Richard Scrushy, former chairman and CEO of a company (HealthSouth) that nearly collapsed, was sentenced in federal court to 6 years, 10 months, in prison for bribery. Two years earlier, Scrushy was acquitted of numerous accounting fraud charges, despite eyewitness testimony against him.
Accounting fraud is a great threat to our economy, and we salute efforts to root it out and punish the offenders. Investors would be a lot stingier should they decide they can't rely on corporate financial statements. Jobs would be lost because companies would have fewer funds for capital and operating expenditures.
28 June 2007
23 June 2007
One More Week in the Second Quarter
It's hard to believe that 2007 is nearly half over. In mid-July, the flood of second quarter earning reports will begin: first as press releases and then as 10-Q or 10-K filings.
For example, the initial reports for INTC and MSFT are due on 17 and 19 July, respectively. PEP's report is due on 24 July; TDW is scheduled for 26 July. NOK, which doesn't have to trouble itself with a 10-Q, reports on 2 Aug. Over the next few weeks, we'll let you know what we're expecting to see in these and other reports.
If possible, we perform preliminary analyses, estimating the gauge scores, with the data in the press releases. Then, we update the scores when the full set of data filed with the SEC becomes available.
The degree of correspondence between the initial reports and the ones that count varies widely from company to company. Firms obviously focus on early preparation their Income Statements because these rarely change in material ways from the initial announcements to the formal submittals. However, the first reports can be missing significant Balance Sheet and Cash Flow details or might even omit these important statements in their entirety.
While waiting for the 10-Q, we will fill any gaps in Balance Sheet details with values from the previous quarter. This approach is generally reasonable, except we lament the lack of up-to-date manufacturers' inventory data. We like to scrutinize inventory data in search of quarter-to-quarter changes in demand or production.
Missing Cash Flow data is harder to manage because it seems to vary more from quarter-to-quarter (new item for the task list: compare standard deviations for income and cash flow). We'll crudely estimate Cash Flow from Operations by adding Depreciation to Net Income and then making some adjustment that reflects how these parameters have correlated historically for the subject company. (A change in the relationship between these parameters can be useful information about earnings' quality).
For example, the initial reports for INTC and MSFT are due on 17 and 19 July, respectively. PEP's report is due on 24 July; TDW is scheduled for 26 July. NOK, which doesn't have to trouble itself with a 10-Q, reports on 2 Aug. Over the next few weeks, we'll let you know what we're expecting to see in these and other reports.
If possible, we perform preliminary analyses, estimating the gauge scores, with the data in the press releases. Then, we update the scores when the full set of data filed with the SEC becomes available.
The degree of correspondence between the initial reports and the ones that count varies widely from company to company. Firms obviously focus on early preparation their Income Statements because these rarely change in material ways from the initial announcements to the formal submittals. However, the first reports can be missing significant Balance Sheet and Cash Flow details or might even omit these important statements in their entirety.
While waiting for the 10-Q, we will fill any gaps in Balance Sheet details with values from the previous quarter. This approach is generally reasonable, except we lament the lack of up-to-date manufacturers' inventory data. We like to scrutinize inventory data in search of quarter-to-quarter changes in demand or production.
Missing Cash Flow data is harder to manage because it seems to vary more from quarter-to-quarter (new item for the task list: compare standard deviations for income and cash flow). We'll crudely estimate Cash Flow from Operations by adding Depreciation to Net Income and then making some adjustment that reflects how these parameters have correlated historically for the subject company. (A change in the relationship between these parameters can be useful information about earnings' quality).
Neural Net
We're thrilled that GCFR might have inspired some ideas for a neural net model based on fundamental analysis. We'll be monitoring the progress on Neural Market Trends, which is a site we like. Incidentally, the author mentions that Tidewater, a company that has had high GCFR scores, came out near the top of their "super duper small cap value scan."
BloggerJacks provides an interesting response to a Reuters article we cited about quantitative analysis on the upswing relative to traditional equity analysis.
BloggerJacks provides an interesting response to a Reuters article we cited about quantitative analysis on the upswing relative to traditional equity analysis.
19 June 2007
HD: Sale of Supply Unit and Stock Repurchase
According to news reports, Home Depot has agreed to sell its Supply division for $10.3 billion and then repurchase $22.5 billion of HD stock. Now, that's a story you don't read about every day.
Does Home Depot have the difference, $12.2 billion, stacked up in the office safe? Alas, no. The balance sheet on 29 April 2007, as published in a 10-Q report, shows that Home Depot held less than $2.1 in cash, cash equivalents, and short-term investment. So, it would appear that they will have to borrow at least $10 billion, plus any proceeds from the sale that can't be converted to cash or have to be paid in taxes.
The company's long-term debt at the end of April was $11.6 billion, and stockholders' equity was $25.7 billion. Therefore, debt/equity was 45 percent.
What will debt/equity be after these transactions? The numerator will increase by $10 billion, give or take, as mentioned above. The effect on stockholders' equity is less certain. If we assume that the sale of the Supply unit doesn't result in a gain or loss, it seems that stockholders' equity would have to drop by the $22.5 billion spent on the stock buyback: from $25.7 billion to $3.2 billion. This is such an extreme result, we hope to be proven wrong (and to learn a lesson along the way).
Could debt/equity really change to (11.6 + 10.1) / (25.7 - 22.5) = 21.7/3.2, or almost 7:1. Would this allow the company finance the modernization of its stores?
This is our reasoning:
1. Sale of Supply unit: We're making two crude assumptions: (1) the sale only affects the composition of the company's assets, but not their total value; and (2) the sale doesn't result in a gain or loss. We're effectively (and simplistically) modeling the sale as an event that increases the company's cash by $10.3 billion (the sale price) and that reduces the value of the company's property, inventory, and other assets by the same amount. The reality will undoubtedly be more complicated.
2. Issuing Debt: When the company borrows $10 billion, assets (the cash borrowed) and liabilities (the debt) will both increase by the same amount and stockholders' equity will be unaffected.
3. Stock Repurchase: When the company spends $22.5 billion on its stock, cash assets will be reduced and stockholders' equity will drop to maintain the balance.
Does Home Depot have the difference, $12.2 billion, stacked up in the office safe? Alas, no. The balance sheet on 29 April 2007, as published in a 10-Q report, shows that Home Depot held less than $2.1 in cash, cash equivalents, and short-term investment. So, it would appear that they will have to borrow at least $10 billion, plus any proceeds from the sale that can't be converted to cash or have to be paid in taxes.
The company's long-term debt at the end of April was $11.6 billion, and stockholders' equity was $25.7 billion. Therefore, debt/equity was 45 percent.
What will debt/equity be after these transactions? The numerator will increase by $10 billion, give or take, as mentioned above. The effect on stockholders' equity is less certain. If we assume that the sale of the Supply unit doesn't result in a gain or loss, it seems that stockholders' equity would have to drop by the $22.5 billion spent on the stock buyback: from $25.7 billion to $3.2 billion. This is such an extreme result, we hope to be proven wrong (and to learn a lesson along the way).
Could debt/equity really change to (11.6 + 10.1) / (25.7 - 22.5) = 21.7/3.2, or almost 7:1. Would this allow the company finance the modernization of its stores?
This is our reasoning:
1. Sale of Supply unit: We're making two crude assumptions: (1) the sale only affects the composition of the company's assets, but not their total value; and (2) the sale doesn't result in a gain or loss. We're effectively (and simplistically) modeling the sale as an event that increases the company's cash by $10.3 billion (the sale price) and that reduces the value of the company's property, inventory, and other assets by the same amount. The reality will undoubtedly be more complicated.
2. Issuing Debt: When the company borrows $10 billion, assets (the cash borrowed) and liabilities (the debt) will both increase by the same amount and stockholders' equity will be unaffected.
3. Stock Repurchase: When the company spends $22.5 billion on its stock, cash assets will be reduced and stockholders' equity will drop to maintain the balance.
16 June 2007
Another Tweak to the Gauge Scoring
The interlude between first and second quarter earnings reports has afforded us an opportunity to try out some improvements to the financial gauges. First, we expanded the Cash Management Gauge to include three additional metrics. Then, we adjusted the weights assigned to each metric that is an input to one gauge or another.
Today, we're announcing that the PEG ratio contribution to the Value Gauge has been replaced with Enterprise Value (EV)/Cash Flow from Operations (CFO, or OCF).
The P/E to earnings Growth (PEG) can be a very important ratio. Many analysts will say that shares of a company are inexpensive when the P/E is less than the earnings growth rate in percent; i.e, when the PEG is less than 1.0. By this reckoning, a company growing its earnings at an annual rate of 20 percent would be a good value when the P/E is below 20. Conversely, shares are deemed wildly expensive when the PEG exceeds, say, 2.0.
The growth rate in the PEG should be the percent increase expected in next year's earnings relative to the current year. This is called forward earnings growth, in contrast with backward-looking trailings earnings growth. Alas, forward earnings growth predictions are very subjective. We sought to avoid this problem by using the trailing earnings growth to calculate PEG; however, this hasn't worked out very well. Too often, we've seen negative correlations between our PEG score and future stock price moves. So, we decided to nix the PEG for something else.
EV/CFO
Despite its arcane name, Enterprise Value / CFO has similarities to the basic P/E ratio with which readers are well acquainted. The "P" in P/E represents the company's market value; i.e., what the price would be to buy every share outstanding. However, the real world is more complicated: the purchaser also has to deal with the company's debt. The EV better reflects the cost to the purchaser. It adds debt (long- and short-term) to the market value, but subtracts the company's cash and short-term investments (which could pay down the debt or offset the cost of the share purchase).
The "E" in P/E obviously represents earnings, and CFO is just another measure of how much money the company is bring in from its core business. Some say that CFO is harder to manipulate than income; we're not sure whether that is true, but cash does have the benefit of being a tangible asset. Our frequent readers know that we use the Accrual Ratio in the Profitability Gauge to distinguish earnings due to cash flow from earnings due to Balance Sheet changes.
For each 5 percent a company's EV/CFO is below its average over the previous four years, it will get one point in our scoring system, with a maximum of five points.
We'll see how well all these adjustments work out when we're analyzing the impending flood of second quarter reports. The beneficial changes will be retained, and the others will be modified discarded. We don't expect to ever stop searching for improvements. While the adjustments change scores that were published previously,we will always use a consistent basis when comparing new scores to old.
Today, we're announcing that the PEG ratio contribution to the Value Gauge has been replaced with Enterprise Value (EV)/Cash Flow from Operations (CFO, or OCF).
The P/E to earnings Growth (PEG) can be a very important ratio. Many analysts will say that shares of a company are inexpensive when the P/E is less than the earnings growth rate in percent; i.e, when the PEG is less than 1.0. By this reckoning, a company growing its earnings at an annual rate of 20 percent would be a good value when the P/E is below 20. Conversely, shares are deemed wildly expensive when the PEG exceeds, say, 2.0.
The growth rate in the PEG should be the percent increase expected in next year's earnings relative to the current year. This is called forward earnings growth, in contrast with backward-looking trailings earnings growth. Alas, forward earnings growth predictions are very subjective. We sought to avoid this problem by using the trailing earnings growth to calculate PEG; however, this hasn't worked out very well. Too often, we've seen negative correlations between our PEG score and future stock price moves. So, we decided to nix the PEG for something else.
EV/CFO
Despite its arcane name, Enterprise Value / CFO has similarities to the basic P/E ratio with which readers are well acquainted. The "P" in P/E represents the company's market value; i.e., what the price would be to buy every share outstanding. However, the real world is more complicated: the purchaser also has to deal with the company's debt. The EV better reflects the cost to the purchaser. It adds debt (long- and short-term) to the market value, but subtracts the company's cash and short-term investments (which could pay down the debt or offset the cost of the share purchase).
The "E" in P/E obviously represents earnings, and CFO is just another measure of how much money the company is bring in from its core business. Some say that CFO is harder to manipulate than income; we're not sure whether that is true, but cash does have the benefit of being a tangible asset. Our frequent readers know that we use the Accrual Ratio in the Profitability Gauge to distinguish earnings due to cash flow from earnings due to Balance Sheet changes.
For each 5 percent a company's EV/CFO is below its average over the previous four years, it will get one point in our scoring system, with a maximum of five points.
We'll see how well all these adjustments work out when we're analyzing the impending flood of second quarter reports. The beneficial changes will be retained, and the others will be modified discarded. We don't expect to ever stop searching for improvements. While the adjustments change scores that were published previously,we will always use a consistent basis when comparing new scores to old.
15 June 2007
It's Nice to be Noticed
GCFR is listed as a resource on the Mad Money and Fast Money Fan Site. This site provides summaries of the CNBC shows "Mad Money" and "Fast Money."
We were also mentioned kindly on The Kirk Report, one of the more highly regarded stock market web sites.
We were also mentioned kindly on The Kirk Report, one of the more highly regarded stock market web sites.
10 June 2007
Weighting Changes
We have tinkered with the relative weights assigned to the financial ratios and metrics that are used to calculate the gauge scores. We have also adjusted how much each individual gauge score is weighted to compute the Overall Gauge score.
Company-specific scores will be recalculated with the new weights the next time the company is analyzed.
These adjustments were made in a quixotic effort to improve the correlation between the Overall Gauge score and future stock price gains. The selection of weights is as much art as science. We typically take a fresh look at the weights when the set of metrics used for a particular gauge are revised, as we recently did on a trial basis for the Cash Management gauge.
We should probably consider weights that vary by industry, since it seems clear that some parameters are more relevant to some industries than others. We could also consider weights that vary with market capitalization, growth vs. value, etc.
We also make occasional revisions to the equations that convert the ratios listed below into point scores.
A few additional comments. We increased the weight of the Cash Management score because three new parameters make it a more robust indicator of corporate health. We trimmed the weight of the Growth gauge because it hasn't correlated well with future stock price performance, which we find counter-intuitive. Perhaps sales and earnings growth are so widely analyzed that they get reflected in stock prices immediately, losing any predictive power they might have had. Or, perhaps the growth metrics we track are reflecting growth by acquisition, which often disappoint, rather than the growth by innovation.
Company-specific scores will be recalculated with the new weights the next time the company is analyzed.
These adjustments were made in a quixotic effort to improve the correlation between the Overall Gauge score and future stock price gains. The selection of weights is as much art as science. We typically take a fresh look at the weights when the set of metrics used for a particular gauge are revised, as we recently did on a trial basis for the Cash Management gauge.
We should probably consider weights that vary by industry, since it seems clear that some parameters are more relevant to some industries than others. We could also consider weights that vary with market capitalization, growth vs. value, etc.
We also make occasional revisions to the equations that convert the ratios listed below into point scores.
| Cash Management (20%, was 15%) | Previous Weight | Current Weight |
| 10 | 5 | |
| 10 | 10 | |
| 40 | 20 | |
| 30 | 17.5 | |
| 10 | 5 | |
| N/A | 10 | |
| N/A | 10 | |
| N/A | 22.5 | |
| | | |
| Growth (10%, was 15%) | | |
| 10 | 10 | |
| 40 | 40 | |
| 20 | 20 | |
| 30 | 30 | |
| | | |
| Profitability (30%, was 25%) | | |
| 20 | 25 | |
| 20 | 10 | |
| 25 | 40 | |
| 35 | 25 | |
| | | |
| Value (40%, was 45%) | | |
| 10 | 10 | |
| 40 | 30 | |
| 25 | 40 | |
| 25 | 20 | |
| | | |
A few additional comments. We increased the weight of the Cash Management score because three new parameters make it a more robust indicator of corporate health. We trimmed the weight of the Growth gauge because it hasn't correlated well with future stock price performance, which we find counter-intuitive. Perhaps sales and earnings growth are so widely analyzed that they get reflected in stock prices immediately, losing any predictive power they might have had. Or, perhaps the growth metrics we track are reflecting growth by acquisition, which often disappoint, rather than the growth by innovation.
Prof. Mohanram's Research: NYT Article
In an article by Barry Rehfeld, today's New York Times reports on research showing that grading companies by their financial parameters can identify future stock gainers and (even more successfully) companies that will under-perform the market.
As this type of quantitative grading, of course, is our own humble objective, we're thrilled to see rigorously compiled evidence that we might be on the right track. We will pore through the research to see how we can incorporate the results into our gauges to make them better predictors of the future.
In this case, the research was conducted by Prof. P.S. Mohanram at Columbia University. The results were published in the Review of Accounting Studies in a paper entitled, " Separating Winners from Losers among Low Book-to-Market Stocks using Financial Statement Analysis."
Mr. Rehfeld summarized Prof. Mohanram's key finding as "stocks whose book value (assets minus liabilities) is much lower than their market value are unlikely to fare well."
We compute Price/Book Value every quarter for each company we evaluate, but we haven't used the data to influence the Value gauge. In a knowledge-based economy, where the key assets are intangible, we had doubted this relevance of the classic Price/Book ratio. We will reconsider.
As this type of quantitative grading, of course, is our own humble objective, we're thrilled to see rigorously compiled evidence that we might be on the right track. We will pore through the research to see how we can incorporate the results into our gauges to make them better predictors of the future.
In this case, the research was conducted by Prof. P.S. Mohanram at Columbia University. The results were published in the Review of Accounting Studies in a paper entitled, " Separating Winners from Losers among Low Book-to-Market Stocks using Financial Statement Analysis."
Mr. Rehfeld summarized Prof. Mohanram's key finding as "stocks whose book value (assets minus liabilities) is much lower than their market value are unlikely to fare well."
We compute Price/Book Value every quarter for each company we evaluate, but we haven't used the data to influence the Value gauge. In a knowledge-based economy, where the key assets are intangible, we had doubted this relevance of the classic Price/Book ratio. We will reconsider.
09 June 2007
HD: Financial Analysis through April 2007
We have updated our analysis of Home Depot's (HD) financial results for the quarter ending on 29 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.
Home Depot is the largest retailer of home improvement merchandise, including large amounts of lumber. Customers include do-it-yourself homeowners and professional contractors.
Management problems and worries about the slowing of the housing market have morphed an erstwhile growth company into a potential target of a value-seeking hedge fund. More likely is the divestiture of the low-margin Home Depot Supply division, which serves contractors, and which was championed by the former CEO.
This update is the first one that includes the additional Cash Management metrics identified here. Prior data has been revised to reflect the new metrics.
When we analyzed Home Depot after the results from January became available, the Overall score was a modest 30 points. Of the four individual gauges that fed into this composite result, Profitability was the strongest at 11 points. Growth was weakest at 4 points each.
Now, with the available data from the April 2007 quarter, our gauges display the following scores:
Cash Management. This gauge dropped 1 point from 7 points in January. The Current Ratio is now 1.4, which is weaker than we like. However, it has moved up from 1.2, and is now above its five-year median value. Long-Term Debt/Equity is a leveraged 45 percent. The debt ratio was 47 percent in January and 24 percent 12 months ago. We suspect the debt increase from last year had something to do with $4.5 billion spent on acquisitions, including $3.5 billion for Hughes Supply and the undisclosed amount for twelve Home Way stores in China. Inventory/Cost of Goods Sold rose to 82 days from 72 days three months ago and 81 days in April 2006. The recent rise in inventory (all product ready for sale) may be due in part to slower sales growth, but it is probably mostly due to the normal spring build up prior to the summer season. Accounts Receivable averaged 14 days of Revenue, compared to the 12-day level seen one year earlier. Debt/CFO is 1.8 years, meaning that about 21.5 months of Cash Flow from Operations would be required to pay off the company's short and long-term debt. This ratio was 1.0 years one year ago and 0.3 years two years ago, so we see that the company is becoming more leveraged. On the other hand, Working Capital/Capitalization is up to 6.6 percent from 4.4 percent a year earlier. The Cash Conversion Cycle Time is 40.2 days, which is a bit less efficient that the 37.4 day period of year ago. Efficiency, as measured by this parameter has been on a long-term decline.
Growth. This gauge increased 2 points from 4 points three months ago. Revenue growth slowed to 8 percent year over year, from 13 percent a year ago. Net Income declined 12 percent; earnings were up 18 percent a year ago. The additional $350 million spent on interest expenses in the recent year contributed to the net income decline. CFO declined 6 percent year over year. Revenue/Assets is 1.62. The long-term trend down in this parameter indicates that the company has become less efficient at generating sales. A stock buyback, reducing assets, wasn't enough to break the negative trend.
Profitability. This gauge dropped 3 points from the prior quarter's 11 points. ROIC slipped to a moderate 15 percent from 19 percent a year ago. FCF/Equity was steady at 11 percent. Operating Expenses/Revenue edged up in the last year from 88 percent to 90 percent. The change was primarily due to a decline in Gross Margin. The Accrual Ratio, which we like to be both negative and declining, moved in the right direction from +6 percent to +4 percent. This tells us that more of the company's Net Income is due to cash flow, and, therefore, less is due to changes in non-operational balance sheet accruals.
Value. Home Depot's stock price fell over the course of the quarter from $40.74 to $37.87. The Value gauge, based on the latter price, increased to a weak 8 points from 6 in the last quarter. It was 10 points twelve months ago. The P/E at the end of the quarter was 14, about the same as recent quarters. The average P/E for the Retail (Home Improvement) industry is just a bit more expensive at 14.7. 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. This discount to the market multiple has expanded over the last five years. Since Net Income fell, 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, declined to 0.8. The decrease suggests the shares have become less expensive. The average Price/Sales for the Retail (Home Improvement) industry is 0.95.
Now at disappointing 30 out of 100 possible points, the Overall gauge has been weak for all but one quarter in the last three years. [In the summer of 2006, when the stock price fell below $35, the Value gauge temporarily stirred.]
Home Depot is the largest retailer of home improvement merchandise, including large amounts of lumber. Customers include do-it-yourself homeowners and professional contractors.
Management problems and worries about the slowing of the housing market have morphed an erstwhile growth company into a potential target of a value-seeking hedge fund. More likely is the divestiture of the low-margin Home Depot Supply division, which serves contractors, and which was championed by the former CEO.
This update is the first one that includes the additional Cash Management metrics identified here. Prior data has been revised to reflect the new metrics.
When we analyzed Home Depot after the results from January became available, the Overall score was a modest 30 points. Of the four individual gauges that fed into this composite result, Profitability was the strongest at 11 points. Growth was weakest at 4 points each.
Now, with the available data from the April 2007 quarter, our gauges display the following scores:
- Cash Management: 6 of 25
- Growth: 6 of 25
- Profitability: 8 of 25
- Value: 8 of 25
- Overall: 30 of 100
Cash Management. This gauge dropped 1 point from 7 points in January. The Current Ratio is now 1.4, which is weaker than we like. However, it has moved up from 1.2, and is now above its five-year median value. Long-Term Debt/Equity is a leveraged 45 percent. The debt ratio was 47 percent in January and 24 percent 12 months ago. We suspect the debt increase from last year had something to do with $4.5 billion spent on acquisitions, including $3.5 billion for Hughes Supply and the undisclosed amount for twelve Home Way stores in China. Inventory/Cost of Goods Sold rose to 82 days from 72 days three months ago and 81 days in April 2006. The recent rise in inventory (all product ready for sale) may be due in part to slower sales growth, but it is probably mostly due to the normal spring build up prior to the summer season. Accounts Receivable averaged 14 days of Revenue, compared to the 12-day level seen one year earlier. Debt/CFO is 1.8 years, meaning that about 21.5 months of Cash Flow from Operations would be required to pay off the company's short and long-term debt. This ratio was 1.0 years one year ago and 0.3 years two years ago, so we see that the company is becoming more leveraged. On the other hand, Working Capital/Capitalization is up to 6.6 percent from 4.4 percent a year earlier. The Cash Conversion Cycle Time is 40.2 days, which is a bit less efficient that the 37.4 day period of year ago. Efficiency, as measured by this parameter has been on a long-term decline.
Growth. This gauge increased 2 points from 4 points three months ago. Revenue growth slowed to 8 percent year over year, from 13 percent a year ago. Net Income declined 12 percent; earnings were up 18 percent a year ago. The additional $350 million spent on interest expenses in the recent year contributed to the net income decline. CFO declined 6 percent year over year. Revenue/Assets is 1.62. The long-term trend down in this parameter indicates that the company has become less efficient at generating sales. A stock buyback, reducing assets, wasn't enough to break the negative trend.
Profitability. This gauge dropped 3 points from the prior quarter's 11 points. ROIC slipped to a moderate 15 percent from 19 percent a year ago. FCF/Equity was steady at 11 percent. Operating Expenses/Revenue edged up in the last year from 88 percent to 90 percent. The change was primarily due to a decline in Gross Margin. The Accrual Ratio, which we like to be both negative and declining, moved in the right direction from +6 percent to +4 percent. This tells us that more of the company's Net Income is due to cash flow, and, therefore, less is due to changes in non-operational balance sheet accruals.
Value. Home Depot's stock price fell over the course of the quarter from $40.74 to $37.87. The Value gauge, based on the latter price, increased to a weak 8 points from 6 in the last quarter. It was 10 points twelve months ago. The P/E at the end of the quarter was 14, about the same as recent quarters. The average P/E for the Retail (Home Improvement) industry is just a bit more expensive at 14.7. 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. This discount to the market multiple has expanded over the last five years. Since Net Income fell, 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, declined to 0.8. The decrease suggests the shares have become less expensive. The average Price/Sales for the Retail (Home Improvement) industry is 0.95.
Now at disappointing 30 out of 100 possible points, the Overall gauge has been weak for all but one quarter in the last three years. [In the summer of 2006, when the stock price fell below $35, the Value gauge temporarily stirred.]
02 June 2007
Quantitative Analysis on the Upswing
In this Reuters article by Dane Hamilton, we really like the part about the great demand and high salaries for quantitative analysts ("rocket scientists") on Wall Street.
WMT: Financial Analysis through April 2007
We have updated our analysis of Wal-Mart's (WMT)'s financial results for the for the quarter ending on 30 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.
Wal-Mart is the world's largest retailer with nearly 6500 stores. With annual sales in excess of $300 billion, Wal-Mart holds the number 2 spot on the Fortune 500 list of America's largest corporations. Wal-Mart's disruptive cost-cutting strategies have revolutionized the marketplace for better and for worse, depending on your point of view. Its visibility and role in advancing globalization have made Wal-Mart a lightning rod for criticism. Wal-Mart transformed 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.
Competition, economic factors, and questionable marketing decisions have combined to shrink Wal-Mart's same-store sales growth 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 taken a bite out of the wallets and pocketbooks of Wal-Mart's core customers. The company is responding by cutting back on plans to open new stores and by offering generic prescriptions drugs for $4.
When we analyzed Wal-Mart after the results from January 2007 became available, the Overall score was a modest 37 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 13 points. Cash Management and Profitability were weakest at 5 points each.
Now, with the available data from the April 2007 quarter, our gauges display the following scores:
Cash Management. This gauge dropped 2 points from 5 points in January. The Current Ratio is now 0.9, which is pretty much where it has been this entire decade. (Our scoring system gives greater rewards to companies with more cash in the till, but Wal-Mart is the master at making do with less). Long-Term Debt/Equity is up to a 49 percent. The debt ratio was 44 percent in January and 47 percent 12 months ago. Inventory/Cost of Goods Sold rose slightly to 48 days from 47 days three months ago, but it is unchanged from April 2006. The steady inventory ratio (all, of course, finished goods ready for sale) hints that sales met expectations. Accounts Receivable are 3.0 days of Revenue, which is somewhat worse than the 2.8-day level one year earlier. It might be indicating the company is finding it more difficult to get its customers to pay their bills.
Growth. This gauge dropped a substantial 10 points from 13 points three months ago. Revenue growth wasn't the reason for the decline. It increased to 10 percent year over year from 9 percent a year ago. Net Income growth, however, slowed to a weak 7 percent from 9 percent a year ago. A 1-percent hike in the income tax rate, from 34 to 35 percent, didn't help. CFO actually declined 3 percent year over year; it was up 13 percent a year ago. Revenue/Assets was steady at 2.26, but below the five-year median of 2.38. The company is not becoming more efficient at generating sales.
Profitability. This gauge dropped 2 points from the prior quarter's 5 points. ROIC slipped to a modest 12 percent from 13 percent a year ago. FCF/Equity edged down to 4 percent from 7 percent. Operating Expenses/Revenue, as always, were 95 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 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. Wal-Mart's stock price was almost unchanged over the course of the quarter, increasing from $47.69 to $47.92. The Value gauge, based on the latter price, dropped to 10 points, compared to 12 and 16 points three and twelve months ago, respectively. The P/E at the end of the quarter was 16, which is low historically, but little changed from recent quarters. The average P/E for the Retail - Department and Discount industry is a somewhat more expensive 17.5. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is about the same as the average P/E, using core-operating earnings, of stocks in the S&P 500. The days when the Wal-Mart commanded a 30 percent premium to the market multiple seem long ago. No longer a growth company, the current multiple tells us that the market is expecting the company's earnings to grow in line with the average company. The PEG ratio of 2.3 is indicative of an expensive stock, given the weak growth. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has stabilized at 0.6. The average Price/Sales for the Retail - D&D industry is 0.7.
Now at a disappointing 23 out of 100 possible points, the Overall gauge has fallen below the 30's, where it had been for the last couple of years. The signs of improvement we thought we saw after January proved to be illusionary.
Wal-Mart is the world's largest retailer with nearly 6500 stores. With annual sales in excess of $300 billion, Wal-Mart holds the number 2 spot on the Fortune 500 list of America's largest corporations. Wal-Mart's disruptive cost-cutting strategies have revolutionized the marketplace for better and for worse, depending on your point of view. Its visibility and role in advancing globalization have made Wal-Mart a lightning rod for criticism. Wal-Mart transformed 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.
Competition, economic factors, and questionable marketing decisions have combined to shrink Wal-Mart's same-store sales growth 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 taken a bite out of the wallets and pocketbooks of Wal-Mart's core customers. The company is responding by cutting back on plans to open new stores and by offering generic prescriptions drugs for $4.
When we analyzed Wal-Mart after the results from January 2007 became available, the Overall score was a modest 37 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at 13 points. Cash Management and Profitability were weakest at 5 points each.
Now, with the available data from the April 2007 quarter, our gauges display the following scores:
- Cash Management: 3 of 25
- Growth: 3 of 25
- Profitability: 3 of 25
- Value: 10 of 25
- Overall: 23 of 100
Cash Management. This gauge dropped 2 points from 5 points in January. The Current Ratio is now 0.9, which is pretty much where it has been this entire decade. (Our scoring system gives greater rewards to companies with more cash in the till, but Wal-Mart is the master at making do with less). Long-Term Debt/Equity is up to a 49 percent. The debt ratio was 44 percent in January and 47 percent 12 months ago. Inventory/Cost of Goods Sold rose slightly to 48 days from 47 days three months ago, but it is unchanged from April 2006. The steady inventory ratio (all, of course, finished goods ready for sale) hints that sales met expectations. Accounts Receivable are 3.0 days of Revenue, which is somewhat worse than the 2.8-day level one year earlier. It might be indicating the company is finding it more difficult to get its customers to pay their bills.
Growth. This gauge dropped a substantial 10 points from 13 points three months ago. Revenue growth wasn't the reason for the decline. It increased to 10 percent year over year from 9 percent a year ago. Net Income growth, however, slowed to a weak 7 percent from 9 percent a year ago. A 1-percent hike in the income tax rate, from 34 to 35 percent, didn't help. CFO actually declined 3 percent year over year; it was up 13 percent a year ago. Revenue/Assets was steady at 2.26, but below the five-year median of 2.38. The company is not becoming more efficient at generating sales.
Profitability. This gauge dropped 2 points from the prior quarter's 5 points. ROIC slipped to a modest 12 percent from 13 percent a year ago. FCF/Equity edged down to 4 percent from 7 percent. Operating Expenses/Revenue, as always, were 95 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 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. Wal-Mart's stock price was almost unchanged over the course of the quarter, increasing from $47.69 to $47.92. The Value gauge, based on the latter price, dropped to 10 points, compared to 12 and 16 points three and twelve months ago, respectively. The P/E at the end of the quarter was 16, which is low historically, but little changed from recent quarters. The average P/E for the Retail - Department and Discount industry is a somewhat more expensive 17.5. To remove the effect of overall market changes on the P/E, we note that the company's current P/E is about the same as the average P/E, using core-operating earnings, of stocks in the S&P 500. The days when the Wal-Mart commanded a 30 percent premium to the market multiple seem long ago. No longer a growth company, the current multiple tells us that the market is expecting the company's earnings to grow in line with the average company. The PEG ratio of 2.3 is indicative of an expensive stock, given the weak growth. The Price/Revenue ratio, which is less affected by the one-time factors that cause wide swings in earnings, has stabilized at 0.6. The average Price/Sales for the Retail - D&D industry is 0.7.
Now at a disappointing 23 out of 100 possible points, the Overall gauge has fallen below the 30's, where it had been for the last couple of years. The signs of improvement we thought we saw after January proved to be illusionary.
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