ADP: Look Ahead to December 2007 Results

When we analyzed ADP (ADP) after the third quarter of the calendar year (first quarter of ADP's fiscal year), we found that the company had achieved its highest Overall Gauge score, 43 out of 100 possible points, since December 2003. However, we noted that corporate restructuring activities, such as the Broadridge spin-off, could have skewed the calculations by degrading the comparability of ADP's recent and historical financial performance.

Quarter-to-quarter and year-to-year comparisons of key metrics greatly influences our gauge scores.

With each new set of quarterly results, we get a chance to see whether recent blips in particular metrics were due to one-time factors or whether they indicate sustained trends in, for example, Growth and Profitability. Given some significant changes at ADP, we're anxiously awaiting the company's results for the waning December quarter.

Also, since ADP invests billions of dollars in client funds in high-quality debt securities, we'll be looking to see if the credit market's problems have seeped into ADP's triple-A world.

ADP's third-quarter report included some helpful guidance for fiscal 2008. The guidance indicated that the company anticipates full year revenue growth between 12 and 13 percent. Therefore, it seems reasonable to expect Revenue in the December quarter of about $2.1 billion. This figure would translate into year-over-year Revenue growth of 12.8 percent, while only being 11.0 percent more than Revenue in the December 2006 quarter.

We don't have explicit guidance for Gross Margin, only hints that margins are improving. Using recent history as guide, we'll look for a Gross Margin of 57 percent in the December quarter. Therefore, we're anticipating Cost of Goods Sold (CGS) -- what ADP calls Operating Expenses -- of 0.43 * $2.1 billion = $903 million.

Depreciation expenses are normally about 3 percent of Revenue. This should work out to be about $63 million in December quarter.

Our estimate for Research and Development (R&D) expenses ("Systems Development and Programming Costs") is 6.5 percent of Revenue. This would equate to $137 million

Sales, General, and Administrative (SG&A) expenses are volatile, but the ratio recently came down to 27 percent of Revenue. For the subject quarter, the estimate would be 0.27 * $2.1 billion = $567 million.

Rolling up the figures identified above, we come up with an estimate for Operating Income in the quarter of $431 million.

For net non-operating income (i.e., other income less interest expense), $15 million would seem to be a reasonable estimate based on recent data.

If the Income Tax Rate is 37.0 percent, Net Income from continuing operations will be $281 million ($0.52 per share).

($ M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue (1)		2100	1893
Operating expenses
	CGS (2)	(903)	(827)
	Depreciation (3)	(63)	(51)
	R&D (4)	(137)	(119)
	SG&A	(567)	(520)
	Other	0	(0)
Operating Income		431	375
Other income
	Investments	0	0
	Interest, etc.	15	28
Pretax income		446	403
Income tax		(165)	(150)
Net Income		281	253
		$0.52/sh	0.46/sh

<sup>1. Total revenues includes interest on funds held for clients and Professional Employer Organization revenues.
2. Operating expenses
3. Depreciation and amortization.
4. System development and programming</sup>

KG: Look Ahead to December 2007 Results

Our last evaluation of King Pharmaceuticals (KG) occurred not long after the decision by the U.S. Court of Appeals on 11 September 2007 to invalidate King's patent for Altace®. (The Court, in December, denied the company's petition for a rehearing.) Altace® is an ACE inhibitor used to treat patients with cardiovascular risks. It had accounted for about 1/3 of King's net sales. As a result of the court's decision, King's third quarter financial statements included asset impairment charges (covering intangible assets and inventory) totaling $250 million. It also led King to accelerate a shift in the company's marketing focus and to layoff 20 percent of staff.

King stock, which had been declining before the ruling, fell further when the news became public. King shares now sell for less than 1/2 of their 52-week high and less than 1/4 of the all-time high.

The drop in the stock price to reflect the loss of expected future profits threw our evaluation methodology out of whack. Our Overall Gauge score for King perversely soared because it compared the diminished stock price to previous earnings and cash flow and saw a bargain. Clearly, however, King Pharmaceuticals' future earnings and cash flow will be much less without Altace® exclusivity.

Given the uncertainties, we're going to have to rely heavily on guidance from King to look ahead to the fourth-quarter results. Fortunately, the conference call with analysts after the third quarter included much useful guidance for the fourth quarter. Unfortunately, top-line Revenue guidance wasn't provided.

King's year-over-year Revenue growth rate has recently been fluctuating between 7 and 12 percent, which is a much slower pace than the company once enjoyed. Considering that it will probably take some time for competitors to take a serious bite out of Altace® sales, but also that the sales force might have lost some motivation, we'll assume Revenue in the fourth quarter will grow at a rate not less than the bottom of the recent range. Fourth-quarter Revenue of $524 million would translate into a 7 percent year-over-year growth rate.

King announced that it anticipates a Gross Margin of approximately 76 percent in the fourth quarter. High margins such as this, or even better, are not unusual for specialty drug manufacturers. This margin would result in a Cost of Goods Sold (CGS) of 24 percent of $524 million, or $126 million.

After shortening the predicted life of intangible assets associated with Altace®, King stated at the conference call that they now expect Depreciation and Amortization expense in the fourth quarter to be approximately $40 million.

The company indicated that its full year 2007 Research and Development (R&D) investment will be in line with last year. Given that R&D was $143.6 million in 2006, and $104.5 million in the first nine months of 2007, it's not hard to figure out that fourth quarter R&D should be about $39.1 million.

King gave guidance for Sales, General, and Administrative (SG&A) expenses in 2008 but not for the fourth quarter of 2007. Historical results would suggest that 33 percent of Revenue is good estimate for SG&A expenses. This would be $173 million if our Revenue estimate stands up.

King often takes special operating charges that determine the quarter's success. The charges range, in no particular pattern, between negligible and huge. We're going to assume, rather arbitrarily, a $50 million charge in the fourth quarter.

Our estimates would lead to Operating Income of $96 million.

Non-operating income has recently been about $7 million per quarter. If the Income Tax Rate (another fluctuating parameter) is 31 percent, Net Income would be $71 million.

($ M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue		524	513
Op expenses
	CGS	(126)	(114)
	Depreciation	(40)	(37)
	R&D	(39)	(41)
	SG&A	(173)	(232)
	Other	(50)	(48)
Operating Income		96	42
Other income
	Investments	0	0
	Interest, etc.	7	7
Pretax income		103	49
Income tax		(32)	(12)
Net Income		71	37
		0.29/sh	0.15/sh

WPI: Look Ahead to December 2007 Results

When we analyzed Watson Pharmaceuticals (WPI) after the third-quarter results became available, we noted continued progress consolidating last year's Andrx Corp. acquisition. We expressed some concern that evidence of operational efficiency improvements was becoming harder to find. We were also troubled that Finished Goods/Inventory moved up to 67.1 percent (believed to be a record high for Watson), from 65.5 percent in June, and 52.3 percent in September 2006 (pre-Andrx).

A good fourth quarter could ameliorate our concerns.

Watson included guidance for the full year in their third-quarter report. With this guidance, it's not hard to model the Income Statement for the fourth quarter. The company's top- and bottom-line expectations for the quarter are clear. This is also true for some in-between figures. Where specific guidance wasn't provided for lines on the Income Statement, we tried to fill the gaps with historically grounded estimates.

The recent guidance began with a $2.5 billion estimate for total net Revenue for the full year of 2007. Since Sales in the first three quarters were $1.87 billion, the company must be expecting Revenue of $630 million in the December quarter. Back in February, Watson estimated that Revenue for 2007 would be between $2.5 and $2.6 billion. They subsequently zeroed in on the lower figure.

Watson's Gross Margin has been declining as a percentage of Revenue -- probably a result of more generics in the product mix -- but this ratio rebounded a few points in the last two quarters. If we assume the Gross Margin in the fourth quarter will match the third quarter's 42 percent of Revenue, our estimate for the Cost of Goods Sold (CGS) is 58 percent of $630 million, which equals $366 million.

Depreciation expenses have been running at about 7 percent of Revenue. For the fourth quarter, this would be about $44 million.

Watson forecast Research and Development (R&D) expenses for 2007 at approximately six percent of Revenue. This equates to $150 million over the year. Since R&D expenses in the first three quarters totaled $109 million, the estimate for the fourth quarter is $41 million.

Similarly, Watson approximated the year's Sales, General, and Administrative (SG&A) expenses at 17 percent of annual Revenue, which would be about $425 million. Since SG&A costs in the first nine months of the year were $313 million, these costs should be $112 million in the fourth quarter.

These estimates would result in an Operating Income of $67 million.

Watson's non-operating income and expenses are typically minor. Lacking specific guidance, we'll assume a $7 million net expense. This would lead to Income before Income Taxes of $60 million.

With a 37 percent Income Tax Rate, Net Income will be $38 million ($0.33/share) for the quarter and $141 million ($1.20/share) for the year. This is consistent with Watson's guidance for Earnings per Share in 2007 between $1.30 and $1.33. The difference in the figures is a consequence of the company excluding from their estimate approximately $19 million ($12 million net of tax, or $0.10 per diluted share) of acquisition, litigation and impairment charges and certain other gains and losses.

Note that the quarter-to-quarter comparison below is skewed by the $500 million charge in the fourth quarter of 2006 for in-process R&D associated with the Andrx acquisition.

($ M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue		630	621
Op expenses
	CGS	(366)	(410)
	Depreciation	(44)	(42)
	R&D	(41)	(41)
	SG&A	(112)	(102)
	Other	0	(501)
Operating Income		67	(476)
Other income
	Investments	0	0
	Interest, etc.	(7)	(6)
Pretax income		60	(481)
Income tax		22	(8)
Net Income		38	(489)
		$0.33/sh	(4.80)/sh

COP: Look Ahead to December 2007 Results

One might assume that soaring crude oil prices equates to windfall profits for energy behemoth ConocoPhillips (COP), which will announce its fourth-quarter earnings on 23 January 2008. In support for this assumption, one could note that Conoco shares have held up fairly well in a volatile market. Although below the $90 high established in July, the share price is up almost 16 percent year to date.

Conoco actually faces several significant challenges. Lower natural gas prices, compressed refining margins, and loss of its Venezuelan operations have all put pressure on Conoco's earnings. As a result, Conoco shares have lagged behind those of other major integrated oil companies.

Our analysis of Conoco after the September quarter produced an Overall Gauge score of 24 points, with the double-weighted Value Gauge contributing zero points to the total. One reason Conoco shares appear overvalued relative to historic norms is the termination of operations in Venezuela. About 9 percent of Conoco's crude-oil production in the September 2006 quarter came from Venezuela. However, we concluded that Venezuela was not the sole explanation for Conoco's low score. The refining margin, the price of natural gas, and operational efficiency all need to improve to impel the gauges upward.

Given its sensitivity to external factors, we struggle each quarter to model Conoco's next earnings report. The difficulty begins with the top line. We haven't found quarterly Revenue guidance provided by the company itself, and estimates of current Revenue based on previous growth rates hasn't been particularly accurate recently. The Yahoo Finance page includes a $74.7 billion Revenue estimate, but that figure was submitted by a single anonymous analyst. By comparison, 16 analysts submitted Earnings per Share estimates.

We have to dismiss the $74.7 billion Revenue estimate as unrealistic, since quarterly sales have been between $40 and $50 billion for the last few years. We're going to set a more modest $48 billion target, admittedly without much conviction, for fourth-quarter revenues. This figure is 4.2 percent greater that sales in the third quarter, and 16 percent greater than the very weak revenue figure of the December 2006 quarter.

Conoco's Gross Margin has edged up over the last couple of years from about 25 percent of revenue to about 30 percent, although it was a couple of points less in the third quarter. We'll set the gross-margin target in the fourth quarter at 29 percent. In other words, we're guessing the Cost of Goods Sold will be 71 percent of $48 billion or $34.1 billion.

We'll also assume, based on historic data, a Depreciation expense of 4.5 percent of revenue, or $2.2 billion. Similarly, we'll estimate SG&A expenses at 12 percent of revenue, or $5.8 billion given our revenue estimate. We will also add $250 million for exploration expense and $200 million for non-recurring operating charges.

These figures would result in an Operating Income just under $5.6 billion.

We then need to consider non-operating income and expenses, such as equity in the earnings of affiliates, minority interests, and interest. The net figure for these income and expense items has been trending up, and we will set our expectation at $1.2 billion. This pushes our estimate of pre-tax income to $6.8 billion

Conoco's effective income tax rate generally seems to be between 40 and 45 percent, so we will split the difference. If the rate is 42.5 percent in the fourth quarter, the tax bill would be $2.9 billion.

Our estimate for Net Income is, therefore, $3.9 billion ($2.35 per share).

($M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue		48000	41519
Op expenses
	CGS	(34080)	(28039)
	Depreciation	(2160)	(2002)
	Exploration	(250)	(391)
	SG&A	(5760)	(5176)
	Other	(200)	(420)
Operating Income		5550	5221
Other income
	Equity income	1100	852
	Interest, etc.	100	(156)
Pretax income		6750	5917
Income tax		(2869)	(2720)
Net Income		3881	3197
		2.35/sh	1.91/sh

Happy Birthday Ted Oglove

footnoted.org, which should be a regular stop for all GCFR readers, is celebrating the 75th birthday of Thornton “Ted” Oglove.

Ted started the "Quality of Earnings Report" newsletter and wrote the book "Quality of Earnings." The book is often cited, such as this recent reference from Motley Fool.

Our copy of the book is working its way through Amazon.com's efficient distribution system.

TDW: Look Ahead to December 2007 Results

It has been a roller coaster year for Tidewater shareholders. The price per share increased linearly from $45 in early January to $80 in July, before returning to its starting point, or nearly so, with the stomach-turning plunges familiar to amusement park patrons.

The drop for this owner of "the world's largest fleet of vessels serving the global offshore energy industry" occurred despite crude oil prices rising to historic levels.

When we analyzed the company's September quarter results, after the first stock price nosedive, we found that our Overall Gauge for Tidewater had declined from lofty levels to a modest 35 out of 100 possible points. We attributed the weaker score to slowing growth and higher costs.

The Overall gauge score peaked in late 2006, anticipating the stock price's rise and its subsequent fall. Revenue started to surge at Tidewater in late 2004, after a couple years of flat (or declining) performance. The maximum growth rate was seen in June 2006, when quarterly revenues were 40 percent greater than the year-earlier period. Year-over-year revenue growth peaked soon thereafter at 34 percent.


By comparison, year-over-year revenue growth through September 2007 was down to 18 percent.

Tidewater's revenue is dependent on the number of vessels they own, the average vessel utilization, and lease charges (typically expressed in dollars per day). The utilization rate has been the weakest of the three components recently. Based on extrapolations, our forecast for Revenue in the December 2007 quarter is $326 million, which is 13 percent greater than Revenue in December 2006. If achieved, year-over-year Revenue growth would be 15 percent.

Tidewater's Gross Margin increased from about 35 percent of revenue in 2004 to almost 55 percent at the end of 2006. It fell back to 49 percent in the September quarter. One factor that increased costs (and reduced Revenues) was "regulatory drydocking." (With Tidewater deploying larger vessels, maintenance activities are making quarterly results more erratic.) Tidewater has already indicated that vessel operating costs in the December quarter will increase as new vessels are added to the fleet and other vessels undergo maintenance. We will look for the Gross Margin in the December quarter to remain at 49 percent. Given our revenue estimate, we're looking for a Cost of Goods Sold (i.e., vessel operating costs plus costs of other marine revenues) of 0.51* $326 million = $166 million.

Depreciation has been about 10 percent of revenue in recent quarters. This would equate to 0.1 * $326 million = $33 million for December. Similarly, if trends continue, SG&A expense should also be about 10 percent of revenue, or another $33 million.

As a result, operating income of $95 million seems attainable. If we guess an additional $10 million in income from asset sales and interest, and a 19 percent income tax rate, our estimate for net income become $85 million ($1.53 per share). This is below for the $93 million earned in the December 2006 quarter. However, with a net income of $6.20 per share over the four quarters, the Price/Earnings ratio would be mere 8.7 using Friday's closing stock price.

($M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue		326	288
Op expenses
	CGS	(166)	(131)
	Depreciation	(33)	(30)
	SG&A	(33)	(25)
Operating Income		95	103
Other income
	Asset sales	3	9
	Interest, etc.	7	4
Pretax income		105	115
Income tax		(20)	(22)
Net Income		85	93
		1.53/sh	1.67/sh

PEP: Look Ahead to December 2007 Results

PepsiCo (PEP) shares, as shown here, have repeatedly established new 52-week highs. With the dollar weak, PepsiCo's significant overseas operations are attractive. Also, with uncertain economic growth, investors are drawn to defensive, non-cyclical industries, such as food and beverages.

Our assessment of PepsiCo after the third quarter was generally positive. Revenue was higher than we forecast, and PepsiCo did a good job controlling expenses in spite of increases in raw material costs. As a result, Operating Income was 14 percent above the predicted value, and Net Income exceeded our forecast by 19 percent. The latter result was aided by a $115 million favorable resolution of foreign tax matters.

The Overall gauge score of 39 in September might seem weak, but that is misleading. The gauge for PepsiCo is now just a few points below the top of its historic range. For whatever reason, the score for PepsiCo never gets very high. Nevertheless, the Overall score correlates fairly well with future increases in PepsiCo's stock price. With 28 quarters of data, the correlation coefficient between the score and one-year price growth is 62 percent.

As usual, prior to the release of another quarter's earnings, we find ourselves wondering if the good times at PepsiCo will continue. By most accounts, they are one of the better managed companies in the country. What is reasonable to expect?

In February, PepsiCo provided guidance for 2007 indicating "the Company expects mid-single-digit volume and net revenue growth, with revenue growth outpacing volume growth." With this in mind, we're looking for fourth-quarter revenues of $10.95 billion. This figure would equate to 9.3 percent year-over-year revenue growth and a 5.5 percent increase over the December 2006 quarter.

The gross margin for PepsiCo always seems to be about 55 percent of revenue, so we're comfortable estimating the Cost of Goods Sold at 0.45 * $10.95 billion = $4.93 billion. Similarly, SG&A expenses have recently been around 35 percent of revenue, but tend to be several points higher in the fourth quarter. Our assumption for these costs in the fourth quarter is 0.39 * $10.95 billion = $4.27 billion. We'll also assume a $60 million charge for amortization of intangible assets and restructuring charges. (The company issued guidance to expect restructuring charges of about $0.03 per share in the fourth quarter.)

Bottler equity income is both significant and erratic. It tends to be relatively weak in the December quarter. Since bottler equity income was $218 million in the September quarter, we think it is reasonable to expect an income of $140 million in the fourth quarter.

A $25 million charge for net interest expenses seems reasonable given recent history.

The income tax rate presents another complication. The company indicated that tax rate volatility will continue, but they are assuming that the average for year will be no more 27.7 percent. We've used this full-year estimate for the fourth quarter.

Rolling up these estimates, we're looking for net income of $1.31 billion ($0.79) for the quarter. The quarter appears weaker than the year-earlier period because the latter benefited from an unusually low tax rate.

($M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue		10951	10383
Op expenses
	CGS	(4928)	(4744)
	SG&A	(4271)	(4072)
	Amortization, etc.	(60)	(54)
Operating Income		1692	1513
Other income
	Equity income	140	131
	Interest, etc.	(25)	(4)
Pretax income		1807	1640
Income tax		(501)	(144)
Net Income		1307	1784
		0.79/sh	$1.06/sh

BUD: Look Ahead to December 2007 Results

Our Overall Gauge score for Anheuser-Busch (BUD) was 27 out of 100 possible points after we analyzed the company's third quarter results. The analysis noted good progress reducing operating costs, but it also noted that earnings were pumped up by a one-time gain on the sale of distribution rights. The Value gauge remained weak at 3 out of 25 points because it appeared that BUD shares were trading at a premium not justified by corporate results.

While the Growth and Profitability scores were decent, the double-weighted Value gauge dragged down the Overall score. It also didn't help that the Finished Goods/Inventory ratio rose to 39.4 percent from only 28.6 percent one year earlier. There might be an operational explanation for the increase, but we tend to worry that unusual growth in the Finished Goods ratio could be signaling that sales were below expectations.

More optimistically, W. Randolph Baker, BUD's vice president and chief financial officer, told investors that Anheuser-Busch is clearly "better positioned for long-term growth." He attributed these good tidings to a transformation in their "selling system," as well as "changes in marketing and media." In addition, BUD is seeing "acceleration of growth in the consumer demand for beer" in the U.S. Mr. Baker reaffirmed the company's expectation for earnings per share growth for the full year 2007 to exceed its 7 to 10 percent long-term objective. [We need to determine how much of this growth is due to fewer shares outstanding after stock repurchases, which have been significant. As we noted previously, the average diluted number of common shares dropped from 775.9 million in the third quarter of 2006 to 745.4 million in the third quarter of 2007.]

BUD doesn't provide explicit Revenue guidance. Given the company's rosy statements, which included mention of phased-in price increases, we're expecting to see Revenue grow at an accelerating pace. However, BUD's Revenue tends to be less in the fourth quarter (between 22 and 23 percent of annual revenues) than the others. Instead of focusing on sequential quarterly growth, we will turn our attention to year-over-year growth. To be specific, we will look for annual revenue in 2007 to be 6 percent more than 2006's revenue, which was 4.5 percent greater than revenue in 2005. Revenue in the current quarter of $3.67 billion would accomplish this goal. It would be 7.1 percent more than in the year-earlier quarter.

With revenue in the fourth quarter typically weak, expenses as percentage of revenue tend to be a little higher than in the other quarters. Cost of Goods Sold (CGS), which are averaging 63 to 65 percent of revenue -- for a Gross Margin of 35 to 37 percent -- will probably be closer to 69 percent in the fourth quarter. Our CGS estimate is 0.69 * $3.67 billion = $2.53 billion.

Sales, General, and Administrative (SG&A) expenses have been around 17 percent of Revenue, but tend to be several points higher in the fourth quarter. If we assume 21 percent, SG&A expenses would work out to be $770 million in the fourth quarter.

These figures would result in Operating Income of $369 million in the quarter.

We're estimating Equity Income to be $167 million. This is 20 percent above the value in 2006's fourth quarter.

If we assume a Net Interest expense of $120 million, pre-tax income will be $414 million. (Strictly speaking, the Equity Income shouldn't be included in this figure since it is net-of-tax.)

Assuming an Income Tax Rate of 32 percent, the tax in the quarter should be about $133 million. This would leave us with Net Income of $282 million ($0.38 per share), compared to $190.7 million ($0.25/share)

($M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue		3669	3425
Op expenses
	CGS	(2531)	(2442)
	SG&A	(770)	(764)
	Other	0	0
Operating Income		367	219
Other income
	Equity income	167	140
	Interest, etc.	(120)	(114)
Pretax income		414	244
Income tax		(133)	(54)
Net Income		282	191
		0.38/sh	0.25/sh

MSFT: Look Ahead to December 2007 Results

Microsoft's (MSFT) earnings and revenue grew substantially in the quarter that ended on 30 September 2007. MSFT shares surged from about $30 before the quarterly report in late October to $37 in the first days of November. The share price fell back in subsequent days, but the price is still above the earlier trading range.

Microsoft's Revenue in the September 2007 quarter was an amazing 27.3 percent greater than in the year-earlier quarter, on brisk sales of the new Halo 3 video game, Windows and Office. A win-win combination of higher Revenue and lower Sales, General, and Administrative (SG&A) expenses resulted in Operating Income more than 21 percent above our forecast value.

Our Overall Gauge for Microsoft moved up to a very good 55 out of 100 possible points after we analyzed September's results.

Today's higher stock price will serve as headwind slowing further increases in the Overall Gauge. Or, will the results from the December quarter overpower the friction and propel the scores higher? We think so.

When the results from September were publicized, Microsoft provided some guidance about what they expect in the current quarter and the fiscal year that will end in June 2008.

The company forecast that Revenue in the December 2007 quarter (the second of fiscal 2008) would be in the range of $15.6 to $16.1 billion. The mid-point, $15.85 billion, which is the figure we will use, is a healthy 26 percent above the $12.5 billion of the December 2006 quarter. This value would also lead to year-over-year revenue growth of 25 percent. These growth rates are rare for a large company and haven't been seen at Microsoft since the dot-com boom.

Microsoft's Gross Margin is typically over 80 percent (!). If we set the target for the current quarter at 82 percent, the Cost of Goods Sold will be 0.18 * $15.85 billion, or $2.85 billion. R&D expenses, as a percentage of revenue, have been declining from about 15 percent of revenue to under 14 percent. We will assume 14 percent for the December quarter. Therefore, we expect R&D expenses of around $2.2 billion. SG&A expenses are more volatile, but they are typically around 30 percent of revenue. This would equate to 0.30 * $15.85 billion = $4.76 billion, for December quarter.

The estimates above would translate into an Operating Income of about $6.02 billion, which is consistent (not coincidentally) with the $5.9 to $6.1 billion range forecast by Microsoft.

The reduction in Microsoft's cash hoard due to share repurchases undoubtedly cut into investment and interest income. We'll assume net other income of $300 million.

We'll also assume an income tax rate of 30 percent, which leads to a Net income value of $4.4 billion ($0.47/share). This is a little above the company's guidance of $0.44 to $0.46 per diluted share. We may have underestimated the income tax rate, or Microsoft might be setting the bar a little lower than they think they can achieve. Net income was $2.626 billion ($0.26/share) in the year-earlier quarter.

($M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue		15850	12542
Op expenses
	CGS	(2853)	(3620)
	R&D	(2219)	(1637)
	SG&A	(4755)	(3813)
	Other	0	0
Operating Income		6023	3472
Other income
	Investments	0	0
	Interest, etc.	300	333
Pretax income		6323	3805
Income tax		(1897)	(1179)
Net Income		4426	2626
		0.47/sh	0.26/sh

INTC: Looking Ahead to 2007 Q4 Results

When we evaluated Intel after the third quarter, we noted improvements in Revenue, Cash Flow from Operations (CFO), and Net Income. These and other financial metrics pushed our Overall Gauge up from 20 to 30 points. This nice increase was limited because the double-weighted Value Gauge made no contribution to the score. [Recent performance improvements will have to be sustained, or the stock price will have to dip, to move our Value gauge.]

From April through October, and into November, Intel's share price moved up smartly. The rise was helped by favorable reviews given to Intel's newest products and predictions that Intel will regain market share from steadfast competitor Advanced Micro Devices (AMD). The closing low price for the shares was $18.86 on 28 March, and the closing high was $27.49 on 6 November, for a gain of nearly 46 percent (hence the Value Gauge's disapproval). The market turmoil during the summer might ironically have contributed to Intel's price rise, as well-capitalized high-tech companies were, for a time, seen as being insulated from the stormy financial and housing industries. By the middle of last month, though, the pessimism had seeped into nearly every sector of the market.

When looking ahead, our approach is to extrapolate from the past and to make some adjustments based on credible current conditions and forecasts. Intel makes our job easy by providing explicit guidance for most of the items on the Income Statement. In their third quarter report, Intel provided several forward-looking statements, with appropriate caveats, about their expectations for the fourth quarter. Since management knows their business infinitely better than we do, their guidance forms the basis for our expectations. All we have to do is a little basic arithmetic and look for figures that deviate from recent trends.

Year-over-year Revenue Growth through the September 2007 quarter was +4.0 percent. This rate doesn't seem impressive, but it was negative after each of the four previous quarters. In October, Intel estimated that revenue in the December quarter would be between $10.5 and $11.1 billion. The midpoint of this range, $10.8 billion, would equate to a 11.4-percent gain over the year-earlier quarter. Year-over-year Revenue Growth would be 8.6 percent, which would be the healthiest rate since 2005. Professional analysts have also centered their aim just a tad above the midpoint value of the range announced by the company; their revenue predictions average $10.83 billion.

To maintain market share in a highly competitive business, Intel's Gross Margin dropped under 50 percent in some recent quarters, before rebounding to 51.2 percent in September. [It would have been another point or so higher if Intel hadn't charged $113 million to Cost of Goods Sold (CGS) to account for the present value of intellectual property licensed as the result of a settlement with Transmeta.] Intel signaled that the Gross Margin in the fourth quarter would soar to 57 percent, plus or minus a couple of percentage points. Intel hasn't had a Gross Margin that high in the last couple of years. On our own, we wouldn't have set the expectations that far above the trendline, but we're going to give the company the benefit of the doubt. Given the revenue estimate above, Intel is telling us to expect a CGS of 0.43 * 10.8 billion = $4.64 billion.

Intel has had some recent success in bringing down R&D and SG&A costs, as a percentage of Revenue. In the December quarter, we're assuming these R&D will be 15 percent of revenue and SG&A will be about 14 percent of revenue. At a total of $3.1 billion, our assumption is little above the company's guidance of $2.8 to $3.0 billion. We will accept without modification the company's $130 million estimate for restructuring and asset impairment charges.

The aforementioned assumptions lead to an estimated Operating Income for the quarter of $2.9 billion, a hefty 94.5 percent gain over the year-earlier figure.

Intel's guidance for non-operating income was $150 million. This would result in a predicted level of Income before Taxes of $3.0 billion. Non-operating income in the December 2006 quarter benefited substantially from a $483 million one-time gain on the divestiture of certain assets of the communications and application processor business to Marvell Technology Group, Ltd.

Effective income tax rates shouldn't change dramatically from quarter to quarter, but the resolution of a dispute with the IRS led to wide swings as Intel was allowed to reverse some previously accrued taxes. This caused the first and second quarter tax rates to be abnormally low. For the tax rate in the fourth quarter, we'll use Intel's estimate of a more typical 29 percent.

With all these assumptions, Net income in the fourth quarter will be almost $2.2 billion ($0.37/share), up from $1.5 billion in the year-earlier quarter. Analysts are assuming $0.40 per share, which suggests they are more optimistic than the company itself.

($M)		Dec 2007 (predicted)	Dec 2006 (actual)
Revenue		10800	9694
Op expenses
	CGS	(4644)	(4884)
	R&D	(1620)	(1426)
	SG&A	(1512)	(1434)
	Other	(130)	(462)
Op income		2894	1488
Other income
	Investments	0	7
	Interest, etc.	150	632
Pretax income		3044	2127
Income tax		(883)	(626)
Net income		2161	1501
		0.37/sh	0.26/sh

HD: Financial Analysis through October 2007 (Update)

We previously posted an analysis of Home Depot's (HD) preliminary report on the October 2007 quarter.  The company's initial report was limited: the Balance Sheet was condensed, and the Cash Flow Statement was omitted.   Home Depot subsequently submitted a more complete quarterly report in a 10-Q filed with the SEC.

Our evaluation, adjusted to account for new information, is reported below.   For completeness, information from our initial post that is still relevant has been repeated. Gauge score calculations, however, have been omitted because we don't have sufficient historical financial data at this time that is representative of Home Depot's new corporate structure.

It has been a momentous year for the largest retailer of "do-it-yourself" merchandise, which includes building materials, home improvement supplies, and lawn and garden products.   Robert Nardelli was forced out as Chairman and CEO because of dissatisfaction with the company's operating performance, stagnant stock price, and bountiful executive compensation.  His elephantine severance package became a cause célèbre.   After Frank Blake took over, the company sold the Home Depot Supply division, which served professional contractors.  The purchase by a consortium of private equity firms closed on 31 August 2007 for $8.5 billion.  The final price was $1.8 billion less than the figure originally negotiated, after problems surfaced in the housing and credit markets.  The company used the proceeds and other funds to complete a $10.7 billion Dutch Auction tender offer for its own shares. The offer is part of a larger $22.5 billion "recapitalization" plan, although there has been speculation that the further share repurchases will be delayed considerably.

A fund controlled by Sears Holdings chairman and successful investor Edward Lampert acquired 16.7 million Home Depot shares, valued at $541.3 million, during the third quarter.

We analyzed Home Depot after the April 2007 quarter, but we passed on the July quarter because there was speculation the Home Depot Supply sale might fall through.

Before we examine the metrics associated with each gauge, let's review the latest quarterly Income Statement.   Please note that the presentation format below, which we use for all analyses, may differ in material respects from company-used formats.  A common difference is the classification of income and expenses as Operating and Non-Operating.  The standardization is simply for convenience and to facilitate cross-company comparisons.

($M)		October 2007 (actual)	October 2006 (actual)
Revenue		18961	19648
Op expenses
	CGS	(12622)	(13044)
	Depreciation	(431)	(401)
	SG&A	(4144)	(3981)
	Other	0	0
Operating Income		1764	2222
Other income
	Investments	0	0
	Interest, etc.	(125)	(92)
Pretax income		1639	2130
Income tax		(568)	(797)
Net Income		1071	1333
		$0.59/sh	$0.65/sh
Discontinued operations (1)		20	157

^{1. Primarily HD Supply}

Revenue in the October 2007 quarter was 3.5 percent less than in the year-earlier quarter.  The Cost of Goods Sold (CGS) was 66.6 percent of Revenue, up slightly from 66.4 percent last year.   Depreciation expenses were 2.3 percent of Revenue, up from 2.0 percent.   Sales, General, and Administrative (SG&A) expenses were 21.9 percent of Revenue, much greater than the 20.3 percent one year ago.

The doubly bad combination of lower Revenue and higher costs, as a percentage of Revenue, led to 20.6-percent decrease in Operating Income.

Net interest and other non-operating expenses were $33 million more than last year.  The Income Tax Rate was 34.7 percent, down from 37.4 percent.  Net Income from continuing operations declined by 19.7 percent.


Key metrics are reviewed below by each gauge.

Cash Management.

The following measures have improved:

• Days of Sales Outstanding (DSO) = 11.9 days, less than the 13.8-day level one year earlier
• Cash Conversion Cycle Time (CCCT) = 44.8 days, down from 46.0 days, for this measure of efficiency.

The following measures have weakened:

• Current Ratio =1.1; much weaker than we prefer, but not too much below the five-year median value of 1.3.
• LTD/Equity = 65 percent up from 24 percent last year at this time; the company has become much more leveraged as it borrows money to repurchase shares.
• Debt/CFO = 1.9 years, up from 1.2 years in October 2006. Debt may be on the rise, but it appears to be affordable.
  
• Inventory/CGS = 89.2 days, compared to 87.3 days 12 months ago. The five-year median is much less at 76 days, which suggests that sales have been slower than expected.
• Working Capital/Market Capitalization = 2.6 percent, down somewhat from 3.2 percent in October 2006.

Growth.

The following measures have improved:

• Revenue/Assets = 176 percent, way up from 154 percent in a year; stock repurchases decrease assets, which create the illusion of improved sales efficiency.

The following measures have weakened:

• Revenue growth = -1.4 percent year-over-year, down from +2.9 percent
• Net Income growth = -22 percent year-over-year, down from +2 percent
• CFO growth = -1.1 percent year-over-year, down from +4.7 percent.

Profitability.

The following measures have improved:

• FCF/Equity = 17.6 percent, up from 11.5 percent
• Accrual Ratio = 3.1 percent, down from 4.7 percent.

The following measures have weakened:

• Operating Expenses/Revenue = 90.5 percent, up from 88.3 percent in a year
• ROIC = 16.4 percent, reasonably healthy, and down just a tad from 16.6 percent in a year.

Value. Home Depot's stock price fell from $40.16 on 31 December 2006 to $31.51 on 31 October 2007. By then end of November, it was down to $28.56. The following metrics were calculated (per our usual practice) using October's closing price.

These value measures all suggest the shares have become less expensive on a relative basis:

• Enterprise Value/Cash Flow = 10.4, down from 12.6 in October 2006
• P/E = 12.8, down from 13.4.  The five-year median P/E is 15.6 (when the company was growing)
  
• P/E to S&P 500 average P/E = 26 percent discount, compared to a five-year median of a 8 percent discount
  
• Price/Revenue ratio = 0.72, lower than its five-year median of 1.07.

The average P/E for the Retail (Home Improvement) Industry is currently 12.6.  The average Price/Revenue for the Industry is currently 0.75.

The slowdown in home sales has trimmed Home Depot's Revenue and slashed its Earnings.   The stock market has punished Home Depot (HD) shares mercilessly, especially since the completion of tender offer, which provided some support to the shares during the summer.  The shares now appear to be on sale, but that may be an illusion.  Investors fear that a recovery in the housing industry is a long way in the future.  Home Depot appears able to, um, weather the storm, although we would have to reconsider this assessment if they borrow another $10 billion to buyback more stock.