30 November 2006

WMT: Analysis through Oct 2006

Wal-Mart (WMT), based in Bentonville, AR, is the world's largest retailer. It operates Wal-Mart stores and Sam's Club warehouses.

Wal-Mart has been a disruptive force, with positive and negative effects, in the U.S. and world economies. These disruptions, when coupled with the company's scale and huge customer base, also makes it a lightning rod for criticism. Wal-Mart revolutionized retailing by using information technology to manage its supply chain and by pressuring manufacturers to squeeze every penny out of their costs. Rival discounters fell by the wayside, and manufacturers with higher costs suffered mightily. On the other hand, Wal-Mart's discounting is responsible for lower inflation (and thus interest rates), although this effect might not have been reflected fully in the published statistics. However, with the U.S. market now saturated, and the company continuing to slash prices, Wal-Mart's growth (as measured by same-store sales) has shrunk to the low single digits. Target, which appeals to a somewhat more affluent customer base, has been eroding Wal-Mart's market share from above. From below, high gas prices have cut the amount of money Wal-Mart's customer have to spend. The stock price, with a few rare exceptions, has been between $43 and $50 per share since March 2005.

When we analyzed WMT after the quarter that ended in July 2006, the Overall score was a modest 36 points. At 14 points, Value was the attribute gauge with the highest score. Cash Management and Profitability were weakest at 4 points.

We have since updated the analysis to incorporate WMT's financial results for the latest quarter, which was the third of fiscal 2007. With data through 31 October 2006, our gauges now display the following scores:

Cash Management. This gauge held steady at 4 points from July to October. The Current Ratio is now 0.85. It has been stable at this level for six years. We generally would prefer to see it higher, but it's a non-issue for WMT. Inventory/Cost of Goods Sold is now 54 days. The inventory level was 46 days at the end of the prior quarter, and it was 57 days at the end of the year-earlier quarter. A review of the historical data indicates that the company always builds inventory in the October quarter for the upcoming holiday season. Therefore, the increase from the second to the third quarter is not worrisome. As a retailer, all of WMT's Inventory is product ready for sale (i.e., Finished Goods). Accounts Receivable/Revenue is 2.7 days. This value trended lower during the late 1990's and the beginning of the current decade, until it bottomed out at 1.5 days in January 2003. It has since be moving higher. The increase, although small, indicates the company ishaving more trouble getting paid by its customers.

Growth. This gauge increased 3 points from July. Revenue growth is 11 percent year over year; it has been holding steady at this level. Net Income growth is 9 percent; it has been holding steady at this modest level for the last and a half, but was significantly higher throughout much of the company's lifetime. Changes in the income tax rate have not been significant enough to have a material effect on Net Income. CFO growth jumped to a strong 25 percent; this rate is the highest in the last three years. Revenue/Assets is 223 percent; it has been trending down, but very slowly. It indicates that the company is becoming somewhat less efficient at generating sales.

Profitability. This gauge increased 1 points from July. ROIC held at a moderate 12 percent. It was also 12 percent a year ago. FCF/Equity held at 7 percent. Years ago, it was in the teens. Operating Expenses/Revenue stayed at 95 percent, which is pretty much where they have always been. Gross Margin and SG&A expenses have been remarkably constant. The Accrual Ratio, which we like to be both negative and declining, edged down to +5 percent. This tells us that more of the company's Net Income is due to CFO, in contrast to changes in balance sheet accruals.

Value. This gauge, based on the stock price of $49.28 at the quarter's end on 31 October, declined to a mediocre 11 points, compared to 14 points 3 and 12 months ago. The P/E at the end of the quarter was 17.5, up a little from recent quarters, but way below the 5-year median of 25. The decrease suggests the shares are becoming less expensive. The average P/E for the industry is 20.7. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is at an 9 percent premium to the average P/E (using core operating earnings) for stocks in the S&P 500. The premium was much higher when the company was growing at faster rate. The PEG ratio of 2.0 is indicative of a modestly expensive stock. It has been increasing slowly (i.e., becoming more expensive. The Price/Revenue ratio has steady 60 percent. The long-term trend is down, suggests the shares are becoming less expensive. The average Price/Sales for the industry is 77 percent.

Now at so-so 32 out of 100 possible points, the Overall gauge has been in the 30's for most of the last four years, with the occasional 20-something or 40 something. There is nothing in these results to suggest that the company's performance is turning a corner.

27 November 2006

BUD: Analysis through Sept 2006

It was big news, back in the Spring of 2005, when Warren Buffet bought a large stake in Anheuser-Busch (BUD). We ran the numbers to determine if we could identify what led the Sage of Omaha to make this assessment. We couldn't: the numbers were lousy. So, we passed.

Mr Buffet recently cut his stake. What do the numbers look like now? They haven't improved a bit.

Cash Management: The Current Ratio is less than 0.9. Long-Term Debt / Equity is a frightening 170%. Accounts Receivable/Revenues are up to 21.1 days from 19.8 days. One positive tidbit: Inventory is 23.7 days (relative to CGS), down from 26.8 days. We can't look at the proportion of Inventory allocated to Finished Goods because BUD has stopped reporting Inventory details in their 10-Q reports (too bad; it's a good indicator).

In a statistical oddity, Revenue Growth and CFO Growth are both a tepid 4.1%. Net Income Growth? A mere 1.0% -- it had been negative after previous quarters. Revenue/Assets has increased from 91.5 to 92.8 percent; a small step in the right direction

The Accrual Ratio is down, which is good, to 0% from 2.7%. The Return on Invested Capital was a reasonable 16 percent, but the company previously attained 20% returns. Free Cash Flow/Equity is an eye-popping 46% (but remember that debt, not equity, dominates the company's capital base). Operating Expenses/Revenues have been oh-so-slowly inching up (so much for cost control) and are now at 82%.

The PEG ratio is about 20 (we prefer somewhere around 1.0). Weak Net Income growth hasn't affected the Price/Earnings, which continues to hold around 19. Price/Revenue is down from 2.8 to 2.4. Remarkably, for a company with next to no growth, BUD commands a premium to the S&P 500.

We like their products. They're a better value than the stock. If you own the stock, you have a more compelling reason to consume the liquid version of BUD.

26 November 2006

TDW: Analysis through Sept 2006

Tidewater (TDW), a rather interesting company, leases ships to firms involved in offshore energy production. When energy prices are high, offshore production becomes more economical, demand for maritime services increases, and TDW can charge more for its vessels. Similarly, when offshore production diminishes, TDW has to work a whole lot harder to find customers for its ships.

TDW's fiscal year ends on March 31. Therefore, September 30, 2006, marked the conclusion of the second quarter of their fiscal year 2007. With the financial reports for that quarter, our financial gauges displayed the following scores:
As was the case for COP, inventory data as expressed on a Balance Sheet -- marine operating supplies, in this case -- is not meaningful to our Cash Management analysis. The Current Ratio is 4.6, which is too much of a good thing by our standards. We have to wonder why they are holding so much cash. Could it be better employed buying more ships, or buying back common stock? Long-term debt is a worry-free 18% of equity. Accounts Receivable are 95 days worth of Revenues, which would be high for most industries, but it is down from 102 days at the end of the September 2005 quarter.

Revenue growth is a healthy 34 percent (and accelerating). Net Income growth is robust 64 percent (actually down from unsustainable rates of previous quarters). Growth in Cash Flow from Operations is a remarkable 100%. The three growth rates are all year-over-year values, and do not signify a single strong quarter. Revenue/Assets, at 42 percent, is at its highest level in more than four years.

As for profitability, the Accrual Ratio is +4.9 percent (we'd prefer a negative value), but down from +7 percent one year ago. The Return on Invested Capital is 15 percent, up substantially over recent years to a level not seen since 1999. Free Cash Flow/Equity is 11 percent, also up substantially over prior years, when negative ratios were typical. Operating Expenses/Revenue is at its lowest level since 1998.

In keeping with our normal practice, the Value score was computed using the $44.19 stock price on September 30. With that price, we saw a PEG ratio of a minuscule 0.13 and a Price/Earnings ratio of 8.2. This P/E was about half of the S&P 500's P/E, whereas TDW's median P/E is an 8 percent premium to the market. Price/Revenue, at 2.4, was a discount to its median of 2.8.

Not surprisingly, TDW's stock price has advanced nicely since the end of the quarter. As we report this analysis, the stock price is 52.80 (up 19.5 percent!). Are we too late? With the current price, the Value score drops from 20 to a still-strong 17. The P/E ratio is still below 10, and the PEG is a mere 0.15. Cheap.

Potential investors will have to decide for themselves whether this performance can continue.

25 November 2006

COP: Analysis through Sept 2006

When analyzing Conoco Phillips (COP), we have to accept that the huge merger that formed the company in August 2002 obliterated the utility of the pre-combination financial statements. This was followed in March 2006 by the purchase of Burlington Resources. If we were especially motivated, we could mash together the financial statements for the predecessor companies. However, we would have no way to test the validity of the many assumptions that would be required for this time consuming exercise.

Since four-plus years have passed since its formation, we now have enough data for the 16-quarter median values that we use to put the company's current Price/Earnings and Price/Revenues ratios into a historical context. We need to be aware, however, that our gauges prior to the current period were computed with fewer data points than typical. We also have precious little data about how the Burlington acquisition might alter these values.

We also need to remember that COP's performance is driven, first and foremost, by the price of oil. If the latter rises, COP will look good irrespective of the esoteric ratios to which we give so much attention.

After the 3Q of 2006, the following scores were computed for our analytical gauges:

Because two of our five Cash Management score components, Inventory/CGS and Finished Goods to Total Inventory, don't have the significance they do for a product manufacturer (we like lean inventories for the latter), we have to rely on the other components when evaluating COP. The Current Ratio is 0.9, which might be sufficient, but it's too low to get points in our scoring system. Long-Term Debt/Equity is an ideal 30 percent, suggesting that COP isn't overextended in spite of its merger spree. Receivables are 24.6 days of revenue, up from 22.7 in September 2005, which is not the direction we prefer.

We see very good Growth in Revenue (15%), CFO (27%), and Net Income (31%). However, each of these rates are substantially less than they had been after prior quarters. Revenue/Assets, at 118%, is a concern because it is much less than the rate a year ago. We suspect that the merger with Burlington Resources increased the asset base more than it did revenues.

On the Profitability side, the Accrual Ratio reduction from 9 to 6 percent is a welcome change, but, remember, our ideal is a negative Accrual Ratio (i.e., Cash Flow exceeding Net Income). Return on Invested Capital is a reasonable 13 percent, but it was higher in 2005. FCF/Equity is a little below 7.5 percent, which is just OK. Operating expenses/Revenue at 87% have been coming down, but only by 2% per year.

Assuming a stock price of around $60 per share, the PEG ratio is mere 0.2, indicating that the stock was selling at a huge discount to earnings growth. The P/E itself is a low 6.2, which is about 40 percent of the equivalent figure for the S&P 500. However, it is in-line with historical figures. Price/Revenue is right at its median value of 0.5.

Overall, we see a profitable company with mixed and, in some cases, weakening fundamentals. We see COP strictly as a play on oil prices. If the latter increase, the resulting growth in Net Income would almost certainly be reflected one-for-one into the stock price because it's hard to see the P/E or PEG going any lower.

23 November 2006

ADP: Analysis through Sept 2006

Using the results of the quarter ending 30 September 2006, ADP's scores were:

Cash Management:10
Growth: 15
Profitability: 10
Value: 3

Overall: 31

The first three scores are good, but the overall score is dragged down by the highly weighted (45 percent) Value score. This suggests that the company's solid financial performance is already reflected in the stock price.

We should note that ADP is one company where our analytical scores have a negative correlation with stock price gains. We might not be looking at the right parameters for this service company.

Let's look at the Valuation parameters more closely. An earlier post identified the components of our Value gauge as being Price/Earnings, Price/Earnings market premium, PEG ratio, and Price/Revenue.

ADP's P/E was 23.6 on 30 Sept, which is a small plus because the P/E is slightly below its 25.8 median value. The current P/E is a 51 percent premium relative to the S&P 500, which is a trivial amount below its 55 percent median premium. The PEG ratio is 2.1, which is too high to signal a value play. The current Price/Revenue is 2.9, which is not enough below its 3.2 median to get our attention.

PEP: Analysis through Sept 2006

We used PepsiCo in numerous posts of this blog to illustrate the organization of financial statements, how we evaluate these statements, and our gauges to depict the analysis results in a simple, easy-to-understand way.

In this post, we have consolidated the analysis results for PEP. It was performed using financial data through the quarter ending in September 2006.

Cash Management gauge read a mere 3.5 out of 25 possible points. The Current Ratio was 1.3, which is rather low. We don't consider this to be a problem because the company has long thrived with a low Current Ratio. On the other hand, LTD/Equity at 16 percent is nearly ideal. This debt ratio was higher in previous years, when the company was digesting acquisitions. Inventory levels, as measured by Cost of Goods Sold, stood at 46.2 days. This is in line with historic levels, but we're a little concerned that Inventory increased by 6.5 percent from the year-earlier quarter. The percentage of Inventory that is product ready for sale (i.e., Finished Goods) edged up from its historic average. This bears watching because it might presage a sales slump. Accounts Receivable/Revenues has been increasing. If we knew the Chief Financial Officer, we would ask why.

The Growth gauge displays an excellent 19 of 25 possible points. Year-over-year Revenue Growth was 11.5 percent, and Net Income Growth was an impressive (and accelerating) 27 percent. The Net Income growth was helped by non-recurring taxes in the earlier year. Also impressive was an increase in Revenue/Assets from 101 percent to 108 percent. The growth story was only marred by a 5.2 percent drop in CFO.

The Profitability score was 9 of 25 possible points. The ROIC was 26.4 percent, significantly above the 21.5 percent at the end of the September 2005 quarter. FCF/Equity was a healthy 22.0 percent, but down from the year-earlier 31.3 percent. Operating Expenses/Revenue have edged up in a year from 80.9 percent to 81.3 percent. The expense ratios have been remarkably constant at PepsiCo for many years. The Accrual Ratio was +4.5 percent at the end of the last quarter, compared to -1.6 percent at the end of the year-earlier quarter. This is disappointing on the basis of the absolute value of the Accrual Ratio -- negative value are better than positive -- and its direction.

The Value gauge score was 4 of 25 possible points. The P/E at the end of September was 22.2, which is below the 23.6 median value (suggesting some room for expansion). The current P/E corresponded to 1.42 (42 percent) premium relative to the S&P 500; since this is greater than PEP's 1.28 historical premium, no value points are earned. More promising, the PEG ratio of 22.2/26.8 = 0.83 is indicative of value for a growing company. The Price/Revenue ratio was 3.16, which exceeded its median value of 3.01.

These gauge scores translate into a tepid Overall score of 29 points out of 100. From the chart below, showing the scores over time, we see that the Overall score bounced due to an increase in Growth. This is all well and good, but without increases in the other scores, we would suggest caution. If the stock price were to drop, which would push up the Value score, we would re-assess to see if the Growth and Value combination presented an appealing scenario for the future.

For PEP, the correlation between the Overall Score and price appreciation over the next 12 months is a rather high 0.68. The financial data that correlated best with price appreciation were Receivables/Revenue, Revenue/Assets, and the Value metrics other than PEG. Interestingly, Revenue Growth shows a strong negative correlation with price appreciation. We see this often and find it difficult to explain.

The Overall Gauge

We've separately discussed the four category gauges: Cash Management, Growth, Profitability, and Value.  Each gauge displays a score between 0 and 25.

The Overall Gauge score is a weighted average of the category gauge scores, with an adjustment made to scale the result to a range between 0 and 100 points.

The weights are listed below:
  • Cash Management: 20
  • Growth: 10
  • Profitability: 30
  • Value: 40

The Overall score is:

    = 4 * [(sum of (scores * weights)] / (sum of weights)

Because we are very stingy when awarding points, an Overall score, in general, above 50 is decent, 60 is very good, and 70 is excellent.  The highest scores we have observed have been in the low 80's.

We also consider a change in the Overall Gauge score to be significant.  While a 40-point score is, by itself, mediocre, we would deem a rise from, say, 20 to 40 points to be a favorable outcome.

In weighting the various metrics that drive each category gauge, and in weighting the category gauge scores to compute the Overall Gauge score, we have used heuristics to align the results with future share price appreciation.  The highest-weighted scores are those that have historically correlated reasonably well with 12-month share price growth for a variety of companies. 

We've seen some good correlation coefficients, as high as 0.8, for some companies, but the correlations are much weaker or even negative for other companies. 

In other words, our scores are meaningful for some companies and less so, or not at all, for others.  We urge readers to look beyond the rolled-up scores to the individual performance and value metrics and draw their own conclusions. 

This post was last modified on 27 June 2009.

04 November 2006

The Value Gauge

The Value gauge score depends on the current and past values for the following metrics:
The gauge value is determined by calculating a score for each of the five items listed above and described below.  A weighted average of the scores is scaled to set its minimum value at zero and its maximum value at 25 points.

Please note there is an overriding zero-point floor and a five-point ceiling for each score component.

Trailing Price/Earnings

A company's Price/Earnings ratio will fluctuate based on investors' assessment of its future prospects.  A sign investors may be undervaluing the company is a P/E at, or below, the low end of the historic range for that company.  Similarly, higher-than-normal P/E values might be an indication of excessive optimism among investors.

A company gets Trailing P/E value points when its current P/E ratio is less than its median value over the last 16 quarters.

Score = (-10) * [(P/E) / (Median P/E)] + 10

If the P/E is 50 percent of its median value, or less, the company gets 5 points.

Trailing Price/Earnings vs. S&P 500 P/E

Company-specific news, such as the success or failure of a new product, will understandably lead to swings in the company's Price/Earnings because it is clear that earnings will grow more or less robustly as a result.  However, changes that affect all companies in an industry or all companies that operate in a particular market can also significantly influence future earnings and, therefore, P/E ratios.

For example, rising interest rates tend to slow economic activity, reducing sales and profits, and also cut the present value of future earnings.

Comparing a company's P/E ratio to the P/E ratio of the overall market, as represented by the S&P 500 index, is one way to filter out the broader factors that affect valuations. When a company's P/E is, say, 10 percent higher the S&P P/E, the company's shares are said to trade at a 10 percent premium to the market.  Similarly, a company P/E that is only 90 percent of the market P/E represents a 10 percent discount.

A lower-than-normal premium, or a greater-than-normal discount, could be indicative of an undervaluation.  We award value points when the ratio of the company's P/E to the market's P/E is less than its median value over the last 16 quarters.

Score = (-10) * [(Current P/E relative to S&P) / (Median P/E relative to S&P)] + 10

If a company's current P/E is 80 percent of the S&P 500's P/E (i.e., a 20 percent discount), but the median ratio is a 10 percent premium, then the score would be:

(-10) * [(0.8) / (1.1)] + 10 = 2.7 points

Many investors consider a low PEG, which indicates that the Price/Earnings is modest relative to earnings growth, to be an important sign of undervaluation. 

The PEG ratio is found by dividing the P/E ratio by the earnings growth rate in percent.  For example, the PEG would be 1.0 when the P/E is 12 and earnings are growing by 12 percent.

The PEG is especially useful if the denominator is the rate the company's earnings will grow in the future.  At GCFR, we're leery of projected earning growth rates, we don't assign any credibility to published five-year forward growth rates.

We've used to the trailing one-year earning growth rate in our PEG calculations, but we have been unsatisfied by the results.  One-time gains and losses make the PEG values erratic.

Instead, after much experimentation, we've settled on using the four-year average rate of growth in Operating Profit after Taxes as the earnings growth rate in the PEG calculations.

We award value points when the PEG is low as determined by this equation:

Score = 5 - [4*(PEG-0.75)]

As usual, the score is limited to a range between 0 and five points.

A PEG less than or equal to 0.75 earns the full five points, and PEG ratios greater than 2.0 get none.

A lower-than-normal Price/Revenue ratio may also be a sign value.  For this reason, we give the company value points when its Price/Revenue ratio is less than its median value over the previous 16 quarters.

Score = (-10) * [(Price/Revenue / (Median Price/Revenue)] + 10

If the Price/Revenue is 50 percent of its median value, or less, the company gets 5 points.

Enterprise Value/Cash Flow
Enterprise Value/Cash Flow is similar to Price/Cash Flow from Operations, but it substitutes Enterprise Value for Market Value.

Enterprise Value is Market Value, plus Debt (long- and short-term), minus the company's Cash and Short-term Investments.  EV is considered a better estimate of the cost to a corporate acquirer than the Market Value because the acquirer is assuming the debt, less any cash on hand that can be used to pay off the debt.

We give the company value points when its EV/CFO ratio is less than its median value over the previous 16 quarters.
Score = (-20) * [(EV/CFO / Median EV/CFO)] + 20

The five-point maximum score is attained when the EV/CFO ratio is 75 percent or less than its median value.

Determining the Value Score
We use the following weights for the different Value score components.

The Value score is 5 * (the sum of each component's score multiplied by its weight) / (100, the total of the weights).

Note: This post was last updated on 1 August 2010.

02 November 2006

The Profitability Gauge

The Profitability gauge score depends on the current and past values for the following quantities:
The Income Statement has the greatest effect on the Profitability gauge, but data from the Balance Sheet and the Cash Flow Statement are also employed.

The Profitability gauge is determined by calculating a score for each of the four quantities listed above.  A weighted average of the scores is scaled to set its minimum value at zero and its maximum value at 25 points.

We're tough graders: it's rare for a company to achieve a 25-point Profitability score.

The scoring details are described below.  Please note there is an overriding zero-point floor and a five-point ceiling for each ratio.

Operating Expenses/Revenue Score

We give points for reducing the Operating Expenses/Revenue ratio over the course of a year.

Score = (50)*(decrease in Operating Expenses / Revenue),

The ratio is expressed as a decimal.  An increase in the ratio from one year to the next automatically gets zero points.
The five-point maximum is obtained when the reduction is 10 percent:  (50) * (0.1) = 5.

In our sample Income Statement, GCFR Inc.'s ratio of Operating Expenses / Revenue decreased from 25.2 percent to 24.7 percent.  This 0.5 percent decrease would earn (50) * (0.005) = 0.25 points.

Return on Invested Capital Score

There are two components to the ROIC score. The first component, which we cap at 4 points, is:

Score = 16 * ROIC

The ROIC is expressed as a decimal.  Note that the four-point limit is hit when ROIC hits 25 percent (0.25).

The second component is a one-point bonus that is awarded only if the ROIC for the last four quarters exceeds the ROIC for the four previous quarters.

In our sample Income Statement, GCFR Inc.'s ROIC was 8.8 percent.  This performance merits 1.4 points (16 * 0.088), with the possibility of one-point bonus.

FCF/Invested Capital Score

There are two components to the Free Cash Flow/Invested Capital score. The first component, which we cap at 4 points, is:

= 16 * (FCF/Invested Capital)

Note that the four-point limit is hit when FCF/Invested Capital hits 25 percent (16) * (0.25) = 4.

The second component is a one-point bonus when the FCF/Invested Capital for the last four quarters exceeds the FCF/Invested Capital for the four previous quarters.

In our sample Cash Flow Statement, GCFR Inc's FCF/Equity was 12.7 percent.  This performance merits 2.0 points (16 * 0.127), with the possibility of one-point bonus.

Accrual Ratio Score

Recall that the Accrual Ratio is proportional to the difference between Net Income and CFO.  A negative Accrual Ratio indicates that CFO exceeds Net Income, which is suggestive of high-quality, operations-driven earnings.

Our score for the Accrual Ratio has two components: the first is proportional to the ratio's value, and the second is proportional to the ratio's change from the previous year.

The first component of this score, worth 2.5 points, is determined by the following equation:

Score = 0, if the Accrual Ratio is positive

= (-50) * Accrual Ratio, if the Accrual Ratio is negative.

The 2.5-point cap is hit when the Accrual Ratio is -5.0 percent or lower.

The second component of this score, worth another 2.5 points, is determined by this equation:

Score = 0, if the Accrual Ratio is higher than it was one year ago

=50 * (decrease in Accrual Ratio), if the Accrual Ratio has dropped

If the Accrual Ratio dropped from -0.5 percent to -1.2 percent, the score would be:

(-50)*(-0.012) + (50)*(0.007) = 0.95 points.

Determining the Profitability Score

We use the following weights for the different Profitability score components.

The Profitability score is 5 * (the sum of each ratio's score multiplied by its weight) / (100, the total of the weights).

Note: This post was last updated on 1 August 2010.