resources and flexibility to pursue new opportunities to grow and diversify. Furthermore, should we require additional funds, they will be available through a $52 million unsecured three-year revolving credit agreement concluded in June with ten U.S. and Canadian banks. An $80 million product financing capability was also arranged through a major U.S. bank to provide financing to customers purchasing P&H products. OUTLOOK Throughout 1985 we believe we will see gradual improvements in most of our U.S. and world markets. For our mining excavator product line, coal and certain metals mining are expected to show a more favorable long-term outlook in selected foreign requirements and our capability to source equipment from the U.S., Japan or Europe places us in a strong marketing position. In the U.S., we see only a moderate strengthening in machinery requirements for coal, while metals mining will remain weak. Continuing shipments of the Turkish order throughout 1985 will help to stabilize our plant utilization levels and improve our operating results for this product line. In our material handling and systems markets, particularly in the U.S., we are experiencing a moderately strong continuation of the improved bookings which we began to see in the third and fourth quarters of last year. Harnischfeger Corporation 110 Overview of Accounting Analysis Harnischfeger Corporation 3-29 Part 2 Business Analysis and Valuation Tools In construction lifting equipment markets, we expect modest overall economic improvement in the U.S., which should help to absorb the large numbers of idle lifting equipment that have been manufacturer, distributor and customer inventories for the last three years. As this overhang on the market is reduced we will see gradual improvement in new sales. Harnischfeger traditionally exports half of its U.S.-produced lifting products. However, as with mining equipment, the continued strength of the U.S. dollar severely restricts our ability to sell U.S.built products in world markets. In addition to the strong dollar and economic instability in many foreign nations, overcapacity in worldwide heavy equipment manufacturing remains a serious problem in spite of some exits from the market as well as consolidations within the industry. The Corporation continues to respond to severe price competition through systematic cost reduction programs and through expanded sourcing of P&H equipment from our European operation and, most importantly, through our 30-year association with our Japanese partner, Kobe Steel, Ltd. P&H engineering and technology have established world standards for quality and performance for construction cranes and mining equipment, which customers can expect from every P&H machine regardless of its source. More than a dozen new models of foreignsourced P&H construction cranes will be made available for the first time in the U.S. during 1985, broadening our existing product lines and giving competitive pricing to our U.S. distributors and customers. To improve our future operating results, we restructured our three operating divisions into two groups. All construction and mining related activities are in the new “P&H Heavy Equipment Group.” All material handling equipment and systems activities are now merged into the “Industrial Technologies Group.” More information on these Groups is reported in their respective sections. We are pleased to announce that John P. Moran was elected Senior Vice President and Group Executive, Industrial Technologies Group, and John R. Teitgen was elected Secretary and General Counsel. In September Robert F. Schnoes became a member of our Board of Directors. He is President and Chief Executive Officer of Burgess, Inc. and of Ultrasonic Power Corporation, and a member of the Board of Signode Industries, Inc. BEGINNING OUR SECOND CENTURY 1984 was the Corporation’s Centennial year and we marked the occasion by rededicating ourselves to excellence through market leadership, customer service and improved operating performance and profitability. Our first century of achievement resulted from the dedicated effort, support and cooperation of our employees, distributors, suppliers, lenders, and shareholders, and we thank all of them. We look back with pride. We move ahead with confidence and optimism. Our major markets have never been more competitive; however, we will strive to take advantage of any and all opportunities for growth and to attain satisfactory profitability. Collectively, we will do what has to be done to ensure that the future will be rewarding to all who have a part in our success. Henry Harnischfeger Chairman of the Board William W. Goessel President January 31, 1985 111 Overview of Accounting Analysis 3-30 Overview of Accounting Analysis MANAGEMENT’S DISCUSSION & ANALYSIS RESULTS OF OPERATIONS 1984 Compared to 1983 Consolidated net sales of $399 million in fiscal 1984 increased $78 million or 24% over 1983. Sales increases were 62% in the Mining and Electrical Equipment Segment, and 10% in the Industrial Technologies Segment. Sales in the Construction Equipment Segment were virtually unchanged reflecting the continued low demand for construction equipment world-wide. Effective at the beginning of fiscal 1984, net sales include the full sales price of construction and mining equipment purchased from Kobe Steel, Ltd. and sold by the Corporation, in order to reflect more effectively the nature of the Corporation’s transactions with Kobe. Such sales aggregated $28.0 million in 1984. The $4.0 million increase in Other Income reflected a recovery of certain claims and higher license and technical service fees. Cost of Sales was equal to 79.1% of net sales in 1984 and 81.4% in 1983; which together with the increase in net sales resulted in a $23.9 million increase in gross profit (net sales less cost of sales). Contributing to this increase were improved sales of higher-margin replacement parts in the Mining Equipment and Industrial Technologies Segments and a reduction in excess manufacturing costs through greater utilization of domestic manufacturing capacity and economies in total manufacturing costs including a reduction in pension expense. Reductions of certain LIFO inventories increased gross profit by $2.4 million in 1984 and $15.6 million in 1983. Product development selling and administrative expenses were reduced, due to the funding of R&D expenses in the Construction Equipment Segment pursuant to the October 1983 Agreement with Kobe Steel, Ltd., to reductions in pension expenses and provision for credit losses, and to the absence of the corporate financial restructuring expenses incurred in 1983. Net interest expense in 1984 increased $2.9 million due to higher interest rates on the outstanding funded debt and a reduction in interest income. Equity in Earnings (Loss) of Unconsolidated Companies included 1984 income of $1.2 million of Harnischfeger Credit Corporation, an unconsolidated finance subsidiary, reflecting an income tax benefit of $1.4 million not previously recorded. The preceding items, together with the cumulative effect of the change in depreciation method described in Financial Note 2, were included in net income of $15.2 million or $1.28 per common share, compared with net loss of $34.6 million or $3.49 per share in 1983. The sales orders booked and unshipped backlogs of orders of the Corporation’s three segments are summarized as follows (in million of dollars): Orders Booked 1984 1983 Industrial Technologies Mining and Electrical Equipment Construction Equipment $132 $106 210 109 $451 135 109 $350 $ 79 $ 71 91 23 50 20 $193 $141 Backlogs at October 31 Industrial Technologies Mining and Electrical Equipment Construction Equipment 1983 Compared to 1982 Consolidated net sales of $321 million in fiscal 1983 were $126 million or 28% below 1982. This decline reflected, for the second consecutive year, the continued low demand in all markets served by the Corporation’s products, with exports even more severely depressed due to the strength of the dollar. The largest decline was reported in the Construction Equipment Segment, down 34%; Mining and Electrical Equipment Segment shipments were down 27%, and the Industrial Technologies Segment, 23%. Cost of Sales was equal to 81.4% of net sales in 1983 and 81.9% in 1982. The resulting gross profit Harnischfeger Corporation 112 Overview of Accounting Analysis Harnischfeger Corporation 3-31 Part 2 Business Analysis and Valuation Tools was $60 million in 1983 and $81 million in 1982, a reduction equal to the rate of sales decrease. The benefits of reduced manufacturing capacity and economies in total manufacturing costs were offset by reduced selling prices in the highly competitive markets. Reductions of certain LIFO inventories increased gross profits by $15.6 million in 1983 and $7.2 million in 1982. Product development, selling and administrative expenses were reduced as a result of expense reduction measures in response to the lower volume of business and undertaken in connection with the Corporation’s corporate recovery program, and reduced provisions for credit losses, which in 1982 included $4.0 million in income support for Harnischfeger Credit Corporation. Net interest expense was reduced $9.1 million from 1982 to 1983, due primarily to increased interest income from short-term cash investments and an accrual of $4.7 million in interest income on refundable income taxes not previously recorded. The Credit for Income Taxes included a federal income tax benefit of $5 million, based upon the recent examination of the Corporation’s income tax returns and refund claims. No income tax benefits were available for the losses of the U.S. operations in 1983. The losses from unconsolidated companies recorded in 1983 included $0.5 million in Harnischfeger Credit Corporation; $2.1 million in Cranetex, Inc., a Corporation-owned distributorship in Texas; and $0.8 million in ASEA Industrial Systems Inc., then a 49%-owned joint venture between the Corporation and ASEA AB and now 19%-owned with the investment accounted for on the cost method. The preceding items were reflected in a net loss of $34.6 million or $3.49 per share. LIQUIDITY AND FINANCIAL RESOURCES In April 1984, the Corporation issued in public offerings 2,150,000 shares of Common Stock, $50 million principal amount of 15% Senior Notes due in 1994, and 100,000 Units consisting of $100 million principal amount of 12% Subordinated Debentures due in 2004 and 2,000,000 Common Stock Purchase Warrants. The net proceeds from the sales of the securities of $149 million were used to prepay substantially all of the outstanding debt of the Corporation and certain of its subsidiaries. During the year ended October 31, 1984, the consolidated cash balances increased $32 million to a balance of $96 million, with the cash activity summarized as follows (in million of dollars): Funds provided by operations Funds returned to the Corporation upon restructuring of the Salaried Employees’ Pension Plan Debt repayment less the proceeds of sales of securities Plant and equipment additions All other changes—net $10 39 (9) (6) (2) $32 In the third quarter of fiscal 1984 the Corporation entered into a $52 million three-year revolving credit agreement with ten U.S. and Canadian banks. While the Corporation has adequate liquidity to meet its current working capital requirements, the revolver represents another step in the Corporation’s program to strengthen its financial position and provide the required financial resources to respond to opportunities as they arise. 113 Overview of Accounting Analysis 3-32 Overview of Accounting Analysis CONSOLIDATED STATEMENT OF OPERATIONS Year Ended October 31 (Dollar amounts in thousands except per share figures) Revenues: Net sales Other income, including license and technical service fees Cost of Sales Operating Income Less: Product development, selling and administrative expenses Interest expense—net Provision for plant closing Income (Loss) Before Provision (Credit) for Income Taxes, Equity Items and Cumulative Effect of Accounting Change Provision (Credit) for Income Taxes Income (Loss) Before Equity Items and Cumulative Effect of Accounting Change Equity items: Equity in earnings (loss) of unconsolidated companies Minority interest in (earnings) loss of consolidated subsidiaries Income (Loss) Before Cumulative Effect of Accounting Change Cumulative Effect of Change in Depreciation Method Net Income (Loss) Earnings (Loss) per Common and Common Equivalent Share: Income (Loss) before cumulative effect of accounting change Cumulative effect of change in depreciation method Net income (loss) Pro forma Amounts Assuming the Changed Depreciation Method Had Been Applied Retroactively: Net (loss) (Loss) per common share (The accompanying notes are an integral part of the financial statements.) 1984 1983 1982 $398,708 $321,010 $447,461 7,067 405,775 315,216 90,559 3,111 324,121 261,384 62,737 5,209 452,670 366,297 86,373 72,196 12,625 — 85,795 9,745 — 113,457 18,873 23,700 5,738 2,425 (32,803) (1,400) (69,657) (1,600) 3,313 (31,403) (68,057) 993 (3,397) (7,891) 170 (583) 4,171 (34,630) (76,531) 11,005 $ 15,176 — $(34,630) — $ (76,531) $ .35 $(3.49) $(7.64) .93 $1.28 — $(3.49) — $(7.64) $ (33,918) $(3.42) $ (76,695) $(7.65) (135) Harnischfeger Corporation 114 Overview of Accounting Analysis 3-33 Part 2 Business Analysis and Valuation Tools CONSOLIDATED BALANCE SHEET October 31 Harnischfeger Corporation (Dollar amounts in thousands except per share figures) Assets Current Assets: Cash and temporary investments Accounts receivable Inventories Refundable income taxes and related interest Other current assets Prepaid income taxes Investments and Other Assets: Investments in and advances to: Finance subsidiary, at equity in net assets Other companies Other assets Operating Plants: Land and improvements Buildings Machinery and equipment Accumulated depreciation 1984 1983 $ 96,007 87,648 144,312 1,296 5,502 14,494 349,259 $ 64,275 63,740 153,594 12,585 6,023 14,232 314,449 8,849 4,445 13,959 27,253 6,704 2,514 6,411 15,629 9,419 59,083 120,949 189,451 (93,259) 96,192 $472,704 10,370 60,377 122,154 192,901 (107,577) 85,324 $415,402 (continued) 115 Overview of Accounting Analysis 3-34 Overview of Accounting Analysis CONSOLIDATED BALANCE SHEET (continued) October 31 (Dollar amounts in thousands except per share figures) Liabilities and Shareholders’ Equity Current Liabilities: Short-term notes payable to banks by subsidiaries Long-term debt and capitalized lease obligations payable within one year Trade accounts payable Employee compensation and benefits Accrued plant closing costs Advance payments and progress billings Income taxes payable Account payable to finance subsidiary Other current liabilities and accruals Long-Term Obligations: Long-term debt payable to: Unaffiliated lenders Finance subsidiary Capitalized lease obligations Deferred Liabilities and Income Taxes: Accrued pension costs Other deferred liabilities Deferred income taxes Minority Interest Shareholders’ Equity: Preferred stock $100 par value—authorized 250,000 shares: Series A $7.00 cumulative convertible preferred shares: authorized, issued and outstanding 117,500 shares in 1984 and 100,000 shares in 1983 Common stock, $1 par value—authorized 25,000,000 shares: issued and outstanding 12,283,563 shares in 1984 and 10,133,563 shares in 1983 Capital in excess of par value of shares Retained earnings Cumulative translation adjustments (The accompanying notes are an integral part of the financial statements.) 1983 1984 $ 9,090 $ 8,155 973 37,716 15,041 2,460 20,619 1,645 — 29,673 117,217 18,265 21,228 14,343 6,348 15,886 3,463 3,436 32,333 123,457 128,550 — 7,870 136,420 139,092 5,400 8,120 152,612 57,611 5,299 6,385 69,295 2,400 19,098 7,777 134 27,009 2,405 11,750 10,000 12,284 114,333 19,901 (10,896) 147,372 $472,704 10,134 88,332 6,475 (5,022) 109,919 $415,402 Harnischfeger Corporation 116 Overview of Accounting Analysis 3-35 Part 2 Business Analysis and Valuation Tools CONSOLIDATED STATEMENT OF CHANGES IN FINANCIAL POSITION Year Ended October 31, Harnischfeger Corporation (Dollar amounts in thousands) Funds Were Provided by (Applied to): Operations: Income (loss) before cumulative effect of accounting change Cumulative effect of change in depreciation method Net income (loss) Add (deduct) items included not affecting funds: Depreciation Unremitted (earnings) loss of unconsolidated companies Deferred pension contributions Deferred income taxes Reduction in accumulated depreciation resulting from change in depreciation method Other—net Decrease in operating working capital (see below) Add (deduct) effects on operating working capital of: Conversion of export and factored receivable sales to debt Reclassification to deferred liabilities: Accrued pension costs Other liabilities Foreign currency translation adjustments Funds provided by operations Financing, Investment and Other Activities: Transactions in debt and capitalized lease obligations —Long-Term debt and capitalized lease obligations: Proceeds from sale of 15% Senior Notes and 12% Subordinated Debentures, net of issue costs Other increases Repayments Restructured debt Debt replaced, including conversion of receivable sales of $23,919, and short-term bank notes payable of $9,028 Net increase (repayment) in short-term bank notes payable Net increase (repayment) in debt and capitalized lease obligations 1983 1982 4,171 11,005 15,176 $ (34,630) — (34,630) $(76,531) — (76,531) 8,077 13,552 15,241 (993) (500) 6,583 3,397 4,834 (3,178) 7, 891 — 1,406 (17,205) (2,168) 7,039 — (67) 11,605 — 2,034 72,172 23,919 — — — (6,009) 10,000 14,264 5,510 (1,919) 37,287 — — (5,943) 16,270 120,530 1,474 (161,500) — — — (760) 158,058 — 25,698 (9,409) — — (39,496) (158,058) (760) — 16,289 (3,982) (2,016) 1984 $ — 2,107 (37,389) (4,742) 14,273 (continued) 117 Overview of Accounting Analysis 3-36 Overview of Accounting Analysis CONSOLIDATED STATEMENT OF CHANGES IN FINANCIAL POSITION (continued) Year Ended October 31, (Dollar amounts in thousands) Issuance of: Common stock Common stock purchase warrants Salaried pension assets reversion Plant and equipment additions Advances to unconsolidated companies Other—net Funds provided by (applied to) financing, investment and other activities Increase in Cash and Temporary Investments Before Cash Dividends Cash Dividends Increase in Cash and Temporary Investments Decrease (Increase) in Operating Working Capital (Excluding Cash Items, Debt and Capitalized Lease Obligations): Accounts receivable Inventories Refundable income taxes and related interest Other current assets Trade accounts payable Employee compensation and benefits Accrued plant closing costs Other current liabilities Decrease in operating working capital (The accompanying notes are an integral part of the financial statements.) 1984 1983 1982 21,310 6,663 39,307 (5,546) (2,882) 269 — — — (1,871) — 1,531 449 — — (10,819) — 848 21,732 (5,082) 4,751 $ 31,732 $ 32,205 $21,021 — $ 31,732 — $ 32,205 (2,369) $ 18,652 $ (23,908) 9,282 11,289 259 16,488 698 (3,888) (3,181) $ 7,039 $ (5,327) 56,904 (2,584) 10,008 (1,757) (15,564) (14,148) (15,927) $ 11,605 $ 42,293 26,124 (6,268) (439) (3,302) (3,702) 20,496 (3,030) $ 72,172 Harnischfeger Corporation 118 (The accompanying notes are an integral part of the financial statements.) $11,750 1,750 10,000 Balance at October 31, 1983 Issuance of: 2,150,000 shares of common stock 2,000,000 common stock purchase warrants 17,500 shares of Series A $7.00 cumulative convertible preferred stock in discharge of dividends payable on preferred stock Net income Translation adjustments, net of deferred income taxes of $300 Other Balance at October 31, 1984 10,000 $10,000 Balance at October 31, 1981 Cumulative translation adjustments through October 31, 1981 Issuance of Common Stock: 10,000 shares to Kobe Steel, Ltd. 38,161 shares under stock purchase and dividend reinvestment plans Net (loss) Cash dividends paid on: Preferred stock Common stock $.20 per share Translation adjustments, net of deferred income taxes of $128 Balance at October 31, 1982 Net (loss) Translation adjustments, including deferred income taxes of $33 Preferred Stock (Dollar amounts in thousands except per share figures) 309 39 $12,284 19,160 6,663 2,150 178 $114,333 88,332 10,134 88,332 91 10 10,134 $ 87,932 $10,085 Common Stock $ 19,901 (1,750) 15,176 6,475 41,105 (34,630) $(10,896) (5,874) (5,874) 178 $147,372 — 15,176 21,310 6,663 109,919 (899) (899) (5,022) 145,448 (34,630) (4,123) (2,928) (350) (2,019) (350) (2,019) (2,928) (1,195) (1,195) 101 $228,022 — Total 348 (76,531) $ Cumulative Translation Adjustments (76,531) $120,005 Retained Earnings 3-37 Capital in Excess of Par Value of Shares CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY Harnischfeger Corporation Overview of Accounting Analysis 119 Part 2 Business Analysis and Valuation Tools Overview of Accounting Analysis Overview of Accounting Analysis FINANCIAL NOTES Note 1 Summary of Significant Accounting Policies: Business Analysis 2 and Valuation Tools 3 Overview of Accounting Analysis Harnischfeger Corporation Consolidation—The consolidated financial statements include the accounts of all majority-owned subsidiaries except a wholly-owned domestic finance subsidiary, a subsidiary organized in 1982 as a temporary successor to a distributor, both of which are accounted for under the equity method, and a wholly-owned Brazilian subsidiary, which is carried at estimated net realizable value due to economic uncertainty. All related significant intercompany balances and transactions have been eliminated in consolidation. Financial statements of certain consolidated subsidiaries, principally foreign, are included, effective in fiscal year 1984, on the basis of their fiscal years ending September 30; previously, certain of such subsidiaries had fiscal years ending July (See Note 2). Such fiscal periods have been adopted by the subsidiaries in order to provide for a more timely consolidation with the Corporation. Inventories—The Corporation values its inventories at the lower of cost or market. Cost is determined by the last-in, first-out (LIFO) method for inventories located principally in the United States, and by the first-in, first-out (FIFO) method for inventories of foreign subsidiaries. Operating Plants, Equipment and Depreciation—Properties are stated at cost. Maintenance and repairs are charged to expense as incurred and expenditures for betterments and renewals are capitalized. Effective in 1981, interest is capitalized for qualifying assets during their acquisition period. Capitalized interest is amortized on the same basis as the related asset. When properties are sold or otherwise disposed of, the cost and accumulated depreciation are removed from the accounts and any gain or loss is included in income. Depreciation of plants and equipment is provided over the estimated useful lives of the related assets, or over the lease terms of capital leases, using, effective in fiscal year 1984, the straight-line method for financial reporting, and principally accelerated methods for tax reporting purposes. Previously, accelerated methods, where applicable, were also used for financial reporting purposes (See Note 2). For U.S. income tax purposes, depreciation lives are based principally on the Class Life Asset Depreciation Range for additions, other than buildings, in the years 1973 through 1980, and on the Accelerated Cost Recovery System for all additions after 1980. Discontinued facilities held for sale are carried at the lower of cost less accumulated depreciation or estimated realizable value, which aggregated $4.9 million and $3.6 million at October 31, 1984 and 1983, respectively, and were included in Other Assets in the accompanying Balance Sheet. Pension Plans—The Corporation has pension plans covering substantially all of its employees. Pension expenses of the principal defined benefit plans consist of current service costs of such plans and amortization of the prior service costs and actuarial gains and losses over periods ranging from 10 to 30 years. The Corporation’s policy is to fund at a minimum the amount required under the Employee Retirement Income Security Act of 1974. Income Taxes—The consolidated tax provision is computed based on income and expenses recorded in the Statement of Operations. Prepaid or deferred taxes are recorded for the difference between such taxes and taxes computed for tax returns. The Corporation and its domestic subsidiaries file a consolidated federal income tax return. The operating results of Harnischfeger GmbH are included in the Corporation’s U.S. income tax returns. Additional taxes are provided on the earnings of foreign subsidiaries which are intended to be remitted to the Corporation. Such taxes are not provided on subsidiaries’ unremitted earnings which are intended to be permanently reinvested. Investment tax credits are accounted for under the flow-through method as a reduction of the income tax provision, if applicable, in the year the related asset is placed in service. Reporting Format—Certain previously reported items have been conformed to the current year’s presentation. Note 2 Accounting Changes: Effective November 1, 1983, the Corporation includes in its net sales products purchased from 3-38 Harnischfeger Corporation 120 Overview of Accounting Analysis Harnischfeger Corporation 3-39 Part 2 Business Analysis and Valuation Tools Kobe Steel, Ltd. and sold by the Corporation, to reflect more effectively the nature of the Corporation’s transactions with Kobe. Previously only the gross margin on Kobe-originated equipment was included. During fiscal year 1984 such sales aggregated $28.0 million. Also, effective November 1, 1983, the financial statements of certain foreign subsidiaries are included on the basis of their fiscal years ending September 30 instead of the previous years ending July 31. This change had the effect of increasing net sales by $5.4 million for the year ended October 31, 1984. The impact of these changes on net income was insignificant. In 1984, the Corporation has computed depreciation expense on plants, machinery and equipment using the straight-line method for financial reporting purposes. Prior to 1984, the Corporation used principally accelerated methods for its U.S. operating plants. The cumulative effect of this change, which was applied retroactively to all assets previously subjected to accelerated depreciation, increased net income for 1984 by $11.0 million or $.93 per common and common equivalent share. The impact of the new method on income for the year 1984 before the cumulative effect was insignificant. As a result of the review of its depreciation policy, the Corporation, effective November 1, 1983, has changed its estimated depreciation lives on certain U.S. plants, machinery and equipment and residual values on certain machinery and equipment, which increased net income for 1984 by $3.2 million or $.27 per share. No income tax effect was applied to this change. The changes in accounting for depreciation were made to conform the Corporation’s depreciation policy to those used by manufacturers in the Corporation’s and similar industries and to provide a more equitable allocation of the cost of plants, machinery and equipment over their useful lives. Note 3 Cash and Temporary Investments: Cash and temporary investments consisted of the following (in thousands of dollars): October 31, 1984 1983 Cash—in demand deposits Cash—in special accounts principally to support letters of credit Temporary investments $ 2,155 $11,910 4,516 89,336 $96,007 — 52,365 $64,275 Temporary investments consisted of short-term U.S. and Canadian treasury bills, money market funds, time and certificates of deposit, commercial paper and bank repurchase agreements and bankers’ acceptances. Temporary investments are stated at cost plus accrued interest, which approximates market value. Note 4 Long-Term Debt, Bank Credit Lines and Interest Expense: Outstanding long-term debt payable to unaffiliated lenders was as follows (in thousands of dollars): October 31, 1984 1983 Parent Company: 15% Senior Notes due April 15, 1994 12% Subordinated Debentures, with an effective interest rate of 16.3%; sinking fund redemption payments of $7,500 due annually on April 15 in 1994–2003, and final payment of $25,000 in 2004 Term Obligations— Insurance company debt: 9% Notes 9 7/8 Notes 8 7/8 Notes Bank debt, at 105% of prime Paper purchase debt, at prime or LIBOR, plus 11⁄4% 9.23% Mortgage Note due monthly to April, 1998 $ 47,700 $ — 100,000 — — — — 20,000 38,750 40,500 — 25,000 — 18,519 4,327 4,481 152,027 147,250 121 Overview of Accounting Analysis 3-40 Overview of Accounting Analysis October 31, 1984 1983 Consolidated Subsidiaries: Notes payable to banks in German marks Contract payable in 1985– 1989, in South African rands, with imputed interest rate of 12% Other Less: Amounts payable within one year Unamortized discounts Long-Term Debt—excluding amounts payable within one year — 9,889 1,024 — 153,051 — 36 157,175 644 23,857 17,799 284 $128,550 $139,092 Note 5 Harnischfeger Credit Corporation and Cranetex, Inc. Condensed financial information of Harnischfeger Credit Corporation (“Credit”), an unconsolidated wholly-owned finance subsidiary, accounted for under the equity method, was as follows (in thousands of dollars): Balance Sheet Assets: Cash and temporary investments Finance receivables—net Factored account note and current account receivable from parent company Other assets Liabilities and Shareholder’s Equity: Debt payable Advances from parent company Other liabilities Shareholder’s equity October 31, 1984 1983 $ 404 4,335 $19,824 11,412 — 4,181 $8,920 8,836 661 $40,733 $ — $32,600 950 71 1,021 7,899 $8,920 — 1,429 34,029 6,704 $40,733 Statement of Operations Revenues Less: Operating Expenses Provision (credit) for income taxes Net income (loss) Year Ended October 31, 1984 1983 1982 $1,165 $2,662 $9,978 1,530 3,386 14,613 (1,560) $1,195 (222) $(502) 180 $(4,815) Credit’s purchases of finance receivables from the Corporation aggregated $1.1 million in 1984, $46.7 million in 1983 and $50.4 million in 1982. In 1982, Credit received income support of $4.0 million from the Corporation. In 1982, the Corporation organized Cranetex, Inc. to assume certain assets and liabilities transferred by a former distributor of construction equipment, in settlement of the Corporation’s and Credit’s claims against the distributor and to continue the business on an interim basis until the franchise can be transferred to a new distributor. The Corporation recorded provisions of $2.5 million in 1983 and $2.3 million in 1982 and Credit recorded a provision of $6.7 million in 1982, for credit losses incurred in the financing of equipment sold to the former distributor. The condensed balance sheet of Cranetex, Inc. was as follows (in thousand of dollars): October 31, 1984 1983 Assets: Cash Accounts receivables Inventory Property and equipment Liabilities and Deficit: Loans payable Other liabilities Shareholder’s (deficit), net of accounts and advances payable to parent company $ 143 566 2,314 1,547 $4,570 $ 49 428 3,464 1,674 $5,615 $4,325 338 4,663 $6,682 620 7,302 (93) $4,570 (1,687) $5,615 Harnischfeger Corporation 122 Overview of Accounting Analysis 3-41 Part 2 Business Analysis and Valuation Tools The net losses of Cranetex, Inc. of $.2 million in 1984, $2.1 million in 1983 and $1.0 million in 1982 were included in Equity in Earnings (Loss) of Unconsolidated Companies in the Corporation’s Statement of Operations. Harnischfeger Corporation Note 6 Transactions with Kobe Steel, Ltd. and ASEA Industrial Systems Inc. Kobe Steel, Ltd. of Japan (“Kobe”), has been a licensee for certain of the Corporation’s products since 1955, and has owned certain Harnischfeger Japanese construction equipment patents and technology since 1981. As of October 31, 1984, Kobe held 1,030,000 shares or 8.4% of the Corporation’s outstanding Common Stock (See Note 13). Kobe also owns 25% of the capital stock of Harnischfeger of Australia Pty. Ltd., a subsidiary of the Corporation. This ownership appears as the minority interest on the Corporation’s balance sheet. Under agreements expiring in December 1990, Kobe pays technical service fees on P&H mining equipment produced and sold under license from the Corporation, and trademark and marketing fees on sales of construction equipment outside of Japan. Net fee income received from Kobe was $4.3 million in 1984, $3.1 million in 1983, and $3.9 million in 1982; this income is included in Other Income in the accompanying Statement of Operations. In October 1983, the Corporation entered into a ten-year agreement with Kobe under which Kobe agreed to supply the Corporation’s requirements for construction cranes for sale in the United States as it phases out its own manufacture of cranes over the next several years, and to make the Corporation the exclusive distributor of Kobe-built cranes in the United States. The Agreement also involves a joint research and development program for construction equipment under which the Corporation agreed to spend at least $17 million over a three-year period and provided it does so, Kobe agreed to pay this amount to the Corporation. Sales of cranes outside the United States continue under the contract terms described in the preceding paragraph. The Corporation’s sales to Kobe, principally components for mining and construction equipment, excluding the R&D expenses discussed in the pre- ceding paragraph, approximated $5.2 million, $10.5 million and $7.0 million during the three years ended October 31, 1984, 1983 and 1982, respectively. The purchases from Kobe of mining and construction equipment and components amounted to approximately $33.7 million, $15.5 million and $29.9 million during the three years ended October 31, 1984, 1983 and 1982, respectively, most of which were resold to customers (See Note 2). The Corporation owns 19% of ASEA Industrial Systems Inc. (“AIS”), an electrical equipment company controlled by ASEA AB of Sweden. The Corporation’s purchases of electrical components from AIS aggregated $11.2 million in 1984 and $6.1 million in 1983 and its sales to AIS approximated $2.6 million in 1984 and $3.8 million in 1983. The Corporation believes that its transactions with Kobe and AIS were competitive with alternative sources of supply for each party involved. Note 7 Inventories Consolidated inventories consisted of the following (in thousand of dollars): October 31, 1984 1983 At lower of cost or market (FIFO method): Raw materials Work in process and purchased parts Finished goods Allowance to reduce inventories to cost on the LIFO method $ 11,003 $ 11,904 88,279 79,111 178,393 72,956 105,923 190,783 (34,081) $144,312 (37,189) $153,594 Inventories valued on the LIFO method represented approximately 82% of total inventories at both October 31, 1984 and 1983. Inventory reductions in 1984, 1983 and 1982 resulted in a liquidation of LIFO inventory quantities carried at lower costs compared with the current cost of their acquisitions. The effect of these liquidations was to increase net income by 2.4 million or $.20 123 Overview of Accounting Analysis 3-42 Overview of Accounting Analysis per common share in fiscal 1984, and to reduce the net loss by approximately $15.6 million or $1.54 per share in 1983, and by $6.7 million or $.66 per share in 1982; no income tax effect applied to the adjustment in 1984 and 1983. Note 8 Accounts Receivable 1984, $6.5million in 1983 and $12.2 million in 1982. Accumulated plan benefits and plan net assets for the Corporation’s U.S. defined benefit plans, at the beginning of the fiscal years 1984 and 1983, with the data for the Salaried Employees’ Retirement Plan as in effect on August 1, 1984, were as follows (in thousands of dollars): Accounts receivable were net of allowances for doubtful accounts of $5.9 million and $6.4 million at October 31, 1984 and 1983, respectively. Note 9 Research and Development Expense Research and development expense incurred in the development of new products or significant improvements to existing products was $5.1 million in 1984 (net of amounts funded by Kobe Steel, Ltd.) $12.1 million in 1983 and $14.1 million in 1982. Note 10 Actuarial present value of accumulated plan benefits: Vested Nonvested Net assets available for benefits: Asset s of the Pension Trusts Accrued contributions not paid to the Trusts 1984 1983 $52,639 2,363 $55,002 $108,123 5,227 $113,350 $45,331 $112,075 16,717 $62,048 12,167 $124,242 Foreign Operations The net sales, net income (loss) and net assets of subsidiaries located in countries outside the United States and Canada and included in the consolidated financial statements were as follows (in thousands of dollars): Year Ended October 31, 1984 1983 1982 Net sales Net income (loss) after minority interests Corporation’s equity in total net assets $78,074 $45,912 $69,216 828 (1,191) 3,080 17,734 7,716 7,287 Foreign currency transaction losses included in Cost of Sales were $2.7 million in 1984, $1.2 million in 1983 and $1.3 million in 1982. Note 11 Pension Plans and Other Postretirement Benefits Pension expense for all plans of the Corporation and its consolidated subsidiaries was $1.9 million in The Salaried Employees’ Retirement Plan, which covers substantially all salaried employees in the U.S., was restructured during 1984 due to overfunding of the Plan. Effective August 1, 1984, the Corporation terminated the existing plan and established a new plan which is substantially identical to the prior plan except for an improvement in the minimum pension benefit. All participants in the prior plan became fully vested upon its termination. All vested benefits earned through August 1, 1984 were covered through the purchase of individual annuities at a cost aggregating $36.7 million. The remaining plan assets, which totaled $39.3 million, reverted to the Corporation in cash upon receipt of regulatory approval of the prior plan termination from the Pension Benefit Guaranty Corporation. For financial reporting purposes, the new plan is considered to be a continuation of the terminated plan. Accordingly, the $39.3 million actuarial gain which resulted from the restructuring is included in Accrued Pension Costs in the accompanying Balance Sheet and is being amortized to income over a ten-year period commencing in 1984. For tax reporting purposes, the asset reversion will be Harnischfeger Corporation 124 Overview of Accounting Analysis Harnischfeger Corporation 3-43 Part 2 Business Analysis and Valuation Tools treated as a fiscal 1985 transaction. The initial unfunded actuarial liability of the new plan, computed as of November 1, 1983, of $10.3 million is also included in Accrued Pension Costs. In 1982 and 1983, the Pension Trusts purchased certain securities with effective yields of 13% and 12%, respectively, and dedicated these assets to the plan benefits of a substantial portion of the retired employees and certain terminated employees with deferred vested rights. These rates, together with 9% for active employees in 1984, 8% in 1983 and 71⁄4% in 1982, were the assumed rates of return used in determining the annual pension expense and the actuarial present value of accumulated plan benefits for the U.S. plans. The effect of the changes in the investment return assumption rates for all U.S. plans, together with the 1984 restructuring of the U.S. Salaried Employees’ Plan, was to reduce pension expense by approximately $4.0 million in 1984 and $2.0 million in 1983, and the actuarial present value of accumulated plan benefits by approximately $60.0 million in 1984. Pension expense in 1983 was also reduced $2.1 million from the lower level of active employees. Other actuarial gains, including higher than anticipated investment results, more than offset the additional pension costs resulting from plan changes and interest charges on balance sheet accruals in 1984 and 1983. The Corporation’s foreign pension plans do not determine the actuarial value of accumulated benefits or net assets available for retirement benefits as calculated and disclosed above. For those plans, the total of the plans’ pension funds and balance sheet accruals approximated the actuarially computed value of vested benefits at both October 31, 1984 and 1983. The Corporation generally provides certain health care and life insurance benefits for U.S. retired employees. Substantially all of the Corporation’s current U.S. employees may become eligible for such benefits upon retirement. Life insurance benefits are provided either through the pension plans or separate group insurance arrangements. The cost of retiree health care and life insurance benefits, other than the benefits provided by the pension plans, is expensed as incurred; such costs approximated $2.6 million in 1984 and $1.7 million in 1983. Note 12 Income Taxes Domestic and foreign income (loss) before income tax effects was as follows (in thousands of dollars): Year Ended October 31, 1984 1983 1982 Domestic Foreign: Harnischfeger GmbH All other Total income (loss) before income tax effects, equity items and cumulative effect of accounting change $1,57 8 $(35,41) 2 $(77,60 0) 432 3,728 4,160 (2,159) 4,768 2,609 (475) 8,418 7,943 $5,73 8 $(32,80 3) $(69,65 7) Provision (credit) for income taxes, on income (loss) before income tax effects, equity items and cumulative effect of accounting change, consisted of (in thousands of dollars): 1984 Currently payable (refundable): Federal State Foreign Deferred (prepaid): Federal State and foreign Provision (credit) for income taxes $ — 136 2,518 2,654 — (229) (229) $2,42 5 1983 1982 $(7,957) 297 3,379 (4,281) $(9,736) 70 5,376 (4,290) 2,955 (74) 2,881 2,713 (23) 2,690 $(1,400) $(1,600) During 1983 an examination of the Corporation’s 1977–1981 federal income tax returns and certain refund claims was completed by the Internal Revenue Service, and as a result, a current credit for federal income taxes of $8.0 million was recorded in 1983, $3.0 million of which was applied to the reduction of prepaid income taxes. 125 Overview of Accounting Analysis Overview of Accounting Analysis In 1984, tax credits fully offset any federal income tax otherwise applicable to the year’s income, and in 1983 and 1982, the relationship of the tax benefit to the pre-tax loss differed substantially from the U.S. statutory tax rate due principally to losses from the domestic operations for which only a partial federal tax benefit was available in 1982. Consequently, an analysis of deferred income taxes and variance from the U.S. statutory rate is not presented. Unremitted earnings of foreign subsidiaries which have been or are intended to be permanently reinvested were $19.1 million at October 31, 1984. Such earnings, if distributed, would incur income tax expense of substantially less than the U.S. income tax rate as a result of previously paid foreign income taxes, provided that such foreign taxes would become deductible as foreign tax credits. No income tax provision was made in respect of the taxdeferred income of a consolidated subsidiary that has elected to be taxed as a domestic international sales corporation. The Deficit Reduction Act of 1984 provides for such income to become nontaxable effective December 31, 1984. At October 31, 1984, the Corporation had federal tax operating loss carry-forwards of approximately $70.0 million, expiring in 1998 and 1999, for tax return purposes, and $88.0 million for book purposes. In addition, the Corporation had for tax purposes, foreign tax credit carry-forwards of $3.0 million (expiring in 1985 through 1989), and investment tax credit carry-forwards of $1.0 million (expiring in 1997 through 1999). For book purposes, tax credit carry-forwards approximately $8.0 million. The carry-forward will be available for the reduction of future income tax provisions, the extent and timing of which are not determinable. Differences in income (loss) before income taxes for financial and tax purposes arise from timing differences between financial and tax reporting and relate to depreciation, consolidating eliminations for inter-company profits in inventories, and provisions, principally, for warranty, pension, compensated absences, product liability and plant closing costs. REPORT OF INDEPENDENT ACCOUNTANTS Milwaukee, Wisconsin November 29, 1984 To the Directors and Shareholders of Harnischfeger Corporation: In our opinion, the financial statements, which appear on pages 18 to 34 of this report, present fairly the consolidated financial position of Harnischfeger Corporation and its subsidiaries at October 31, 1984 and 1983, and the results of their operations and the changes in their financial position for each of the three years in the period ended October 31, 1984, in conformity with generally accepted accounting principles consistently applied during the period except for the change, with which we concur, in the method of accounting for depreciation expense as described in Note 2 on page 23 of this report. Our examinations of these statements were made in accordance with generally accepted auditing standards and accordingly included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. Price Waterhouse 3-44 Harnischfeger Corporation 126 44 As s e t A n a lysis chapter A Business Analysis and 2Valuation Tools ssets are resources owned by a firm that are likely to produce future economic benefits and that are measurable with a reasonable degree of certainty. Assets can take a variety of forms, including cash, marketable securities, receivables from customers, inventory, fixed assets, long-term investments in other companies, and intangibles. The key principles used to identify and value assets are historical cost and conservatism. Under the historical cost principle, assets are valued at their original cost; conservatism requires asset values to be revised downward if fair values are less than cost. Analysis of assets involves asking whether an outlay should be recorded as an asset in the firm’s financial statements, or whether it should be reported as a current expense. This requires analysts to understand who has the rights of ownership to the resource, whether it is expected to generate future benefits, and whether those benefits are measurable with reasonable certainty. Finally, asset analysis involves evaluating the value of the assets reported in the financial statements, requiring an evaluation of amortization, allowances, and write-downs. In this chapter we discuss the key principles underlying the recording of assets. We also show the challenges in asset reporting and opportunities for analysis. HISTORICAL COST AND CONSERVATISM Assets are used to generate future profits for owners. Investors are interested in learning whether the resources they have invested in the firm have been spent wisely. The balance sheet provides a useful starting point for this type of analysis because it provides information on the value of the resources that management acquires or develops. In most countries the assets reported in the balance sheet are valued at historical exchange prices. Historical exchange prices rather than fair values, replacement values, or values in use, are used to record assets because they can typically be more easily verified. From the perspective of investors, this is important because managers have an incentive to present a favorable view of their stewardship of the firm’s resources. By requiring that transactions be recorded at historical exchange prices, accounting places a constraint on managers’ ability to overstate the value of the assets that they have acquired or developed. Of course, historical cost also limits the information that is available to investors about the potential of the firm’s assets, since exchange prices are usually different from fair values or values in use. 4-1 127 128 Asset Analysis Asset Analysis The conservatism principle establishes one exception to the use of historical cost values. It requires management to write down to their fair value assets that have been impaired. The lower of cost or market rule for valuing inventory, the estimation of expected receivable losses from uncollectible accounts, and write-downs of operating assets that are not expected to recover their cost are all applications of this concept. Conservatism therefore provides additional assurance for investors that management’s estimate of the value of the firm’s resources is not overstated. As a result, asset values reported on the balance sheet can be considered a lower bound on the value of future benefits resulting from management’s current business strategy. Adherence to the principles of historical cost and conservatism has been challenged recently. In the U.S., some financial instruments are required to be valued at fair values rather than historical cost. Further, in the U.K., Australia, and several other countries, other classes of tangible and intangible assets are permitted to be valued at fair values. ASSET REPORTING CHALLENGES The critical challenge for financial reporting is to determine which types of expenditures qualify as assets. Figure 4-1 shows the major criteria for recognizing an asset. Not surprisingly, these are related to the criteria used for recognizing expenses, discussed in Chapter 7. The key questions for recognizing an asset involve assessing who has ownership of the resources in question, whether those resources are expected to provide future economic benefits, and whether benefits can be measured with reasonable certainty. Criteria for Recognizing Assets and Implementation Challenges Figure 4-1 First Criterion Second Criterion Third Criterion Resources are owned by the firm. Resources are expected to provide future economic benefits sufficient to recover their cost. The future economic benefits are measurale with a reasonable degree of certainty. Record an asset. Challenging Transactions 1. Ownership of the resource is uncertain 2. Future benefits from outlays are uncertain or difficult to measure. 3. Resource values have changed. 4-2 Asset Analysis 4-3 Part 2 Business Analysis and Valuation Tools As we discuss throughout this chapter, asset recognition creates a number of opportunities for management to exercise financial reporting judgment. These opportunities are particularly prevalent for transactions where ownership of a resource is uncertain. They can also arise when the economic benefits from outlays are uncertain or difficult to quantify, or when resource values have changed. Below we discuss these types of reporting challenges. Challenge One: Ownership of Resources Is Uncertain For most resources used by a firm, ownership is relatively straightforward: the firm using the resource owns the asset. However, for some transactions the question of who owns a resource can be subtle. We discuss two examples of transactions that provide interesting challenges for deciding on ownership. The first is for a leased resource. Who is the effective owner of the asset—the lessor or the lessee? The second transaction is for employee training. Who effectively owns the benefits created by a training program—the company providing the training or the employee? EXAMPLE: LEASED RESOURCES. On December 31, 1998, American Airlines re- ported that it leased 42 percent of its fleet of aircraft (273 planes) for lease periods of 10 to 25 years. American Airlines reported that it had annual obligations under these leases in excess of $1 billion for each of the next five years and $13.4 billion thereafter. In its annual report the company noted that “aircraft leases can generally be renewed at rates based on fair market value at the end of the lease term for one to five years. Most aircraft leases have purchase options at or near the end of the lease term at fair market value, but generally not to exceed a stated percentage of the defined lessor’s cost of the aircraft or at a predetermined fixed amount.” Who was the effective owner of these aircraft? Did American Airlines effectively purchase them using financing provided by the lessor, or were the leases really rental arrangements? Assessing whether a lease arrangement is equivalent to a purchase or rental is subjective. It depends on whether the lessee has effectively accepted risks of ownership, such as obsolescence and physical deterioration. In an attempt to standardize the reporting of lease transactions, accounting standards have created clear criteria for distinguishing between the two types. Under SFAS 13, a lease transaction is equivalent to an asset purchase if any of the following conditions hold: (1) ownership of the asset is transferred to the lessee at the end of the lease term, (2) the lessee has the option to purchase the asset for a bargain price at the end of the lease term, (3) the lease term is 75 percent or more of the asset’s expected useful life, and (4) the present value of the lease payments is 90 percent or more of the fair value of the asset. As noted above, American Airlines had purchase options for many of its aircraft at estimated market prices. In addition, the company reported that the assumed life for aircraft that it owned was 25 years. Lease contracts that satisfy the criteria for an effective purchase are recorded as capital leases at the present value of the lease payments. This same amount is also shown as 129 130 Asset Analysis Asset Analysis a liability, to reflect the financing of the asset purchase. In subsequent periods, the leased equipment is depreciated over the life of the lease, and the lease payments are treated as interest and liability payments. In 1998 American capitalized leases for 187 planes and recorded a lease liability for these aircraft for $1,671 million. Lease contracts that do not qualify as an effective purchase for accounting purposes are termed operating leases. The lessee then reports rental expense throughout the lease term. American Airlines reported only 86 lease agreements as operating leases in 1998. Of course, because the criteria for reporting leases are objective, they create opportunities for management to circumvent the spirit of the distinction between capital and operating leases. For example, American Airline’s management can write the lease terms in such a way that a transaction satisfies the definition of either an operating lease or a capital lease. In addition, implementing the lease reporting standards requires management to forecast leased planes’ useful lives and their fair values. By comparing the company’s capital lease liability ($1,671 million) to the payments for all lease obligations from 1999 to 2003, analysts can see that although it had more capital than operating leases, American used operating leases for its most expensive equipment. Was this a conscious operating strategy, or was the company seeking to keep the effective liability to finance its more expensive aircraft off the balance sheet? EXAMPLE: HUMAN CAPITAL. Companies spend considerable amounts on profes- sional development and training for their employees. Formal employee training by U.S. firms is estimated to cost anywhere from $30 to $148 billion per year. If one factors in informal, on-the-job training these costs increase by a factor of two to three times.1 Training programs range from those that emphasize the enhancement of firm-specific skills that are unlikely to be transferable to other jobs, to training that upgrades an employee’s general skills and would be valued by other employers. Firms may be willing to provide general training only if the employee makes a commitment to remain with the company for some period after completing the training. This type of commitment is typical for firms that pay for employees to attend MBA programs. Firms that spend resources for formal training typically do so in anticipation that they will have long-term benefits for the firm through increased productivity and/or product or service quality. How should these expenditures be recorded? Should they be viewed as an asset and amortized over the employees’ expected life with the firm? Or should they be expensed immediately? Accountants argue that skills created through training are not owned by the firm but by the employee. Thus, employees can leave one firm and take a position with another without the current employer’s approval. It is also difficult to calibrate the effect of training on future performance. As a result, accounting standards in the U.S. and elsewhere require that training costs be written off immediately. Given the accounting treatment of training costs, financial analysis can add value by distinguishing between firms that succeed and those that fail to create value through employee training. This can be critical for firms where human capital is a key resource. Such is the case for professional firms. Training can also create a valuable asset for firms 4-4 Asset Analysis 4-5 Part 2 Business Analysis and Valuation Tools that rely on sales staffs with specialized knowledge of the technical details of their firms’ products. Training for these types of firms may be critical to the creation of customer value and to the firms’ reputations in their product markets. Key Analysis Questions The above discussion implies that when ownership is difficult to define, management sometimes has the opportunity to use judgment to decide whether to record the acquisition of a resource as an asset. In other cases management may not have any judgment because accounting standards do not permit any firms to record the acquisition of resources as assets. Both situations create opportunities for financial analysis. The first creates an opportunity to evaluate the assumptions that underlie the method of reporting used by management. The second creates an opportunity to distinguish firms that are likely to retain the benefits of resource outlays, even when ownership is vague, from those that cannot. As a result, the following questions are likely to be useful for analysts: • What resources for a firm are excluded from its balance sheet because ownership of resulting benefits is uncertain? If these resources are critical to its strategy and value creation, what alternative metrics are available for evaluating how well these resources have been managed? For example, if human capital is a key asset, how much does the firm spend on training? What is the rate of employee turnover? What metrics does the firm use to evaluate the effectiveness of its training programs? • Does management appear to be deliberately writing contracts to avoid full ownership of key resources? If so, what factors explain this behavior? For example, what types of leasing arrangement does the firm have? Are leases used to manage technology risks that are outside management’s control or to report key assets (and liabilities) off the balance sheet? • If leases are used to avoid reporting key assets and liabilities, what is the effect of recording these items on the financial statements? • Has the firm changed its method of reporting for resource outlays where there are ownership questions? For example, has it changed its method of amortizing capital lease assets? What factors explain these decisions? Has it changed its business or operating model? Challenge Two: Economic Benefits Are Uncertain or Are Difficult to Measure A second challenge in determining whether an outlay qualifies as an asset arises when the future economic benefits attributable to the outlay are difficult to measure or highly 131 132 Asset Analysis Asset Analysis uncertain. It is almost always difficult to accurately forecast any future benefits associated with capital outlays because the world is uncertain. A company does not know whether a competitor will offer a new product or service that makes its own obsolete. It does not know whether the products manufactured at a new plant will be the type that customers want to buy. It does not know whether changes in the price of oil make its oil drilling equipment less valuable. When do accountants view these uncertainties and measurement problems to be sufficiently severe that they require outlays with multiperiod benefits to be expensed? When can such expenditures be capitalized? The economic values of most resources are based on estimates of uncertain future economic benefits. For example, receivables values are net of uncollectibles, leased and owned assets have future residual values, and marketing and R&D outlays create brand values. Below we discuss reporting for three types of outlays to illustrate how accountants view uncertainty in recording assets: goodwill, brands, and deferred tax assets. EXAMPLE: GOODWILL. On February 9, 1996, Walt Disney Co. acquired Capital Cities/ABC Inc. for $10.1 billion in cash and 155 million shares of Disney valued at $8.8 billion based on the stock price at the date the transaction was announced. Cap Cities owned and operated the ABC Television Network, eight television stations, the ABC Radio Networks and 21 radio stations, and 80 percent of ESPN, Inc., and it provided programming for cable television. It also published daily and weekly newspapers, shopping guides, various specialized and business periodicals, and books. The bulk of these assets were intangible. In 1994, immediately prior to the acquisition, Cap Cities estimated that approximately 85 percent of its $5.3 billion of broadcasting revenues and 70 percent of its $1.1 billion publishing revenues came from the sale of advertising, rather than any tangible product or service. Disney estimated the fair value of ABC’s tangible assets at $4.0 billion ($1.5 billion in cash) and its liabilities at $4.3 billion. How should the acquisition be recorded on Disney’s books? Should the difference between the $18.9 billion purchase price and the $0.3 billion of net liabilities be recorded as an intangible asset on Disney’s books? If so, what are the benefits Disney expects to realize from the acquisition? Alternatively, should the $19.2 billion difference be written off? Prior to Disney’s offer, the market valued ABC’s equity at approximately $9 billion. This implies that Disney paid more than a 100 percent premium for ABC’s intangible assets. Here is where the accounting issues become tricky. If the full acquisition price is to be shown as an asset, Disney’s management and auditors have to be confident that this outlay is recoverable. But what makes ABC’s intangibles worth twice as much to Disney as they were to the company’s prior owners? Or did Disney simply overpay for Cap Cities/ABC, implying that it is unlikely to recover the $19 billion in goodwill? Accountants in most countries now require companies like Disney to record the value of acquired tangible assets and liabilities at their fair values and to show the full $19 billion of goodwill as an asset. The justification for this approach is that there has been an arm’s-length transaction between the buyer and seller. There is a presumption that Disney’s management has made an acquisition that does not destroy value for its own stock- 4-6 Asset Analysis 4-7 Part 2 Business Analysis and Valuation Tools holders, and that it has the best information on the value created as a result of its plans for the new firm. These presumptions underlie the valuation of goodwill, unless there is evidence to the contrary. After the acquisition, Disney is required under U.S. accounting to amortize the goodwill over a maximum of forty years (see Chapter 7). Two challenges arise from this form of accounting. First, since it is difficult to assess whether the merger is achieving the expected benefits, it is difficult to estimate whether goodwill has become “badwill.” This is complicated by management’s incentives. If the merger does not work out as planned, management is unlikely to want to own up to making a mistake. Second, the creation of an arbitrary period for amortizing goodwill makes it difficult for firms that make successful acquisitions to distinguish themselves from those that make neutral ones. If both use a forty-year amortization period, the firm that has enhanced shareholder value reports the acquisition in exactly the same manner as the firm that created no new value. EXAMPLE: BRANDS. Coca-Cola Inc. reports a book value of equity of $8.4 billion and has a market value of $165 billion. Much of this difference is attributable to the value of Coke’s brand. Coke created the brand through years of investment in advertising, promotion, and packaging. Other well-known brands include Marlborough, Nescafe, Kodak, Microsoft, Budweiser, Kellogg’s, Gillette, McDonald’s, Gucci, Mercedes, and Baccardi. Brand-name products can create value for their owners by (a) permitting lower levels of marketing than the competition, due to high market awareness, (b) creating leverage with distributors and retailers, since customers expect them to carry the brand, and (c) enabling higher prices than the competition, due to higher customer perception of value. Unlike patents or copyrights, brands have no limit in terms of how long they can apply. If they are well managed, they can be enduring assets. As noted in Chapter 7, the advertising, promotion, and packaging activities that give rise to brands are typically expensed. This convention was adopted because of the difficulty in linking advertising outlays with brand creation. Given the difficulty in valuing brands in the first place, and given the challenge in assessing when and how much advertising enhances brand values and affects only the current period’s sales, accountants have traditionally avoided showing brand capital as an asset. In the U.S., even brands that have been acquired are not reported separately and are included as part of intangible assets. In Australia and the U.K., however, firms have been permitted to report brand assets on their books. The driving force behind this phenomenon has been mergers and acquisitions. Target firms have valued and revalued brands on their books. For example, in 1989, following an increased acquisition interest from General Cinema, Cadbury Schweppes valued brands acquired since 1985. These assets were not amortized but reviewed annually for any diminution in value. In 1997 Cadbury reported brand intangibles on its balance sheet at £1.575 billion, representing one-third of its total assets. Showing brands on the books as assets provides management with a way of communicating their value to investors. It also signals that managers are aware of the importance of these assets and provides an annual indication of how well they have been 133 134 Asset Analysis Asset Analysis managed. Brands that have been managed well are likely to retain their value, whereas mismanaged brands will have to be written down. However, including brands on the balance sheet also raises opportunities for misuse of management judgment. Given the difficulty in estimating brand values, investors are likely to be concerned that management overstates the value of brands and fails to recognize any declines in value on a timely basis. Management may be able to mitigate these concerns by using independent valuation experts to value brand assets and by having auditors sign off on the valuations. However, even these forms of verification are unlikely to completely eliminate investors’ concerns. For firms where brands are not reported as assets (i.e., most firms), the challenge for management is to provide other ways to convince investors of the value of brands. For example, in its 1998 annual report, Coca-Cola provided the following performance data for its key brands in North America: AVERAGE ANNUAL GROWTH U.S. UNIT CASE VOLUME GROUP PROFILE 1 Year Coca-Cola USA 6% BRAND HIGHLIGHTS 1998 vs. 1997 Unit Case Sales Growth Rest of Industry* 3% 5 Years Coca-Cola USA 6% Rest of Industry* 2% *Rest of industry includes soft drinks only. Population Per Capita High Per Capita Low Per Capita 305 million 377 Rome, Georgia, at 821 Quebec, Canada, at 142 Coca-Cola Classic Diet Coke Sprite Also Notable: Fruitopia POWERaDE Minute Maid soft drinks Nestea Barq’s 3% 4% 9% 105% 33% 29% 20% 18% Source: Coca-Cola Annual Report, 1998 Coca-Cola also outlined its initiatives to support its brands. In North America these included sponsorship of NASCAR and the distribution of 50 million Coca-Cola cards offering discounts at more than 10,000 retailers across the United States. In addition, the company announced 1999 plans for extensions of its brands by adding two new POWERaDE flavors (Arctic Shatter and Dark Downburst), a new flavor for Fruitopia (Kiwiberry Ruckus), and the launch of Dasani, a purified water with added minerals. Similar details were provided for Coke’s other markets. For example, in Argentina a new marketing campaign was initiated to encourage use of Coke products at meal times. In Asia the company focused on increasing the availability of its products through expanded use of vending machines. In Mexico sponsorship of basketball was used to boost consumption of Sprite. The challenge for investors and financial statement users is to assess whether these marketing initiatives and brand extensions are likely to be successful in creating value for Coca-Cola. 4-8 Asset Analysis 4-9 Part 2 Business Analysis and Valuation Tools EXAMPLE: DEFERRED TAX ASSETS. Tax laws in the U.S. and many other coun- tries permit firms with tax operating losses to carry them forward to future periods when they can be offset against positive earnings. These carryforwards potentially provide future economic benefits in the form of reduced future tax obligations. In 1998, for example, Amazon.com, the Internet retailer of books, music, and video products, had generated operating losses of $207 million, equivalent to $73.1 million of future tax savings since its inception. These “tax loss carryforwards” provided potential future economic benefits for Amazon.com. Of course, the carryforwards are only valuable if Amazon.com actually earns future profits. The company reported that these loss carryforwards begin to expire in 2011. How should financial reports record the operating loss carryforwards for Amazon.com? Should they be reported as an asset in the balance sheet? If so, what is their value given the likelihood that they may never be used if the firm continues to show losses? Under SFAS 109, U.S. firms are required to show a deferred tax asset for the value of operating loss carryforwards, net of a valuation allowance for the portion of the asset that is unlikely to be realized. The FASB stated that deferred tax assets with more than a 50 percent probability of being unrealized should be included in the valuation allowance. This approach is similar to the valuation of accounts or notes receivable. Receivables are shown at their gross value, net of an allowance for bad debts. Deferred tax assets can also arise if tax reporting realizes income prior to financial reporting. For example, prepaid revenues are often recognized for tax purposes prior to financial reporting recognition. Warranty expenses are accrued for financial reporting purposes but are recognized when an obligation is incurred for tax purposes. As a result of these temporary differences between taxable and reported income, taxes can be paid prior to recognition of earnings in financial statements. The matching principle requires the creation of an accrual to recognize this prepayment. SFAS 109 rules for recording these prepayments are similar to those used to report operating loss carryforwards. A deferred tax asset is created and a valuation allowance is set up to record the portion of the asset that is unlikely to be realized. Financial reporting for deferred tax assets provides management with an opportunity to exercise judgment in estimating the valuation allowance. The basis for this estimate is management forecasts of whether the firm is likely to earn future profits and, if so, whether they are sufficient to take full advantage of operating loss carryforwards and tax prepayments. Recent research finds little evidence that managers use this judgment to manage earnings.2 Amazon.com reported that it has $12.8 million of deferred tax benefits due to temporary differences between tax and financial reporting methods of recognizing income. Combined with its $73.1 million of operating loss carryforwards, this amounted to an $85.9 million gross deferred tax asset. The challenge for financial reporting was to estimate what portion of this asset was actually likely to be realizable. The company had never earned a profit. Since 1996 its operating performance had actually deteriorated, with losses of $6.2 million in 1996, $31.0 million in 1997, and $124.5 million in 1998. Further, as of March 19, 1999, financial analysts did not anticipate the company to report 135 136 Asset Analysis Asset Analysis a profit in either 1999 or 2000. Forecasts for these years are for losses of $400 million and $140 million, respectively. On this basis it seemed unlikely that Amazon.com would be able to take advantage of its deferred tax asset anytime soon.3 Consequently, the company reported that it included the full value of the deferred tax asset in the valuation allowance, leaving a net book value of zero. Key Analysis Questions The above discussion illustrates three methods of reporting for outlays whose economic benefits are uncertain or difficult to measure. The first, which requires immediate expensing of the outlays, does not allow for any use of management judgment in financial reporting. This method is commonly used for brand development outlays and for R&D. The second method, which records an asset at the amount of the outlay, provides for management judgment in subsequent periods through amortization or write-downs. Examples include goodwill and fixed assets. The third method requires the expected value of benefits from an outlay to be recorded, requiring considerable management judgment. Examples include receivables and deferred tax assets. These three methods give rise to the following challenges and questions for financial analysts: • Which assets reported on the balance sheet are most difficult to measure and value? Assets with liquid markets, such as marketable securities, are relatively easy to value, whereas unique or firm-specific assets, such as goodwill and brands, are most challenging. What is the basis for valuing these types of assets? What assumptions have been made for financial reporting? For example, what are the amortization lives of these assets, and what are management’s estimates of allowances? • How do any assumptions or estimates made by management in valuing assets compare with assumptions in prior years? Has there been a change in assumed goodwill lives? Is the current receivable or deferred tax asset allowance as a percentage of the gross asset very different from prior years? What factors might explain any changes? Has the firm made changes to its business strategy or its operating policies? Has there been a change in the outlook for the industry or the economy as a whole? • How do management’s assumptions for valuing assets compare to those made by competitors? Once again, if there are any differences, what are the potential explanations? Do the firms have different business strategies? Do they operate in different geographic regions? Does management have different incentives to manage earnings? • Does management have a history of over- or underestimating the value of difficult-to-value assets? For example, does it consistently sell these types of assets at a loss or at a gain? 4-10 Asset Analysis 4-11 Part 2 Business Analysis and Valuation Tools • What key assets are not reported on the balance sheet because of measurement difficulties or uncertainties? These include brands, R&D, and other intangibles. How does the firm appear to be managing these assets? Does management discuss its strategy for preserving, enhancing, and leveraging these assets? What indicators does the firm look at to evaluate how well it has managed these assets? Challenge Three: Changes in Future Economic Benefits The final challenge in recording assets is how to reflect changes in their values over time. What types of assets, if any, should be marked up or down to their fair values? Below we discuss this question for changes in values of operating assets, financial instruments, and foreign exchange rate fluctuations. EXAMPLE: CHANGES IN VALUES OF OPERATING ASSETS. Changes in operat- ing asset values are reflected in financial statements in a variety of ways. For example, changes in receivable values are reflected in bad debt allowances, changes in the value of loan portfolios are reflected in loss reserves, revisions in asset lives and residual values are reflected in amortization estimates, and declines in inventory and long-term asset values are reflected in write-downs. Accounting standards in the U.S. do not permit the recognition of any increases in operating asset values beyond their historical cost. However, as noted in Chapter 7, SFAS 121 requires operating assets whose value is impaired to be written down to their market value, below cost. This approach is consistent with the conservatism principle. Of course, the challenge in implementing this standard is that it is often difficult to assess whether an asset has been impaired and, if so, the amount of the loss. As a result, there appears to be considerable management discretion in deciding when to recognize that an asset has been impaired and how much to write it down. Questions can arise as to whether firms delay recording asset impairments or underestimate the effect of impairments. Alternatively, some have questioned whether managers use impairment charges to overzealously write down assets to improve future reported performance. In some other parts of the world, management is permitted to value assets at their fair values. U.K. and Australian standards, for example, permit managers to revalue fixed assets and intangibles if they have appreciated in value. Thus, in its 1998 annual report, News Corp, the Australian news and media company run by Rupert Murdoch, reported that the intangible asset Publishing Rights, Titles, and Television Licenses was revalued to its fair value. Fair values were estimated by “discounting the expected net inflow of cash arising from their continued use or sale.” (See Footnote 1 of News Corp’s annual report.) As a result, the firm showed intangible assets that cost A$7,283 million at a fair value of A$12,030 million. 137 138 Asset Analysis Asset Analysis By permitting firms to revalue assets, U.K. and Australian standards potentially permit managers to communicate their estimates of the value of the firm’s key assets to investors. However, they also provide increased opportunity for asset overstatements.4 EXAMPLE: CHANGES IN FINANCIAL INSTRUMENT VALUES. Many financial as- sets are traded in a liquid capital market, permitting relatively objective values to be obtained. For debt securities, even though markets may not be very deep or liquid, financial valuation models enable relatively reliable estimates of value to be made. Finance theory posits that firms (or individuals) can typically buy or sell financial instruments in financial markets at the current market price, provided they are perceived to have the same information on the instruments’ values as other investors. As a result, since fair values can be obtained at low cost, can be independently verified, and are more relevant to financial statement users than acquisition cost, a good argument can be made for marking assets up or down to market prices. Of course, if the owner of financial instruments exercises control over the other company, the owner is unlikely to be able to transact at market prices. Attempts to sell the instruments will be interpreted by other investors as indicating that the seller considers it a good time to sell, reducing the price. This suggests that marking such assets to market is less appropriate. Figure 4-2 summarizes the valuation effects of accounting for changes in values of financial instruments. It shows that the reporting effects depend primarily on the owner’s motives. U.S. accounting rules do not permit instruments to be recorded at their fair values if they are owned for control reasons. Instead, the investment is recorded using either the equity method or the consolidation approach. The equity method is used when a firm owns 20–50 percent of another company’s stock and is considered to have partial but not full control of the other company (called an associated company). The investment is then valued at its original cost plus the owner’s share of the associated company’s accumulated changes in retained earnings since the investment was acquired. For investments in excess of 50 percent, the owner is considered to have full control over the subsidiary company. The acquirer then consolidates the assets of the subsidiary with its own assets. Two methods of consolidation are used. If the subsidiary is purchased in a cash transaction, purchase accounting is used. The assets of the subsidiary are then included in the owner’s balance sheet at their fair values at acquisition and subsequently amortized. Any difference between the purchase price and the fair value of net tangible assets is recorded as goodwill and amortized over its useful life up to a maximum of forty years. If the subsidiary is acquired for stock, the pooling of interest method is used to record the acquisition. The assets of the subsidiary are then included in the owner’s balance sheet at their original book values. No goodwill is recognized. If the owner of financial instruments does not exercise control over the other company, accountants are more inclined to value the instruments at their fair market values. For example, if the purpose of ownership is to hedge changes in the fair value of another 4-12 Asset Analysis 4-13 Part 2 Business Analysis and Valuation Tools Figure 4-2 Valuation of Financial Instruments Q: What is the motivation for ownership of the financial instruments? A: Used as a way to exercise some level of control over another company. If so, what is the level of control? A: Own between 20% and 50% of the other company. Valuation Method: Equity method: Investment shown at initial cost plus share of accumulated changes in associated company’s retained earnings. A: Short-term alternative to holding cash. 1. Intend to sell or make available for sale. Valuation Method: Fair value 2. Intend to hold to maturity. Valuation Method: Cost A: Used as part of strategy to hedge fair values of assets or liabilities, or to hedge uncertain future cash flows. Valuation Method: Fair value A: Own more than 50% of the other company. Valuation Methods: Purchase accounting: Tangible assets recorded at fair values at acquisition, and then depreciated. Goodwill recorded at difference between purchase price and fair value of net assets, and then amortized. Pooling: All assets recorded at book values at acquisition. No goodwill. item or to hedge fluctuations in expected future cash inflows or outflows, the instrument is reported at fair value. If a firm holds an instrument as a store of cash and either intends to sell it or has it available for sale, it is reported at fair value. Only if management expects that an instrument will be held to maturity is it reported at historical cost. EXAMPLE: CHANGES IN VALUES OF FOREIGN SUBSIDIARIES. Many companies have foreign subsidiaries that subject their assets to exchange rate fluctuations. How are these fluctuations recognized? Are assets of foreign subsidiaries translated into local currency at the historical rates when the assets were acquired? Alternatively, are they translated at current rates? U.S. rules for reporting foreign currency effects on assets require management to make a decision about the exchange rate risk borne by a new foreign venture at the time it is undertaken. A foreign subsidiary is considered to be largely insulated from the effect 139 140 Asset Analysis Asset Analysis of exchange rates if its sales, costs, and sources of financing primarily occur in the local currency rather than in the parent’s currency, and there are few transactions between the parent and subsidiary. In this case, the subsidiary’s assets and liabilities provide a natural hedge against much of any exchange rate volatility. Only the net asset value is considered to be subject to exchange rate effects. SFAS 52 therefore requires the subsidiary’s assets (and liabilities) to be translated at the current rate. The parent will only be subject to the effect of changes in exchange rates on net assets. These effects are reflected in shareholders’ equity as a translation adjustment.5 Foreign currency risks for the combined firm are considered to be more severe if the subsidiary’s sales or costs are incurred in the parent’s currency or if there are frequent transactions between the two. SFAS 52 then requires assets and liabilities for the subsidiary to be valued using the monetary/nonmonetary method. Under this approach, monetary assets and liabilities (such as cash, receivables, payables, and financing) are translated at current rates, whereas nonmonetary assets and liabilities (such as inventory, fixed assets, and intangibles) are valued at the historical rate (when the transaction occurred). 6 Key Analysis Questions The above discussion indicates that the management judgment involved in reporting the effect of changes in asset values depends on the type of asset, the country in which the firm operates, and the way it manages its businesses. For financial analysts, these factors raise the following questions: • Do operating assets appear to be impaired? Evidence of impairment could include systemic poor performance and/or write-downs by other firms in the industry. If assets appear to be impaired but are not written down, what is management’s justification for not recognizing any impairment? • Does management appear to have over- or understated prior impairment losses for operating assets, making it difficult to evaluate future performance? Has the firm consistently reported impairment losses, indicating an unwillingness to appreciate the full extent of the impairment? Does management appear to have a viable business model or plan to correct the problems? • If management revalues operating assets, either up or down, what is the basis for the estimation of the fair value? Is the valuation based on an independent appraisal, or is it a management estimate? • What are management’s reasons for revaluing assets that have increased in value? • What is management’s motive for holding financial instruments? Is that motivation consistent with shareholders’ interests? For example, is the firm hedging risks for shareholders’ benefits or for the benefit of managers? • What is the market value of all financial instruments? 4-14 Asset Analysis 4-15 Part 2 Business Analysis and Valuation Tools • What are the foreign currency risks the company is exposed to from its foreign operations? What foreign currency gains and losses are reported, either in the income statement or in the equity section of the balance sheet? Does management hedge foreign currency risks? How effective are these hedges? COMMON MISCONCEPTIONS ABOUT ASSET ACCOUNTING The above discussion of accounting for assets reveals a number of popular misconceptions about the nature of accounting. 1. If a firm paid for a resource, it must be an asset. This logic is frequently used to justify showing goodwill as an asset. It gives management the benefit of the doubt in recording the full value of acquisition outlays as an asset, presupposing that management would not have made the outlay if it did not anticipate the prospect of some future benefit. However, this logic ignores the possibility that well-intended managers can make mistakes or that some managers take actions that are not in the best interests of shareholders. Mergers and acquisitions have frequently been cited as such events. Recent evidence indicates that mergers and acquisitions typically do not create value for acquiring shareholders. The value of the goodwill recorded for these transactions may very well not be an asset, but simply reflect management’s overpayment for the target or its overestimate of any merger benefits. Indeed, the negative stock returns for many acquirers at the announcement of an acquisition indicate that investors are skeptical of merger benefits. Accountants, however, do not reflect this skepticism in goodwill values until there is evidence of its impairment. It is also worth noting that the logic that payment is evidence of an asset is not used consistently in accounting. For example, outlays for research and development are not viewed as assets, even though managers also make outlays for R&D in expectation of generating future benefits. Several justifications for the apparent contradiction in treatment have been offered. One is that there is considerable risk of failure for any single research project. However, a research program is more likely to generate successes. Indeed, it is not obvious which is more risky—a research program or a takeover program. A second justification for the different treatments is that R&D is more difficult to verify than goodwill. However, even this is not clear. After all, for many acquisitions it is not clear exactly what benefits are likely to be generated from the acquisition, making it difficult to verify whether goodwill has been impaired. In contrast, research programs have identifiable output to verify whether outlays generated successful products. 141 142 Asset Analysis Asset Analysis 2. If you can’t kick a resource, it really isn’t an asset. This view is commonly used to justify the rapid write-off or exclusion of intangibles from the balance sheet. It is certainly true that it can be difficult to estimate the economic benefits from some intangibles. As noted above, this is particularly true for goodwill. However, the intangible nature of some assets does not mean that they do not have value. Indeed, for many firms these types of assets are their most valued. For example, Merck’s two most valued assets are its research capabilities which permit it to generate new drugs, and its sales force which enables it to sell those drugs to doctors. Yet neither is recorded on Merck’s balance sheet. From the investors’ point of view, accountants’ reluctance to value intangible assets does not diminish their importance. If they are not included in financial statements, investors have to look to alternative sources of information on these assets. 3. If you bought a resource, it must be an asset; if you developed it, it must not be. This statement is frequently used to justify recording acquired intangible assets, such as R&D and brands, but not recording assets for the cost of internally generated intangibles. The logic for this distinction seems to be that intangible assets that are completed, such as completed R&D and established brands, can be valued more readily than intangible assets that are in development. While this may be true, it permits two firms that own the same types of intangible assets to have very different accounting for their activities. Firms that generate these assets internally show no values for the assets, whereas firms that purchase these assets reflect them on the balance sheet. The real question for investors in distinguishing between purchased and internally developed assets is whether there is any difference in the certainty of expected future benefits for the two assets. If there is no difference, investors will view both as valuable assets and are interested in assessing their value, how they are managed, and whether they have been impaired during the period. Consequently, if accountants do not choose to recognize internally generated assets, investors will be forced to find alternative sources of information on these assets. 4. Market values are only relevant if you intend to sell an asset. It has been common among accountants to regard fair values of assets as only being relevant if the owner intends to sell them. For example, as discussed above, U.S. rules for valuing marketable securities held as a store for cash require owners to value these assets at their fair values only if they intend to sell them or the instruments are available for sale. If management intends to hold these instruments to maturity, they are valued at their historical cost. 4-16 Asset Analysis 4-17 Part 2 Business Analysis and Valuation Tools This logic implies that it is possible to avoid incurring an economic loss by simply not selling the asset. An economist would view such an approach as ludicrous. If you own stock in Microsoft and its fair value increases, your own equity increases accordingly. This is true regardless of whether you intend to sell the Microsoft stock. The fair value of the stock reflects the market’s best estimate of the resources that would be available if you sold the asset. Your plans to sell or hold are irrelevant to its value. Note that this may not be true for operating assets. A plant’s fair value may be less than its value in use. Further, assets with high values in use are precisely the types of assets that firms are likely to retain. Thus, fair values of separable operating assets may not be fully reflected in their values to the firm. SUMMARY The recording of assets is primarily determined by the principles of historical cost and conservatism. Under the historical cost principle, resources owned by a firm that are likely to produce reasonably certain future benefits are valued at their cost. However, if an asset’s cost exceeds its fair value, the conservatism principle requires that the resource be written down to fair value. The U.S. has been a strong advocate of the historical cost/conservatism approach to valuing assets. However, even in the U.S., adherence to these rules has diminished during the last twenty years as firms have been permitted to revalue marketable securities to fair values. Outside the U.S., some countries permit firms to revalue other types of assets, including intangibles. The implementation of the principles of historical cost and conservatism can be challenging if: 1. There is uncertainty about the ownership of those resources, as is the case for lease transactions and training outlays. 2. Future benefits associated with resources are highly uncertain and/or difficult to measure, such as for goodwill, R&D, brands, and deferred tax assets. 3. Resource values have changed, as in the case of impaired operating assets, changes in fair values of financial instruments, and changes in exchange rates for valuing foreign subsidiaries. Corporate managers are likely to have the best information on the ownership risks and uncertainty about future benefits associated with their firms’ resources. As a result, they are assigned the primary responsibility for deciding which outlays qualify as assets and which do not, and for assessing whether assets have been impaired. Of course, given managers’ incentives to report favorably on their stewardship of owners’ investments and accounting requirements that preclude recording some key economic assets (e.g., R&D, brands, human capital), there is ample opportunity for analysts to independently assess how a firm’s resources are being managed. 143 144 Asset Analysis Asset Analysis DISCUSSION QUESTIONS 1. An airline operator signs an agreement to lease an aircraft for twenty years. Annual lease obligations, payable at the beginning of the year, are $4.7 million. What are the financial statement effects of this transaction if the lease is recorded as (a) a capital lease or (b) an operating lease? As a corporate manager, what forecasts do you have to make to decide which alternative to use? Which method would you prefer to use to report the lease? Why? As a financial analyst, what questions would you raise with the firm’s CFO? 2. The American Society for Training and Development has recently advocated that firms be permitted to report training costs as an asset on their balance sheet. As a corporate manager, how would you respond to this proposal? What are its merits and what concerns would you have? 3. In 1991 AT&T, the largest long-distance telephone operator in the U.S., paid $7.5 billion to acquire NCR, a computer manufacturer. Prior to the acquisition, the book value of NCR’s assets was $4.5 billion, and its liabilities were $1.5 billion. Assuming that there was little significant difference between the fair value and the book value of NCR’s assets, show the effect of the acquisition on AT&T’s balance sheet from using (a) the pooling of interests method and (b) the purchase method. 4. AT&T’s managers had a strong preference for recording the acquisition of NCR under the pooling of interests method. Indeed, the offer was actually contingent on approval for pooling. Why do you think AT&T’s managers were so concerned about the accounting used for the transaction? As a financial analyst, what questions would you raise with the firm’s CFO? 5. What approaches would you use to estimate the value of brands? What assumptions underlie these approaches? As a financial analyst, what would you use to assess whether the brand value of £1.575 billion reported by Cadbury Schweppes in 1997 was a reasonable reflection of the future benefits from these brands? What questions would you raise with the firm’s CFO about the firm’s brand assets? 6. A firm records bad debt expenses on an accrual basis for financial reporting and on a cash basis for tax reporting. In its 1999 annual report, it reported that the opening and closing balances in Allowance for Uncollectibles (a contra against receivables) were $1,200 million and $1,650 million, respectively, and that customers owing $550 million defaulted during the year. The company’s tax rate is 40 percent. How much is the deferred tax asset as a result of this temporary difference between financial and tax reporting? If 30 percent of the asset is deemed to be unrecoverable, how would the transaction be recorded? As a financial analyst, what questions would you raise with the firm’s CFO about the firm’s deferred tax asset? 7. As the CFO of a company, what indicators would you look at to assess whether your firm’s long-term assets were impaired? What approaches could be used, either by management or an independent valuation firm, to assess the dollar value of any asset impairment? As a financial analyst, what indicators would you look at to assess 4-18 Asset Analysis 4-19 Part 2 Business Analysis and Valuation Tools whether a firm’s long-term assets were impaired? What questions would you raise with the firm’s CFO about any charges taken for asset impairment? 8. Give two examples of instruments designed to hedge changes in the fair values of assets or liabilities. When would you recommend that a firm hedge against changes in the fair values of its assets or liabilities? Give two examples of instruments designed to hedge uncertain future cash flows. When would you recommend hedging uncertain cash flow obligations or inflows? NOTES 1. See Lisa M. Lynch, “A Needs Analysis of Training Data,” in Labor Statistics Measurement Issues: Studies in Income and Wealth, Volume 60 (Chicago: University of Chicago Press, 1998). 2. See G. Miller and D. Skinner, “Determinants of the Valuation Allowance for Deferred Tax Assets Under SFAS No. 109,” The Accounting Review 73, No. 2, 1998. 3. Despite this poor reported performance, in the 22 months since its initial public offering, the company’s stock price increased from $1.70 to in excess of $170, indicating that investors were very optimistic about the company’s long-term prospects. 4. P. Easton, P. Eddey, and T. Harris, “An Investigation of Revaluations of Tangible LongLived Assets,” Journal of Accounting Research 31, 1993, examine asset revaluations by Australian firms and find that they are weakly related to lagged returns, suggesting that investors view revaluations as relevant but not very timely disclosures. 5. Owners’ equity is therefore translated at historical rates (when equity was invested), and any gain or loss on adjustment is reported as a translation adjustment. All revenues and expenses are translated at the weighted average rate for the year. No exchange rate gains and losses are reflected in the income statement. 6. Under the monetary/nonmonetary approach, owners’ equity is again translated at historical rates (when equity was invested). Ongoing revenues and expenses are translated at the weighted average rate for the period, but depreciation is translated at the historical rate. Finally, any exchange gain or loss is included in income. 145 Boston Chicken, Inc. 2 Business Analysis and Valuation Tools 4 Asset Analysis Boston Chicken P erhaps no company better captures the spirit of the new economy than Boston Chicken Inc., which aims to do for the rotisserie what Colonel Sanders did for the deep fryer. . . . There is nothing particularly new about rotisserie chicken—those birds have been turning succulently in delicatessen windows for generations. But Boston Chicken is not really about poultry—it is about developing a market-winning formula for picking real estate, designing stores, organizing a franchise operation and analyzing data. These are Boston Chicken’s innovations—trade secrets that can be every bit as valuable as a new drug or computer chip design. With them, Boston Chicken has not only developed the secret for delivering generous quantities of home-cooking at affordable prices, but also transformed what had been a mom-and-pop business into a new national category— take-out home-cooked food—that potentially can draw business away from both supermarkets and restaurants. The Washington Post, July 4, 1994 Boston Chicken was founded in 1989 by Scott Beck to operate and franchise food service stores that sold meals featuring rotisserie-cooked chicken, fresh vegetables, salads, and other side dishes. The firm’s concept was to combine fresh, flavorful, and appealing meals associated with traditional home cooking with a high level of convenience and value. Meals cost less than $5 per person, were sold in bright, inviting retail stores, and were available for take-out or for on-site consumption. “Our strategy,” Beck noted, “is to be a home meal replacement. Our number one competitor is pizza.”1 To help operationalize his vision, Beck assembled a management team with considerable prior experience in both the fast-food business and franchising operations. Beck himself became one of the first and largest franchisees for Blockbuster Video while still in his twenties. He later sold his franchises back to the parent company for $120 million. Other top executives included the former president of Kentucky Fried Chicken, and former vice-presidents of Bennigan’s, Taco Bell, Red Lobster, Chili’s, and Baker’s Square. ......................................................................................................................... Professor Paul M. Healy prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright  1997 by the President and Fellows of Harvard College. Harvard Business School case 9-198-032. 1. The Washington Post, July 4, 1994. 146 Asset Analysis 4-21 Part 2 Business Analysis and Valuation Tools Boston Chicken COMPANY STRUCTURE AND GROWTH STRATEGY By the end of 1994, the Boston Chicken system operated 534 stores, compared to only 34 stores at the end of 1991. This translated to an annual rate of growth of almost 500 percent per year, with a new store being opened on average every two days. As reported in the financial statements presented in Exhibit 1, revenues for this period increased dramatically, from $5.2 million in 1991 to $96.2 million in 1994 and net income rose to $16.2 million (from a loss of $2.6 million). This growth continued throughout 1995; by the third quarter there were more than 750 stores in operation and quarterly sales had reached $38 million (see Exhibit 2 for a summary of quarterly results). The company was voted “America’s Favorite Chicken Chain” in a 1995 survey published by Restaurant and Institutions magazine. To provide financing for its rapid growth, Boston Chicken went public in November 1993. The offering, for 1.9 million shares, was highly successful, as the stock price soared from the initial offering price of $10 to a high of $26.50. However, within months of the offer the stock had fallen back to $18. Nonetheless, a second offering for two million shares at $18.50 in August 1994 was oversubscribed. The company responded by increasing the offer to six million shares, raising $105 million of new capital (after issue costs). Competition in the $200 billion restaurant industry was fierce, and several other companies were quick to take advantage of Boston Chicken’s success. For example, in mid1993 Pepsico’s Kentucky Fried Chicken (KFC) introduced “rotisserie-gold” roasted chicken in most of its 5,100 restaurants. Within four months KFC reported that sales of the new chicken had topped $160 million, making KFC the world’s largest rotisserie chicken chain. KFC spent $100 million to launch the new product, including a national network advertising campaign. However, some analysts believed that Boston Chicken’s biggest challenge would not come from other competitors, but on how well the company met its goals.2 In its 1994 Annual Report, Boston Chicken described its main goals as strengthening its area developer organizations, creating communications infrastructure to support area developers, building an organization to continue new market development, and continuing operational improvements to ensure that the retail concept kept pace with changes in consumer tastes. Area Developer Organizations The company’s franchising strategy was different from that of most other successful franchisers. Instead of selling store franchises to a large number of small franchisees, ......................................................................................................................... 2. See discussion by Stacy Dutton at Kidder Peabody’s equity research department, quoted in Reuters news report, November 9, 1993. 147 Asset Analysis Asset Analysis 4-22 Boston Chicken focused on franchising to large regional developers. It established a network of 22 regional franchises, which targeted the 60 largest U.S. metropolitan markets. Each franchise was expected to have the scale necessary to ensure operational efficiency and marketing clout. The typical franchisee was an independent businessman with 15– 20 years of relevant management experience, strong financial resources, and a mandate to open 50 to 100 new stores in the region. This structure was intended to provide the entrepreneurial energy of a franchise operation with the control and economies of scale of company-owned operations. Under typical franchise agreements, developers paid Boston Chicken a one-time $35,000 per store franchise fee, a $10,000 fee to cover grand opening expenses, and an annual 5 percent royalty on gross revenues. In addition, franchisees contributed 2 percent and 3.75 percent of sales per year, respectively, for national and local advertising campaigns. In 1994 royalties from these agreements amounted to $17.4 million, and initial franchise fees for new stores were $13 million. The company also earned interest income from franchise developers, since it provided a line of credit to assist them in new store development. This source of revenue grew rapidly in 1994 to $11.6 million. Other revenue sources included income from leasing some of its stores to franchise operators, and fees for software services provided to developers. Area developer financing was provided to qualifying developers to assist them in expanding their operations. Under these arrangements, Boston Chicken provided the developer with a revolving line of credit which became available once at least 75 percent of the developer’s equity capital had been spent on developing stores. The agreement provided limits on the amount that the developer could draw over time, primarily as a function of developers’ equity capital. Once the drawing period expired, the loan converted to an amortizing four- to five-year term loan, with a variable interest rate set at 1 percent over the Bank of America Illinois “reference rate.” Some loans also included a conversion option, permitting Boston Chicken to convert the loan into equity in the developer after two years, usually at a 12–15 percent premium over the equity price at the loan’s inception. Communications Infrastructure The company invested $8–10 million to build computer software that provided support for its network of stores, and linked headquarters to developer stores. This software used information entered at the checkout counter to advise store managers when to put on another rack of chickens or to heat up another tray of mashed potatoes. It made appropriate adjustments for the day of the week, the season, and customer preferences at a particular store in making its recommendations. The software also provided information on employee work schedules to match daily peaks in customer purchases, automatically reordered food supplies from approved vendors, and updated the store’s financial performance on an hourly basis. Boston Chicken 148 Asset Analysis 4-23 Part 2 Business Analysis and Valuation Tools New Market Development New store site selection was critical to the company’s future success. In 1995 it employed more than 180 real estate and construction professionals to ensure that the pace of development was sustained and that site standards were maintained. Given these resources the company was optimistic that it could open at least 325 new stores per year in the foreseeable future. Boston Chicken Operating Improvements In 1994 the company implemented a number of plans to improve operating efficiency and reduce store-level costs. These included long-term agreements with key suppliers, the introduction of flagship stores, expanded menus, in-store computer feedback from customers, and drive-thru lanes. Long-term agreements with suppliers provided opportunities to lock in prices for key inputs. For example, in October 1994 the firm reached a five-year cost-plus agreement with Hudson Foods to purchase the entire capacity from two Hudson poultry processing plants. Flagship stores included a retail store and a kitchen facility with enough space and equipment to perform the initial stages of food preparation, such as washing and chopping vegetables, for up to 20 “satellite” stores. Prepared food was then sent to satellite stores, which completed the cooking process and served the products. This concept increased the quality and freshness of the side items, because a flagship had more frequent delivery of fresh ingredients. It also led to greater consistency in food taste, facilitated increased innovation in menu items (since there were fewer production people to train), and utilized facilities more effectively. In fall 1994 the company added vegetable pot pies, Caesar salad, and cinnamon apples to its menu to satisfy customer demand for more variety in food offerings. Rotisserie-roasted turkey, ham, and meat loaf entrees were added in mid-1995. Stores offering these new products showed double-digit sales gains without any significant new advertising campaign. A new line of deli-type sandwiches featuring turkey, ham, and meat loaf on fresh-baked bread was also added to boost lunch sales. In 1995 the firm invested $20 million in Progressive Bagels (PBCI), a retailer of fresh gourmet bagels. Under this agreement, Boston Chicken provided an eight-year senior secured loan to Progressive Bagels, as well as providing administrative, real estate, and systems support services. Management argued that this investment provided the firm with the opportunity to learn more about the potential of morning service, which could further increase store productivity. By late 1995 this investment was increased to $80 million, and PBCI had grown to 53 stores (from a base of 20 units), with plans to open 200–225 stores in 1996. Finally, in an attempt to increase sales in the traditionally weak fourth quarter, the company began offering whole hams and turkeys for Thanksgiving and Christmas meals. As a result of these expanded product offerings, Boston Chicken decided to change its name to Boston Market. 149 Asset Analysis Asset Analysis In 1995 the company began using technology to keep in better touch with store customers. Touch-activated computer terminals were added to some stores, enabling customers to rate the quality of food and service. Blaine Hurst, the former Ernst & Young partner who headed Boston Chicken’s computer operations, pointed out, “If I can save half a percentage point on food costs, that’s a lot of money. But if I can know almost instantaneously that customers don’t like the drink selection and I can have that changed within a week—that’s worth a lot more money.” Finally, to improve convenience for customers, the company decided to add drivethru lanes to its stores. By late 1994, 62 stores in eighteen states had drive-thru windows. In some cases, as much as 30 percent of store sales came from these windows. The company’s market research indicates that as many as two-thirds of these customers would not have visited the stores had this convenience not been available. Drive-thrus were planned for a further 65 stores in 1995, and ultimately 70 percent of the stores were expected to be converted to drive-thru. EXPECTED FUTURE PERFORMANCE In late 1995, most restaurant analysts were bullish about Boston Chicken’s future performance. For example, Michael Moe of Lehman Brothers noted: “Boston Chicken is truly the leader in the home meal replacement market. . . . Dual-income families are searching for an affordable alternative to preparing meals at home. Boston Chicken satisfies this need by preparing food that customers view as high quality, healthy and convenient. This home meal replacement is a hit with value-minded consumers. The bagel industry is another hot area of opportunity for Boston Chicken. Presently the bagel industry is one of the hottest growth areas in America.” 3 Moe rated the stock to be a strong buy, and projected that EPS would be $0.63 in 1995, $0.90 in 1996, and would continue to grow by 45 percent per year from 1997 to 2001. However, not everyone was impressed. Roger Lipton of Lipton Financial Services contended that Boston Chicken’s franchisees had actually lost money. Lipton Financial Services is an affiliate of Axiom Capital Management, which had shorted the stock. He estimated that sales at a franchised store had to average $23,000 a week (net of promotional discounts) to cover labor, cost of sales, and other expenses. Actual average weekly sales, Lipton claimed, were only $18,900 per store, implying that franchisees were losing money. Lipton pointed out that “the quality of earnings is very low, since all of Boston Chicken’s income comes from fees, royalties, and interest payments from franchisees, most of whom were financed by the franchiser.” 4 Management responded to concerns about the economics of franchisees by reporting that average weekly store sales were $23,388 for the third quarter of 1995, versus ......................................................................................................................... 3. Michael Moe, Lehman Brothers, October 25, 1995. 4. Inside Wall Street,” Business Week, June 12, 1995. 4-24 Boston Chicken 150 Asset Analysis 4-25 Part 2 Business Analysis and Valuation Tools Boston Chicken $22,227 for the second quarter, and that EBITDA store margins were running at about 15–16 percent. On December 1, 1995, the stock closed at $33.75, up more than 100 percent over the beginning of the year price (versus a 56 percent increase for the S&P 500).5 But uncertainty about the company persisted. Short interest positions in the stock were at an all-time high of 10 million shares, more than 20 percent of the shares outstanding and double the short interest position at the beginning of 1995. ......................................................................................................................... 5. The equity beta for Boston Chicken was 1.50, and at December 1, 1995, the 30-year U.S. Government Treasuries yielded 6.04%. 151 Asset Analysis Asset Analysis 4-26 EXHIBIT 1 Boston Chicken, Inc., Abridged 1994 Annual Report, Financial Highlights Fiscal Years Ended (dollars in thousands, except per share data) Systemwide store revenue Company revenue Net income Net income per share Shareholders’ equity Weighted average number of shares outstanding December 25, 1994 December 26, 1993 $383,691 96,151 16,173 $0.38 $259,815 42,861 $152,056 42,530 1,647 $0.06 $94,906 32,667 Boston Chicken 152 Asset Analysis 4-27 Part 2 Business Analysis and Valuation Tools MANAGEMENT’S DISCUSSION AND ANALYSIS GENERAL Boston Chicken The total number of stores in the Boston Market system increased from 34 at the year ended December 29, 1991, to 534 at the year ended December 25, 1994. This rapid expansion significantly affects the comparability of results of operations from year to year as well as the Company’s liquidity and capital resources. The following table sets forth information regarding store development activity for the years indicated. Stores at Beginning of Year Net Stores Opened in Year Net Stores Transferred in Yeara Stores at End of Year Year Ended December 27, 1992: Company-operated Financed area developers Non-financed area developers and other Total 5 0 29 34 15 3 31 49 (1) 0) 1) 0) 19 3 61 83 Year Ended December 26, 1993: Company-operated Financed area developers Non-financed area developers and other Total 19 3 61 83 28 66 40 134 (9) 9) 0) 0) 38 78 101 217 Year Ended December 25, 1994: Company-operated Financed area developers Non-financed area developers and other Total 38 78 101 217 49 168 100 317 (46) 68) (22) 0) 41 314 179 534 aStores transferred during the year primarily reflect the Company’s practice of opening new Company-operating stores to seed development in targeted markets prior to execution of area development agreements relating to such markets. At the time such agreements are executed, the Company typically sells Company-operating stores located in the market to the area developer in that market. Stores transferred also reflect the purchase and/or sale of Boston Market stores in markets with multiple area developers in order to facilitate consolidation of such markets. RESULTS OF OPERATIONS Fiscal Year 1994 Compared to Fiscal Year 1993 Revenue Total revenue increased $53.7 million (126%) from $42.5 million for 1993 to $96.2 million for 1994. Royalty and franchise-related fees increased $42.5 million (335%) to $55.2 million for 1994, from $12.7 million for 1993. This increase was primarily due to an increase in royalties attributable to the larger base of franchise stores operating systemwide, from 179 stores at December 16, 1993 to 493 stores at December 5, 1994, an increase in franchise fees related to the increase in the number of stores that commenced operation as franchised stores during the year, and higher interest income generated on increased loans made to certain area developers. Additional factors contributing to the 153 Asset Analysis Asset Analysis 4-28 increase in revenue from royalty and franchise-related fees include an increase in lease income due to a higher number of store sites which the Company owns and leases to area developers, and recognition of software license and maintenance fees for store-level computer software systems developed by the Company for use by franchisees. No software-related fees were earned in 1993. Revenue from Company-operated stores increased $11.1 million (37%) from $29.8 million for 1993 to $40.9 million for 1994. This increase was due to a higher average number of Company-operated stores open during the year. The Company had 38 Company-operated stores at December 26, 1993, compared to 41 at December 25, 1994. During 1994, the Company sold 54 Company-operated stores which it had opened to seed new markets. Cost of Products Sold Cost of products sold increased $4.6 million (41%) , to $15.9 million for 1994 compared with $11.3 million for 1993. This increase was primarily due to an increase in the number of Company-operated stores open during the periods. Management does not believe that the cost of products sold as a percentage of store revenue at Company-operated stores is indicative of cost of products sold as a percentage of store revenue at franchise stores due to the Company’s practice of opening new stores primarily to seed new markets. These newer stores, which constitute the majority of the Company-operated store base, tend to have higher food and paper costs as a result of increased food usage for free tasting, inefficiencies resulting from employee inexperience, and a lack of store-specific operating history to assist in forecasting daily food production needs. Salaries and Benefits Salaries and benefits increased $7.2 million (47%), from $15.4 million in 1993 to $22.6 million in 1994. The increase resulted from an increase in the number of employees at the Company’s support center necessary to support systemwide expansion and an increase in the number of employees at Company-operated stores due to a higher average number of Company-operated stores open during the year. General and Administrative General and administrative expenses increased $14.0 million (101%) to $27.9 million for 1994 from $13.9 million for 1993. The increase is attributable to the development of the Company’s support center infrastructure necessary to support systemwide expansion and higher general and administrative expenses at Company-operated stores resulting from a higher average number of Company-operated stores open during the year. Included in general and administrative expenses were depreciation and amortization charges of $6.1 million in 1994 and $2.0 million in 1993. The increase in depreciation and amortization expense is primarily attributable to a substantially higher fixed asset base reflecting the Company’s investment in its infrastructure. Provision for Relocation In September 1994, the Company consolidated its four Chicago-based support center facilities into a single facility and relocated to Golden, Colorado. The total cost of relocation was $5.1 million. Other Expense The Company incurred other expense of $4.2 million in 1994, compared with other expense of $0.3 million in 1993. This increase reflects higher interest expense, primarily attributable to the $130.0 million of convertible subordinated debt and short-term borrowings under its unsecured credit facility, partially offset by higher interest income. Boston Chicken 154 Asset Analysis 4-29 Part 2 Business Analysis and Valuation Tools Income Taxes Included in income taxes in 1994 is a $3.5 million benefit reflecting the realization of deferred tax assets attributable to the increased level of operating income, offset by a current provision for income taxes. Boston Chicken Liquidity and Capital Resources Liquidity The Company’s primary capital requirements are for store development, including providing partial financing for certain of its area developers, purchasing real estate which is then leased to its area developers, and opening Company-operated stores. The remainder of the Company’s capital requirements related primarily to investments in corporate infrastructure, including property and equipment and software development, which are necessary to support the increase in the number of stores in operation systemwide. For the year ended December 25, 1994, the Company expended approximately $268.1 million on store development, including financing area developers, purchasing real estate and opening Company-operated stores. The Company also expended approximately $52.3 million on corporate infrastructure, including its new support center facility. The Company has entered into secured loan agreements with certain of its area developers whereby the area developers may draw on a line of credit, with certain limitations, in order to provide partial funding for expansion of their operations. In connection with certain of these loans, after a specified moratorium period, the Company has the right to convert the loan which typically results in a controlling equity interest in the area developer. As of December 25, 1994, The Company had secured loan commitments aggregating approximately $332.5 million, of which approximately $201.3 million had been advanced. The Company anticipates fully funding its commitments pursuant to its loan agreements with these area developers, and anticipates increasing such loan commitments and entering into additional loan commitments with other area developers in targeted market areas. In connection with entering into new area development agreements, the Company intends to sell Company-operated stores located in any such areas to the respective area developer. The Company is currently negotiating such agreements for a number of metropolitan areas, including Kansas City, Minneapolis, Omaha, New York, and San Francisco/San Jose. The timing of such transactions will have significant effect on the size and timing of the Company’s capital requirements. In 1994, the Company sold 54 Company-operated stores to its area developers in the Philadelphia, Detroit, Denver, Colorado Springs, Phoenix, Tucson, Las Vegas, Albuquerque, Salt Lake City, Southern New Jersey, and Boston metropolitan areas. In addition to opening stores to seed development in new markets and subsequently selling such stores to the new area developer for such market, the Company purchases and resells Boston Market stores in markets with multiple area developers in order to facilitate consolidation of such markets. In connection with these consolidation activities, the Company has issued a total of 1,112,436 shares of common stock pursuant to its shelf registration statement for the acquisition of 32 Boston Market stores and paid cash for 2 Boston Market stores. Of the 34 stores purchased, 26 stores were subsequently sold. The Company believes that all of the shares issued in connection with these consolidation activities have been sold by the recipients pursuant to Rule 145 (d) under the Securities Act of 1933, as amended. The aggregate proceeds from the sale of Company-operated stores to seed new markets and from the sale of stores which were acquired to consolidate markets 155 Asset Analysis Asset Analysis 4-30 were approximately $62.3 million. There were no material gains recognized as a result of these sales. In March 1995, the Company entered into a secured loan agreement providing $20 million of convertible debt financing to Progressive Bagel Concepts, Inc. (“PBCI”). The Company has agreed to increase the amount available to PBCI under the loan agreement subject to PBCI’s ability to meet certain conditions. Capital Resources For the year ended December 25, 1994, the Company’s primary sources of capital included $35.9 million generated from operating activities, $130.0 million from the issuance of 41⁄ 2% convertible subordinated debentures maturing February 1, 2004 (the “Debentures”), and $125.7 million from the sale of shares of common stock. The Debentures are convertible at any time prior to maturity into shares of the Company’s common stock at a conversion rate of $27.969 per share, subject to adjustment under certain conditions. Beginning February 1, 1996, the Debentures may be reduced at the option of the Company, provided that until February 1, 1997, the Debentures cannot be redeemed unless the closing price of the Company’s common stock equals or exceeds $39.16 per share for at least 20 out of 30 consecutive trading days. The Debentures are redeemable initially at 103.6% of their principal amount and at declining prices thereafter, plus accrued interest. Interest is payable semi-annually on February 1 and August 1 of each year. In 1994, the Company entered into a $75.9 million master lease agreement to provide equipment financing for stores owned by certain of its area developers and certain Company-operated stores. The lease bears interest at LIBOR plus an applicable margin and, including renewal terms, expires in December 1998. As of December 25, 1994, the Company had utilized $66.1 million of the facility. As of December 25, 1994, the Company had $25.3 million available in cash and cash equivalents, $75.0 million available under its unsecured revolving credit facility, and $8.9 million available under its master lease agreement. The Company anticipates that it and its area developers will have need for additional financing during the 1995 fiscal year. The timing of the Company’s capital requirements will be affected by the number of Company-operated and franchise stores opened, operational results of stores, the number of real estate sites purchased by the Company for Company use and for leasing by the Company to franchisees, and the amount and timing of borrowings under the loan agreements between the Company and certain of its existing or future area developers and by PBCI. As the Company’s capital requirements increase, the Company will seek additional funds from future public or private offerings of debt or equity securities. There can be no assurance that the Company will be able to raise such capital on satisfactory terms when needed. Seasonality Historically, the Company has experienced lower average store revenue in the months of November, December, January, and February as a result of the holiday season and inclement weather. The Company’s business in general, as well as the revenue of Company-operated stores, may be affected by a variety of other factors, including, but not limited to, general economic trends, competition, marketing programs, and special or unusual events. Such effects, however, may not be apparent in the Company’s operating results during a period of significant expansion. Boston Chicken 156 Asset Analysis 4-31 Part 2 Business Analysis and Valuation Tools CONSOLIDATED BALANCE SHEETS Boston Chicken 1994 Assets Current assets Cash Accounts receivable, net Due from affiliates Notes receivable Prepaid expenses & other current assets Deferred income taxes Total current assets Property & equipment, net Notes receivable Deferred financing costs Other assets Total assets Liabilities & Stockholders’ Equity Current liabilities Accounts payable Accrued expenses Deferred franchise revenue Total current liabilities Deferred franchise revenue Convertible subordinated debt Other noncurrent liabilities Deferred income taxes Stockholders’ Equity Common stock Additional paid-in capital Retained earnings (deficit) Total liabilities and stockholders’ equity $25,304 6,540 6,462 16,906 2,282 1,835 59,329 163,314 185,594 8,346 10,399 $426,982 1993 $ 4,537 2,076 3,126 1,512 1,843 13,094 51,331 44,204 358 1,077 $110,064 $15,188 6,587 5,505 27,280 5,815 130,000 1,061 3,011 $6,216 1,835 2,255 10,306 3,139 447 252,298 7,070 259,815 $426,982 347 103,662 (9,103) 94,906 $110,064 1,713 157 Asset Analysis Asset Analysis 4-32 CONSOLIDATED STATEMENTS OF OPERATIONS Revenue Royalties & franchise-related fees Company-operated stores Total revenues Costs and expenses Cost of products sold Salaries and benefits General and administrative Provision for relocation Total costs and expenses Income (loss) from operations Other income (expense) Interest income (expense), net Other income, net Total other income (expense) Income (loss) before income taxes Income taxes Net income (loss) Net income (loss) per share common and equivalent share Number of shares 1994 1993 1992 $55,235 40,916 96,151 $12,681 29,849 42,530 $2,627 5,656 8,283 15,876 22,637 27,930 5,097 71,540 24,611 11,287 15,437 13,879 — 41,603 927 2,241 7,110 5,241 — 14,592 (6,309) (4,235) 74 (4,161) 20,450 4,277 $16,173 (440) 160 (280) 647 — 647 270 189 459 (5,850) — $(5,850) $0.06 32,667 $ (0.21) 28,495 $0.38 42,861 $ Boston Chicken 158 Asset Analysis 4-33 Part 2 Business Analysis and Valuation Tools CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Boston Chicken Fiscal Years Ended Dec. 25, 1994 Dec. 26, 1993 Dec. 27, 1992 $ 16,173 $ 1,647 $ (5,850) 6,074 4,277 1,970 260 (368) (150) 39 (29) (7,800) 13,724 5,926 (2,088) 35,198 (4,343) 6,247 3,236 (561) 8,046 (689) 1,102 1,223 332 (3,612) Cash from investing activities Purchase of plant, property & equipment Proceeds from sale of assets Acquisition of other assets Issuance of notes receivable Repayment of notes receivable Net cash used in investing activities (163,622) 62,342 (12,790) (225,282) 68,498 (270,854) (49,151) 6,161 (1,093) (45,690) 747 (89,026) (8,453) 385 (273) (773) — (9,114) Cash from financing activities Proceeds from issue common stock Proceeds from convertible subordinate notes Borrowings under credit facility Repayments under credit facility Payment of capital lease obligation Net cash from financing activities Net increase (decrease) in cash Cash, beginning of year Cash, end of year 125,703 130,000 96,130 (96,130) — 255,703 20,767 4,537 $ 25,304 66,150 9,658 32,275 (32,275) — 75,808 (5,172) 9,709 $ 4,537 19,843 Supplemental cash flow information Interest paid $ 3,395 $ Noncash transactions Conversion of convt. subord. notes into common stock Issuance of common stock for assets $ — $ 19,931 $ 10,072 $ — Cash from operating activities Net income (loss) Adjustments to reconcile income (loss) to net cash provided by (used in) operating activities Depreciation and amortization Deferred income taxes Vesting of common stock for services rendered Gain on disposal of assets Changes in assets and liabilities Accounts receivable and due from affiliates Accounts payable and accrued expenses Deferred franchise revenue Other assets and liabilities Net cash from (used in) operations (300) 19,543 6,817 2,892 $ 9,709 226 The accompanying notes to the consolidated financial statements are an integral part of these statements. $ 29 $ $ — — 159 Asset Analysis Asset Analysis 4-34 OTHER INFORMATION 1994 Store Information Company operated Finance area developers Nonfinanced area developers Total Systematic store revenue Quarterly Data Revenue 1st quarter 2nd quarter 3rd quarter 4th quarter Net Income 1st quarter 2nd quarter 3rd quarter 4th quarter 1993 1992 1991 41 314 179 534 38 78 101 217 19 3 61 83 5 0 29 34 383.7 152.1 42.7 20.8 23,449 20,360 25,186 27,165 2,561 3,383 4,679 5,550 Boston Chicken 160 Asset Analysis 4-35 Part 2 Business Analysis and Valuation Tools NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Boston Chicken 1. Description of Business Boston Chicken, Inc., and Subsidiary (the “Company”) operate and franchise food service stores that specialize in complete meals featuring home style entrees, fresh vegetables, salads, and other side items. At December 26, 1993, there were 217 stores systemwide, consisting of 38 Company-operated stores and 179 franchise stores. At December 25, 1994, there were 534 stores systemwide, consisting of 41 Company-operated stores and 493 franchise stores. In 1992, 1993, and 1994, in connection with its practice of opening new stores to seed development in targeted markets, the Company sold 1, 13, and 54 Company-operated stores, respectively, to new formed area developers or franchisees of the Company. During 1994, in connection with its practice of acquiring stores in markets with multiple area developers in order to facilitate consolidation of such markets, the Company purchased 34 stores and resold 26 of them. 2. Summary of Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and its subsidiary. All material intercompany accounts and transactions have been eliminated in consolidation. Fiscal Year The Company’s fiscal year is the 52/53-week period ending on the last Sunday in December. Fiscal years 1992, 1993, and 1994 each contained 52 weeks, or thirteen four-week periods. The first quarter consists of four periods and each of the remaining three quarters consists of three periods, with the first, second, and third quarters ending 16 weeks, 28 weeks, and 40 weeks, respectively, into the fiscal year. Cash and Cash Equivalents Cash and cash equivalents consist of cash on hand and on deposit, and highly liquid instruments purchased with maturities of three months or less. Inventories Inventories, which are classified in prepaid expenses and other current assets, are stated at the lower of cost (first-in, first-out) or market and consist of food, paper products, and supplies. Property and Equipment Property and equipment is stated at cost, less accumulated depreciation and amortization. The provision for depreciation and amortization has been calculated using the straight-line method. The following represent the useful lives over which the assets are depreciated and amortized: Buildings and improvements Leasehold improvements Furniture, fixtures, equipment and computer software Pre-Opening costs 15–30 years 15 years 6–8 years 1 year Property and equipment additions include acquisitions of property and equipment, costs incurred in the development and construction of new stores, major improvements to existing stores, and costs incurred in the development and purchase of computer software. Pre-opening costs consist primarily of salaries and other direct expenses relating to the set-up, initial stocking, training, and general management activities incurred prior to the opening of new stores. Expenditures for maintenance and repairs are charged to expense as incurred. Development costs for franchised stores are expensed when the store opens. Deferred Financing Costs Deferred financing costs are amortized over the period of the related financing, which ranges from two to ten years. Revenue Recognition Revenue from Company-operated stores is recognized in the period related food and beverage products are sold. Revenue derived from initial franchise fees and area development fees is recognized when the franchise store opens. Royalties are recognized in the same period related franchise store revenue is generated. The components of royalties and franchise-related fees are comprised of the following: 161 Asset Analysis Asset Analysis (In thousands of dollars) Royalties Initial franchise and area development Interest income from area developer financing (See Note 8) Lease income Software fees Other Total royalties and franchiserelated fees Dec. 25, 1994 Dec. 26, 1993 Dec. 27, 1992 $17,421 $5,464 $1,491 13,057 5,230 1,136 11,632 5,361 6,480 1,284 1,130 253 — 604 — — — — $55,235 $12,681 $2,627 Subject to the provisions of the applicable franchise agreements, the Company is committed and obligated to allow franchisees to utilize the Company’s trademarks, copyrights, recipes, operating procedures, and other elements of the Boston Market system in the operation of franchised Boston Market stores. Per Share Data Net income (loss) per common share is computed by dividing net income (loss), adjusted in 1993 for interest related to the conversion of 7% convertible subordinated notes (See Note 9), by the weighted average number of common shares and dilutive common stock equivalent shares outstanding during the year. Common and equivalent share include any common stock, options, and warrants issued within one year prior to the effective date of the Company’s initial public offering, with a price below the initial public offering price. These have been included as common stock equivalents outstanding, reduced by the number of shares of common stock which could be purchased with the proceeds form the assumed exercise of the options and warrants, including tax benefits assumed to be realized. Employee Benefit Plan The Company has a 401(k) plan for which employee participation is discretionary and to which the Company makes no contribution. Reclassification Certain amounts shown in the 1992 and 1993 financial statements have been reclassified to conform with the current presentation. 4. Debt The Company has entered into a revolving credit agreement on an unsecured basis providing for borrowings of up to $75 million through June 30, 1997. Borrowings under the agreement may be either floating rate loans with interest at the bank’s reference rate of eurodollar loans with interest at the eurodollar rate, plus an applicable margin. In addition, a commitment fee of .25% of the average daily unused portion of the loan is required. The agreement contains various covenants including restricting other borrowings, prohibiting cash dividends, and requiring the Company to maintain interest coverage and cash flow ratios and a minimum net worth. As of December 25, 1994, no borrowings were outstanding. In February, 1994, the Company issued $130 million of 4.5% convertible subordinated debentures maturing February 1, 2004. Interest is payable semi-annually on February 1 and August 1 of each year. The debentures are convertible at any time prior to maturity into share of common stock at a conversion rate of $27.969 per share, subject to adjustment under certain conditions. Beginning February 1, 1996, the debentures may be redeemed at the option of the Company, provided that through February 1, 1997, the debentures cannot be redeemed unless the closing price of the common stock equals or exceeds $39.16 per share for at least 20 out of 30 consecutive trading days. The debentures are redeemable initially at 103.6% of their principal amount and at declining prices thereafter, plus accrued interest. 5. Income Taxes As of December 25, 1994, the Company has cumulative Federal and state net tax operating loss carryforwards available to reduce future taxable income of approximately $30.5 million which begin to expire in 2003. The Company has recognized the benefit of the loss carryforwards for financial reporting, but not for income tax purposes. Certain ownership changes which have occurred will result in an annual limitation of the Company’s utilization of its net operating losses. At December 28, 1992, the first day of fiscal 1993, the Company adopted SFAS No. 109 “Accounting for Income Taxes” (“SFAS 109”). Upon adoption of SFAS 109 there was no cumulative effect on the Company’s financial statements 4-36 Boston Chicken 162 Asset Analysis 4-37 Part 2 Business Analysis and Valuation Tools because the Company’s deferred tax assets exceeded its deferred tax liabilities and a valuation allowance was recorded against the net deferred tax assets due to uncertainty regarding realization of the related tax benefits. The primary components that comprise the deferred tax assets and liabilities at December 26, 1993, and December 25, 1994, are as follows: Boston Chicken (In thousands of dollars) Deferred tax assets: Accounts payable and accrued expenses Deferred franchise revenue Other noncurrent liabilities Net operating losses Other Total deferred tax assets Less valuation allowance Net deferred taxes Deferred tax liabilities: Due from area developers Property and equipment Other assets Total deferred tax liabilities Net deferred tax liability Dec. 25, 1994 Dec. 26, 1993 $ $ 794 3,469 262 11,639 173 16,337 — 16,337 — (17,047) (466) (17,513) $ (1,176) 78 1,992 623 4,844 52 7,589 (3,847) 3,742 (814) (2,807) (121) (3,742) $ — The decrease in the valuation allowance from December 26, 1993 to December 25, 1994 was $3,847,000 and the decrease in the valuation allowance from December 27, 1992 to December 26, 1993 was $180,000, which was net of a $446,000 increase related to the tax benefit from the exercise of stock options. The provision for income taxes for the fiscal year ended December 25, 1994, consists of $4,277,000 of deferred income taxes, which is net of an income tax benefit of $3,102,000 pertaining to the exercise of stock options. The difference between the Company’s 1993 and 1994 actual tax provision and the tax provision by applying the statutory Federal income tax rate is attributable to the following: Fiscal Years Ended (In thousands of dollars) Income tax expense at statutory rate State taxes, net of Federal benefit Other Change in valuation allowance Provision for income taxes Dec. 25, 1994 Dec. 26, 1993 $6,953 818 26 (3,520) $4,277 $ 560 66 — (626) $ — 6. Marketing and Advertising Funds The Company administers a National Advertising Fund to which Company-operated stores and franchisees make contributions based on individual franchise agreements (currently 2% of base revenue). Collected amounts are spent primarily on developing marketing and advertising materials for use systemwide. Such amounts are not segregated from the cash resources of the Company, but the National Advertising Fund is accounted for separately and not included in the financial statements of the Company. The Company maintains Local Advertising Funds that provide comprehensive advertising and sales promotion support for the Boston Market stores in particular markets. Periodic contributions are made by both Company-operated and franchise stores (currently 3% to 3.75% of base revenue). The Company disburses funds and accounts for all transactions related to such Local Advertising Funds. Such amounts are not segregated from the cash resources of the Company, but are accounted for separately and are not included in the financial statements of the Company. The National Advertising Fund and certain Local Advertising Funds had accumulated deficits at December 26, 1993, and December 25, 1994, which were funded by advances from the Company. Such advances are reflected in Due from affiliates, net. 8. Area Developer Financing The Company currently offers partial financing to certain area developers for use in expansion of their operations. Only developers which are developing a significant portion of an area of dominant influence (“ADI”) or metropolitan area of a major city and which meet all of the Company’s requirements are eligible for such financing. Certain of these financing arrangements permit the Company to obtain an equity interest in the developer at a predetermined price after a moratorium (generally two years) on conversion of the loan into equity. The maximum loan amount is generally established to give the Company majority ownership of the developer upon conversion (or option exercise, as described further below) provided the Company exercises its right 163 Asset Analysis 4-38 Asset Analysis to participate in any intervening financing of the developer. (b) Commitment to Extend Area Developer Financing Area developer financing generally requires the developer to expend at least 75% of its equity capital toward developing stores prior to drawing on the revolving loan account, with draws permitted during a two- or three-year draw period in a pre-determined amount, generally equal to two to four times the amount of the developer’s equity capital. Upon expiration of the draw period, the loan converts to an amortizing term loan payable over four to five years in periodic installments, sometimes with a final balloon payment. Interest is generally set at 1% over the applicable “reference rate” of Bank of America Illinois from time to time and is payable each period. The loan is secured by a pledge of substantially all of the assets of the area developer and any franchisees under its area development agreement and generally by a pledge of equity of the owners of the developer. The following table summarizes credit commitments for area developer financing, certain of which are conditional upon additional equity contributions being made by area developers: (a) Loan Conversion Option For loans with a conversion option, all or any portion of the loan amount may be converted at the Company’s election (at any time after default of the loan or generally after the second anniversary of the loan and generally up to the later of full repayment of the loan or a specified date in the agreement) into equity in the developer at the conversion price set forth in such loan agreement, generally at a 12% to 15% premium over the per equity unit price paid by the developer for the equity investment made concurrently with the execution of the loan agreement or subsequent amendments thereto. To the extent such loan is not fully drawn or has been drawn and repaid, the Company has a corresponding option to acquire at the loan conversion price the amount of additional equity it could have acquired by conversion of the loan, had it been fully drawn. There can be no assurance the Company will or will not convert any loan amount or exercise its option at such time as it may be permitted to do so and, if it does convert, that such conversion will constitute a majority interest in the area developer. Absent a default under any such agreement, the Company currently cannot exercise these conversion or option rights. (In thousands of dollars, except number of area developers) Number of area developers receiving financing Loan commitments Unused loans Loans outstanding (included in Notes Receivable) Allowance for loan losses Dec. 25, 1994 Dec. 26, 1993 13 $332,531 (131,265) 5 $ 51,041 (7,243) $201,266 $ — $ 43,798 $ — The principal maturities on the aforementioned notes receivable are as follows: (In thousands of dollars) 1995 1996 1997 1998 1999 Thereafter $16,288 4,456 13,132 12,132 15,417 139,841 $201,266 (c) Credit Risk and Allowance for Loan Losses The allowance for credit losses is maintained at a level that in management’s judgment is adequate to provide for estimated possible loan losses. The amount of the allowance is based on management’s review of each area developer’s financial condition, store performance, store opening schedules, and other factors, as well as prevailing economic conditions. Based upon this review and analysis, no allowance was required as of December 26, 1993 and December 25, 1994. 11. Relocation In September 1994, the Company consolidated its four Chicago-based support center facilities into a single facility and relocated to Golden, Colorado. The cost of the relocation, including moving personnel and facilities, severance payments, and the write-off of vacated leasehold improvements was $5.1 million. Boston Chicken 164 Asset Analysis 4-39 Part 2 Business Analysis and Valuation Tools 12. Subsequent Events Boston Chicken In March 1995, the Company entered into a convertible secured loan agreement providing $20 million of financing to Progressive Bagel Concepts, Inc. (“PBCI”). The Company has agreed to provide PBCI additional convertible secured loans subject to PBCI’s ability to meet certain conditions. In March 1995, PBCI entered into stock purchase agreements with the Company to purchase $19.5 million of common stock. The number of shares to be issued will be based upon the market value of the stock two days prior to the closing date. The Company has granted PBCI registration rights and has provided a price guarantee equal to the per share purchase price on any shares sold within a specified number of days of the registration becoming effective. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Boston Chicken, Inc.: We have audited the accompanying consolidated balance sheets of Boston Chicken, Inc. (a Delaware corporation) and Subsidiary as of December 25, 1994 and December 26, 1993, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the fiscal years ended December 25, 1994, December 26, 1993, and December 27, 1992. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Boston Chicken, Inc. and Subsidiary as of December 25, 1994 and December 26, 1993, and the results of their operations and their cash flows for the fiscal years ended December 25, 1994, December 26, 1993, and December 27, 1992, in conformity with generally accepted accounting principles. (Arthur Andersen LLP) Denver, Colorado January 31, 1995 (except with respect to the matters discussed in Note 12, as to which the date is March 24, 1995) 165 Asset Analysis Asset Analysis 4-40 EXHIBIT 2 Boston Chicken Inc., Summary of 1994–1995 Quarterly Results 1st Quarter 2nd Quarter 3rd Quarter 1995 Revenue ($000) Net Income ($000) EPS $40,107 7,116 $0.15 $34,800 7,420 $0.15 $38,671 8,814 $0.17 1994 Revenue ($000) Net Income ($000) EPS $23,449 2,561a $0.06 $20,360 3,383a $0.08 $25,186 4,679a $0.11 4th Quarter $27,165 5,550 $0.12 a. Pre-tax provisions for relocation were $4,708,000 in the second quarter of 1994, and $389,000 in the third quarter of 1994. Boston Chicken 166 55 L iabilit y an d E qu it y An alysis chapter F 2 Business Analysis and Valuation Tools irms have two broad classes of financial claims on their assets: liabilities and equity. The key distinction between these claims is the extent to which their payoffs can be specified contractually. The firm’s obligations under liabilities are specified relatively clearly, whereas equity claims tend to be difficult to specify. The economic differences between liabilities and equity are reflected in their accounting definitions. Liabilities are defined as economic obligations that arise from benefits received in the past, and for which the amount and timing is known with reasonable certainty. Liabilities include obligations to customers that have paid in advance for products or services; commitments to public and private providers of debt financing; obligations to federal and local governments for taxes; commitments to employees for unpaid wages, pensions, and other retirement benefits; and obligations from court or government fines or environmental cleanup orders. For accounting purposes, equity financing is defined as the claim on the gap between assets and liabilities. It can therefore be thought of as a residual claim. Equity funds can come from issues of common and preferred stock, from profits that are reinvested, and from any reserves set aside from profits. It is important for users of financial statements to analyze the nature of the firm’s liabilities and its equity in order to assess the financial risks faced by both debt and equity investors. Managers are likely to have the best information about the extent of the firm’s future commitments. However, they also have incentives to understate the value of these commitments and the firm’s financial risks. Analysis of liabilities involves assessing the extent, nature, and measurability of any obligations the firm has incurred. Equity values are a primary input for the valuation approach discussed in Chapters 10, 11, and 12. It is therefore important that equity values be reliable estimates of stockholders’ claims on the firm’s assets. However, since equity is defined as a residual, analysis of equity is indirect, through analysis of assets, liabilities, revenues, and expenses. Additional questions about equity focus on classification of items within equity and hybrid securities. In this chapter we discuss the key principles underlying the recording of liabilities and equity. We also show the challenges in reporting these types of claims and the opportunities for analysis of each. LIABILITY DEFINITION AND REPORTING CHALLENGES Under accrual accounting, liabilities can arise in three ways. First, they can arise when a firm has received cash from a customer but has yet to fulfill any of its contractual 5-1 167 168 Liability and Equity Analysis Liability and Equity Analysis obligations required for recognizing revenue (see Chapter 6). These types of liabilities are termed deferred or unearned revenues. Second, a liability can arise if a firm has used goods and/or services in the course of its operating cycle or during the current period, but has yet to pay the suppliers of these inputs. These are called payables and accrued liabilities. Finally, a firm incurs a liability when it raises debt capital from banks, financial institutions, and the public. Under this form of financing arrangement, the firm borrows a fixed amount of capital that it commits to repay, with interest, over a fixed period. As shown in Figure 5-1, under accrual accounting these three types of liabilities are reflected in the financial statements when a firm incurs an obligation to another party for which the amount and timing are measurable with reasonable certainty. Measurement challenges for liabilities arise when there is ambiguity about whether an obligation has really been incurred, whether the obligation can be measured, and when there have been changes in the value of liabilities. Challenge One: Has an obligation been incurred? For most liabilities there is little ambiguity about whether the firm has incurred an obligation. For example, when a firm buys supplies on credit, it has incurred an obligation to the supplier. However, for some transactions it is more difficult to decide whether there is any such obligation. Consider a situation where a firm assigns the cash flows from a note receivable to a bank, but where the bank has recourse against the firm should the receivable default. Has the firm effectively sold its receivables, or has it really used the receivables as collateral for a bank loan? If a firm announces a plan to restructure its business Figure 5-1 Criteria for Recording Liabilities and Implementation Challenges First Criterion Second Criterion An obligation has been incurred. The amount and timing of the obligation is measurable with reasonable certainty. Record a liability. Challenging Transactions 1. It is uncertain whether the firm has incurred an obligation. 2. The amount and timing of future obligations is difficult to measure. 3. Liability values have changed. 5-2 Liability and Equity Analysis 5-3 Part 2 Business Analysis and Valuation Tools by laying off employees, has it made a commitment that would justify recording a liability? Similarly, has an airline that uses a frequent flyer program as a marketing device created an obligation to provide future travel to its customers? Finally, has a firm that is subject to a legal suit incurred an obligation? Below we discuss several of these types of transactions and the challenges they provide for financial reporting. Although our discussion of these transactions focuses on whether they create future commitments for the firm, they frequently also raise questions about whether any commitment can be measured. EXAMPLE: RESTRUCTURING RESERVES. On October 12, 1994, in response to in- tense competition from the Australian spice producer Burns, Philp & Co., McCormick & Co. announced plans to lay off 7 percent of its 8,600-person staff, close two spice plants, and sell off a money-losing onion-ring operation. How should this announcement be recorded in McCormick’s financial statements? Had McCormick actually made a commitment to expend resources to restructure its business? If so, what were the estimated costs of these actions? Alternatively, had McCormick merely announced a plan to restructure the firm? A plan does not necessarily create an obligation on McCormick’s part. It can be modified or abandoned, just as announcements of projected capital outlays for the coming year can be changed. The question of whether a restructuring announcement creates an economic liability from the firm’s standpoint is difficult to resolve. It depends on management’s intentions when it announces the plan. It is also worth noting that a successful restructuring not only creates a commitment, but an associated benefit in terms of improved subsequent performance. How are these effects reflected in firms’ financial statements? Current accounting rules on restructuring charges are covered by a number of accounting standards (APB 30 and SFAS 5) as well as SEC rulings. These rules require firms to create a liability when management has a formal restructuring plan. The liability includes estimates for costs of eliminating product lines, relocating plants and workers, new system costs, retraining costs, and severance pay. However, the SEC has argued that the mere announcement of employee terminations is not sufficient grounds for accruing a liability until specific affected employees have been notified. It is also interesting to note that accounting rules do not permit restructuring firms to recognize any future benefits expected from these activities. These rules leave considerable room for management judgment in reporting for restructuring charges. Indeed, as noted in Chapter 7, the SEC has expressed concern that managers have overstated restructuring charges by making aggressive asset write-downs, called “taking a bath.” Future performance is then enhanced both by the effect of any restructuring benefits and by reduced depreciation charges or restructuring credits. The McCormick restructuring raised concerns among some analysts that the firm had used write-offs to manage future earnings. In its financial statements for the fourth quarter of 1994, McCormick created a $70.5 million liability for the costs of the restructuring. However, in February 1995 it reduced the amount of the charge by $3.9 million, which it added to earnings in the first quarter of 1995. As a result, it reported a 5.7 percent increase in earnings for the quarter, when earnings would otherwise have declined. 169 170 Liability and Equity Analysis Liability and Equity Analysis Analysts criticized McCormick for failing to mention the restructuring credit in its earnings announcement and only disclosing the fact in later reports to the SEC. Subsequent disclosures on restructuring activities at McCormick further illustrate the difficulties in assessing whether a restructuring announcement is a commitment, and whether firms have deliberately overestimated the restructuring liability to create a cushion for future years. In 1996 McCormick announced a second restructuring. Most of the costs of the restructuring ($58.1 million) were recognized as a restructuring liability immediately. However, the firm noted that some charges related to costs of moving equipment and personnel from a closed U.S. packaging plant could not be accrued. These charges (for $1.9 million) were eventually recognized in the fourth quarter of 1998. In the third quarter of 1997, McCormick reevaluated its restructuring plans and recorded a restructuring credit of $9.5 million because plans to sell an overseas food brokerage and distribution business were not completed. The 1996 restructuring was concluded in the fourth quarter of 1998, and a further restructuring credit of $3.1 million was reported. EXAMPLE: FREQUENT FLYER OBLIGATIONS. Many airlines have frequent flyer programs for their passengers. These programs are designed to enhance customer loyalty by offering bonus award miles every time the passenger flies with the same airline. Passengers who accumulate sufficient award miles can then redeem them for future flights, hotel accommodations, or rental cars. Since their creation in the early 1980s, airline mileage programs have become increasingly popular, prompting some airlines to actually sell award miles to credit card and phone companies to offer their members as promotions. The challenge for accounting is to assess whether the airlines have incurred a liability for the future travel commitments under the mileage programs. There are several reasons for not viewing the program as creating a commitment. First, the airlines have discretion to modify or even abandon their mileage programs, should they wish to avoid the commitments. For example, in 1987, United Airlines (UAL) made it more difficult for passengers to earn free flights, at least in part in response to growing concerns about the potential liability under the program. The changes reduced the number of double and triple mileage bonuses offered to passengers who flew during certain months or on certain routes. It also required more miles to be earned to qualify for a free ticket to Hawaii, one of the most popular destinations in the program, and to destinations in Asia and the South Pacific. Finally, the company announced that awards would expire within three years of the date of issue. Airlines can also regulate their commitment under frequent flyer programs by limiting the number of seats available to frequent flyers. In 1997 the number of outstanding frequent flyer miles totaled 3 trillion, compared to only 16.3 billion a decade earlier. Yet the number of available free seats had not expanded at the same rate. Randy Petersen, of the trade magazine Inside Flyer, estimated that most airlines made only 7 percent of their seats available for frequent flyer awards on a particular route. In addition to questions on whether an obligation has been incurred, frequent flyer programs raise questions about the amount of the obligation. For example, what is the 5-4 Liability and Equity Analysis 5-5 Part 2 Business Analysis and Valuation Tools cost of frequent flyer obligations? Given normal load factors and the incremental costs of an additional passenger, the opportunity and out-of-pocket costs of frequent flyer awards could be minimal. Of course, changing the requirements for mileage awards and making it more difficult to collect on awards can be costly—UAL was sued over its plan changes. Further, the recent sale of mileage awards by airlines reduces the likelihood that there can be significant additional reductions in program benefits. As a result of these conflicting views on the economics of the programs, there are legitimate differences in opinion about the nature of airlines’ commitments under these programs. Current accounting rules reflect the uncertainty about the extent of the commitment. They provide no definitive guidance on how to report these obligations, potentially providing an opportunity for management to exercise judgment. In its 1999 annual report, United Airlines noted that approximately 6.1 million frequent flyer awards were outstanding. Based on historical data, the firm estimated that 4.6 million of these awards would ultimately be redeemed. The firm predicted that the remainder would never be redeemed, would be redeemed for nontravel benefits, or would be redeemed on partner carriers. The firm recorded a liability for $195 million for award redemption, reflecting the “additional costs of providing service for what would otherwise be a vacant seat, such as fuel, meal, personnel and ticketing costs” (see UAL 1999 10-K). EXAMPLE: LITIGATION. In November 1988, the Public Citizen’s Health Research Group requested that the U.S. Food and Drug Administration ban silicone gel implants because a new study by the major manufacturer, Dow Corning Corp., found that the gel causes a type of cancer in laboratory rats. A number of other experts in the field, however, disputed the risks of silicone gel implants, pointing out that the type of cancer found in the rats has never been observed in women with implants. Dow Corning also argued that the implants should be allowed to remain on the market. However, the company subsequently faced a litigation deluge related to the research findings. How should these legal claims be reflected in Dow Corning’s financial statements? Should a liability be recognized for potential costs of fighting the claims? Should a liability be created for the potential cost of any settlement? If so, should the liability be reported on a discounted or undiscounted basis? Or is there no basis for recording any liability? Dow Corning can certainly argue that any estimate of liability could be viewed as an admission of guilt and thereby prejudice its case. However, from the perspective of financial statement users, the uncertainty surrounding the firm’s legal status is critical to valuing the firm, and potentially to assessing the performance of its management. The accounting rules for these types of contingencies are covered in the U.S. by SFAS 5. Under this standard, a firm is required to accrue a loss if it is probable that a liability has been incurred and the amount can be reasonably estimated. The standard argues that if a range of estimates is available, the best estimate within this range should be reported as a liability. If there is no best estimate, the minimum estimate should be reported. The FASB recognized that the most difficult issue that arose in reporting con- 171 172 Liability and Equity Analysis Liability and Equity Analysis tingencies was for litigation. It resolved that in most cases such events are reflected only in the footnotes. Between 1988 and 1993, Dow Corning provided no liability for the litigation, although it recognized that monetary damages claimed in the cases might be substantial. In September 1993, the company announced that it had reached an agreement with representatives of the plaintiffs and with other defendants for a settlement of up to $4.75 billion to be paid out over a period of 30 years. As a result, in January 1994, a charge of $640 million (before tax) was taken for the fourth quarter of 1993. A further pretax charge of $221 million for the fourth quarter of 1994 was announced in January 1995. These charges included Dow Corning’s best estimate of its potential liability under the agreement and were determined on a present value basis. In the second quarter of 1995, the company changed the method of accounting for the potential losses from the present value basis to an undiscounted basis. On May 15, 1995, it voluntarily filed for protection under Chapter 11 of the U.S. Bankruptcy Code. Given the delicate nature of litigation, management has a strong incentive to underestimate potential losses. Indeed, this is likely to also be in shareholders’ best interests. However, for important litigation cases, such as those for Dow Corning and for cigarette companies, this implies that investors will have to analyze firms’ effective litigation risks and costs without much guidance from the firm, leading to potential speculation. Challenge Two: Can the obligation be measured? Many liabilities specify the amount and timing of obligations precisely. For example, a twenty-year $100 million bond issue, with an 8 percent coupon payable semi-annually, specifies that the issuer will pay the holders $100 million in twenty years, and will pay out interest of $4 million every six months for the duration of the loan. However, for some liabilities it is difficult to estimate the amount of the obligation. We saw that this can be an issue for accrued restructuring charges and frequent flyer programs. Other examples include environmental liabilities, pension and retirement benefit liabilities, insurance company loss reserves, and warranties. These examples are discussed below. EXAMPLE: ENVIRONMENTAL LIABILITIES. In 1980 the Comprehensive Environ- mental Response, Compensation, and Liability Act (CERCLA) was passed by the U.S. Congress to clean up inactive hazardous waste sites. The legislation authorized the federal government to make those responsible for the improper disposal of hazardous waste at the nation’s worst hazardous waste sites (termed Superfund sites) bear the cost of cleanup. In addition, polluters must pay to restore damaged or lost natural resources at Superfund sites. By December 23, 1996, 1,259 current and proposed Superfund sites had been identified. Estimates of the cost of cleanups at known sites ranged from $34 to $75 billion.1 There are two challenges in estimating the costs of Superfund cleanups. First, responsibility for the damage and cleanup is uncertain. All parties associated with a site, even 5-6 Liability and Equity Analysis 5-7 Part 2 Business Analysis and Valuation Tools those that have contributed only a small amount of low-toxicity waste, are liable for the cost of cleaning it up. Consequently, there are protracted negotiations and legal disputes over the allocation of costs among these parties. Firms involved in these disputes are reluctant to report an estimate of the cost of their share of a Superfund site cleanup, since to do so could affect their negotiations and legal liability. Second, there is considerable uncertainty about the actual costs of cleanup, since prior to a detailed study of the site it is difficult to assess the extent of the damage and the cost of cleanup. Consistent with this concern, research shows that the explanatory power of models to predict the relation between cleanup costs and hazard site characteristics is relatively low.2 As a result of the difficulty in estimating the costs of cleanups, it is unclear when a company responsible for waste cleanup should record a liability for its cost. Should it be when the party is suspected of being responsible for hazardous waste? Should it be when it is named as a responsible party for a particular site cleanup? Should it occur when a study has been conducted to estimate the cleanup costs? Or, should it be when a settlement has been reached with other liable parties for the cost of the cleanup? The difficulties in assessing legal liability for cleanup are illustrated by the case of Hanson Plc, a U.K. building materials firm that was formed from the breakup of the Hanson conglomerate. In 1991 Hanson acquired the U.S. firm Beazer, a homebuilding firm. Prior to its acquisition by Hanson, Beazer had owned and then sold a chemical company, Koppers, which had been prosecuted by the Environmental Protection Agency (EPA) for leaking dangerous chemicals at 119 sites in the U.S. Under U.S. law, Hanson was considered liable for some of the environmental cleanup costs for Koppers’ sites. The cleanup costs were initially thought to be in excess of $2 billion. Hanson, however, disputed the cost effectiveness of the cleanup procedures required by the EPA and its share of these costs relative to its own insurers. In its 1996 annual report, Hanson noted that it had set aside £938 million as a liability to cover the cleanup costs. However, in 1997 the company reported that, based on a third-party appraisal, its estimate could be reduced by £430.3 million. The liability was consequently reduced and an exceptional credit recorded in the profit and loss account. In 1998 Hanson agreed to pay further costs of £168 million, and two insurance companies guaranteed to cover any remaining costs to settle the dispute, up to £488 million. After the agreement, £67 million of the estimated liability was no longer required and was recorded as an unusual credit. Given the challenges in measuring cleanup costs, accounting rules permit firms to delay recording a liability for environmental costs until much of the uncertainty over the cost of cleanup and the firm’s responsibility have been resolved. SFAS 5 and Statement of Position 96-1 require that an obligation be reported when the following conditions hold: 1. 2. 3. 4. A firm has been identified as a potentially responsible party. The firm is participating in a remedial feasibility study. A remedial feasibility study has been completed. A decision has been made as to the method of cleanup and an estimate made of the cleanup cost. 5. The firm has been ordered to clean up a site. 173 174 Liability and Equity Analysis Liability and Equity Analysis Research findings indicate that there is considerable variation in the quality of financial statement disclosures on estimated environmental cleanup liabilities for affected firms. Factors influencing firms’ disclosures include regulatory enforcement, management’s information on allocation uncertainty, litigation and negotiation concerns, and capital market concerns.3 EXAMPLE: PENSION AND OTHER POSTEMPLOYMENT BENEFIT LIABILITIES. Many firms make commitments to employees under defined benefit plans for prespecified pension or retirement benefits at some point in the future. The challenge that arises in reporting on these commitments comes from the difficulty in measuring the benefits provided. For example, consider the September 1996 agreement reached between the Big Three U.S. auto manufacturers and the United Auto Workers union. The agreement provided the following incremental benefits for hourly employees: a. Basic pension benefits were increased by $4.55 ($1.15) a month for every year worked for new (current) retirees. New retirees are employees who retired after September 1996, and current retirees are those who retired before this date. b. New retirees who retired prior to age 62 but had 30 years of service received an $80-a-month increase in pension benefits in 1997, a $160-per-month increase in 1998, and a $265-per-month increase thereafter. Current retirees who had retired prior to 62 but had 30 years of service received an $80-a-month increase in pension benefits. c. Current retirees received two cost-of-living lump sum payments in 1997 and 1998. The amount of the payment depended on the retiree’s years of service and inflation rates for those years. d. Retired employees (new and current) were eligible for up to $1,000 a year in tuition assistance for approved courses through the Retiree Tuition Assistance Plan. What are the economic obligations that GM, Ford, and Chrysler incurred under this pension plan? To estimate the timing and expected pension benefits for current and past employees, the firms have to forecast the life expectancies of current and past employees, as well as the future working lives with the firm and retirement ages of current employees. The present value of these future commitments, net of pension plan assets, represents the economic obligation under the pension plan. The obligation increases over time to reflect the incremental pension earned with years of service, and interest accruing on the liability. The obligation also changes if the firm retroactively changes the benefits to be paid to employees for past service. Finally, the pension obligation decreases as the firm funds its obligation, as plan assets increase in value, and as the firm pays out benefits to retired employees. How does accounting reflect this obligation, given the challenge of making actuarial assumptions about employees’ working lives and retirement decisions? The current rules, discussed in SFAS 87, recognize most of the above effects, but they require firms to amortize changes in the obligations that arise from retroactive changes in pension 5-8 Liability and Equity Analysis 5-9 Part 2 Business Analysis and Valuation Tools benefits (called prior service costs) and from changes in pension asset values over time, rather than recognizing them immediately. As a result, the reported pension liability is likely to be understated. However, current rules also require firms to disclose in the footnotes the full liability, termed the projected benefit obligation, and the fair value of plan assets.4 For example, in its 1996 annual report, Ford reported the projected benefit obligation for U.S. plans at $28.2 billion, and the fair value of the plan s assets at $30.9 billion. In contrast, GM ’s projected benefit obligation was reported at $44.5 billion, and its plan assets had fair values of $40.2 billion. Ford thus had surplus assets in its pension plan, whereas GM showed a shortfall for which the company is ultimately liable. The range of actuarial assumptions, discount rate assumptions, and amortization periods for prior period service costs and gains or losses on plan assets all provide management with an opportunity to exercise discretion in the reporting of pension and postemployment benefit liabilities.5 In addition, accounting rules for these liabilities do not always reflect the full effect of changes in plan obligations and fair values. Both these factors create opportunities for analysis. EXAMPLE: INSURANCE LOSS RESERVES. Insurance companies typically recog- nize revenues before the amount and timing of claims for the period have been fully resolved. As a result, insurance managers have to estimate the expected costs of unreported claims and reported claims where the claim amount has not been settled. Management bases its estimates on data on reported claims and estimates of the costs of settlement, as well as historical data and experience in estimating unreported losses. For example, in its 1995 financial statements, Travelers Property Casualty Corp. estimated that its gross loss reserve was $13.9 billion. The company also reported details on differences between its estimated losses on a yearly basis and subsequent loss realizations for those years. It estimated loss reserves for 1985 claims at $5.5 billion in 1985. In subsequent years, Travelers management steadily revised this estimate upward. In 1986 the estimate was increased to $5.9 billion, in 1990 to $6.9 billion, and in 1995 to $8.5 billion. A similar pattern of under-reserving arose for each of the years 1986 to 1992. The deficiencies amounted to $2.6 billion, $2.3 billion, $2.0 billion, $1.7 billion, $1.2 billion, $0.7 billion, and $0.3 billion for these years. The data for Travelers illustrate how difficult it can be to forecast future claims. The data also show that there are potentially significant opportunities for management to make mistakes in forecasting, and to bias its estimates either for regulatory purposes or for stock market valuation purposes.6 The disclosures of estimates and subsequent revisions of estimates provide analysts with extensive information to evaluate management’s reporting for reserves. However, even with these data, it can be challenging to assess whether systematic under- or overestimates arose from poor management forecasting, unforeseen events, or management bias in reporting. EXAMPLE: WARRANTIES. Many manufacturers provide implicit or explicit product warranties on their products. How should these be reported in the financial statements? 175 176 Liability and Equity Analysis Liability and Equity Analysis Should a liability be created when sales are recognized to reflect an estimate of the costs of returns or repairs? Alternatively, should firms wait until returns actually occur before recognizing the financial implications of the warranty commitment? Accounting rules require that firms that offer warranties establish a liability for probable losses that have been incurred at the financial statement date. Thus, in its 1998 annual report, General Motors reported that it had a $14.6 billion liability for “warranties, dealer and customer allowances, claims and discounts.” Of course, estimating the potential commitment for warranty costs is not an easy task. It should come as no surprise that there are sometimes sizable errors in management’s estimates. For example, on December 21, 1994, Intel, the world’s largest silicon chip manufacturer, bowed to consumer pressure and agreed to replace millions of Pentium chips that contained a flaw in long-division calculations requiring maximum precision. The recall was the largest in computer history. Intel announced that it would replace all the chips without question, and gave users the option of requesting a replacement chip to fit into their own computers or having the work done by a dealer. Since no prior liability had been created to allow for any such possibility, Intel created a $475 million liability at the end of the fourth quarter. This liability covered replacement costs, replacement material, and inventory write-down related to the division problem. It is interesting to note that Intel still has not created a liability for other possible losses from explicit or implicit warranties on their products. Key Analysis Questions Given the role of management judgment in assessing whether a firm has incurred an obligation that can be measured with reasonable certainty, there is ample opportunity for analysts to question whether there are significant liabilities that are not reported on the balance sheet. Specific questions can include the following: • What potential obligations are not included on the balance sheet? What factors explain these omissions? Does the firm adopt a business strategy that gives rise to off-balance-sheet financing? Does management appear to be using off-balance-sheet financing to improve the balance sheet’s appearance? If so, what factors underlie this decision? • Are any off-balance-sheet liabilities likely to be significant in terms of evaluating the firm’s effective leverage and financing risks, either relative to its own historical standard or relative to the norms of other firms in the industry? If so, is it possible to make an estimate of their effect? • Does the firm report liabilities where the amount and timing of the obligations are based largely on management judgment? If so, what are the key management assumptions? 5-10 Liability and Equity Analysis 5-11 Part 2 Business Analysis and Valuation Tools • If liability values are dependent on management assumptions or forecasts, is management likely to have information about these parameters that is superior to that of analysts? If so, what is management’s track record in prior years’ forecasts? Has management systematically made optimistic or pessimistic forecasts? • If liability values are dependent on management assumptions or forecasts, are analysts likely to be as informed on these parameters as management? For example, management is unlikely to have any superior insight about market interest rates. In such cases, are management’s estimates consistent with those of experts in the market? Challenge Three: Changes in the Value of Liabilities Fixed-rate liabilities are subject to changes in fair values as interest rates change. Rates can change, either because of market-wide fluctuations or because of firm-specific rate fluctuations attributable to changes in the market assessment of risks borne by debt owners. How are such changes in value reflected in the financial statements? Does the firm report liabilities at their historical cost, or mark them up or down to fair values? We examine the reporting for troubled debt to illustrate the issues in reporting for changes in liability values. EXAMPLE: TROUBLED DEBT. On January 15, 1996, Muscocho Explorations Ltd., Flanagan McAdam Resources, and McNellen Resources Inc., three Canadian gold mining companies, signed an agreement with their principal secured creditor, Canadian Imperial Bank, to restructure the CA$8.95 million secured debt the three companies owed the bank. Under the agreement, Canadian Imperial received proceeds from the sale of the Magnacon Mill as well as a $500,000 payment for the Magino Mill. The bank agreed to convert its remaining debt to 10 percent of the equity in a new company created by combining Muscocho, Flanagan, and McNellen. The companies’’ other major secured creditor, Echo Bay Mines Ltd., also agreed on similar terms to convert the CA$4.46 million owed by Flanagan and McNellen. What are the economic effects of a debt restructuring? A troubled debt restructuring arises when a firm’s assets and cash flow generation decline. Most of this decline in asset values is borne by the shareholders. However, the creditors can also suffer a loss if there is an increase in the likelihood that the firm will be unable to meet debt principal and interest obligations. The creditors then have to decide whether to make concessions to the firm by exchanging their current claims for new claims, or to force the firm into bankruptcy. How would the above events be reported in the firm’s financial statements? Impairments in asset values should have been recorded as asset write-downs, with accompanying disclosures about the reasons for impairment and management’s future plans. 177 178 Liability and Equity Analysis Liability and Equity Analysis Further, under SFAS 107, U.S. firms would continue to show liabilities at their historical cost, but would disclose the fair value of interest-bearing debt instruments in a footnote. It is worth noting that fair value estimates of debt are likely to be imprecise when a firm is in financial distress. This occurs because the debt claim can be converted into equity if the firm defaults. As discussed below, equity claims are more complex to value since they are residual claims on the firm’s cash flows, rather than fixed commitments. How would the troubled debt restructuring itself be recorded? Under SFAS 15, there would be no change in the valuation of the debt until a formal restructuring takes place. If such an agreement provides for the debt to be retired in exchange for assets, as is the case for Muscocho, Flanagan, and McNellen, an extraordinary gain is recognized to reflect the difference between the book value of the debt and the fair value of the assets. This transaction may require the firm to initially revalue the assets involved to their fair values, recording a gain or loss as ordinary income. Alternatively, as discussed in SFAS 118, if the terms of the debt are modified (by changing the interest rate or principal, or by extending the payment dates), no gain is recorded. Instead, the implied interest rate on the modified debt is computed to equate the present value of the modified and original payments. The debt continues to be reported at its book value, and the new interest rate is used to compute the revised interest expense. The above method of reporting for a troubled debt restructuring indicates that investors potentially have access to relevant information about declines in asset and debt values prior to the actual restructuring. However, management has considerable opportunity to bias this information by delaying reporting losses for asset impairments, or by misestimating the fair values of assets at a debt restructuring. Key Analysis Questions As noted above, both debt and equity investors are interested in changes in the fair value of liabilities. Current reporting rules require U.S. firms to report these values and to estimate the consequences of changes in value for restructured debt instruments. However, these rules create opportunities for management to use judgment in reporting these effects. This raises several opportunities for analysts: • Has the fair value of debt declined? If so, what factors prompted this decline? Have interest rates in the economy increased since the debt was issued at a fixed rate? Or have the firm’s assets and future cash flows become riskier, increasing the risk faced by creditors? If the latter, has the firm written down the value of impaired assets? • Has the fair value of debt increased? If so, is the change due to decreases in interest rates or to a change in the firm’s business? • If debt has become riskier, how reliable are the management estimates of the debt’s value? • If the firm’s debt value has increased, does it appear to be in financial difficulty? 5-12 Liability and Equity Analysis 5-13 Part 2 Business Analysis and Valuation Tools COMMON MISCONCEPTIONS ABOUT LIABILITY ACCOUNTING The above discussion of accounting for liabilities reveals a number of popular misconceptions about the nature of accounting for liabilities. 1. It’s prudent to provide for a rainy day. Some firms take the approach that it pays to be conservative in financial reporting and to set aside as much as possible for contingencies. This logic is commonly used to justify large loss reserves for insurance companies, for merger expenses, and for restructuring charges. This argument presumes that investors are not able to see through current overestimates and will give the firm credit for its performance when it reverses these charges. From the standpoint of a financial statement user, it is important to recognize that conservative accounting is not the same as “good” accounting. Financial statement users want to evaluate how well a firm’s accounting captures business reality in an unbiased manner, and conservative accounting can be as misleading as aggressive accounting in this respect. Further, conservative accounting often provides managers with opportunities for “income smoothing,” which may prevent analysts from recognizing poor performance in a timely fashion. Finally, over time, investors are likely to figure out which firms are conservative and may discount their management’s disclosures and communications. 2. Off-balance-sheet financing is preferable to on-balance-sheet financing. Some managers appear to believe that off-balance-sheet financing is preferable to financing on the balance sheet because unsophisticated financial statement users are then likely to underestimate the firm’s true leverage. Once again, this view is predicated on investors being financially naïve. There may be good reasons for using types of debt arrangements that are off-balance-sheet. For example, operating leases tend to reduce the risks of ownership of assets, which may be important for firms that want to be able to quickly upgrade to the latest technology. However, it seems unlikely that investors will continuously be fooled by off-balance-sheet liabilities, particularly given the increased importance of well-trained institutional investors in the market. Further, there is a risk that once they have discovered the firm’s attempts to mislead them, investors will be wary of subsequent management reports. EQUITY DEFINITION AND REPORTING CHALLENGES As noted earlier, it is difficult to specify the payoffs attributable to stockholders, which in turn makes it difficult to value equity. Accountants therefore treat equity as a residual claim, whose value is defined exclusively by the values assigned to assets and liabilities. 179 180 Liability and Equity Analysis Liability and Equity Analysis Consequently, the challenges discussed for valuing assets and liabilities also apply to equity valuation. In addition, there are two reporting challenges that are specific to equity: the reporting for hybrid securities, and the allocation of equity values between reserves, capital, and retained earnings. Challenge One: Hybrid Securities On August 11, 1998, Helix Hearing Care of America Corp., a Montreal-based hearing aid chain, sold $2 million of convertible debentures. The debentures had a five-year term and a 13 percent coupon rate and were convertible into Helix common shares at CA$1.70. Is this security a debt instrument or an equity claim? This question is further complicated by the fact that the likelihood that the claim will be converted to equity changes over time as Helix’s stock price increases and decreases. Convertible debt is a hybrid security. Typically it commands a lower rate of interest than a straight debenture, since the seller also receives the option to convert the debt into common shares. The value of the conversion right depends on the conversion price, the firm’s current stock price, the government bond rate, and the estimated variance of the firm’s stock returns. A good case can be made for separating the debt and equity components of a convertible issue, since the value of each can be separately estimated. The value of the debt claim will vary over time with interest rates. The value of the option will vary with the firm’s stock price. However, accounting rules do not recognize any value attached to the conversion right. The convertible debenture is therefore reported as if it were nonconvertible debt (see APB 14). If the debt converts, it can be recorded using either the book value or market value methods. The book value approach records the exchange at the book value of the convertible debt. No gain or loss is recorded on conversion. The market value method values the equity issued at its market value and records any difference between the market value of the equity and the book value of the convertible debt as an ordinary gain or loss. The accounting rules for hybrid securities are simplifications of the underlying economics. This raises questions about how to compare two firms that use the same effective capital structure, but where one uses hybrid securities and the other does not. Simply looking at the financial statements of the two will not give an accurate reflection of the leverage of each. The firm with the hybrid securities will appear to be more highly leveraged, using book values of debt and equity, because the conversion right is not recorded. Ideally, an analyst would attempt to separate the debt and equity components of hybrid securities to make a more valid comparison of capital structures. Challenge Two: Classification of Unrealized Gains and Losses The second challenge for equity valuation relates to how to allocate certain unrealized gains and losses within the equity segment of the balance sheet. Should these items be included in the income statement and then in retained earnings? Alternatively, should 5-14 Liability and Equity Analysis 5-15 Part 2 Business Analysis and Valuation Tools they be treated as separate non-operating items that can only go through income when they have been realized? As discussed in other chapters on accounting, current accounting rules require some unrealized gains and losses to be charged to a reserve rather than going through the income statement. These include gains and losses on • financial instruments that are available for sale (see Chapter 7), • financial instruments used to hedge uncertain future cash flows (see Chapter 7), and • foreign currency translations for foreign operations whose transactions occur in the local currency rather than in the parent’s currency (see Chapter 4). These types of gains and losses are sometimes referred to as “dirty surplus” charges, since they are not recorded in the income statement. A system where all accounting charges are reflected in income is called “clean surplus” accounting. We will see that this concept is important in subsequent chapters, where we discuss earnings-based valuation models. It is worth noting that changes in equity book values from many of the “dirty surplus” gains and losses are difficult to predict from year to year, since they depend on changes in financial instrument and foreign currency prices, which are themselves difficult to forecast. Consequently, their expected impact in any given year is likely to be zero. How should analysts and users of financial statements view equity changes that are not reported in income? Conceptually, there is no strong economic justification for treating them differently from gains and losses that are included in the income statement. For example, from an analyst’s point of view they are no different from gains and losses on asset sales, realized gains and losses on sales of financial instruments, and unrealized gains and losses on financial instruments intended to be traded, all of which are included in income. The justification for treating all gains and losses comparably is reinforced by the potential concern that management might use reporting judgment to exclude certain types of gains and losses from earnings. Perhaps in response to these concerns, the FASB now requires firms to prepare a statement of comprehensive income, showing all changes in equity, other than capital transactions, in one place (see SFAS 130). Key Analysis Questions Analysis of equity values is largely covered in the earlier discussion of asset and liability analysis. The following questions are unique to equity analysis: • What charges are included in earnings, and what are excluded? How should these charges be viewed? • Does the firm have hybrid securities? If so, is it worthwhile separating their debt and equity components? How has the conversion value changed since their issue? Is it likely that the debt will be converted, making it closer to equity than debt? 181 182 Liability and Equity Analysis Liability and Equity Analysis SUMMARY To recognize a liability, a firm has to have incurred an obligation to provide a future benefit to another entity, and to be able to estimate the value of that obligation with reasonable certainty. Liabilities continue to be recorded at their historical cost on the balance sheet. However, in footnote disclosures, firms are required to report fair value estimates for interest-bearing debt. In future years we may even see balance sheet values based on fair values as accountants become more confident that fair values of liabilities can be estimated reliably. However, valuation of certain types of liabilities can be challenging if there is uncertainty about 1. whether an obligation has been incurred, as is the case for restructuring reserves, frequent flyer programs, and litigation; 2. the value of the obligation, as in the case of environmental liabilities, warranty reserves, insurance loss reserves, and pensions; and 3. changes in values of liabilities, as in the case of a troubled debt restructuring. Managers are likely to have the best information about the extent of the firm’s liabilities. However, they also have incentives to understate the firm’s financial risks, creating opportunities for liability analysis. The other major claimant on the firm’s assets—equity—can be viewed as the residual owner of the firm. Because it represents that portion of the claims on the firm that are most difficult to specify, it cannot be valued as precisely as liabilities. Consequently, financial reporting treats equity as the difference between asset and liability values. The challenges in measuring and reporting for assets and liabilities are therefore also relevant to the valuation of equity. In addition, there are several challenges that are specific to equity reporting, such as the valuation of hybrid securities (e.g., convertible debt) and the classification of certain gains and losses. DISCUSSION QUESTIONS 1. As discussed in the chapter, the following restructuring events were reported by McCormick: a. In October 1994, the company announced plans to lay off 7 percent of its 8,600person staff, close two spice plants, and sell off a money-losing onion-ring operation. A $70.5 million restructuring liability was created for the costs of the restructuring. b. In February 1995, the company reduced the amount of the charge by $3.9 million, which it added to earnings in the first quarter of 1995. c. In 1996 McCormick announced a second restructuring. Most of the costs of the restructuring ($58.1 million) were recognized immediately as a restructuring liability. However, the firm noted that some charges related to costs of moving 5-16 Liability and Equity Analysis 5-17 Part 2 Business Analysis and Valuation Tools 2. 3. 4. 5. equipment and personnel from a closed U.S. packaging plant could not be accrued. These charges (for $1.9 million) were eventually recognized in the fourth quarter of 1998. d. In the third quarter of 1997, McCormick reevaluated its restructuring plans and recorded a restructuring credit of $9.5 million because plans to sell an overseas food brokerage and distribution business were not completed. e. The 1996 restructuring was concluded in the fourth quarter of 1998 and a further restructuring credit of $3.1 million was reported. What are the financial statement effects of these events? As a corporate manager, what forecasts do you have to make to record these events? As a financial analyst, what questions would you raise with the firm’s CFO about the restructuring events? What are the economic costs and benefits to airlines from frequent flyer programs? What information would you need to measure these costs and benefits? As a financial analyst, what questions would you raise with the firm’s CFO about its frequent flyer program? The cigarette industry is subject to litigation for health hazards posed by its products. The industry has been negotiating a settlement of these claims with state and federal governments. As the CFO for Philip Morris, one of the larger firms in the industry, what information would you report to investors in the annual report on the firm’s litigation risks? How would you assess whether the firm should record a liability for this risk, and if so, how would you assess the value of this liability? As a financial analyst following Philip Morris, what questions would you raise with the CEO over the firm’s litigation liability? As discussed in the chapter, Hanson Plc incurred an environmental liability from its 1991 acquisition of the U.S. firm Beazer. In 1997 the company reported that, based on third party appraisal, its estimate could be reduced by £430.3 million. In 1998 Hanson agreed to pay further costs of £168 million, and two insurance companies guaranteed to cover any remaining costs up to £488 million. After the agreement, £67 million of the estimated liability was no longer required and was recorded as an unusual credit. What are the financial statement effects of these events? Hewlett Packard reported the following information on its U.S. retiree medical plan: Key Assumptions Discount rate Expected return on assets Current medical cost trend rate Ultimate medical cost trend rate Year current medical cost trend rate decreases to ultimate rate Effect of a 1% increase in the medical cost trend rate (millions): Increase in benefit obligation Increase in annual retiree medical cost 1998 1997 1996 6.5% 9.0% 8.65% 5.5% 7.0% 9.0% 9.6% 6.0% 7.5% 9.0% 10.0% 6.0% 2007 2007 2007 $116% $17% $101% $15% $90% $13% 183 184 Liability and Equity Analysis Liability and Equity Analysis Funding Status (in millions) 1998 1997 Fair value of plan assets Benefit obligation Plan assets in excess of (less than) benefit obligation Unrecognized net experience (gain) loss Unrecognized prior service cost (benefit) related to plan changes Prepaid (accrued) costs $503 (543) (40) (255) $448 (475) (27) (268) (144) $(439) (154) $(449) What assumption is Hewlett Packard making about medical cost inflation in 2000 and 2010? What is the firm assuming it will earn on plan assets? As a financial analyst, how would you evaluate these assumptions? Are these rates reasonable? In 1998, what is the liability for the medical plan reported on the balance sheet? Is the plan over- or underfunded? What other factors would you consider in evaluating Hewlett Packard’s liability and risk under its medical plan? 6. Acceptance Insurance Companies Inc. underwrites and sells specialty property and casualty insurance. The company is the third largest writer of crop insurance products in the United States. In its 1998 10-K report to the SEC, it discloses the following information on the loss reserves created for claims originating in 1990: Cumulative net liability paid through: One year later Two years later Three years later Four years later Five years later Six years later Seven years later Eight years later Net reserves reestimated as of: One year later Two years later Three years later Four years later Five years later Six years later Seven years later Eight years later Net cumulative redundancy (deficiency) 12/31/90 40.6 70.8 88.5 101.2 107.5 109.7 111.4 111.8 100.3 102.3 107.4 110.7 112.7 112.0 112.5 113.4 –13.4 What was the initial estimate for loss reserves originating in 1990? How has the firm updated its estimate of this obligation over time? What liability remains for 1990 claims? As a financial analyst, what questions would you have for the CFO on its 1990 liability? 5-18 Liability and Equity Analysis 5-19 Part 2 Business Analysis and Valuation Tools 7. At the end of fiscal year 1997, Intel reported that it had set aside a liability of $87.9 million for potential warranty costs. At the end of 1998, Intel increased this estimate to $115.5 million. As a financial analyst, what questions would you ask the firm’s CFO about the warranty liability? 8. As discussed in the chapter, Muscocho Explorations Ltd., Flanagan McAdam Resources, and McNellen Resources Inc. signed an agreement in January 1996 with their principal secured creditor, Canadian Imperial Bank, to restructure the CA$8.95 million secured debt the three companies owed the bank. Under the agreement, Canadian Imperial received proceeds from the sale of the Magnacon Mill as well as a $500,000 payment for the Magino Mill. The bank agreed to convert its remaining debt to 10 percent of the equity in a new company created by combining Muscocho, Flanagan, and McNellen. What information would you need to record the effects of this transaction in the books of the new combined firm? What financial statement effects of the transaction can you quantify? As a financial analyst, what questions would you ask management of the new firm about the debt restructuring? 9. As discussed in the chapter, on August 11, 1998, Helix Hearing Care of America Corp. sold $2 million of convertible debentures. The debentures had a five-year term and a 13 percent coupon rate and were convertible into Helix common shares at CA$1.70. If Helix’s common stock were valued at $2.50 at conversion, what would be the financial statement effects of conversion under (a) the book value method and (b) the market value method? Which method do you consider best reflects the economics of the conversion? Why? 10. For the first quarter of 1998, Microsoft reported the following reconciliation between net income and comprehensive income: Three Months Ended September 30 (millions of dollars): 1997 1998 Net income Net unrealized investment gains Translation adjustments and other Comprehensive income $663 56 (117) 602 1,683 150 43 1,876 What types of events give rise to the adjustments made by Microsoft? As a financial analyst, what questions would you have for the CFO about the comprehensive income statement? NOTES 1. See Milton Russell and Kimberly L Davis. “Resource Requirements for NPL Sites: Phase II Interim Report,” Knoxville, JIEE, September 1995; and U.S. Congress Budget Office, “The Total Costs of Cleaning Up Nonfederal Superfund Sites,” Washington, D.C., U.S. GPO, 1994. 185 186 Liability and Equity Analysis Liability and Equity Analysis 2. See Mary E. Barth and Maureen McNichols, 1994, “Estimation and Market Valuation of Environmental Liabilities Relating to Superfund Sites,” Journal of Accounting Research 32, Supplement. 3. See Mary E. Barth, Maureen F. McNichols, and G. Peter Wilson, 1997, “Factors Influencing Firms’ Disclosures about Environmental Liabilities,” Review of Accounting Studies 2, (1): 35–64. 4. M. Barth, “Relative Measurement Errors Among Alternative Pension Asset and Liability Measures,” The Accounting Review 66, No. 3, 1991, finds that investors regard these footnote disclosures to be more useful than the liability reported in the financial statements. 5. E. Amir and E. Gordon, “A Firm’s Choice of Estimation Parameters: Empirical Evidence from SFAS No. 106,” Journal of Accounting, Auditing & Finance 11, No. 3, Summer 1996, show that firms with larger postretirement benefit obligations and more leverage tend to make more aggressive estimates of postretirement obligation parameters. 6. Research by K. Petroni, “Optimistic Reporting in the Property Casualty Insurance Industry,” Journal of Accounting and Economics 15, 1992; K. Petroni, S. Ryan, and J. Wahlen, “Discretionary and Non-discretionary Revisions of Loss Reserves by Property-Casualty Insurers: Differential Implications for Future Profitability, Risk, and Market Value,” working paper, Indiana University; and R. Adiel, “Reinsurance and the Management of Regulatory Ratios and Taxes in the Property-Casualty Insurance Industry, Journal of Accounting and Economics 22, Nos. 1–3, 1996, shows that financially weak property-casualty insurers that risk regulatory attention understate claim loss reserves and engage in reinsurance transactions. 5-20 Manufactured Homes, Inc. T his Winston-Salem company sells affordable Southern comfort: fully furnished and carpeted mobile homes for as little as $10,000. Robert Sauls, the 59-year-old founder and chairman, was an orphaned boy who never finished high school. Through acquisitions, Sauls has built the retailer into the industry’s largest, with annual sales ballooning to about $180 million in four years. The company sells the homes, built primarily by Fleetwood Enterprises and Redman Industries, to rural blue-collar workers in the Southeast. “Our people buy in good times and bad,” says Sauls. If he can raise the capital, he foresees a doubling of sales in four to five years. The stock recently sold at 6.5 times estimated 1988 earnings. Jane Edwards, Director of Research at a small Boston-based investment management firm specializing in growth stocks, noted the above review of Manufactured Homes in the February 15, 1988 issue of Fortune magazine’s Companies To Watch column. She knew that attractive growth stocks are hard to find and wondered whether Manufactured Homes would be a good addition to her firm’s growth stock portfolio. She checked the recent performance of Manufactured Homes’ common stock and noted that the stock performed favorably relative to the stock market (see Exhibit 1). Jane Edwards asked her assistant Peter Herman to gather additional information on the company and to write a report analyzing the company’s recent financial statements. Business Analysis 2 and Valuation Tools 5 Liability and Equity Analysis Manufactured Homes COMPANY BACKGROUND AND MARKETING FOCUS Herman’s preliminary research on Manufactured Homes indicated that the company was founded in 1975 with two retail outlets for mobile homes. The company grew rapidly and by March 31, 1987, had a network of 120 retail outlets located in seven southeastern states. Eighty-five percent of the company’s retail centers were located in North Carolina, South Carolina, Alabama, Georgia, and Florida, with the remaining sales centers in Virginia and West Virginia. The company went public in 1983 and was listed on the American Stock Exchange in January 1987. The southeastern U.S. was the country’s fastest growing market for mobile homes due to suitable climate, the easy availability of vacant land for mobile-home parks, and ......................................................................................................................... Professor Krishna G. Palepu prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright  1989 by the President and Fellows of Harvard College. Harvard Business School case 9-190-090. 187 Liability and Equity Analysis Liability and Equity Analysis the region’s demographics. Potential customers for manufactured homes included individuals seeking a single-family primary residence but lacking the ability to purchase conventional housing, retirees, and those wanting a second home for vacation purposes. The company targeted individuals in the low income category, which was a segment of the manufactured homes market in the company’s seven-state operating area. The company’s customers were typically between the ages of 18 and 40, blue-collar workers in manufacturing, service, and agricultural industries, and earned approximately $20,000 per year. Many of them were seeking single-family accommodations for their families and turned to manufactured homes because conventional low-cost housing was becoming increasingly less affordable. Manufactured homes came in a wide variety of styles, including both single and multi-sectional units. They typically had a living room, a kitchen and dining area, and bedrooms and baths, with a wide variety in the size, number and layout of rooms among the various models. The single-sectional homes ranged in size from 588 to 1008 square feet and retailed at prices between $10,000 and $25,000, with the majority selling below $17,000. The multi-sectional homes were 960–2016 square feet and sold at prices ranging from $17,000 to $40,000. Single-sectional homes represented most of the company’s sales. While approximately 30 percent of all unit sales in the industry in 1986 were multi-sectional homes, they represented only about 20 percent of Manufactured Homes’ unit volume. The company believed that its focus on the lower end of the market had two advantages. First, since its customers were seeking to fulfill an essential housing need, sales were less affected by changes in general economic conditions. Second, the company’s repossession rates were significantly lower than those of the industry since its customers were likely to work very hard to keep their primary residences even when times were bad. REVENUES Most of Manufactured Homes’ sales were credit sales where the customer paid a down payment of 5 to 10 percent of the sales price and entered into an installment sales contract with the company to pay the remaining amount over periods ranging from 84 to 180 months. The company generally sold the majority of its retail installment contracts to unrelated financial institutions on a recourse basis. Under this agreement, Manufactured Homes was responsible for payments to the financial institution if the customer failed to make the payments specified in the installment contract. While the installment sale interest rate that Manufactured Homes charged its customers was limited by competitive conditions, it was typically higher than market interest rates. Therefore, the financial institutions to whom these contracts were sold on a recourse basis usually paid the company the stated principal amount of the contract and a portion of the differential between the stated interest rate and the market rate. (The remainder of the interest rate differential was retained by the financial institutions as a se- 5-22 Manufactured Homes 188 Liability and Equity Analysis Manufactured Homes 5-23 Part 2 Business Analysis and Valuation Tools curity against credit losses and was paid to the company in proportion to customer payments received. The reserve required varied up to seven percent of the aggregate amount financed, including principal and interest.) The company therefore had two sources of revenue: the sale of homes (sales revenue), and the interest rate “spread” (finance participation income). Peter Herman noted that Financial Accounting Board’s Statement 77 (FASB-77) governs the accounting treatment for installment sales receivables that are transferred by a company to a third party on a recourse basis. Transfers of receivables that are subject to recourse must be reported as sales if the following three conditions are satisfied: 1. The seller unequivocally surrenders the receivable to the buyer. 2. The seller’s remaining obligations to the buyer under the recourse provision must be subject to reasonable estimation on the date of the transfer of the receivable. For this purpose, the seller should be able to estimate: (a) The amount of bad debts and related costs of collection and repossession, and (b) The amount of prepayments. If the seller cannot make these estimates reasonably well, a transfer of the receivable cannot be reported as a sale. 3. The seller cannot be required to repurchase the receivable from the buyer except in accordance with the recourse provision. If any of the above conditions is not satisfied, the seller of the receivable must report the proceeds from the transfer as a loan against the receivable. FINANCIAL PERFORMANCE Manufactured Homes’ revenues increased rapidly in recent years, from $11 million in 1983 to $120 million in 1986. In the company’s 1986 annual report, Robert Sauls, the CEO, forecasted the company’s growth to continue and expected the 1987 revenues to be $140–$145 million. Herman noted that the company’s sales for the first nine months of 1987 exceeded this forecast. The company’s latest 10-Q statement reported $148 million revenues for the nine months ended September 30, 1987. Based on the performance in the first nine months of 1987, the Value Line Investment Survey forecasted that Manufactured Homes would achieve $180 million revenues and $6 million net income (or $1.65 per share) in 1987, and $210 million revenues and $7.5 million net income (or $2.00 per share) in 1988. Value Line commented on the company’s near term prospects as follows:1 We look forward for [per] share net [income] to advance 20% in 1988, despite a difficult selling environment. Industrywide shipments for the company’s core Carolina markets were down in the December quarter and are likely to remain soft ......................................................................................................................... 1. Reprinted with permission from Value Line Investment Survey, February 26, 1988. 189 Liability and Equity Analysis Liability and Equity Analysis in the year ahead. We think, however, that Manufactured Homes will nevertheless find growth opportunities. True, the number of retail centers probably won’t increase much this year. On the other hand, the rapid expansion of retail centers over the past five years has put in place a large number of dealerships that have plenty of opportunity for increasing volume. Management is seeking to average 100 units per store as these sales locations mature. At the end of 1986, stores were selling 47 units per year on average, and that figure rose 20% for the first nine months of 1987. Although the market will be very competitive this year, we think the company’s special attention to the low-end of the market, to which many large competitors pay less attention, will give Manufactured Homes a solid niche position. Adding in the reduced tax rate, we think full year [per] share net [income] may well reach the $2.00 mark. Volume buying gives this retailer an edge. Because Manufactured Homes buys in bulk, it can negotiate lower prices from the manufacturers it deals with. And by passing the savings on to customers, the company is able to underprice smaller, “mom and pop” outlets. Furthermore, because of its size, the company is able to more efficiently handle inventory financing and mortgage assistance for its customers. Before making a final recommendation to Edwards, Herman wanted to take a detailed look at Manufactured Homes’ financial statements for the fiscal year 1986 (Exhibit 2) and the interim statements for the first nine months of 1987 (Exhibit 3). QUESTIONS 1. Identify the accounting policies of Manufactured Homes which have the most significant impact on the company’s financial statements. What are the key assumptions behind these policies? Do you think that these assumptions are justified? 2. Evaluate the company’s financial and operating performance during 1986 and the first nine months of 1987. 3. Given the company’s business strategy, accounting policies, and recent performance, what is your assessment of its current condition and future potential? 5-24 Manufactured Homes 190 Liability and Equity Analysis 5-25 Part 2 Business Analysis and Valuation Tools EXHIBIT 1 Performance of Manufactured Homes’ Common Stock and S&P 500 Stock Index Relative to Their Levels on January 2, 1987 Performance of Manufactured Homes’ Common Stock and S&P 500 Stock Index Manufactured Homes 250 200 150 100 50 1/1 2/1 3/1 4/1 5/1 6/1 1987 7/1 8/1 9/1 Manufactured Homes Common Stock Manufactured Homes’ Stock Price January 2, 1987 March 1, 1988 Value Line estimated β $ 9.000 14.875 1.05 10/1 11/1 12/1 S&P 500 Stock Index S&P 500 246.45 267.82 1.0 1/1 2/1 1988 3/1 191 Liability and Equity Analysis Liability and Equity Analysis 5-26 EXHIBIT 2 Manufactured Homes, Annual Report for the Year Ended December 31, 1986 Chairman’s Letter to Stockholders The year 1986 was a period of significant accomplishment for your company which served to strengthen our leadership position in the manufactured homes industry. The results achieved were the culmination of a corporate development plan set in motion years ago. For the fourth consecutive year revenues reached record levels, $120 million compared with $80 million in 1985. We are now one of the largest retailers of manufactured, single-family homes in the nation. As part of our long-term efforts to increase market share, we added 39 retail outlets, bringing the total to 114 at year end. We now have retail outlets in seven states that combined represent approximately 40 percent of the total U.S. market for manufactured homes. We continue to be primarily a sales and marketing company with manufacturing and retail financing on a limited basis to support the company’s growth plan. We completed a major financing in April 1986 and a second financing in February 1987, both managed by Wertheim Schroder and Company, that totaled $43 million. A portion of the proceeds was used to pay down variable rate debt associated with inventory financing with fixed rate debt and save money in the process. The remainder of the proceeds is to be used for general corporate purposes. We were pleased at the recognition we received for the growth we have achieved over the last four years as both Business Week and INC. Magazine included our company in their lists of the fastest growing companies in America. Some describe our growth as explosive. We, however, consider these accomplishments a direct result of a well-structured and carefully executed corporate development plan. Our plans for growth are founded on the basic premise that expansion not exceed our ability to manage our affairs. From $11 million in revenues in 1983 and a position of near obscurity in the industry, our progress has led us to a position of leadership in the industry. While we are extremely pleased with our revenue performance, we are also mindful that we must operate profitably. Net earnings per share for 1986 were only 53 cents. The sharp decline in 1986 earnings is directly related to a fourth quarter net loss of $1,347,642. Charges against earnings in the fourth quarter for losses on credit sales and other charges totaling more than three million dollars, coupled with the cost of strengthening your company’s position in the marketplace, created a temporary setback in earnings while establishing a basis for a strong 1987. A strategic plan can only be confirmed as correct when tested by adversity; and last year was something of an acid test for our industry. During 1986, many retailers, in hopes of gaining greater market share, or in some cases hoping for survival, engaged in excessive price cutting. In addition, financial institutions in response to concern over the economy in some geographic areas tightened their policies. We not only dealt with the problems that confronted us but turned some into opportunities. Over the years management has made it a practice to monitor the various retailers of the manufactured homes in our operating area. First, we wanted to understand our competition; and second, we were looking for acquisition candidates. From a large list of companies, we singled out those that best met our standards of performance. We wanted only those firms with superior management and sales teams. We were able to acquire two of these firms on favorable terms and left management in place. As a result we succeeded in not only enlarging our market penetration in our traditional states of North Carolina, South Carolina, Georgia, Florida and Alabama, but were able to enter new markets with nine retail outlets in Virginia and West Virginia and six additional outlets in Alabama. Our independent dealer network continues to grow, and now numbers 26 in five states. The independent dealer program offers important advantages and opportunities. Because of the advantages we bring Manufactured Homes 192 Liability and Equity Analysis 5-27 Part 2 Business Analysis and Valuation Tools Manufactured Homes to these small dealers, we continue to receive more requests to join our team. During the last half of 1986 we sacrificed short-term results to increase market share. We attained that share and as expected it cost us dearly. Selling, general and administrative expense increased from an average of $4.5 million in the first and second quarters to $6 million in the third quarter and to $8 million in the fourth quarter. As we look to 1987, it is with the knowledge that we are working from a solid foundation. Our financial position is strong. Our debt service requirements are manageable without impairing future earnings performance. Our retail network continues to mature, and sales by location will increase. Our goal in 1987 is to maintain our market share and show a substantial increase in profit margins. Your Board of Directors has shown confidence in our ability to perform by authorizing me to give you a conservative estimate of our 1987 revenues. Our first quarter revenues are expected to be $32 million with earnings per share of 24 cents. If current economic conditions continue, we expect 1987 revenues to be $140-145 million. The expected significant increase in margins should make this a great year. I am grateful for the confidence and support of our employees, financial institutions, suppliers and customers; and to you, our shareholders, I would like to say a special “Thanks!” Robert M. Sauls Chairman of the Board, President and Chief Executive Officer Operating Philosophy We are convinced that a company is no better than the people selected to manage its affairs. Quality of product and service are vital to any successful enterprise; but again without quality managers and line employees, the business will not succeed. Manufactured Homes has consistently sought and employed only the highest quality individuals at every level within the organization. It is our practice to provide our employees, at all levels with suitable working conditions and remunera- tion. We ask only that they perform to the highest level of ability and be innovative in terms of how we can best operate our business. We believe that the results of the past four years speak for themselves in terms of the invaluable contributions made by our management team and employees. Industry Profile The manufactured homes industry is fragmented. At this time there are approximately 10,000 manufactured home retailers throughout the nation, most of which fall into the category of “mom and pop” operations. The industry is presently undergoing a period of transition and consolidation. More and more of the smaller firms, lacking volume buying power and adequate capitalization, are disappearing or becoming a part of a larger company like Manufactured Homes. The industry has always been competitive but has become more so in recent years. The continuing increases in the average price of conventional housing have forced low income families to seek other alternatives. And more and more are turning to manufactured homes, which have much more to offer than an apartment with the added advantage of equal to lower monthly payments. In the past, the manufactured home industry suffered from consumer misconceptions created in large part by the use of the term “mobile home.” While manufactured homes can be transported from place to place, only five percent are ever relocated once in place. In addition, 60 percent of all homes sold are placed on private property. Furthermore, the features offered in today’s homes are equal to that found in conventional housing but at far less cost. Industry estimates indicate there are 12 million people living in 6 million manufactured homes. Because of the quality and price advantage, this number is expected to increase on a year-to-year basis for the foreseeable future. As competition for market share increases, companies like Manufactured Homes will benefit if for no other reason than the financial advantages volume buying affords. This is the primary reason so many 193 Liability and Equity Analysis Liability and Equity Analysis independent dealers are actively seeking a working relationship with our company. The same can be said of those companies willing to be acquired. Retail Operations During 1986 we sold 6,239 new and used homes, a 61 percent increase over the previous year. These sales generated $113 million in revenues or 46 percent above the previous year. With our enlarged retail network in place, we anticipate that sales will again reach record levels in 1987. The potential market for manufactured homes includes individuals seeking a single-family residence, but lacking the ability to purchase conventional housing. In addition, these homes are sold to retirees and those wanting a second home for vacation purposes. The latter two groups are increasing in great numbers as our population grows older. However, for our company we have concentrated on a single portion of the marketplace, those individuals in the low income category. This market segment is in great numbers in our seven-state operating area as well as other parts of the nation. Manufactured Homes had its beginning 11 years ago in Winston-Salem, North Carolina. We began with one retail outlet. Our initial growth took place in North Carolina and eventually South Carolina. These two states accounted for 90 percent of sales in 1985. To continue to market only in these two states eventually could have resulted in corporate stagnation. In 1983, the year we became a publiclyheld company, we began to formulate what might be best termed as a geographic expansion plan. The real question was, in which states could we operate most effectively and profitably. Our initial planning went beyond the southeastern states, which remain the largest single regional source of manufactured home sales. We looked at a number of states including Texas which, at the time, was the number one state in manufactured home sales. After careful evaluation, we concluded that our interests and those of our stockholders would best be served in the southeastern portion of the United States. Texas was the most tempting, but it was obvious to management that the reward was not worth the risk; and as time has proven, Texas 5-28 has become a graveyard for many manufactured home retail companies. Like many other retail businesses, presence in the marketplace is critical. After determining to concentrate in the seven states management selected, North Carolina, South Carolina, Georgia, Alabama, Florida, Virginia and West Virginia, we moved aggressively to open new retail outlets and acquire others. In 1983, we had 13 retail outlets; in 1984, the number was 32 and as of March 31, 1987 it’s 120. One of the major keys to success for our company is the insistence that our retail people listen to the customers in terms of interior design and features. When we sense a major trend developing, we go to our suppliers seeking what eventually becomes an entire new line of homes. We also provide important incentives for our retail managers and sales force. Our base salaries are among the finest in the industry, and we add to that a bonus incentive plan tied directly to margin performance. When times require, we can deal with competitive pricing, but our goal is to maximize sales without sacrificing margins. Manufacturing We acquired a manufacturing facility but not as a means of competing with the major manufacturers. In fact, last year we were the largest single retailer of Fleetwood and Redman homes, two of the nation’s largest builders of manufactured homes. We acquired the facility to safeguard the company during periods when demand for homes outpaced supply. It also provides the opportunity to manufacture especially designed homes in smaller numbers, thereby eliminating the major commitment that would be required by unaffiliated suppliers. The firm we acquired was Craftsman Homes, and we continue to manufacture under this brand name. When we acquired the company in 1985, it was producing one home per day. That operation is now producing ten floors per day. Large numbers of our customers have been asking for more entertainment features in the home. With our manufacturing capabilities, we have responded with a home we call the Entertainment Center, and sales have been most rewarding. Manufactured Homes 194 Liability and Equity Analysis 5-29 Part 2 Business Analysis and Valuation Tools We have no immediate need nor intention to enlarge this facility. As it stands, manufacturing can make important contributions, but we can also put this operation on hold without damage to either revenues or earnings. Manufactured Homes Financial Considerations Believing that interest rates will eventually return to the double digit range, we have been successful in replacing our variable rate debt with fixed rate debt. In April 1986, we completed an $18 million private placement of 9% convertible subordinated notes, due 2001. The notes are convertible into common stock at $17.50 per share. The notes were purchased by Prudential Insurance Company of America and Equity-Linked Investors. In February 1987, we completed a private placement of $25 million of unsecured senior notes in two series. Series A notes, due 1990, were issued in the amount of $15 million at an interest rate of 8.64%. Series B notes, due 1992, were issued in the amount of $10 million at an interest rate of 9.42%. The entire placement was managed by Wertheim Schroder and Co. and purchased by Prudential Insurance Company of America, and we are gratified with the trust they have placed in the future of Manufactured Homes. There are four key elements that bear on our financial performance related to the sale of homes. These elements are repossessions, recourse financing, loan losses and finance participation. In almost all cases mortgages executed by the Company are sold to financial institutions. At this moment all of the elements mentioned come into play. The recourse financing provision requires that the Company reassume ownership of the home when the buyer becomes in default of mortgage payments. We knew this when the company was started 11 years ago, and the actions required to deal with this situation are a part of each year’s operating plan. The possibility of repossessions is another reason for selecting the low income segment of the marketplace. Families in this category will make extreme sacrifices to save their homes. We experience one of the lowest repossession rates in the industry. Of the homes returned, we move quickly to renovate and refurbish them and have them resold, normally within 60 to 90 days, at a price equal to or greater than the loan payoff. We also make provisions for those instances when loan losses do occur. Based on our historical experience, we now maintain a financial reserve equal to 1.7 percent of total net contingent liability for credit sales. Our annual loan loss provisions have consistently exceeded actual losses by more than 20 percent, even though homes which have been sold for four or more years are seldom repossessed. Finance participation is an important source of income for the Company. Simply, funds derived from finance participation is the “spread” between the finance charges included in the mortgage agreement initiated by the Company and those required by the financial institution. A portion of the “spread” is paid in cash to the Company and the remainder over the life of the mortgage contract. The portion retained by the financial institution is accounted for by discounting to present value based on the time period, normally 120 to 180 months, required to actually collect the funds. Financial Services Subsidiary Plans for our finance operations, MANH Financial Services Corp., are similar in nature to that for our manufacturing division. The company did not enter this business segment to compete with the financial institutions that have historically provided our mortgage banking requirements. This new entity will be employed primarily to facilitate financing agreements with our banks. Financial Services does have mortgage lending capabilities that will only be employed at those times when our conventional banking arrangements are unable to act on a timely basis. Again, like our manufacturing operations, management has no intention of expanding Financial Services. As it exists now, it provides the Company with the flexibility required to deal quickly with mortgage finance transactions. 195 Liability and Equity Analysis 5-30 Liability and Equity Analysis Selected Financial Data Years Ended December 31, Operating Results: Revenues Earnings (loss) before cumulative effect of change in accounting principle1 Earning (loss) per share Net earnings (loss) Net earnings (loss) per share Financial Position at Year-End: Total assets Long-term debt Stockholders’ equity Working capital 1986 1985 1984 1983 1982 $120,264,954 $79,525,988 $36,195,802 $10,986,036 $7,477,966 2,033,425 .53 2,033,425 .53 3,718,325 .98 3,213,754 .85 2,694,529 .77 2,694,529 .77 536,881 .21 536,881 .21 (59,570) (.03) (59,570) (.03) $81,377,803 18,609,987 14,167,119 15,111,883 $50,944,924 1,082,543 11,052,759 4,820,912 $17,660,984 400,000 7,633,005 4,819,203 $6,836,087 — 4,938,654 3,699,184 $5,025,130 491,280 733,195 (147,124) Quarterly Financial Data (unaudited) Quarter 19862: Revenues Net earnings (loss) Net earnings (loss) per share Average shares and equivalents 1985: Revenues Earnings before cumulative effect of change in accounting principle1 Earnings per share Net earnings Net earnings per share Proforma amounts: Net earnings Net earnings per share Average shares and equivalents First Second Third Fourth Total $23,324,633 641,702 .17 $29,724,418 1,562,205 .40 $33,295,241 1,177,160 .30 $33,920,662 (1,347,642) (.36) $120,264,954 2,033,425 .53 3,850,277 3,944,518 3,922,406 3,733,968 3,864,161 $10,965,457 $22,103,134 $24,083,556 $22,373,841 $ 79,525,988 741,395 .21 236,824 .08 1,312,511 .34 1,312,511 .34 1,112,714 .29 1,112,714 .29 551,705 .14 551,705 .14 3,718,325 .98 3,213,754 .85 741,395 .21 1,312,511 .34 1,112,714 .29 551,705 .14 3,718,325 .98 3,488,968 3,820,016 3,870,857 3,838,486 3,802,693 1 See Note 2 of notes to consolidated financial statements for information regarding a change in accounting principle for finance participation income in 1985. 2 During the fourth quarter of 1986, the Company provided approximately $3,000,000 for losses on credit sales, primarily due to industry conditions, which are causing unusually high costs relating to the repossession of homes. In addition, the Company incurred abnormal costs in the fourth quarter of approximately $300,000 relating primarily to the write-off of previously recognized finance participation income. The aggregate provision for these items amounted to approximately $3,300,000 in the fourth quarter. The Company cannot determine the extent to which these fourth quarter provisions may be applicable to the first, second and third quarter of 1986. Manufactured Homes 196 Liability and Equity Analysis 5-31 Part 2 Business Analysis and Valuation Tools Common Stock Prices and Dividend Information The Company’s common stock is traded on the American Stock Exchange under the symbol MNH. Manufactured Homes 1986 First Second Third Fourth 1985 High Low High Low 15 3/4 16 1/2 15 12 10 12 1/4 9 3/4 8 7/8 8 3/4 13 1/4 15 3/8 14 4 3/8 8 1/4 10 1/2 8 3/4 The Company has never paid a cash dividend and does not intend to for the foreseeable future. The weighted average number of shares outstanding for 1986 was 3,660,048 shares, for 1985 and 1984, 3,488,968 shares, for 1983, 2,588,518 shares and for 1982, 2,100,000 shares. The approximate number of stockholders at March 1987 was 2,000. MANAGEMENT DISCUSSION AND ANALYSIS Results of Operations 1986 Versus 1985 The Company’s net sales in 1986 were $106,095,667 compared with $68,674,779 in 1985, an increase of $37,420,888 or 54%. The Company’s program of managed sales growth resulted in greater penetration due to: An increase of 44% in the number of company-owned and operated sales centers A 100% expansion of the MANH Independent Retailer network A total increase of 52% in sales centers for the year 1986 1985 Increase 92 64 28 22 11 11 114 75 39 The total number of new and used homes sold in 1986 was 6,239, a 61% increase over the 3,866 homes sold in 1985. New home sales for both years were 87% of total home sales. A manufactured home sales center usually experiences a five-year growth and development period. The Manufactured Homes (AMEX Symbol: MNH) sales center should develop a sales production level of at least 100 new homes per year at maturity, although this average annual sales volume can vary widely by geographic location. The Company in 1986 averaged 47 new sales per sales center versus 45 in 1985. The average reflects the rapid expansion of new sales centers. Approximately 47% of the average potential capacity per sales center had been achieved, leaving significant growth potential within the Company’s current sales center network without the need for significantly increasing the number of sales centers. New home sales were 80% single-wides in 1986, as compared with 84% in 1985. This reflects a shift to more double-wides resulting from the acquisition of 197 Liability and Equity Analysis Liability and Equity Analysis two subsidiaries. In addition, a number of our customers are able to purchase double-wide homes since interest rates are lower. However, the primary emphasis of MNH’s marketing plan continues to be towards the less expensive, single-wide home which fits the economic capability of a significant percentage of potential customers within the MNH market area of the five southeastern states, plus Virginia and West Virginia. The average MNH selling price of new homes by Company sales centers for 1986 was $17,300 versus $17,400 in 1985. The gross profit margins were unchanged for 1985. Craftsman Manufactured Homes, Inc., a wholly owned subsidiary of MNH, expanded its production capability from one production line to two. Revenues in 1986 were in excess of $15,746,000 of which $7,489,000 were direct sales to non-affiliated dealers with $8,257,000 being sold to Company sales centers for resale. The Company purchased the manufacturing facility in September 1985. The Craftsman manufacturing subsidiary sold 481 homes directly to dealers not associated with MNH in 1986 as compared with 130 homes in 1985. Repossessions and Early Pay-offs Manufactured housing, as an industry, has been significantly impacted by the slow economic growth of the economy coupled with an extended period of low interest rates. These factors are reflected by a year-to-year decrease in 1986 of 15% in manufactured homes sold throughout the Company’s market area. Lower interest rates have resulted in two noticeable shifts within the housing industry: (1) certain owners may select conventional homes over manufactured homes; and (2) an intensive marketing effort by financial institutions for mortgage refinancing has resulted in many home owners refinancing their mortgages at lower interest rates, which for MNH usually means a mortgage prepayment. The Company’s experience relative to prepayments of home mortgages, until 1986, had been minor. However, late in 1986, prepayments became a recognized concern. Prepayment of mortgages caused management to reevaluate certain assumptions resulting in a significant increase in the reserve for 5-32 credit losses related to mortgage prepayments in order to address the prospects of mortgage interest rates continuing to remain at present levels of 81⁄2 to 91⁄2 percent. Repossessions of homes result primarily from customers’ inability to meet their mortgage payment commitment. Approximately 70% of all MNH credit sales are with recourse, which means the Company will buy back from the financial institution holding a customer’s mortgage those homes repossessed by the mortgage holder which were originally sold by MNH subsidiaries. The Company’s experience related to repossessions has shown very little change during the past ten years. However, during the fourth quarter of 1986, approximately $2,000,000 of repossession expense and interest chargebacks were experienced and charged off. Therefore, a charge to earnings, for both prepayments and repossessions, was made and the reserve for credit losses was increased to $3,000,000 at December 31, 1986. One of the causes of the $2,000,000 charge was the refusal of some unrelated financial institutions to refinance the repossession that occurred in their portfolio, and a second cause was that the Company had to finance them through MANH Financial Services thereby having an immediate charge in finance participation on the pay-off and not recognizing the finance participation income of the resale. During the first three quarters of 1986, the provision for credit losses was approximately 1% of net sales. Due to the recent fourth quarter charges, management will increase the provision for losses for 1987 to 11⁄2% of net sales as a precautionary measure against future repossession and early pay-off. Finance Participation Finance participation was $12,084,108 in 1986 versus $9,715,558 in 1985, a 24.4% increase. As a percentage of net sales, it was 11.4% in 1986 compared with 14.1% in 1985. Several factors caused the percentage of decrease in realized finance participation: (1) increased cash sales; (2) increased non-recourse sales where no finance participation is received; (3) contributions of manufacturing to the sales volume where no finance participation is received; and (4) a decrease in the interest rate Manufactured Homes 198 Liability and Equity Analysis 5-33 Part 2 Business Analysis and Valuation Tools Manufactured Homes spread earned by the Company when the sales contracts are sold to financial institutions. The decreased “spread” was the most important factor in 1986 as two major financial institutions changed their “retail rate” and reduced the “spread” received by the Company by 33%. Finance participation is an important part of the Company’s revenue. This source of revenue is monitored closely and alternative sources of financing are considered for customer mortgage funding on an ongoing basis. Insurance The Company earns commissions for writing homeowner insurance policies at the time of sale of the home and from renewal premiums. Income from insurance sales was $721,758 in 1986 compared with $413,282 in 1985, a 75% increase. Selling, General and Administrative The Company’s selling, general and administrative expense (SG&A) has historically ranged around 17% of revenue. This range varies according to the Company’s growth pattern and marketing emphasis. In 1986, the significant factors affecting the Company’s SG&A expense, which was 19% of revenue, were that: (1) the Company initiated a second production line at its manufacturing plant; (2) acquired two additional subsidiaries — Piggy Bank Homes of Alabama and Jeff Brown Homes in Virginia and West Virginia, in mid-September 1986; (3) initiated two additional operating subsidiaries — AAA Mobile Homes (formerly part of MNH), and MANH Independent Retailers Corp. (formerly spread among several subsidiaries for operational purposes); (4) opened 13 new company sales centers; added 11 independent dealers to the retail network; and (5) formed MANH Financial Services Corp. as of October 1986. This expansion and realignment of subsidiaries, which occurred mostly during the fourth quarter, were part of an overall marketing strategy to more effectively penetrate the Company’s market. The significant increase in sales over 1985 of 54% resulted from staffing an additional 13 companyowned sales centers, with special emphasis on bonus programs to sell aged inventory and homes received in trade for new sales, as well as improving the percentage of homes which were sold with recourse. This aggressive marketing program was designed to achieve momentum for a strong 1987, but increased SG&A expense significantly at the same time. Several other cost factors effecting SG&A expense were: (1) An increase in liability insurance rates on policy renewals during 1986 at an annual rate 40% higher than in 1985, or approximately an additional $350,000; and (2) the cost incurred during the year related to the completion of a 15-month standardization of accounting procedures and data processing enhancement program which centralized the Company’s management information with on-line capability to each subsidiary. This is a significant step forward in better data management and timely preparation of financial information. Interest Expense Interest expense increased $1,543,352 to $3,367,940 in 1986 from $1,824,588 in 1985, or 85%. The increase resulted from a $12,536,000 increase in total inventory and approximately an $8,000,000 increase in total receivables directly related to the expansion of 39 sales centers in 1986. Income Taxes The Company’s effective income tax rate was 49.8% in 1986 compared to 47.2% in 1985. This increase resulted primarily from the elimination of investment tax credits under the Tax Reform Act of 1986. Organization Each of the Company’s nine subsidiaries are profit centers. Each subsidiary has its own chief executive officer with total profit and loss responsibility. The Company’s long-range plan for growth is by strategic acquisitions, expanding market share, and developing management talent through a newly organized salesperson training program, all to meet the need of providing low-cost housing to the American consumer. Manufacturing Craftsman Manufactured Homes, Inc., the MNH manufacturing subsidiary, commenced operations in September 1985. It has grown from virtually a startup operation to a sales volume in excess of $15,000,000 in 1986. Approximately 57% of the 199 Liability and Equity Analysis Liability and Equity Analysis 1,119 homes manufactured were sold to and through Company related sales centers. The balance of the homes were sold to non-related independent retailers. The Craftsman plant operates two production lines with a plant capacity of approximately 3,500 floors (multi-section homes require more than one floor) per year. Financial Services MANH Financial Services Corp. was organized on October 14, 1986 to facilitate the marketing of new, repossessed and pre-owned homes. Two major retail financial sources curtailed the purchase of conditional sales contracts which resulted in slow response to contract applications and therefore lost sales. The Company responded with the formation of MANH Financial Services Corp. to operate on a limited basis. The growth of this subsidiary will depend largely on whether or not the unrelated financial institutions continue to service the Company’s growth. 1985 Versus 1984 The Company’s net sales for 1985 were $68,674,779 compared to $30,480,571 for 1984, an increase of 125%. The majority of this increase was due to the addition of eight retail sales centers during the first quarter and the acquisition of Country Squire Mobile Homes, Inc. on March 22, 1985, with 20 retail sales centers. The Company also opened seven retail sales centers in the second quarter, six in the third quarter, and two in the fourth quarter. Volume increases in sales centers which were in operation at the end of 1984 also occurred while the average sales price per unit remained fairly constant from 1984 to 1985. The Company’s purchase of a manufacturing facility on September 4, 1985, contributed approximately 7% of the 1985 sales increase. Finance participation income for 1985 was $9,715,558 compared to $5,221,279, an increase of 86%. This was less than the percentage increase in sales due to three factors: (1) The election to discount the unreceived portion of finance participation income to its present value; (2) Country Squire earned significantly less finance participation income than the other retail groups, primarily because of non-recourse sales; and, (3) the inclu- 5-34 sion of manufacturing sales which do not earn finance participation income. Insurance commissions, interest and other revenues increased proportionally in relation to the increase in sales. Cost of sales as a percentage increased approximately 2% in 1985. This increase was due to the substantial increase in sales to independent retailers which traditionally have lower margins, and a slight decrease in margins at Company-owned sales centers. Selling, general and administrative expenses increased in 1985 as a result of increased sales volume and reflect the increase in number of sales centers and additional personnel to support our continued growth. Provision for losses on credit sales remained relatively constant as a percentage of net sales from 1984 to 1985. Interest rates were generally lower in 1985; however, total interest cost increased significantly due to increased inventories to support the added sales centers. Liquidity and Capital Resources The Company, in April 1986, sold $18,000,000 of 9% convertible subordinated notes due May 15, 2001. The proceeds were used primarily to reduce floor plan notes payable and to significantly improve the Company’s liquidity. During 1986, the Company purchased Jeff Brown Homes, Inc. with nine sales centers and Piggy Bank Homes of Alabama, Inc. with six sales centers, added 13 Company-owned sales centers, formed a finance company subsidiary with an initial capitalization of $500,000, expanded the principal offices of its wholly-owned subsidiary, Tri-County Homes, Inc., and opened a second production line at its manufacturing facility, using funds generated from the sale of the subordinated notes and from operations. At December 31, 1986, the Company had available $1,000,000 in a bank line of credit and $8,000,000 in unused floor plan lines of credit. On February 13, 1987, the Company sold $25,000,000 of unsecured senior notes due in 1990 and 1992 bearing interest at a blended rate of 8.95%. The proceeds have been partially used to reduce floor plan notes payable. Although working capital increased significantly in 1986, operations used working capital of $2,956,041 compared to providing working capital of $2,847,026 in 1985 and $2,599,953 in 1984. Manufactured Homes 200 Liability and Equity Analysis 5-35 Part 2 Business Analysis and Valuation Tools Manufactured Homes The use of working capital by operations in 1986 was principally due to the interest rate spread applicable to finance participation and significant reductions in deferred income taxes applicable to the provision for credit losses and finance participation income. The Tax Reform Act of 1986 will benefit the Company through a reduction of the corporate income tax rate. However, beginning January 1, 1987, the Act will require the Company to accelerate the payment of Federal income taxes. However, the Company believes that funds to be generated by operations, combined with credit lines currently available, will be sufficient to satisfy capital needs for current operations. 201 Liability and Equity Analysis 5-36 Liability and Equity Analysis CONSOLIDATED BALANCE SHEET December 31, 1986 1985 ASSETS Current Assets Cash and cash equivalents: Cash and temporary investments Contract proceeds receivable from financial institutions (Note 9) Total cash and cash equivalents Finance participation receivable – current portion (Note 2) Deferred finance participation income Net finance participation receivable Other receivables (Note 4) Refundable income taxes (Note 11) Inventories (Notes 5 and 9) Prepaid expenses Deferred income taxes (Note 11) Total current assets Finance participation receivable – noncurrent portion (Note 2) Deferred finance participation income Net finance participation receivable Property, plant and equipment at cost (Notes 6 and 10) Accumulated depreciation and amortization Net property, plant and equipment Excess of costs over net assets of acquired companies less amortization (Note 3) Other assets $2,486,024 11,496,078 13,982,102 2,691,497 (801,511) 1,889,986 3,746,863 778,971 38,163,712 538,419 761,262 59,861,315 $2,968,837 5,189,535 8,158,372 2,486,001 (523,038) 1,962,963 2,057,674 — 25, 628,156 408,124 436,496 38,651,785 16,128,799 (3,923,178) 12,205,621 7,504,272 (2,410,812) 5,093,460 10, 269,713 (2,968,629) 7,301,084 5,467,164 (1,555,427) 3,911,737 2,107,874 2,109,533 $81,377,803 973, 860 106,458 $50,944,924 Manufactured Homes 202 Liability and Equity Analysis 5-37 Part 2 Business Analysis and Valuation Tools December 31, 1986 1985 Manufactured Homes LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities Notes payable Long-term debt – current installments (Note 10) Floor plan notes payable (Note 9) Accounts payable Income taxes (Note 11) Accrued expenses and other liabilities (Note 8) Total current liabilities Long-term debt – noncurrent installments (Note 10) Reserve for losses on credit sales (Note 7) Deferred income taxes (Note 11) Total liabilities Stockholders’ Equity (Notes 10 and 12) Common stock — $.50 par value per share; authorize 10,000,000 shares; issued and outstanding 3,733,968 shares in 1986 and 3,488,968 shares in 1985 Additional paid-in capital Retained earnings Total stockholders’ equity Commitments and contingent liabilities (Notes 3 and 13) $1,099,971 810,901 35,207,386 4,899,250 — 2,731,924 44,749,432 18,609,987 3,000,000 851,265 67,210,684 $ — 1,100,624 27,468,153 2,210,560 1,828,234 1,223,302 33,830,873 1,082,543 1,863,992 3,114,757 39,892,165 1,866,984 3,508,351 8,791,784 14,167,119 1,744,484 2,549,916 6,758,359 11,052,759 $81,377,803 $50,944,924 203 Liability and Equity Analysis 5-38 Liability and Equity Analysis CONSOLIDATED STATEMENTS OF EARNINGS Years Ended December 31, Revenues: Net sales Finance participation income Insurance commissions Interest Other Total revenues Costs and expenses: Cost of sales Selling, general and administrative Provision for losses on credit sales (Note 7) Interest Total costs and expenses Earnings before income taxes Income taxes (Note 11) Earnings before cumulative effect of change in accounting principle (Note 2) Cumulative effect on prior years of change in accounting principle for finance participation (Notes 2 and 11) Net earnings Earnings per share: Before cumulative effect of change in accounting principle Cumulative effect on prior years of change in accounting principle for finance participation Net earnings per share — primary Net earnings per share — fully diluted Proforma amounts assuming retroactive application of the change in accounting principle (Note 2): Net earnings Net earnings per share — primary 1986 1985 1984 $106,095,667 12,084,108 721,758 338,447 1,024,974 120,264,954 $68,674,779 9,715,558 413,282 163,663 558,706 79,525,988 $30,480,571 5,221,279 231,618 123,564 138,770 36,195,802 86,212,901 22,852,093 3,777,900 3,367,940 116,210,834 4,054,120 2,020,695 56,222,412 13,639,942 793,497 1,824,588 72,480,439 7,045,549 3,327,224 24,324,851 5,895,891 253,004 570,527 31,044,273 5,151,529 2,457,000 2,033,425 3,718,325 2,694,529 — $2,033,425 (504,571) $3,213,754 — $2,694,529 $.53 $.98 $.77 — $.53 $.53 (.13) $.85 $.84 — $.77 $.77 $2,033,425 $.53 $3,718,325 $.98 $2,365,334 $.68 Manufactured Homes 204 Liability and Equity Analysis 5-39 Part 2 Business Analysis and Valuation Tools CONSOLIDATED STATEMENTS OF CHANGES IN FINANCIAL POSITION Manufactured Homes Year Ended December 31, Working capital was provided by Operations: Net earnings Adjustments for items not requiring (providing) working capital: Depreciation and amortization Noncurrent deferred income taxes Provision for losses on credit sales, net of actual charges Issuance of nonqualified stock options Finance participation income Collections, current and deferred finance participation income portion of finance participation receivable Other Working capital provided (used) by operations Proceeds from long-term debt Exercise of stock options Decrease in other assets Working capital was used for Net assets, exclusive of working capital of $806,363 in 1985 and deficits in working capital of $1,109,080 in 1986 and $140,604 in 1984, of acquired companies (Note 3) Additions to property, plant and equipment Current installments and repayment of long-term debt Additions to other assets and excess costs 1986 1985 1984 $2,033,425 $3,213,754 $2,694,529 946,858 (2,197,061) 699,343 142,000 (12,084,108) 556,23 6 78,637 (217,402) 206,000 (9,715,558) 210,699 1,412,812 134,614 — (5,221,279) 7,503,502 — 8,725,359 — 3,316,397 52,181 (2,956,041) 18,396,000 938,935 — 2,847,026 1,651,822 — 4,024 2, 599,953 400,000 — — 16,378,894 4,502,872 2,999,953 1,285,935 1,917,489 1,071,308 1,813,191 422,179 2,756,178 1,322,806 — 1,220,198 580,259 70,423 9,054 6,087,923 Increase in working capital Changes in working capital, by component Cash and cash equivalents Finance participation receivable – current portion Other receivables Refundable income taxes Inventories Prepaid expenses Deferred income taxes Notes payable Long-term debt -current installments Floor plan notes payable Accounts payable Income taxes Accrued expenses and other liabilities Increase in working capital 4,501,163 1,879,934 1,709 $1,120,019 $10,290,971 $ $ 5,823,730 (72,977) 1,689,189 778,971 12,535,556 130,295 324,766 (1,099,971) 289,723 (7,739,233) (2,688,690) 1,828,234 (1,508,6 22) $10,290,971 $6,136,129 1,193,013 1,715,543 — 17,448,795 371,403 102,710 — (900,624) (22,962,163) (1,896,668) (620,489) (585,940) $ 1,709 $ 579,418 569,838 233,696 — 5,616,654 25,918 203,000 — (200,000) (3,986,435) (219,293) (1,207,745) (495,032) $ 1,120,019 205 Liability and Equity Analysis Liability and Equity Analysis 5-40 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 1986, 1985 and 1984 Note 1 Summary of Significant Accounting Policies Principles of Consolidation and Nature of Business The consolidated financial statements include the accounts of Manufactured Homes, Inc. and all subsidiaries, each wholly-owned, and hereafter referred to collectively as the “Company.” All significant intercompany items are eliminated. The Company is engaged principally in the retail sale of new and used manufactured single-family homes. Inventories Inventories are stated at the lower of cost or market, with cost being determined using the specific unit method for new and used manufactured homes and average cost for materials and supplies. Property, Plant and Equipment Depreciation of property, plant and equipment is provided principally by the straight-line method over the estimated useful lives of the respective assets. Amortization of leasehold improvements is provided by the straight-line method over the shorter of the lease terms or the estimated useful lives of the improvements. Income Taxes Deferred income taxes are recognized for income and expense items that are reported in different periods for financial reporting and income tax purposes. Income Recognition A sale is recognized when payment is received or, in the case of credit sales, when a down payment (generally 10% of the sales price) is received and the Company and the customer enter into an installment contract. Installment contracts are normally payable over periods ranging from 120 to 180 months. Credit sales represent the majority of the Company’s sales. Under existing financing arrangements, the majority of installment contracts are sold, with recourse to unrelated financial institutions at an agreed upon rate which is below the contractual interest rate of the installment contract. At the time of sale, the Company receives immediate payment for the stated principal amount of the installment contract and a portion of the finance participation resulting from the interest rate differential. The remainder of the interest rate differential is retained by the financial institution as security against credit losses and is paid to the Company in proportion to customer payments received by the financial institution. The Company accounts for these transactions as sales in accordance with Statement of Financial Accounting Standards No. 77, “Reporting by Transferors for Transfers of Receivables with Recourse,” and recognizes finance participation income equal to the difference between the contractual interest rates of the installment contracts and the agreed upon rates to the financial institutions; the portion retained by the financial institutions is discounted for estimated time of collection and carried at its present value (see Note 2). Reserve for Losses on Credit Sales Estimated losses arising from the recourse provisions of the Company’s financing arrangements with unrelated financial institutions are provided for currently based on historical loss experience and current economic conditions and consist of estimated future rebates of finance participation income due to prepayment or repossession, estimated future losses on installment contracts repurchased from financial institutions and estimated future losses on installment contracts transferred to new purchasers in lieu of repossession. Actual losses are charged to the reserve when incurred. Excess of Costs over Net Assets of Acquired Companies The excess of costs over net assets of acquired companies is being amortized over 30 years on the straight-line method. Manufactured Homes 206 Liability and Equity Analysis 5-41 Part 2 Business Analysis and Valuation Tools Earnings per Share Primary earnings per share are based on the weighted average number of common and common equivalent shares outstanding. Such average shares are as follows: Manufactured Homes Years Ended December 31, Outstanding shares Equivalent shares 1986 1985 1984 3,660,048 3,488,968 3,488,968 204,113 3,864,161 313,725 3,802,693 — 3,488,968 The equivalent shares in 1986 and 1985 represent the shares issuable upon exercise of stock options and warrants after the assumed repurchase of common shares with the related proceeds at the average price during the period. Common equivalent shares were not considered in 1984 as the resulting dilution was insignificant. Fully diluted earnings per share are based on the weighted average number of common and common equivalent shares outstanding plus the common shares issuable upon the assumed conversion of the convertible subordinated notes and elimination of the applicable interest expense less related income tax benefit. In determining equivalent shares, the assumed repurchase of common shares is at the higher of the average or period-end price. Note 2 Accounting Change Prior to 1985, the Company recognized finance participation income without discounting for the estimated time of collection of the portion retained by the unrelated financial institutions as security against credit losses. However, in 1985 the Company adopted the practice whereby the portion of finance participation income retained by the financial institutions is recorded at its present value based upon estimated time of collection. The Company believes the new method is preferable since it more accurately reflects the value of the finance participation receivable at the date the installment contracts are sold to the financial institutions. As a result of this change, earnings in 1985, before the cumulative effect of the change on prior years, were decreased by $538,466 ($.14 per share). Net earnings were further decreased by $504,571 ($.13 per share), which represents the cumulative effect of the change on prior years. Proforma net earnings and earnings per share amounts reflecting retroactive application of the change are shown in the consolidated statements of earnings. Note 3 Acquisitions On January 6, 1984, Manufactured Homes, Inc. acquired the outstanding common stock of TriCounty Homes, Inc., a retailer of manufactured housing located in eastern North Carolina. The purchase agreement required cash payments of $400,000 and potential earn-out payments of $600,000, all earned at December 31, 1984. The acquisition has been accounted for as a purchase and, accordingly, the operations of Tri-County are included in the consolidated financial statements of Manufactured Homes, Inc. beginning in 1984. Effective March 22, 1985, Manufactured Homes, Inc. acquired the outstanding common stock of Country Squire Mobile Homes, Inc., a retailer of manufactured housing located principally in South Carolina. The purchase agreement required cash payments of $873,000 and includes potential earn-out payments of $1,960,000 over the period 1985 to 1990. The potential earn-out is based on a percentage of Country Squire’s pre-tax earnings as defined. At December 31, 1986, $642,947 ($396,000 in 1986 and $246,947 in 1985) of the potential earn-out had been earned and recorded as an adjustment of the purchase price. The acquisition has been accounted for as a purchase and, accordingly, the operations of Country Squire are included in the consolidated financial statements of Manufactured Homes, Inc. since March 22, 1985. The following unaudited proforma data presents the results of operations of the Company and Country Squire as if the acquisition had occurred at January 1, 1984. Years Ended December 31, Total revenues Net earnings Net Earnings per share: Primary Fully diluted 1985 1984 $87,729,677 3,090,464 $59,696,534 2,812,632 $ .81 $ .80 $ .81 $ .81 207 Liability and Equity Analysis 5-42 Liability and Equity Analysis In September 1986, Manufactured Homes, Inc. acquired the outstanding common stock of two companies engaged in the retail sale of manufactured homes. The purchase agreements required aggregate cash payments of $151,000 and potential earn-out payments of $874,000 over the period 1987 to 1992. The potential earn-outs are based on a percentage of the respective companies’ pre-tax earnings as defined. The acquisitions have been accounted for as purchases and, accordingly, their operations, which are not material, are included in the consolidated financial statements of Manufactured Homes, Inc., since September 1986. At date of acquisition, one company had operating loss carryforwards of $612,049 and to the extent utilized, the income tax reductions will be accounted for as adjustments of the purchase price. At December 31, 1986, $324,510 (tax benefit of $159,226) of the carryforwards had been utilized. The net assets, exclusive of working capital of $806,363 in 1985 and deficits in working capital of $1,109,080 in 1986 and $140,604 in 1984, of the acquired companies were as follows: Years Ended December 31, Finance participation receivable Property, plant and equipment Other assets Long-term debt Reserve for losses on credit sales Other liabilities Excess of costs over net assets of acquired companies 1986 1985 $1,337,147 $1,172,853 169,092 493,089 747,092 23,403 131,367 61,016 (202,752) (353,527) (70,423) (436,665) (1,675,000) (74,615) — (679,524) — 1,022,588 $ 422,179 Other receivables consist of the following: December 31, 1986 Manufacturers’ volume bonuses Sundry $1,979,021 1,767,842 $3,746,863 1985 $1,557,029 500,645 $2,057,674 Note 5 Inventories Inventories consist of the following: December 31, 1986 New manufactured homes Used manufactured homes Materials and supplies 1985 $31,920,134 $22,766,030 4,971,040 1,272,538 $38,163,712 2,068,099 794,027 $25,628,156 Note 6 Property, Plant and Equipment The cost and estimated useful lives of the major classifications of property, plant and equipment are as follows: 1984 $ 323,931 939,240 $1,285,935 Note 4 Other Receivables — $1,220,198 Estimated Useful Life Land Buildings Manufactured homes– office units Leasehold improvements Furniture & equipment Vehicles Signs December 31, 1986 1985 — 15–20 yrs. $ 735,329 1,660,321 $ 620,083 849,427 5–7 yrs. 1,048,571 1,013,543 3–5 yrs. 615,319 3–10 yrs. 3–5 yrs. 3–7 yrs. 1,921,101 1,485,222 38,409 $7,504,272 1,108,123 1,124,154 185,196 $5,467,164 Manufactured Homes 208 Liability and Equity Analysis 5-43 Part 2 Business Analysis and Valuation Tools Note 7 Reserve for Losses on Credit Sales An analysis of the reserve for losses on credit sales follows: Manufactured Homes Years Ended December 31, 1986 Balance at beginning of year Amount at date of acquisition applicable to acquired companies, less actual charges of $69,236 in 1986 and $604,403 in 1985 Provision for losses Actual charges Balance at end of year $1,863,992 1985 1984 $ 406,394 $197,165 367,429 1,070,597 74,615 3,777,900 793,497 253,004 (3,009,321) (406,496) (118,390) $3,000,000 $1,863,992 $406,394 Note 8 Accrued Expenses and Other Liabilities A summary of accrued expenses and other liabilities follows: December 31, Payroll and related costs Other 1986 $1,580,235 1,151,689 $2,731,924 1985 $ 697,287 526,015 $1,223,302 Note 9 Floor Plan Notes Payable A substantial portion of the Company’s new manufactured home inventories are financed through floor plan arrangements with certain unrelated financial institutions. A summary of floor plan notes payable follows: December 31, General Electric Credit Corporation ITT Diversified Credit Corporation CIT Financial Services Whirlpool Acceptance Corporation U.S. Home Acceptance Citicorp Acceptance Company, Inc. Others Rate Floor Plan Lines 1986 1985 Prime + 1.75 (9.25%) Prime + 2.00 (9.50%) Prime + 2.00 (9.50%) Prime + 1.50 (9.00%) Prime + 0.00 (7.50%) Prime + 2.00 (9.50%) Various $27,052,000 7,200,000 4,000,000 1,500,000 1,000,000 975,000 1,850,000 $43,577,000 $22,601,520 5,869,438 3,958,932 1,210,586 36,680 — 1,530,230 $35,207,386 $17,183,988 5,224,373 1,761,854 — 815,066 1,706,728 776,144 $27,468,153 The floor plan liability at December 31, 1986 is collateralized by inventories and contract proceeds receivable from financial institutions. The floor plan arrangements generally require periodic partial repayments with the unpaid balance due upon sale of the related collateral. 209 Liability and Equity Analysis 5-44 Liability and Equity Analysis The weighted average interest rate paid on the outstanding floor plan liability was 10.9%, 11.0%, and 14.7% for 1986, 1985, and 1984, respectively. The maximum amount outstanding at any month end during each year was $35,207,386 for 1986, $27,468,153 for 1985, and $4,508,319 for 1984, with a weighted average balance outstanding for each year of approximately $25,500,000, $16,000,000 and $3,750,000, respectively. Note 10 Long-Term Debt A summary of long-term debt follows: December 31, 9% convertible subordinated notes payable, due in annual installments of $1,800,000 beginning May 15, 1992 through May 15, 2001 Note payable, due in monthly installments of $66,667 through October 1, 1987, interest at prime rate (71⁄2% at December 31, 1986) and collateralized by property, plant and equipment with a depreciated cost of $1,160,640 Obligation payable in January 1988, interest at the prime rate (7 1⁄2% at December 31, 1986) and collateralized by the common stock of Country Squire Mobile Homes, Inc. (Note 3) Obligation payable in annual installments of $200,000 through April 15, 1987, repaid in 1986 Various notes payable, due in monthly installments, including interest at rates ranging from 8% to 18% Less current installments 1986 1985 $18,000,000 — 666,670 1,466,667 396,000 — — 400,000 358,218 19,420,888 810,901 $18,609,987 316,500 2,183,167 1,100,624 $1,082,543 The aggregate annual maturities of the long-term debt for the five years following December 31, 1986 are: 1987, $810,901; 1988, $508,497; 1989, $53,498; 1990, $33,255; 1991, $14,737. Pursuant to an agreement dated April 25, 1986 (the “1986 Agreement”), the Company sold its Convertible Subordinated Notes due May 15, 2001, in the amount of $18,000,000 to two lenders. The proceeds from these notes have been used principally to reduce floor plan notes payable. The notes are convertible into shares of the Company’s common stock at the conversion price of $17.50 per share. The conversion price is subject to adjustment in the event of stock dividends, stock splits, payment of extraordinary distributions, granting of options or sale of additional shares of common stock. The notes are subject to prepayment at the option of the Company between October 28, 1986 and May 15, 1996 at 100% of par if for a specified period preceding the written notice of prepayment the closing market price per share of the Company’s common stock is equal to or greater than a percentage of the conversion price. Such percentage decreases from 200% through May 15, 1989 to 110% at May 15, 2001. The 1986 Agreement contains various restrictive covenants which include, among other things, maintenance of a minimum level of working capital as defined, maintenance of a minimum level of net earnings available for fixed charges as defined, consolidated current assets as defined, equal or greater than senior debt, payment of cash dividends and the creation of additional indebtedness. Manufactured Homes 210 Liability and Equity Analysis Manufactured Homes 5-45 Part 2 Business Analysis and Valuation Tools Subsequent to December 31, 1986 and pursuant to an agreement dated February 13, 1987 (the “1987 Agreement”), the Company sold the Prudential Insurance Company of America Series A and Series B Senior notes in the aggregate of $25,000,000. The Series A notes in the amount of $15,000,000 bear interest at the rate of 8.64% and are due February 15, 1990. The Series B notes in the amount of $10,000,000 bear interest at the rate of 9.42% and are due February 15, 1992. The proceeds from these notes have been used partially to reduce floor plan notes payable and the remainder added to corporate funds. The 1987 Agreement also contains restrictive financial covenants. The 1987 Agreement financial covenants were changed to reflect more accurately the Company’s current financial structure. Concurrent with the execution of the 1987 Agreement, the financial covenants contained in the 1986 Agreement were amended to conform to the covenants in the 1987 Agreement. At December 31, 1986, the Company was in compliance with the various restrictive covenants in the 1986 Agreement with the exception of the net earnings available for fixed charges covenant. The Company was in compliance with all of the restrictive covenants in the 1986 Agreement, as amended. Retained earnings available for the payment of cash dividends amounted to $1,516,712 at December 31, 1986. Note 11 Income Taxes Before cumulative effect of change in accounting principle Cumulative effect on prior years of change in accounting principle Years Ended December 31, Current: State Federal Deferred: State Federal 1986 1985 $ 550,653 3,942,668 4,493,321 1984 $ 342,085 2,366,685 2,708,770 $ 166,000 1,075,000 1,241,000 (305,198) 20,529 (2,167,428) 147,936 (2,472,626) 168,465 $2,020,695 $2,877,235 143,000 1,073,000 1,216,000 $2,457,000 A reconciliation of the statutory Federal income tax rate with the Company’s actual income tax rate follows: Years Ended December 31, Statutory Federal income tax rate State income tax rate less applicable Federal income tax benefit Investment and jobs tax credit Nontaxable items – net Other – net Actual income tax rate 1986 1985 1984 46.0% 46.0% 46.0% 3.2 3.2 3.2 — 1.1 (.5) 49.8% (1.2) (.2) (.6) 47.2% (.4) .2 (1.3) 47.7% The sources of deferred income tax expenses (benefits) and their tax effects are as follows: Income taxes are reflected in the consolidated statements of earnings as follows: Years Ended December 31, Components of income tax expense (benefit) are as follows: 1986 1985 1984 $2,020,695 $3,327,224 $2,457,000 — $2,020,695 (449,989) — $2,877,235 $2,457,000 211 Liability and Equity Analysis 5-46 Liability and Equity Analysis Years Ended December 31, 1986 1985 1984 Provision for losses on credit sales $(1,622,079) $743,032 $705,000 Finance participation income (778,939) (521,030) 453,000 Operating loss and tax credit carryforwards — — 244,000 Manufacturers’ volume bonuses (105,058) (32,062) (203,000) Depreciation 103,519 50,415 17,000 Accrued compensation 63,027 (101,434) — Allowance for doubtful accounts — 29,544 — Other – net (133,096) — — $(2,472,626) $168,465 $1,216,000 The operating loss and tax credit carryforwards in 1984 represent the reinstatement of deferred tax credit recognized in previous years for financial reporting purposes. The Tax Reform act of 1986 will benefit the Company through a reduction of the statutory Federal income tax rate. Note 12 Common Stock In connection with a public offering of common stock in 1983, the Company sold to the primary underwriter warrants to purchase 142,500 shares of common stock at a price equal to 120% of the public offering price. The warrants are exercisable for a four-year period beginning in 1984 at $3.84 per share. On June 14, 1983, the Board of Directors approved an Incentive Stock Option Plan and reserved 608,900 shares of the Company’s authorized common stock for award to officers, directors and key employees. Under the Plan, options are granted at the discretion of a committee appointed by the Board of Directors and may be either incentive stock options or nonqualified stock options. Incentive options must be at a price equal to or greater than fair market value at date of grant. Nonqualified options may be at a price lower than fair market value at date of grant. The Plan expires June 13, 1993. Activity and price information regarding the plan follows: Shares Balance December 31, 1983 Granted Canceled Balance December 31, 1984 Granted Canceled Balance December 31, 1985 Granted Exercised Canceled Balance December 31, 1986 Option Price Range 104,750 $2.40– $3.20 119,250 $2.40– $3.75 (20,500) $3.20 203,500 $2.40– $3.75 297,600 $4.06–$11.25 (5,250) $2.40– $3.75 495,850 $2.40–$11.25 32,300 $11.00–$17.50 (245,00 0) $2.40– $4.06 (18,250) $2.70–$10.38 264,900 $2.40–$17.50 At December 31, 1986, options for 17,000 shares were currently exercisable. The remaining options become exercisable through the expiration date of the Plan. The excess, if any, of the fair market value at date of grant over the exercise price of nonqualified options is considered compensation and is charged to operations as earned. For 1986 and 1985, the charge to operations was $142,000 and $206,000, respectively. No options were granted at prices lower than fair market value prior to 1985. At December 31, 1986, 1,534,971 shares of the Company’s authorized common stock were reserved for issuance as follows: 142,500 shares for the outstanding warrants, 363,900 shares for the Incentive Stock Option Plan, and 1,028,571 shares for the convertible subordinated notes. Note 13 Commitments and Contingent Liabilities The Company leases office space, the majority of its retail sales centers and certain equipment under noncancellable operating leases that expire over the next five years. Total rental expense under such leases amounted to $1,335,809 in 1986, $888,719 in 1985, and $433,759 in 1984. Approximately 10%, 18%, and 22%, respectively, of such amounts were paid to the Company’s majority stockholder and the officers of certain subsidiaries. Manufactured Homes 212 Liability and Equity Analysis 5-47 Part 2 Business Analysis and Valuation Tools Future minimum payments under noncancellable operating leases as of December 31, 1986 follow: Note 14 Supplementary Income Statement Information Year Ending December 31, Advertising costs amounted to $1,569,658, $1,021,978 and $311,285 in 1986, 1985 and 1984, respectively. Maintenance and repairs, depreciation and amortization of intangible assets, preoperating costs and similar deferrals, taxes, other than payroll and income taxes, and royalties did not exceed 1% of revenues in 1986, 1985 or 1984. Manufactured Homes 1987 1988 1989 1990 1991 Minimum Payments $1,298,346 787,572 498,572 312,510 192,912 $3,089,912 At December 31, 1986 the Company was contingently liable as guarantor on approximately $180 million (net) of installment sales contracts sold to financial institutions on a recourse basis. [Case writer’s note: This contingent liability was $150 million at December 31, 1985, $116 million at December 31, 1984, and $45 million at December 31, 1983.] REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS THE BOARD OF DIRECTORS AND STOCKHOLDERS MANUFACTURED HOMES, INC.: We have examined the consolidated balance sheets of Manufactured Homes, Inc. and subsidiaries as of December 31, 1986 and 1985 and the related consolidated statements of earnings, stockholders’ equity and changes in financial position for each of the years in the three-year period ended December 31, 1986. Our examinations were made in accordance with generally accepted auditing standards and, accordingly, included such tests of the accounting records and such other auditing procedures as we considered necessary in the circumstances. In our opinion, the aforementioned consolidated financial statements present fairly the financial position of Manufactured Homes, Inc. and subsidiaries at December 31, 1986 and 1985 and the results of their operations and the changes in their financial position for each of the years in the three-year period ended December 31, 1986, in conformity with generally accepted accounting principles consistently applied during the period except for the change, with which we concur, in the method of recording the uncollected portion of finance participation income as explained in Note 2 to the consolidated financial statements. PEAT, MARWICK, MITCHELL & CO. Charlotte, North Carolina March 10, 1987 213 Liability and Equity Analysis 5-48 Liability and Equity Analysis EXHIBIT 3 Manufactured Homes, Consolidated Financial Statements for the First Nine Months of 1987 CONSOLIDATED BALANCE SHEETS (unaudited) September 30, 1987 December 31, 1986 ASSETS Current Assets: Cash and cash equivalents: Cash and temporary investments (includes) $5,212,849 of restricted cash in 1987 Contract proceeds receivable from financial institutions Total cash and cash equivalents Finance participation receivable - current portion Deferred finance participation income Net finance participation receivable Installment sales contracts held for resale (less unearned interest of $3,648,675) Other receivables Refundable income taxes Inventories Prepaid expenses Deferred income taxes Total current assets Finance participation receivable - noncurrent portion Deferred finance participation income Net finance participation receivable Property, plant and equipment, at cost Accumulated depreciation and amortization Net property, plant and equipment Deferred income taxes Excess of costs over net assets of acquired companies, less amortization Other assets $9,311,240 17,435,191 26,746,431 4,572,042 (1,208,275) 3,363,767 $2,486,024 11,496,098 13,982,102 2,691,497 (801,511) 1,889,986 2,382,573 6,343,052 — 41,638,452 587,749 1,000,262 82,062,286 25,020,194 (5,984,910) 19,035,284 9,248,065 (3,166,445) 6,081,620 1,847,735 — 3,746,863 778,971 38,163,712 538,419 761,262 59,861,315 16,128,799 (3,923,178) 12,205,621 7,504,272 (2,410,812) 5,093,460 — 2,130,099 1,446,657 $112,603,681 2,107,874 2,109,533 $81,377,803 (continued) Manufactured Homes 214 Liability and Equity Analysis 5-49 Part 2 Business Analysis and Valuation Tools September 30, 1987 December 31, 1986 Manufactured Homes LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Notes payable Long-term debt—current installments Floor plan notes payable. Accounts payable Income taxes Accrued expenses and other liabilities Total current liabilities Long-term debt - noncurrent installments Reserve for losses on credit sales Deferred income taxes Total liabilities Stockholder’s equity: Common stock—$.50 par value per share; authorized 10,000 shares; issued and outstanding 3,777,168 shares in 1987 and 3,733,968 in 1986 Additional paid-in capital Retained earnings Total stockholders’ equity $ — 90,038 28,306,796 8,181,736 2,469,015 5,351,963 44,399,548 43,000,000 4,850,000 — 92,249,548 $ 1,099,971 810,901 35,207,386 4,899,250 — 2,731,924 44,749,432 18,609,987 3,000,000 851,265 67,210,684 1,888,584 3,830,314 14,635,235 20,354,133 $112,603,681 1,866,984 3,508,351 8,791,784 14,167,119 $81,377,803 215 Liability and Equity Analysis 5-50 Liability and Equity Analysis CONSOLIDATED STATEMENT OF EARNINGS (unaudited) Three Months Ended September 30, Revenues: Net sales Finance participation income Insurance commissions Interest Other Total revenues Costs and expenses: Cost of sales Selling, general and administrative Provision for losses on credit sales Interest Total costs and expenses Earnings before income taxes Income taxes Net earnings Net earnings per share: Primary Fully diluted Nine Months Ended September 30, 1987 1986 1987 1986 $44,590,244 8,439,473 291,868 373,415 534,916 54,229,916 $29,464,161 3,277,085 180,870 98,327 121,378 33,141,821 $126,599,392 18,895,975 976,128 925,116 786,971 148,183,582 $76,396,868 8,629,223 465,577 230,602 221,448 85,943,718 36,325,647 23,741,484 101,997,757 61,554,367 10,806,534 5,905,930 27,973,865 14,823,385 1,096,027 1,568,906 49,797,114 4,432,802 2,038,000 $2,394,302 294,716 877,531 30,819,661 2,322,160 1,145,000 $1,177,160 3,203,913 4,416,596 137,592,131 10,591,451 4,748,000 $5,843,451 772,417 2,303,482 79,453,651 6,490,067 3,109,000 $3,381,067 $ .60 $ .30 $ 1.48 $ .87 $ .53 $ .28 $ 1.31 $ .83 Manufactured Homes 216 Liability and Equity Analysis 5-51 Part 2 Business Analysis and Valuation Tools CONSOLIDATED STATEMENTS OF CHANGES IN FINANCIAL POSITION (unaudited) Manufactured Homes Nine Months Ended September 30 Working capital was provided by: Operations: Net earnings Adjustments for items not requiring (providing) working capital: Depreciation and amortization Noncurrent deferred income taxes Provision for losses on credit sales, net of actual changes Issuance of nonqualified stock options Finance participation income Collections and net change in noncurrent portion of finance participation receivable Working capital used by operations Proceeds from long-term debt Exercise of stock options Decrease in other assets Working capital was used for: Net assets, exclusive of working capital, of acquired companies: Finance participation receivable Property and equipment Other assets Long-term debt Reserve for losses on credit sales Deferred income taxes Excess of costs over net assets of acquired companies Additions to property, plant and equipment Current installments and repayment of long-term debt Additions to other assets and excess costs Increase in working capital Changes in working capital, by component: Cash and cash equivalents Finance participation receivable - current portion Installment sales contracts held for resale Other receivables Refundable income taxes Inventories Prepaid expenses Deferred income taxes Notes payable Long-term debt - current installments Floor plan notes payable Accounts payable Income taxes Accrued expenses and other liabilities Increase in working capital 1987 1986 $ 5,843,451 $ 3,381,067 921,388 (2,699,000) 1,850,000 39,000 (18,895,975) 664,769 (345,000) (318,539) 106,500 (8,629,223) 12,066,312 (874,824) 25,000,000 304,563 662,876 25,092,615 5,019,381 (121,045) 18,000,000 1,060,805 — 18,939,760 — — — — — — — — 1,851,773 609,987 80,000 2,541,760 $22,550,855 349,749 212,716 509,514 (257,571) (436,664) 78,486 867,849 1,324,079 1,365,703 1,015,876 879,665 4,585,323 $14,354,437 $12,764,329 1,473,781 2,382,573 2,596,189 (778,971) 3,474,740 49,330 239,000 1,099,971 720,863 6,900,590 3,282,486) (2,469,015) (2,620,039) $22,550,855 $ 6,425,144 239,967 — 2,818,093 — 6,923,301 59,791 52,001 (1,391,500) 167,046 1,424,866 (2,811,331) 1,820,226 (1,373,167) $14,354,437 217 Liability and Equity Analysis Liability and Equity Analysis 5-52 Notes to Consolidated Financial Statements 1. Pursuant to an agreement dated February 13, 1987, the Company sold to Prudential Insurance Company of America Series A and Series B Senior notes in the aggregate of $25,000,000. The Series A notes in the amount of $15,000,000 bear interest at the rate of 8.64% and are due February 15, 1990. The Series B notes in the amount of $10,000,000 bear interest at the rate of 9.42% and are due February 15, 1992. The proceeds from these notes have been used partially to reduce floor plan notes payable and to fund the Company’s finance subsidiary with the remainder added to working capital. 2. On August 18, 1987, the Company’s finance subsidiary sold, with recourse, a portfolio of retail installment sales contracts with a principal balance of approximately $8,300,000 to an unrelated financial institution. As a result, the Company recognized, in the third quarter, finance participation income, net of discounts and estimated future servicing costs, of $1,688,690. The terms of the sale required the Company to provide to the unrelated financial institution as security against credit losses, an irrevocable reducing letter of credit in the amount of $3,000,000 secured by a six-month renewable certificate of deposit equal in amount to the letter of credit. At September 30, 1987, approximately $2,200,000 of the proceeds from the sale was held in an escrow account pending receipt, from the appropriate state agencies, of the titles to certain of the new and preowned homes securing the retail installment sales contracts in accordance with the terms of the sale. 3. Primary earnings per share are based on the weighted average number of common and common equivalent shares outstanding. Such average shares are as follows: Three Months Ended September 30, Outstanding shares Equivalent shares Nine Months Ended September 30, 1987 1986 1987 1986 3,773,894 205,159 3,979,053 3,726,427 195,979 3,922,406 3,758,245 187,848 3,946,093 3,635,137 272,150 3,907,287 The equivalent shares represent shares issuable upon exercise of stock options and warrants after the assumed repurchase of common shares with the related proceeds at the average price during the period. Fully diluted earnings per share are based on the weighted average number of common and common equivalent shares outstanding plus the common shares issuable upon the assumed conversion of the convertible subordinated notes and elimination of the applicable interest expense less related income tax benefit. In determining equivalent shares, the assumed repurchase of common shares is at the higher of the average or period-end price. 4. Certain amounts in the 1986 financial statements have been reclassified to conform to the presentation adopted in 1987. 5. In the opinion of management, all adjustments which are necessary for a fair presentation of operating results are reflected in the accompanying interim financial statements. All such adjustments are considered to be of a normal recurring nature. Manufactured Homes 218 Liability and Equity Analysis 5-53 Part 2 Business Analysis and Valuation Tools MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Manufactured Homes Results of Operations The Company’s net sales for the three-month period ended September 30, 1987 were $44,590,244 compared to $29,464,161 for the comparable period of 1986, an increase of 51%. Net sales for the nine-month period ended September 30, 1987 were $126,599,392 compared to $76,396,868 for the comparable period of 1986, an increase of 66%. These increases are due primarily to the acquisitions in September 1986 of Jeff Brown Homes, Inc., with nine retail sales centers, and Piggy Bank Homes of Alabama, Inc., with six retail sales centers, and the opening of 24 additional retail centers between September 30, 1986 and September 30, 1987. In addition, the average number of homes sold per retail sales center for the three-month and the nine-month periods ended September 30, 1987 increased by 28% and 20% respectively, over the corresponding periods of 1986. Finance participation income for both the three-month and the nine-month periods ended September 30, 1987 was greater as a percentage of net sales than in the comparable periods of 1986 due primarily to improved financing terms from third-party finance sources and the sale in August 1987 of a portfolio of retail installment sales contracts with a principal balance of approximately $8,300,000, which resulted in finance participation income of $1,688,690 net of discounts and estimated future servicing costs. This portfolio consisted of retail installment sales contracts originated during 1987 and the fourth quarter of 1986. Insurance commissions increased as a percentage of net sales due to added emphasis being placed on this revenue source. Interest income increased significantly due to an improved cash position in 1987 and the interest earned on retail installment sales contracts while held in the Company’s finance subsidiary. Other income increased primarily due to a gain of $400,000 recognized in September 1987 on the cancellation of a lease on one of the Company’s sales centers. Cost of sales increased as a percentage of net sales for the three-month period ended September 30, 1987 as compared to the corresponding period of 1986 primarily as a result of extremely competitive market conditions. For the nine-month period ended September 30, 1987, cost of sales as a percentage of net sales was unchanged from the comparable period of 1986. Selling, general and administrative expenses were higher, as a percentage of total revenues, for both the three-month and nine-month periods ended September 30, 1987 as a result of expenses incurred for the following activities: the acquisitions in September 1986 of Piggy Bank Homes of Alabama, Inc. and Jeff Brown Homes, Inc.; the segregation and expanded operations of MANH Independent Retailers Corp. and AAA Mobile Homes, Inc. as separate subsidiaries of the Company; the increased number of retail sales centers; and the establishment in October 1986 of the Company’s finance subsidiary. The provision for losses on credit sales, as a percentage of total revenues, increased significantly for both the three-month and nine-month periods ended September 30,1987 as compared to the corresponding periods of 1986, primarily as a result of industry-wide problems which became evident in the second half of 1986 and which caused the Company to incur increased costs relating to the prepayment of retail installment sales contracts, the repossession of homes and the resale of repossessed homes. 219 Liability and Equity Analysis Liability and Equity Analysis 5-54 Interest rates were generally lower in 1987; however, total interest expense increased significantly in 1987 due to increased borrowings to support additional retail sales centers and to fund the activities of the Company’s finance subsidiary. Liquidity and Capital Resources Liquidity and capital resources were greater at September 30, 1987 than at September 30, 1986 due to the sale in February 1987 of $25,000,000 of unsecured senior notes due in 1990 and 1992 bearing interest at a blended rate of 8.95% and to increased floor plan lines of credit. At September 30, 1987, the Company had available $3,000,000 in a bank line of credit and approximately $18,500,000 in unused floor plan lines of credit. In addition, the Company filed a registration statement with the Securities and Exchange Commission on September 22, 1987 for the proposed sale by the Company of 1,200,000 shares of its previously unissued common stock. Due to recent events in the financial market place, the status of this proposed sale is now uncertain. The Tax Reform Act of 1986 is benefiting the Company through a reduction of the corporate income tax rate. However, beginning January 1, 1987, the Act required the Company to change from the reserve method to the direct write-off method for providing for losses on credit sales, which is requiring the Company to accelerate the payment of federal income taxes. However, the Company believes that funds to be generated by operations, combined with financial resources and credit lines currently available, will be sufficient to satisfy capital needs for current operations. Manufactured Homes 220 66 R ev e n u e An alysis chapter R Business Analysis and 2Valuation Tools evenues are economic resources earned during a time period. Firms earn revenues from a variety of different sources. Manufacturers of consumer goods earn revenues from sales of their products to distributors and to consumers. Banks generate revenues from interest earned from loans to borrowers. Insurance companies receive premiums from policyholders. Lawyers receive fees from providing services to clients. Leasing companies generate income from leasing assets to lessees. Analysis of revenues focuses on assessing when it is appropriate to recognize revenues in the financial statements. Should they be recorded when the service is provided or the product is shipped? Should they be recorded when cash is received from the customer? Or should they be recorded after cash is received and the customer has indicated that the product or service was satisfactory? Revenue recognition occurs when two critical uncertainties are resolved: the product or service has been provided, and cash collection is reasonably likely. Management typically has the best information on these uncertainties. However, given management’s reporting incentives and the limitations of accounting rules discussed in Chapter 3, there are opportunities for analysis of revenues by financial statement users. In this chapter, we overview the revenue recognition rule, discuss types of transactions where application of this rule has proven challenging, and identify the key risks and opportunities for revenue analysis by users of financial statements. THE REVENUE RECOGNITION RULE As discussed in Chapter 1, cash accounting usually does not provide the most informative or relevant way of measuring a firm’s performance. For example, in some transactions where the firm has received cash, it has yet to fulfill any of its contractual obligations to the customer. In other cases, it has provided the full service or product to the customer but has yet to receive cash. For both these types of transactions, accountants argue that cash receipts from customers typically do not reflect the most relevant measure of revenue performance for the business. Accrual accounting attempts to reflect the economic substance of a firm’s revenue performance by formulating two criteria for revenue recognition. As Figure 6-1 shows, 6-1 221 222 Revenue Analysis Revenue Analysis Figure 6-1 Criteria for Revenue Recognition and Implementation Challenges First Criterion Second Criterion The good or service has been provided. Cash is collected or is reasonably likely to be collected. Revenue is realizable. Implementation Challenges 1. Customers pay in advance of delivery. 2. Products/services provided over multiple years. 3. Rights to use product/service sold, but seller retains residual rights. 4. Credit-worthiness of customer questionable. 5. Refunds for dissatisfied customers. the first criterion deals with uncertainty over whether the earnings process is essentially complete, that is, whether the firm has provided all, or substantially all, of the goods or services to be delivered to the customer. The second criterion focuses on uncertainty over whether cash is likely to be received. If both these criteria are satisfied, revenue is recognizable. For corporate managers and external users of financial statements, the above two criteria are likely to generate questions about whether effective business processes or thirdparty contracts are in place to manage the inherent risks. For example, firms can manage the risk that substantially all the goods and services have been delivered to the customer through effective quality programs to reduce the risk of product returns and warranties, or by sales contracts that limit customer returns and warranties. The collectibility risk can be managed through effective credit analysis or by transferring receivables to a third party. Managers are likely to have the best information about the processes in place to manage revenue risks, but they are also likely to have incentives to manage reported earnings. Consequently, analysis of revenues helps financial statement users independently assess the reporting risks underlying revenues. Also, under accounting rules, a transaction either satisfies or does not satisfy the revenue recognition criteria. Revenue analysis allows financial statement users to better understand where on the “product/service delivery–collectibility” continuum a transaction lies. 6-2 Revenue Analysis 6-3 Part 2 Business Analysis and Valuation Tools There are several ways that financial statement users can analyze the uncertainties associated with revenue recognition. They can evaluate the processes used to manage risks that revenues are unearned or uncollectible, such as quality programs and credit analysis. They can also analyze a firm’s track record in managing these types of risks. Finally, they can analyze management’s financial reporting incentives in a particular period. REVENUE REPORTING CHALLENGES To provide a deeper understanding of how to analyze revenue recognition risks, we discuss challenges in implementing the revenue recognition criteria. Although we use specific industries or transactions to illustrate the implementation challenges, the conceptual issues apply at a general level. Challenge One: Customers Pay in Advance For some businesses, customers pay in advance of receiving the service or product. Examples include magazine subscriptions, insurance policies, and service contracts. For these types of products, there is no uncertainty about collectibility. The only question is when the revenue will be earned. If revenues are recognized prior to the service delivery process, there is a risk that subsequent costs incurred are larger than expected, particularly if dissatisfied purchasers demand additional work or reimbursement from the seller. Indeed, given management’s reporting incentives, users of financial reports are likely to be concerned that early revenue recognition provides management with the opportunity to boost current earnings by shading product quality and underreporting the cost of returns, reducing the credibility of financial reports. Of course, if accountants wait for all uncertainties associated with sales to be fully resolved, financial statements are likely to provide tardy information on the firm’s performance. Below we discuss revenue recognition rules for service contracts and property-casualty insurance policies. These examples illustrate revenue recognition issues for contracts where cash is received prior to product delivery or provision of the service. EXAMPLE: SERVICE CONTRACTS. Many firms provide service contracts for products that they sell. In some cases, they actually charge customers a fee for the service contract. For example, some consumer electronics chains sell service contracts separately from the sale of the product. Customers then pay a fee to secure protection for an extended period. In other cases, the service contract is included as a part of the purchase price of the product. Such is typically the case for manufacturers’ warranties on new automobiles. How should revenue be recognized on these contracts? Should they be recorded at the 223 224 Revenue Analysis Revenue Analysis sale of the product, prorated over the warranty period, recognized when service is required, or deferred until the end of the contract period? Let’s first consider cases where the service contract can be purchased separately from the product. At this time, the product sale can be recognized; but since product servicing has yet to be provided, there are likely to be many uncertainties about the frequency and cost of future service claims. As a result, generally accepted accounting principles require firms to record service revenues during the contract period rather than when the contract is signed. For service contracts that are included as a part of the purchase price, it is difficult to separate the price of the product from the price of the warranty. They are sold as a package. Indeed, some customers may buy the package primarily because of the service agreement rather than the product itself. For such sales, the seller typically recognizes revenue at delivery of the product or service. Most of the uncertainties associated with the sale (collectibility and the product’s cost) have been resolved at this point. The only outstanding uncertainty is the future service contract claims against the seller. If the frequency and cost of claims can be predicted with reasonable certainty, revenues from the bundled product and service are recognized at the sale of the product. An estimate of the expected cost of servicing the contracts is then recorded as an expense. EXAMPLE: PROPERTY CASUALTY INSURANCE POLICIES. Property casualty com- panies provide policyholders with insurance against certain risks, such as property damage from fire or natural disaster, automobile damage from an accident, or personal injury as a result of accidents. Policyholders typically pay insurance premiums at the beginning of the coverage period. Claims are then reported when damage or injury occurs. When should property casualty firms recognize revenue on insurance contracts? Revenue could be reported when a customer is billed or pays. Alternatively, it could be recognized during (or at the end of) the contractual coverage period. Finally, it could be recognized when the costs of meeting reported claims are known or payments are made. Property casualty firms face no collectibility risk, since premiums are received from policyholders at the beginning of the contract period. However, as discussed in Chapter 5, there are considerable uncertainties about the timing and cost of the claims to be covered. Some claims are not reported until subsequent periods. In addition, the amounts of the payments due for current and unreported claims are often not resolved for several years. Given these uncertainties, a case could be made for deferring revenue recognition until there is assurance that all claim reports have been made and the cost of the claims is known. However, insurance companies are in the business of managing risk. They hire actuaries to analyze the historical frequencies and costs of claims. Given these estimates and the law of large numbers, property casualty firms are able to make reasonable estimates of expected claim costs. As a result, SFAS 60 requires that they recognize revenue during the contract period and make an estimate of the expected costs of meeting both reported and unreported claims for that period. 6-4 Revenue Analysis 6-5 Part 2 Business Analysis and Valuation Tools Key Analysis Questions When customers pay in advance of delivery of a product or service, accounting rules typically require revenues to be deferred. However, if revenues can be recognized, managers are required to make reasonable forecasts of the costs of delivering the product or service. This raises the following questions for financial analysts: • Are management’s costs estimates comparable to those for prior years? If not, why does management expect costs to be unusually high or low? For example, has the firm changed its marketing strategy, or has there been a change in the mix of its customers? • How accurate have management’s estimates been for prior years? Does the firm appear to systematically over- or underestimate these types of costs? • How do the firm’s estimates compare to those for other firms in the same line of business? If there are differences, does the firm have a different strategy from its competitors that could explain the cost differences. For example, are there differences in customer base, location, or product mix that are consistent with the cost estimate differences? Challenge Two: Products or Services Provided over Multiple Periods It can also be difficult to assess whether to recognize revenues for products or services that are provided over multiple years. These may or may not be paid in advance. Examples include long-term construction contracts and airline ticket sales with frequent flyer miles attached. The challenge for these types of contracts is to decide how to allocate revenue over the contractual period. Typically, long-term contracts face two types of uncertainties: (1) a risk that purchasers will be dissatisfied with the quality of future work or service and demand additional work or reimbursement, and (2) a risk that the cost of providing the future service will be greater than anticipated. Both these types of risk raise concerns for financial statement users that revenue recognized prior to full completion of the service provides a misleading indicator of the value created by the completed product or service. How, then, should revenues be recorded on these types of contracts? Should they be recorded as the service is being performed or the product manufactured, which presumably helps external readers of financial reports assess interim results? Alternatively, should revenues be deferred until the full product or service has been completed and all uncertainties have been resolved? Below we discuss long-term construction contracts and frequent flyer contracts to better understand the issues and the way that they are typically handled in financial reporting. 225 226 Revenue Analysis Revenue Analysis EXAMPLE: LONG-TERM CONSTRUCTION CONTRACTS. In February 1999, Turk- menistan awarded a $2.5 billion contract to an American consortium that included Bechtel Enterprises and General Electric to build a pipeline for bringing natural gas out of the Caspian Sea region. How should revenues under this contract be recorded? Conceptually, two methods can be considered. The more conservative method, the completed contract method, records the revenues when the contract is actually completed. Bechtel and GE would then show costs of construction as an asset, Construction in Progress, until the construction is complete. These costs would then be matched against the $2.5 billion of revenues. The second approach, the percentage of completion method, recognizes revenues on a contract as construction progresses. The percentage of construction progress for a given year is estimated by the ratio of construction costs incurred during that year relative to total estimated costs of contract completion. This percentage of total contract revenues is then recognized as revenues for the year. Construction costs for the year are actual costs incurred. Under U.S. GAAP, construction firms are expected to use the percentage of completion method if “estimates of the cost to complete and extent of progress toward completion of long-term contracts are reasonably dependable” (Accounting Research Bulletin 45). Of course, implementation of this rule requires management judgment, potentially creating an opportunity for earnings management. In the Bechtel-GE example, the consortium faces many uncertainties. Funding for the pipeline is unlikely to be finalized until the former Soviet republic solves a territorial dispute with Azerbaijan, and until the five Caspian Sea nations (Turkmenistan, Azerbaijan, Kazakhstan, Russia, and Iran) agree on the division of the sea’s rich reserves, potentially delaying the start of construction. These uncertainties imply that there are also likely to be serious political risks associated with the project that could cause delays and cost overruns once construction begins. As a result, Bechtel and GE are likely to have to record the transaction under the completed contract method. EXAMPLE: FREQUENT FLYER MILES. As discussed in Chapter 5, most airlines have frequent flyer programs that enable customers to earn awards for free flights, flight upgrades, hotel stays, and car rentals. For example, under United Airlines’ Star Alliance reward system, passengers earn one free mile for each mile flown on United or its partner airlines (Air Canada, Lufthansa, SAS, and Thai). Passengers who fly for 25,000 miles can redeem their bonus miles for a free economy class round-trip ticket within the continental U.S. Given its frequent flyer program, how should United record the purchase of a roundtrip ticket from London to Boston for $750? This ticket sale provides the passenger with round-trip passage from Boston to London. But it also provides the passenger with 5000 bonus miles. Two methods of recording the ticket sale can be considered. The first views passengers as purchasing two tickets—the first for a flight at the time the ticket is purchased, 6-6 Revenue Analysis 6-7 Part 2 Business Analysis and Valuation Tools and the second for a possible flight at some future date. Under this approach, revenues are split between those earned for the current flight and those deferred to the future in the event the passenger redeems the bonus miles for another flight. The second approach views the award miles program as a form of promotion to attract passengers and records the incremental costs expected to be incurred to provide the promotion service, such as fuel, baggage handling, and meal costs. This method was discussed in Chapter 5. Both methods are used by airlines throughout the world. United Airlines uses the second method, the incremental cost approach. Key Analysis Questions Accounting for products or services provided over multiple periods is particularly challenging when revenues are recognized prior to completion of the product or service. Managers are then required to either forecast the costs of completion or estimate revenues that are earned and those that are deferred. These challenges raise the following questions for financial analysts: • What are the risks associated with working on multi-period contracts? These could include political risks, weather risks, competitive risks, forecasting risks, and so forth. How is the firm managing these risks? What is its track record in managing these risks? Are the risks likely to be severe enough that the firm should defer recognizing revenues until the project is completed? • How does management break apart current period revenues from future revenues in multi-period contracts? What assumptions and estimates are inherent in this analysis? What is the basis for these estimates? Are they based on historical data or industry data? How relevant is the data used for this analysis? Has the firm changed its strategy or operations significantly over time? Does it follow a different strategy from its competitors? • Does accounting require management to forecast the full cost of a multi-period program? If so, what types of costs are included in the analysis and what types are excluded? What information does management use as a basis for their forecasts—internal budgets, industry data, historical data, etc.? How accurate have management’s forecasts of costs been for prior years? If cost forecasts are systematically under- or over-budget, what are the implications for performance reported in the current period? Challenge Three: Products or Services Sold but Residual Rights Retained by Seller The third area where challenges arise in revenue recognition is where the seller retains some ongoing rights in the product or service sold. For example, a firm sells its receiv- 227 228 Revenue Analysis Revenue Analysis ables to a bank, but the bank has recourse against the seller if the creditor fails to pay off the receivable. Has the receivable been sold or has the firm simply borrowed against its receivables? Alternatively, if a firm signs a long-term agreement to lease equipment from the manufacturer but the manufacturer retains the residual rights to the equipment, has the equipment been sold or has it been rented? To determine which of the above approaches best reflects the economics of the transaction, analysts need to understand the risks that are borne by the parties involved and how those risks are managed. Accounting standards frequently attempt to regulate the reporting of these types of transactions. However, the transactions frequently arrange for risks to be shared by both parties involved, making accounting complex. Receivable sales and long-term leasing contracts are discussed further to illustrate the reporting challenges for these types of transactions. EXAMPLE: RECEIVABLE SALE WITH RECOURSE. Many companies sell receiv- ables to banks, financial institutions, or public investors as a way to accelerate the collection of cash. Two forms of sale are typically used: factoring and securitization. Under factoring, a finance company or bank purchases the rights to the cash flows under the receivable. Under securitization, a portfolio of receivables (such as credit card, auto loan, or mortgage receivables) is packaged into securities that represent claims on the interest and principal payments under the receivables. These securities are then sold to multiple buyers. Securitization as a form of financing has become increasingly popular. For example, on February 17, 1999, the Financial Times reported that many Japanese finance houses have been launching “asset-backed securities, which allow consumer finance companies, among others, to remove assets from their balance sheets. These assets, typically equipment leases, car purchase loans and other types of consumer receivables, are transferred to a ‘special purpose vehicle,’ which stands legally at arm’s-length from its originator. The special purpose vehicle launches a bond, often rated AAA because it is backed by the collateral of the asset’s cash flow (such as repayments on car loans).” How should these types of transactions be recorded? One approach is to view the receivables as having been sold at a gain or loss, depending on any difference between the interest rate on the receivable and the rate charged by the bank. Under this treatment, the seller creates a reserve to reflect any default and prepayment risks borne by the seller. Alternatively, the contract can be viewed as a bank loan where the receivables are a form of collateral. Which of these two approaches best captures the economics of the transaction? Have the receivables really been sold, or should we consider the transaction as a bank loan using the receivables as collateral? To answer this question, we have to understand the potential risks faced by the seller. These include default and prepayment risks. Default risk arises if the receivables subsequently default and the bank is forced to recover from the seller. Prepayment risk arises if the receivables are fixed rate notes and interest rates subsequently fall. Receivables are then likely to be refinanced through alternative financing sources at lower interest rates. As a result, the seller of the receivables will no longer 6-8 Revenue Analysis 6-9 Part 2 Business Analysis and Valuation Tools receive any spread difference between the interest rate on the note and the rate charged by the bank. Accounting rules in the U.S. (SFAS 77) argue that receivables sold with recourse can only be accounted for as a sale if (a) the seller gives up control of the economic benefits associated with the receivable, (b) the seller can make a reliable estimate of any obligations due to the default and prepayment risks, and (c) the buyer of the receivables cannot require the seller to repurchase the receivables. Otherwise, the transaction should be treated as a loan. EXAMPLE: SALES-TYPE LEASE AGREEMENTS. IBM sells mainframe computers to its customers under two different contractual arrangements. First, the customer can purchase the computer using either its own funds or financing through a third party. Second, the customer can sign a long-term lease agreement with IBM for use of the computer for much of its useful life. At the end of the lease term, IBM retains the residual value of the asset. The first of these options (outright sale) is straightforward. However, it is more complex to determine how to record the other contractual arrangement. A long-term lease contract is very similar in form to an outright sale. IBM sells the use of the computer to the lessee for much of its useful life. However, instead of requiring the customer to raise external financing for the purchase, IBM agrees to provide financing. At the end of the lease term, IBM retains some residual claim to the computer. Should this transaction be viewed as a rental agreement or as a sale? Under a rental agreement, the lessor continues to own the asset and rents it to the lessee for the lease term. Financial reporting for leases attempts to reflect these different types of lease arrangements. The critical accounting question is whether the lease terms are equivalent to the sale of the asset or to a rental agreement. In substance, a lease can be thought of as the equivalent of a sale if the lessee bears most of the risks normally associated with ownership. Thus, if the IBM customer contracts to use the computer for the bulk of its life, it bears much of the loss in value from obsolescence. The lease is then equivalent to a sale. Alternatively, if IBM bears most of these risks, the contract is more like a rental agreement. Accounting rules in the U.S. are intended to reflect these differences in the nature of lease contracts. Under SFAS 13, a lease transaction is viewed as equivalent to a sale if any of the following conditions hold: (1) ownership of the asset is transferred to the lessee at the end of the lease term; (2) the lessee has the option to purchase the asset for a bargain price at the end of the lease term; (3) the lease term is 75 percent or more of the asset’s expected useful life; or (4) the present value of the lease payments is 90 percent or more of the fair value of the asset. Lease contracts that satisfy the criteria for an effective sale for accounting purposes are recorded as sales-type leases. For IBM, revenues from the sale would be recognized at the present value of the lease payments. This would also be shown as a receivable— Investment in Sales-Type Leases—on IBM’s balance sheet. The expected residual value of the computer at the end of the lease term would be removed from inventory and in- 229 230 Revenue Analysis Revenue Analysis cluded in the asset Investment in Sales-Type Leases. Finally, the balance of the book value of the computer would be removed from inventory and recorded as the cost of goods sold. The markup on the computer “sale” would then be reflected in the gross profit. In subsequent periods, the lease payments received by the lessor are separated into interest income and principal repayments of the note receivable. Lease contracts that do not qualify as an effective sale for accounting purposes are termed operating leases. The lessor then reports rental income throughout the lease term and continues to depreciate the cost of the asset. Key Analysis Questions Accounting can become complex when a seller retains a residual value in a product or service. Managers are then required to determine whether the asset has been sold and, if so, how to value the residual owned by the seller. For financial analysts, the following questions are likely to arise: • What are the residual risks borne by the seller? What factors affect these risks? Does the seller have control over these risks? • What processes does the seller have in place to manage its residual risks? How effective are these processes? • What have been the historical outcomes of risks borne by the seller relative to forecasts? If these risks have been poorly managed, where on the financial statements are they reflected? Have historical forecasts of the seller’s residual risks systematically over- or understated subsequent realizations? • What has been the seller’s experience in managing its residual risks relative to other firms in its industry? If its historical experience has been different from its industry peers, does it follow a different strategy, or target different customers? • If the firm does not have a strong track record in managing and forecasting residual risks, is it appropriate to view the transaction as a sale? Accounting rules typically require that a transaction either be recorded as a sale or that revenue be deferred. As a result, among the transactions that meet the requirements for current revenue recognition, some are closer to satisfying the minimum requirements than others. Where on this continuum do the transactions being analyzed lie? Challenge Four: Credit-Worthiness of Customer Many firms provide credit to their customers. In most instances, customers are expected to pay for the product or service within thirty days of billing. However, for some businesses, sellers provide long-term financing. 6-10 Revenue Analysis 6-11 Part 2 Business Analysis and Valuation Tools Transactions where there are significant credit risks for the seller raise a number of questions for financial statement users. Does the seller have a system in place to evaluate and manage credit risks of customers? Has the firm done a good job of managing credit risk in the past? Is past success in managing credit risk likely to be a good indicator of the future? Credit risk can be particularly difficult to analyze if (a) customers have experienced a change in circumstances, (b) sales growth has led to a change in the mix of a firm’s customers, or (c) the seller has an innovative strategy that makes it difficult to use historical data to assess credit risk. The following two transactions illustrate these points and the challenges of assessing collectibility. EXAMPLE: REAL ESTATE TRANSACTIONS. Real estate companies frequently provide long-term financing for their customers. A customer may put down 5 percent of the full purchase price of a property and arrange a mortgage with the seller to cover the remaining 95 percent. If the buyer is unable to pay off the loan, the seller can reclaim possession of the property, resell it, and use the proceeds to cover the remaining balance on the mortgage. This transaction raises several questions about collectibility. First, is the initial 5 percent payment refundable? If so, the buyer can potentially renege on the contract with no penalty. Second, is the owner’s equity in the property sufficient to provide some assurance to the seller that the buyer is likely to be committed to meeting the payments, particularly if the property value subsequently declines? For example, if the property in the above transaction declines in value by 20 percent, a buyer with only a 5 percent equity stake has a strong incentive to return the property to the seller. The buyer then loses the equity investment, but avoids further losses that would arise from continuing to make mortgage payments. Accounting standards attempt to capture the above risks. Under SFAS 66, retail land sales can be recognized as revenue only if all of the following conditions are met: 1. The buyer signs a legally binding contract for the land purchase and pays a nonrefundable down payment of 10 percent or more of the sales price. 2. The seller’s collection experience on similar sales indicates that at least 90 percent of the receivables will be collected in full. A down payment of 20 percent or more is an acceptable substitute for this test. 3. The seller’s receivable for the property is not subject to subordination of new loans. 4. The seller is not obliged to construct amenities or other facilities or to make other improvements to the property. If a real estate contract satisfies the above requirements for recognizing a property sale, the seller can recognize the full price of the land as revenue. Otherwise, accounting rules require that revenue be recognized on a cash basis. EXAMPLE: SUBPRIME LENDING. The subprime lending industry is a relatively re- 231 232 Revenue Analysis Revenue Analysis cent phenomenon. Subprime lenders provide consumer credit to individuals who have incomplete or poor credit records and who are unable to obtain financing from traditional bank financing. Subprime lenders thus provide consumer credit through credit cards, automobile financing, and home equity loans. Yields on these loans and service fees tend to be high. Of course, there are significant risks associated with these loans, notably a higher default rate than traditional lending. To manage these risks, subprime lenders attempt to stratify the additional default risk inherent in the loans and to price them accordingly. Key Analysis Questions Credit risks require management to estimate the effect of default risks, raising the following questions for financial analysts: • What is the seller’s business strategy and how does that strategy affect its ability to manage credit risks? For example, does the firm use low-cost financing as a form of marketing for its product? Alternatively, does it offer low prices on its product and make money on financing? What are the risks of these different strategies? • Do the accounting rules governing whether a transaction is a sale factor in all of the risks faced by the seller? Are there risks that are not considered in accounting rules? If so, how serious are these risks? How do firms manage these risks? • Does the seller have a credit process in place to help manage default risk? This process will access customers’ credit histories, job security, assets, and other liabilities. From this information, the seller can adequately assess the risks and price the loan accordingly. • Is the estimated provision for doubtful debts consistent with historical data and with industry norms? If the provision appears to be lower than these norms, what factors explain the differences? For example, has the firm changed its strategy, or does it follow a different strategy from other firms in the industry, making these norms less reliable benchmarks? Is it growing rapidly and selling to different types of customers than historically? If so, are these new customers likely to be more or less risky than the current portfolio mix? Challenge Five: Refunds for Dissatisfied Customers Questions about cash collection can also arise when firms provide open-ended offers to refund returned merchandise from dissatisfied customers. Such is frequently the case for magazine and textbook publishers. It can also arise for some manufacturers and retailers. 6-12 Revenue Analysis 6-13 Part 2 Business Analysis and Valuation Tools For example, L. L. Bean, the mail-order clothing retailer, provides its customers the following assurance: “Our products are guaranteed to give 100% satisfaction in every way. Return anything purchased from us at any time if it proves otherwise. We will replace it, refund your purchase price or credit your credit card. We do not want you to have anything from L. L. Bean that is not completely satisfactory.” This assurance, of course, creates a risk for the company if it fails to deliver on its customer satisfaction pledge. How do firms manage return risks? The most straightforward way is to have a product or service that is attractive to customers. As a result, these types of offers tend to make sense only for firms that follow a differentiated strategy, offering their customers a highquality product or service at full price. However, even for these firms, it can be difficult to manage the risks associated with returns. For example, consider L. L. Bean’s risks from returns by customers who bought incorrectly sized clothing. The company can provide clear directions to customers on how to estimate their sizes, but it cannot eliminate these types of returns. At best, the customer will want to replace the clothing for the correct size. However, if the desired size is out of stock, the company has to refund the purchase price. Given the seasonal nature of the clothing industry, this type of risk may be largely out of L. L. Bean’s control. How are customer dissatisfaction and return risks reflected in financial reporting? Typically, the sale is recognized at point of delivery of the product or service, and at the end of the period an estimate is made for the cost of returns, requiring the exercise of management judgment. However, SFAS 48 recognizes that this approach only works if “the amount of future returns can be reasonably estimated.” If such is not the case, the seller cannot recognize revenues until the return privilege has effectively expired. Key Analysis Questions Businesses where there are significant risks of customer returns and refunds raise a number of questions for financial analysts. • How does the selling firm position its business relative to competitors and how does that strategy relate to its ability to manage return risks? • Does the seller have a process in place to help manage return risk? This process could include customer satisfaction and/or product/service quality programs to limit the likelihood of returns. • Is the estimated allowance for returns consistent with historical data and with industry norms? If the allowance is lower than these norms, what factors explain the differences? For example, has the firm changed its strategy, or does it follow a different strategy from other firms in the industry, making these norms less reliable benchmarks? Is it growing rapidly and selling to different types of customers than historically? Has there been any change in product quality or customer satisfaction with the firm’s product or service that is likely to impact returns? 233 234 Revenue Analysis Revenue Analysis SUMMARY In this chapter, we overviewed the revenue recognition rule and discussed its implications for analysis of revenues by financial statement users. Under the rule, revenues can be recognized only if (1) the seller has provided all, or substantially all, of the goods or services to be delivered to the customer, and (2) the customer has paid cash or is expected to pay cash with reasonable certainty. For certain types of transactions, implementing this rule can be challenging. For example, it can be difficult to assess whether revenues have been earned if: 1. Customers pay for a product or service prior to its delivery, as in the case of magazine subscriptions, property and casualty insurance policies, and service contracts. 2. Products or services are provided over multiple years, as is the case for long-term construction contracts and frequent flyer awards. 3. Products or services are sold with some residual rights retained by the seller, reflected in sales of receivables with recourse and lease agreements. 4. Sellers of products or services provide their customers with long-term financing, as in the case of some real estate developers. 5. Sellers provide an open-ended offer to refund dissatisfied customers. In general, corporate managers of the selling firm are likely to have the best information on whether revenue has been earned and cash is likely to be received from the customer. Revenues (net of estimates of costs for default and returns) then potentially provide users of financial statements with information on managers’ assessment of these risks. However, the value of this information has to be tempered by management’s incentive to report favorable information on its stewardship of the firm. This provides a role for analysis of revenues. Such analysis involves independently assessing whether revenues have been earned, and whether cash is likely to be collected. DISCUSSION QUESTIONS 1. A customer pays $1,000 in advance for a service agreement. What are the financial statement effects of this transaction if (a) revenue is recognized at receipt of cash, and (b) revenue is recognized at delivery of the product? What forecasts, if any, do you have to make to complete the recording of this transaction? What factors would determine which of these two approaches is appropriate? As a financial analyst, what questions would you raise with the firm’s CFO? 2. A firm signs a long-term contract to construct a building for $10,000,000. The building is to be completed in two years at a cost of $8,000,000. At the end of the first year, $6,000,000 of costs has been incurred. Under the contract terms, the customer pays for the building during the first year. What are the financial statement effects of this transaction if (a) revenue is recognized under the completed contract method, and (b) revenue is recognized using the percentage of completion method? What fore- 6-14 Revenue Analysis 6-15 Part 2 Business Analysis and Valuation Tools 3. 4. 5. 6. casts, if any, do you have to make to complete the recording of this transaction? What factors would determine which of these two approaches is appropriate? As a financial analyst, what questions would you raise with the firm’s CFO? United Airlines sells a round-trip ticket for a flight from Boston to London for $750. The customer also receives 5,000 award miles, equivalent to 20 percent of the miles required for a free domestic flight. United expects 20 percent of its customers to redeem awards for future air travel, and the average forgone revenues from these flights to be $400 per passenger. Finally, United estimates that the incremental costs associated with redemption of frequent flyer awards amount to $100 per passenger. What are the financial statement effects of this transaction if (a) the incremental cost approach is used, and (b) revenue is recognized using the deferred revenue approach? What forecasts, if any, do you have to make to complete the recording of this transaction? What factors would determine which of these two approaches is appropriate? As a financial analyst, what questions would you raise with the firm’s CFO? A firm sells $200,000 of interest-bearing two-year notes receivable to a bank, with recourse, for $208,978. The interest rate on the notes is 10 percent, and the bank’s effective interest rate is 7.5 percent. What are the financial statement effects of this transaction if (a) the receivable is viewed as sold, and (b) the receivable is viewed as providing collateral for a bank loan? What forecasts, if any, do you have to make to complete the recording of this transaction? What factors would determine which of these two approaches is appropriate? As a financial analyst, what questions would you raise with the firm’s CFO? Consider a lessor that sells the right to use a depreciable asset, with a book value of $1,500, to a customer for two years for $1,000 per year, payable at the beginning of the year. At the end of the lease term, the rights to the asset revert to the seller. Assuming a discount rate of 10 percent, the present value of the lease payments is $1,909. What are the financial statement effects of this transaction if (a) revenue is recognized under the sales-type lease approach, and (b) revenue is recognized using the operating lease method? What forecasts, if any, do you have to make to complete the recording of this transaction? What factors would determine which of these two approaches is appropriate? As a financial analyst, what questions would you raise with the firm’s CFO? A real estate developer sells land parcels to its customers and provides them with financing. In 2000, the first year of operation, the firm signed new land sale contracts for $25,000,000. This land had originally been acquired for $20,000,000, implying a gross margin of 20 percent. Customer receipts for the year were $8,000,000 for deposits on property sold and $1,000,000 in principal repayments under financing agreements with customers. What are the financial statement effects of this transaction if (a) revenue is recognized at sale, and (b) revenue is recognized when cash is received? What forecasts, if any, do you have to make to complete the recording of this transaction? What factors would determine which of these two approaches is appropriate? As a financial analyst, what questions would you raise with the firm’s CFO? 235 236 Revenue Analysis Revenue Analysis 7. A publishing company delivers 130,000 copies of a new textbook to bookstores during the year. The bookstores pay the publisher $10 per book, but have the right to be reimbursed for any books returned within one year. The cost of the books to the publisher is $5 per book. What are the financial statement effects of this transaction if (a) revenue is recognized at sale, and (b) revenue is recognized when return rights expire? What forecasts, if any, do you have to make to complete the recording of this transaction? What factors would determine which of these two approaches is appropriate? As a financial analyst, what questions would you raise with the firm’s CFO? 6-16 Oracle Systems Corporation I n August 1990 Lawrence J. Ellison, CEO of Oracle Systems Corporation, was facing increasing pressure from analysts about the method the company used to recognize revenue in its financial reports. Analysts’ major concerns were clearly articulated by a senior technology analyst at Hambrecht & Quist, Inc. in San Francisco: 2 Business Analysis and Valuation Tools Under Oracle’s current set of accounting rules, Oracle can recognize any revenue they believe will be shipped within the next twelve months. . . . Many other software firms have moved to booking only the revenue that has been shipped. Given its aggressive revenue-recognition policy and relatively high amount of accounts receivable, many analysts argued that Oracle’s stock was a risky buy. As a result, the company’s stock price had plummeted from a high of $56 in March to around $27 in mid-August. This poor stock performance concerned Larry Ellison for two reasons. First, he worried that the firm might become a takeover candidate, and second that the low price made it expensive for the firm to raise new equity capital to finance its future growth. 6 Revenue Analysis ORACLE’S BUSINESS AND PERFORMANCE Since its formation in California in June 1977, Oracle Systems Corporation has grown rapidly to become the world’s largest supplier of database management software. Its principal product is the ORACLE relational database management system, which runs on a broad range of computers, including mainframes, minicomputers, microcomputers, and personal computers. The company also develops and distributes a wide array of products to interface with its database system, including applications in financial reporting, manufacturing management, computer aided systems engineering, computer network communications, and office automation. Finally, Oracle offers extensive maintenance, consulting, training, and systems integration services to support its products. Oracle’s leadership in developing software for database management has enabled it to achieve impressive financial growth. As reported in Exhibit 1, the company’s sales grew from $282 million in 1988 to $971 million two years later. Larry Ellison was proud of this rapid growth and committed to its continuance. He often referred to Genghis Khan as his inspiration in crushing competitors and achieving growth. ......................................................................................................................... This case was prepared for class discussion by Cholthicha Srivisal and Paul M. Healy of the MIT Sloan School of Management. 237 Revenue Analysis Revenue Analysis 6-18 The primary factors underlying Oracle’s strong performance have been its successes in R&D and its committed sales force. The firm’s R&D triumphs are proudly noted in the 1990 annual report: In 1979, we delivered ORACLE, the world’s first relational database management system and the first product based on SQL. In 1983, ORACLE was the first database management system to run on mainframes, minicomputers, and PCs. In 1986, ORACLE was the first database management system with distributed capability, making access to data on a network of computers as easy as access on a single computer. We continued our tradition of technology leadership in 1990, with three key achievements in the area of client-server computing. First, we delivered software that allows client programs to automatically adapt to the different graphical user interfaces on PCs, Macintoshes, and workstations. Second, we delivered our complete family of accounting applications running as client programs networked to an ORACLE database server. Third, the ORACLE database server set performance records of over 400 transactions per second on mainframes, 200 transactions per second on minicomputers, and 20 transactions per second on PCs. Oracle’s sales force has also been responsible for its success. The sales force is compensated on the basis of sales, giving it a strong incentive to aggressively court large corporate customers. In some cases salespeople even have been known to offer extended payment terms to a potentially valuable customer to close a sale. Oracle’s growth slowed in early 1990. In March the firm announced a 54 percent jump in quarterly revenues (relative to 1989’s results)—but only a 1 percent rise in earnings (see Exhibit 2 for quarterly results for 1989 and 1990). Management explained that several factors contributed to this poor performance. First, the company had recently redrawn its sales territories and, as a result, for several months salespeople had become unsure of their new responsibilities, leaving some customers dissatisfied. Second, there were problems with a number of new products, such as Oracle Financials, which were released before all major bugs could be fixed. However, the stock market was unimpressed by these explanations, and the firm’s stock price dropped by 31 percent with the earnings announcement. REVENUE RECOGNITION The deterioration in its financial performance prompted analysts to question Oracle’s method of recognizing revenues. For example, one analyst commented: Oracle’s accounting practices might have played a role in the low net income results. The top line went up over 50%, though the net bottom line did not do so well, because Oracle’s running more cash than it should be as a result of financial mismanagement. The company’s aggressive revenue-recognition policy and relatively high amount of accounts receivables make the stock risky. Oracle Systems Corporation 238 Revenue Analysis Oracle Systems Corporation 6-19 Part 2 Business Analysis and Valuation Tools Oracle’s major revenues come from licensing software products to end users, and from sublicensing agreements with original equipment manufacturers (OEMs) and software value-added relicensors (VARs). Initial license fees for the ORACLE database management system range from $199 to over $5,500 on micro- and personal computers, and from $5,100 to approximately $342,000 on mini- and mainframe computers. License fees for Oracle Financial and Oracle Government Financial products range from $20,000 to $513,000, depending on the platform and number of users. A customer may obtain additional licenses at the same site at a discount. Oracle recognizes revenues from these licenses when a contract has been signed with a financially sound customer, even though shipment of products has not occurred. OEM agreements are negotiated on a case-by-case basis. However, under a typical contract Oracle receives an initial nonrefundable fee (payable either upon signing the contract or within 30 days of signing) and sublicense fees based on the number of copies distributed. Under VAR agreements the company charges a development license fee on top of the initial nonrefundable fee, and it receives sublicense fees based on the number of copies distributed. Sublicense fees are usually a percentage of Oracle’s list price. The initial nonrefundable payments and development license fees under these arrangements are recorded as revenue when the contracts are signed. Sublicense fees are recorded when they are received from the OEM or VAR. Oracle also receives revenues from maintenance agreements under which it provides technical support and telephone consultation on the use of the products and problem resolution, system updates for software products, and user documentation. Maintenance fees generally run for one year and are payable at the end of the maintenance period. They range from 7.5 percent to 22 percent of the current list price of the appropriate license. These fees are recorded as unearned revenue when the maintenance contract is signed and are reflected as revenue ratably over the contract period. The major questions about Oracle’s revenue recognition concern the way the firm recognizes revenues on license fees. There is no currently accepted standard for accounting for these types of revenues.1 However, Oracle tends to be one of the more aggressive reporters. The firm’s days receivable exceeds 160 days, substantially higher than the average of 62 days receivable for other software developers (see Exhibit 3 for a summary of days receivable for other major software developers in 1989 and 1990). As a result, some analysts argue that the firm should recognize revenue when software is delivered rather than when a contract is signed, consistent with the accounting treatment for the sale of products. In addition, the collectibility of license fees is considered questionable by some analysts, who have urged the firm to recognize revenue only when there is a reasonable basis for estimating the degree of collectibility of a receivable. Estimates by Oracle’s controller indicate that if Oracle were to change to a more conservative revenue recognition policy, the firm’s days receivable would fall to about 120 days. ......................................................................................................................... 1. The Financial Accounting Standards Board was considering the issue of revenue recognition for software developers at this time. It was widely expected that the Board would make a pronouncement on the topic early in 1991. 239 Revenue Analysis Revenue Analysis 6-20 MANAGEMENT’S CONCERNS Oracle’s management was concerned about analysts’ opinions and the downturn in the firm’s stock. The company had lost credibility with investors and customers due to its recent poor performance and its controversial accounting policies. One of the items on the agenda at the upcoming board meeting was to consider proposals for changing the firm’s revenue recognition method and for dealing with its communication challenge. Ellison knew that his opinion on this question would be influential. As he saw it, the company had three alternatives. One was to modify the recognition of license fees so that revenue would be recognized only when substantially all the company’s contractual obligations had been performed. However, he worried that such a change would have a negative impact on the firm’s bottom line and further depress the stock price. A second possibility was to wait until the FASB announced its position on software revenue recognition before making any changes. Finally, the company could make no change and vigorously defend its current accounting method. Ellison carefully considered which alternative made the most sense for the firm. QUESTIONS 1. What factors might have led analysts to question Oracle Systems’ method of revenue recognition in mid-1990? Are these legitimate concerns? 2. Estimate the earnings impact for Oracle from recognizing revenue at delivery, rather than when a contract is signed. 3. What accounting or communication changes would you recommend to Oracle’s Board of Directors? Oracle Systems Corporation 240 Revenue Analysis 6-21 Part 2 Business Analysis and Valuation Tools EXHIBIT 1 Oracle Systems Corporation – Consolidated Financial Statements Oracle Systems Corporation CONSOLIDATED BALANCE SHEETS As of May 31, 1990 and 1989 (in $000, except per share data) 1990 1989 ..................................................................................................................................... ASSETS CURRENT ASSETS: Cash and cash equivalents Short-term investments Receivables Trade, net of allowance for doubtful accounts of $28,445 in 1990 and $16,829 in 1989 Other Prepaid expenses and supplies Total current assets PROPERTY, net COMPUTER SOFTWARE DEVELOPMENT COSTS, net of accumulated amortization of $14,365 in 1990 and $6,180 in 1989 OTHER ASSETS TOTAL ASSETS $ 44,848 4,980 $ 44,893 4,500 468,071 28,899 22,459 569,257 171,945 261,989 16,175 9,376 336,933 94,455 33,396 12,649 $787,247 13,942 14,879 $460,209 $ 31,236 11,265 64,922 18,254 61,164 42,121 32,417 22,193 — 283,572 89,129 4,936 22,025 $ 388 118,715 267,475 1,007 387,585 $787,247 346 84,931 150,065 (4,788) 230,554 $460,209 LIABILITIES AND STOCKHOLDERS’ EQUITY CURRENT LIABILITIES: Notes payable to banks Current maturities of long-term debt Accounts payable Income taxes payable Accrued compensation and related benefits Customer advances and unearned revenues Other accrued liabilities Sales tax payable Deferred income taxes Total current liabilities LONG-TERM DEBT OTHER LONG-TERM LIABILITIES DEFERRED INCOME TAXES STOCKHOLDERS’ EQUITY: Common stock, $.01 par value-authorized, 200,000,000 shares; outstanding: 131,138,302 shares in 1990 and 126,933,288 shares in 1989 Additional paid-in capital Retained earnings Accumulated foreign currency translation adjustments Total stockholders’ equity TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY 9,747 13,587 51,582 14,836 39,063 15,403 23,400 8,608 2,107 178,333 33,506 5,702 12,114 ..................................................................................................................................... 241 Revenue Analysis 6-22 Revenue Analysis CONSOLIDATED STATEMENTS OF INCOME For the Years Ended May 31, 1990 to 1988 (in $000, except per share data) 1990 1989 1988 .................................................................................................................................... REVENUES Licenses Services $689,898 280,946 $417,825 165,848 $205,435 76,678 970,844 583,673 282,113 Sales and marketing Cost of services Research and development General and administrative 465,074 160,426 88,291 67,258 272,812 100,987 52,570 34,344 124,148 51,241 25,708 17,121 Total operating expenses 781,049 460,713 218,218 OPERATING INCOME 189,795 122,960 63,895 OTHER INCOME (EXPENSE): Interest income Interest expense Other income (expense) Total other income (expense) 3,772 (12,096) (8,811) (17,135) 2,724 (4,318) (1,121) (2,715) 2,472 (1,540) 152 1,084 172,660 55,250 120,245 38,479 64,979 22,093 $117,410 $ .86 $81,766 $ .61 $42,886 $ .32 136,826 135,066 132,950 Total revenues OPERATING EXPENSES INCOME BEFORE PROVISION FOR INCOME TAXES PROVISION FOR INCOME TAXES NET INCOME EARNINGS PER SHARE NUMBER OF COMMON AND COMMON EQUIVALENT SHARES OUTSTANDING .................................................................................................................................... Oracle Systems Corporation 242 Revenue Analysis 6-23 Part 2 Business Analysis and Valuation Tools CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended May 31, 1990 to 1988 (in $000) 1990 1989 1988 Oracle Systems Corporation ...................................................................................................................................... CASH FLOWS FROM OPERATING ACTIVITIES Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Provision for doubtful accounts Increase in receivables Increase in prepaid expenses & supplies Increase in accounts payable Increase income taxes payable Increase in other accrued liabilities Increase in customer advances and unearned revenues Increase (decrease) in deferred taxes Increase (decrease) in other non-current liabilities $117,410 $ 81,766 $ 42,886 44,078 16,625 (227,046) (12,834) 12,491 3,002 42,166 23,156 9,211 (149,900) (5,684) 25,236 6,821 38,057 12,973 4,839 (74,777) (1,458) 12,854 7,940 21,420 25,786 7,728 (766) 6,496 (10,857) 1,938 5,682 8,170 — 28,640 26,240 40,529 (480) (89,275) 2,998 (68,428) (7,498) (30,959) (27,639) (1,116) — (10,526) (2,084) (6,650) (4,447) (481) — (118,510) (84,690) (43,385) Notes payable to banks Proceeds from issuance of long-term debt Payments of long-term debt Proceeds from common stock issued Tax benefits from stock options 21,156 68,530 (34,239) 18,460 15,366 10,305 37,539 (6,205) 11,060 10,593 (169) 1,445 (3,638) 4,712 3,992 Net cash provided by financing activities 89,273 63,292 6,342 EFFECT OF EXCHANGE RATE CHANGES ON CASH 552 (1,061) 69 NET INCREASE (DECREASE) IN CASH (45) 3,781 3,555 44,893 41,112 37,557 $44,848 $44,893 $41,112 Net cash provided by operating activities CASH FLOWS FROM INVESTING ACTIVITIES Increase in short-term investments Capital expenditures Capitalization of computer software development costs Increase in other assets Purchase of a business Net cash used for investing activities CASH FLOWS FROM FINANCING ACTIVITIES CASH: BEGINNING OF YEAR CASH: END OF YEAR ...................................................................................................................................... 243 Revenue Analysis Revenue Analysis 6-24 EXCERPTS FROM NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Significant Accounting Policies Organization Oracle Systems Corporation (the Company) develops and markets computer software products used for database management, applications development, decision support, programmer tools, computer network communication, end user applications, and office automation. The Company offers maintenance, consulting, and training services in support of its clients’ use of its software products. Basis of Financial Statements The consolidated financial statements include the Company and its subsidiaries. All transactions and balances between the companies are eliminated. Business Combination In November 1988, the Company’s subsidiary, Oracle Complex Systems Corporation, acquired all of the outstanding shares of Falcon Systems, Inc., a systems integrator, for $13,714,000 in cash and $4,600,000 in notes which become due November 1, 1991. The acquisition was accounted for as a purchase and the excess of the cost over the fair value of assets acquired was $5,648,000, which is being amortized over 5 years on a straight-line method. Pro forma results of operations, assuming the acquisition had taken place June 1, 1987, would not differ materially from the Company’s actual results of operations. Software Development Costs Effective June 1, 1986, the Company began capitalizing internally generated software development costs in compliance with Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed.” Capitalization of computer software development costs begins upon the establishment of technological feasibility for the product. Capitalized software development costs amounted to $27,639,000, $10,526,000, and $4,447,000 in fiscal 1990, 1989, and 1988, respectively. Amortization of capitalized computer software development costs begins when the products are available for general release to customers, and is computed product by product as the greater of: (a) the ratio of current gross revenues for a product to the total of current and anticipated future gross revenues for the product, or (b) the straight-line method over the remaining estimated economic life of the product. Currently, estimated economic lives of 24 months are used in the calculation of amortization of these capitalized costs. Amortization amounted to $8,185,000, $3,504,000, and $2,345,000 for fiscal years ended May 31, 1990, 1989, and 1988, respectively, and is included in sales and marketing expenses. Statements of Cash Flows The Company paid income taxes in the amount of $33,731,000, $29,006,000, and $711,000 and interest expense of $8,026,000, $4,274,000 and $1,540,000 during the fiscal years ended 1990, 1989, and 1988, respectively. The Company purchased equipment under capital lease obligations in the amount of $17,616,000, $4,692,000, and $4,108,000 in fiscal 1990, 1989 and 1988, respectively. Oracle Systems Corporation 244 Revenue Analysis 6-25 Part 2 Business Analysis and Valuation Tools Oracle Systems Corporation Revenue Recognition The Company generates several types of revenue including the following: License and Sublicense fees. The Company licenses ORACLE products to end users under license agreements. The Company also has entered into agreements whereby the Company licenses Oracle products and receives license and sublicense fees from original equipment manufacturers (OEMs) and software value-added relicensors (VARs). The minimum amount of license and sublicense fees specified in the agreements is recognized either upon shipment of the product or at the time such agreements are effective (which in most instances is the date of the agreement) if the customer is creditworthy and the terms of the agreement are such that the amounts are due within one year and are nonrefundable, and the agreements are noncancellable. The Company recognizes revenue at such time as it has substantially performed all of its contractual obligations. Additional sublicense fees are subsequently recognized as revenue at the time such fees are reported to the Company by the OEMs and VARs. Maintenance Agreements. Maintenance agreements generally call for the Company to provide technical support and certain systems updates to customers. Revenue related to providing technical support is recognized proportionately over the maintenance period, which in most instances is one year, while the revenue related to systems updates is recognized at the beginning of each maintenance period. Consulting, Training, and Other Services. The Company provides consulting services to its customers; revenue from such services is generally recognized under the percentage of completion method. 2. Short-Term Debt Year Ended May 31 ................................ Short term debt (in $000) consists of: 1990 1989 ................................................................................................... Unsecured revolving lines of credit Other $18,198 13,038 $5,955 3,792 Total $31,236 $9,747 ................................................................................................... At May 31, 1990, the Company had short-term unsecured revolving lines of credit with two banks providing for borrowings aggregating $42,000,000, of which $18,198,000 was outstanding. These lines expire in September 1990 ($2,000,000), November 1990 ($10,000,000), and January 1991 ($30,000,000). Interest on these borrowings is based on varying rates pegged to the banks’ prime rate, cost of funds, or LIBOR. The Company also had other unsecured short-term indebtedness to banks of $13,038,000 at May 31, 1990, payable upon demand. The average interest rate on short-term borrowings was 9.4% at May 31, 1990. The Company is required to maintain certain financial ratios under the line of credit agreements. The Company was in compliance with these financial covenants at May 31, 1990. 245 Revenue Analysis Revenue Analysis 6-26 3. Long-Term Debt At May 31, 1990, the Company had long-term unsecured revolving lines of credit with four banks providing for borrowings aggregating $135,000,000, of which $61,460,000 was outstanding. Of the $61,460,000 outstanding, $58,210,000 was classified as longterm debt and $3,250,000 was classified as current maturities of long-term debt. These lines of credit expire in December 1991 ($60,000,000), March 1992 ($15,000,000), July 1992 ($20,000,000), January 1991 ($20,000,000), and March 1991 ($20,000,000). The Company has the option to convert $20,000,000 of its line expiring in January of 1991 and $8,000,000 of that expiring in March of 1991 into two term loans which would mature in 1993. Interest on these borrowings vary based on the banks’ cost of funds rates. At May 31, 1990 the interest rate on outstanding domestic and foreign currency borrowings ranged from 8.6% to 15.6%. The aggregate amount available under these lines of credit at May 31, 1990 was $73,540,000. Under the line-of-credit agreements, the Company is required to maintain certain financial ratios. At May 31, 1990 the Company was in compliance with these financial covenants. Subsequent to May 31, 1990, the Company obtained two additional unsecured revolving lines of credit, one which expires May 1992 ($20,000,000) and one which expires January 1991 ($20,000,000). 4. Stockholders’ Equity Stock Option Plan The Company’s stock option plan provides for the issuance of incentives stock options to employees of the Company and nonqualified options to employees, directors, consultants, and independent contractors of the Company. Under the terms of this plan, options to purchase up to 23,335,624 shares of Common Stock may be granted at not less than fair market value, are immediately exercisable, become vested as established by the Board (generally ratably over four to five years), and generally expire ten years from the date of grant. The Company has the right to repurchase shares issued upon the exercise of unvested options at the exercise price paid by the stockholder should the stockholder leave the Company prior to the scheduled vesting date. At May 31, 1990, 271,300 shares of Common Stock outstanding were subject to such repurchase rights. Options to purchase 5,005,720 common shares were vested at May 31, 1990. Non-Plan Options In addition to the above option plan, nonqualified stock options to purchase a total of 5,712,000 common shares have been granted to employees and directors of the Company. These options were granted at the fair market value as determined by the Board of Directors, became exercisable immediately, vest either immediately (for directors) or ratably over a period of up to five years (for individuals other than directors) and generally expire ten years from the date of grant. The Company has the right to repurchase shares issued upon the exercise of unvested options at the exercise price paid by the stockholder should the stockholder leave the Company prior to the scheduled vesting date. Options to purchase 160,000 common shares were vested as of May 31, 1990. As of May 31, 1990, the Company had reserved 11,135,194 shares of Common Stock for exercise of options. Oracle Systems Corporation 246 Revenue Analysis Oracle Systems Corporation 6-27 Part 2 Business Analysis and Valuation Tools Stock Purchase Plan In October 1987, the Company adopted an Employee Stock Purchase Plan and reserved 8,000,000 shares of Common Stock for issuance thereunder. Under this plan, the Company’s employees may purchase shares of Common Stock at a price per share that is 85% of the lesser of the fair market value as of the beginning or the end of the semiannual option period. Through May 31, 1990, 2,326,772 shares have been issued and 5,673,228 shares are reserved for future issuances under this plan. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Oracle Systems Corporation: We have audited the accompanying consolidated balance sheets of Oracle Systems Corporation (a Delaware corporation) and subsidiaries as of May 31, 1990 and 1989 and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended May 31, 1990. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Oracle Systems Corporation and subsidiaries as of May 31, 1990 and 1989 and the results of their operations and their cash flows for each of the three years in the period ended May 31, 1990, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed under Item 14(a)2. are presented for purposes of complying with the Securities and Exchange Commission’s rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole ARTHUR ANDERSEN & CO. SAN JOSE, CALIFORNIA JULY 9, 1990 247 Revenue Analysis Revenue Analysis 6-28 EXHIBIT 2 Oracle Systems Corporation – Review of Quarterly Results in Fiscal 1989 and 1990 (in $000 except per share data) Fiscal 1990 Quarter Ended .................................................................................. Aug. 31 1989 Nov. 30 1989 Feb. 28 1990 May 31 1990 .......................................................................................................................... Revenues Net income Earnings per sharea $175,490 11,679 $ .09 $209,023 28,491 $ .21 $236,165 24,282 $ .18 $350,166 52,958 $ .39 Fiscal 1989 Quarter Ended .................................................................................. Aug. 31 1988 Nov. 30 1988 Feb. 28 1989 May 31 1989 .......................................................................................................................... Revenues Net income Earnings per sharea $90,639 7,067 $ .05 $123,745 17,189 $ .13 $153,354 23,964 $ .18 $215,935 33,546 $ .25 .......................................................................................................................... a. Adjusted to reflect the two-for-one stock splits in the third quarter of fiscal 1988 and the first quarter of fiscal 1990. EXHIBIT 3 Days Receivable for Selected Companies in the Software Industry for 1989–90 Company 1989 1990 ................................................................................................. Borland International Corp. Lotus Development Corp. Microsoft Corp. Novell Corp. 49 64 51 85 45 64 56 81 Average 62 62 ................................................................................................. Oracle Systems Corporation – Review of Quarterly Results in Fiscal 1989 and 1990 Oracle Systems Corporation 248 77 E x pe n s e An alysis chapter E Business Analysis and 2Valuation Tools xpenses are the economic resources that have been consumed or have declined in value. Firms incur expenses to acquire or produce products or services that are sold. In addition, expenses are incurred for marketing (including advertising costs, sales force salaries and commissions, and salaries of marketing management), for managing the firm (salaries of the head office staff and depreciation on headquarters), for the cost of any debt financing, for taxes, and for realized and unrealized declines in asset values. Analysis of expenses focuses on assessing when expenses should be recognized in the financial statements. Should they be recognized when the resources are used? Should they be recognized when the firm is billed for resources? Should they be recognized when payment for resources is made? Or should they be reported when the revenues generated from using the resources are recognized? The key principles in accounting that dictate how expenses are recorded are matching and conservatism. Under these principles, resources directly associated with revenues are recorded in the same period as revenues are recognized. Resources that are more closely associated with a specific period are recorded in that period. Finally, all other costs are recognized as an expense when they are incurred or can be reasonably estimated. Challenges in recognizing expenses arise when resources provide benefits over multiple periods, when resources have been consumed but there is uncertainty about the timing and amount of payment, when the value of resources consumed is difficult to define, and when resources have declined in value. These challenges give rise to opportunities for financial analysis of expenses. MATCHING AND CONSERVATISM Cash outlays are a poor indicator of resource use when a firm acquires (and pays for) resources but has yet to use them, or when a firm uses resources but has yet to pay for them. Indeed, recognizing resource use at the outlay of cash can be misleading and can provide perverse incentives for managers to improve reported performance by deferring payments for resources. This incentive to delay making cash outlays is likely to be magnified for big-ticket items, such as purchases of assets that provide benefits for multiple periods. 7-1 249 250 Expense Analysis Expense Analysis Figure 7-1 Criteria for Recognizing Expenses and Implementation Challenges First Criterion Second Criterion Third Criterion Resources consumed have a cause-and-effect relation with revenues recognized during the period. Resources have no causeand-effect relation with revenues but are consumed during the period. There is a decline in the future benefits expected from resources. Recognize expense. Challenging Transactions 1. Resources provide benefits over multiple periods. 2. Resources are consumed, but the timing and amount of future payments is uncertain. 3. The value of resources consumed is difficult to define. 4. Unused resources have declined in value. Accrual accounting relies on the matching and conservatism principles to determine the cost of resources used. As shown in Figure 7-1, these principles classify expenses into three types. First, the matching principle views expenses as the cost of consumed resources that have a cause-and-effect relation with revenues. These include the cost of materials consumed in manufacturing a product or the cost of acquiring merchandise by retailers. Matching therefore makes it easier for financial statement readers to assess whether a firm’s products or services are profitable. The cost of resources that have no clear cause-and-effect relation to revenues are recorded as expenses during the period they are consumed. Examples include general administration and marketing costs. Finally, under the conservatism principle, accountants require firms to record expenses when there is a decline in the future benefits expected to be generated by resources, or when it becomes difficult to estimate benefits with reasonable certainty. Write-downs of impaired assets are one such form of expense. EXPENSE REPORTING CHALLENGES Four types of resource uses are particularly challenging from a financial reporting viewpoint. These arise when resources have benefits across multiple accounting periods, when resources are consumed but the timing and amount of payment is uncertain, when the value of resources consumed is difficult to define, and when unused resources have declined in value. Considerable management judgment is involved in recording these types of expenses. Managers are likely to have better information on the cost of resources 7-2 Expense Analysis 7-3 Part 2 Business Analysis and Valuation Tools consumed by the firm during the period, but they are also self-interested. Further, accounting rules sometimes require certain outlays to be recorded as an expense, regardless of the future economic benefits they provide. Both these reporting limitations create incentives for analysis of expenses by financial statement users. Below we analyze the key challenges in implementing the criteria for expense recognition and use specific industries and types of transactions to illustrate the key points. However, the challenges discussed are quite general. Challenge One: Resources Provide Benefits over Multiple Periods Many resources acquired by a firm provide benefits over multiple years. These include outlays for plant and equipment, research and development, advertising, and drilling oil and gas wells. A challenge in accounting for these types of transactions is how to allocate the cost of these types of resources over multiple periods. Should it be allocated equally over their useful life? Or should it be recorded conservatively as an expense when it is incurred? The matching principle argues for spreading out the cost of a resource over its expected life if it has a clear and reasonably certain cause-and-effect relation with future revenues. Alternatively, if the cause-and-effect relation is unclear or highly uncertain, the resource cost is recognized as an expense in the period incurred. To illustrate the issues in reporting for outlays for resources with multi-period benefits, we discuss the financial reporting treatment of fixed asset depreciation, goodwill amortization, research and development outlays, and advertising outlays. EXAMPLE: FIXED ASSET DEPRECIATION. Fixed assets include plant, buildings, manufacturing equipment, computer equipment, automobiles, and furnishings, all of which have multi-year lives. There is typically little question that these resources are expected to directly or indirectly help generate future revenues for the firm. Thus, the cause-and-effect relation between outlays for such resources and future revenues is typically reasonably certain. It is more challenging, however, to assess how the cost of these types of resources should be matched with future revenues. Generally accepted accounting rules require managers to make estimates of the expected useful lives of these assets and their expected salvage values at the end of their lives. These estimates are then used to allocate the cost of the fixed assets over their useful lives in a systematic manner. Assets’ useful lives are determined by the risk of technological obsolescence and physical use. Managers’ estimates of these effects are therefore likely to depend on their firms’ business strategies and their prior experience in operating, managing, and reselling similar assets. For example, in 1998 Delta Air Lines depreciated new aircraft over 25 years and estimated salvage values at 5 percent of cost. In contrast, Singapore Airlines estimated the life of aircraft at 10 years and salvage values at 20 percent of cost. These estimates partially reflect differences in the two airlines’ business strategies. Singapore Airlines targets business travelers who are typically less price conscious and 251 252 Expense Analysis Expense Analysis demand reliable service. In contrast, Delta focuses more on economy travelers who are highly price-sensitive and for whom on-time arrival is less critical. As a result, the two airlines follow very different operating strategies for their aircraft. Singapore Airlines replaces older aircraft regularly to maintain a relatively new fleet. This reduces the risk of flight delays for maintenance problems, enabling the company to have high on-time arrival rates. In contrast, Delta holds its aircraft longer, lowering its equipment outlays, but at the cost of increased maintenance and lower on-time arrival rates. These differences in operations are reflected in the depreciation estimates made by the two companies. Of course, there may be other factors that influence management’s estimates for the two companies. For example, Delta is likely to face more pressure to report profits for owners since it is 100 percent publicly owned. In contrast, Singapore Airlines is majority owned by the Singapore government. A variety of depreciation methods are permitted under generally accepted accounting rules. The standard method used for financial reporting in the U.S. is straight-line depreciation, which allocates the depreciable cost (defined as purchase price less estimated salvage value) equally over the asset’s estimated useful life. More than 90 percent of all publicly owned firms in the U.S. use this method. Outside the U.S., many companies employ accelerated depreciation, in conformance with their tax reporting method.1 Accelerated depreciation generates higher depreciation expenses than the straight-line method in the early years of an asset’s life, and lower expenses toward the end of its life. A third depreciation method, the units of production method, is used for assets whose lives can be measured in physical units. The depreciation expense for a given year is then the cost of the asset multiplied by the percentage of lifelong physical capacity used during that period. This method is commonly used by natural resource companies to record depreciation on production assets whose useful lives are tied to the resource capacity at a particular mine or well site. Management uses its judgment in estimating asset lives and salvage values and in selecting depreciation methods. Thus, there is a risk that depreciation expenses reflect management’s reporting incentives as well as the economics of the business. EXAMPLE: GOODWILL AMORTIZATION. As discussed in Chapter 4, when a firm acquires another firm and accounts for the acquisition using purchase accounting, goodwill is recorded. Goodwill represents the premium paid for the target’s intangible assets. These assets include brand names, research and development, customer base, superior management, well trained employees, patents, and other sources of superior performance. For several reasons, the cause-and-effect relation between purchased goodwill resources and future revenues is less obvious than for fixed assets. First, the particular source of the future benefits to be derived from goodwill is less clear than for fixed assets. Second, goodwill can represent any overpayment by the acquirer for the target’s business as well as payment for intangibles. As a result of these uncertainties, goodwill amortization policies permitted by standard setters have differed across countries. For example, in the Netherlands goodwill is not amortized against income at all, but is 7-4 Expense Analysis 7-5 Part 2 Business Analysis and Valuation Tools written off against shareholders’ equity at the completion of the acquisition. Goodwill is amortized on a straight-line basis over a maximum of forty years in the U.S., five years in Japan, and four years in Germany. In the U.K., goodwill is reported as an asset, but does not have to be amortized at all if it has not been impaired. The expected value and economic life of goodwill depend on a number of factors. First, they depend on the ability of acquiring management to price the intangible assets of the target appropriately, avoiding overpayment. Second, they depend on acquiring management’s ability to integrate the target firm without destroying intangible assets that it purchased, such as superior management, existing customers, or key employees. Finally, the value and expected life depend on the strategy and strategy implementation capabilities of the new firm, which can either leverage or destroy the target firm’s intangible assets.2 To illustrate, Cooper Industries, a diversified company operating in the electrical, hand-tool, automotive, and energy equipment businesses, acquired Cameron Iron Works, a manufacturer of oil and gas machinery, for $967 million in 1989.3 Cooper’s strategy was to acquire manufacturing businesses, strengthen their management, and improve their reporting and control systems. However, several problems arose with this strategy and its implementation at Cameron. First, Cooper’s expertise was in understanding manufacturing. Its management mistakenly believed that this was critical to Cameron’s success. Only after the acquisition did it learn that service and marketing were the key performance drivers for Cameron. Second, in implementing the acquisition, Cooper became preoccupied with control, making it difficult for management at Cameron to run its business. As a result, Cooper took $440 to $750 million of writedowns related to the acquisition, and it divested Cameron in 1994. Given management’s self-interest in communicating to investors that an acquisition is successful and the challenge in estimating future benefits from outlays for goodwill, there is a risk that managers making value-decreasing acquisitions will fail to recognize any deterioration in goodwill values on a timely basis. Equally, for acquisitions that do create shareholder value, accounting rules for goodwill amortization often do a poor job of reflecting merger benefits, since many countries require firms to amortize goodwill even if the asset has not declined in value. EXAMPLE: RESEARCH AND DEVELOPMENT OUTLAYS. Research and develop- ment outlays are intended to create value for the firm in future periods. This suggests that they should be expensed in the same periods as when the new product revenues they are expected to generate are recognized. However, research and development (R&D) is a highly uncertain process. There are typically many failed projects for every successful one. As a result, accounting rules in most countries require R&D outlays to be expensed as incurred (see SFAS 2).4 In the U.S., there are several exceptions to the rule requiring expensing of R&D. First, completed R&D that is purchased from another company is capitalized and amortized over its useful life (see SFAS 68). Second, software development costs are capitalized upon completion of a detailed program design plan or working model. Amortization of 253 254 Expense Analysis Expense Analysis this asset for a particular year is proportional to the project revenues generated during that year relative to total expected project revenues (see SFAS 86).5 The rules on capitalizing and amortizing outlays for completed R&D and software development provide management with opportunity to exercise judgment in financial reporting. Management can potentially use this judgment to match R&D costs with revenues they generate. Alternatively, it can misuse this judgment to accelerate or defer earnings, either in their assessments of the types of outlays that satisfy the criteria for capitalization and amortization against future revenues, or in the estimates of future lives of any outlays to be amortized.6 The diversity in reporting practice on these issues is likely to raise questions for users of financial reports. For example, Microsoft, the most successful software developer in the world, expenses all software development outlays immediately. In contrast, Peoplesoft, one of the smaller players in the software industry, capitalizes its development costs and amortizes them over three years. Is Microsoft being conservative in its reporting? Is Peoplesoft reporting aggressively? Or do the two firms have very different models of developing software consistent with their reporting differences? Analysis is also important for firms whose managers have no opportunity to exercise judgment in reporting on R&D outlays. For example, firms in the R&D-intensive pharmaceutical industry are required to expense all R&D outlays immediately. For these firms, financial reporting does not help investors discriminate between firms with the most and the least effective research labs, a critical issue for evaluating the performance of management and for valuation. As a result, analysts research other sources of information on firms’ research capabilities and successes, such as patent filings and FDA approvals. EXAMPLE: ADVERTISING OUTLAYS. Advertising outlays create an even greater challenge for financial reporting than R&D. As discussed in Chapter 4, companies such as Coca-Cola have been able to create long-term sustainable economic rents from advertising their products. However, it is often unclear what link, if any, exists between advertising outlays in a period and future revenues. To illustrate the difficulty in linking a firm’s advertising program to long-term revenues, consider Microsoft’s $220 million campaign to launch Windows 95. The role of this campaign in the success of the new product is difficult to estimate. Because of the company’s dominant position in its market, there was widespread public interest in the product well before the first paid advertisement for Windows appeared on August 24, 1995. The Wall Street Journal estimated that 3,000 headlines, 6,852 stories, and over 3 million words had been dedicated to Windows 95 during the period July 1 to August 24, 1995. In addition, during the launch week, Microsoft engaged in a series of publicity stunts to promote the new product. A 600-foot Windows 95 banner was hung from the CN Tower in Toronto, the Empire State Building was lit in the colors of the Windows 95 logo, and the company paid The London Times to distribute an entire day’s run of 1.5 million copies free. What was the role of these promotions relative to the $220 million advertising campaign in making the product a market success? 7-6 Expense Analysis 7-7 Part 2 Business Analysis and Valuation Tools As shown by the Windows 95 example, the long-term effectiveness of a firm’s advertising is typically difficult to assess because so many other factors aside from the company’s advertising strategy are likely to influence its campaign effectiveness. Intervening factors include the firm’s own pricing and promotion decisions, the price, promotion, and advertising responses of competitors, the market position of the firm relative to its competitors, and the stage of the product market (growing, mature, or declining). Given the difficulty in quantifying these effects and isolating any cause-and-effect relation between advertising outlays and future revenues, accounting standards typically require advertising expenditures to be expensed as incurred. However, for several industries it is possible to link some forms of marketing outlays and future revenues. For example, life insurance companies pay commissions to compensate sales representatives for signing up new policyholders. The benefits of these contracts can be short-term (for property-casualty insurers) or long-term (for life insurers). As a result, SFAS 60 and SFAS 120 require insurers to capitalize these outlays and to expense them over the life of the contract. Direct response advertising costs are another type of advertising outlay where it may be possible to establish a link between outlays and future revenues. Credit card companies, telephone companies, Internet service providers, satellite television providers, magazine publishers, and membership service companies spend heavily on direct response advertising to attract new members. Many of these firms can document the signup rates from their programs, as well as the rates of membership renewal. Indeed, many of these firms use market research to target customers that are most likely to sign up and subsequently renew their memberships. Consequently, accounting standards (see Statement of Practice 93-7) permit firms to capitalize these types of costs provided they can document that (a) customers have responded directly to the advertising campaign, and (b) future benefits from the expenditures are reasonably certain. The first requirement can be satisfied by use of coded order forms, coupons, or response cards. The second can be satisfied by reference to historical data on membership renewals. Of course, there are always risks that future renewals will not follow historical patterns, perhaps due to increased competition or to customer disappointments over service. Key Analysis Questions The above discussion indicates that management sometimes has an opportunity to use judgment to expense resources that provide value over multiple periods. In addition, accounting standards for reporting on some of these resources require all firms to immediately expense outlays. This makes it more difficult for analysts to distinguish firms that are able to create multi-period benefits from these outlays from firms that are not. As a result, the following questions are likely to be useful for analysts: • What assumptions are made by management to amortize resources with multi-period benefits? Are these assumptions consistent with the firm’s busi- 255 256 Expense Analysis Expense Analysis • • • • ness strategy? How do they compare to assumptions made by other firms in the industry? If there are significant differences, what factors can explain these differences? Has the firm changed its amortization assumptions over time? What factors explain these decisions? For example, is it following a different business or operating model? Is there evidence that management has consistently over- or underamortized long-lived assets? Such evidence includes systematic reporting of gains (or losses) on asset sales, or persistent asset write-downs. What is the value and reliability of benefits expected from capitalized current period outlays? These are affected by the firm’s position in its product market and the sustainability of that position. For example, if the firm records significant goodwill as a result of an acquisition, is there an economic basis for this asset, or did the acquirer overpay for the target? If accounting standards require outlays for intangible resources to be expensed as incurred, analysts may want to discount the effect of these expenses on earnings, particularly for firms that appear to be capable of creating long-term value from these outlays. This requires an analysis of the expected benefits and associated risks from these outlays. Does the firm have a track record of creating new products through its R&D labs, or brand names through its marketing campaigns? Challenge Two: The Timing and Amount of Payment for Resources Is Uncertain Some transactions require firms to make long-term commitments for resources that have no long-term benefits to the firm. For example, many firms offer pension and other postretirement benefits to their employees. Firms also incur long-term obligations to pay for the cleanup of environmental hazards for which they are responsible. These obligations represent expenses, since they provide no future benefit to the firm. Any benefits have already been realized in either the current period or prior periods. However, they are challenging to record, since the timing and amount of the obligations is frequently uncertain. How should these types of commitments be recorded? Should an expense be estimated for the expected obligation or for the present value of the expected obligation? If so, how should errors in management’s forecasts of these obligations and interest rates be reflected? Alternatively, should recording the expense be delayed until the timing and amount of the obligation can be determined more accurately? To illustrate the challenges associated with recording expenses for long-term obligations with no future benefits, we discuss the accounting for pension and post-retirement benefits and environmental obligations. 7-8 Expense Analysis 7-9 Part 2 Business Analysis and Valuation Tools EXAMPLE: PENSIONS AND OTHER POST-RETIREMENT BENEFITS. Many firms offer employees a pension plan and other forms of post-retirement benefits. Typically, employees are entitled to receive some form of benefit after working for a firm for a minimum period. Thereafter, the magnitude of the benefits typically increases for each year the employee works. As discussed in Chapter 5, companies are required to estimate liabilities for the expected future obligations under pension and post-retirement plans. This is a significant challenge for recording the liability associated with defined benefit plans, where an employer guarantees certain future levels of benefits for employees.7 For these types of plans, managers have to forecast current employees’ future working lives with the firm, their life expectancies, retirement ages, and the expected cost of the future benefits. These data are used to estimate the present value of the expected future benefits for all current employees. This value is amortized as a benefit expense by using a straight-line method over the employees’ expected working lives with the firm. In addition, the benefit expense reflects increases in the value of the obligation as employees get closer to receiving benefits (an interest effect) and decreases as any assets invested by the company to fund the benefit plan increase in value. Expenses are also adjusted as management revises its forecasts of future plan commitments. Of course, under this approach, management has considerable judgment in estimating the annual benefit cost. Estimating the cost of obligations provided under such plans is challenging for management. However, it does ensure that the risks associated with the plans, such as uncertainty over employee turnover, medical cost inflation, and employee life expectancy, are reflected in the financial statements. It is likely to be important for management and for external users of financial statements to understand the implications of these risks and the value of the benefits provided to employees. EXAMPLE: ENVIRONMENTAL COSTS. As discussed in Chapter 5, the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) empowers the federal government to make those responsible for the improper disposal of hazardous waste at the nation’s worst hazardous waste sites bear the cost of cleanup. The challenges in measuring environmental liabilities, namely the difficulties in estimating the cost of the cleanup and in assessing how the cleanup cost will be shared by the parties associated with the site, also make it challenging to record an expense. How should the expense be recorded? For example, should it be recorded as a one-time charge at the same time as the liability is recorded, or should it be spread out over the cleanup period? Should it be shown as an extraordinary item, as a non-operating item, or as a part of normal operations? As noted in Chapter 5, a liability must be recorded when much of the uncertainty over the cost of cleanup and the firm’s responsibility have been resolved (see SFAS 5 and Statement of Position 96-1). The Statement of Position also requires firms to recognize the full cost of cleanup as an operating expense when the liability is recorded. Cleanup costs cannot be considered extraordinary or included in the “other income and expense” 257 258 Expense Analysis Expense Analysis category. Of course, if these costs are large and unlikely to be ongoing, analysts may want to consider them separately from operating income in order to improve the forecasts of future operating earnings. Key Analysis Questions Considerable management judgment is involved in estimating the costs for future obligations that are uncertain in timing and amount. In addition, for some of these costs, accounting standards do not require an expense to be recorded because the amount is too uncertain, making it difficult to assess which firms’ costs are likely to be understated. As a result, the following questions are likely to be useful for financial analysts: • What assumptions are made by management to recognize the cost of uncertain future obligations? Have these assumptions changed in relation to prior years? If so, what factors explain this change? For example, has the firm altered its benefit plans or its business operations? If management changed the discount rate used to compute the present value of pension obligations, has there been a comparable change in interest rates? • Are there any differences in the firm’s assumptions for estimating the costs of uncertain future obligations in relation to other firms in the same industry? If so, what factors can explain these differences? Does the firm have a different relationship with the suppliers of these resources? • Is there any evidence that the firm’s managers have a record of systematically over- or underestimating costs for long-term obligations? • How seriously are a firm’s expenses likely to be affected by accounting standards that delay recording costs for future obligations because of uncertainty in estimating the future outlays, such as the cost of environmental liabilities? How does the firm manage these risks? Are there indicator variables that can be used to help identify firms with high and low risks? Challenge Three: It Is Difficult to Define the Value of Resources Consumed Some types of resources used to generate revenues are difficult to value. For example, inventory is purchased or manufactured at different prices and then has to be matched to revenues. Which inventory units should be reported as a cost of sales and which should be reported as inventory? Executive stock options also raise questions about the value of the resources consumed in return for the options, and the timing of when these costs should be treated as an expense. We discuss how these types of resources are recorded and the challenges involved. 7-10 Expense Analysis 7-11 Part 2 Business Analysis and Valuation Tools EXAMPLE: COST OF SALES. If a firm purchases or manufactures products at different costs and then sells some of those units, it faces a question of determining the cost of the units that were sold and the cost of units remaining in inventory. Costs of merchandise purchased or produced can differ over time if there is inflation in the economy or if there is a demand or supply shock for the firm’s merchandise or inputs. Manufacturing costs can also vary over time if the firm changes the number of units it produces. Since capacity costs of production are fixed in the short run, these costs will be allocated over more or less units, affecting unit costs. For some types of products, the valuation of the cost of sales and inventory can be easily resolved, since the specific units that are purchased and sold are identifiable. Such is the case for auto dealerships. New and used cars are identifiable by make, model, color, year, accessories, and if necessary by vehicle identification number. Consequently, when a vehicle is sold, management can identify its specific cost to match against the sales revenue. However, for most businesses it is not feasible to specifically identify each unit purchased and sold. For example, a large automobile manufacturer that purchases thousands of inputs to make a new automobile would find it inefficient to keep track of the cost of each specific part. Consequently, some other form of accounting is required to estimate the cost of sales. The approach taken by accountants is to make an assumption about how products flow from inventory to cost of sales. Three major methods are permitted. The first, called the last-in-first-out method (or LIFO), assumes that the last units purchased or manufactured are the first units to be sold. This method therefore matches recent costs with revenues, leading some to argue that it gives a better indication of the firm’s future profit margins than do the other methods.8 However, it can also lead to inventory valuations that are long out of date, and it provides the potential for management to temporarily boost profits by reducing inventory levels, thereby selling merchandise carried at old costs. The second method is the first-in-first-out (or FIFO) method. This approach assumes that the first units purchased or manufactured are the first to be sold. The advantage to this approach is that it ensures that inventories are valued at recent costs. However, it makes it more difficult to interpret profit margins, since margins include holding gains on units purchased at old cost levels. The third approach, the average cost method, is a compromise between LIFO and FIFO. It values the cost of sales and inventory at the average cost of units purchased or manufactured. Several points are worth noting about inventory valuation. First, the particular method followed does not have to represent the actual physical flow of merchandise from the warehouse. Thus, a company that bakes bread can report under the LIFO method, but it would not follow such an approach for managing its physical inventory. Second, the LIFO method cannot be used in some countries. For example, it is not permitted under U.K., French, or Canadian accounting. Third, in the U.S., tax factors are a 259 260 Expense Analysis Expense Analysis consideration for managers deciding which method to use for financial reporting. Tax rules require that the method used for financial reporting must also be used for tax reporting. Consequently, firms in industries with increasing factor or merchandise costs have tax incentives to select the LIFO method, since it lowers the present value of their tax obligations. For firms in industries with declining factor or merchandise costs, there are tax advantages from using FIFO. In summary, the valuation of the cost of sales provides several opportunities for managers to exercise judgment in financial reporting. Managers can select the inventory flow method, increase or reduce production to allocate capacity costs over more or less units, or, if the firm uses LIFO, deplete inventory to match old costs against revenues.9 EXAMPLE: EXECUTIVE STOCK OPTION COMPENSATION. In the U.S., most public companies provide stock option remuneration to top executives. A stock option permits an executive to purchase stock at a given price, known as the exercise or strike price, at some point in the future, known as the exercise or expiration date. For example, Walt Disney Company’s 1999 proxy statement disclosed that on September 30, 1996, the Compensation Committee granted the firm’s CEO, Michael Eisner, the option to purchase 15,000,000 Disney shares at an exercise price of $21.10, the stock price when the option was granted. The option expires on September 30, 2008. At fiscal year-end on September 30, 1998, Disney’s stock price was $25.375. Stock option compensation, like that reported for Michael Eisner, is intended to provide top management with a powerful incentive to maximize shareholder value, since managers get to share in any upside in the stock price. For several reasons, options are a more popular form of compensation than straight stock awards. They protect management against downside risk from holding the stock. Compensation that imposes downside risk on risk-averse managers can induce them to be more cautious in their decisions than owners would like. Also, stock option compensation is often tax advantageous relative to stock awards.10 The challenging question for financial reporting is how to record these forms of compensation. Should an expense be recorded for these types of compensation awards, or is it too difficult to estimate their value? If an expense is to be recorded, when should it be shown and at what value? Should the value of the compensation be recognized when the award is granted? If so, what is its value? Should the compensation cost be shown throughout the option exercise period? Again, what is the value of the compensation provided? Should compensation be recorded when the options are exercised and the value of shares awarded is known? Should the compensation expense be recognized when management actually sells the shares awarded under option grants? Prior to 1995, U.S. firms were required under APB Opinion 25 to use the “intrinsic value” method of reporting for option grants. Under this approach, a compensation expense was recorded for the difference between the market price of the stock at the date the option was granted and its exercise price. However, since most options had an exercise price equal to the stock price at the grant date, no compensation expense was 7-12 Expense Analysis 7-13 Part 2 Business Analysis and Valuation Tools reported. In 1995 the FASB released an Exposure Draft on stock option compensation, recommending the “fair value” method to value options. This involved creating at the grant date a deferred compensation expense for the market value of options awarded, estimated using Black-Scholes or binomial option-valuation models.11 The compensation expense, reflecting compensation effectively earned by managers from option awards, is then recorded by amortizing the deferred compensation expense over the option’s vesting period. Considerable controversy surrounded the stock option exposure draft, and the FASB decided to tone down its recommendation. The final standard, SFAS 123, permitted managers to decide whether to report under APB 25 or SFAS 123. However, if a firm elects to use APB 25, it is also required to disclose the fair value of options awarded in its footnotes.12 Key Analysis Questions When it is difficult to define the value of resources consumed, accounting rules have to either suggest definitive methods that can be used to estimate resource consumption, or permit management to exercise judgment in recording their consumption. Both outcomes create an opportunity for financial analysis of expenses. Some questions that are likely to arise for financial analysts include the following: • What method does management use to account for and value the cost of sales, stock option compensation, and other expenses for resources whose use is difficult to value? Has this method changed over time? Does the firm use the same method as other firms in the industry? If the method used differs over time or across firms in the industry, what factors are likely to explain this difference? Has the firm changed its business strategy or is it following a different model for value creation than its competitors that could explain any method differences? Has it changed its tax status or tax management strategy? Or does it appear to be trying to report positive performance to the capital market? • What earnings effects, if any, arise from the accounting methods used to value the cost of sales, stock options, and other expenses for resources that are difficult to value? For example, are there any one-time effects on the cost of sales from LIFO inventory liquidations? How do changes in production capacity utilization affect the cost of sales? If firms use FIFO or average cost methods to record the cost of sales, how are future margins likely to be affected by any recent increases in input prices? If the firm uses the “intrinsic value” method to record option expenses, what would have been the effect of using the “fair value” approach? Is management being compensated appropriately, given the firm’s performance? 261 262 Expense Analysis Expense Analysis Challenge Four: Unused Resources Decline in Value The final challenge in recording expenses arises for unused resources whose values change over time. In most cases the financial reporting implications of these value changes are based on the application of the conservatism principle. This principle holds that permanent declines in resource values should be recorded as a loss, but if values have increased, no gain should be recognized until the resource is sold. The issues are the same as those discussed for asset impairments in Chapter 4. Below we discuss the expense reporting challenges for changes in values of operating assets and financial instruments. EXAMPLE: OPERATING ASSET IMPAIRMENTS. As discussed in Chapter 4, the conservatism principle requires that an asset whose value is impaired should be written down to its market value, below cost. For example, in December 1997, following a disappointing performance in its core business, Eastman Kodak recorded a $1.5 billion restructuring charge. Of this amount, $428 million was for asset impairments (7 percent of pre-written-down fixed assets), and $165 million was for inventory write-downs (12 percent of pre-written-down inventory). The remainder was primarily to reflect the severance costs for 16,100 personnel to be laid off. The challenge in recognizing losses from asset impairments is that it is often difficult to assess whether an asset has been impaired and, if so, the amount of the loss. Accounting for asset impairments in the U.S. is regulated by SFAS 121. Under this standard, firms are required to review assets for impairment whenever there is a change in the firm’s circumstances or an indication that the book value cannot be recovered. Changes in circumstances can arise if the asset is used less extensively or in a different manner, if legal or regulatory changes affect the asset’s value, or if the firm has a history of cashflow losses. If management’s forecast of the undiscounted future cash flows associated with an asset is less than its book value, the asset is required to be written down to fair value and a loss recognized. The decision to recognize an impairment loss and the estimation of the value of the loss under SFAS 121 involves considerable management judgment. Management must decide what level of asset grouping is appropriate for evaluating asset impairments.13 It must also forecast and value the expected future cash flows from these assets. In late 1998 the SEC expressed concern about management abuse of its reporting judgment for asset impairments. Arthur Levitt, Chairman of the SEC, articulated this concern as follows: “When earnings take a major hit, the theory goes that Wall Street will look beyond a one-time loss and focus only on future earnings. And if these charges are conservatively estimated with a little extra cushioning, that so-called estimate is miraculously reborn as income when estimates change or future earnings fall short.”14 EXAMPLE: CHANGES IN VALUE OF FINANCIAL INSTRUMENTS. As discussed in Chapter 4, firms are required to record at fair values their financial instruments that 7-14 Expense Analysis 7-15 Part 2 Business Analysis and Valuation Tools are held as investments and are intended to be sold or are available for sale. A key question is whether gains and losses on these types of investment should be reflected in the income statement or charged directly to owners’ equity. Current rules require that if a firm holds an instrument as a store of cash and intends to sell it, the unrealized fair value of gains and losses must be shown as a part of income. If the instrument is available for sale, only realized gains and losses are shown in income. Financial instruments that are potentially available for sale are valued at fair values. Unrealized gains or losses are recorded as a part of the comprehensive income and are not included in the income statement.15 Finally, instruments expected to be held to maturity are valued at historical cost, and only realized gains and losses are reported in the income statement. However, as noted earlier, these distinctions based on management’s intentions are not relevant from an economic perspective. Analysts should, therefore, regard both realized and unrealized gains as relevant for evaluating management’s performance. Firms with financial instruments that are held for hedging purposes are also required to record the instruments at fair values (see Chapter 4). The income effect of marking these types of instruments to market depends on the purpose of ownership. If the purpose is to hedge changes in the fair value of another item, fair value gains and losses on both the hedge item and the financial instrument are included in income. However, if the instrument is held to hedge fluctuations in expected future cash inflows or outflows, fair value gains and losses on the effective portion of the hedge are deferred and included in income only when the cash flows are reported. Fair value gains and losses on the ineffective portion of the hedge are included in income immediately. Key Analysis Questions The management judgment involved in estimating impairments of operating assets and changes in values of financial instruments raises a number of questions for financial analysts. They include the following: • For operating assets, is the timing and amount of any asset impairment charge taken by management consistent with changes in the firm’s operating performance and the performance of other firms in the same industry? Does management appear to have delayed recording a loss from asset impairment? • Does management appear to have over- or understated prior impairment losses on operating assets, thereby making it difficult to evaluate future performance? Has the firm consistently reported impairment losses, indicating an unwillingness to appreciate the full extent of the impairment? • What is the basis for the estimation of the fair value of the impaired operating resource? For example, is the valuation based on an independent appraisal, or is it a management estimate? 263 264 Expense Analysis Expense Analysis • For financial instruments, what is management’s purpose for owning the financial instruments? Is that purpose consistent with shareholders’ interests? For example, is the firm hedging risks for shareholders’ benefits or for managers? • What is the extent of unrealized gains and losses on holding financial instruments, regardless of whether they are reported in the income statement? What factors explain any significant gains or losses? For example, does management appear to be using financial instruments to hedge risks or to take on additional risk? Is this decision consistent with shareholders’ interests? Are there appropriate controls in place to avoid excessive risks being taken? SUMMARY The recording of a firm’s expenses is determined primarily by the matching and conservatism principles. Under these principles, three classes of expenses arise: 1. Costs of consumed resources that have a cause-and-effect relation with revenues and are matched with revenues; 2. Costs of resources that have no clear cause-and-effect relation to revenues and are recorded as expenses during the period they are consumed; and 3. Costs from declines in the future benefits expected to be generated by resources, which are recorded when the decline in value occurs. For certain types of transactions, implementing these principles can be challenging. For example, it can be difficult to assess whether to record expenses if: 1. Resources acquired by a firm provide benefits over multiple years, such as for fixed assets, goodwill, research and development outlays, and advertising. 2. Firms make uncertain long-term commitments for resources that have no longterm benefits to the firm. This arises for pension and other post-retirement benefits and for environmental liabilities. 3. Resources used to generate revenues are difficult to value, as in the cost of sales and executive stock options. 4. Unused resources have declined in value over time, such as for operating and financial asset impairments. In general, corporate managers are likely to have the best information to estimate expenses for the period. However, their incentives to report favorable information on their stewardship of the firm raise questions for users of financial information about the reliability of management’s estimates. In addition, accounting standards require all firms to expense certain types of outlays, such as R&D, even though they generate future benefits 7-16 Expense Analysis 7-17 Part 2 Business Analysis and Valuation Tools for successful firms. This creates another role for financial analysis: to understand how accounting standards affect reported performance for different firms. DISCUSSION QUESTIONS 1. A firm purchases an asset for $10,000,000. Management forecasts that the asset will have an expected life of ten years and a salvage value of 5 percent. What are the financial statement effects from recording depreciation for this asset in the first two years of its life if financial reporting depreciation is recorded under (a) the straightline method, and (b) the double-declining balance method? As a financial analyst, what questions would you raise with the firm’s CFO about its depreciation policy? 2. On February 9, 1996, Walt Disney Co. acquired Capital Cities/ABC Inc. for $10.1 billion in cash and 155 million shares of Disney valued at $8.8 billion, based on the stock price at the date the transaction was announced. Disney estimated that goodwill under the acquisitions would amount to $19 billion. What forecasts does Disney’s management have to make to record amortization of this goodwill? What factors would underlie these forecasts? As a financial analyst, what questions would you raise with the firm’s CFO about the amortization of goodwill? 3. In 1997 Peoplesoft, a software company, presented the following footnote information in its annual report: The Company capitalizes software purchased from third parties if the related software product under development has reached technological feasibility or if there are alternative future uses for the purchased software, provided that capitalized amounts will be realized over a period not exceeding five years. In addition, the Company capitalizes certain internally incurred costs, consisting of salaries, related payroll taxes and benefits, and an allocation of indirect costs related to developing computer software products. Costs incurred prior to the establishment of technological feasibility are charged to product development expense. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs require considerable judgment by management with respect to certain external factors, including, but not limited to, anticipated future revenues, estimated economic life and changes in software and hardware technologies. Upon the general release of the software product to customers, capitalization ceases and such costs are amortized (using the straight-line method) on a product by product basis over the estimated life, which is generally three years. All other research and development expenditures are charged to research and development expense in the period incurred. Capitalized software costs and accumulated amortization at December 31, 1995, 1996 and 1997 were as follows (in thousands): 265 266 Expense Analysis Expense Analysis 1995 Capitalized software: Internal development costs Purchased from third parties Accumulated amortization $7,016 5,137 12,153 (4,811) $7,342 1996 $10,737 6,832 17,569 (6,396) $11,173 1997 $13,232 6,832 20,064 (10,358) $9,706 How much did Peoplesoft capitalize for software costs in 1996? How much was capitalized in 1997? How much did Peoplesoft record as amortization expense for software costs in 1997? What was the amortization expense in 1996? If Peoplesoft had never capitalized any software research and development outlays, how would its earnings before taxes have been affected in 1997? What would have been the effect for 1996? Why is the earnings effect of expensing versus capitalizing different in 1996 versus 1997? Microsoft does not capitalize any software costs. Why might Peoplesoft choose to capitalize some of its software costs and Microsoft expense all its costs? As a financial analyst, what questions would you raise with Peoplesoft’s CFO about the firm’s policy for amortizing software development costs? 4. Procter and Gamble is a consumer products firm that owns such brands as Pampers diapers, Crisco vegetable shortening, Tide laundry detergent, and Crest toothpaste. In its 1998 annual report, the company reported: “Worldwide marketing, research and administrative expenses were $10.04 billion compared to $9.77 billion in the prior year. This equates to 27.0 percent of sales, compared with 27.3 percent in the prior year.” As a financial analyst, what questions would you raise with the firm’s CFO about the advertising and research and administrative costs for 1998? As the CFO of Procter and Gamble, what other information would you recommend the firm include in its annual report on these outlays? 5. A firm hires a 27-year-old MBA at a salary of $85,000 for the first year. It also agrees to provide a pension upon retirement at age sixty-five and estimates that the present value of that pension is $150,000. What forecasts did management have to make to estimate this value? What factors determine how much of the pension cost is recognized as an expense at the end of the employee’s first year of service? As a financial analyst, what questions would you raise with the firm’s CFO about its pension costs? 6. In the contingent liability section of its 1998 annual report, Dow Chemical Company reported the following: Accruals for environmental matters are recorded when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based on current law and existing technologies. The Company had accrued $364 million at December 31, 1998, for environmental matters, including $9 million for the remediation of Superfund sites. This is management’s best estimate of the costs for remediation and restoration with respect to environmental matters for which the Company has accrued liabilities, although the ultimate cost with respect to these particular 7-18 Expense Analysis 7-19 Part 2 Business Analysis and Valuation Tools matters could range up to twice that amount. Inherent uncertainties exist in these estimates primarily due to unknown conditions, changing governmental regulations and legal standards regarding liability, and evolving technologies for handling site remediation and restoration. It is the opinion of the Company’s management that the possibility is remote that costs in excess of those accrued or disclosed will have a material adverse impact on the Company’s consolidated financial statements. As a financial analyst, what questions would you raise with the firm’s CFO about the firm’s environmental disclosures? 7. Eastman Kodak reported the following information on inventory valuation in its 1998 annual report: (In millions) At FIFO or average cost (approximates current cost) Work in process Raw materials and supplies 1998 $ 907 569 439 1,915 (491) $1,424 LIFO reserve Total 1997 $ 788 538 460 1,786 (534) $1,252 Kodak reported that its cost of sales was $72.93 million for 1998. What would the firm’s cost of sales have been if it had valued inventory exclusively under the FIFO method? What factors are likely to be relevant to Kodak in setting its inventory valuation policies? As a financial analyst, what questions would you raise with the firm’s CFO about the firm’s inventory valuation and cost of sales? 8. In its 1998 annual report, Eastman Kodak reported the following information on its stock option program: Pro forma net earnings and earnings per share information, as required by SFAS No. 123, “Accounting for Stock-Based Compensation,” has been determined as if the Company had accounted for employee stock options under SFAS No. 123’s fair value method. The fair value of these options was estimated at grant date using a BlackScholes option pricing model. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period (2–3 years). The Company’s pro forma information follows: Year Ended December 31 (In millions, except per share data) Net earnings (loss): As reported Pro forma Basic earnings (loss) per share: As reported Pro forma 1998 1997 1996 $1,390 1,272 $ 5) (52) $1,288 1,262 $4.30 3.93 $.01) (.16) $3.82 3.74 267 268 Expense Analysis Expense Analysis Is stock option compensation a material item for Kodak? As a financial analyst, what questions would you raise with the firm’s CFO about this disclosure? 9. In a meeting of the Board of Directors over a proposal to restructure, a firm’s CEO states: “I recommend we take as large a charge against current earnings as our auditors will permit, since Wall Street will love us for being tough. Further, in future years our earnings will look improved, giving us a long-term boost from the current hit.” Do you agree with these comments? Explain why or why not. 10. The CFO of a large bank argues: “It is ridiculous to recognize any fair-value gains or losses on our debt instruments that we intend holding to maturity. Since we intend holding these securities, we are insulated from the whims of the market.” Do you agree? Explain why or why not. Given your answer, what are the implications for financial analysts following the company? NOTES 1. The most common accelerated depreciation method is called double-declining-balance. Under this approach, the depreciation expense in any year is twice the straight-line rate multiplied by the book value of the asset in question. For example, under this method an asset with a five-year life and an initial cost of $100,000 depreciates $40,000 in year one ($100,000 × .4), $24,000 in year two ($60,000 × .4), and so on. 2. P. Healy, K. Palepu, and R. Ruback, “Which Takeovers Are Profitable—Strategic or Financial?” Sloan Management Review, Summer 1997, find that acquisitions add value for approximately one-third of the 50 largest acquisitions during the early 1980s. 3. See Steven N. Kaplan, Mark L. Mitchell, and Karen H. Wruck, “A Clinical Exploration of Value Creation and Destruction in Acquisitions: Organizational Design, Incentives, and Internal Capital Markets,” working paper, (July 1997), Harvard Business School. 4. Accounting rules in the U.S., the U.K., Canada, and Germany require expensing R&D outlays. Expensing is the norm in Japan and France, even though capitalization is permitted. 5. E. Eccher, “The Value Relevance of Software Capitalized Costs,” working paper, 1998, MIT, finds that the amortization of capitalized software development costs provides investors with valuable information on management’s estimate of the future revenues for the software. D. Aboody and B. Lev, “The Value-Relevance of Intangibles: The Case of Software Capitalization,” 1998, working paper, University of California, Los Angeles, and New York University, find that investors value capitalized software assets and changes in their values. They conclude that management judgment in capitalizing software development costs does not adversely affect the quality of reported earnings. 6. P. Healy, S. Myers, and C. Howe, “R&D Accounting and the Tradeoff Between Relevance and Objectivity,” working paper, 1999, Harvard University and MIT, show that, even if managers abuse reporting judgment by delaying writing down R&D assets, accounting methods that capitalize R&D and write-off costs of unsuccessful projects provide better information for investors on firm values than do expense rules. 7. Defined contribution plans, where companies agree to contribute fixed amounts today to cover future benefits, require very little forecasting to estimate their annual cost, since the firm’s obligation is limited to its annual obligation to contribute to the employees’ retirement funds. 7-20 Expense Analysis 7-21 Part 2 Business Analysis and Valuation Tools 8. Consistent with this view, R. Jennings, P. Simko, and R. Thompson, “Does LIFO Inventory Accounting Improve the Income Statement at the Expense of the Balance Sheet?” Journal of Accounting Research 34, No. 1 (1996), find that LIFO earnings are more related to equity values than non-LIFO earnings. 9. Research findings indicate that management’s inventory method decisions are related to tax considerations, (see R. Hagerman and M. Zmijewski, “Some Economic Determinants of Accounting Policy Choice,” Journal of Accounting and Economics 1, 1979, and B. Cushing and M. LeClere, “Evidence on the Determinants of Inventory Accounting Policy,” The Accounting Review 67, No. 2, 1992), corporate governance (see G. Niehaus, “Ownership Structure and Inventory Method Choice,” The Accounting Review 64, No. 2, 1989), and firm characteristics such as R&D and labor intensity (see R. Bowen, L. DuCharme, and D. Shores, “Stakeholders’ Implicit Claims and Accounting Method Choice, Journal of Accounting and Economics 20, No. 3, 1995). 10. See M. Scholes and M. Wolfson, Taxes and Business Strategy: A Planning Approach, Englewood Cliffs, NJ: Prentice-Hall, 1992, Chapter 10. 11. The Black-Scholes option-pricing model estimates the value of an option as a nonlinear function of the exercise price, the remaining time to expiration, the estimated variance of the underlying stock, and the risk-free interest rate. Studies of the valuation of executive stock options include T. Hemmer, S. Matsunaga, and T. Shevlin, “Optimal Exercise and the Cost of Granting Employee Stock Options with a Reload Provision,” Journal of Accounting Research 36, No. 2 (1998), C. Cuny and P. Jorion, “Valuing Executive Stock Options with Endogenous Departure,” Journal of Accounting and Economics 20, No. 2; and S. Huddart, “Employee Stock Options,” Journal of Accounting and Economics 18, No. 2. 12. P. DeChow, A. Hutton, and R. Sloan, “Economic Consequences of Accounting for StockBased Compensation,” Journal of Accounting Research, Supplement, 1996, find evidence that lobbying against SFAS 123 was motivated by concerns about reporting higher levels of executive compensation. 13. J. Francis, D. Hanna, and L. Vincent, “Causes and Effects of Discretionary Asset WriteOffs,” Journal of Accounting Research 34 (1996), Supplement, find that management is more likely to exercise judgment in its self-interest for goodwill write-offs and restructuring charges than for inventory or PP&E write-offs. 14. Arthur Levitt, “The Numbers Game,” remarks at NYU Center for Law and Business, New York, September 28, 1998. Consistent with this concern, J. Elliott and D. Hanna, “Repeated Accounting Write-Offs and the Information Content of Earnings,” Journal of Accounting Research 34 (1996), Supplement, find evidence that the market reacts to unexpected earnings declines in the quarter subsequent to large write-downs. 15. See Chapter 8 for a discussion of comprehensive income. 269 Pre-Paid Legal Services, Inc. P re-paid Legal plans are designed to help middle-income Americans have affordable access to quality legal assistance. Pre-Paid Legal Services Corporate Vision Business Analysis 2 and Valuation Tools 7 Expense Analysis Pre-Paid Legal Services Harland C. Stonecipher founded Pre-Paid Legal Services, Inc. (PPLS) in 1972 after an expensive encounter with lawyers stemming from an automobile accident. PPLS sold legal expense insurance that provided for partial payment of legal fees in connection with the defense of certain civil and criminal actions. The company went public in 1979 and grew rapidly throughout the 1980s as an increasing number of Americans subscribed to legal service insurance (see Exhibit 1). In 1998 the company had membership revenues of $110 million, earnings of $30.2 million, and end-of-year book equity of $101.1 million. In May 1999 it began trading on the New York Stock Exchange, and in August 1999 its market capitalization reached $738 million, an increase of 101 percent over the previous year. Despite its strong financial performance, opinions about the future of Pre-Paid Legal Services varied widely among U.S. equity analysts in the period late 1997 to mid-1999. The company was highly recommended by a number of analysts, but there was also persistent short selling of the stock.1 Short sellers’ primary concern about the company was outlined in a Fortune article in late 1997. The business publication alleged that the company was using an inappropriate method of accounting for sales commissions. As a result of this uncertainty, the company’s stock price fluctuated widely from a high of $40.50 to a low of $13.50 between late 1997 and mid-1999. BUSINESS DESCRIPTION PPLS offered its customers (termed members) a wide range of legal insurance. The most popular plan, The Family Plan, accounted for 94 percent of all memberships in 1998. This plan provided reimbursement for a broad range of legal expenses incurred by mem......................................................................................................................... Professor Paul M. Healy and Teaching Fellow Jacob Cohen J.D. prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1999 by the President and Fellows of Harvard College. Harvard Business School case 9-100-03. 1. A short seller borrows stock certificates from a brokerage firm and sells the stocks on the open market. If the stock price declines, the short seller can buy back stock, cover his loan from the brokerage firm, and earn a profit. Of course, if the price increases, the short seller takes a loss. 270 Expense Analysis Pre-Paid Legal Services 7-23 Part 2 Business Analysis and Valuation Tools bers and their spouses, including will preparation, document review and letter writing, some of the legal costs associated with employment-related trial defense, traffic violations, and Internal Revenue Service audits.2 The Family Plan specified limits on the number of hours of attorney time that a member was entitled to receive for many of these services. It also provided a 25 percent discount on attorney rates for the purchase of any legal services over and above those provided under the insurance contract. PPLS’s membership premiums in 1998 averaged $19.08 per month (or $229 per year). Premiums were typically paid on a monthly basis either by automatic charges to the member’s credit card or through employee payroll deductions. The premiums were generally guaranteed renewable and noncancelable except for fraud, nonpayment of premiums, or upon written request by a member. The annual membership renewal rate in 1998 was high; 75 percent of members at the beginning of 1998 were still members at the end of the year. At March 31, 1999, PPLS had 648,475 active members, and membership had been increasing at about 40 percent per year. Marketing of Services PPLS marketed its memberships through a multilevel marketing program that encouraged buyers to become salespeople. Members that sought to become sales associates paid the company a fee, typically $65, to cover the cost of training materials, training meetings, and home office support services. Registered sales associates sold the company’s services to their friends and business associates. The most successful even recruited and developed their own sales forces. In 1998 PPLS generated 76 percent of its annual sales from the roughly 150,000 members registered as sales associates. The remaining 24 percent of sales were generated through arrangements with insurance and service companies with established sales forces, such as CNA and Primerica Financial Services. Sales associates were compensated on a commission basis (see Exhibit 2). Prior to 1995, associates that signed up a new member received a commission of 70 percent of the first year premium, and a 16 percent commission for subsequent year renewals. Firstyear commissions were paid in advance whereas renewal commissions were paid as premiums were received. For example, if a new member signed up at a premium of $229 per year, the associate responsible for the sale received a first-year commission of $160 (0.70 × $229) at sign up. If the member renewed in subsequent years, the sales associate received a monthly commission of $3.04 (0.16 × $19). After 1995 PPLS modified its commission formula to a flat 25 percent commission for both initial year and subsequent renewal memberships. To retain and attract sales associates, PPLS advanced the sales associate three years of commission on every new membership sold. If a membership lapsed before the advances had been recovered, PPLS deducted 50 percent of any unearned advances from future commissions to the relevant associate. ......................................................................................................................... 2. Legal services specifically excluded from coverage included domestic matters, bankruptcy, deliberate criminal acts, alcohol or drug-related matters, business matters, and pre-existing conditions. 271 Expense Analysis Expense Analysis 7-24 Claim Cost Management PPLS had historically offered two forms of legal services, each with very different im- plications for managing legal claim costs. The first form of service, termed open panel, allowed members to use their own attorney to provide legal services available under their policy. Members’ attorneys were reimbursed for their services using a payment schedule that reflected “usual, reasonable and customary fees” for a particular service and geographic area. The second form of service, closed panel memberships, required members to access legal services through a network of independent attorneys that were under contract with PPLS. These provider attorneys were paid a fixed monthly fee on a per capita basis to provide services to plan members living within the state in which the attorney was licensed to practice. PPLS contracted with one large, highly rated legal firm in each of its 36 major markets. These were selected after a detailed review by PPLS management. Martindale-Hubbell, a legal rating firm, typically rated PPLS’s provider attorneys AV, its highest rating. Average costs of membership claims in 1998 were 33 percent of membership premiums, and management reported that these costs were expected to remain at around 35 percent in the future. FINANCIAL PERFORMANCE PPLS reported record financial performance in the period 1997 and 1998 (see Exhibit 3 for summary financial data). Membership revenues during this period grew by an average of 52 percent per year, net income grew by 61 percent per year, and operating cash flows grew 270 percent per year. The firm’s financial performance for the first six months of 1999 continued to be strong. Membership revenues grew by 20 percent, earnings by 54 percent, and operating cash flows by 138 percent (from $2.4 million to $5.7 million). As a result of the company’s growth performance, a number of equity analysts that followed the stock recommended it to their clients. For example, David Strasser of Salomon Brothers issued strong buy recommendations for PPLS in August 1997 and commented on the stock as follows: We reiterate our Strong Buy recommendation on the shares of Pre-Paid Legal Services, Inc. . . . We have recently increased our one-year price to $34 from $26. We did this for several reasons. First, the company continues to demonstrate consistent earnings growth, in line with Wall Street estimates, which gives us greater visibility of our projected 36% growth rate. . . . We are also encouraged by the company’s ability to generate positive operating cash flow while still growing revenues 53%. This positive cash flow is indicative of the seasoned membership base that generates cash in spite of the company’s policy of paying commission advances to its associates for new sales. We continue to believe that the company will announce an alliance with a major insurance company to sell the company’s Pre-Paid Legal Services 272 Expense Analysis 7-25 Part 2 Business Analysis and Valuation Tools products. This would essentially double the size of the company’s productive sales force and increase overall visibility of the prepaid legal product.3 Pre-Paid Legal Services ACCOUNTING DISPUTE Despite its strong financial performance, in late 1997 PPLS was a target of short selling. On November 24, 1997, Fortune published an article titled “Will Pre-Paid Keep Growing?” The article cited short seller Robert Olstein of Olstein’s Financial Alert Fund, who explained that his concern arose because “PPLS’s accounting for commissions is unrealistic and not in accordance with economic reality.”4 The Fortune article noted: Rather than record the commissions as an instant hit to earnings, Pre-Paid spreads them out over a three-year period. Such deferrals, the shorts argue, make today’s earnings growth look stronger than it really is. In the first half of this year, for example, if the company had swallowed commissions when they were paid, it would have shown little if any earnings growth—certainly not a level of growth to justify the stock’s trading at nearly 40 times earnings. Plus, trouble could emerge if the company’s cancellation rate on its policies increases and it can’t somehow recover the commissions it has already paid. PrePaid shrugs this off, arguing that its historic cancellation rate is a manageable 24%. And, Harp (PPLS’s CEO) boasts, “I can predict this business more precisely than anybody you want to mention.” Maybe so, but the company’s own figures, disclosed in SEC filings, show that the rate is on an upward trend. The filings also state that Pre-Paid’s cancellation rate will rise if newly written policies make up a greater portion of its business, and the company warns (deep in its 10-K annual report) that it experienced a “significant increase” in sales of new contracts last year. Unless this shift is offset by “other factors,” the 10-K says, financial performance could be severely hurt. In other words, Olstein contends, Pre-Paid may face a big write-off at some point. Exhibit 4 presents the company’s footnote disclosure on its method of accounting for sales commissions. MANAGEMENT RESPONSE PPLS argued that its policy of accounting for commissions resulted in a commission expense that was more consistent with the collection of the premiums generated by the sale of such contracts. In addition, between October 1998 and June 1999, management ac......................................................................................................................... 3. Analyst Report, David Strasser, Salomon Brothers, August 1997. 4. Herb Greenberg, “Will Pre-Paid Keep Growing? A Company’s HMO-Style Approach to Legal Services Has Won It Plenty of Fans —And a Soaring Price. But Shortsellers Say the Numbers Don’t Add Up,” Fortune, November 24, 1997. 273 Expense Analysis Expense Analysis quired 1,384,440 of the firm’s shares on the open market at an average price of $28 per share.5 Nonetheless, concern over the company’s accounting persisted. In late June 1999, short sales were 6.5 percent of outstanding shares, more than four times the level of typical companies.6 The company’s stock traded at $26.63, well off its yearly high of $39.25 and the all-time high of $40.50. Rick Nelson, an analyst at Furman Selz, summed up the market sentiment this way: “Insiders feel they’ve got a company that’s trading well off its high where the operating fundamentals are going gangbusters. But the shorts have caught on the notion that from a cash flow standpoint, the company just can’t handle the growth, and that their business model itself will come back to haunt them.”7 QUESTIONS 1. Based on the post-1995 commission formula, calculate the commission that would be earned by a sales associate who sold a Family Plan with a $19 per month premium. How much would the company attempt to recover from the sales associate if the customer chose not to renew the contract after two years? 2. How should PPLS account for the above transactions? 3. Who do you think has it right? Fortune or PPLS’s management? Why? 4. What actions could PPLS’s management take to change the unease among key investors about the firm’s accounting and its business model? ......................................................................................................................... 5. Quicken.com, “Insider Trading in Pre-Paid Legal Services.” 6. “Uncovered Short Positions Rise on Big Board and Amex,” The New York Times, June 22, 1999. 7. Ian Mount, “The Long and Short of It,” SmartMoney.com, May 25, 1999. 7-26 Pre-Paid Legal Services 274 Expense Analysis 7-27 Part 2 Business Analysis and Valuation Tools EXHIBIT 1 Number of Subscribers to Legal Service Plans in the U.S., 1981 to 1997 Millions Pre-Paid Legal Services 120 105 100 98 80 60 58 40 20 0 1980 15 4 1985 1990 1995 2000 The above estimates were developed by The National Resources Center for Consumer Legal Services (NRC) and reported by PPLS in its 1998 10-K Report. NRC estimates included free member plans sponsored by labor unions, the American Association for Retired Persons, the National Education Association, and military services, as well as employer-paid plans. PPLS estimated that 10 percent of the total legal insurance market was covered by plans comparable to those provided by PPLS. The other major companies servicing this market were Hyatt Legal Services, ARAG Group, LawPhone, National Legal Plan, and the Signature Group. The NRC estimated that in 1997 the market share of these firms (and PPLS) was 79 percent. The market share of PPLS alone was estimated at 15 percent. Source: Pre-Paid Legal Annual Report, 1998. EXHIBIT 2 Summary of Commission Rates and Timing of Payment for PPLS First-Year Commission Subsequent Year Commissions Pre-1995: Commission rate 70% of subscription 16% of subscription Timing of payment At customer sign-up Monthly 1995: Commission rate 25% of subscription 25% of subscription Advance of three years’ worth of commissions at customer sign-up None for first three years, then monthly Timing of payment 275 Expense Analysis 7-28 Expense Analysis EXHIBIT 3 Summary Financial information for Pre-Paid Legal Services Year ended December 31 ............................................................................... (in $000) 1998 1997 1996 1995 ...................................................................................................................................... Membership revenues Net income $110,003 30,210 $76,688 18,790 $50,582 12,470 $31,290 7,312 Cash from operations $9,895 $7,733 $942 $548 $167,903 101,304 $91,912 70,511 $57,532 45,474 $35,629 29,740 391,827 603,017 283,723 425,381 194,483 294,151 109,922 203,535 Total assets Book value of equity New memberships sold Period-end memberships in force ...................................................................................................................................... Source: Annual Reports, 1995–98. EXHIBIT 4 Financial Footnotes Disclosure of Commission Advance from 1998 10-K Commission Advances represent the unearned portion of the commissions advanced to Associates on the sales of Memberships. Commissions are earned as premiums are collected, usually on a monthly basis. The Company reduces commission advances as premiums are paid and commissions earned. Unearned commission advances on lapsed Memberships are recovered through collection of premiums on an associate’s active Memberships. At December 31, 1998 and 1997, the Company had an allowance of $4.0 million and $3.7 million, respectively, to provide for estimated uncollectible balances. The Company charges interest at the prime rate on unearned commission advances relating to Memberships that canceled subsequent to the advance being made. Data on Commission Advances reported in PPLS’s 1995–98 annual reports are as follows: Year ended December 31 ............................................................................. (in $000) 1998 1997 1996 1995 ........................................................................................................................................ Commission advances — current Noncurrent commission advances, net $21,224 60,661 $15,705 38,038 $9,108 21,744 $3,923 8,548 ........................................................................................................................................ Pre-Paid Legal Services 276 88 E n t i t y A cc o u n t in g An alysis chapter F Business Analysis and 2Valuation Tools or financial reporting purposes, an entity is an organization that controls some economic resources. Entities can take many different forms: they can be individuals, partnerships (such as many professional firms), private or public corporations, divisions of corporations, private nonprofit organizations, and government departments. Business entity analysis involves understanding how the boundaries of entities are defined to better evaluate how they are performing. For financial reporting purposes, an entity’s boundaries can be specified narrowly, using a strict legal definition. Such an approach has been popular in Germany and Japan until relatively recently. However, it frequently fails to provide investors with comprehensive information on the legal entity’s risks and performance. Accountants and analysts therefore typically take a broader view of the entity. This approach focuses on the resources over which managers have control, rather than the legal entity. Entity analysis is important for shareholders because it clarifies which resources they have a claim over and how those resources are performing. Three specific concerns arise for shareholders in entity analysis. First, does the firm have hidden commitments or hidden losses arising from its investments in other firms? Second, is management siphoning off resources to other entities that they can control? This can arise if a firm sells to or buys from related parties that are largely owned by management. Finally, is management overinvesting in “pet projects” that generate low or negative returns for shareholders? Entity analysis attempts to answer these questions by understanding how an entity is defined, what resources it controls, how it performs, what related-party transactions it undertakes, and how its business segments perform. Many firms have sizable and complex relations with other companies that create financial reporting challenges. These include stock investments, stakes in research and development limited partnerships, and franchising arrangements. For these types of business relations, a critical accounting challenge is to decide whether financial performance of the two companies should be aggregated as if the firms were a single entity, or reported for each unit separately. If performance is aggregated, a follow-up question for analysts is to evaluate how the separate entities are performing, particularly if they are in very different business segments. The answer to this question is particularly challenging if the entities buy goods and services from one another. ENTITY REPORTING CHALLENGES As shown in Figure 8-1, the critical entity challenge in financial reporting is deciding how an entity is to be defined. From an economic perspective, if one firm has complete 8-1 277 278 Entity Accounting Analysis Entity Accounting Analysis Figure 8-1 Criteria for Aggregating Performance of Units and Implementation Issues Aggregation Criteria The resources of one unit are controlled by another. Aggregate the controlled unit’s performance with that of the controlling entity. Separately disclose performance data for key business segments. Challenging Transactions 1. A firm has partial control over another. 2. Control is difficult to measure. 3. Defining and measuring performance for core business segments is difficult. control over the resources of another, the two can be considered to be a single entity. Of course, many firms have only partial rather than complete control over the resources of another. One entity question for financial reporting is therefore determining whether one firm’s level of control over another is sufficient to justify viewing the two as a single entity. A second challenge is that, for some business relations, it is difficult to measure the extent of one firm’s control over another. The decision to account for two or more firms as a single entity for financial reporting purposes does not eliminate investors’ demand for information on each of the subunits, particularly if they are in dissimilar businesses. Consequently, firms with different businesses report summary financial information for each segment. Of course, segment reporting has its own complications. How are segments defined? How is segment performance measured when there are transactions between segments? Challenge One: Partial Control For many company investments, the purchaser clearly acquires control of another entity. For example, on June 25, 1999, Lucent Technologies Inc., the leading maker of telephone equipment, agreed to acquire 100 percent of the stock of Nexabit Networks, a private company that developed high-speed switches for moving data traffic on telecommunications networks. Lucent’s offer was for nearly $900 million in stock. By offering to acquire 100 percent of Nexabit’s stock, Lucent ensured that it would have complete control over Nexabit’s assets. 8-2 Entity Accounting Analysis 8-3 Part 2 Business Analysis and Valuation Tools Typically, when one firm owns more than 50 percent of the voting stock of another, it has control. In this case, it is required to combine or consolidate the performance of the acquiree with its own financial results. As discussed below and in Chapter 4, two methods of consolidation have been used in the U.S., the pooling-of-interests method and the purchase method. An acquirer can also exercise considerable control over an acquiree when it owns less than 50 percent of its voting stock. At what point, then, should one firm be viewed as having control over another? Should an investing firm with less than 50 percent ownership in another consolidate its performance with that of the acquiree? In addition, for some business combinations, it can be difficult to ascertain who has control over whom. How should these types of combinations be reported? Both situations are discussed below. EXAMPLE: INVESTMENTS OF LESS THAN 50 PERCENT INTEREST. On May 19, 1999, Amazon.com, a leading Internet retailer specializing in books, music, and videos, announced that it had acquired a 35 percent stake in Homegrocer.com, an online grocery delivery service in Portland and Seattle, for $42.5 million. Amazon.com announced that its investment would allow Homegrocer.com to accelerate its expansion into new cities. How should Amazon.com record this investment? How much control, if any, does the company have over Homegrocer.com? Should Amazon.com consolidate its results with those of Homegrocer.com? Assessing whether a company has control over the resources of another is clearly subjective. It depends on the percentage ownership acquired, the purpose of the acquisition, as well as the voting strength of the other owners. Accounting rules in the U.S. (APB 18 and FASB Interpretation 35) recognize this ambiguity and require firms to use the equity method to report investments where an investor has “significant influence” over the operations of another firm but lacks control.1 The equity method is effectively a “oneline consolidation.” It provides a way of recognizing that there is a middle ground between full consolidation and treating an investment as a marketable security. Under the equity method, the investor reports its share of the other company’s earnings (less any goodwill amortization or depreciation on written-up assets) in a separate line item in its income statement. In other words, the investor’s bottom-line earnings under the equity method are identical to those under purchase accounting, even though the details presented in the income statement differ. In the balance sheet, the investor reports the investment asset as a one-line item at cost plus its share of undistributed profits since acquisition. The FASB notes that prima facie evidence of “significant influence” is the ownership of more than 20 percent and less than 50 percent of another company’s common voting stock. However, the 20 percent minimum threshold is not intended to be a hard-and-fast rule. An investor with a stake of less than 20 percent in another company may be viewed as having significant influence, and an acquirer with a stake of more than 20 percent may not. In February 1999, the FASB proposed modifying the 50 percent threshold that had been used to distinguish whether a firm has significant influence or outright control over another. Under the proposal, some firms with less than 50 percent ownership stakes but 279 280 Entity Accounting Analysis Entity Accounting Analysis effective control over another entity may be required to consolidate the entities, rather than using the equity method to record their investments. The accounting rules that define the boundaries of an entity permit managers to exercise judgment in deciding how to define the firm’s boundaries. Managers certainly have the best information on the nature of the relation between their firm and other companies. However, the rules also provide opportunities for managers to use their discretion to window-dress their firms’ reported performance. For example, if managers classify the securities as “available for sale” rather than as investments reported under the equity method, income statement effects from the investment are limited to dividend income. EXAMPLE: WHO CONTROLS WHOM? For some combinations it is difficult to infer who controls whom. For example, on April 6, 1998, Citicorp and Travelers Group announced an agreement to merge to become a global financial service provider. The merged firm, Citigroup Inc., served over 100 million customers in 100 countries around the world and had interests in traditional banking, consumer finance, credit cards, investment banking, securities brokerage and asset management, and property casualty and life insurance. Under the merger, each company’s shareholders owned 50 percent of the combined firm. Citicorp shareholders exchanged each of their shares for 2.5 shares of Citigroup, whereas Travelers shareholders retained their existing shares, which automatically became shares of the new company. The new firm also announced that John S. Reed, Citicorp’s Chairman and CEO, and Sanford I. Weill, the chairman and CEO of Travelers, would serve as cochairmen and coCEOs of the merged firm. In the Citicorp-Travelers combination, it is not clear which company is the acquirer and which the acquired. How, then, should accounting reflect this combination? The boundaries of the new entity are clear. But what is the value of its assets, liabilities, revenues, and expenses? Given the difficulty in identifying which party is the acquirer, accountants have historically simply summed up the two firms’ financial statements. Under this approach, called “pooling-of-interests,” the consolidated financials are the aggregated book values of the two firms’ individual statements. In contrast to the Citicorp-Travelers merger, most combinations do have an identifiable acquirer and target. For these types of investments, investors want to know how much the acquirer paid for the target firm and whether the investment creates value for shareholders. The pooling-of-interests approach does a poor job of providing this type of information, since it consolidates the two firms’ financial statements at their book values. Acquirers typically pay a considerable premium over book value, and even over preacquisition market value, to take control over other companies. The second method of consolidation, called purchase accounting, provides more relevant information by combining the target firm’s assets and liabilities into the balance sheet of the acquirer at their market values. Any difference between the price the acquirer paid for the target firm’s equity and the market value of the separable net assets is then reported as goodwill. Goodwill is subsequently amortized over as many as 40 years, or in some countries is written off if there is evidence of impairment. 8-4 Entity Accounting Analysis 8-5 Part 2 Business Analysis and Valuation Tools One challenge in accounting for business combinations has been in assessing when pooling-of-interests or when purchase values provide more relevant information for investors. Under APB 16, firms were required to use the pooling method when both partners had been autonomous companies for more than two years, the deal was largely a stock swap, voting and dividend rights for shareholders were unchanged, and there were no major asset sales for at least two years following the combination. Otherwise, acquisitions have to be accounted for using the purchase method. However, in April 1999, the FASB proposed new rules that would require all mergers and acquisitions to be reported using the purchase method and would limit the maximum life of goodwill to twenty years. Key Analysis Questions Several opportunities for financial analysis arise from the difficulty in assessing whether one company has control over another. First, accounting rules provide management with some latitude in entity reporting. Management can use this discretion to ensure that financial statements reflect the underlying entity’s performance. However, it can also seek to omit important resources or commitments from the firm’s financial statements. Second, accounting rules require a firm to consolidate, to use the equity method, or to mark an investment to market. In contrast, the degree of control that one company has over another lies on a continuum between no control and complete control. Consequently, the information generated by entity accounting rules is unlikely to reflect all of the subtleties associated with control. Given these challenges, the following questions are likely to be useful for analysts: • What are a firm’s major investments in other companies? What percentage of these companys’ stock does it own? Who are the other key owners of the same firms, and how much stock do they own? Is there other evidence of a firm’s control over others, such as representation on the boards of directors? • What are the assets and leverage of related companies that are not consolidated? Does the investor’s management appear to be using its reporting discretion to keep key resources and commitments off the balance sheet? What is the performance of related companies that are not accounted for using the equity method? What are the investor management’s incentives for this reporting choice? • How have significant acquisitions been recorded? Does management of the acquirer appear to have used the pooling-of-interests method to avoid showing the full cost of the acquisition? If so, what was the effective cost of the acquisition? Has it generated an adequate return for shareholders? If the purchase method has been used, has the acquirer been forced to write down the value of the assets it acquired? 281 282 Entity Accounting Analysis Entity Accounting Analysis Challenge Two: Control Is Difficult to Measure Certain complex business relations, such as research and development (R&D) limited partnerships and franchise agreements, raise questions about whether one party in the relation effectively has control over the other, or whether the two parties are separate entities. Also, in some situations, a firm’s managers but not its stockholders have control over another company. EXAMPLE: R&D LIMITED PARTNERSHIPS. In 1997 Dura Pharmaceuticals Inc., a company that developed respiratory drugs, formed a limited partnership with Spiros Development II Inc. to raise capital for development of a new form of pulmonary drug delivery process. Under the partnership agreement, Spiros II made a $94 million public offering of a package of securities that included its own callable common stock (valued at $81.3 million) and warrants for Dura’s common stock (valued at $12.7 million). Dura also invested $75 million in Spiros II. In exchange for the warrants and $75 million investment, Dura received an option to purchase Spiros II’s callable common stock at prices that increase over time, as well as the exclusive rights to any products developed. Spiros then uses these funds to acquire research from Dura to develop the new products. The contractual relationship between Dura and Spiros II is called an R&D limited partnership. Under this type of relationship, one general partner (in this case Dura) performs the research, and the limited partners (public investors in this case) supply financing. The arrangement differs from more traditional equity financing in that the limited investors receive a claim on only the specific research project covered in the agreement. In contrast, if Dura were to raise the funding itself through a public offer of its own stock, the new shareholders would have a claim on all of Dura’s research output. The arrangement also provides a way for Dura to offload some of the risks associated with specific research projects. Dura effectively reduces its exposure to development failures and in return shares the upside if a drug is developed and becomes a market success. How should Dura’s relation with Spiros II be recorded? Does Dura exercise control over Spiros? If it does, then Spiros is effectively a Dura subsidiary. If it does not, Spiros can be considered a separate entity. A key question for investors is to understand how much of the project’s risk and upside has been sold by Dura. If most of the risk resides with Spiros II’s public owners, it is inappropriate to consolidate the two firms. Alternatively, if most of the risk resides with Dura, consolidation of Spiros II’s results with those of Dura’s is more likely to give investors an accurate understanding of Dura’s performance. Historically, the decision to consolidate Spiros II has been determined by Dura’s ownership of Spiros II’s stock. If Dura owns more than 50 percent of Spiros II’s voting stock, it is required to consolidate; otherwise it is not. However, in 1999 the FASB suggested broadening the definition of control. Under the proposed approach, control is likely to be defined as “the ability to derive benefits from the use of individual assets” (of another firm) “in essentially the same way a controlling entity can direct the use of its own assets.” Evidence of control is likely to include domination of another entity’s board of directors, 8-6 Entity Accounting Analysis 8-7 Part 2 Business Analysis and Valuation Tools ability to obtain a majority voting interest in another entity through ownership of convertible securities, a sole general-partner interest in a limited partnership, and the ability to dissolve an entity and assume control of its assets. This broader view of control would almost surely require Dura to consolidate Spiros II, both because it is the general partner in a limited partnership and because it has an option to acquire Spiros II. It is interesting to consider Dura’s reporting of its relation with Spiros in its 1997 annual report. The key transactions are recorded as follows: • The initial $75 million contribution to Spiros II is reported as a Purchase Option Expense, included in Dura’s income statement. • The warrants issued as part of Spiros II’s public offering are included in Dura’s Additional Paid-In Capital and Warrants Proceeds Receivable recorded on its balance sheet. • Annual payments from Spiros II for contracted research are recorded as contract revenues by Dura and effectively offset the research costs of the development program. • Finally, when Dura has exercised its option to acquire limited partners in similar earlier agreements, it has written off much of the outlay as purchased R&D. The fact that R&D limited partnerships permit R&D risks to be shared between partners along a continuum, whereas consolidation is a binary decision, implies that it is difficult for accountants to fully capture the risk-sharing complexities involved in these types of relations. As a result, they provide an opportunity for analysts to add value by clearly identifying how the partners share risks and rewards under the agreement, and whether these events are portrayed in the financial statements. Franchising is a popular organizational form in the U.S., where franchise operations employ more than 8 million people and account for more than 30 percent of all retail sales. Franchise companies include McDonalds, Burger King, Kentucky Fried Chicken, Pizza Hut, Holiday Inn, Marriott, Avis, Hertz, H&R Block, and 7 Eleven Stores. A typical franchise arrangement works as follows. A franchisor sells the right to operate a retail operation in a given location to a franchisee. The franchisee typically pays an initial franchise fee to cover such services as management training, advertising and promotion, site selection assistance, bookkeeping services, and construction supervision. Franchisees are also frequently required to purchase critical equipment and supplies from the franchisor, and to pay annual fees that vary with franchise sales. Finally, franchise agreements often provide the franchisor with the right to purchase profitable or unsuccessful franchise operations. Franchising is viewed as an effective organizational form because it provides the franchisee with some of the rights and incentives associated with ownership. Of course, there are also potential problems arising from franchising. For example, franchisees can underinvest in quality and free ride on the franchisor’s reputation. Franchise arrange- EXAMPLE: FRANCHISE OPERATIONS. 283 284 Entity Accounting Analysis Entity Accounting Analysis ments also make it cumbersome to coordinate corporate-wide changes in product offerings and strategy. Finally, franchisees are often concerned that after they have invested in establishing a market in a particular location, the franchisor will sell another (competing) franchise outlet in the same location. The accounting entity question that arises for franchise arrangements is whether the franchisor effectively has control over the franchisees and should therefore consolidate their performance with its own. Several factors suggest that franchisors do have considerable control over franchisees. First, as noted above, franchise contracts give franchisors significant control over the franchisee’s business operations by requiring them to maintain certain quality standards and to acquire supplies from the franchisor. Second, many franchisors have the right to acquire successful and also unsuccessful franchisees. Finally, franchisors often provide significant financing to franchisees or guarantee their debt. Given the considerable control exercised by franchisors over franchisees, some have argued in favor of considering franchise operations as a system, rather than as independent franchisor and franchisee entities. Consolidated reports for a franchise system would provide information on the overall profitability of the business concept. This type of information could be very valuable to investors, particularly if franchisors do not operate any established franchise outlets. However, consolidation fails to provide information on that portion of the rewards of the franchise system that go to the franchisor. Successful franchisors, after all, are likely to capitalize on their brand name by writing franchise contracts that ensure that they, rather than the franchisees, earn most of the rents from the system. This potentially creates a challenge for financial reporting, since if the franchisor demands too much of the franchisee, it is likely to fail and have to be acquired by the franchisor. Because of the limitations of considering franchise operations as a system, franchisors typically do not consolidate franchisees. Under SFAS 45, franchisors are required to defer recognizing revenues from initial franchise fees until all services have been performed. These services could include the guarantee of debt or the control of the franchisee’s operations. However, these rules do not require franchisors to provide key data on the performance of their franchisees. This information is likely to be critical to help investors evaluate whether the concept is successful and whether the franchisor has been too demanding in its contractual relations with franchisees. As a result, there is considerable scope for financial analysis of franchise operations. EXAMPLE: MANAGEMENT CONTROL OF A RELATED PARTY. Some compa- nies have business relations with other companies that are owned by management. For example, on November 17, 1997, Zaitun Bhd, a Malaysian personal care products company, proposed acquiring a piece of land for RM36 million from Benua Rezeki Sdn Bhd. Benua Rezeki Sdn Bhd was partially owned by two of the directors of Zaitun (Datuk Mohd Kamal Mohd Eusuff and Aisha Mohd Eusuff). On December 31, 1997, Zaitun put down a deposit on the land for RM18 million, which was 50 percent of the total amount. For the public owners of Zaitun, this type of transaction raised questions about 8-8 Entity Accounting Analysis 8-9 Part 2 Business Analysis and Valuation Tools whether the proposed price for the land was a fair market price, or whether Zaitun overpaid for the land, permitting the Zaitun directors to benefit at the expense of the company’s external owners. In subsequent developments (on April 15, 1998), Zaitun canceled the sale agreement and agreed to refund the deposit. In the case of related-party transactions, external shareholders do not have any control over the related party. Consequently, there is no justification for aggregating the performance of the two parties. The challenge for shareholders is to understand management’s incentives in these types of transactions. This can be assessed by comparing management’s stake in the related party and in the company it is managing. If management owns more in the related party than it owns in the company it manages, there are potential conflicts of interest. Shareholders are then interested in understanding the magnitude of the related-party transactions and their profitability for the related party versus the company. Not surprisingly, almost all countries require companies to make disclosures of related-party transactions to ensure that shareholders have full information on any potential management conflicts of interest. It is interesting to note that on September 26, 1998, the Malaysian Securities Commission reprimanded Zaitun for failing to disclose the related-party land sale. Key Analysis Questions Complex business relations between companies can make it difficult to measure whether one firm has control over another. Financial analysts can add value by understanding the details of these types of relations and their potential financial implications. The following questions are likely to be useful for this purpose: • Does a firm have complex and/or unusual relations with other firms, such as those discussed above for franchising and R&D limited partnerships? If so, what is the primary purpose of these relations? Is it for risk management, for raising capital, for keeping core assets and commitments off the balance sheet, or for managing earnings? • Does it make sense to consolidate the performance of related entities that have complex business relations? If not, what other information is needed and available to fully understand the financial implications of the relations? • How is the company using the business relation to manage risk? If it has an option to acquire another company, how is it exercising that option? Is it exercising it in a way that is consistent with its stated purpose? • Does the company have any related party transactions? If so, who are the related parties? What governance mechanisms protect the rights of external stockholders? Is there any evidence that resources are being siphoned out of the company in related party transactions at the expense of external stockholders? 285 286 Entity Accounting Analysis Entity Accounting Analysis Challenge Three: Defining and Measuring Core Business Units’ Performance For firms in diverse businesses, consolidated information provides investors with a good overview of the performance of the entire entity. However, investors are also likely to be interested in understanding how the separate business units are performing. Consequently, diversified companies provide disaggregated data on the performance of their major business segments in the financial statement footnotes. Segment reporting generates a number of measurement challenges. First, there are many different ways of defining business segments, making it difficult to compare performance of supposedly similar segments across firms or even over time for the same firm. Second, analysis is particularly challenging for firms with financial services segments whose business models are very different from those of the other operating segments. Finally, if there are transactions between business segments involving intercompany transfer prices, it can be difficult to evaluate the performance of individual segments. EXAMPLE: DEFINING BUSINESS SEGMENTS. Managers have traditionally been able to exercise considerable judgment in deciding how to define business units for segment reporting. A number of factors affect how business segments are organized. They can be structured to create operating and management synergies between units with overlapping development, production, or distribution processes. For example, in its 1998 annual report, Eastman Kodak disclosed separate information for four segments that were primarily defined by the imaging needs of the company’s main customer groups: Consumer Imaging, Kodak Professional, Health Imaging, and Other Imaging. The Consumer Imaging segment produced film, paper, chemicals, cameras, photoprocessing equipment, and photoprocessing services for consumers. The Kodak Professional segment catered to professional customers. The Health Imaging segment manufactured medical film and processing equipment. Finally, the Other Imaging segment was a catch-all for Kodak’s many other imaging businesses, including motion picture film, copiers, microfilm equipment, printers, scanners, and other business equipment. Segment definitions can also reflect management’s desire to conceal information that it regards as sensitive. For example, prior to 1998, Merck & Co. Inc. operated two primary businesses, Merck Pharmaceutical and Merck-Medco Managed Care, but avoided reporting any segment data on the two. Merck Pharmaceutical discovered, developed, manufactured, and marketed prescription drugs for treating human disorders, whereas Merck-Medco generated revenues from filling and managing prescriptions and health management programs. Merck’s management was concerned that reporting segment data for these two businesses would make its pricing strategies more transparent to customers, potentially reducing the firm’s future bargaining power in its negotiations with medical providers. However, in 1998 it was required to report segment data for the two businesses to satisfy new FASB rules on segment disclosures. 8-10 Entity Accounting Analysis 8-11 Part 2 Business Analysis and Valuation Tools Finally, segment definitions can be used by management as a way of concealing from investors the poor performance in one or more business units. For example, management may be particularly sensitive about poor performance of a recent acquisition and may elect to combine it with a strong performer for segment reporting purposes. In 1998 the FASB attempted to reduce the degree of management judgment in the definition of reporting segments. SFAS 131 defined segments for financial reporting using a “management” approach. Under this approach, firms were required to report segment data for significant business units whose “separate financial information is . . . regularly reviewed by the chief operating decision makers in deciding how to allocate resources and in assessing performance.” 2 A significant segment is one whose assets, revenues, or profits comprise at least 10 percent of consolidated assets, revenues, or profits. The standard requires companies to disclose revenues, profits, and assets for core segments. The overall impact of the FASB standard on segment disclosures has yet to be analyzed. However, it has had an effect on reporting by some companies. For example, as noted above, Merck expanded its segment disclosures to report data for both Merck Pharmaceutical and Merck-Medco Managed Care. In addition, prior to 1998, IBM only reported revenues for its business segments. Some analysts speculated that this decision was made to avoid disclosing large losses in the personal computing segment. In 1998 IBM adopted SFAS 131 and began reporting operating profit data for all its segments. The results showed that the company had a sizable loss in 1998 in its Personal Systems segment (a pretax loss of $1.0 billion on revenues of $12.8 billion). EXAMPLE: FINANCE COMPANIES. Another challenge in analyzing segment data arises for companies with leasing, real estate, financing, or insurance subsidiaries. The economic model for these companies is quite different from those for retail, manufacturing, or other service companies. Many firms with finance subsidiaries argue that consolidation of such “nonhomogeneous” operations distorts the parent’s key ratios, particularly leverage, working capital ratios, and gross margins. For example, consider the impact of IBM’s finance subsidiary on its performance. In 1998 the finance subsidiary had assets of $40.1 billion versus $46 billion for the parent, and pretax profit margins of 32 percent versus 11 percent for the company as a whole. It also had significantly higher leverage than the parent company. These factors made it difficult to compare the performance of IBM with that of other computer companies that had no such finance subsidiary. Prior to SFAS 94, many U.S. companies elected to account for finance subsidiaries using the equity method rather than full consolidation. Frequently, a summary income statement and balance sheet for the finance subsidiary were also disclosed. SFAS 94 stopped this practice and required that finance companies be consolidated. Companies that provided separate financial statements for finance subsidiaries were required to continue this practice. The question of whether to use consolidated or segment information to best evaluate firms with finance subsidiaries is a complex one. Many companies with finance subsidiaries provide additional disclosure to help analysts benchmark core segments with the 287 288 Entity Accounting Analysis Entity Accounting Analysis performance of companies that operate as stand-alone entities.3 However, this approach ignores any interactions that occur between operating and finance segments. For example, some companies use finance subsidiaries to provide low-cost financing to their customers, affecting pricing and selling strategies for the other segments. Comparing segment performance data for these firms to that of other firms in the same industries is likely to uncover this strategy. It is then important to analyze consolidated data to understand the performance of the entire portfolio of services provided to customers. EXAMPLE: INTERSEGMENT TRANSACTIONS. The final challenge for segment reporting comes from intersegment transactions, such as intersegment sales and allocation of common costs across segments. SFAS 131 requires companies to use the same transfer prices and cost allocations for segment reporting that are used internally. However, this permits management to have considerable control over the reported performance of both segments. For example, by setting a relatively high transfer price, management can enhance the reported performance of the selling segment at the expense of the buying one. Many factors can influence managers’ transfer pricing decisions. These include facilitating the efficient allocation of resources within the enterprise, motivating segment management, optimizing taxes, and affecting reported financial performance. It is therefore difficult to know how to interpret segment performance when there are high levels of intersegment sales. Is one segment outperforming its industry peers because of the firm’s transfer pricing policy? If so, what are management’s motives for such a policy? Similarly, the allocation of common costs can give rise to difficulty in interpreting segment performance. Does one segment outperform its peers because it receives a relatively low allocation of a common cost? If so, what are management’s motives for this policy? Does the firm simply have a poor cost allocation system? Or is management attempting to understate the performance of one of its segments? What are the potential internal implications of the firm’s cost allocation approach? Key Analysis Questions The challenge in defining business segments and measuring their performance provides several opportunities for financial analysis. Given management’s control over the way the firm is structured and segments are reported, analysts can add value by evaluating the way the firm’s business segments are defined as well as the reported performance for each segment. The following questions are likely to be useful for analyzing segment data: • What are a multibusiness firm’s major businesses? How are these aggregated into segments for reporting purposes? Does management appear to have aggregated segment data in such a way that it avoids presenting information for 8-12 Entity Accounting Analysis 8-13 Part 2 Business Analysis and Valuation Tools an important part of its operations? If so, is management legitimately concerned that these data are proprietary, or is it concealing poor-performing units? • What are the business relations between segments? This question is the heart of the firm’s corporate strategy. How do these relations affect intersegment transactions? Does a firm use one segment to subsidize the customers of another? What are the financial effects of these intercompany transactions and customer subsidies? How useful are segment data, given the relations between segments? • What is the performance of segments relative to other firms in the same industries? Is management propping up poor-performing segments at the expense of other business units? SUMMARY The entity principle defines the boundaries of the firm for financial reporting purposes. When one firm has control over the resources of another, it consolidates the performance of the two firms as if they were a single entity, using either the purchase method or the pooling-of-interests method. If it does not have control but has significant influence over the other firm, it reports its investment using the equity method of “one-line consolidation.” Control has typically been assessed when one company owns more than 50 percent of the voting stock of another. One company is viewed as having significant influence over another when it owns between 20 percent and 50 percent of its voting stock. However, as we have seen in this chapter, the implementation of these entity principles is not always straightforward. The key implementation challenges arise when: 1. One company is able to control or have significant influence over another without owning more than 50 percent or 20 percent, respectively, of its stock. 2. It is difficult to assess who has control over whom in a business combination. 3. There are complex business relations between firms that are difficult to classify using the traditional definitions of control. These include R&D limited partnerships and franchise arrangements. For firms that consolidate the operations of multibusiness units, investors are also interested in the separate performance of each business unit. Firms therefore report segment data in their financial statement footnotes. Segment reporting poses a number of challenges. First, there are multiple ways of defining segments, making it difficult to compare segments across firms or even for the same firm over time. Second, managers often create multibusiness segments because they believe that there are opportunities for synergies. For example, some companies use finance subsidiaries to subsidize customers 289 290 Entity Accounting Analysis Entity Accounting Analysis of operating divisions. Other companies have significant intersegment transactions. In either case, it is difficult to know how to interpret segment data, since it is subject to cross-subsidies, transfer prices, and cost allocations that would not arise for single business firms. Both entity accounting rules and segment disclosures provide opportunities for financial analysts to evaluate a firm’s entity accounting. The rules for measuring control have traditionally permitted management to avoid consolidating some types of firms where it has effective control. Rules on pooling-of-interests have permitted some firms to use the pooling method to avoid including the real cost of an acquisition in its financial statements. The entity questions raised by these rules and practices enable analysts to add value by assessing whether a firm’s accounting presents an accurate picture of its entire operations. If not, analysts can attempt to estimate the effect of consolidation. For segment disclosures, analysts can add value by assessing the quality of management’s segment definitions, given the firm’s businesses. They can also assess the relevance of segment data for business analysis, given the extent of intersegment transactions and subsidies across segments. DISCUSSION QUESTIONS 1. The Coca-Cola Company owns 42 percent of Coca-Cola Enterprises, the largest softdrink bottler in the world. On December 31, 1998, The Coca-Cola Company reported the following information in its financial statement footnotes: “The excess of our equity in the underlying net assets of Coca-Cola Enterprises over our investment is primarily amortized on a straight-line basis over 40 years. The balance of this excess, net of amortization, was approximately $442 million at December 31, 1998. A summary of financial information for Coca-Cola Enterprises is as follows (in millions): December 31, 1998 1997 Current assets Noncurrent assets $ 2,285 18,847 $ 1,813 15,674 Total assets $21,132 $17,487 $3,397 15,297 $3,032 12,673 $18,694 $15,705 $2,438 $1,782 $584 $184 $13,414 8,391 $11,278 7,096 Current liabilities Noncurrent liabilities Total liabilities Share-owners’ equity Company equity investment Operating revenues Cost of goods sold (continued ) 8-14 Entity Accounting Analysis 8-15 Part 2 Business Analysis and Valuation Tools December 31, 1998 1997 $5,023 $4,182 Operating income $869 $720 Net income $142 $171 Net income available to common share owners $141 $169 $51 $59 Gross profit Company equity income “Our net concentrate/syrup sales to Coca-Cola Enterprises were $3.1 billion in 1998. Coca-Cola Enterprises purchases sweeteners through our Company. . . . These transactions amounted to $252 million in 1998.” Show the 1998 financial statement effects of reporting Coca-Cola Enterprises using the equity method for The Coca-Cola Company. How much control does The CocaCola Company have over Coca-Cola Enterprises? Is the equity method the most appropriate method for recording this investment? 2. On April 22, 1999, MediaOne Group and AT&T agreed to merge. Under the merger, MediaOne Group’s shareowners will receive .95 of a share of AT&T common stock and $30.85 in cash for each share of MediaOne Group. The total package of cash and stock was valued at $85 per share. MediaOne has 604.4 million shares outstanding. Income Statement December 31, 1998 (in $ millions) Revenues Business Services Consumer Services Wireless Services Broadband and Internet Services Other and Corporate AT&T MediaOne $23,611 22,885 5,406 — 1,321 — — $361 2,491 30 53,223 45,736 2,882 3,121 Total Operating Income (Loss) Other income, net 7,487 1,247 (239) 3,368 Earnings (Loss) Before Interest and Taxes Interest expense 8,734 427 3,129 491 Income from Continuing Operations Before Income Taxes Provision for income taxes 8,307 2,638 3,072 1,208 Total Revenues Operating Expenses 291 292 Entity Accounting Analysis Entity Accounting Analysis Income Statement December 31, 1998 (in $ millions) Income (Loss) from Continuing Operations Income from discontinued operations Gain on sale of discontinued operations Extraordinary loss Net Income Balance Sheet December 31, 1998 (in $ millions) Assets Total Current Assets Property, plant and equipment, net of accumulated depreciation Licensing costs, net of accumulated amortization Investments Prepaid pension costs Goodwill Other assets Total Assets Liabilities and Equity Short-term debt Other current liabilities Total Current Liabilities Long-term debt Deferred credits and other Minority interest in consolidated subsidiaries Preferred stock Common shareowners’ equity Total Liabilities and Equity AT&T MediaOne 5,235 10 1,290 137 1,430 25,208 $ 6,398 $26,305 333 AT&T MediaOne $14,118 26,903 $1,200 4,069 7,948 4,434 2,074 2,205 1,868 11,647 1,571 $59,550 $28,192 1,171 14,271 569 1,045 15,442 5,556 12,921 109 25,522 1,614 4,853 6,676 1,099 1,161 12,789 $59,550 $28,192 9,705 If MediaOne’s asset book values are approximately equal to their market values, how much goodwill did AT&T pay for MediaOne? Prepare a pro forma income statement and balance sheet for the merged firm for 1998. 3. As discussed in the chapter, on April 6, 1998, Citicorp and Travelers Group announced an agreement to merge to become Citigroup Inc., a global financial service provider. Under the merger, each company’s shareholders owned 50 percent of the 8-16 Entity Accounting Analysis 8-17 Part 2 Business Analysis and Valuation Tools combined firm. Citicorp shareholders exchanged each of their shares for 2.5 shares of Citigroup, whereas Travelers shareholders retained their existing shares, which automatically became shares of the new company. The financial statements for Citicorp and Travelers for 1997, the year prior to the merger, are as follows: Income Statement December 31, 1997 (in $ millions) Citicorp Travelers $21,164 5,817 7,716 $16,214 8,995 5,119 7,281 34,697 37,609 13,081 1,907 13,987 11,443 277 7,714 13,163 28,975 32,597 5,722 2,131 5,012 1,696 212 Net Income $ 3,591 $ 3,104 Balance Sheet December 31, 1997 (in $ millions) Citicorp Travelers $ $ Revenues Interest and dividends Insurance premiums Commissions and fees Other Total Revenues Expenses Interest Provision for credit losses Insurance benefits and claims Other operating costs Total Expenses Income Before Taxes Income taxes Minority interest Assets Cash Deposits with banks Securities and real estate investments Trading account assets Loans Receivables Other Total Assets 8,585 13,049 33,361 40,356 181,712 3,288 30,546 $310,897 4,033 — 171,568 139,732 — 21,360 49,862 $386,555 293 294 Entity Accounting Analysis Entity Accounting Analysis Balance Sheet December 31, 1997 (in $ millions) Citicorp Travelers Liabilities and Equity Deposits Trading account liabilities Securities sold under repurchase agreements Insurance reserves Long-term debt Other Preferred stock Common shareholders’ equity $199,121 30,986 — — 19,785 39,809 1,903 19,293 — $ 96,166 120,921 43,782 28,352 76,441 1,450 19,443 Total Liabilities and Equity $310,897 $386,555 Estimate the pro forma income, common shareholders’ equity, and total assets for Citigroup in 1997, using the pooling-of interests method. What concerns would you have as a shareholder about Citigroup using the pooling-of-interests method? What criteria would you use as an analyst to decide when, if ever, the pooling-of-interests method is an appropriate method of recording a business combination between two firms? Does the Citicorp-Travelers merger satisfy these criteria? 4. Review the financial statement effects for the Dura investments in Spiros II described in the chapter. How would these effects be reflected in Dura’s books if its investment were consolidated? 5. Below is the segment disclosure reported by General Electric in its 1998 annual report. In addition, General Electric provided the following information about the businesses comprising CECS: “Consumer services — private-label and bank credit card loans, personal loans, time sales and revolving credit and inventory financing for retail merchants, auto leasing and inventory financing, mortgage servicing, and consumer savings and insurance services. Equipment management — leases, loans, sales and asset management services for portfolios of commercial and transportation equipment, including aircraft, trailers, auto fleets, modular space units, railroad rolling stock, data processing equipment, containers used on ocean-going vessels, satellites. Mid-market financing — loans, financing and operating leases and other services for middle-market customers, including manufacturers, distributors and end users, for a variety of equipment that includes vehicles, corporate aircraft, data processing equipment, medical and diagnostic equipment, and equipment used in construction, manufacturing, office applications, electronics and telecommunications activities. 8-18 Entity Accounting Analysis 8-19 Part 2 Business Analysis and Valuation Tools Revenues for the years ended December 31 Total revenues Intersegment revenues (in millions) GE Aircraft Engines Appliances Industrial Products and Systems NBC Plastics Power Systems Technical Products and Services All Other Eliminations 1998 1996 $ 10,294 $ 7,799 $ 6,302 5,619 5,801 5,586 11,222 10,984 10,401 5,269 5,153 5,232 6,633 6,695 6,509 8,466 7,915 7,643 5,323 4,861 4,700 264 308 291 (1,367) (1,176) (1,032) Total GE segment revenues Corporate items (a) GECS net earnings Total GE GECS Eliminations Consolidated revenues 1997 External revenues 1998 1997 1996 $ 292 12 479 — 20 166 14 — (983) $101 12 491 — 24 80 18 — (726) $ 86 5 453 — 22 67 23 — (656) 1998 1997 1996 $ 10,002 $ 7,698 $ 6,216 5,607 5,789 5,581 10,743 10,493 9,948 5,269 5,153 5,232 6,613 6,671 6,487 8,300 7,835 7,576 5,309 4,843 4,677 264 308 291 (384) (450) (376) 51,723 507 3,796 48,340 2,919 3,256 45,632 1,116 2,817 — — — — — — — — — 51,723 507 3,796 48,340 2,919 3,256 45,632 1,116 2,817 56,026 48,694 (4,251) 54,515 39,931 (3,606) 49,565 32,713 (3,099) — — — — — — — — — 56,026 48,694 (4,251) 54,515 39,931 (3,606) 49,565 32,713 (3,099) $— $— $— $100,469 $90,840 $79,179 $100,469 $90,840 $79,179 GE revenues include income from sales of goods and services to customers and other income. Sales from one Company component to another generally are priced at equivalent commercial selling prices. (a) Includes revenues of $944 million and $789 million in 1997 and 1998, respectively, from an appliance distribution affiliate that was deconsolidated in 1998. Also includes $1,538 million in 1997 from exchanging preferred stock in Lockheed Martin Corporation for the stock of a newly formed subsidiary . Property, plant and equipment additions (including equipment leased to others) For the years ended December 31 Assets at December 31 (in millions) GE Aircraft Engines Appliances Industrial Products and Systems NBC Plastics Power Systems Technical Products and Services All Other Total GE segments Investments in GECS Corporate items and eliminations (a) Total GE GECS Eliminations Consolidated totals $ 1998 1997 1996 8,866 $ 2,436 6,466 3,264 9,813 7,253 3,858 189 8,895 $ 2,354 6,672 3,050 8,890 6,182 2,438 224 5,423 2,399 6,574 3,007 9,130 6,322 2,245 239 42,145 19,727 12,798 38,705 17,239 11,482 35,339 14,276 10,310 74,670 67,426 59,925 303,297 255,408 227,419 (22,032) (18,822) (14,942) $355,935 $304,012 $272,402 Depreciation and amortization (including goodwill and other intangibles) For the years ended December 31 1998 1997 1996 1998 1997 1996 480 150 428 105 722 246 254 — $ 729 83 487 116 618 215 189 — $ 551 168 450 176 748 185 154 — $ 398 137 440 127 591 215 143 52 $ 292 131 408 142 494 199 137 46 $ 282 123 362 121 552 184 123 40 2,385 — 158 2,437 — 129 2,432 — 114 2,103 — 189 1,849 — 180 1,787 — 176 2,543 8,110 — 2,566 7,320 — 2,546 5,762 — 2,292 3,568 — 2,029 3,240 — 1,963 2,805 — $10,653 $9,886 $8,308 $5,860 $5,269 $4,768 $ Additions to property, plant and equipment include amounts relating to principal businesses purchased. (a) Depreciation and amortization includes $84 million of unallocated RCA goodwill amortization in 1998, 1997 and 1996 that relates to NBC. 295 296 Entity Accounting Analysis Entity Accounting Analysis Specialized financing — loans and financing leases for major capital assets, including industrial facilities and equipment and energy-related facilities; commercial and residential real estate loans and investments; and loans to and investments in public and private entities in diverse industries. Specialty insurance — U.S. and international multiple-line property and casualty reinsurance; certain directly written specialty insurance and life reinsurance; financial guaranty insurance, principally on municipal bonds and structured finance issues; private mortgage insurance; and creditor insurance covering international customer loan repayments. Very few of the products financed by GECS are manufactured by GE’s segment.” How useful is GE’s segment information? What do you learn from this information that you cannot learn from the consolidated results? How important is GECS to GE’s overall performance? What other information would you want to have to analyze the performance of GECS? NOTES 1. Most countries outside the U.S. follow similar reporting practices for controlling and “influential” investments in other companies. However, these practices are relatively recent in some countries, including Germany and Japan, where parent companies formerly reported using a strict legal definition of an entity. 2. SFAS No 131, Disclosures About Segments of Enterprise and Related Information. 3. Gilson et al. (1999) show that since financial analysts specialize by industry and it is not economical for investment brokers to have more than one analyst follow a single firm, firms with diverse segments are underfollowed and undervalued relative to stand-alone entities. See Gilson, Healy, Noe, and Palepu, “Changes in Organizational Form and Capital Market Intermediation: Analyst Coverage After Stock Breakups,” working paper, Harvard Business School, 1999. 8-20 Thermo Electron Corporation I n technology, things that have a high payoff are very risky. You need the ability to pursue risky ventures and yet not risk the company. If that means pursuing a lot of little things instead of one big thing, so be it—especially if the one big thing never panned out. —George Hatsopolous Forbes, 11/16/87 In early July 1994, research analyst John Kolmanoff was considering the recent performance of Thermo Electron (NYSE: TMO), a technology creation company with an impressive track record for capitalizing on internally developed and externally acquired research. In the past, Kolmanoff had strongly recommended Thermo Electron to his clients, and many had profited from its extraordinary price appreciation during the last five years (see Exhibit 1). However, the firm’s stock had recently been lagging the S&P 500, declining 19 percent for the six months ended June 30, 1994 (versus only a 10 percent decline for the S&P 500). This decline had been accompanied by an increase in short positions in the stock, and by criticism of the company’s accounting. As a result of these developments, Kolmanoff decided that it was time to reconsider the company. Business Analysis 2 and Valuation Tools 8 Entity Accounting Analysis COMPANY BACKGROUND Dr. George Hatsopolous founded Thermo Electron in 1956 in his Belmont, Massachusetts, garage using a $50,000 loan from his friend Peter Nomikos, heir to a Greek shipping fortune. A graduate student at the Massachusetts Institute of Technology, Hatsopolous hoped to capitalize on his doctoral research by commercializing the process of converting heat directly into electricity without moving parts. Two years later his prototype was completed and was widely acclaimed in the popular press as a breakthrough. One article proclaimed that the invention could be used to power satellites, military equipment, and even motor vehicles. Money flowed in from the venture capital community and the federal government. Although the process subsequently proved to be uneconomical, the research led to several spillover products which were economically viable, and which formed the basis for Thermo Electron’s early success. ......................................................................................................................... Souren G. Ouzounian and Professor Paul M. Healy prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. We are also grateful to Don McAllister for his helpful input. Copyright © 1998 by the President and Fellows of Harvard College. Harvard Business School case 9-198-033. 297 Entity Accounting Analysis Entity Accounting Analysis During the 1960s the company provided contract research for public utilities and government agencies such as NASA, the U.S. Air Force, and the now defunct Atomic Energy Commission. In 1971, when the U.S. Congress required car manufacturers to monitor exhaust emissions, no instruments with the required precision were available. Dr. Hatsopolous saw the opportunity this presented and quickly contacted Ford Motor Company to offer his company’s services in developing the new instruments. At the time Ford was skeptical of Thermo Electron’s ability to complete the contract, but the instruments were delivered on time, ahead of any competitors. As a result, many other auto companies came to Thermo Electron for the same devices. This infant instruments business grew to become Thermo Instrument Systems, Inc. The company continued to grow rapidly in the 1980s and early 1990s by developing a wide range of innovative new products. These included a portable device for detecting plastic bombs, a portable drug detector used by customs agents and police, a cardiac assist device to keep patients alive while awaiting transplants, the first commercial detector and analyzer for nitrosamines (carcinogens), a portable remediation system that removes gasoline from contaminated soil, soil-analysis instrumentation for the Environmental Protection Agency, a home-use radon detector kit, and the first commercially practical instrument for monitoring concentrations of NO2. Other recent innovations included mammography systems, paper-recycling and papermaking equipment, alternative energy systems, industrial process equipment, and a number of other specialized products. While much of Thermo Electron’s research success was internally generated at the company’s own research labs, it was not afraid to buy other developers. For example, in 1989 it acquired a San Diego-based laser lab. At the time of the acquisition the lab relied almost exclusively on the shrinking Star Wars budget for funding. Following a remarkable transformation, it developed a painless method to remove unwanted hair using laser technology, and as a result of a spinout in 1991, became ThermoTrex. But not all of the company acquisitions were so successful. A small metal-plate company that had been acquired ended up costing Thermo Electron $18 million, and an environmental engineering company acquired in 1988 cost $6 million. MANAGEMENT PHILOSOPHY AND CORPORATE STRUCTURE Thermo Electron mirrored the psyche of its founder, Dr. George Hatsopolous, whose talents spanned many fields—he is an inventor, teacher, self-taught economist, and CEO. He has used the Socratic method to encourage organizational learning and growth, and fostered an open-door policy for employees to discuss problems and ideas. The almost 9,000-person company was unique in several other ways. First, it had always retained the right to use the technology it developed. This permitted it to use the technology created for one project as a springboard for new ventures. At times this policy was costly, and the firm undertook research at a reduced fee to retain the rights to the technology. 8-22 Thermo Electron Corporation 298 Entity Accounting Analysis Thermo Electron Corporation 8-23 Part 2 Business Analysis and Valuation Tools Thermo Electron’s corporate structure, designed by Dr. Hatsopolous and his brother John Hatsopolous, the Company’s Chief Financial Officer, was also a unique feature of the business. The firm sold a minority interest to the public in subsidiaries that focused on the best ideas and products that came from the parent company’s R&D labs. The parent company typically kept between 70 and 80 percent of the stock in these “spinouts,” but the units functioned as independent companies with their own management and their own shareholders. As John Hatsopolous explained, “The plan is simple: let employees develop an idea, spend some time and money testing the quality and market potential of the product, then set up a subsidiary and let it grow.”1 The first unit to be “spun out” was Thermedics, which was sold in August 1983 for $2.51 per share. In March 1994, Thermedic’s stock was valued at $12.13. In mid-1994 Thermo Electron had nine “pups,” as the spinouts became known on Wall Street. Most had performed well following the initial offering. (See Exhibit 2 for details of stock performance of these units following the spinouts). For example, Thermo Instrument Systems, Inc., which grew out of the successful instrument project with Ford and which was spun out in 1986, was initially sold for $3.56 per share and in mid-1994 sold for more than $32. There were several differences between the spinout concept pioneered by Thermo Electron and the more traditional spinoffs. First, under a traditional spinoff all of the subsidiary’s equity was distributed to either the parent-company shareholders or to new shareholders through an Initial Public Offering (IPO). In the Thermo spinout the parent company sold off only a minority stake in the division, either through an IPO, a private placement, or both. Second, traditional spinoffs typically arose when the parent wanted to raise cash, to reduce debt obligations, or to rid itself of poor-performing units and focus on its “core” competencies. Consequently, announcements of spinoffs tended to have a negative impact on the parent company stock.2 In contrast, announcements of spinouts, or “equity carveouts” as they are sometimes called, usually had a positive 2 to 3 percent effect on the stock of the parent company. Theo Melas-Kyriazi, Thermo’s treasurer explained, “We don’t sell poor performers, the dogs; we sell our core technologies.”3 The cash generated from these sales was then used to provide working capital for the spun-out units. Dr. Hatsopolous believed that the company’s spinout strategy enabled it to combine the vibrancy of a small high-growth start-up with the financial stability and research strength of an established company. The structure provided strong incentives for management and key researchers, who were rewarded with stock options in the newly created publicly traded subsidiaries. As a result, there was virtually no turnover among key employees at Thermo Electron. In addition, Dr. Hatsopolous was convinced that, by creating a series of “pure plays” on specific technologies, the firm helped investors to better understand its business, and hence lowered its cost of raising capital. ......................................................................................................................... 1. Boston Business Journal 13, November 19, 1993, Sec. 1:3. 2. See Schipper and Smith, Journal of Financial Economics, 1986: 153–186. 3. Wall Street Journal, August 5, 1993: 1. 299 Entity Accounting Analysis Entity Accounting Analysis 8-24 Accounting for Spinouts One issue that arose from the spinout strategy was how to account for the spinouts. There was no FASB ruling on this accounting practice. However, two options were available to Thermo Electron: (1) record any realized gain or loss on sale of shares in the spun-out unit as an increase or decrease in equity reserves; or (2) report any gain or loss in the income statement. The footnotes in the annual report explained that Thermo Electron followed the second of these options: At the time a subsidiary sells its stock to unrelated parties at a price in excess of its book value, the Company’s net investment in that subsidiary increases. If at that time the subsidiary is an operating entity and not engaged principally in research and development, the Company records the increase as a gain. If gains have been recognized on issuance of a subsidiary’s stock and shares of the subsidiary are subsequently repurchased by the subsidiary or by the Company, gain recognition does not occur on issuances subsequent to the date of repurchase until such time as shares have been issued in an amount equivalent to the number of repurchased shares. The impact of this accounting decision was significant. Since the first spinout in 1983, 50 percent or more of the firm’s net income arose from gains on spinouts. For example, in 1993 the gain on sale (both before and after tax effects) was $39.9 million, compared to net income of $76.6 million. Management believed that the accounting policy has been critical in helping the company raise funds, since it enabled the firm to generate smooth earnings growth in its income statement. However, analysts remained concerned about the quality of the firm’s earnings. Recent Financial Performance In Fortune magazine’s 1994 ranking of the nation’s top 500 industrial companies, Thermo Electron was ranked number one for largest growth in earnings per share from 1983 to 1993. The company also ranked twenty-ninth on the Fortune list of firms with the highest total return to investors over for the last ten years. “We attribute our success in large part to our strategy of spinning out promising businesses that serve energy, environmental, and biomedical markets,” said Dr. Hatsopolous. “By forming these entities, we are able to tap the capital markets and create an entrepreneurial environment that spurs ingenuity.”4 For its fiscal year ended January 1, 1994, Thermo Electron reported its ninth consecutive year of record financial performance. Its revenues were $1.2 billion and income before an accounting change was $76.6 million, or $1.75 per share. See Exhibit 3 for a ......................................................................................................................... 4. Wall Street Journal, August 5, 1993: 1. Thermo Electron Corporation 300 Entity Accounting Analysis Thermo Electron Corporation 8-25 Part 2 Business Analysis and Valuation Tools ten-year summary of the company’s financial data and Exhibit 4 for its most recent financial statements. Despite its impressive record, John Kolmanoff was uncertain about whether he should continue to recommend the stock to his clients. Many analysts were forecasting that the company’s earnings would grow at a rate of 18 to 22 percent for the next five years. Given the stock price in early July 1994 of $24.75, the company was trading at 1.38 times its book value. However, others were more cautious, and questioned the quality of the firm’s earnings, given that much of its income was derived from gains on spinouts. Short sales in the company’s stock had grown 21 percent in the previous six months, to approximately 11 percent of its outstanding stock. Given the mixed opinions on the company, Kolmanoff decided that he should undertake a complete review of its business, accounting, and valuation.5 ......................................................................................................................... 5. In early July 1994, Thermo Electron’s equity beta was 1.1, the 3-month Treasury Bill rate was 4.2%, and the 30-year Government Bond Rate was 7.68%. 301 Entity Accounting Analysis 8-26 Entity Accounting Analysis EXHIBIT 1 Five-Year Summary of Stock Performance: Thermo Electron and SPX Thermo Electron Corporation Percentage Change 140% 120% 100% 80% TMO SPX 60% 40% 20% 0% 6/30/94 3/31/94 12/31/93 9/30/93 6/29/93 3/31/93 12/31/92 9/30/92 6/30/92 3/31/92 12/31/91 9/30/91 6/28/91 3/28/91 12/31/90 9/28/90 6/29/90 3/30/90 12/29/89 9/29/89 –20% 6/30/89 302 Entity Accounting Analysis 8-27 Part 2 Business Analysis and Valuation Tools EXHIBIT 2 Stock Performance for Thermo Electron Spinouts 3/3/94 Thermo Electron Corporation ................................... Split-adjusted Shares Company IPO Date IPO Price Price Outstanding CAGR ................................................................................................................................................... Thermedics Thermo Instrument Systems Thermo Process Systems Thermo Power Thermo Cardiosystemsa Thermo Voltek ThermoTrex Thermo Fibertek Thermo Remediationb 8/10/83 8/5/86 8/21/86 6/26/87 1/12/89 3/19/90 7/24/91 11/2/92 12/16/93 $2.51 3.56 1.83 8.50 2.27 2.56 7.92 8.00 12.50 $12.13 32.25 9.00 8.75 19.25 9.00 15.50 14.63 14.13 31,978 45,865 16,041 12,232 n/a 3,929 17,093 26,832 6,503 15.40% 31.70 22.00 0.50 51.70 36.90 25.10 82.90 15.00 ................................................................................................................................................... a. Reflects combined ownership by Thermo Electron and Thermedics b. Reflects ownership by Thermo Process Source: Centre for Research in Security Prices. 303 Entity Accounting Analysis 8-28 Entity Accounting Analysis EXHIBIT 3 Thermo Electron Ten-Year Financial Summary (in millions except per-share amounts) 1993a 1992b 1991c 1990d 1989 1988 1987 1986 1985 1984 ....................................................................................................................................................... Revenues $1,249.7 Costs and Expenses: Cost of revenues 755.5 Expenses for R&D and new lines of business 87.0 Selling, general and administrative expenses 283.6 Costs associated with divisional and product restructuring 8.3 1,134.4 Gain on Issuance of Stock by Subsidiaries 39.9 Other Income (Expense), Net (24.1) Income Before Income Taxes, Minority Interest, and Cumulative Effect of Change in Accounting Principle 131.1 Provision for Income Taxes 33.4 Minority Interest Expense 21.1 Income Before Cumulative Effect of Change in Accounting Principle 76.6 Cumulative Effect of Change in Accounting Principle, Net of — Taxe Net Income $76.6 Earnings per Share Before Cumulative Effect of Change in Accounting Principle: Primary $ 1.75 Fully diluted $ 1.57 Earnings per Share: Primary $ 1.75 Fully diluted $ 1.57 Balance Sheet Data: Working capital $ 828.3 Total assets 2,473.7 Net assets related to construction projects 9.4 Long-term obligations 647.5 Minority interest 277.7 Common stock of subsidiaries subject to redemption 14.5 Shareholders’ investment 858.5 $ 949.0 $ 805.5 $720.7 $623.0 $540.7 $419.9 $359.1 $286.2 $253.3 609.0 533.6 465.3 424.2 359.6 280.3 244.8 194.9 172.6 62.3 52.6 54.0 46.4 43.2 31.4 26.5 21.5 21.6 209.4 177.3 163.1 130.0 113.7 91.5 72.7 56.9 48.2 — 880.7 3.7 767.2 1.0 683.4 2.2 602.8 0.9 517.4 3.5 406.7 7.1 351.1 4.3 277.6 0.1 242.5 30.2 3.5 27.4 13.5 20.3 2.3 16.8 3.3 6.0 4.5 16.1 (0.6) 15.9 (3.3) 9.1 (4.7) — (5.1) 102.0 27.5 13.9 79.2 24.8 7.3 59.9 17.8 7.1 40.3 10.4 3.3 33.8 9.0 2.0 28.7 6.0 1.9 20.6 4.0 0.5 13.0 2.5 (0.1) 5.7 0.1 (0.1) 60.6 47.1 35.0 26.6 22.8 20.8 16.1 10.6 5.7 1.4 — — — — — — — — $59.2 $ 47.1 $ 35.0 $ 26.6 $ 22.8 $ 20.8 $ 16.1 $ 10.6 $ 5.7 $ 1.51 $ 1.31 $1.09 $ .86 $ .77 $ .68 $ .55 $ .42 $ .24 $ 1.41 $ 1.23 $1.03 $ .84 $ .75 $ .67 $ .54 $ .41 $ .23 $ .48 $ 1.38 $ 1.31 $ 1.23 $1.09 $1.03 $ .86 $ .84 $ .77 $ .75 $ .68 $ .67 $ .55 $ .54 $ .42 $ .41 $ .24 $ .23 $ 503.4 1,818.3 $ 463.5 1,199.5 $241.4 904.4 $276.0 664.1 $218.8 524.4 $210.9 460.8 $124.3 332.6 $ 79.1 240.9 $ 51.3 208.0 23.8 494.2 164.3 29.4 255.0 122.5 — 210.0 83.9 — 176.9 51.8 — 152.7 22.6 — 135.7 25.8 — 61.4 20.1 — 49.1 6.6 — 47.5 1.3 5.5 552.9 5.5 480.9 8.7 310.2 13.1 226.4 — 194.3 — 173.5 — 153.1 — 106.7 — 87.8 ....................................................................................................................................................... a. Reflects the February 1993 acquisition of Spectra-Physics Analytical and the Company’s 1993 public offering of common stock for net proceeds of $246.0 million. b. Reflects the August 1992 acquisition of Nicoles Instrument Corporation and the issuance of $260.0 million principal amount of convertible debentures. c. Reflects the issuance of $164.0 million principal amount of convertible debentures. d. Reflects the May 1990 acquisition of Finnigan Corporation. e. Reflects the adoption in fiscal 1992 of Statement of Financial Accounting Standards No. 106, “Accounting for Post-retirement Benefits Other Than Pensions.” Thermo Electron Corporation 304 Entity Accounting Analysis 8-29 Part 2 Business Analysis and Valuation Tools EXHIBIT 4 Thermo Electron Summarized Financial Statements Thermo Electron Corporation CONSOLIDATED INCOME STATEMENT (in thousands except per-share amounts) 1993 1992 1991 ................................................................................................................................................. Revenues: Product sales and revenues Service revenues Research and development contract revenues Costs and Expenses: Cost of products Cost of services Expenses for research and development and new lines of businessa Selling, general and administrative expenses Costs associated with division and product (Note 11) Gain on Issuance of Stock by Subsidiaries (Note 9) Other Income (Expense), Net (Note 10) Income Before Income Taxes, Minority Interest, and Cumulative Effect of Change in Accounting Principle Provision for Income Taxes (Note 8) Minority Interest Expense Income Before Cumulative Effect of Change in Accounting Principle Cumulative Effect of Change in Accounting Principle, Net of Tax (Note 7) Net Income Earnings per Share Before Cumulative Effect of Change in Accounting Principle: Primary Fully diluted Earnings per Share: Primary Fully diluted Weighted Average Shares: Primary Fully diluted $1,103,558 121,987 24,173 1,249,718 $ 808,928 114,268 25,776 948,972 $ 666,565 112,003 26,916 805,484 664,201 91,292 521,668 87,307 444,273 89,347 87,027 283,390 8,261 1,134,371 39,863 (24,091) 62,343 209,392 — 880,710 30,212 3,496 52,609 177,304 3,709 767,242 27,367 13,564 131,119 33,400 21,086 101,970 27,474 13,902 79,173 24,850 7,269 76,633 60,594 47,054 — 76,633 1,438 $ 59,156 — $ 47,054 $ 1.75 $ 1.57 $ 1.51 $ 1.41 $ 1.31 $ 1.23 $ 1.75 $ 1.57 $ 1.48 $ 1.38 $ 1.31 $ 1.23 43,779 55,520 40,049 47,163 35,836 41,711 $ ................................................................................................................................................. a. Includes costs of: Research and development contracts a. Includes costs of: Internally funded research and development a. Includes costs of: Other expenses for new lines of business $ $ 20,435 58,943 7,649 87,027 $ 19,426 38,675 4,242 $ 62,343 $ 21,196 26,171 5,242 $ 52,609 305 Entity Accounting Analysis 8-30 Entity Accounting Analysis CONSOLIDATED BALANCE SHEET (in thousands except per-share amounts) 1993 1992 ...................................................................................................................................... ASSETS Current Assets: Cash and cash equivalents $ 325,744 Short-term investments, at cost (quoted market value of $377,183 and $180,060) 374,450 Accounts receivable, less allowances of $14,129 and $11,341 267,377 Unbilled contract costs and fees 32,574 Inventories: Work in process and finished goods 82,385 Raw materials and supplies 110,437 Prepaid income taxes (Note 8) 39,258 Prepaid expenses 12,318 $ 190,601 178,101 204,750 25,941 60,629 106,619 54,377 8,716 1,244,543 829,734 34,100 128,040 95,348 133,876 162,140 229,224 40,570 116,895 199,800 224,629 35,729 99,502 30,554 205,508 581,894 371,293 134,423 113,383 447,471 257,910 43,630 44,497 Other Assets 102,347 92,870 Cost in Excess of Net Assets of Acquired Companies (Note 2) 473,579 364,030 $2,473,710 $1,818,265 Assets Related to Projects Under Construction: Restricted funds (quoted market value of $34,100 and $95,639) Facilities under construction Property, Plant and Equipment, at Cost: Land Buildings Alternative-energy facilities Machinery, equipment and leasehold improvements Less: Accumulated depreciation and amortization Long-term Marketable Securities, at Cost (quoted market value of $45,125 and $45,731) ...................................................................................................................................... Thermo Electron Corporation 306 Entity Accounting Analysis 8-31 Part 2 Business Analysis and Valuation Tools CONSOLIDATED BALANCE SHEET (continued) (in thousands except per-share amounts) 1993 1992 Thermo Electron Corporation ................................................................................................................................................... LIABILITIES AND SHAREHOLDERS’ INVESTMENT Current Liabilities: Notes payable Accounts payable Billings in excess of contract costs and fees Accrued payroll and employee benefits Accrued income taxes (Note 8) Accrued installation and warranty costs Other accrued expenses (Note 2) Deferred Income Taxes (Note 8) Other Deferred Items Liabilities Related to Projects Under Construction (Note 5): Payables and accrued expenses Tax-exempt obligations Long-term Obligations (Note 5): Senior convertible obligations Subordinated convertible obligations Nonrecourse tax-exempt obligations Other Minority Interest Commitments and Contingencies (Note 6) Common Stock of Subsidiaries Subject to Redemption ($15,390 and $5,468 redemption values) Shareholders’ Investment (Notes 3 and 4): Preferred stock, $100 par value, 50,000 shares authorized; none issued Common stock, $1 par value, 100,000,000 shares authorized; 47,950,580 and 27,099,598 shares issued Capital in excess of par value Retained earnings Treasury stock at cost, 31,898 and 85,342 shares Cumulative translation adjustment Deferred compensation (Note 7) $ 45,851 85,278 8,564 49,029 7,713 26,049 193,762 416,246 48,387 $ 22,034 69,473 7,987 45,115 9,796 17,179 154,786 326,370 34,171 58,152 35,500 10,680 142,069 152,749 5,874 199,536 205,410 275,000 238,386 108,800 25,275 647,461 260,000 199,829 — 34,323 494,152 277,681 164,293 14,511 5,468 47,951 467,076 362,138 877,165 (1,212) (13,591) (3,839) 858,523 $2,473,710 27,100 257,105 285,505 569,710 (3,810) (7,949) (5,050) 552,901 $1,818,265 ................................................................................................................................................... 307 Entity Accounting Analysis 8-32 Entity Accounting Analysis CONSOLIDATED CASH FLOW STATEMENT (in thousands) 1993 1992 1991 .............................................................................................................................................. OPERATING ACTIVITIES: Net income Adjustments to reconcile net income to net cash provided by operating activities: Cumulative effect of change in accounting principle (Note 7) Depreciation and amortization Costs associated with divisional and product restructuring (Note 11) Equity in losses of unconsolidated subsidiaries Provision for losses on accounts receivable Increase in deferred income taxes Gain on sale of investments Gain on issuance of stock by subsidiaries (Note 9) Minority interest expense Other noncash expenses Changes in current accounts, excluding the effects of acquisitions: Accounts receivable Inventories Other current assets Accounts payable Other current liabilities Other Net cash provided by operating activities $ 76,633 $ 59,156 $ 47,054 — 42,356 8,261 21,076 2,675 13,888 (2,469) (39,863) 21,086 7,850 1,438 29,228 — 3,948 2,021 12,273 (4,968) (30,212) 13,902 11,549 — 23,391 3,709 1,663 3,020 169 (7,622) (27,367) 7,269 6,804 (43,171) (6,525) (230) 10,014 15,355 (198) 126,738 (10,763) (4,753) (9,860) (2,479) (15,363) (175) 54,942 (10,220) 8,224 5,276 (10,140) (11,684) (142) 39,404 (142,962) (56,580) (20,573) 16,651 (193,894) (3,781) 1,848 (399,291) (251,738) (60,007) (70,340) 35,899 68,260 (132,971) 313 (410,584) (7,552) (33,469) (21,278) 15,814 (175,701) (67,790) (4,834) (294,810) 102,151 (11,732) — 378,790 (57,198) (941) 411,070 (3,374) 135,143 190,601 $325,744 255,694 (27,415) 133,536 100,749 (45,334) 485 417,715 (2,424) 59,649 130,952 $190,601 162,273 (10,493) 66,000 64,947 (11,663) (430) 270,634 (2,499) 12,729 118,223 $130,952 CASH PAID FOR: Interest Income taxes $ 29,438 $ 9,699 $ 18,287 $ 16,593 $ 15,426 $ 15,723 NONCASH ACTIVITIES: Conversions of convertible obligations Subsidiary stock issued for acquired business (Note 2) Purchase of electric-generating facility through assumption of debt $ 50,403 $— $ 66,900 $ 13,863 $ 9,673 $— $109,865 $ 1,026 $— INVESTING ACTIVITIES: Acquisitions, net of cash acquired (Note 2) Purchases of property, plant and equipment Purchases of long-term investments Proceeds from sale of short-term investments (Increase) decrease in short-term investments Increase in assets related to construction projects Other Net cash used in investment activities FINANCING ACTIVITIES: Proceeds from issuance of long-term obligations Repayment and repurchase of long-term obligations Proceeds from issuance of tax-exempt obligations Proceeds from issuance of Company and subsidiary common stock Purchases of Company and subsidiary common stock Other Net cash provided by financing activities Exchange Rate Effect on Cash Increase in Cash and Cash Equivalents Cash and Cash Equivalents at Beginning of Year Cash and Cash Equivalents at End of Year .............................................................................................................................................. Thermo Electron Corporation 308 Entity Accounting Analysis 8-33 Part 2 Business Analysis and Valuation Tools SELECTED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Thermo Electron Corporation 1. SIGNIFICANT ACCOUNTING POLICIES 2 and Business Analysis Valuation Tools Principles of Consolidation The accompanying consolidated financial statements include the accounts of Thermo Electron Corporation and its majority- and wholly owned subsidiaries (the Company). All material intercompany accounts and transactions have been eliminated. Majority-owned public subsidiaries include Thermedics, Inc., Thermo Instrument Systems, Inc., Thermo Process Systems Inc., Thermo Power Corporation, ThermoTrex Corporation, and Thermo Fibertek Inc. Thermo Cardiosystems Inc. and Thermo Voltek Corp. are majority-owned public subsidiaries of Thermedics. Thermo Remediation Inc. is a majority-owned public subsidiary of Thermo Process. Thermo Energy Systems Corporation is a majorityowned, privately held subsidiary of the Company; ThermoLase Inc. is a majority-owned, privately held subsidiary of TherTrex; and J. Amerika N.V. is a majority-owned, privately held subsidiary of Thermo Process. The Company accounts for investments in businesses in which it owns between 20% and 50% under the equity method. Thermo Electron Cor- Fiscal Year The Company has adopted a fiscal year ending the poration 8 Entity Accounting Analysis Saturday nearest December 31. References to 1993, 1992, and 1991 are for the fiscal years ended January 1, 1994, January 1, 1992, and December 28, 1991, respectively. Fiscal years 1993 and 1991 each included 52 weeks; 1992 included 53 weeks. Revenue Recognition For the majority of its operations, the Company recognizes revenues based upon shipment of its products or completion of services rendered. The Company provides a reserve for its estimate of warranty and installation costs at the time of shipment. Revenues and profits on substantially all contracts are recognized using the percentage-of-completion method. Revenues recorded under the percentageof-completion method were $176,727,000 in 1993, $186,407,000 in 1992, and $173,210,000 in 1991. The percentage of completion is determined by relating either the actual costs or actual labor, respectively, to be incurred on each other. If a loss is indicated on any contract in process, a provision is made currently for the entire loss. The Company’s contracts generally provide for billing of customers upon attainment of certain milestones specified in each contract. Revenues earned on contracts in process in excess of billings are classified as “Unbilled contract costs and fees,” and amounts billed in excess of revenues earned are classified as “Billings in excess of contract costs and fees” in the accompanying balance sheet. There are no significant amounts included in the accompanying balance sheet that are not expected to be recovered from existing contracts at current contract values or that are not expected to be collected within one year, including amounts that are billed but not paid under retainage provisions. Gain on Issuance of Stock by Subsidiaries At the time a subsidiary sells its stock to unrelated parties at a price in excess of its book value, the Company’s net investment in that subsidiary increases. If at that time the subsidiary is an operating entity and not engaged principally in research and development, the Company records the increase as a gain. If gains have been recognized on issuances of a subsidiary’s stock and shares of the subsidiary are subsequently repurchased by the subsidiary or the Company, gain recognition does not occur on issuances subsequent to the date of a repurchase until such time as shares have been issued in an amount equivalent to the number of repurchased shares. Such transactions are reflected as equity transactions and the net effect of these transactions is reflected in the accompanying statement of shareholders’ investment as “Effect of majority-owned subsidiaries’ common stock transactions.” Income Taxes The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, “Accounting for Income Taxes,” as of the beginning of 1992. Under SFAS No. 109, deferred income taxes are recognized based on the expected future tax consequences of differences between the financial statement basis and the tax basis of assets and liabilities calculated using enacted tax rates in effect for 309 Entity Accounting Analysis Entity Accounting Analysis the year in which the differences are expected to be reflected in the tax return. Prior to 1992, the Company recorded income taxes on timing differences between financial statement and tax treatment of income and expenses under Accounting Principles Board Opinion No. 11. The implementation of SFAS No. 109 and the effect of adoption were not material to the Company’s financial statements. Earnings per Share Primary earnings per share have been computed based on the weighted average number of common shares outstanding during the year. Because the effect of common stock equivalents was not material, they have been excluded from the primary earnings per share calculation. Fully diluted earnings per share assumes the effect of the conversion of the Company’s dilutive convertible obligations and elimination of the related interest expense, the exercise of stock options, and their related income tax effects. Stock Splits All share and per share information has been restated to reflect a three-for-two stock split, effected in the form of a 50% stock dividend that was distributed in October 1993. In addition, all share and per share information pertaining to Thermedics, Thermo Instrument, ThermoTrex, and Thermo Voltek has been restated to reflect three-for-two stock splits, effected in the form of 50% stock dividends, that were distributed in 1993. All share and per share information pertaining to Thermo Cardiosystems and ThermoLase has been restated to reflect two-for-one stock splits, effected in the form of 100% stock dividends, that was distributed for Thermo Cardiosystems in 1993 and will be effected for ThermoLase on March 15, 1994. Cash and Cash Equivalents Cash equivalents consist principally of U.S. government agency securities, bank time deposits, and commercial paper purchased with an original maturity of three months or less. These investments are carried at cost. The fair market value of cash and cash equivalents was $325,823,000 and $191,004,000 at January 1, 1994 and January 2, 1993, respectively. Short- and Long-term Investments Short- and long-term investments consist principally of corporate notes and U.S. government agency securities. Securities with an original maturity of greater than three months, which the Company intends to hold for less than one year, are classified as short-term. Securities that are intended to be held for more than one year are classified as long-term. These investments are carried at the lower of cost or market value. In May 1993, the Financial Accounting Standards Board issued SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” SFAS No. 115 requires that marketable equity and debt securities considered trading securities be accounted for at market value with the difference between cost and market value recorded currently in the statement of income; that securities considered available for sale be accounted for at market value, with the difference between cost and market value, net of related tax effects, recorded currently as a component of shareholders’ investment; and that debt securities considered held-to-maturity be recorded at amortized cost. The Company is required to adopt SFAS No. 115 at the beginning of fiscal 1994. Management believes that the marketable equity and debt securities in the accompanying balance sheet will be considered available-for-sale and that the adoption of SFAS No. 115 will result in a total increase to shareholders’ investment of approximately $2,600,000. Inventories Inventories are stated at the lower of cost (on a firstin, first-out or weighted average basis) or market value and include materials, labor, and manufacturing overhead. Property, Plant and Equipment The costs of additions and improvements are capitalized, while maintenance and repairs are charged to expense as incurred. The Company provides for depreciation and amortization using the straight-line method over the estimated useful lives of the property as follows: buildings and improvements—10 to 40 years; alternative-energy facilicties—25 years, machinery and equipment—3 to 20 years; and lease-hold improvements—the shorter of the term of the lease or the life of the asset. 8-34 Thermo Electron Corporation 310 Entity Accounting Analysis 8-35 Part 2 Business Analysis and Valuation Tools Thermo Electron Corporation 1. SIGNIFICANT ACCOUNTING POLICIES (continued) Assets Related to Projects Under Construction “Facilities under construction” in the accompanying 1992 balance sheet included an alternative-energy facility that was under construction in Delano, California. This facility was completed in 1993 and is included in “Alternative-energy facilities” in the accompanying 1993 balance sheet. “Facilities under construction” in fiscal 1993 and 1992 include a waste-recycling facility located in San Diego County, California. Construction costs for this facility were capitalized as incurred. Construction was completed in early 1994. “Restricted funds” in the accompanying balance sheet represents unexpended proceeds from the issuance of tax-exempt obligations (Note 5), which are invested principally in U.S. government agency securities and municipal tax-exempt obligations. These investments are carried at the lower of cost or market value. In August 1993, the Company agreed, in exchange for a cash settlement, to terminate a power sales agreement between a subsidiary of the Company and a utility. The power sales agreement required the utility to purchase the power to be generated by the Company’s 55-megawatt natural gas cogeneration facility under development on Staten Island, New York. Under the termination agreement, the Company received $9.0 million in August 1993, with subsequent payments to be made as follows: $3.6 million in 1994; $2.7 million in 1995; $1.8 million in 1996; and $0.9 million in 1997. The Company will be obligated to return $8.2 million of this settlement if the Company elects to proceed with the Staten Island facility and it achieves commercial operation before January 1, 2000. Accordingly, the Company has deferred recognition of $8.2 million of revenues, pending final determination of the project’s status. During 1993, the Company recorded revenues of $9.8 million and segment income of $5.4 million from the termination of the power sales agreement. Other Assets “Other assets” in the accompanying balance sheet include capitalized costs associated with the Company’s operation of certain alternative-energy power plants, as well as the cost of acquired trade- marks, patents, and other identifiable intangible assets. These assets are being amortized using the straight-line method over their estimated useful lives, which range from 4 to 20 years. These assets were $41,252,000 and $49,646,000, net of accumulated amortization of $16,699,000 and $11,002,000, at year-end 1993 and 1992, respectively. Cost in Excess of Net Assets of Acquired Companies The excess of cost over the fair value of net assets of acquired businesses is amortized using the straightline method principally over 40 years. Accumulated amortization was $32,439,000 and $20,954,000 at year-end 1993 and 1992, respectively. The Company continually assesses whether a change in circumstances has occurred subsequent to an acquisition that would indicate that the future useful life of the asset should be revised. The Company considers the future earnings potential of the acquired business in assessing the recoverability of this asset. Common Stock of Subsidiaries Subject to Redemption In March 1993, ThermoLase sold 3,078,000 units at $5 per unit, each unit consisting of one share of ThermoLase common stock and one redemption right. A redemption right allows holders to redeem ThermoLase common stock for $5 per share, and is exercisable in December 1996 and 1997. The redemption rights are guaranteed on a subordinated basis by the Company. “Common stock of subsidiaries subject to redemption” in the accompanying 1992 balance sheet represents amounts associated with redemption rights outstanding that were issued in connection with the Thermo Cardiosystms 1989 initial public offering and were guaranteed on a subordinated basis by the Company. These redemption rights expired at the end of 1993 and, as a result, the Company transferred $5,468,000 of “Common stock of subsidiary subject to redemption” to “Minority interest” and “Capital in excess of par value.” Foreign Currency All assets and liabilities of the Company’s foreign 311 Entity Accounting Analysis 8-36 Entity Accounting Analysis subsidiaries are translated at year-end exchange rates, and revenues and expenses are translated at average exchange rates for the year in accordance with SFAS No. 52, “Foreign Currency Translation.” Resulting translation adjustments are reflected as a separate component of shareholders’ investment titled “Cumulative translation adjustment.” Foreign currency transaction gains and losses are included in the accompanying statement of income and are not material for the three years presented. 2. ACQUISITIONS aggregate cost of these acquisitions exceeded the estimated fair value of the acquired net assets by $325 million, which is being amortized principally over 40 years. Allocation of the purchase price was based on the fair value of the net assets acquired and, for acquisitions completed in fiscal 1993, is subject to adjustment. Based on unaudited data, the following table presents selected financial information for the Company, Spectra-Physics Analytical, and Nicolet on a pro forma basis, assuming the companies had been combined since the beginning of 1992. Net income and earnings per share are shown before Nicolet’s discontinued operations, which occurred in fiscal 1992. The effect on the Company’s financial statements of the acquisitions not included in the pro forma data was not significant. In February 1993, Thermo Instrument acquired Spectra-Physics Analytical, a manufacturer of liquid chromatography and capillary electrophoresis analytical instruments, for $6.7 million in cash. In 1993, the Company’s majority-owned subsidiaries made several other acquisitions for $76.5 million in cash. In 1992, Thermo Instruments acquired Nicolet Instrument Corporation. The total purchase price to the Company was approximately $175 million. Nicolet designs, manufactures, and markets instrumentation for a broad range of analytical chemistry, neurodiagnostic, and electronic engineering problem-solving applications in science and industry. In 1992, the Company’s majority-owned subsidiaries made several other acquisitions for $77.7 million in cash, assumption of debt in the amount of $7.3 million, prepayment of debt in the amount of $1.5 million, and issuance of common stock and stock options of a majority-owned subsidiary valued at approximately $12.3 million. These acquisitions have been accounted for as purchases and their results of operations have been included in the accompanying financial statements from their respective dates of acquisition. The 9. TRANSACTIONS IN STOCK OF SUBSIDIARIES “Gain on issuance of stock by subsidiaries” in the accompanying statement of income results primarily from the following transactions: 1993 Public offering of 3,225,000 shares of Thermedics common stock at $10.00 per share for net proceeds Presentation Certain amounts in 1992 and 1991 have been reclassified to conform to the 1993 financial statement presentation. (In thousands, except per share amounts) Revenues Earnings per share before cumulative effect of change in accounting principal: Primary Fully diluted 1993 1992 $1,257,523 $1,105,907 75,631 1.73 1.55 43,016 1.07 1.04 of $29,980,000 resulted in a gain of $10,707,000. Public offering of 4,312,500 shares of Thermo Power common stock at $9.00 per share for net proceeds of $35,998,000 resulted in a gain of $10,578,000. Private placements of 2,062,500 shares of ThermoTrex common stock at $11.17 and $14.50 per share for net proceeds of $27,463,000 resulted in a gain of $11,400,000. Thermo Electron Corporation 312 Entity Accounting Analysis 8-37 Part 2 Business Analysis and Valuation Tools Thermo Electron Corporation 9. TRANSACTIONS IN STOCK OF SUBSIDIARIES (continued) Private placement of 200,000 shares and initial public offering of 1,100,000 shares of Thermo Remediation at $9.89 and $12.50 per share, respectively, for net proceeds of $14,554,000 resulted in a gain of $4,239,000. Conversion of $7,270,000 of Thermedics 61⁄ 2% subordinated convertible debentures convertible at $10.42 per share into 697.919 shares of Thermedics common stock resulted in a gain of $2,506,000. 1992 Private placement of 2,709,356 shares and initial public offering of 3,000,000 shares of Thermo Fibertek common stock at $6.70 to $8.00 per share in net proceeds at $39,748,000 resulted in a gain of $34,303,000. Issuance of 1,566,480 restricted shares of ThermoTrex common stock valued at $6.17 per share, or $9,673,000 to acquire Lorad Corporation resulted in a gain of $3,081,000. Private placement of 375,000 shares of ThermoTrex common stock at $10.67 per share for net proceeds of $3,556,000 resulted in a gain of $1,745,000. 1991 Conversion of $9,099,000 of Thermo Instrument 6% and 61⁄ 2% subordinated convertible debentures convertible at $12.19 and $10.83 per share, respectively, into 766.786 shares of Thermo Instrument common stock resulted in a gain of $3,707,000. Conversion of $6,200,000 of Thermo Process 61⁄ 2% subordinated convertible debentures convertible at $10.33 per share into 600.191 shares of Thermo Process common stock resulted in a gain of $3,043,000. Repurchases of $3,700,000 of Thermedics 61⁄ 2% subordinated convertible debentures convertible at $10.42 per share for $941,000 in cash and 367,500 shares of Thermedics common stock valued at $7.14 per share, or $2,623,000, resulted in a gain of $1,010,000. Private placement of 1,660,197 shares and initial public offering of 2,250,000 shares of ThermoTrex common stock at $5.55 and $8.00 per share, respectively, for net proceeds of $24,764,000 resulted in a gain of $13,958,000. Private placement of 1,591,549 shares of common stock of J. Amerika N.V. at 6.00 Dutch guilders per share for net proceeds of $4,573,000 resulted in a gain of $2,148,000. Sale of 244,200 shares of Thermo Cardiosystems common stock by Thermedics at an average price of $8.43 per share for net proceeds of $2,040,000 resulted in a taxable gain of $1,958,000. The Company’s ownership percentage in these subsidiaries changed primarily as a result of the transactions listed above, as well as the Company’s purchases of shares of majority-owned subsidiary stock, the subsidiaries’ purchases of their own stock, the sale of subsidiaries’ stock by the Company or by the subsidiaries under employees’ and directors’ stock plans or in other transactions, and the conversion of convertible obligations held by the Company, its subsidiaries, or by third parties. The Company’s ownership percentages at yearend were as follows: Thermo Instrument Thermo Fibertek Thermedics Thermo Power ThermoTrex Thermo Process Thermo Energy Systems Thermo Cardiosystems (a) Thermo Voltek (a) Thermo Remediation (b) ThermoLase (c) 1993 1992 1991 81% 80% 52% 52% 55% 72% 88% 57% 67% 67% 81% 81% 80% 59% 81% 62% 71% 87% 58% 57% 85% 100% 80% 100% 59% 81% 70% 71% 87% 55% 52% 93% 100% (a) Reflects combined ownership by Thermo Electron and Thermedics. (b) Reflects ownership by Thermo Process. (c) Reflects ownership by ThermoTrex. 313 Entity Accounting Analysis Entity Accounting Analysis REPORT OF INDEPENDENT AUDITORS TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF THERMO ELECTRON CORPORATION: We have audited the accompanying consolidated balance sheet of Thermo Electron Corporation (a Delaware corporation) and subsidiaries as of January 1, 1994 and January 2, 1993, and the related consolidated statements of income, shareholders, investment, and cash flows for each of the three years in the period ended January 1, 1994. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material aspects, the financial position of Thermo Electron Corporation and subsidiaries as of January 1, 1994 and January 2, 1993, and the results of their operations and their cash flows for each of the three years in the period ended January 1, 1994, in conformity with generally accepted accounting principles. As discussed in Note 7 to the consolidated financial statements, effective December 29, 1991, the Company has changed its method of accounting for post-retirement benefits other than pensions. Arthur Andersen & Co. Boston, Massachusetts February 17, 1994 8-38 MANAGEMENT DISCUSSION AND ANALYSIS Overview The Company develops and manufactures a broad range of products that are sold worldwide. The Company expands its products and services by developing and commercializing its own core technologies and by making strategic acquisitions of complementary businesses. The majority of the Company’s businesses fall into three broad market segments: environmental, energy, and selected health and safety instrumentation. An important component of the Company’s strategy is to establish leading positions in its markets through the application of proprietary technology, whether developed internally or acquired. A key contributor to the growth of the Company’s segment income (as defined in the results of operations below), particularly over the last two years, has been the ability to identify attractive acquisition opportunities, complete those acquisitions, and derive a growing income contribution from these newly acquired businesses as they are integrated into the Company’s business segments. The Company seeks to minimize its dependence on any specific product or market by maintaining and diversifying its portfolio of businesses and technologies. Similarly, the Company’s goal is to maintain a balance in its businesses between those affected by various regulatory cycles and those more dependent on the general level of economic activity. To date, the Company’s overall financial performance has been relatively unaffected by the recession in the U.S. economy in 1991 and 1992 and the general economic weakness in Europe and Japan in 1992 and 1993. This is due in large part to strong contributions from newly acquired businesses and the continued strength of businesses primarily driven by environmental regulation. Although the Company is diversified in terms of technology, product offerings, and geographic markets served, the future financial performance of the Company as a whole depends upon, among other factors, the strength of worldwide economies and the continued adoption and diligent enforcement of environmental regulations. Thermo Electron Corporation 314 Entity Accounting Analysis Thermo Electron Corporation 8-39 Part 2 Business Analysis and Valuation Tools The Company believes that maintaining an entrepreneurial atmosphere is essential to its continued growth and development. In order to preserve this atmosphere, the Company adopted in 1983 a strategy of spinning out certain of its businesses into separate subsidiaries and having these subsidiaries sell a minority interest to outside investors. The Company believes that this strategy provides additional motivation and incentives for the management of the subsidiaries through the establishment of subsidiary-level stock option incentive programs, as well as capital to support the subsidiaries’ growth. As a result of the sale of stock by subsidiaries, the issuance of shares by subsidiaries upon conversion of indebtedness, and similar transactions, the Company records gains that represent the increase in the Company’s net investment in the subsidiaries and are classified as “Gain on issuance of stock by subsidiaries” in the accompanying statement of income. These gains have represented a substantial portion of the net income reported by the Company in recent years. Although the Company expects to continue this strategy in the future, its goal is to continue increasing segment income over the next few years so that gains generated by sales of stock by its subsidiaries will represent a decreasing portion of net income. The size and timing of these transactions are dependent on market and other conditions that are beyond the Company’s control. Accordingly, there can be no assurance that the Company will be able to generate gains from such transactions in the future. OTHER INFORMATION (In thousands) 1993 1992 1991 $ 584,176 137,088 80,220 77,360 54,329 53,839 987,012 262,706 $1,249,718 $ 423,199 125,577 45,778 43,904 19,843 47,082 705,383 243,589 $ 948,972 $ 338,747 124,731 32,295 29,131 16,801 50,632 592,337 213,147 $ 805,484 $ 96,786 15,902 8,292 2,707 485 1,338 125,510 17,122 142,632 (21,076) 9,563 $ 63,373 15,716 841 715 (1,185) 371 79,831 7,237 87,068 (3,948) 18,850 $ 49,742 14,652 (3,048) (3,158) (113) (1,487) 56,588 7,315 63,903 (1,663) 16,933 $131,119 $101,970 $ 79,173 Revenues: Thermo Instrument Systems, Inc. Thermo Fibertek Inc. Thermedics Inc. (a) Thermo Power Corporation ThermoTrex Corporation Thermo Process Systems Inc. (b) Wholly and majority-owned nonpublic companies Segment Income(c): Thermo Instrument Systems Inc. Thermo Fibertek Inc. Thermedics Inc. (a) Thermo Power Corporation ThermoTrex Corporation Thermo Process Systems Inc. (b) Wholly and majority-owned nonpublic companies Equity in Losses of Unconsolidated Subsidiaries Corporate Income Before Income Taxes, Minority Interest, and Cumulative Effect of Change in Accounting Principle (a) Includes Thermo Cardiosystems Inc. and Thermo Voltek Corp. (b) Includes Thermo Remediation Inc. (c) Segment income is income before corporate general and administrative expenses, costs associated with divisional and product restructuring, other income and expense, minority interest expense, and income taxes. 315 Entity Accounting Analysis Entity Accounting Analysis COMMON STOCK MARKET INFORMATION The following table shows the market range for the Company’s common stock based on reported sales prices on the New York Stock Exchange (symbol TMO) for 1993 and 1992. Prices have been restated to reflect a three-for-two stock split distributed in October 1993. 1993 1992 Quarter High Low High Low First Second Third Fourth $38 411⁄ 6 431⁄ 4 43 $311⁄ 3 361⁄ 3 371⁄ 4 381⁄ 8 $312⁄ 3 291⁄ 12 281⁄ 3 311⁄ 2 $261⁄ 4 251⁄ 6 25 261⁄ 2 The closing market price on the New York Stock Exchange for the Company’s common stock on February 25, 1994, was 391⁄ 2 per share. DIVIDEND POLICY The Company has never paid cash dividends and does not expect to pay cash dividends in the foreseeable future because its policy has been to use earnings to finance expansion and growth. Payments of dividends will rest within the discretion of the Board of Directors and will depend upon, among other factors, the Company’s earnings, capital requirements, and financial condition. 8-40 As of February 25, 1994, the Company had 6,406 holders of record of its common stock. This does not include holdings in street or nominee names. Common stock of the following majority-owned public subsidiaries is traded on the American Stock Exchange: Thermedics Inc. (TMD; Thermo Instrument Systems Inc. (THI); Thermo Power Corporation (THP); Thermo Process Systems Inc. (TPI); Thermo Voltek Corp. (TVL); ThermoTrex Corporation (TKN); Thermo Fibertek Inc. (TFT); and Thermo Remediation Inc. (THN). Thermo Electron Corporation 316 99 F in an c ial An alysis chapter T Business Analysis and 2Valuation Tools he goal of financial analysis is to assess the performance of a firm in the context of its stated goals and strategy. There are two principal tools of financial analysis: ratio analysis and cash flow analysis. Ratio analysis involves assessing how various line items in a firm’s financial statements relate to one another. Cash flow analysis allows the analyst to examine the firm’s liquidity, and how the firm is managing its operating, investment, and financing cash flows. Financial analysis is used in a variety of contexts. Ratio analysis of a company’s present and past performance provides the foundation for making forecasts of future performance. As we will discuss in later chapters, financial forecasting is useful in company valuation, credit evaluation, financial distress prediction, security analysis, mergers and acquisitions analysis, and corporate financial policy analysis. RATIO ANALYSIS The value of a firm is determined by its profitability and growth. As shown in Figure 9-1, the firm’s growth and profitability are influenced by its product market and financial market strategies. The product market strategy is implemented through the firm’s competitive strategy, operating policies, and investment decisions. Financial market strategies are implemented through financing and dividend policies. Thus, the four levers managers can use to achieve their growth and profit targets are: (1) operating management, (2) investment management, (3) financing strategy, and (4) dividend policies. The objective of ratio analysis is to evaluate the effectiveness of the firm’s policies in each of these areas. Effective ratio analysis involves relating the financial numbers to the underlying business factors in as much detail as possible. While ratio analysis may not give all the answers to an analyst regarding the firm’s performance, it will help the analyst frame questions for further probing. In ratio analysis, the analyst can (1) compare ratios for a firm over several years (a time-series comparison), (2) compare ratios for the firm and other firms in the industry (cross-sectional comparison), and/or (3) compare ratios to some absolute benchmark. In a time-series comparison, the analyst can hold firm-specific factors constant and examine the effectiveness of a firm’s strategy over time. Cross-sectional comparison facilitates examining the relative performance of a firm within its industry, holding industrylevel factors constant. For most ratios, there are no absolute benchmarks. The exceptions are measures of rates of return, which can be compared to the cost of the capital associ9-1 317 318 Financial Analysis Financial Analysis Figure 9-1 Drivers of a Firm’s Profitability and Growth Growth and Profitability Product Market Strategies Financial Market Policies Operating Management Investment Management Financing Decisions Dividend Policy Managing Revenue and Expenses Managing Working Capital and Fixed Assets Managing Liabilities and Equity Managing Payout ated with the investment. For example, subject to distortions caused by accounting, the rate of return on equity (ROE) can be compared to the cost of equity capital. In the discussion below, we will illustrate these approaches using the example of Nordstrom, Inc., a prominent U.S. retailer. We will compare Nordstrom’s ratios for the fiscal year ending January 31, 1999, with its own ratios for the fiscal year ending January 31, 1998, and with the ratios for TJX Companies, Inc., another U.S. retailer, for the fiscal year ending January 31, 1999.1 Nordstrom is a leading fashion specialty retailer, offering a wide variety of high-end apparel, shoes, and accessories for men, women, and children. The company pursues a strategy of high quality, extraordinary service, and premium price. Dissatisfied with the inconsistent earnings performance in recent years, the company’s management has focused in the last two years on improving its profit performance. We will use the financial statements for the year ending January 31, 1999, to examine how successful the management has been in achieving this objective. TJX Companies pursues a strategy quite different from Nordstrom’s: it operates off-price apparel and home fashions retail stores through its T.J. Maxx and Marshalls stores. The company’s strategy is to offer brandname goods at 20–60 percent below department store regular prices. The company seeks to accomplish this by buying opportunistically and by operating with a highly efficient 9-2 Financial Analysis 9-3 Part 2 Business Analysis and Valuation Tools distribution network and low cost structure. Nordstrom and TJX seem to follow different investment and financing strategies as well. Nordstrom makes significant investment in its stores whereas TJX leases its stores. Nordstrom has a credit card operation whereas TJX does not. We will illustrate how these differences between the two companies affect their ratios. We will also try to see which strategy is delivering better performance for shareholders. Measuring Overall Profitability The starting point for a systematic analysis of a firm’s performance is its return on equity (ROE), defined as: ROE = Net income ------------------------------------------------Shareholder’s equity ROE is a comprehensive indicator of a firm’s performance because it provides an indication of how well managers are employing the funds invested by the firm’s shareholders to generate returns. On average over long periods, large publicly traded firms in the U.S. generate ROEs in the range of 11 to 13 percent. In the long run, the value of the firm’s equity is determined by the relationship between its ROE and its cost of equity capital.2 That is, those firms that are expected over the long run to generate ROEs in excess of the cost of equity capital should have market values in excess of book value, and vice versa. (We will return to this point in more detail in the chapter on valuation.) A comparison of ROE with the cost of capital is useful not only for contemplating the value of the firm but also in considering the path of future profitability. The generation of consistent supernormal profitability will, absent significant barriers to entry, attract competition. For that reason, ROEs tend over time to be driven by competitive forces toward a “normal” level—the cost of equity capital. Thus, one can think of the cost of equity capital as establishing a benchmark for the ROE that would be observed in a longrun competitive equilibrium. Deviations from this level arise for two general reasons. One is the industry conditions and competitive strategy that cause a firm to generate supernormal (or subnormal) economic profits, at least over the short run. The second is distortions due to accounting. Table 9-1 shows the ROE based on reported earnings for Nordstrom and TJX. Table 9-1 Return on Equity for Nordstrom and TJX Ratio Nordstrom 1998 Nordstrom 1997 TJX 1998 ......................................................................................................................... Return on equity 15.6% 12.6% 34.5% ......................................................................................................................... 319 320 Financial Analysis Financial Analysis Nordstrom’s ROE showed a significant improvement, from 12.6 percent to 15.6 percent, between 1997 and 1998. This indicates that Nordstrom’s strategy of focusing on profit improvement is beginning to show positive results. Compared to the historical trends of ROE in the economy, Nordstrom’s 1997 performance can be viewed as being just about average. Further, its ROE in 1997 is barely adequate to cover reasonable estimates of its equity cost of capital. The three percentage points increase in ROE in 1998 allowed Nordstrom to comfortably exceed both these benchmarks.3 Unfortunately, despite the improvement in 1998, Nordstrom’s performance is still far behind TJX’s ROE of 34.5 percent. At that performance, TJX was earning excess returns relative to both the historical trends in ROE in the U.S. economy, as well as its own ROE. TJX’s superior performance relative to Nordstrom is reflected in the difference in the two companies’ ratio of market value of equity to its book value. As of June 1999, Nordstrom’s market value to book value ratio was 3.6, while the same ratio for TJX was 8.6. Decomposing Profitability: Traditional Approach A company’s ROE is affected by two factors: how profitably it employs its assets and how big the firm’s asset base is relative to shareholders’ investment. To understand the effect of these two factors, ROE can be decomposed into return on assets (ROA) and a measure of financial leverage, as follows: ROE = ROA × Financial leverage ROE = Net income Assets --------------------------- × ------------------------------------------------Assets Shareholders’ equity ROA tells us how much profit a company is able to generate for each dollar of assets in- vested. Financial leverage indicates how many dollars of assets the firm is able to deploy for each dollar invested by its shareholders. The return on assets itself can be decomposed as a product of two factors: ROA = Net income Sales --------------------------- × --------------Sales Assets The ratio of net income to sales is called net profit margin or return on sales (ROS); the ratio of sales to assets is known as asset turnover. The profit margin ratio indicates how much the company is able to keep as profits for each dollar of sales it makes. Asset turnover indicates how many sales dollars the firm is able to generate for each dollar of its assets. Table 9-2 displays the three drivers of ROE for our retail firms: net profit margins, asset turnover, and financial leverage. Nordstrom’s ROE increased from 12.6 percent to 15.6 percent. This increase is largely driven by an increase in its financial leverage and, to a lesser extent, by a small increase in its net profit margin. In fact, its return on equity in 1998 was hurt by a decline in its asset turnover. TJX’s superior ROE seems to be driven 9-4 Financial Analysis 9-5 Part 2 Business Analysis and Valuation Tools Table 9-2 Traditional Decomposition of ROE Nordstrom 1998 Ratio Nordstrom 1997 TJX 1998 ......................................................................................................................... Net profit margin (ROS) × Asset turnover = Return on assets (ROA) × Financial leverage = Return on equity (ROE) 4.1% 1.61 6.6% 2.37 15.6% 3.85% 1.68 6.5% 1.95 12.6% 5.3% 2.89 15.3% 2.25 34.5% ......................................................................................................................... by higher profit margins and better asset utilization; TJX was able to achieve higher ROE than Nordstrom even though it has a slightly lower financial leverage ratio. Decomposing Profitability: Alternative Approach Even though the above approach is popularly used to decompose a firm’s ROE, it has several limitations. In the computation of ROA, the denominator includes the assets claimed by all providers of capital to the firm, but the numerator includes only the earnings available to equity holders. The assets themselves include both operating assets and financial assets such as cash and short-term investments. Further, net income includes income from operating activities, as well as interest income and expense, which are consequences of financing decisions. Often it is useful to distinguish between these two sources of performance. Finally, the financial leverage ratio used above does not recognize the fact that a firm’s cash and short-term investments are in essence “negative debt” because they can be used to pay down the debt on the company’s balance sheet.4 These issues are addressed by an alternative approach to decomposing ROE discussed below.5 Before discussing this alternative ROE decomposition approach, we need to define some terminology used in this section as well as in the rest of this chapter. This terminology is given in Table 9-3. We use the terms defined in Table 9-3 to decompose ROE in the following manner: ROE = (Net interest expense after tax) NOPAT ----------------- – -------------------------------------------------------------------------Equity Equity ROE = Net interest expense after tax Net debt Net assets NOPAT ------------------------ × ------------------------ – ---------------------------------------------------------------------- × -------------------Net assets Net debt Equity Equity ROE = Net interest expense after tax Net debt Net debt NOPAT ------------------------ × 1 + --------------------  – ---------------------------------------------------------------------- × ------------------- Net assets Net debt Equity Equity  Operating ROA + ( Operating ROA – Effective interest rate after tax ) ROEMY = × Net financial leverage ROE = Operating ROA + Spread × Net financial leverage ROE = 321 322 Financial Analysis Financial Analysis Table 9-3 Definitions of Accounting Items Used in Ratio Analysis Item Definition ......................................................................................................................... Net interest expense after tax (Interest expense – Interest income) × (1 – Tax rate) Net operating profit after taxes (NOPAT) Net income + Net interest expense after tax Operating working capital (Current assets – Cash and marketable securities) – (Current liabilities – Short-term debt and current portion of long-term debt) Net long-term assets Total long-term assets – Non-interest-bearing long-term liabilities Net debt Total interest bearing liabilities – Cash and marketable securities Net assets Operating working capital + Net long-term assets Net capital Net debt + Shareholders’ equity ......................................................................................................................... Operating ROA is a measure of how profitably a company is able to deploy its operating assets to generate operating profits. This would be a company’s ROE if it were financed with all equity. Spread is the incremental economic effect from introducing debt into the capital structure. This economic effect of borrowing is positive as long as the return on operating assets is greater than the cost of borrowing. Firms that do not earn adequate operating returns to pay for interest cost reduce their ROE by borrowing. Both the positive and negative effect is magnified by the extent to which a firm borrows relative to its equity base. The ratio of net debt to equity provides a measure of this net financial leverage. A firm’s spread times its net financial leverage, therefore, provides a measure of the financial leverage gain to the shareholders. Operating ROA can be further decomposed into NOPAT margin and operating asset turnover as follows: Operating ROA = Sales NOPAT ----------------- × -----------------------Sales Net assets NOPAT margin is a measure of how profitable a company’s sales are from an operating perspective. Operating asset turnover measures the extent to which a company is able to use its operating assets to generate sales. Table 9-4 presents the decomposition of ROE for Nordstrom and TJX. The ratios in this table show that there is a significant difference between Nordstrom’s ROA and operating ROA. In 1998, for example, Nordstrom’s ROA was 6.6 percent, and its operating ROA was 11.7 percent. This difference in ROA and operating ROA is even more remarkable for TJX: its ROA in 1998 was 15.3 percent whereas the operating ROA was 43 percent. Because TJX had a large amount of non-interest-bearing liabilities and shortterm investments, its operating ROA is dramatically larger than its ROA. This shows that, for at least some firms, it is important to adjust the simple ROA to take into account interest expense, interest income, and financial assets. 9-6 Financial Analysis 9-7 Part 2 Business Analysis and Valuation Tools Table 9-4 Distinguishing Operating and Financing Components in ROE Decomposition Ratio Nordstrom 1998 Nordstrom 1997 TJX 1998 ......................................................................................................................... Net operating profit margin × Net operating asset turnover = Operating ROA Spread × Net financial leverage = Financial leverage gain ROE = Operating ROA + Financial leverage gain 4.7% 2.49 11.7% 7.3% 0.54 3.9% 4.3% 2.27 9.8% 6.4% 0.45 2.8% 5.3% 8.11 43.0% 42.9% (0.20) (8.5)% 15.6% 12.6% 34.5% ......................................................................................................................... The appropriate benchmark for evaluating operating ROA is the weighted average cost of debt and equity capital, or WACC. In the long run, the value of the firm’s assets is determined by where operating ROA stands relative to this norm. Moreover, over the long run and absent some barrier to competitive forces, operating ROA will tend to be pushed towards the weighted average cost of capital. Since the WACC is lower than the cost of equity capital, operating ROA tends to be pushed to a level lower than that to which ROE tends. The average operating ROA for large firms in the U.S., over long periods of time, is in the range of 9 to 11 percent. Nordstrom’s operating ROA in 1997 and 1998 is in this range, indicating that its operating performance is about average. At 43 percent, TJX’s operating ROA is far larger than Nordstrom’s and also the U.S. industrial average and any reasonable estimates of TJX’s weighted average cost of capital. This dramatic superior operating performance of TJX would have been obscured by using the simple ROA measure.6 TJX dominates Nordstrom in terms of both operating drivers of ROE—it has a better NOPAT margin and a dramatically higher operating asset turnover. TJX’s higher operating asset turnover is primarily a result of its strategy of renting its stores, unlike Nordstrom, which owns many of its stores. What is surprising is TJX’s higher NOPAT margin, which suggests that Nordstrom is unable to price its merchandise high enough to recoup the cost of its high service strategy. Nordstrom is able to create shareholder value through its financing strategy. In 1997 the spread between Nordstrom’s operating ROA and its after-tax interest cost was 6.4 percent; its net debt as a percent of its equity was 45 percent. Both these factors contributed to a net increment of 2.8 percent to its ROE. Thus, while the Nordstrom’s operating ROA in 1997 was 9.8 percent, its ROE was 12.6 percent. In 1998 Nordstrom’s spread increased to 7.3 percent, its net financial leverage went up to 0.54, leading to a 3.9 percent net increment to ROE due to its debt policy. With an operating ROA of 11.7 percent in that year, its ROE in 1998 went up to 15.6 percent. 323 324 Financial Analysis Financial Analysis Even though TJX had a very high spread in 1998, it did not exploit this advantage due an inefficient financial strategy. Because the company had a large cash balance in 1998, in effect it had negative net financial leverage. As a result, the company had a lower ROE than its operating ROA. As a result of its ineffective financial management, even though TJX’s operating ROA in 1998 was almost four times as large as Nordstrom’s, its ROE was only about twice as large as Nordstrom’s in that year. Assessing Operating Management: Decomposing Net Profit Margins A firm’s net profit margin or return on sales (ROS) shows the profitability of the company’s operating activities. Further decomposition of a firm’s ROS allows an analyst to assess the efficiency of the firm’s operating management. A popular tool used in this analysis is the common-sized income statement in which all the line items are expressed as a ratio of sales revenues. Common-sized income statements make it possible to compare trends in income statement relationships over time for the firm, and trends across different firms in the industry. Income statement analysis allows the analyst to ask the following types of questions: (1) Are the company’s margins consistent with its stated competitive strategy? For example, a differentiation strategy should usually lead to higher gross margins than a low cost strategy. (2) Are the company’s margins changing? Why? What are the underlying business causes—changes in competition, changes in input costs, or poor overhead cost management? (3) Is the company managing its overhead and administrative costs well? What are the business activities driving these costs? Are these activities necessary? To illustrate how the income statement analysis can be used, common-sized income statements for Nordstrom and TJX are shown in Table 9-5. The table also shows some commonly used profitability ratios. We will use the information in Table 9-5 to investigate why Nordstrom had a net income margin (or return on sales) of 4.1 percent in 1998 and 3.8 percent in 1997, while TJX had a net margin of 5.3 percent. GROSS PROFIT MARGINS. The difference between a firm’s sales and cost of sales is gross profit. Gross profit margin is an indication of the extent to which revenues exceed direct costs associated with sales, and it is computed as: Gross profit margin = Sales – Cost of sales ----------------------------------------------------Sales Gross margin is influenced by two factors: (1) the price premium that a firm’s products or services command in the marketplace and (2) the efficiency of the firm’s procurement and production process. The price premium a firm’s products or services can command is influenced by the degree of competition and the extent to which its products are unique. The firm’s cost of sales can be low when it can purchase its inputs at a lower cost than competitors and/or run its production processes more efficiently. This is generally the case when a firm has a low-cost strategy. 9-8 Financial Analysis 9-9 Part 2 Business Analysis and Valuation Tools Table 9-5 Common-Sized Income Statement and Profitability Ratios Nordstrom 1998 Nordstrom 1997 TJX 1998 ......................................................................................................................... Line Items as a Percent of Sales Sales Cost of Sales Selling, general, and admin. expense Other income/expense Net interest expense/income Income taxes Unusual gains/losses, net of taxes Net Income Key Profitability Ratios Gross profit margin EBITDA margin NOPAT margin Net Margin 100% (66.5) (28.0) 2.1 (0.9) (2.6) — 4.1% 100% (67.9) (27.3) 2.2 (0.7) (2.5) — 3.8% 100% (74.9) (16.2) — — (3.4) (0.1) 5.3% 33.5% 10.4% 4.7% 4.1% 32.1% 9.7% 4.3% 3.8% 25.1% 10.6% 5.3% 5.3% ......................................................................................................................... Table 9-5 indicates that Nordstrom’s gross margin in 1998 increased slightly to 33.5 percent, validating the company’s stated intention in its annual report of focusing on profitability. Consistent with Nordstrom’s premium price strategy, its gross margins in both 1998 and 1997 were significantly higher than TJX’s gross margin in 1998, which stood at 25.1 percent. SELLING, GENERAL, AND ADMINISTRATIVE EXPENSES. A company’s selling, general, and administrative (SG&A) expenses are influenced by the operating activities it has to undertake to implement its competitive strategy. As discussed in Chapter 2, firms with differentiation strategies have to undertake activities to achieve differentiation. A company competing on the basis of quality and rapid introduction of new products is likely to have higher R&D costs relative to a company competing purely on a cost basis. Similarly, a company that attempts to build a brand image, distribute its products through full-service retailers, and provide significant customer service is likely to have higher selling and administration costs relative to a company that sells through warehouse retailers or direct mail and does not provide much customer support. A company’s SG&A expenses are also influenced by the efficiency with which it manages its overhead activities. The control of operating expenses is likely to be especially important for firms competing on the basis of low cost. However, even for differentiators, it is important to assess whether the cost of differentiation is commensurate with the price premium earned in the marketplace. Several ratios in Table 9-5 allow us to evaluate the effectiveness with which Nordstrom and TJX were managing their SG&A expenses. First, the ratio of SG&A expense 325 326 Financial Analysis Financial Analysis to sales shows how much a company is spending to generate each sales dollar. We see that Nordstrom has a significantly higher ratio of SG&A to sales than does TJX. This should not be surprising given that TJX pursues a low-cost off-price strategy whereas Nordstrom pursues a high service strategy. However, despite its stated goal to manage its profitability better, Nordstrom did not improve its cost management: its SG&A expense as a percent of sales increased marginally from 27.3 percent in 1997 to 28 percent in 1998. Given that Nordstrom and TJX are pursuing radically different pricing, merchandising, and service strategies, it is not surprising that they have very different cost structures. As a percent of sales, Nordstrom’s cost of sales is lower, and its SG&A expense is higher. The question is, when both these costs are netted out, which company is performing better? Two ratios provide useful signals here: net operating profit margin ratio and EBITDA margin: NOPAT margin = EBITDA margin = NOPAT ----------------Sales Earnings before interest, taxes, depreciation, and amortization ----------------------------------------------------------------------------------------------------------------------------------------------------Sales NOPAT margin provides a comprehensive indication of the operating performance of a company because it reflects all operating policies and eliminates the effects of debt policy. EBITDA margin provides similar information, except that it excludes depreciation and amortization expense, a significant noncash operating expense. Some analysts prefer to use EBITDA margin because they believe that it focuses on “cash” operating items. While this is to some extent true, it can be potentially misleading for two reasons. EBITDA is not a strictly cash concept because sales, cost of sales, and SG&A expenses often include noncash items. Also, depreciation is a real operating expense, and it reflects to some extent the consumption of resources. Therefore, ignoring it can be misleading. From Table 9-5 we see that Nordstrom’s NOPAT margin has improved a little between 1997 and 1998. However, even with this improvement, the company is able to retain only 4.7 cents in net operating profits for each dollar of sales, whereas TJX is able to retain 5.3 cents. TJX also has a slightly better EBITDA margin than Nordstrom, but the difference seems insignificant. However, this comparison is potentially misleading because TJX leases most of its stores while Nordstrom owns its; TJX’s leasing expense is included in the EBITDA calculation, but Nordstrom’s store depreciation is excluded. This is an example of how EBITDA margin can sometimes be misleading. TAX EXPENSE. Taxes are an important element of firms’ total expenses. Through a wide variety of tax planning techniques, firms can attempt to reduce their tax expenses.7 There are two measures one can use to evaluate a firm’s tax expense. One is the ratio of tax expense to sales, and the other is the ratio of tax expense to earnings before taxes (also known as average tax rate). The firm’s tax footnote provides a detailed account of why its average tax rate differs from the statutory tax rate. 9-10 Financial Analysis 9-11 Part 2 Business Analysis and Valuation Tools When evaluating a firm’s tax planning, the analyst should ask two questions: (1) Are the company’s tax policies sustainable, or is the current tax rate influenced by one-time tax credits? (2) Do the firm’s tax planning strategies lead to other business costs? For example, if the operations are located in tax havens, how does this affect the company’s profit margins and asset utilization? Are the benefits of tax planning strategies (reduced taxes) greater than the increased business costs? Table 9-5 shows that Nordstrom’s tax rate did not change significantly between 1997 and 1998. Nordstrom’s taxes as a percent of sales were somewhat lower than TJX’s. An important reason for this is that TJX’s pretax profits as a percent of sales were higher. In fact, the average tax rate (ratio of tax expense to pretax profits) for both Nordstrom and TJX were the same, 39 percent. In summary, we conclude that Nordstrom’s small improvement in return on sales is primarily driven by a reduction in its cost of sales. In all other areas, Nordstrom’s performance either stayed the same or worsened a bit. TJX is able to earn a superior return on its sales despite following an off-price strategy because it is able to save significantly on its SG&A expenses. Evaluating Investment Management: Decomposing Asset Turnover Asset turnover is the second driver of a company’s return on equity. Since firms invest considerable resources in their assets, using them productively is critical to overall profitability. A detailed analysis of asset turnover allows the analyst to evaluate the effectiveness of a firm’s investment management. There are two primary areas of asset management: (1) working capital management and (2) management of long-term assets. Working capital is defined as the difference between a firm’s current assets and current liabilities. However, this definition does not distinguish between operating components (such as accounts receivable, inventory, and accounts payable) and the financing components (such as cash, marketable securities, and notes payable). An alternative measure that makes this distinction is operating working capital, as defined in Table 9-3: Operating working capital = (Current assets – cash and marketable securities) – (Current liabilities – Short-term and current portion of long-term debt) WORKING CAPITAL MANAGEMENT. The components of operating working capi- tal that analysts primarily focus on are accounts receivable, inventory, and accounts payable. A certain amount of investment in working capital is necessary for the firm to run its normal operations. For example, a firm’s credit policies and distribution policies determine its optimal level of accounts receivable. The nature of the production process and the need for buffer stocks determine the optimal level of inventory. Finally, accounts payable is a routine source of financing for the firm’s working capital, and payment practices in an industry determine the normal level of accounts payable. 327 328 Financial Analysis Financial Analysis The following ratios are useful in analyzing a firm’s working capital management: operating working capital as a percent of sales, operating working capital turnover, accounts receivable turnover, inventory turnover, and accounts payable turnover. The turnover ratios can also be expressed in number of days of activity that the operating working capital (and its components) can support. The definitions of these ratios are given below. Operating working capital --------------------------------------------------------------Sales Operating working capital-to-sales ratio = Operating working capital turnover Sales --------------------------------------------------------------Operating working capital Accounts receivable turnover Inventory turnover = = Sales -----------------------------------------------Accounts receivable Cost of goods sold -------------------------------------------Inventory Accounts payable turnover Days’ receivables = = = Purchases Cost of goods sold ------------------------------------------ or -------------------------------------------Accounts payable Accounts payable Accounts receivable ---------------------------------------------------Average sales per day Days’ inventory = Inventory -----------------------------------------------------------------------------------Average cost of goods sold per day Days’ payables = Accounts payable -----------------------------------------------------------------------------------------------------------------------Average purchases (or cost of goods sold) per day Operating working capital turnover indicates how many dollars of sales a firm is able to generate for each dollar invested in its operating working capital. Accounts receivable turnover, inventory turnover, and accounts payable turnover allow the analyst to examine how productively the three principal components of working capital are being used. Days’ receivables, days’ inventory, and days’ payables are another way to evaluate the efficiency of a firm’s working capital management.8 LONG-TERM ASSETS MANAGEMENT. Another area of investment management concerns the utilization of a firm’s long-term assets. It is useful to define a firm’s investment in long-term assets as follows: Net long-term assets = (Total long-term assets − Non-interest-bearing long-term liabilities) Long-term assets generally consist of net property, plant, and equipment (PP&E), intangible assets such as goodwill, and other assets. Non-interest-bearing long-term liabilities include such items as deferred taxes. We define net long-term assets and net working capital in such a way that their sum, net operating assets, is equal to the sum of net debt 9-12 Financial Analysis 9-13 Part 2 Business Analysis and Valuation Tools and equity, or net capital. This is consistent with the way we defined operating ROA earlier in the chapter. The efficiency with which a firm uses its net long-term assets is measured by the following two ratios: net long-term assets as a percent of sales and net long-term asset turnover. Net long-term asset turnover is defined as: Net long-term asset turnover = Sales ------------------------------------------------Net long-term assets Property plant and equipment (PP&E) is the most important long-term asset in a firm’s balance sheet. The efficiency with which a firm’s PP&E is used is measured by the ratio of PP&E to sales, or by the PP&E turnover ratio: PP&E turnover = Sales -----------------------------------------------------------------------------------Net property, plant, and equipment The ratios listed above allow the analyst to explore a number of business questions in four general areas: (1) How well does the company manage its inventory? Does the company use modern manufacturing techniques? Does it have good vendor and logistics management systems? If inventory ratios are changing, what is the underlying business reason? Are new products being planned? Is there a mismatch between the demand forecasts and actual sales? (2) How well does the company manage its credit policies? Are these policies consistent with its marketing strategy? Is the company artificially increasing sales by loading the distribution channels? (3) Is the company taking advantage of trade credit? Is it relying too much on trade credit? If so, what are the implicit costs? (4) Are the company’s investment in plant and equipment consistent with its competitive strategy? Does the company have a sound policy of acquisitions and divestitures? Table 9-6 shows the asset turnover ratios for Nordstrom and TJX. Nordstrom achieved an improvement in its working capital management between 1997 and 1998, as can be seen from a reduction of operating working capital as a percent of sales and an increase in operating working capital turnover. This improvement is attributable to a reduction in accounts receivable and better inventory management. There was also a marginal improvement in its accounts payable days as well. In contrast, Nordstrom’s long-term asset utilization did not improve in 1998: its net long-term asset turnover and PP&E turnover show marginal declines. In its annual report, Nordstrom acknowledges that the sales from stores that it operated for more than a year (also called same-store sales) showed a small decline in 1998 because management was focusing on controlling inventory to cut costs. TJX achieved dramatically better asset utilization ratios in 1998 relative to Nordstrom. TJX was able to invest a negligible amount of money in its operating working capital by taking full advantage of trade credit from its vendors and by delaying payment of some of its operating expenses. Also, because TJX has no credit card operations of its own, it is able to collect its receivables in 3 days, in contrast to Nordstrom’s 43 receivable days. TJX is also managing its inventory more efficiently, perhaps because of its more focused merchandising strategy. Finally, because TJX uses operating leases to rent its stores, it has significantly lower capital tied up in its stores. As a result, its PP&E turn- 329 330 Financial Analysis Financial Analysis Table 9-6 Asset Management Ratios Ratio Nordstrom 1998 Nordstrom 1997 TJX 1998 ............................................................................................................................. Operating working capital/Sales Net long-term assets/Sales PP&E/Sales Operating working capital turnover Net long-term assets turnover PP&E turnover Accounts receivable turnover Inventory turnover Accounts payable turnover Days’ accounts receivable Days’ inventory Days’ accounts payable 16.2% 24.0% 27.1% 6.17 4.17 3.69 8.56 4.46 9.85 42.6 81.8 37.1 20.8% 23.2% 25.8% 4.81 4.31 3.88 7.30 3.99 10.26 50 91.5 35.6 (0.3)% 12.6% 9.5% Not meaningful 7.94 10.52 117.9 5.0 9.6 3.1 73 38 ............................................................................................................................. over is almost three times as much as Nordstrom’s. One should, however, be cautious in interpreting this difference between the two companies, because, as TJX discloses in its footnotes, it owes a substantial amount of money in the coming years on noncancelable operating leases. TJX’s financial statements do not fully recognize its potential investment in its stores through these noncancelable leases, potentially inflating its operating asset turns. Evaluating Financial Management: Financial Leverage Financial leverage enables a firm to have an asset base larger than its equity. The firm can augment its equity through borrowing and the creation of other liabilities like accounts payable, accrued liabilities, and deferred taxes. Financial leverage increases a firm’s ROE as long as the cost of the liabilities is less than the return from investing these funds. In this respect, it is important to distinguish between interest-bearing liabilities such as notes payable, other forms of short-term debt and long-term debt, which carry an explicit interest charge, and other forms of liabilities. Some of these other forms of liability, such as accounts payable or deferred taxes, do not carry any interest charge at all. Other liabilities, such as capital lease obligations or pension obligations, carry an implicit interest charge. Finally, some firms carry large cash balances or investments in marketable securities. These balances reduce a firm’s net debt because conceptually the firm can pay down its debt using its cash and short-term investments. 9-14 Financial Analysis 9-15 Part 2 Business Analysis and Valuation Tools While a firm’s shareholders can potentially benefit from financial leverage, it can also increase their risk. Unlike equity, liabilities have predefined payment terms, and the firm faces risk of financial distress if it fails to meet these commitments. There are a number of ratios to evaluate the degree of risk arising from a firm’s financial leverage. CURRENT LIABILITIES AND SHORT-TERM LIQUIDITY. The following ratios are useful in evaluating the risk related to a firm’s current liabilities: Current ratio Quick ratio Cash ratio = = = Current assets -----------------------------------------Current liabilities Cash + Short-term investments + Accounts receivable ----------------------------------------------------------------------------------------------------------------------------------------Current liabilities Cash + Marketable securities ------------------------------------------------------------------------Current liabilities Operating cash flow ratio = Cash flow from operations ---------------------------------------------------------------Current liabilities All the above ratios attempt to measure the firm’s ability to repay its current liabilities. The first three compare a firm’s current liabilities with its short-term assets that can be used to repay the current liabilities. The fourth ratio focuses on the ability of the firm’s operations to generate the resources needed to repay its current liabilities. Since both current assets and current liabilities have comparable duration, the current ratio is a key index of a firm’s short-term liquidity. Analysts view a current ratio of more than one to be an indication that the firm can cover its current liabilities from the cash realized from its current assets. However, the firm can face a short-term liquidity problem even with a current ratio exceeding one when some of its current assets are not easy to liquidate. Quick ratio and cash ratio capture the firm’s ability to cover its current liabilities from liquid assets. Quick ratio assumes that the firm’s accounts receivable are liquid. This is true in industries where the credit-worthiness of the customers is beyond dispute, or when receivables are collected in a very short period. However, when these conditions do not prevail, cash ratio, which considers only cash and marketable securities, is a better indication of a firm’s ability to cover its current liabilities in an emergency. Operating cash flow is another measure of the firm’s ability to cover its current liabilities from cash generated from operations of the firm. The liquidity ratios for Nordstrom and TJX are shown in Table 9-7. Nordstrom’s liquidity situation in 1998 was comfortable when measured in terms of current ratio or quick ratio. Both these ratios improved in 1998. Because Nordstrom accumulated a large cash balance and improved its cash flow from operations through better inventory management in 1998, its cash ratio and operating cash flow ratio also show dramatic improvement in 1998. All this is good news for Nordstrom’s short-term creditors. TJX also has a comfortable liquidity position, thanks to its large cash balance and a sound operating cash flow. Because of its tight management of operating working capital, however, 331 332 Financial Analysis Financial Analysis Table 9-7 Liquidity Ratios Nordstrom 1998 Ratio Nordstrom 1997 TJX 1998 ......................................................................................................................... Current ratio Quick ratio Cash ratio Operating cash flow ratio 2.19 1.08 0.31 0.78 1.71 0.73 0.03 0.32 1.33 0.40 0.35 0.49 ......................................................................................................................... TJX’s current and quick ratios are smaller than Nordstrom’s. If TXJ were to pay out its cash balance, its liquidity ratios would show a significant decline. DEBT AND LONG-TERM SOLVENCY. A company’s financial leverage is also influ- enced by its debt financing policy. There are several potential benefits from debt financing. First, debt is typically cheaper than equity because the firm promises predefined payment terms to debt holders. Second, in most countries, interest on debt financing is tax deductible whereas dividends to shareholders are not tax deductible. Third, debt financing can impose discipline on the firm’s management and motivate it to reduce wasteful expenditures. Fourth, it is often easier for management to communicate their proprietary information on the firm’s strategies and prospects to private lenders than to public capital markets. Such communication can potentially reduce a firm’s cost of capital. For all these reasons, it is optimal for firms to use at least some debt in their capital structure. Too much reliance on debt financing, however, is potentially costly to the firm’s shareholders. The firm will face financial distress if it defaults on the interest and principal payments. Debt holders also impose covenants on the firm, restricting the firm’s operating, investment, and financing decisions. The optimal capital structure for a firm is determined primarily by its business risk. A firm’s cash flows are highly predictable when there is little competition or there is little threat of technological changes. Such firms have low business risk, and hence they can rely heavily on debt financing. In contrast, if a firm’s operating cash flows are highly volatile and its capital expenditure needs are unpredictable, it may have to rely primarily on equity financing. Managers’ attitude towards risk and financial flexibility also often determine a firm’s debt policies. There are a number of ratios which help the analyst in this area. To evaluate the mix of debt and equity in a firm’s capital structure, the following ratios are useful: Liabilities-to-equity ratio Debt-to-equity ratio = Net-debt-to-equity ratio = Total liabilities ------------------------------------------------Shareholders’ equity Short-term debt + Long-term debt ------------------------------------------------------------------------------------Shareholders’ equity = Short-term debt + Long-term debt – Cash and marketable securities ------------------------------------------------------------------------------------------------------------------------------------------------------------------------Shareholders’ equity 9-16 Financial Analysis 9-17 333 Part 2 Business Analysis and Valuation Tools Debt-to-capital ratio = Short-term debt + Long-term debt ------------------------------------------------------------------------------------------------------------------------------------------------Short-term debt + Long-term debt + Shareholders’ equity Net-debt-to-net-capital ratio = "" Interest bearing liabilities – Cash and marketable securities "" = ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Interest bearing liabilities – Cash and marketable securities + Shareholders’ equity The first ratio restates the assets-to-equity ratio (one of the three primary ratios underlying ROE) by subtracting one from it. The second ratio provides an indication of how many dollars of debt financing the firm is using for each dollar invested by its shareholders. The third ratio uses net debt, which is total debt minus cash and marketable securities, as the measure of a firm’s borrowings. The fourth and fifth ratios measure debt as a proportion of total capital. In calculating all the above ratios, it is important to include all interest bearing obligations, whether the interest charge is explicit or implicit. Recall that examples of line items which carry an implicit interest charge include capital lease obligations and pension obligations. Analysts sometimes include any potential off-balance-sheet obligations that a firm may have, such as noncancelable operating leases, in the definition of a firm’s debt. The ease with which a firm can meet its interest payments is an indication of the degree of risk associated with its debt policy. The interest coverage ratio provides a measure of this construct: Net income + Interest expense + Tax expense Interest coverage (earnings basis) = -------------------------------------------------------------------------------------------------------------------Interest expense Interest coverage (cash flow basis) = Cash flow from operations + Interest expense + Taxes paid ----------------------------------------------------------------------------------------------------------------------------------------------------Interest expense One can also calculate coverage ratios that measure a firm’s ability to measure all fixed financial obligations, such as interest payment, lease payments and debt repayments, by appropriately redefining the numerator in the above ratios. In doing so, it is important to remember that while some fixed charge payments, such as interest and lease rentals, are paid with pretax dollars, others payments, such as debt repayments, are made with after-tax dollars. The earnings-based coverage ratio indicates the dollars of earnings available for each dollar of required interest payment; the cash-flow-based coverage ratio indicates the dollars of cash generated by operations for each dollar of required interest payment. In both these ratios, the denominator is the interest expense. In the numerator, we add taxes back because taxes are computed only after interest expense is deducted. A coverage ratio of one implies that the firm is barely covering its interest expense through its operating activities, which is a very risky situation. The larger the coverage ratio, the greater the cushion the firm has to meet interest obligations. 334 Financial Analysis Financial Analysis Key Analysis Questions Some of the business questions to ask when the analyst is examining a firm’s debt policies are: • Does the company have enough debt? Is it exploiting the potential benefits of debt—interest tax shields, management discipline, and easier communication? • Does the company have too much debt given its business risk? What type of debt covenant restrictions does the firm face? Is it bearing the costs of too much debt, risking potential financial distress and reduced business flexibility? • What is the company doing with the borrowed funds? Investing in working capital? Investing in fixed assets? Are these investments profitable? • Is the company borrowing money to pay dividends? If so, what is the justification? We show debt and coverage ratios for Nordstrom and TJX in Table 9-8. While Nordstrom recorded an increase in its liabilities-to-equity and debt-to-equity ratios, its net financial leverage after taking into account its increased cash balance in 1998 shows little increase. The company’s interest coverage also remained at comfortable levels. All these ratios suggest that Nordstrom has been following a fairly conservative debt policy. Table 9-8 Debt and Coverage Ratios Ratio Nordstrom 1998 Nordstrom 1997 TJX 1998 ......................................................................................................................... Liabilities to equity Debt to equity Net debt to equity Debt to capital Net debt to net capital Net debt to equity, including operating lease obligations Interest coverage (earnings based) Interest coverage (cash flow based) Fixed charges coverage, including lease payments (earnings based) Fixed charges coverage, including lease payments (cash flow based) 1.37 0.72 0.54 0.42 0.35 0.95 0.46 0.48 0.38 0.31 1.25 0.18 (0.20) 0.15 (0.25) Not available 8.2 16.4 Not available 9.6 13.4 1.19 410 541.2 4.6 4.8 3.17 8.7 6.2 3.87 ......................................................................................................................... 9-18 Financial Analysis 9-19 Part 2 Business Analysis and Valuation Tools TJX’s debt ratios confirm that it is primarily relying on non-interest-bearing liabilities such as accounts payable and accrued expenses to finance its operations. Given its large cash balance, its net debt is in fact negative. Its interest coverage ratios are extraordinarily high. However, this picture changes when one considers the fact that TJX relies heavily on operating leases for its stores. If the present value of minimum lease rental obligations is added to TJX’s net debt, its net-debt-to-equity ratio increases dramatically. Similarly, when one includes minimum rental payments in the fixed charge coverage ratio, TJX’s coverage drops dramatically. This illustrates the importance of considering off-balance-sheet obligations in analyzing a company’s financial management. RATIOS OF DISAGGREGATED DATA. So far we have discussed how to compute ratios using information in the financial statements. Often, analysts probe the above ratios further by using disaggregated financial and physical data. For example, for a multibusiness company, one could analyze the information by individual business segments. Such an analysis can reveal potential differences in the performance of each business unit, allowing the analyst to pinpoint areas where a company’s strategy is working and where it is not. It is also possible to probe financial ratios further by computing ratios of physical data pertaining to a company’s operations. The appropriate physical data to look at varies from industry to industry. As an example in retailing, one could compute productivity statistics such as sales per store, sales per square foot, customer transactions per store, and amount of sale per customer transactions; in the hotel industry, room occupancy rates provide important information; in the cellular telephone industry, acquisition cost per new subscriber and subscriber retention rate are important. These disaggregated ratios are particularly useful for young firms and young industries (for example, the Internet firms) where accounting data may not fully capture the business economics due to conservative accounting rules. Putting It All Together: Assessing Sustainable Growth Rate Analysts often use the concept of sustainable growth as a way to evaluate a firm’s ratios in a comprehensive manner. A firm’s sustainable growth rate is defined as: Sustainable growth rate = ROE × ( 1 – Dividend payout ratio ) We already discussed the analysis of ROE in the previous four sections. The dividend payout ratio is defined as: Dividend payout ratio = Cash dividends paid -----------------------------------------------Net income A firm’s dividend payout ratio is a measure of its dividend policy. As we discuss in detail in Chapter X, firms pay dividends for several reasons. Dividends are a way for the firm to return to its shareholders any cash generated in excess of its operating and investment needs. When there are information asymmetries between a firm’s managers and its 335 336 Financial Analysis Financial Analysis shareholders, dividend payments can serve as a signal to shareholders about managers’ expectation of the firm’s future prospects. Firms may also pay dividends to attract a certain type of shareholder base. Sustainable growth rate is the rate at which a firm can grow while keeping its profitability and financial policies unchanged. A firm’s return on equity and its dividend payout policy determine the pool of funds available for growth. Of course, the firm can grow at a rate different from its sustainable growth rate if its profitability, payout policy, or financial leverage changes. Therefore, the sustainable growth rate provides a benchmark against which a firm’s growth plans can be evaluated. Figure 9-2 shows how a firm’s sustainable growth rate can be linked to all the ratios discussed in this chapter. These linkages allow an analyst to examine the drivers of a firm’s current sustainable growth rate. If the firm intends to grow at a higher rate than its sustainable growth rate, one could Figure 9-2 Sustainable Growth Rate Framework for Financial Ratio Analysis SUSTAINABLE GROWTH RATE Dividend Payout ROE Financial Leverage Effect Operating ROA Net Operating Profit Margin Gross profit margin SG&A/Sales R&D/Sales Effective tax rate on operating profits Operating Asset Turnover Operating working capital turnover Operating long-term asset turnover Receivables turnover Inventory turnover Payables turnover PP&E turnover Spread Net effective interest rate Interest income/Cash and marketable securities Interest expense/Total debt Net Financial Leverage Debt/Equity Cash and marketable securities/Equity Interest coverage • earnings basis • cash basis 9-20 Financial Analysis 9-21 Part 2 Business Analysis and Valuation Tools assess which of the ratios are likely to change in the process. This analysis can lead to asking business questions such as: Where is the change going to take place? Is management expecting profitability to increase? Or asset productivity to improve? Are these expectations realistic? Is the firm planning for these changes? If the profitability is not likely to go up, will the firm increase its financial leverage, or cut dividends? What is the likely impact of these financial policy changes? Table 9-9 shows the sustainable growth rate and its components for Nordstrom and TJX. Nordstrom had a lower ROE and a higher dividend payout ratio relative to TJX, leading to a significantly lower sustainable growth rate in both 1998 and 1997. However, Nordstrom improved its sustainable growth rate because of its improved ROE and a marginal decline in its payout ratio. Nordstrom’s actual growth rate in 1998 in sales, assets, and liabilities was lower than its sustainable growth rate in 1997. In 1998 Nordstrom’s sales grew by 3.6 percent, net operating assets declined by 5.3 percent, and its net debt grew by 6.9 percent. These differences in Nordstrom’s sustainable growth rate and its actual growth rates in sales, net assets, and net debt are reconciled by the fact that Nordstrom reduced its equity base through significant stock repurchases. Nordstrom has the room to grow in future years at much higher levels without altering its operating and financial policies. Historical Patterns of Ratios for U.S. Nonfinancial Firms To provide a benchmark for analysis, Table 9-10 reports historical values of the key ratios discussed in this chapter. These ratios are calculated using financial statement data for all nonfinancial publicly listed U.S. companies. The table shows the values of ROE, its key components, and the sustainable growth rate for each of the years 1979 to 1998, and the average for this twenty-year period. The data in the table show that the average ROE during this period has been 11.2 percent, average operating ROA has been 9 percent, and the average spread between operating ROA and net borrowing costs after tax has been 2.7 percent. Average sustainable growth rate for U.S. companies during this period has been 4.6 percent. Of course, an individual company’s ratios might depart from these economy-wide averages for a number of reasons, including industry effects, company strategies, and management effectiveness. Nonetheless, the average values in the table serve as useful benchmarks in financial analysis. Table 9-9 Sustainable Growth Rate Ratio Nordstrom 1998 Nordstrom 1997 TJX 1998 ......................................................................................................................... ROE Dividend payout ratio Sustainable growth rate 15.6% 0.21 12.3% 12.6% 0.22 9.8% 34.5% 0.09 31.4% ......................................................................................................................... 337 338 Financial Analysis 9-22 Financial Analysis Table 9-10 Historical Values of Key Financial Ratios Year ROE NOPAT Margin Operating Asset Operating Turnover ROA Spread Net Sustainable Financial Growth Leverage Rate ....................................................................................................................................... 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average 14.7% 13.9% 13.5% 10.5% 10.5% 12.4% 9.6% 8.8% 11.6% 13.5% 12.5% 10.4% 6.5% 3.1% 6.8% 12.9% 11.7% 13.7% 12.9% 13.7% 11.2% 7.2% 7.0% 7.4% 6.8% 6.9% 7.4% 6.4% 6.4% 7.4% 8.2% 8.1% 7.1% 5.7% 3.9% 4.9% 6.7% 6.3% 7.1% 6.7% 7.0% 6.7% 1.77 1.81 1.77 1.61 1.61 1.64 1.61 1.51 1.52 1.42 1.40 1.42 1.41 1.49 1.51 1.57 1.58 1.56 1.55 1.45 1.56 11.5% 11.3% 11.3% 9.4% 9.6% 10.6% 8.7% 8.1% 9.8% 10.0% 9.5% 8.3% 6.3% 4.2% 5.9% 9.1% 8.5% 9.7% 9.1% 8.9% 9.0% 5.4% 4.3% 3.7% 1.7% 1.6% 3.1% 1.4% 0.9% 2.7% 3.7% 2.9% 1.9% 0.1% –1.3% 0.8% 4.0% 3.3% 4.7% 4.2% 4.4% 2.7% 0.57 0.58 0.59 0.60 0.53 0.56 0.60 0.65 0.69 0.93 1.03 1.06 1.01 1.03 1.00 0.92 0.93 0.85 0.88 0.93 0.80 8.8% 8.0% 7.5% 4.2% 4.2% 6.1% 3.2% 1.9% 4.7% 5.9% 5.3% 3.3% –0.5% –4.0% –0.2% 6.3% 4.8% 7.6% 6.9% 7.9% 4.6% ....................................................................................................................................... Source: Financial statement data for all nonfinancial companies publicly traded in the U.S., listed in the Compustat files. CASH FLOW ANALYSIS Ratio analysis discussed above focused on analyzing a firm’s income statement (net profit margin analysis) or its balance sheet (asset turnover and financial leverage). The analyst can get further insights into the firm’s operating, investing, and financing policies by examining its cash flows. Cash flow analysis also provides an indication of the quality of the information in the firm’s income statement and balance sheet. As before, we will illustrate the concepts discussed in this section using Nordstrom’s and TJX’s cash flows. Cash Flow and Funds Flow Statements All U.S. companies are required to include a statement of cash flows in their financial statements under Statement of Financial Accounts Standard No. 95 (SFAS 95). In the Financial Analysis 9-23 Part 2 Business Analysis and Valuation Tools reported cash flow statement, firms classify their cash flows into three categories: cash flow from operations, cash flow related to investments, and cash flow related to financing activities. Cash flow from operations is the cash generated by the firm from the sale of goods and services after paying for the cost of inputs and operations. Cash flow related to investment activities shows the cash paid for capital expenditures, intercorporate investments, acquisitions, and cash received from the sales of long-term assets. Cash flow related to financing activities shows the cash raised from (or paid to) the firm’s stockholders and debt holders. Firms use two cash flow statement formats: the direct format and the indirect format. The key difference between the two formats is the way they report cash flow from operating activities. In the direct cash flow format, which is used by only a small number of firms in practice, operating cash receipts and disbursements are reported directly. In the indirect format, firms derive their operating cash flows by making adjustments to net income. Because the indirect format links the cash flow statement with the firm’s income statement and balance sheet, many analysts and managers find this format more useful. As a result, the FASB required firms using the direct format to report operating cash flows in the indirect format as well. Recall from Chapter 3 that net income differs from operating cash flows because revenues and expenses are measured on an accrual basis. There are two types of accruals embedded in net income. First, there are current accruals like credit sales and unpaid expenses. Current accruals result in changes in a firm’s current assets (such as accounts receivable, inventory, prepaid expenses) and current liabilities (such as accounts payable and accrued liabilities). The second type of accruals included in the income statement is noncurrent accruals such as depreciation, deferred taxes, and equity income from unconsolidated subsidiaries. To derive cash flow from operations from net income, adjustments have to be made for both these types of accruals. In addition, adjustments have to be made for nonoperating gains included in net income such as profits from asset sales. Most firms outside the U.S. report a funds flow statement rather than a cash flow statement of the type described above. Prior to SFAS 95, U.S. firms also reported a similar statement. Funds flow statements show working capital flows, not cash flows. It is useful for analysts to know how to convert a funds flow statement into a cash flow statement. Funds flow statements typically provide information on a firm’s working capital from operations, defined as net income adjusted for noncurrent accruals, and gains from the sale of long-term assets. As discussed above, cash flow from operations essentially involves a third adjustment, the adjustment for current accruals. Thus, it is relatively straightforward to convert working capital from operations to cash flow from operations by making the relevant adjustments for current accruals related to operations. Information on current accruals can be obtained by examining changes in a firm’s current assets and current liabilities Typically, operating accruals represent changes in all the current asset accounts other than cash and cash equivalents, and changes in all the current liabilities other than notes payable and the current portion of long-term debt.9 Cash from operations can be calculated as: 339 340 Financial Analysis Financial Analysis Working capital from operations − Increase (or + decrease) in accounts receivable − Increase (or + decrease) in inventory − Increase (or + decrease) in other current assets excluding cash and cash equivalents + Increase (or − decrease) in accounts payable + Increase (or − decrease) in other current liabilities excluding debt. Funds flow statements also often do not classify investment and financing flows. In such a case, the analyst has to classify the line items in the funds flow statement into these two categories by evaluating the nature of the business transactions that give rise to the flow represented by the line items. Analyzing Cash Flow Information Cash flow analysis can be used to address a variety of questions regarding a firm’s cash flow dynamics: • How strong is the firm’s internal cash flow generation? Is the cash flow from operations positive or negative? If it is negative, why? Is it because the company is growing? Is it because its operations are unprofitable? Or is it having difficulty managing its working capital properly? • Does the company have the ability to meet its short-term financial obligations, such as interest payments, from its operating cash flow? Can it continue to meet these obligations without reducing its operating flexibility? • How much cash did the company invest in growth? Are these investments consistent with its business strategy? Did the company use internal cash flow to finance growth, or did it rely on external financing? • Did the company pay dividends from internal free cash flow, or did it have to rely on external financing? If the company had to fund its dividends from external sources, is the company’s dividend policy sustainable? • What type of external financing does the company rely on? Equity, short-term debt, or long-term debt? Is the financing consistent with the company’s overall business risk? • Does the company have excess cash flow after making capital investments? Is it a long-term trend? What plans does management have to deploy the free cash flow? While the information in reported cash flow statements can be used to answer the above questions directly in the case of some firms, it may not be easy to do so always for a number of reasons. First, even though SFAS 95 provides broad guidelines on the format of a cash flow statement, there is still significant variation across firms in how cash flow data are disclosed. Therefore, to facilitate a systematic analysis and comparison across firms, analysts often recast the information in the cash flow statement using their own cash flow model. Second, firms include interest expense and interest income 9-24 Financial Analysis 9-25 Part 2 Business Analysis and Valuation Tools in computing their cash flow from operating activities. However, these two items are not strictly related to a firm’s operations. Interest expense is a function of financial leverage, and interest income is derived from financial assets rather than operating assets. Therefore, it is useful to restate the cash flow statement to take this into account. Analysts use a number of different approaches to restate the cash flow data. One such model is shown in Table 9-11. This presents cash flow from operations in two stages. The first step computes cash flow from operations before operating working capital investments. In computing this cash flow, the model excludes interest expense and interest income. To compute this number starting with a firm’s net income, an analyst adds back three types of items: (1) after-tax net interest expense because this is a financing item that will be considered later, (2) nonoperating gains or losses typically arising out of asset disposals or asset write-offs because these items are investment related and will be considered later, and (3) long-term operating accruals such as depreciation and deferred taxes because these are noncash operating charges. Several factors affect a firm’s ability to generate positive cash flow from operations. Healthy firms that are in a steady state should generate more cash from their customers than they spend on operating expenses. In contrast, growing firms, especially those investing cash in research and development, advertising and marketing, or building an organization to sustain future growth, may experience negative operating cash flow. Firms’ working capital management also affects whether they generate positive cash flow from operations. Firms in the growing stage typically invest some cash flow in operating working capital items like accounts receivable, inventories, and accounts payable. Net investments in working capital are a function of firms’ credit policies (accounts receivable), payment policies (payables, prepaid expenses, and accrued liabilities), and expected growth in sales (inventories). Thus, in interpreting firms’ cash flow from operations after working capital, it is important to keep in mind their growth strategy, industry characteristics, and credit policies. The cash flow analysis model next focuses on cash flows related to long-term investments. These investments take the form of capital expenditures, intercorporate investments, and mergers and acquisitions. Any positive operating cash flow after making operating working capital investments allows the firm to pursue long-term growth opportunities. If the firm’s operating cash flows after working capital investments are not sufficient to finance its long-term investments, it has to rely on external financing to fund its growth. Such firms have less flexibility to pursue long-term investments than those that can fund their growth internally. There are both costs and benefits from being able to fund growth internally. The cost is that managers can use the internally generated free cash flow to fund unprofitable investments; such wasteful capital expenditures are less likely if managers are forced to rely on external capital suppliers. Reliance on external capital markets may make it difficult for managers to undertake long-term risky investments if it is not easy to communicate to the capital markets the benefits from such investments. Any excess cash flow after these long-term investments is free cash flow that is available for both debt holders and equity holders. Payments to debt holders include interest payments and principal payments. Firms with negative free cash flow have to borrow 341 342 Financial Analysis Financial Analysis Table 9-11 Cash Flow Analysis Line Item Nordstrom 1998 Nordstrom 1997 TJX1 1998 ......................................................................................................................... Net income (dollars in millions) After-tax net interest expense (income) Nonoperating losses (gains) Long-term operating accruals Operating cash flow before working capital investments Net (investments in) or liquidation of operating working capital Operating cash flow before investment in long-term assets Net (investment in) or liquidation of operating long-term assets Free cash flow available to debt and equity After-tax net interest (expense) or income Net debt (repayment) or issuance Free cash flow available to equity Dividend (payments) Net stock (repurchase) or issuance Net increase (decrease) in cash balance 206.7 30.6 — 186.7 186.2 22.3 — 156.9 420.6 1.1 6.0 139.3 424.0 365.4 567.0 199.1 (45.0) 73.3 623.1 320.4 640.3 (259.3) 363.8 (30.6) 258.1 591.3 (44.1) (330.6) 216.6 (257.7) 62.7 (22.3) 140.4 180.8 (41.2) (143.1) (3.5) (198.3) 442 (1.1) (23.4) 417.5 (38.1) (322.6) 56.8 ......................................................................................................................... additional funds to meet their interest and debt repayment obligations, or cut some of their investments in working capital or long-term investments, or issue additional equity. This situation is clearly financially risky for the firm. Cash flow after payments to debt holders is free cash flow available to equity holders. Payments to equity holders consist of dividend payments and stock repurchases. If firms pay dividends despite negative free cash flow to equity holders, they are borrowing money to pay dividends. While this may be feasible in the short term, it is not prudent for a firm to pay dividends to equity holders unless it has a positive free cash flow on a sustained basis. On the other hand, firms that have a large free cash flow after debt payments run the risk of wasting that money on unproductive investments to pursue growth for its own sake. An analyst, therefore, should carefully examine the investment plans of such firms. The model in Table 9-11 suggests that the analyst should focus on a number of cash flow measures: (1) cash flow from operations before investment in working capital and interest payments, to examine whether or not the firm is able to generate a cash surplus from its operations, (2) cash flow from operations after investment in working capital, to assess how the firm’s working capital is being managed and whether or not it has the flexibility to invest in long-term assets for future growth, (3) free cash flow available to 9-26 Financial Analysis 9-27 Part 2 Business Analysis and Valuation Tools debt and equity holders, to assess a firm’s ability to meet its interest and principal payments, and (4) free cash flow available to equity holders, to assess the firm’s financial ability to sustain its dividend policy and to identify potential agency problems from excess free cash flow. These measures have to be evaluated in the context of the company’s business, its growth strategy, and its financial policies. Further, changes in these measures from year to year provide valuable information on the stability of the cash flow dynamics of the firm. Key Analysis Questions The cash flow model in Table 9-11 can be also used to assess a firm’s earnings quality, as discussed in Chapter 3. The reconciliation of a firm’s net income with its cash flow from operations facilitates this exercise. Some of the questions an analyst can probe in this respect are: • Are there significant differences between a firm’s net income and its operating cash flow? Is it possible to clearly identify the sources of this difference? Which accounting policies contribute to this difference? Are there any onetime events contributing to this difference? • Is the relationship between cash flow and net income changing over time? Why? Is it because of changes in business conditions or because of changes in the firm’s accounting policies and estimates? • What is the time lag between the recognition of revenues and expenses and the receipt and disbursement of cash flows? What type of uncertainties need to be resolved in between? • Are the changes in receivables, inventories, and payables normal? If not, is there adequate explanation for the changes? Finally, as we will discuss in Chapter 12, free cash flow available to debt and equity and free cash flow available to equity are critical inputs into the cash-flow-based valuation of firms’ assets and equity, respectively. Analysis of Nordstrom’s Cash Flow Nordstrom and TJX reported their cash flows using the indirect cash flow statement. Table 9-11 recasts these statements so that we can analyze the two companies’ cash flow dynamics, as discussed above. Cash flow analysis presented in Table 9-11 shows Nordstrom had an operating cash flow before working capital investments of $424 million in 1998, a substantial improvement from $365.4 million in 1997. The difference between earnings and these cash flows is primarily attributable to the depreciation and amortization charge included in the com- 343 344 Financial Analysis Financial Analysis pany’s income statement. In 1998 Nordstrom managed to squeeze an additional $199 million from its operating working capital, primarily by reducing its investment in accounts receivable and inventory. This contrasts with a net operating working capital investment of $45 million in 1997. As a result of this, the company had an operating cash flow before long-term investments to the tune of $623 million in 1998, more than adequate to meet its total investment in long-term assets. Nordstrom thus had $363.8 million of free cash flow available to debt and equity holders in 1998, compared to a total of only $62.7 million in 1997. Both in 1997 and 1998, the company was a net borrower. As a result, there was considerable free cash flow available to equity holders in both years. The company utilized this free cash flow to pay its regular dividends and also buy back stock in both the years. The difference between the two years, however, is that in 1998 the company had adequate internal cash flow to pay dividends and buy back stock, while in 1997 the company could not have made these payments to equity holders either without borrowing or without cutting its long-term investments. Clearly, Nordstrom’s cash flow improved significantly in 1998. TJX also had a very strong cash flow situation in 1998. It had $567 million in operating cash flow before working capital investments. TJX was also able to reduce its investments in operating working capital. There is, however, a significant difference between the way investments in working capital appear to have been managed by TJX and Nordstrom. While Nordstrom reduced its investments in inventory and accounts receivable, TJX stretched its payables and accrued expenses. Similar to Nordstrom, TJX was able to fund all its long-term investments in operating assets from its own operating cash flow. As a result, TJX had $442 million in free cash flow available to debt and equity holders. From this, the company paid out approximately $25 million in interest and principal to its debt holders and $360.7 million in dividends and stock repurchases to its equity holders, leaving a cash increase of about $57 million. SUMMARY This chapter presents two key tools of financial analysis: ratio analysis and cash flow analysis. Both these tools allow the analyst to examine a firm’s performance and its financial condition, given its strategy and goals. Ratio analysis involves assessing the firm’s income statement and balance sheet data. Cash flow analysis relies on the firm’s cash flow statement. The starting point for ratio analysis is the company’s ROE. The next step is to evaluate the three drivers of ROE, which are net profit margin, asset turnover, and financial leverage. Net profit margin reflects a firm’s operating management, asset turnover reflects its investment management, and financial leverage reflects its liability management. Each of these areas can be further probed by examining a number of ratios. For example, common-sized income statement analysis allows a detailed examination of a firm’s net margins. Similarly, turnover of key working capital accounts like accounts receivable, inventory, and accounts payable, and turnover of the firm’s fixed assets allow further 9-28 Financial Analysis 9-29 Part 2 Business Analysis and Valuation Tools examination of a firm’s asset turnover. Finally, short-term liquidity ratios, debt policy ratios, and coverage ratios provide a means of examining a firm’s financial leverage. A firm’s sustainable growth rate—the rate at which it can grow without altering its operating, investment, and financing policies—is determined by its ROE and its dividend policy. Therefore, the concept of sustainable growth provides a way to integrate the ratio analysis and to evaluate whether or not a firm’s growth strategy is sustainable. If a firm’s plans call for growing at a rate above its current sustainable rate, then the analyst can examine which of the firm’s ratios is likely to change in the future. Cash flow analysis supplements ratio analysis in examining a firm’s operating activities, investment management, and financial risks. Firms in the U.S. are currently required to report a cash flow statement summarizing their operating, investment, and financing cash flows. Firms in other countries typically report working capital flows, but it is possible to use this information to create a cash flow statement. Since there are wide variations across firms in the way cash flow data are reported, analysts often use a standard format to recast cash flow data. We discussed in this chapter one such cash flow model. This model allows the analyst to assess whether a firm’s operations generate cash flow before investments in operating working capital, and how much cash is being invested in the firm’s working capital. It also enables the analyst to calculate the firm’s free cash flow after making long-term investments, which is an indication of the firm’s ability to meet its debt and dividend payments. Finally, the cash flow analysis shows how the firm is financing itself, and whether or not its financing patterns are too risky. The insights gained from analyzing a firm’s financial ratios and its cash flows are valuable in forecasts of the firm’s future prospects, a topic we address in the chapter. DISCUSSION QUESTIONS 1. Which of the following types of firms do you expect to have particularly high or low asset turnover? Explain why. • a supermarket • a pharmaceutical company • a jewelry retailer • a steel company 2. Which of the following types of firms do you expect to have high or low sales margins? Why? • a supermarket • a pharmaceutical company • a jewelry retailer • a software company 3. James Broker, an analyst with an established brokerage firm, comments: “The critical number I look at for any company is operating cash flow. If cash flows are less than earnings, I consider a company to be a poor performer and a poor investment prospect.” Do you agree with this assessment? Why or why not? 345 346 Financial Analysis Financial Analysis 4. In 1995 Chrysler has a return on equity of 20 percent, whereas Ford’s return is only 8 percent. Use the decomposed ROE framework to provide possible reasons for this difference. 5. Joe Investor claims: “A company cannot grow faster than its sustainable growth rate.” True or false? Explain why. 6. What are the reasons for a firm having lower cash from operations than working capital from operations? What are the possible interpretations of these reasons? 7. ABC Company recognizes revenue at the point of shipment. Management decides to increase sales for the current quarter by filling all customer orders. Explain what impact this decision will have on: • Days receivable for the current quarter • Days receivable for the next quarter • Sales growth for the current quarter • Sales growth for the next quarter • Return on sales for the current quarter • Return on sales for the next quarter 8. What ratios would you use to evaluate operating leverage for a firm? 9. What are the potential benchmarks that you could use to compare a company’s financial ratios? What are the pros and cons of these alternatives? 10. In a period of rising prices, how would the following ratios be affected by the accounting decision to select LIFO, rather than FIFO, for inventory valuation? • Gross margin • Current ratio • Asset turnover • Debt-to-equity ratio • Average tax rate NOTES 1. We will call the fiscal year ending January 1999 as the year 1998, and the fiscal year ending January 1998 as the year 1997. 2. In computing ROE, one can either use the beginning equity, ending equity, or an average of the two. Conceptually, the average equity is appropriate, particularly for rapidly growing companies. However, for most companies, this computational choice makes little difference as long as the analyst is consistent. Therefore, in practice, most analysts use ending balances for simplicity. This comment applies to all ratios discussed in this chapter where one of the items in the ratio is a flow variable (items in the income statement or cash flow statement) and the other item is a stock variable (items in the balance sheet). Throughout this chapter, we use the ending balances of the stock variables for computational simplicity. 3. We discuss in greater detail in Chapter 12 how to estimate a company’s cost of equity capital. The equity beta for both Nordstrom and TJX was close to one in 1999, and the yield on longterm treasury bonds was approximately 6 percent. If one assumes a risk premium of 6 percent, the two firms’ cost of equity is 12 percent; if the risk premium is assumed to be 8 percent, then their 9-30 Financial Analysis 9-31 Part 2 Business Analysis and Valuation Tools cost of equity is 14 percent. Lower assumed risk premium will, of course, lead to lower estimates of equity capital. 4. Strictly speaking, part of a cash balance is needed to run the firm’s operations, so only the excess cash balance should be viewed as negative debt. However, firms do not provide information on excess cash, so we subtract all cash balance in our definitions and computations below. An alternative possibility is to subtract only short-term investments and ignore the cash balance completely. 5. See “Ratio Analysis and Valuation,” by Doron Nissim and Stephen Penman, unpublished manuscript, March 1999, for a more detailed description of this approach. 6. TJX has a small amount of debt and a cash balance larger than its debt. Therefore, its weighted average cost of capital is likely to be similar to its cost of equity. We will discuss in Chapter 12 how to estimate a company’s weighted average cost of capital. 7. See Taxes and Business Strategy, by Myron Scholes and Mark Wolfson, Englewood Cliffs, NJ: Prentice-Hall, 1992. 8. There are a number of issues related to the calculation of these ratios in practice. First, in calculating all the turnover ratios, the assets used in the calculations can either be year-end values or an average of the beginning and ending balances in a year. We use the year-end values here for simplicity. Second, strictly speaking, one should use credit sales to calculate accounts receivable turnover and days’ receivables. However, since it is usually difficult to obtain data on credit sales, total sales are used instead. Similarly, in calculating accounts payable turnover or days’ payables, cost of goods sold is substituted for purchases for data availability reasons. 9. Changes in cash and marketable securities are excluded because this is the amount being explained by the cash flow statement. Changes in short-term debt and the current portion of longterm debt are excluded because these accounts represent financing flows, not operating flows. 347 The Home Depot, Inc. T 2 Business Analysis and Valuation Tools 9 Financial Analysis The Home Depot he difference between a company with a concept and one without is the difference between a stock that sells for 20 times earnings and one that sells for 10 times earnings. The Home Depot is definitely a concept stock, and it has the multiple to prove it – 27-28 times likely earnings in the current fiscal year ending this month. On the face of it, The Home Depot might seem like a tough one for the concept-mongers to work with. It’s a chain of hardware stores. But, as we noted in our last visit to the company in the spring of ’83, these hardware stores are huge warehouse outlets – 60,000 to 80,000 feet in space. You can fit an awful lot of saws in these and still have plenty of room left over to knock together a very decent concept. And in truth, the warehouse notion is the hottest thing in retailing these days. The Home Depot buys in quantum quantities, which means that its suppliers are eager to keep within its good graces and hence provide it with a lot of extra service. The company, as it happens, is masterful in promotion and pricing. The last time we counted, it had 22 stores, all of them located where the sun shines all the time. Growth has been sizzling. Revenues, a mere $22 million in fiscal ’80, shot past the quarter billion mark three years later. As to earnings, they have climbed from two cents in fiscal ’80 to an estimated 60 cents in the fiscal year coming to an end [in January 1985]. Its many boosters in the Street, moreover, anticipate more of the same as far as the bullish eye can see. They’re confidently estimating 30% growth in the new fiscal year as well. Could be. But while we share their esteem for the company’s merchandising skills and imagination, we’re as bemused now as we were the first time we looked at The Home Depot by its rich multiple. Maybe a little more now than then.1 The above report appeared on January 21, 1985, in “Up & Down Wall Street,” a regular column in Barron’s financial weekly. COMPANY BACKGROUND Bernard Marcus and Arthur Blank founded The Home Depot in 1978 to bring the warehouse retailing concept to the home center industry. The company operated retail “do-it........................................................................................................................ This case was prepared by Professor Krishna Palepu as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 1988 by the President and Fellows of Harvard College. Harvard Business School case 9-188-148.1. 1. Reprinted with permission from Barron’s, January 21, 1985. 348 Financial Analysis The Home Depot 9-33 Part 2 Business Analysis and Valuation Tools yourself” (DIY) warehouse stores which sold a wide assortment of building materials and home improvement products. Sales, which were on a cash-and-carry basis, were concentrated in the home remodeling market. The company targeted as its customers individual homeowners and small contractors. The Home Depot’s strategy had several important elements. The company offered low and competitive prices, a feature central to the warehouse retailing concept. The Home Depot’s stores, usually in suburbs, were also the warehouses, with inventory stacked over merchandise displayed on industrial racks. The warehouse format of the stores kept the overhead low and allowed the company to pass the savings to customers. Costs were further reduced by emphasizing higher volume and lower margins with a high inventory turnover. While offering low prices, The Home Depot was careful not to sacrifice the depth of merchandise and the quality of products offered for sale. To ensure that the right products were stocked at all times, each Home Depot store carried approximately $4,500,000 of inventory, at retail, consisting of approximately 25,000 separate stock-keeping units. All these items were kept on the sales floor of the store, thus increasing convenience to the customer and minimizing out-of-stock occurrences. The company also assured its customers that the products sold by it were of the best quality. The Home Depot offered nationally advertised brands as well as lesser known brands carefully chosen by the company’s merchandise managers. Every product sold by The Home Depot was guaranteed by either the manufacturer or by the company itself. The Home Depot complemented the above merchandising strategy with excellent sales assistance. Since the great majority of the company’s customers were individual homeowners with no prior experience in their home improvement projects, The Home Depot considered its employees’ technical knowledge and service orientation to be very important to its marketing success. The company pursued a number of policies to address this need. Approximately 90% of the company’s employees were on a full-time basis. To attract and retain a strong sales force, the company maintained salary and wage levels above those of its competitors. All the floor sales personnel attended special training sessions to gain thorough knowledge of the company’s home improvement products and their basic applications. This training enabled them to answer shoppers’ questions and help customers in choosing equipment and material appropriate for their projects. Often, the expert advice the sales personnel provided created a bond that resulted in continuous contact with the customer throughout the duration of the customer’s project. Finally, to attract customers, The Home Depot pursued an aggressive advertising program utilizing newspapers, television, radio, and direct mail catalogues. The company’s advertising stressed promotional pricing, the broad assortment and depth of its merchandise, and the assistance provided by its sales personnel. The company also sponsored in-store demonstrations of do-it-yourself techniques and product uses. To increase customers’ shopping convenience, The Home Depot’s stores were open seven days a week, including weekday evenings. Fortune magazine commented on The Home Depot’s strategy as follows: 349 Financial Analysis Financial Analysis Warehouse stores typically offer shoppers deep discounts with minimal service and back-to-basics ambiance. The Home Depot’s outlets have all the charm of a freight yard and predictably low prices. But they also offer unusually helpful customer service. Although warehouse retailing looks simple, it is not: As discounting cuts into gross profit margins, the merchant must carefully control buying, merchandising, and inventory costs. Throwing in service, which is expensive and hard to systematize, makes the job even tougher. In the do-it-yourself (DIY ) segment of the industry – which includes old-style hardware stores, building supply warehouses, and the everything-under-one-roof home centers – The Home Depot is the only company that has successfully brought off the union of low prices and high service.2 The Home Depot’s strategy was successful in fueling an impressive growth in the company’s operations. The first three Home Depot stores, opened in Atlanta in 1979, were a quick success. From this modest beginning, the company grew rapidly and went public in 1981. The company’s stock initially traded over-the-counter and was listed on the New York Stock Exchange in April 1984. Several new stores were opened in markets throughout the Sunbelt, and the number of stores operated by The Home Depot grew from 3 in 1979 to 50 by the end of fiscal 1985. As a result, sales grew from $7 million in 1979 to $700 million in 1985. Exhibit 1 provides a summary of the growth in the company’s operations. The company’s stock price performance during 1985 is summarized in Exhibit 2. INDUSTRY AND COMPETITION The home improvement industry was large and growing during the 1980s. The industry sales totaled approximately $80 billion in 1985 and strong industry growth was expected to continue, especially in the do-it-yourself (DIY) segment, which had grown at a compounded annual rate of 14 percent over the last 15 years. With the number of two-wageearner households growing, there was an increase in families’ average disposable income, making it possible to increase the frequency and magnitude of home improvement projects. Further, many homeowners were undertaking these projects by themselves rather than hiring a contractor. Research conducted by the Do-It-Yourself Institute, an industry trade group, showed that DIY activities had become America’s second most popular leisure-time activity after watching television. The success of warehouse retailing pioneered by The Home Depot attracted a number of other companies into the industry. Among the store chains currently operating in the industry were Builders Square (a division of K Mart), Mr. HOW (a division of Service Merchandise), The Home Club (a division of Zayre Corp.), Payless Cashways (a division of W.R. Grace), and Hechinger Co. Most of these store chains were relatively new and not yet achieving significant profitability. ......................................................................................................................... 2. Reprinted with permission from Fortune, February 1988, p. 73. 9-34 The Home Depot 350 Financial Analysis 9-35 Part 2 Business Analysis and Valuation Tools The Home Depot Among The Home Depot’s competitors, the most successful was Hechinger, which had operated hardware stores for a long time and recently entered the do-it-yourself segment of the industry. Using a strategy quite different from The Home Depot’s, Hechinger ran gleaming upscale stores and aimed at high profit margins. As of the end of fiscal 1985, the company operated 55 stores, located primarily in southeastern states. Hechinger announced that it planned to expand its sales by 20 to 25 percent a year by adding 10 to 14 stores a year. A summary of Hechinger’s recent financial performance is presented in Exhibit 3. THE HOME DEPOT’S FUTURE While The Home Depot had achieved rapid growth every year since its inception, fiscal 1985 was probably the most important in the company’s seven-year history. During 1985 the company implemented its most ambitious expansion plan to date by adding 20 new stores in eight new markets. Nine of these stores were acquired from Bowater, a competing store chain which was in financial difficulty. As The Home Depot engaged in major expansion, its revenues rose 62 percent from $432 million in fiscal 1984 to $700 million in 1985. However, the company’s earnings declined in 1985 from the record levels achieved during the previous fiscal year. In fiscal 1985, The Home Depot earned $8.2 million, or $0.33 per share, as compared with $14.1 million or $0.56 per share in fiscal 1984. Bernard Marcus, The Home Depot’s chairman and chief executive officer, commented on the company’s performance as follows: Fiscal 1985 was a year of rapid expansion and continued growth for The Home Depot. Feeling the time was ripe for us to enhance our share of the do-it-yourself market, we seized the opportunity to make a significant investment in our longterm future. At the same time, we recognized that our short-term profit growth would be affected. The Home Depot’s 1985 annual report (Exhibit 4) provided more details on the firm’s financial performance during the year. As fiscal 1985 came to a close, The Home Depot faced some critical issues. The competition in the do-it-yourself industry was heating up. The fight for market dominance was expected to result in pressure on margins, and industry analysts expected only the strongest and most capable firms in the industry to survive. Also, The Home Depot had announced plans for further expansion that included the opening of nine new stores in 1986. The company estimated that site acquisition and construction would cost about $6.6 million for each new store, and investment in inventory (net of vendor financing) would require an additional $1.8 million per store. The company needed significant additional financing to implement these plans. Home Depot relied on external financing—both debt and equity—to fund its growth in 1984 and 1985. However, the significant drop in its stock price in 1985 made further 351 Financial Analysis Financial Analysis 9-36 equity financing less attractive. While the company could borrow from its line of credit, it had to make sure that it could satisfy the interest coverage requirements (see Note 3 in Exhibit 4 for a discussion of debt covenant restrictions). Clearly, generating more cash from its own operations would be the best way for Home Depot to invest in its growth on a sustainable basis. QUESTIONS 1. Evaluate Home Depot’s business strategy. Do you think it is a viable strategy in the long run? 2. Analyze Home Depot’s financial performance during the fiscal years 1983–1985. Compare Home Depot’s performance in this period with Hechinger’s performance. (You may use the ratios and the cash flow analysis in Exhibit 3 in this summary.) 3. How productive were Home Depot’s stores in the fiscal years 1983–1985? (You may use the statistics in Exhibit 1 in this analysis.) 4. Home Depot’s stock price dropped by 23 percent between January 1985 and February 1986, making it difficult for the company to rely on equity capital to finance its growth. Covenants on existing debt (discussed in Note 3 of Exhibit 4) restrict the magnitude of the company’s future borrowing. Given these constraints, what specific actions should Home Depot take with respect to its current operations and growth strategy? How can the company improve its operating performance? Should the company change its strategy? If so, how? The Home Depot 352 Financial Analysis 9-37 Part 2 Business Analysis and Valuation Tools EXHIBIT 1 The Home Depot, Inc. – Summary of Performance During Fiscal Years 1981–1985 $ in millions STOCKHOLDERS’ EQUITY 80.2 8.2 85 81 82 83 84 85 18.4 84 5.2 5.3 1.4 83 65.3 10.3 700.7 256.2 432.8 117.6 51.5 82 81 82 83 CUSTOMER COUNT SQUARE FOOTAGE millions millions 2.4 14.3 84 85 NUMBER OF STORES 50 81 82 83 84 NUMBER OF EMPLOYEES AT YEAR END 85 5.4 83 .7 82 15 NUMBER OF MARKETS 81 .6 85 1.4 8.5 84 4.2 83 1.9 82 85 4.0 380.2 105.2 249.4 33.0 16.9 81 84 23.3 TOTAL ASSETS $ in millions 84 85 82 .7 81 83 84 85 81 1.1 19 83 10 82 8 5 81 2.4 7 31 4.0 11 thousands 2 The Home Depot 81 $ in millions 89.1 NET EARNINGS $ in millions 14.1 NET SALES 82 83 84 85 353 Financial Analysis Financial Analysis 9-38 EXHIBIT 2 The Home Depot’s Common Stock Price and Standard & Poor’s 500 Composite Index from January 1985 to February 1986 Date Home Depot Stock Price S&P 500 Composite Index ......................................................................................................................... 1/2/85 2/1/85 3/1/85 4/1/85 5/1/85 6/3/85 7/1/85 8/1/85 9/2/85 10/1/85 11/1/85 12/2/85 1/2/86 2/3/86 $17.125$ 16.375 19.000 17.000 18.000 16.125 13.000 12.625 11.875 11.375 10.750 11.000 12.625 13.125 165.4 178.6 183.2 181.3 178.4 189.3 192.4 192.1 197.9 185.1 191.5 200.5 209.6 214.0 Cumulative Return: –23.4% 29.4% ......................................................................................................................... The Home Depot’s ß = 1.3 ( Value Line estimate). The Home Depot’s Common Stock Price and Standard & Poor’s 500 Composite Index The Home Depot 354 Financial Analysis 9-39 Part 2 Business Analysis and Valuation Tools EXHIBIT 3 The Home Depot, Inc. – Summary of Financial Performance of Hechinger Company I. HECHINGER’S FINANCIAL RATIOS Year Ending ....................................................................... The Home Depot February 1, 1986 February 2, 1985 January 28, 1984 ..................................................................................................................................... Profit Before Taxes/Sales (%) × Sales/Average Assets × Average Assets/Average Equity × (1 − Average Tax Rate) = Return on Equity (%) × (1 − Dividend Payout Ratio) = Sustainable Growth Rate (%) 7.80 1.48 2.21 0.62 15.80 0.93 14.70 9.40 1.72 2.12 0.55 18.90 0.95 18.00 9.80 2.02 1.79 0.54 19.10 0.95 18.10 Gross Profit/Sales (%) Selling, General and Administrative Expenses/Sales (%) Interest Expenses/Sales (%) Interest Income/Sales (%) Inventory Turnover Average Collection Perioda (Days) Average Accounts Payable Periodb (Days) 29.30 30.10 32.10 21.60 2.10 2.20 4.50 32.00 21.10 1.30 1.70 4.50 33.00 22.90 0.70 1.30 4.40 35.00 58.00 61.00 63.00 ..................................................................................................................................... a. Assumed 365 days in the fiscal year. b. Payables also include accrued wages and expenses. Purchases are computed as cost of sales plus increase in inventory during the year. Assumed 365 days in the fiscal year. 355 Financial Analysis 9-40 Financial Analysis II. HECHINGER’S CASH FLOW Year Ending .................................................................... (Dollars in Thousands) February 1, 1986 February 2, 1985 January 28, 1984 ................................................................................................................................................... Cash Provided from Operations Net earnings Items not requiring the use of cash or marketable securities: Depreciation and amortization Deferred income taxes Deferred rent expense Cash Invested in Operations Accounts receivable Merchandise inventories Other current assets Accounts payable and accrued expenses Taxes on income – current Net Cash Provided from Operations Cash Used for Investment Activities Expenditures for property, furniture and equipment, net of disposals, and other assets Cash Used to Pay Dividends to Shareholders Cash Provided from Financing Activities Proceeds from public offering of 81⁄2% converted subordinated debentures, net of expenses Proceeds from public offering of common stock net of expenses Proceeds from sale and leaseback transactions under operating leases Increase (decrease) in long-term debt Decrease in short-term debt Exercise of stock options including income tax benefit Decrease in capital lease obligations Increase in Cash and Marketable Securities $23,111 $20,923 $16,243 6,594 1,375 2,321 33,401 4,622 2,040 2,064 29,649 3,429 1,515 1,463 22,650 4,657 17,998 4,891 (6,620) 285 21,211 7,905 8,045 3,760 (12,099) 3,031 10,642 7,954 20,596 1,304 (9,767) (575) 19,512 12,190 19,007 3,138 (36,037) (25,531) (16,346) (1,550) (1,091) (868) 85,010 — — 28,969 — — — 180 (311) 28,838 $ 3,441 — 13,439 8,338 (4,750) — 6,874 6,366 (318) 674 (280) 88,992 $81,377 611 (254) 26,718 $12,642 ................................................................................................................................................... The Home Depot 356 Financial Analysis 9-41 Part 2 Business Analysis and Valuation Tools EXHIBIT 4 The Home Depot, Inc.—Abridged Annual Report for Fiscal Year 1985 The Home Depot A Letter to Our Shareholders: Fiscal 1985 was a year of rapid expansion and continued growth for The Home Depot. Feeling the time was ripe for us to enhance our share of the do-ityourself market, we seized the opportunity to make a significant investment in our long-term future. At the same time, we recognized that our short-term profit growth would be affected. The Home Depot intends to be the dominant factor in every market we serve. The key to our success has been that upon entering a new market, we make a substantial commitment—opening multiple stores, providing excellent customer service, creating highly visible promotions, and growing the entire market. We turn the novice into a do-it-yourselfer and enable the expert to do more for less money. From shortly before the end of fiscal 1984 to the close of fiscal 1985, The Home Depot entered eight new markets—Dallas, Houston, Jacksonville, San Diego, Los Angeles, Shreveport, Baton Rouge and Mobile—in a period of approximately 13 months. In that time, the number of Home Depot stores rose dramatically, from 22 to 50, including 9 stores acquired in the Bowater acquisition which had not been in our original plan. Twenty of these stores were opened during the past fiscal year alone. During this time span, we have become the only national warehouse retailing chain serving markets across the Sunbelt. This expansion program required a tremendous investment of capital expenditures and inventory, as well as in personnel. As a result, our net earnings declined from record levels achieved during the previous fiscal year. In fiscal 1985, The Home Depot earned $8,219,000, or $.33 per share, as compared with $14,122,000, or $.56 per share, in fiscal 1984. However, as The Home Depot engaged in this major thrust forward, it also increased its market share and market presence as revenues rose 62% from $432,779,000 in fiscal 1984 to $700,729,000 in fiscal 1985. Despite our significant investments, we still continue to be in a very strong financial condition. In Decem- ber, The Home Depot replaced a prior $100 million bank credit line with an eight-year decreasing revolving credit agreement of $200 million. In addition, we are pursuing sale-and-leaseback negotiations for an aggregate of approximately $50 million for ten of our stores. These sources of additional funds, along with internally generated cash flow, will provide us with an ample financial foundation to continue to underwrite our growth over the next several years. We are also quite proud that The Home Depot achieved its substantial gain in sales and market share in what turned out to be a very difficult year for our industry and retailing in general. The do-ityourself “warehouse” industry, which we pioneered only a few short years ago, has recently attracted many competitors, some of whom have already fallen by the wayside, having mistaken our dramatic success as a path towards easy profits. Now the industry is faced with a situation when only the strongest and most capable will survive. As this process continues, we expect to encounter additional cost competition in the fight for market dominance. However, with our strengths—both financial and our successful ability to develop a loyal customer base— we are confident that The Home Depot will emerge an even stronger company. We have never doubted The Home Depot’s ability to be a leader in our business. We have the market dominance, the superior retailing concepts and the necessary foundation of experienced management. Further, we have the determination to maintain our position. Looking at some of our markets individually, clearly our most difficult environment has been in Houston, where the oil-related economy is undergoing painful contractions combined with particularly fierce industry competition. This has caused our newly-opened stores to operate at a sub par level. In Dallas/Fort Worth, the stores we acquired at the end of fiscal 1984 have not yet generated the profits we expect. Such difficult market conditions demand a flexible 357 Financial Analysis Financial Analysis reaction both in merchandising and operations. Recognizing the future potential of both of these markets, our management team is addressing the issues and feels confident that the final outcome will be positive. In the other markets entered this year, the situation has been considerably more positive. There, our stores are experiencing growth much closer to our historical patterns. In support of our California and Arizona operations, a West Coast division was inaugurated to facilitate a timely response to the demands of that marketplace. With management personnel in place, this division is now responsible for the merchandising and operations of all stores in the western states. Other highlights of the past year’s activities include the progress we have made in expanding our management team, and the computer systems we installed into our operations to enhance our efficiency. During the year, we completed the store price lookup phase of our management information system. This facilitates tracking individual items’ sales through our registers, resulting in a more concise method of inventory reorder and margin management with the information now available. During the coming year we will be testing a perpetual inventory tie-in with our price look-up system, eliminating pricing of our merchandise at the store level. The latter is being tested in several stores presently and hopefully will be expanded to include all of our stores by year end. This will have a significant effect on labor productivity at the store level. The Home Depot is always looking for ways in which to do things better, priding ourselves on our flexibility and ability to innovate and to react to changing conditions. Whether it is a matter of developing state-of-the-art computer systems, reevaluating our store layouts or adapting to fast-changing markets and new types of merchandising, flexibility has always been a Home Depot characteristic. In fiscal 1986, The Home Depot will continue to expand, but at a much more moderate pace. We plan to open nine new stores. These stores will be in existing markets except for two locations in the new market of San Jose, California. 9-42 When we open stores in existing markets, sharing advertising costs and operational expenses, we achieve a faster return than stores in new markets. With this in mind, in January 1986, we withdrew from the Detroit market and delayed the opening of stores in San Francisco. These stores were targeted for a substantial initial loss in earnings that would have been necessary to achieve market dominance. From our standpoint, these new markets would have had the combined effect of diluting our personnel and negatively affecting our earnings. It has always been Home Depot’s philosophy to maintain orderly growth and achieve market dominance as we expand to new markets. Indeed, growth for growth’s sake has never been and never will be our objective. We intend to invest prudently and expand aggressively in our business and our markets only when such expenditures meet our criteria for long-term profitability. We are quite optimistic about our company’s future—both for fiscal 1986 and for the years to follow. Essential to this optimism is the fact that The Home Depot has consistently proven that we can grow the market in every geographical area we enter. Simply, this means that we do not have to take business away from hardware stores and other existing home-improvement outlets, but rather, to create new do-it-yourselfers out of those who have never done their own home improvements. Our philosophy is to educate our customers on how to be do-it-yourselfers. Our customers have come to expect The Home Depot’s knowledgeable sales staff to guide them through any project they care to undertake, whether it be installing kitchen cabinets, constructing a deck, or building an entire house. Our sales staff knows how to complete each project, what tools and material to include, and how to sell our customers everything they need. The Home Depot traditionally holds clinics for its customers in such skills as electrical wiring, carpentry, and plumbing, to name a few. Upon the successful completion of such clinics, our customers are confident in themselves and in The Home Depot. This confidence allows them to attempt increasingly advanced and complex home improvements. Concerning our facilities, Home Depot’s warehouse retailing concept allows us to carry a truly fantastic The Home Depot 358 Financial Analysis The Home Depot 9-43 Part 2 Business Analysis and Valuation Tools selection of merchandise and offer it at the lowest possible prices. Each of our stores ranges from about 65,000 to over 100,000 square feet of selling space, with an additional 4,000 to 10,000 square feet of outdoor selling area. In these large stores, we are able to stock all the materials and tools needed to build a house from scratch, and to landscape its grounds. With each store functioning as its own warehouse, with a capacity of over 25,000 different items, we are able to keep our prices at a minimum while providing the greatest selection of building materials and name brand merchandise. For the majority of Americans, their home is their most valuable asset. It is an asset that consistently appreciates. It is also an asset in need of ongoing care and maintenance. By becoming do-it-yourselfers, homeowners can significantly enhance the value of their homes. We at The Home Depot have found that by successfully delivering this message, we have created loyal and satisfied customers. And by maintaining leadership in our markets, we have established a sound basis on which to build a future of growth with profitability. The Home Depot management and staff are dedicated to the proposition that we are—and will remain—America’s leading do-it-yourself retailer. Bernard Marcus Chairman and Chief Executive Officer Arthur M. Blank President and Chief Operating Officer 359 Financial Analysis 9-44 Financial Analysis CONSOLIDATED STATEMENTS OF EARNINGS Fiscal Year Ended Net Sales (note 2) Cost of Merchandise Sold Gross Profit Operating Expenses: Selling and store operating expenses Preopening expenses General and administrative expenses Total Operating Expenses Operating Income Other Income (Expense): Net gain on disposition of property and equipment (note 7) Interest income Interest expense (note 3) Earnings Before Income Taxes Income Taxes (note 4) Net Earnings Earnings per Common and Common Equivalent Share (note 5) Weighted Average Number of Common and Common Equivalent Shares February 2, 1986 (52 weeks) February 3, 1985 (53 weeks) January 29, 1984 (52 weeks) $700,729,000 519,272,000 181,457,000 $432,779,000 318,460,000 114,319,000 $256,184,000 186,170,000 70,014,000 134,354,000 7,521,000 20,555,000 162,430,000 19,027,000 74,447,000 1,917,000 12,817,000 89,181,000 25,138,000 43,514,000 2,456,000 7,376,000 53,346,000 16,668,000 — 5,236,000 (4,122,000) 1,114,000 26,252,000 12,130,000 $ 14,122,000 — 2,422,000 (104,000) 2,318,000 18,986,000 8,725,000 $ 10,261,000 $ .33 $ .56 $ .41 25,247,000 25,302,000 24,834,000 1,317,000 1,481,000 (10,206,000) (7,408,000) 11,619,000 3,400,000 $ 8,219,000 The Home Depot 360 Financial Analysis 9-45 Part 2 Business Analysis and Valuation Tools CONSOLIDATED BALANCE SHEETS February 2, 1986 February 3, 1985 The Home Depot ASSETS Current Assets: Cash, including time deposits of $43,374,000 in 1985 Accounts receivable, net (note 7) Refundable income taxes Merchandise inventories Prepaid expenses Total current assets Property and Equipment, at Cost (note 3): Land Buildings Furniture, fixtures, and equipment Leasehold improvements Construction in progress Less accumulated depreciation and amortization Net property and equipment Cost in Excess of the Fair Value of Net Assets Acquired, net of accumulated amortization of $730,000 in 1985 and $93,000 in 1984 (note 2) Other $ 9,671,000 21,505,000 3,659,000 152,700,000 2,526,000 190,061,000 $ 52,062,000 9,365,000 — 84,046,000 1,939,000 147,412,000 44,396,000 38,005,000 34,786,000 23,748,000 27,694,000 168,629,000 7,813,000 160,816,000 30,044,000 3,728,000 18,162,000 11,743,000 14,039,000 77,716,000 4,139,000 73,577,000 24,561,000 25,198,000 4,755,000 $380,193,000 3,177,000 $249,364,000 $ 53,881,000 5,397,000 13,950,000 — 10,382,000 83,610,000 $ 32,356,000 3,819,000 10,214,000 626,000 287,000 47,302,000 100,250,000 99,693,000 $199,943,000 100,250,000 17,692,000 $117,942,000 LIABILITIES AND STOCKHOLDERS’ EQUITY Current Liabilities: Accounts payable Accrued salaries and related expenses Other accrued expenses Income taxes payable (note 4) Current portion of long-term debt (note 3) Total current liabilities Long-Term Debt, Excluding Current Installments (note 3): Convertible subordinated debentures Other long-term debt (continued) 361 Financial Analysis 9-46 Financial Analysis February 2, 1986 Other Liabilities 861,000 1,320,000 6,687,000 2,586,000 1,258,000 48,900,000 38,934,000 89,092,000 1,253,000 48,246,000 30,715,000 80,214,000 $380,193,000 $249,364,000 Deferred Income Taxes (note 4) Stockholders’ Equity (note 5): Common stock, par value $.05. Authorized: 50,000,000 shares; issued and outstanding – 25,150,063 shares at February 2, 1986 and 25,055,188 shares at February 3, 1985 Paid-in capital Retained earnings Total stockholders’ equity Commitments and Contingencies (notes 5, 6 and 8) February 3, 1985 CONSOLIDATED STATEMENTS OF CHANGES IN FINANCIAL POSITION Fiscal Year Ended Sources of Working Capital: Net earnings Items which do not use working capital: Depreciation and amortization of property and equipment Deferred income taxes Amortization of cost in excess of the fair value of net assets required Net gain on disposition of property and equipment Other Working capital provided by operations Proceeds from disposition of property and equipment Proceeds from long-term borrowings Proceeds from sale of common stock, net February 2, 1986 February 3, 1985 January 29, 1984 $8,219,000 $14,122,000 $ 10,261,000 4,376,000 3,612,000 2,275,000 1,508,000 903,000 713,000 637,000 93,000 — — 77,000 — 59,000 15,707,000 18,075,000 11,936,000 9,469,000 92,400,000 659,000 $118,235,000 861,000 120,350,000 814,000 $140,100,000 3,000 4,200,000 36,663,000 $ 52,802,000 (1,317,000) 180,000 (continued) The Home Depot 362 Financial Analysis 9-47 Part 2 Business Analysis and Valuation Tools CONSOLIDATED STATEMENTS OF CHANGES IN FINANCIAL POSITION (continued) The Home Depot Fiscal Year Ended Uses of Working Capital: Additions to property and equipment Current installments and repayments of longterm debt Acquisition of Bowater Home Center, Inc., net of working capital of $9,227,000 (note 2): Property and equipment Cost in excess of the fair value of net assets acquired Other assets, net of liabilities Other, net Increase in working capital Changes in Components of Working Capital: Increase (decrease) in current assets: Cash Receivables, net Merchandise inventories Prepaid expenses Increase (decrease) in current liabilities: Accounts payable Accrued salaries and related expenses Other accrued expenses Income taxes payable Current portion of long-term debt Increase in Working Capital February 2, 1986 February 3, 1985 January 29, 1984 $ 99,767,000 $50,769,000 $ 16,081,000 10,399,000 6,792,000 52,000 — 4,815,000 — — — 1,728,000 6,341,000 $118,235,000 25,291,000 (913,000) 2,554,000 50,792,000 $140,100,000 — — 252,000 36,417,000 $ 52,802,000 (42,391,000) 15,799,000 68,654,000 587,000 42,649,000 $29,894,000 7,170,000 25,334,000 1,206,000 63,604,000 $ 13,917,000 1,567,000 41,137,000 227,000 56,848,000 21,525,000 1,578,000 3,736,000 (626,000) 10,095,000 36,308,000 $ 6,341,000 10,505,000 (93,000) 2,824,000 (657,000) 233,000 12,812,000 $ 50,792,000 17,150,000 2,524,000 341,000 406,000 10,000 20,431,000 $ 36,417,000 363 Financial Analysis 9-48 Financial Analysis SELECTED FINANCIAL DATA Fiscal Year Ended February 3, 1985a January 29, 1984 January 30, 1983 January 31, 1982 $432,779,000 114,319,000 $256,184,000 70,014,000 $117,645,000 33,358,000 $51,542,000 14,735,000 26,252,000 18,986,000 9,870,000 1,963,000 14,122,000 10,261,000 5,315,000 1,211,000 — — — 234,000 $ 14,122,000 $10,261,000 $5,315,000 $1,445,000 $ .56 — $ .41 — $ .24 — $.06 .01 $ .33 $ .56 $ .41 $ .24 $ .07 25,247,000 25,302,000 24,834,000 22,233,000 21,050,000 $100,110,000 249,364,000 117,942,000 80,214,000 $ 49,318,000 105,230,000 4,384,000 65,278,000 $ 12,901,000 33,014,000 236,000 18,354,000 $ 5,502,000 16,906,000 3,738,000 5,024,000 February 2, 1986 Selected Consolidated Statement of Earnings $700,729,00 Net sales 0 Gross profit 181,457,000 Earnings before income taxes and extraordinary item 11,619,000 Earnings before extraordinary item 8,219,000 Extraordinary item-reduction of income taxes arising from carryforward of prior years’ operating losses — $ 8,219,00 Net earnings 0 Data: Per Common and Common Equivalent Share: Earnings before extraordinary item $ .33 Extraordinary item — Net earnings Weighted average number of common and common equivalent shares Selected Consolidated Balance Sheet Data: $106,451,00 Working capital 0 Total assets 380,193,000 Long-term debt 199,943,000 89,092,000 Stockholders’ equity a. 53-week fiscal year; all others were 52-week fiscal years. The Home Depot 364 Financial Analysis 9-49 Part 2 Business Analysis and Valuation Tools MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The data below reflect the percentage relationship between sales and major categories in the Consolidated Statements of Earnings and selected sales data of the percentage change in the dollar amounts of each of the items. Percentage Increase (Decrease) of Dollar Amounts The Home Depot Fiscal Yeara 1985 Selected Consolidated Statements of Earnings Data: Net sales Gross profit Cost and expenses: Selling and store operating Preopening General and administrative Net gain on disposition of property and equipment Interest income Interest expense 1984 100.0% 100.0% 61.9% 68.9% 25.9 26.4 27.3 58.7 63.3 19.2 1.1 2.9 17.2 .4 3.0 17.0 .9 2.9 80.5 292.3 60.4 71.1 (21.9) 73.8 — (1.2) .9 — (.9) — 24.2 Selected Consolidated Sales Data: Number of customer transactions Average amount of sale per transaction Weighted average weekly sales per operating store 20.3 1.7 .5 1.2% 6.1 2.8 3.3% 23,324,000 $30.04 $ 1984 v. 1983 100.0% (.2) (.2) 1.4 Earnings before income taxes Income taxes Net earnings 1985 v. 1984 1983 342,500 $ 19.9 7.4 3.4 4.0% — (71.7) 147.6 — 116.2 3,863.5 92.9 72.6 (55.7) (72.0) (41.8%) 38.3 39.0 37.6% 14,256,000 $30.36 8,479.000 $30.21 63.6% (1.1) 68.1% .5 365,500 $ 360,300 (6.3) 1.4 a. Fiscal years 1985, 1984 and 1983 refer to the fiscal years ended February 2, 1986, February 3, 1985 and January 29, 1984, respectively. Fiscal 1984 consisted of 53 weeks while 1985 and 1983 each consisted of 52 weeks. Results of Operations For an understanding of the significant factors that influenced the Company’s performance during the past three fiscal years, the following discussion should be read in conjunction with the consolidated financial statements appearing elsewhere in this annual report. Fiscal Year Ended February 2, 1986 Compared to February 3, 1985 Net sales in fiscal year 1985 increased 62% from $432,779,000 to $700,729,000. The growth is attributable to several factors. First, the Company opened 20 new stores during 1985 and closed one store. Second, second-year sales increases were realized 365 Financial Analysis Financial Analysis 9-50 from the three new stores opened in 1984 and from the nine former Bowater Home Center stores acquired duri