25 December 2006

INTC: Analysis through Sept 2006

Down about 20 percent in 2006, Intel was the worst performer in the Dow Jones Industrial Average in a year that turned out to be pretty good for stocks. It will get attention as a rebound candidate from those that subscribe to the Dogs of the Dow theory. Is there evidence to support an expectation of a bounce back? As explained below, we don't see it in the financial results through the quarter ending in September 2006.

Cash Management. Intel's cash management gauge reads 6 out of 25 possible points. When we dig into this, we see that the points reflect the company's first-rate financial strength, rather than operating efficiencies. We don't need to worry for a nanosecond about this company's creditworthiness, but we'll note for the record that the current ratio is a solid 1.94. This figure is down somewhat from previous years, probably because the company has been using its cash hoard for capital investments and to buy back stock. Long-term debt to equity is a scant 6 percent, which might be surprising given how expensive it is to build and retool chip foundries. Accounts receivable are 34 days of revenue, which is down a bit (good) from recent levels. On the other hand, and this is important, the company is holding 101 days of inventory, as measured by the cost of goods sold. This is the highest inventory level in 10 years and far above the five-year median value of 67 days. When coupled with the fact that finished goods constitute 37 percent of inventory, which is at the upper end of its historic range, we can't be optimistic about future revenue growth and pricing power.

Growth. The growth metrics are horrible, with the company undeserving of a single point of the 25 possible on the growth gauge. Revenues are down 6 percent year-over-year. Cash flow from operations is down 33 percent. Net income is down 28 percent. Revenue/assets is 77 percent, down from 81 percent a year ago, but within the historic range.

Profitability. Also dismal. This gauge reads 5 out of 25 points. The accrual ratio is +4 percent. A negative number is preferred for this ratio, and it was negative for Intel a year ago. The return on invested capital in 17 percent, which is the slimmest ROIC figure in the last 3 years. At 12 percent, free cash flow to equity has taken an even steeper decline. And, to put the final nail in the coffin, a 79-percent ratio of operating expenses to revenue is 10 percentage points higher than a year ago.

Valuation. A sad 4 of 25 possible points. This suggests that the fall in the stock price hasn't been painful enough to account for the poor operating performance. Since net income is contracting, the PEG ratio is meaningless. The trailing P/E ratio is 20, a 30 percent premium to the market, which is odd unless one knows of a reason (Vista?) to believe future earnings growth will outpace the market. Price/Sales, down to 3.3, is the one sign of value; it suggests that a turnaround in revenues might translate into a stock price gain.

Overall. Rolling up all of the above, the overall gauge stands at a weak 16 out of 100 possible points. It's almost sad to see how fast this once-mighty bellwether has fallen. However, the semiconductor market is notoriously cyclic. Intel has bounced back before from bad market conditions. Will there be early warning signs of a comeback? We would look first at the total inventory level and then at the finished goods component of the total inventory. A drop in these figures, assuming no inventory write-down, would indicate an uptick in demand for the company's products.

24 December 2006

HD: Analysis through Oct 2006

In a remarkably short period of time, Home Depot has morphed from a premier growth stock to a potential value stock. The shares can't seem sustain a price rise no matter how many billions the company spends on buybacks, nor how many times they hike the dividend.

Unfortunately, the reasons for optimism are few indeed. One possibility raised in the media (and quickly denied) was that a hedge fund or two might offer to buy the company. A cynic might believe this rumor was floated by short-term traders looking to boost the stock price for quick profit. We'll see.

Cash Management. This gauge reads 5 points of the 25 possible. The current ratio was a mere 1.17 after the quarter ending in October. Accounts receivable to revenue were 15 days, whereas receivables were reliably less than 10 days from 1994 to 2004. The company is holding 83 days worth of inventory, as measured by cost of goods sold. Inventory levels have been edging up modestly. Against the same measure, Wal-Mart has about 50 days of inventory. At least debt is under control: we consider the LTD/Equity value of 24 percent to be ideal. To be fair, there's no evidence to suggest that improvements to any of the cash management parameters would translate into stock price gains. In fact, we see the opposite situation. The cash management score has a negative correlation with stock price performance.

Growth. The growth gauge also stands at 5 out of 25 possible points. While revenue increases of 14 percent does not a growth stock make, it is, at least, better than more anemic results over the last few years. Revenue/assets equals 1.71, continuing a long trend of less efficient use of resources. While the company brings in more than $6 billion of operating cash flow every 4 quarters, the amount has been more or less static for more than four years. Net Income growth had been a better story, but the weak 9 percent year-over-year growth seen in the latest results is troubling.

Profitability. Only 7 of 25 points here. The accrual ratio is +6 percent (negative values are ideal). This can be attributed to the failure to increase cash flow from operations. We have no particular complaint with 18 percent return on invested capital other than that we were seeing values in the low 20 percents not that long ago. You can probably guess that there is nothing in the free cash flow to equity value of 11 percent to get us excited. The same is true for the operating expenses to revenue figure, which is stuck at 89 percent.

Value. All of the preceding was insignificant, compared to the Value gauge. Of the four gauges, it is the only one that correlates well (correl. coeff. = 0.6) with Home Depot's stock price. The current score of 12 of 25 points reflects how inexpensive the stock has become, but it's not a raging buy sign. The PEG ratio is 1.33 (using the 31 Oct stock price of $37.33, per our custom). The trailing P/E was 12.5. Price/revenue was 0.85. And, the P/E was only 78 percent of the S&P 500 P/E.

Overall. The overall gauge, after the October 2006 quarter, reads 34 out of 100 possible points. When the score bumped up to 45 after the July 2006 quarter, we were hoping October's results would show a confirmation that HD had turned the corner. We were disappointed.

11 December 2006

KG: Analysis through Sept 2006

King Pharmaceuticals develops, manufactures, and markets a diverse array of pharmaceutical products. Over the last few years, KG has had its share of problems, including Medicaid overcharge allegations, inventory write-downs, financial restatements, and a proposed merger with Mylan Labs that fell apart after Carl Icahn raised objections.

Our analysis indicated that King turned the corner in the second and third quarters of 2005. The scores shown on the Overall gauge were in the upper 70's at the conclusion of both of these two quarters, after having been in the 20's three previous quarters. [The stock price on 30 June 2005 was $10.42, and it was around $17 most of 2006.] The scores then cooled off to around 50 points at the end of 2005 and beginning of 2006.

As will be shown below, the scores dropped further when we looked at King's results from the quarter that ended on 30 September 2006.

Cash Management: The Current Ratio was a solid 2.65, its highest level in about three years. Long-Term Debt/Equity was an affordable 18 percent; the debt ratio has been between 17 and 20 percent for most of the last several years. Accounts Receivable/Revenue have also been stable at around 50 days. The big news of the September quarter was that Inventory/CGS dropped to 179 days; this was the first time the Inventory level went below 200 days since March 2003. The Finished Goods percentage of Inventory was 30 percent, which was consistent with historical data.

Growth: Revenue growth decelerated to 12 percent year over year; the growth rate had been much higher the five previous quarters. Net Income dropped 30 percent over this period, but the results were skewed by special charges. Operating Profit was actually up 24 percent. Cash Flow from Operations was 19 percent less than during the previous year. Revenue/Assets was 58 percent, down a little from recent quarters, but much higher than the historic average.

Profitability: The ROIC was 16 percent, down from a strong 20 percent one year earlier. FCF/Equity was (coincidentally) also 16 percent, and it had also weakened from the year-earlier value. Operating Expenses/Revenue was 68 percent; this value had been going down, but might have stabilized. The Accrual Ratio was a nice -6 percent, suggesting high quality earnings, but King often has even better values for this parameter.

Value: It's not easy to establish a baseline for King's valuation metrics because its earnings have been on a roller coaster. At the end of September, the P/E was 26.3, about a 70 premium above the P/E for the S&P 500. We also don't get any insight from the PEG ratio, since negative earnings growth makes the PEG not applicable. Since Revenue is more stable than earnings, we can learn a more about the valuation from the Price/Revenue. At 2.18, it is inline with recent quarters and down quite a bit from the company's salad days.