Enhancing the Cash Management Gauge

We have used the following five ratios, mostly derived from the Balance Sheet, to calculate the Cash Management Gauge:

• Current ratio
• Long term debt / Equity
• Inventory /CGS
• Finished Goods / Total inventory
• Receivables/Revenue

The two ratios involving Inventory are overweighted, relative to the other three figures, such that Inventory influences half of the Cash Management gauge score. The overweighting reflects our belief that Inventory data can reveal much about current and future business conditions at manufacturing companies and how deftly corporate managers are handling these conditions. Manufacturers buy raw materials, fabricate or assemble these items, and output finished goods for sale. The various components of Inventory give us insight into each step.

A microsecond of further thought suggests that services such as financing, marketing, and transportation are also important. Banks, advertising firms, and shippers have, to name three, long provided services to manufacturers and other companies. Today, work that manufacturers traditionally performed in house, such as design or payroll processing, is being contracted out to specialty service firms.

Service firms, such ADP (IT services) and TDW (marine services), might have capital equipment in abundance, but they don't have Inventory in the same sense as manufacturers. The notion of Inventory also differs when we consider retailers (all inventory is product ready for sale), energy companies (inventory value varies with commodity prices), electric utilities (the final product is hard to store), and software companies (the raw material is intellectual property).

It should be clear from the preceding that an inventory-weighted Cash Management gauge is less applicable, to one extent or another, to service companies than manufacturers. Not surprisingly, we've seen the gauge behave erratically when evaluating service companies.

In an attempt to address this problem, we have identified three additional cash management ratios as candidates to broaden the gauge calculations. We will experiment with these parameters when analyzing second quarter financial statements. We will then evaluate each candidate to determine if it added to the analysis process or not.

The three candidate ratios are:

Working Capital / Market Capitalization. We learned about this ratio from the Motley Fool. Working Capital is Current assets minus Current Liabilities. Market Capitalization is Market Value + Debt. Market capitalization is, therefore, an approximation for the true cost to an acquirer. A greater percentage of working capital would presumably be attractive to the acquirer. For this reason, the ratio might also be considered for the Value Gauge.

Debt/CFO. The ratio indicates how many years of operating cash flow are required to pay off the company's short-term and long-term debt.

Cash Conversion Cycle (CCC) Time. This one is a little complicated, but it is well explained here. Short CCC times indicate that the company is using its working capital efficiently. The CCC time is the sum of days of inventory [Inventory/(CGS/day)] and days of sales outstanding [Receivables/(Revenues/day)], less days of purchases outstanding {Accounts payable / [(CGS+ increased inventory)/day)]}. Note that the first two terms show the company consuming working capital for inventory held and sales for which customers haven't yet paid. We subtract the working capital the company is "saving" by not yet paying for its own purchases.

In computing the Cash Management gauge score, we're going to give 1 point for each 2 percent reduction in the CCC time, each 2 percent reduction in Debt/CFO, and each 1 percent increase in Working Capital to Total capitalization. As we gain more experience with these ratios, it is likely that we will adjust the scoring.

We will weight our five original and three new ratios, relative to each other, as listed below:

• Current ratio: 5
• LTD/Equity: 10
• Finished Goods/Inventory: 20
• Receivables/Revenue: 17.5
• Inventory/CGS: 5
• Working Capital / Market Capitalization: 22.5
• Debt/CFO: 10
• Cash Conversion Cycle Time: 10

If a ratio doesn't apply to a particular company under analysis, the weight for that ratio will be zero.

BP: Financial Analysis through March 2007

We have analyzed BP p.l.c's (BP) financial results through the quarter 31 March 2007. This post reports on our evaluation.

BP, the former British Petroleum, is the Integrated Oil and Gas company with the third-most sales and the fourth largest market capitalization in the world. BP became a behemoth by acquiring Amoco, Arco, and other companies. Significant problems over the last two years have cast a negative light on the company. A fatal explosion in 2005 at a BP refinery in Texas was followed by a major leak and pipeline corrosion in Alaska, where BP operates the Prudhoe Bay field. These events led to fears BP was not safely maintaining its properties and equipment. The bad news also did much damage to the green image the company has been cultivating in its marketing.

In 2006, BP began reporting its results in accordance with International Financial Reporting Standards (IFRS) as adopted for use by the European Union. Previous finance statements complied with UK Generally Accepted Accounting Principles. The differences between these two approaches makes it difficult to identify historic norms to which current results can reasonably be contrasted. Comparability is also complicated by significant corporate acquisitions and divestitures, such as the $9 billion sale in December 2005 of a chemical business. However, we have to give credit to BP for putting enough consistent financial data on their web site for us to feel confident in using the results from the last 13 quarters.

As best we can determine, with the available data from periods through the March 2007 quarter, our gauges display the following scores:

• Cash Management: 10 of 25
• Growth: 3 of 25
• Profitability: 5 of 25
• Value: 6 of 25
  

• Overall: 23 of 100

Cash Management. The Current Ratio is now 0.98, which is weaker than we like (not that we're questioning this blue chip's creditworthiness). The ratio has been stable at this level, with no sign of deterioration. Long-Term Debt/Equity is a mere 14 percent. The debt ratio bottomed out at 12 percent last year, probably as a result of the sale of the chemical business. We don't factor inventory data into the scoring of oil companies, because we're not sure inventory levels reveal much about current or future sales -- we need to study this. However, we'll note for the record that Inventory/Cost of Goods Sold at BP are now 34 days, and the inventory level as determined by this measure has declined from 40-plus days in 2005. Accounts Receivable are 54 days of Revenue, which improved on the 58-day level one year earlier.

Growth. Revenue growth is a weak 5 percent year over year, down from 26 percent a year ago. Given the current high prices for oil and oil-related products, we have to suspect poor operations hampered revenue growth. Net Income declined 3 percent year over year; a year ago, earnings were up moderate 13 percent. To be sure, net income was adversely affected by an increase in the effective income tax rate from 31 to 36 percent. CFO growth is a tepid 4 percent, although up from 2 percent a year ago. Revenue/Assets is 1.22. This parameter has been stable for the last year, but it's up compared to values near 1.0 in 2005. It's hard to tell, but we suspect that the increase is less about improved efficiency at generating sales and more about reduced assets after divestitures and stock repurchases.

Profitability. ROIC slipped to a moderate 15 percent from 21 percent a year ago. FCF/Equity edged down to 14 percent from 17 percent. Operating Expenses/Revenue moved up in the last year from 88 percent to 91 percent. The change was primarily due to a 2-percent decline in Gross Margin. The Accrual Ratio, which we like to be both negative and declining, didn't move off of +4 percent. This tells us that no more of the company's Net Income is due to cash flow, which is considered higher quality than non-operational balance sheet accruals.

Value. BP's stock price fell over the course of the quarter from $67.10 to $64.75, although it has since made up that ground. The P/E at the end of the quarter was 9.8, which was essentially unchanged from recent quarters. The average P/E for the Integrated Oil and Gas industry is a more expensive 10.9. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is about 62 percent of the average P/E, using core-operating earnings, of stocks in the S&P 500. The current discount to the market multiple is a few percent greater than the average for BP over the last few years. The discount tells us that the market is expecting the company's earnings to grow slower than the average company. With declining earnings, the PEG ratio is N/A. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has declined to 0.79 from 0.94 one year earlier. The decrease suggests the shares have become somewhat less expensive. The average Price/Sales for the Integrated Oil and Gas industry is 1.1.


Now at a disappointing 23 out of 100 possible points, the Overall gauge has slipped over the last few quarters from scores in the mid-40's. While the shares appear to be inexpensive, shortfalls in BP's operational shortfalls have had material adverse effects in their finances. Revenue growth has been weak, the gross margin and other profitability measures have declined, earnings are down, and increases in cash flow from operations have been minimal.

TDW: Financial Analysis through March 2007

We have updated our analysis of Tidewater's (TDW) financial results for the fiscal year and quarter ending on 31 March 2007 to address the data reported to the SEC on Form 10-K. Our evaluation, adjusted to account for a handful of minor changes to the Balance Sheet and Cash Flow Statement, is reported in this post.

Tidewater, which is in the Oil Well Services and Equipment business, claims to own the world's largest fleet of vessels serving the global offshore energy industry.

When energy prices are high, offshore production becomes more profitable, demand for maritime services increases, and Tidewater can charge higher leasing rates. Similarly, when offshore production diminishes, the company has to work harder to find customers for its ships.

When we analyzed Tidewater after the results from December 2006 became available, the Overall score was a superlative 75 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 22 points. Cash Management was weakest, if you can call it that, at 15 points.

The following table shows how the data for the March quarter, in millions of dollars, compared to our expectations:

	Actual	Predicted
Revenue	$294	$291
CGS	$137	$146
Depreciation	$30	$35
SG&A	$26	$29
Operating income	$100	$82
Other income	$10	$10
Net income	$88	$69
EPS	$1.56	$1.21

Tidewater clearly did a better job at keeping their costs under control than we had hoped.

With the available data from the most recent quarter, our gauges now display the following scores:

• Cash Management: 9 of 25
• Growth: 22 of 25
• Profitability: 15 of 25
• Value: 18 of 25
  

• Overall: 66 of 100
  

Cash Management. This gauge dropped 6 points from 15 to 9. This seemingly large change is not as significant as it first appears. It was the result of a small change in Accounts Receivable/Revenues. With Inventory data not meaningful for Tidewater, changes to the other Cash Management parameters get amplified. Since Cash Management only contributes 15 percent to the Overall Gauge calculation, the overemphasis of one change isn't important. The Current Ratio, has now increased to an oddly high 5.0, which by our standards is too much of a good thing. Maybe the company is keeping the till full of cash to pay for the new vessels scheduled for delivery this year and next. If so, we would view the transformation of low-return financial resources into productive assets as a positive step. Long-Term Debt/Equity has been reduced to a manageable 16 percent; therefore, debt could be tapped for capital investments. The debt ratio has steadily declined since it hit 28 percent in September 2004. Accounts Receivable/Revenues equal 93 days, up from 91 days last quarter. These levels would be considered very high for many companies, but it happens to be the long-term average at Tidewater.


Growth. This gauge held onto December's strong 22 points. Revenue growth is now 28 percent year over year, about the same as a year ago, although the growth was more robust in the earlier quarters of the year. Net Income growth is an explosive 51 percent year over year, yet down from the even-more spectacular 133 percent a year ago. The increase significantly benefited from a change in the income tax rate from 27 to 21 percent. CFO growth is an impressive 46 percent, down from a tremendous 86 percent a year ago. Revenue/Assets is now 42 percent, having moved up from 31 percent in the last two years. The uptrend, which signifies improved efficiency, seems to have reached a plateau.

Profitability. This gauge dropped 3 points from the 18-point level in December. ROIC grew to a healthy 17 percent from 10 percent a year ago, continuing a two-year series of increases. FCF/Equity edged up to 11 percent from 8 percent. Operating Expenses/Revenue moved down in the last year from 74 percent to 65 percent, and these expenses are now the lowest they have been since 1998. The change was primarily due to an increase in Gross Margin of 6 percent. The Accrual Ratio, which we like to be both negative and declining, moved in the wrong direction from 5 percent to 6 percent. This tells us that a bit less of the company's Net Income is due to cash flow, and, therefore, more is due to changes in non-operational balance sheet accruals.


Value. Tidewater's stock price rose significantly over the course of the quarter from $48.36 to $58.58, and it has continued to increase. The Value gauge, based on the 31 March price, dropped to a still-strong 18 points, compared to 20 and 11 points three and twelve months ago, respectively. The P/E at the end of the quarter was 9.2, which is consistent with recent quarters, but only half of the five-year median value. The decrease in P/E indicates the shares have become much less expensive, even though the share price has increased. The average P/E for the Oil Well Services & Equipment Industry is also a more expensive 18. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is 40 percent below the average P/E, using core-operating earnings, for stocks in the S&P 500. The company's P/E has been a significantly below the market's P/E in recent years, but this wasn't always the case. Companies tend to trade at a discount when their growth rates are lower than average, or when the growth rates are unlikely to be sustained. The PEG ratio of 0.18 is indicative of a dirt-cheap stock. The PEG has been strangely low for a long time, suggesting that the market is expecting the earnings growth rate to decline precipitously. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, is 2.9. Since the average Price/Sales for the Oil Well Services & Equipment Industry is 3.7, Tidewater seems less expensive than its peers by this measure.


Now at a very good 66 out of 100 possible points, the Overall gauge has dropped off its recent highs. Tidewater's operations are performing exceptionally well. The stock price, which has run up significantly, still seems to hold a lot of value.

CSCO: Financial Analysis through April 2007

We have updated our analysis of Cisco Systems' (CSCO) financial results for the quarter ending on 28 April 2007 to address the data reported to the SEC on Form 10-Q. Our evaluation, adjusted to account for new information, is reported in this post.

Cisco, the proud plumber of the Internet, has a commanding position in the market for enterprise-level networking devices. After acquiring Linksys and, more recently, Scientific Atlanta, Cisco now also sells devices intended for home use. Cisco shares move up nicely in the second half of 2006, but the stock price has vacillated in a narrow range around $27 this year.

When we analyzed Cisco after the results from January 2007 became available, the Overall score was a modest 27 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 14 points. Value was weakest at 1 point.

Now, with the available data from the April quarter, our gauges display the following scores:

• Cash Management: 12 of 25
• Growth: 24 of 25
• Profitability: 13 of 25
• Value: 4 of 25
  

• Overall: 41 of 100
  

Cash Management. This gauge increased 3 points from 9 points in January. The Current Ratio is now 2.6, which is a sign of strength. It has been inching up during the last two years. Long-Term Debt/Equity is a manageable 23 percent. The debt ratio was 24 percent in January and 26 percent in April 2006. Inventory/Cost of Goods Sold dropped substantially to 39 days from 52 days three months ago. This surprisingly large drop in inventory was almost entirely the result of a massive $323 million reduction in work-in-process. Raw materials, finished goods, and other inventory changed by much smaller amounts over the quarter. Did Cisco cut back on production because they are expecting sales to slow? Even though Finished Goods inventory dropped in absolute terms, it increased as a percentage of total inventory from 48 to 58 percent. Accounts Receivable are 35 days of Revenue, which is in line with its average value.

Growth. This gauge increased a hefty 10 points from 14 points in January. Revenue growth is now 24 percent year over year, up from 12 percent a year ago. Net Income growth is a vibrant 25 percent, up from flat levels a year ago. The increase benefited from a change in the income tax rate from 27 to 23 percent. CFO growth is a solid 21 percent, up from 13 percent a year ago. Revenue/Assets is 69 percent. The acquisition of Scientific Atlanta had lowered this parameter in early 2006, but some ground has since been regained.

Profitability. This gauge increased 1 point from the prior quarter's 12 points. ROIC grew to a healthy 23 percent from 20 percent a year ago. FCF/Equity held steady at 30 percent. Operating Expenses/Revenue stayed at 74 percent. Gross Margin edged down a couple percentage points, but reductions in other expenses softened the blow. The Accrual Ratio, which we like to be both negative and declining, moved in the wrong direction from -4 percent to -3 percent. This tells us that a little less of the company's Net Income is due to cash flow, and, therefore, a little more is due to changes in non-operational balance sheet accruals.

Value. Cisco's stock price rose a fraction over the course of the quarter from $26.62 to $26.74. The Value gauge, based on the latter price, increased to 4 points from 1 point three months ago, but down from 7 points twelve months ago. The P/E at the end of the quarter was 24, which is about the same as the average P/E for the Computer Peripherals industry. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is 45 percent greater than the average P/E, using core operating earnings, of stocks in the S&P 500. This premium to the market multiple is not unreasonable for Cisco, with its prodigious growth rate, but the premium averaged closer to 35 percent over the last 10 quarters. The PEG ratio of 1.0 is indicative of an inexpensive stock. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has been stable at 5.0. The average Price/Sales for the Computer Peripherals industry is 3.75.


Now at a modest 41 out of 100 possible points, the Overall gauge has recently bounced back. In summary, the recent quarter showed strong growth and steady (but not really improving) profitability. The Value gauge is troubling, as is the apparent reduction in production suggested by the inventory data.

EIX: Financial Analysis through March 2007

We have analyzed Edison International's (EIX) financial results, as reported to the SEC on Form 10-Q, for the quarter ending on 31 March 2007. This post reports on our evaluation.

Edison is the parent of Southern California Edison and other companies that generate or distribute electricity or that provide financing for these activities. Edison, which traces its roots back to 1886, is one of the largest investor-owned utilities in the U.S.

In the late 1990s, the State of California deregulated the electric industry, which, due to loopholes and questionable practices, led to the famous power crisis in the early years of this decade. Edison managed to skirt bankruptcy during the debacle, and its stock price has recovered dramatically from a low point in 2002 under $8.00.

When we analyzed Edison after the results from December 2006 became available, the Overall score was a weak 20 points. Of the four individual gauges that fed into this composite result, Cash Management was the strongest at 16 points. Value was weakest at 0 points.

Now, with the available data from the March 2007 quarter, our gauges display the following scores:

• Cash Management: 1 of 25
• Growth: 10 of 25
• Profitability: 13 of 25
• Value: 2 of 25
  

• Overall: 23 of 100
  

Cash Management. This gauge dropped 15 points from an artificially inflated 16 points in December. The Current Ratio is now 1.3, and it has been stable at this level since September 2004. Long-Term Debt/Equity is a leveraged 102 percent, which might seem high, but it is not excessive for the Electric Utility industry. The debt ratio, which has been declining for almost three years, was 106 percent in December and 116 percent 12 months ago. Accounts Receivable are 27.0 days of Revenue, up a fraction from 26.7 days one year earlier. [This analysis, as a few others have before, indicates that we need to tweak the scoring of the CM gauge for non-manufacturers to prevent excessive quarter-to-quarter changes. The score for EIX this quarter was low because a couple of the parameters didn't improve, not because of problems.]

Growth. This gauge increased 4 points from 6 points three months ago. However, this positive move change wasn't because of Revenue growth, which declined to 5 percent year-over-year from 15 percent a year ago. Net Income growth is a solid 12 percent, but down from a post-crisis 131 percent a year ago. The increase was slowed by a change in the income tax rate from 30 to 33 percent. CFO growth is an impressive 47 percent, although this value also pales in comparison to the unsustainable 123-percent growth rate from a year ago. Revenue/Assets has steadied at 35 percent.

Profitability. This gauge increased 7 points from the prior quarter's 6 points. ROIC grew to healthy 13 percent from 11 percent a year ago. FCF/Equity jumped up to 11 percent from 6 percent. Operating Expenses/Revenue moved down sharply in the last year from 81 percent to 74 percent. The change was primarily due to an increase in Gross Margin. The Accrual Ratio, which we like to be both negative and declining, moved in the wrong direction from +2 percent to +1 percent. This tells us that a little less of the company's Net Income is due to cash flow, and, therefore, more is due to changes in non-operational balance sheet accruals.

Value. Edison's stock price rose over the course of the quarter from $45.48 to $49.13. The Value gauge, based on the latter price, is a weak 2 points; it has been low for a few years now. The P/E at the end of the quarter was 13.2, which doesn't seem too high, but it is above historic averages. Reuters tells us that the average P/E for the Electric Utilities industry is 20, which is, um, shockingly expensive to those who remember when utilities had single-digit multiples. The Reuters average includes many non-U.S. companies, which might be pushing up the average. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is 20 percent less than the average P/E, using core-operating earnings, of stocks in the S&P 500. This discount has been common in recent years, but there was a time when 30-40 percent discounts were typical. The market is telling us that utilities might grow at a slower rate than the average company, but not that much slower. The very reasonable PEG ratio of 1.1 could be used as evidence that the higher valuation is reasonable. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has increased to 1.3 from a five-year median below 1.0. The average Price/Sales for the Electric Utilities industry is 1.85.


Now at 23 out of 100 possible points, the Overall gauge has been below 30 for the last few years. One reason for the low scores is that the rebound from the California power crisis can only carry the company so far. But, the greater concern is that utility stocks have become popular -- as has every stock associated with the energy industry -- and most valuation metrics have moved substantially above historic levels. This might be justified in many cases, but Edison's revenue only grew 5 percent year over year. What will happen to cash flow and earnings if interest rates increase? We suggest caution.

KG: Financial Analysis through March 2007

King Pharmaceuticals (KG), a manufacturer of branded, prescription pharmaceutical products, filed a 10-Q with the SEC for the quarter ending on 31 March 2007. This post reports on our analysis of those results.

About 1/3 of King's net sales are due to Altace®, an ACE inhibitor, which is used to treat patients with cardiovascular risks.

Over the last few years, KG has overcome a series of problems, including Medicaid overcharge allegations, hefty "intangible asset impairment charges" due to disappointing sales, inventory management challenges, financial restatements, and a proposed merger with Mylan Labs that fell apart after Carl Icahn raised objections.

When we analyzed King after the results from December 2006 became available, the Overall score was a very good 60 points. Of the four individual gauges that fed into this composite result, Value was the strongest at 20 points. Growth was weakest at 7 points. We noted that the good results could be attributed to lower intangible asset impairment charges, which, more than core operations, translated into a large increase in Net Income. Since Cash Flow from Operations actually dropped, we were not convinced that business at King was as healthy as the gauges suggested.

Now, with the available data from the March 2007 quarter, our gauges display the following scores:

• Cash Management: 19 of 25
• Growth: 17 of 25
• Profitability: 10 of 25
• Value: 19 of 25
  

• Overall: 65 of 100
  

Cash Management. This gauge increased 2 points from 17 points in December. The Current Ratio is now 3.0, which is a sign of strength. We might have deemed the Current Ratio to be a little too high, except that it makes the recovery from a weak 1.3 in a mere 15 months even more impressive. Long-Term Debt/Equity is an easily manageable 17 percent. The debt ratio was also 17 percent in December, and it was 20 percent 12 months ago. Inventory/Cost of Goods Sold dropped to 173 days from 187 days three months ago and 226 days at the end of March 2006. The percentage of Inventory that is product ready for sale is 28 percent; the Finished Goods ratio has been averaging around 30 percent. Taken together, the two inventory ratios hint that sales were somewhat greater than expectations. Accounts Receivable are 48 days of Revenue, which improved on the 52-day level one year earlier. It might be indicating the company is finding it less difficult to get its customers to pay their bills.

Growth. This gauge increased a hefty 10 points from 7 points three months ago. Revenue growth, however, weakened to 7 percent year over year from 37 percent a year ago. Net Income growth is a jaw-dropping 253 percent, although down from a crazy 600 percent a year ago when the company was rebounding from earlier troubles. The increase in Net Income is not as excellent as first appears: it can fully be attributed to the elimination of the previous year's special charges, such as intangible asset impairment charges. CFO growth is a solid 18 percent, although also down from unsustainable levels in March 2006. Revenue/Assets is 61 percent. It has held steady at this level for the last year or so, after having been much lower. Since its problems a couple of years ago, King has becoming more efficient at generating sales.

Profitability. This gauge increased 2 points from the prior quarter's 10 points. ROIC, however, slipped to a still-good 14 percent from 19 percent a year ago. FCF/Equity held at a strong 22 percent. Operating Expenses/Revenue moved up in the last year from 66 percent to 72 percent. The change was primarily due to a decline in Gross Margin and an increase in R&D expenses. The Accrual Ratio, which we like to be both negative and declining, has the right sign, but it moved in the wrong direction from -10 percent to -5 percent. This tells us that less of the company's Net Income is due to cash flow, and, therefore, more is due to changes in non-operational balance sheet accruals.

Value. King's stock price rose over the course of the quarter from $15.92 to $19.67. The Value gauge, based on the latter price, dropped 1 point from 20 to 19 points over this period. The P/E at the end of the quarter was a modest and seemingly inexpensive 14. The average P/E for the Biotechnology and Drug Industry is a much more expensive 34. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is 15 percent less than the average P/E, using core-operating earnings, of stocks in the S&P 500. Historically, the company's P/E has had a substantial premium to the market multiple. The current discount tells us that the market is expecting the company's earnings to grow slower than the average company. We consider the PEG ratio to be N/A because non-recurring factors have had such a significant effect on the earnings growth rate. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has increased to 2.4, which is much, much less than the average Price/Sales for the Biotechnology and Drug Industry of 9.


Now at a very good 65 out of 100 possible points, the Overall gauge would appear to reflect, or even signal, a substantial increase in King's fortunes. However, we suspect that our gauges are giving to much credit to the rebound that has already occurred and is unlikely to be sustained. With the low Valuation metrics, investors are certainly displaying their skepticism about future sales and earnings. Net Income would have declined in the recent four-quarter period if "special" charges had been excluded. The declining Gross Margin will have to be reversed for the good times to continue. This will be difficult to achieve with some of the company's most notable products approaching the end of the patent lifetimes. If King were to confound expectations and grow earnings at the healthy rate of other drug stocks, the upside potential in the stock would seem to be very high.

WPI: Financial Analysis through March 2007

Watson Pharmaceuticals (WPI), a manufacturer of generic and (to a lesser extent) branded pharmaceuticals, filed a 10-Q with the SEC for the quarter ending on 31 March 2007. We updated our analysis to address certain details in this formal submittal that were not available in the original press release. Our results, adjusted to account for the new information, are reported in this post.

In November 2006, after resolving an FTC challenge, Watson completed an all-cash, $1.9 billion acquisition of Andrx Corporation. Andrx was both a maker of generic drugs (often controlled-release versions) and a distributor. Watson had been expanding beyond its roots as a generic drug manufacturer into higher-margin branded pharmaceuticals. However, the Andrx acquisition was something of a strategic U-turn because it increased Watson's concentration on generics. In addition, $497.8 million, more than 25 percent of the cost of buying Andrx, was classified as "in-process R&D" and expensed in its entirety during the fourth quarter of 2006.

When we analyzed Watson after the results from December 2006 became available, the Overall score was a modest 29 points. Of the four individual gauges that fed into this composite result, Profitability was the strongest at 12 points. Cash Management was weakest at 4 points.

Now, with the available data from the March 2007 quarter, our gauges display the following scores:

• Cash Management: 3 of 25
• Growth: 16 of 25
• Profitability: 13 of 25
• Value: 5 of 25
  

• Overall: 34 of 100

Cash Management. This gauge dropped 1 point from 4 points in December. The Current Ratio is now 2.4, rebounding solidly after the Andrx acquisition temporarily depleted cash reserves. Long-Term Debt/Equity, as another consequence of the Andrx acquisition, is now a highly leveraged 63 percent. The debt ratio was 67 percent in December and 27 percent one year ago. Inventory/Cost of Goods Sold dropped sharply to 126 days from 153 days three months ago. The inventory level is back down almost exactly to the 125-day level seen in March 2006. The percentage of Inventory that is product ready for sale is 62 percent; the Finished Goods ratio was a record-high 65 percent in December, but it has been averaging under 50 percent. Taken together, the two inventory ratios hint that sales met or marginally exceeded expectations. Accounts Receivable were 61 days of Revenue, essentially matching the 60-day value one year earlier.

Growth. This gauge doubled the 8 points it achieved in December. Revenue growth, supercharged because of the inclusion of Andrx, is now 36 percent year over year, up from a mere 1 percent a year ago. Net Income growth is N/A because a massive, acquisition-induced in-process R&D charge produced a trailing 12-month Net Loss. CFO growth is a solid 19 percent, up from a 12 percent decline a year ago. Revenue/Assets jumped sharply to 63 percent, which probably reflects the increase in the proportion of sales due to high-volume generic drugs. The increase was probably also helped by last year's huge asset write off.

Profitability. This gauge increased 1 point from 12 points after the prior quarter. ROIC grew slightly to a weak 7 percent from 6 percent a year ago. FCF/Equity jumped up to a strong 22 percent from 13 percent. Operating Expenses/Revenue moved up in the last year from 87 percent to 92 percent. The change was due to a big decline in Gross Margin that was somewhat offset by reductions in Depreciation and R&D expenses. The Accrual Ratio, which we like to be both negative and declining, moved in the right direction from -5 percent to -9 percent (ignoring the asset write down).

Value. Watson's stock price rose a little over the course of the quarter from $26.03 to $26.43. The Value gauge, based on the latter price, dropped to a weak 5 points, compared to 6 points three months ago. The P/E and the PEG ratio are N/A because of the net loss over the last twelve months. If we ignore the $500 million write-down, the P/E is 49, but the PEG is still N/A. The average P/E for the Biotechnology and Drugs industry is 33. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, is 1.4, much less than Watson's historical average. The average Price/Sales for the Biotechnology and Drugs industry is 9.5.


Now at a moderate 34 out of 100 possible points, the Overallgauge moved up 5 points in the last quarter. Watson is in a state of transition as it digests Andrx, and, as a result, the financial story is confused. Sales and CFO is strong, and the drop in Inventory allayed one of our concerns. On the other hand, Gross Margin might stay weak because generic drugs are essentially commodities. The ROIC needs to be much higher to keep up with the company's expanded debt levels. The company appears expensive on the basis of adjusted P/E, but cheap on the basis of Price/Revenue. We need more time to see what financial form the company takes.

INTC: Financial Analysis through March 2007

Intel (INTC), the semiconductor manufacturer, filed a 10-Q with the SEC for the quarter ending on 31 March 2007. We updated our analysis to address certain details (e.g., cash flow from operations) in this formal submission that were not available in the original press release. Our results, adjusted to account for the new information, are reported in this post.

Intel was the worst performer in the Dow Jones Industrial Average in 2006, when its stock price dropped about 20 percent. Improved performance in 2007 might be due favorable reviews given to Intel's newest products and predictions that Intel will regain market share from steadfast competitor Advanced Micro Devices (AMD).

When we analyzed Intel after the results from December 2006 became available, the Overall score was a weak 16 points. Of the four individual gauges that fed into this Overall result, Cash Management was the strongest at 12 points. Growth was weakest at 0 points, but Value wasn't much better at 2 points.

Now, with the available data from the March 2007 quarter, our gauges display the following scores:

• Cash Management: 12 of 25
• Growth: 0 of 25
• Profitability: 5 of 25
• Value: 3 of 25

• Overall: 17 of 100

Cash Management. This gauge didn't change from December to March. The Current Ratio surged to 2.7, primarily because reduced taxes-payable lowered current liabilities. Long-Term Debt/Equity remained an insignificant 5 percent. The debt ratio was 6 percent one year ago. Intel's inventory reached alarming levels during parts of 2006, with Inventory/Cost of Goods Sold eclipsing 100 days (compared to the five-year median Inventory level of 70 days). In the most recent quarter, Inventory/Cost of Goods Sold edged down to 91 days from December's 92 days. The percentage of Inventory that is product ready for sale is 35 percent; the Finished Goods ratio was 39 percent in December. Taken together, the two inventory ratios hint more at stabilization than improved sales. Accounts Receivable/Revenues were 29 days. This is a week less than the historic value for the company, and it might indicate the company is doing a better job getting its customers to pay their bills.

Growth. This gauge is stuck at zero because growth is non-existent in the parameters we track. Revenue declined 8 percent year over year. Despite the first quarter's Net Income jump because a tax reversal reduced the income tax rate, Net Income still dropped a substantial 32 percent on a year-over-year basis. CFO dropped 23 percent. Revenue/Assets is 72 percent; it was 81 percent a year ago, and it indicates that the company is becoming less efficient at generating sales.

Profitability. This gauge also didn't change from December. ROIC declined to 13 percent from 23 percent a year ago. FCF/Equity also dropped to 13 percent from, in this case, 21 percent. Operating Expenses/Revenue moved up in the last year from 72 percent to 82 percent. The change was primarily due to a decline in Gross Margin of 8 percent. (Intel indicated that a shift to a more advanced manufacturing technology lowered manufacturing costs but this isn't apparent in the gross margin.) The Accrual Ratio, which we like to be both negative and declining, held steady at +1 percent.

Value. This gauge, based on the stock price of $19.13 at the quarter's end on 31 March, is a weak 3 points, compared to 2 and a strong 19 points, three and twelve months ago, respectively. The P/E at the end of the quarter was 21. The average P/E for the industry is a more expensive 26. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is at a 33 percent premium to the average P/E, using core-operating earnings, for stocks in the S&P 500. Companies tend to trade at a premium when their growth rates are greater than average, particularly when the growth rates seem more likely to be sustained. The PEG ratio is N/A because Net Income is declining. The Price/Revenue ratio, which isn't affected by the one-time factors that cause wide swings in earnings, has held around to 3.2. The average Price/Sales for the industry is 4.5.


Now at disappointing 17 out of 100 possible points, the Overall gauge has been at weak levels for the last three quarters. If there had been an aggregate increase in demand for Intel's products, either because of an expanding market or an improved competitive position, we would have expected stronger revenue numbers and a more robust gross margin. Intel said the average selling prices "held up" during the quarter, which doesn't say much good about the revenue figure. Operating income bettered our expectations as result of lower SG&A expenses. We want to know if this reduction is the result of more efficient operations, which would be recurring, or is the result of a one-time event. Net income far exceeded all predictions, but we clearly see that this was due to a lower effective income tax rate. The resolution of a dispute with the IRS allowed $300 million of previously accrued taxes to be reversed.

PEP: Analysis through March 2007

PepsiCo (PEP), a leading global purveyor of beverages and snacks, filed a 10-Q with the SEC for the 12 weeks ending on 24 March 2007. We updated our analysis to address certain details in this formal submittal that were not available in the original press release. Our results, adjusted to account for the new information, are reported in this post.

PepsiCo is known for good management, steady growth, the defensive characteristics of the food and beverage industries, and significant international exposure. While famously locked in a battle with Coca-Cola for market share, PepsiCo's snack food business results in a more diversified company. In the North American markets, the Frito-Lay division takes in more revenue and contributes more to operating profit than the Pepsi Bottling division.

When we analyzed PepsiCo after the results from December 2006 became available, the Overall score was a modest 39 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 19 points. Cash Management was weakest at 3 points.

We observed that the recent 10-Q filing modified the income statement for the quarter ending 25 March 2006. Revenue was reduced from $7.205 billion to $6.719 billion. Net Income was reduced from $1.019 billion to $0.947 billion. The modification isn't directly explained in the 10-Q, but there is a Note indicating that the reporting calendar for some international units was revised. We're less concerned about the change than the likelihood that revenue and expenses were shifted, in amounts not publicly announced, to other quarters. These shifts, if they occurred, will add errors to our year-over-year comparisons. We seemingly have no recourse other than to wait for subsequent 10-Q filings to learn if other 2006 quarters were revised.


With the available data from the most recent quarter, our gauges now display the following scores:

• Cash Management: 3 of 25
• Growth: 23 of 25
• Profitability: 11 of 25
• Value: 8 of 25
  

• Overall: 42 of 100

Cash Management. This gauge held at 3 points from December. The Current Ratio is now 1.16, down from 1.3 in December, but the same as March 2006. PepsiCo keeps this value lower than many other companies. Long-Term Debt/Equity is a minimal 12 percent, down from 17 percent the previous quarter. The debt ratio was 16 percent one year ago. Inventory/Cost of Goods Sold rose to 48 days from 45 days at the end of the prior quarter and 47 days in March 2006. The percentage of Inventory that is product ready for sale (i.e., Finished Goods) is now 49 percent, compared to 48 percent at the end of the prior quarter and 51 percent in March 2006. The inventory levels suggest sales met, or were at least close to, expectations. Accounts Receivable/Revenues equal 43 days. This is a couple days more than the value one year ago, but it is within the normal variability for this parameter.

Growth. This gauge increased 3 points from December. Revenue growth was 8 percent year over year (aided by the restatement of last year's results?), down from 10 percent a year ago. Net Income growth is an eye-opening 39 percent, up from -4 percent a year ago. The increase benefited greatly from a change in the income tax rate from 36 to 19 percent. CFO growth is an impressive 24 percent, up from a tepid 4 percent a year ago. Revenue/Assets is 118 percent; it has been trending up. It indicates that the company is becoming more efficient at generating sales. The $3 billion per year spent repurchasing common shares, reducing assets, might also be a non-operational explanation for the increase.

Profitability. This gauge increased 1 point from the prior quarter. ROIC grew to an impressive 31 percent from 21 percent a year ago. FCF/Equity jumped up to 29 percent from 23 percent. Operating Expenses/Revenue were 81 percent; these expenses have been within 1 percent of 81 percent for the last six years. The Accrual Ratio, which we like to be both negative and declining, moved in the wrong direction from +2 percent to +4 percent. This tells us that less of the company's Net Income is due to cash flow, and, therefore, more is due to changes in non-operational balance sheet accruals.

Value. PepsiCo's stock price rose from $62.55 at the end of December to $63.56 at the end of March. The Value gauge, based on the latter price, is a so-so 8 points, compared to 8 and 1 points three and twelve months ago, respectively. The P/Eat the end of the quarter was 18.6, down its historic median value in the low 20's. The decrease suggests the shares have become less expensive, even though the share price has risen. The average P/E for the Non-alcoholic Beverages industry is 22. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is at a 17 premium to the average P/E, using core operating earnings, for stocks in the S&P 500. Historically, the company's P/E has had a 28 percent premium to the market, as expressed by this measure. Companies tend to trade at a premium when their growth rates are greater than average, particularly when the growth rates seem more likely to be sustained. The PEG ratio of 0.5 is indicative of a bargain stock. It has been decreasing (i.e., suggesting greater value). The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has been stable at 3.0. The average Price/Sales for the Non-alcoholic Beverages industry is 3.9.


Now a moderate 42 out of 100 possible points, the Overallgauge has been inching up. Net income, Cash Flow, and ROIC are all very good, and Operating Expenses are under control. The stock price is not excessive by normal measures. Yet, we're troubled by the possibility that the income gains were more due to tax adjustments than sustainable operations. As mentioned above, we're also concerned that the restatement of 2006's first-quarter results might have thrown of our comparisons.