NOK: Look Ahead to 2008 First Quarter Results

Our analysis of Nokia (NOK) through the fourth quarter of 2007 produced a disappointing Overall gauge score of 28 points out 100 possible points. The Growth and Profitability gauge scores were good, and the Cash Management gauge score was OK, but the double-weighted Value gauge contributed only 1 of 25 possible points.

The Value gauge was weak because the price of Nokia ADRs advanced from $20.32 to $38.39, a gain of 89 percent, over the course of 2007. Revenue and Net Income grew smartly during this period, but they they were outpaced by the soaring stock price. The weak dollar undoubtedly added to the ADR price rise. (Nokia's results are expressed in Euros.)

The creation in April 2007 of Nokia Siemens Networks, a 50/50 partnership with the German powerhouse, has made it difficult to compare Nokia's current and past results. Recent financial statements fully consolidate the operations of the partnership. However, previous results, including the relevant year-earlier periods, do not include data for the businesses Siemens contributed to the partnership. This is a significant difference since the partnership would, by itself, be considered a large-cap company.

On 17 April 2008, Nokia will report its results for the first quarter of 2008. The company, in January, provided some qualitative guidance about expected business conditions and anticipated sales volumes. However, we have to make many material assumptions to forecast the first quarter Income Statement.

Given the strong Revenue growth Nokia has been achieving recently, we can expect Revenue in the first quarter of 2008 to be significantly greater than the €9.9 billion figure in the March 2007 quarter. However, Revenue will almost certainly be less than the €15.7 billion racked up in the December 2007 quarter. Sales in the first quarter are traditionally weaker than those in the holiday-focused fourth quarter of the previous year.

Our working estimate for first quarter Revenue is €12 billion. Professional analysts are a little more optimistic: their average estimate for Nokia's first quarter Revenue is $19.94 billion (€12.64 billion at the current exchange rate ). Our estimate translates into year-over-year Revenue growth of 28 percent; it would also be 22 percent greater than the €9.9 billion in the first quarter of 2007.

Nokia's Gross Margin has been around 33 percent of Revenue, give or take a couple of points, for the last couple of years. Since the company seems to emphasizing increased market share, we're not going to look for a significant improvement in profitability in the first quarter. Matching the 33 percent figure with our Revenue projection, our expectation for Costs of Goods Sold in the quarter is €8.04 billion.

Research and Development and Sales, General and Administrative expenses have each been between 10 and 11 percent of Revenue recently. We will split the difference and use an estimate of 10.5 percent of Revenue for each expense. With these figures, our estimate for Operating Income works out to be €1.44 billion.

Investment and interest income/expenses are tough to predict because they vary greatly from quarter to quarter. For the record, we're assuming €60 million net non-operating income. If we subtract €420 million for income taxes, assuming an effective 28 percent tax rate, the prediction for Net Income is €1.08 billion (€0.28/share). The analyst consensus estimate is $0.57 (€0.36) per share.

(€M)		March 2008 (predicted)	March 2007 (actual)
Revenue		12000	9856
Op expenses
	CGS	(8040)	(6954)
	R&D	(1260)	(925)
	SG&A	(1260)	(962)
	Other	0	(103)
Operating Income		1440	1272
Other income
	Investments	0	(4)
	Interest, etc.	60	48
Pretax income		1500	1316
Income tax		(420)	(337)
Net Income		1080	979
		€0.28/sh	0.25/sh

INTC: Look Ahead to 2008 First Quarter Results

When we evaluated Intel after the fourth quarter of 2007, we noted rises in our Cash Management, Growth, and Profitability gauges. These improvement increased the Overall Gauge score to 33 points, but the advance was limited because the double-weighted Value Gauge made no contribution to the total.

In other words, the Intel's (INTC) financial and operating performance was improving, but it was already reflected in the $26.66 closing price of Intel shares last December.

The shares, however, are now selling for only about $21. When Intel's first quarter results are reported on 15 April 2008, we will get some indication of how much this high-tech bellwether is being affected by the slowing economy. Is Revenue slowing? Are margins dropping? Is inventory backing up? If not, we could have a situation where all four of our component gauges are displaying healthy values.

When looking ahead, the GCFR 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. (We have to make many more assumptions to estimate the results of other companies.) In the fourth quarter report, Intel provided several forward-looking statements, with appropriate caveats, about their expectations for the first quarter and full year of 2008. 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.

Intel estimated that Revenue in the March 2008 quarter will be between $9.4 and $10.0 billion. The midpoint of this range, $9.7 billion, would equate to a 9.6-percent gain over the year-earlier quarter. Professional analysts have also centered their aim at the midpoint value; their revenue predictions average $9.67 billion. If achieved, year-over-year Revenue Growth would be 11.0 percent, the healthiest rate since 2005.

To maintain market share, Intel's Gross Margin slipped in 2006. As the company's competitive position improved, the margin rebounded nicely in the second half of 2007. In January, Intel predicted that the first quarter 2008 Gross Margin would be 56 percent "plus or minus a couple of points." A few weeks ago, though, they reduced this forecast to 54 percent "plus or minus a point." The reduction was attributed "to lower than expected prices for NAND flash memory chips."

Given the revenue estimate above, Intel is telling us to expect a CGS of about (1 - 0.54) * $9.7 billion = $4.5 billion.

After a major spike in 2006, Intel has successfully brought down R&D and SG&A costs, as a percentage of Revenue. For the first quarter of 2008, the company predicted these two expenses would total between $2.8 and $2.9 billion. This is about 29.4 percent of the forecast Revenue. Since the company didn't break down this figure for us, we will allot 15 of the 29.4 percent to R&D and the remaining 14.4 percent to SG&A.

We will accept without question the company's $100 million estimate for restructuring and asset impairment charges.

The aforementioned assumptions lead to an estimated Operating Income for the quarter of $2.3 billion, a substantial 36 percent gain over the year-earlier figure.

Intel's guidance for non-operating income was $175 million. This would result in a predicted level of Income before Taxes just under $2.5 billion.

Effective income tax rates shouldn't change dramatically from quarter to quarter, but the resolution of a dispute with the IRS led to abnormally low rates in parts of 2007 as Intel was allowed to reverse some previously accrued taxes. For the tax rate in the first quarter of the new year, we'll use Intel's estimate of a more typical 31 percent.

With all these assumptions, Net income in the first quarter will be $1.7 billion ($0.28/share), up modestly from $1.6 billion in the year-earlier quarter. The comparison with the March 2007 quarter is made more difficult because the effective income tax rate in the earlier quarter was under 13 percent. Analysts are assuming $0.29 per share in the current quarter, which suggests they are expecting the company to surpass company guidance by a small amount.

($M)		March 2008 (predicted)	March 2007 (actual)
Revenue		9700	8852
Operating expenses
	CGS	(4462)	(4420)
	R&D	(1455)	(1400)
	SG&A	(1397)	(1277)
	Other	(100)	(80)
Operating Income		2286	1488
Other income
	Investments	0	29
	Interest, etc.	175	169
Pretax income		2461	1873
Income tax		(763)	(237)
Net Income		1698	1636
		0.28/sh	0.28/sh

WPI: Financial Analysis through December 2007 (Updated)

We previously posted an analysis of Watson Pharmaceuticals' (WPI) preliminary report on the quarter and year that ended 31 December 2007. The initial report, as is typically the case for Watson, didn't include a full Balance Sheet. Details characterizing inventories, current liabilities, and stockholder's equity were missing. These omissions, however, did not prevent us from estimating GCFR gauge scores.

A full set of financial statements became available when Watson filed a 10-K annual report with the SEC. The additional detail, combined with some adjustments made to the scoring algorithms, pushed up Watson's gauge scores.

• Cash Management: 15 of 25
  
• Growth: 13 of 25
  
• Profitability: 15 of 25 (was 12)
  
• Value: 13 of 25

• Overall: 56 of 100 (was 51)

Our previous analysis of the quarterly Income Statement did not change.

An Overall gauge score in the 50's would normally, as shown in the figure, be a cause for optimism about the potential for future gains in Watson's share price. In this case, we have to be extra cautious because the acquisition of Andrx Corporation in the fourth quarter of 2006, for $1.9 billion in cash, distorts year-to-year comparisons. The company took an enormous $500 million charge for in-process R&D in the immediate aftermath of the acquisition. To a certain extent, Watson's current results appear rosier simply because 2007 did not include a similar cash expenditure and associated write-off.

The Cash Management gauge would have been higher if not for two Inventory metrics. Inventory/CGS rose over the last year from 118 to 122 days, and the ratio of Finished Goods to Total Inventory soared from 65 percent to 70 percent Increases in these ratios can hint that a company's products sold at a slower pace than expected. If this is the case, the company might then have to cut production or take back unsold goods from wholesalers.

The Profitability gauge score rose primarily because of the Accrual Ratio. This measure of earnings quality improved because cash used for investments was so much less in 2007, as mentioned above.

PEP: Financial Analysis through December 2007 (Update)

We previously posted an analysis of PepsiCo's (PEP) preliminary financial results for the quarter and fiscal year that ended on 29 December 2007. The company subsequently submitted more detailed financial statements in a 10-K annual report filed with the SEC.

The additional data in the 10-K did not significantly alter the analysis. However, one of our gauge scores ticked up a point because of an adjustment we've made to the GCFR scoring algorithms.

• Cash Management: 8 of 25
• Growth: 5 of 25
• Profitability: 12 of 25 (was 11)
  
• Value: 0 of 25

• Overall: 23 of 100 (was 22)
  

In our earlier analysis report, we remarked that the scores were adversely affected by a rising stock price, increasing costs, and slowing income growth. To be fair, 2006 featured substantial non-recurring tax benefits, which skewed the 2007 vs. 2006 comparisons. The decreasing Gross Margin, which swallowed up seemingly impressive (and hard to sustain) Revenue Growth, was probably affected by increasing commodity prices that don't appear to be waning.

Readers are alerted that the Value gauge score listed above reflects PepsiCo's $75.90 stock price at the end of December. PEP shares now trade for $68.45. With the lower share price, the Value gauge would rise to 5 points, and the Overall gauge would lift by seven points to 30. The higher figures are still rather weak, although our scores for PepsiCo in the best of times don't get above the 40's.

As can be seen in the chart, which is based on seven years of data, PepsiCo shares tend to rise more in the following year when the Overall score gets over 35 points, and they are probably best avoided when the Overall score is below 30. There are counter examples on both sides showing that that this tendency is not a certainty.

The 10-K includes some interesting information tidbits. Here are a few:

1. 12 percent of Net Revenue during 2007 is associated with Wal-Mart.

2. Sales incentives and discounts, which reduce Revenue, were 27.3 percent of Revenue in 2005, 29.3 percent of Revenue in 2006, and 28.6 percent of Revenue in 2007. This must be indicative of the competitiveness of the beverage and snack food businesses.

3. Distribution costs, which include the costs of shipping and handling, were $5.1 billion in 2007, or 35.9 percent of SG&A expenses. Are higher energy costs going to push this up in 2008?

4. PepsiCo is able to defer only $42 million of last year's $2 billion income tax provision. However, lower taxes on foreign results reduces the effective tax rate by 6.5 percent. 44 percent of Net Revenue is generated outside the U.S.

5. It's a sign of shareholder-friendly corporate governance that PepsiCo requires shareholder approval to reprice (i.e., reduce) the exercise price of previously issued stock options. This has not occurred.

6. When projecting its U.S. pension liability, PepsiCo assumes a 7.8 percent annual return on pension plan assets. The company assumes a long-term return on equity assets (targeted at 60 percent assets) of 9.3 percent per year, and a long-term return on on fixed-income investments of 5.8 percent.

7. Approximately 3 percent of securities in the investment portfolio of the U.S. pension plans were in subprime mortgage holdings at the end of 2007.

8. PepsiCo has been aggressively converting short-term debt to long-term debt. $1.4 billion in debt was reclassified from short-term to long-term in 2007. (Long-term debt to equity rose from 17 to 24 percent.)

INTC: Financial Analysis through December 2007 (Updated)

Intel's (INTC) preliminary financial results for the quarter that ended on 29 December 2007 did not include a complete Cash Flow statement. In our initial analysis of these results, we estimated Net Cash Flow from Operations (CFO) from other data. Intel subsequently submitted a complete set of financial statements, which included the Cash Flow data, in a 10-K Annual Report filed with the SEC.

CFO was significantly greater in the quarter than we estimated.

We have updated our analysis, and recalculated the gauges, to incorporate the actual data.

• Cash Management: 15 of 25 (was 13)
• Growth: 14 of 25 (was 11)
• Profitability: 13 of 25 (was 12)
• Value: 0 of 25 (unchanged)
  

• Overall: 33 of 100 (was 29)
  

The latest data changed the following metrics from the values reported earlier:

• Cash Management
  

• Debt/CFO = 0.2 years, unchanged from December 2006
  

• Growth
  

• CFO growth = 18.7 percent year-over-year, much better than our 8.3 percent estimate, and a major turn-around when compared to last year's -28 percent.
  

• Profitability
  

• Accrual Ratio = 7.7 percent, up (i.e., worsening) from last year's -1.2 percent. We're employing a a different equation to compute this metric, and it is indicating a decline in quality of earnings.
• FCF/Equity = 17.8 percent, up from 13.2 percent one year earlier
  

• Value
  

• Enterprise Value/Cash Flow (EV/CFO) is 11.6, up from 10.4 in December 2006.

There's another point that needs to be made. Intel's share price was $26.66 on 31 December, when the quarter ended. This price was used in the calculation of the Value gauge score, in keeping with our standard practice. Now, however, Intel shares are around $21, and they were recently below $20 per share. We recalculated the scores with with a share price of $21. The Value gauge score increased from 0 to 8 points, and the Overall gauge increased from 33 to a much healthier 47 points.

CSCO: Financial Analysis through January 2008 (Updated)

We previously posted an analysis of Cisco Systems' (CSCO) preliminary results for the January 2008 quarter. Cisco subsequently submitted a more complete quarterly report in a 10-Q filed with the SEC.

The additional data in the 10-Q did not affect the analysis results, but a recent tweak to our scoring algorithms had a small effect on the gauge scores, as shown below. For details, please see the earlier post.

• Cash Management: 12 of 25
• Growth: 10 of 25
• Profitability: 13 of 25 (was 12 points)
• Value: 12 of 25
  
• Overall: 49 of 100 (was 47 points)

49 points is a very good score, if somewhat short of definitive bullish sign. At current levels, the ratio of the share Price to the last four quarters of Cash Flow from Operations is about 14, for a Cash Flow yield of about 7 percent. It's true that Cash Flow isn't growing at the pace it did a year ago, but Cash Flow in the last four quarters was still 12 percent more than Cash Flow in the four prior quarters.

COP: Financial Analysis through December 2007 (Updated)

ConocoPhillips's (COP) preliminary financial results for the quarter and year that ended on 31 December 2007 did not include a Balance Sheet. This omission is typical for Conoco, and it was later rectified in the 10-K filed with the SEC. In our original analysis of these results, we simply assumed that the Balance Sheet did not change between 30 September and 31 December. We have now updated the analysis to take the latest data in the 10-K into account.

The new data did not significantly change the Gauge scores, as can be seen below:

• Cash Management: 10 of 25 (was 11)
• Growth: 3 of 25 (unchanged)
• Profitability: 12 of 25 (was 11)
• Value: 0 of 25 (unchanged)
  

• Overall: 24 of 100 (was 23)

The data in the 10-K didn't change our examination of Conoco's fourth-quarter Income Statement, which was included here.

The updated Balance Sheet did change the values for some of the Cash Management metrics. The latest figures are listed below:

The metrics that contributed the most to the score were:

• LTD/Equity = 22.8 percent; down significantly from 27.9 percent in December 2006
• Cash Conversion Cycle Time (CCCT) = -2.1 days, down from 0.9 days last year, for this measure of efficiency
• Debt/CFO = 0.9 years, compared to 1.3 years 12 months ago
  

The metrics that contributed the least to the score were:

• Working Capital/Market Capitalization = -1.3 percent, down from -0.9 percent
• Days of Sales Outstanding (DSO) = 29.7 days, up from 25.9 days in December 2006
• Current Ratio = 0.9; weaker than we like, but hardly a concern for this behemoth
  

With the new way we are calculating the Accrual Ratio, the figure dropped (a good thing) from 14.6 percent in 2006 to -2.3 percent in 2007. The decreasing Accrual Ratio indicates that more of the company's Net Income is due to CFO, and, therefore, less is due to changes in non-operational Balance Sheet accruals.

BUD: Financial Analysis through December 2007 (Update)

We previously posted an analysis of Anheuser-Busch's (BUD) preliminary report on the December 2007 quarter. This report was, for our gauge-calculation purposes, reasonably complete. The only missing data was the decomposition of total Inventories into their Raw Materials, Work in Process, and Finished Goods components. We obtained the Inventory data when BUD filed a 10-K annual report with the SEC.

With the Inventory breakout figures, we are now able to compute the Finished Goods/Inventory ratio. This metric, which contributes to the Cash Management gauge, was 34.3 percent on 31 December 2007, a rather substantial increase from 28.6 percent in December 2006. In general, we do not like to see a sharp increase in the Finished Goods ratio because it could be an early warning that Sales were below expectations. In this case, our concern is eased by knowledge that total Inventories are under control, as seen by Inventory/CGS dropping from 24.2 to 23.9 days.

The additional data did not change the gauge scores, which remain as shown below:

• Cash Management: 3 of 25
• Growth: 9 of 25
• Profitability: 11 of 25
• Value: 1 of 25
  

• Overall: 22 of 100

We also recalculated the Accrual Ratio using a formula we've been using in the analyses performed recently. The value was determined to be +0.9, a slight improvement over last year's value of 1.0 percent (lower values may indicate higher quality earnings). With the older formula, the values were +0.3 and +0.4 percent, respectively.

See our previous post for an examination of BUD's Income Statement for the quarter ending on 31 December 2007.

We had an opportunity to scan the 10-K's notes to the financial statements. Our sense is that the notes are above-average in clarity. We didn't find anything out of the ordinary, but there were a few tidbits worth mentioning:

One note describes the different methods the company uses to establish the values of its Inventories. At the end of the note, a statement indicates that the December 2007 total valuation would have increased by $183.6 million had BUD used the average-cost method (to the exclusion of all other methods) for valuing all inventories. This amount is 25 percent of the reported total inventory level of $723.5 million. It is a reminder that many assumptions determine the figures shown in a company's financial statements, and changes to these assumptions can lead to significantly different results.

BUD's investment in Mexican brewer Grupo Modelo seems to be paying off. Dividends to BUD from Grupo Modelo increased from $240 million in 2006 to $403 million in 2007. The dividend amount is determined by a formula involving Grupo Modelo's Free Cash Flow. FCF evidently grew by more than Net Income, since the latter was up only $136 million, from $1.14 billion in 2006 to $1.28 billion in 2007.

Dividends from BUD's $276.7 million investment in China's Tsingtao brewery were $10.2 million (3.7 percent) in 2007.

BUD assumes a long-term return on pension-plan assets of 8.5 percent per annum. What's interesting about this is that BUD shareholder Warren Buffett recently commented that it is unrealistic to assume an 8 percent return. However, to the credit of BUD's investment advisors, the actual annual rate of return on plan assets, net of fees, was 14.8, 10.5 and 13.7 percent in the last three years. More than a quarter of BUD's pension plan assets are in debt securities.

The company reports total 2007 tax provisions of $1.04 billion, with only $66 million deferred.

BR: Financial Analysis through December 2007

We have analyzed the financial statements of Broadridge Financial Solutions (BR) for the quarter that ended on 31 December 2007. Broadridge's results were reported in this press release and this 10-Q filed with the SEC.

Broadridge was spun off by Automatic Data Processing (ADP) to shareholders on 30 March 2007. The new company provides investor communication, securities processing, and clearing services to financial companies. Company shares advanced nicely during the final quarter of 2007, despite the ills of the financial industry; however, the continuation, if not deepening, of these problems have caused Broadridge's stock price to decline during the last few weeks, as can be seen in the figure to the right.

We first evaluated Broadridge after the September 2007 quarter. We didn't compute gauge scores at that time because the GCFR methodology requires a historical record to which current financial metrics can be compared.

Before we review the latest values for these metrics, we will examine the Income Statement for the recent quarter. We didn't attempt to predict Broadridge's earnings in advance. Note that Broadridge was part of ADP during the year-earlier period. Please also note that the tabular format below, which we use for all analyses, can and often does 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)		Dec 2007 (actual)	Dec 2006 (actual)
Revenue (1)		465	431
Operating expenses
	CGS (2)	(346)	(333)
	SG&A	(63)	(51)
	Other	0	(0)
Operating Income		57	47
Other income
	Investments	0	0
	Interest, etc. (3)	(10)	(1)
Pretax income		47	46
Income tax		(18)	(18)
Net Income		29	28
		$0.21/sh	0.20/sh

<sup>1. Net revenues= Services revenues + Other revenues - Interest expense from securities operations.
2. Cost of net revenues
3. Other expenses, net (mostly interest)</sup>


Revenue in the quarter was 7.8 percent above the value in the year-earlier period. Year-over-year Revenue Growth was 7.0 percent. The Cost of Goods Sold (CGS) -- called Cost of Net Revenues on Broadridge's Income Statement -- was 74.3 percent of Revenue, down 3 percentage points from 77.3 percent in the December 2006 quarter. However, Sales, General, and Administrative (SG&A) expenses increased by 1.6 percentage points, from 11.8 percent to 13.4 percent of Revenue.

Operating Income, as we defined it, was 21 percent more than the amount attained in December 2006.

So-called "Other expenses" hurt the recent quarter in the comparison with the year-earlier quarter. These expense were up $8.6 million. The 10-Q indicates that increased interest costs on borrowings was the reason "other expenses" soared. These borrowings might not have been necessary when Broadridge was part of ADP.

The Income Tax Rate was about 39 percent in both quarters.

The greater interest expense in the December 2007 quarter limited the increase in Net Income to a mere 3.4 percent, when compared to the year-earlier value.


Since it has only been nine months since Broadridge became a separate company, we're going to need at least one more quarter before we have a solid enough financial baseline to compute gauge scores. In addition, a temporary cash flow situation described below would have had a misleadingly negative effect on the gauges if we had tried to estimate the scores.

Cash Management.

• Current Ratio = 1.3; down from 1.4 in June 2007. We prefer values over 2.0, but lower figures aren't unusual for well-capitalized companies.
• LTD/Equity = 86 percent, which is a pretty significant amount of leverage, but the debt level dropped from 116 percent six months earlier.
• Debt/CFO = N/A because CFO was negative as a result of one-time expense.
• Days of Sales Outstanding (DSO) = down to 55.7 days from 85.8 days last June, using the current level of receivables instead of an average
• Working Capital/Market Capitalization = 12.3 percent; down from 15.6 percent
• Cash Conversion Cycle Time (CCCT) = 46.2 days, down (good) from 66.3 days; we need more data to determine if this measure of efficiency is relevant.
  

Growth.

• Revenue growth = 7.0 percent year-over-year, using proforma data
• Revenue/Assets = 75 percent, for this measure of sales efficiency
• Net Income growth = 7.9 percent year-over-year, using proforma data
• CFO growth = -67 percent year-over-year; we're skeptical that this number is representative of the company's future cash flows.
  

Cash Flows from Operations was -$272.5 million in the December 2007 quarter -- the negative number signifies that cash was used for operations -- primarily because of a $380.0 million loan that was repaid on 17 January 2008.

Profitability.

• ROIC = 15.4 percent.
• FCF/Equity = N/A because of the aforementioned Cash Flow situation
• Accrual Ratio = a horrible 16 percent because of the same Cash Flow situation.
• Operating Expenses/Revenue = 83.3 percent, down from 84.3 percent one year earlier
  

Value. Broadridge's stock price edged up over the course of the quarter from $22.15 to $22.43, which wasn't bad performance when one considers the price was $19.51 when the company was spun off from ADP. However, the shares are now back down to about $19.00. [In the ratios below, the first number is based on the 31 December share price, and the number in parenthesis uses the current price.]

• Enterprise Value/Cash Flow = N/A
• P/E = 15.4 (13.0)
  
• P/E to S&P 500 average P/E = 10 (23) percent discount
  
• Price/Revenue ratio = 1.4 (1.2)
  

The average P/E for stocks in the Business Services" target="_blank" href="http://biz.yahoo.com/ic/760.html" id="iq:h">Business Services industry is 24.5.

NT: Financial Analysis through December 2007

We have analyzed the financial statements in the 10-K for 2007 filed by Nortel Networks (NT) with the SEC. These results caused the stock price to decline substantially. This post reports on our evaluation.

Nortel is the Canadian-based supplier of products and services to telecom carriers, other networking enterprises, and businesses. Nortel has defied the worst-case predictions and managed to stay in business and even independent, unlike fellow fallen telecom Lucent Technologies. Losses have been the norm at Nortel for most of this decade, resulting in an unfathomable accumulated earnings deficit of $35 billion (U.S.).

Tougher times also revealed shortfalls in the company's internal financial controls, resulting in numerous restatements, and, sadly, allegations of fraud. The restatements complicate any financial analysis of Nortel.

When we analyzed Nortel after the September quarter, the Overall score was only 26 points. Recent changes to our scoring algorithms have bumped that up to a still-weak 29 points. Of the four individual gauges that fed into this composite result, Profitability was strongest at 9 points. Growth was weakest at 2 points.

Now, with the full-year data from the 10-K, our gauges display the following scores:

• Cash Management: 5 of 25
• Growth: 8 of 25
• Profitability: 8 of 25
• Value: 9 of 25
  

• Overall: 32 of 100
  

Before we examine the factors that affected each gauge, let's examine the Income Statements for the December 2007 quarter. We didn't issue a forecast for the quarterly results, so all figures are actuals. Please note that the table format below, which we use for all analyses, can and often does 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)		Dec 2007 (actual)	Dec 2006 (actual)
Revenue (1)		3198	3322
Op expenses
	CGS	(1801)	(1999)
	R&D	(475)	(488)
	SG&A	(678)	(694)
	Other (2)	(45)	(42)
Operating Income		199	99
Other income
	Investments (3)	(39)	(55)
	Asset sales	23	164
	Interest, etc. (4)	13	(63)
Pretax income		196	145
Income tax		(1040)	(9)
Net Income		(844)	154
		($1.69)/sh	$0.35/sh
Extraordinary items (5)			(234)

<sup>1. Total revenues includes products and services.
2. Amortization of intangible assets + Special charges + In-process R&D
3. Minority interests + Equity in net income of associated companies. Both figures are net of tax.
4. Other income - Interest expense
5. Shareholder litigation settlement expense.</sup>


Revenue was 3.7 percent less than in the year-earlier quarter. On a year-over-year basis, Revenue was down 4.1 percent. On a more positive note, Gross Margin increased as Cost of Goods Sold dropped from 60.2 to 56.3 percent of Revenue. Research and Development (R&D) expense edged up from 14.7 to 14.9 percent of Revenue. Sales, General, and Administrative (SG&A) expenses increased from 20.9 to 21.2 percent of Revenue.

The lower levels of CGS outweighed the higher R&D and SG&A costs. As a result, Operating Income essentially doubled.

Net non-operating income dropped by almost $50 million, primarily because the gain on asset sales was much greater in the December 2006 quarter.

Income taxes bizarrely turned a quarter with a modest gain into a quarter with a huge loss in Net Income. The income tax amount reflects Nortel's decision to record a non-cash charge over $1 billion to increase the valuation allowance associated with Canadian deferred tax assets.


Cash Management. This gauge decreased from 6 points in September to 5 points at the end of the year.

The following measures contributed the most to the score:

• Current Ratio =1.4; weaker than we prefer, but stable.
• Finished Goods/Inventory = 40 percent, although it is up from 36.6 percent one year ago, it has come down a lot from long-term averages
  

The following measures held the score down:

• LTD/Equity = 138.4 percent; still too high, but at least it is down from last year's 397 percent! Equity is so minimal that small reductions in debt are magnified.
• Debt/CFO = N/A (CFO has been negative)
  
• Inventory/CGS = 115 days, compared to 106.4 days last year.
• Cash Conversion Cycle Time (CCCT) = 138 days, up from 135 days a year ago, for this measure of efficiency
• Working Capital/Market Capitalization = 19.7 percent, almost unchanged from 19.9 percent in December 2006.
• Days of Sales Outstanding (DSO) = 89.5 days, almost unchanged from 89.7 days last year
  

Growth. This gauge increased from 2 points in September to 8 points now.

The following measure was the one positive contributor:

• Revenue/Assets = 64.1 percent, up from 60.2 percent last year.
  

The following measures held the score down:

• Revenue growth = -4.1 percent year-over-year, down from +8.6 percent
• Net Income growth = N/A
• CFO growth = N/A
  

Profitability. This gauge decreased from 9 points in September to 8 points now.

The following measures pushed the score up the most:

• Operating Expenses/Revenue = 96.3 percent, down from 100.0 percent in a year
• Accrual Ratio = -5.6 percent, down from -0.9 percent in a year
  

As the result of a reader comment, we're experimenting with a different way to calculate the Accrual Ratio. We'll explain the details in a subsequent post, but the new approach provides a different view of the relationship between Net Income and Cash Flow. Low Accrual Ratios, preferably below 0, indicate 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.

The following measures held the score down:

• FCF/Equity = -23 percent, down from -7 percent last year
• ROIC = 0 percent
  

Value. Nortel's stock price dropped over the course of the quarter from $16.98 to $15.09 (it's much less now). Based on the latter price, the Value gauge increased from 8 points in September to 9 points.

The following measures contributed the most to the score:

• Price/Revenue ratio = 0.7, down from 1.0 in December 2006
  

The following measures held the score down:

• Enterprise Value/Cash Flow = N/A
• P/E = N/A
  
• P/E to S&P 500 average P/E = N/A
  

The average P/E for the Communication Equipment industry is currently 23. The average Price/Revenue for the industry is currently 4.8.

Now at 32 out of 100 possible points, the best we can say about the Overall gauge score for Nortel is that has been worse. More than 6 years after the high-tech bubble burst, we don't yet see any firm signs that Nortel has turned the corner towards sustained profitability. Over the years, there have been a couple of encouraging moments. But, they proved evanescent. We need to see more.

EIX: Financial Analysis through December 2007

We have analyzed Edison International's (EIX) financial statements for the quarter and year that ended on 31 December 2007. Edison filed its 10-K annual report with the SEC on the same day the preliminary results were issued in a press release.

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.

When we analyzed Edison after the September quarter, the Overall gauge score was only 12 points. Of the four individual gauges that fed into this composite result, Profitability was the strongest at 7 points. Value was weakest at 1 point.

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

• Cash Management: 7 of 25
• Growth: 1 of 25
• Profitability: 5 of 25
• Value: 0 of 25
  

• Overall: 13 of 100
  

Before we examine the factors that affected each gauge, let's review the latest quarterly Income Statement. We did not issue a pre-release prediction of Edison's earnings for this quarter. 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)		Dec 2007 (actual)	Dec 2006 (actual)
Revenue (1)		3211	3067
Op expenses
	CGS (2)	(2319)	(2055)
	Depreciation (3)	(327)	(258)
	Other (4)	(82)	(281)
Operating Income		483	473
Other income
	Investments (5)	(16)	11
	Asset sales	(2)	1
	Interest, etc. (6)	(151)	(153)
Pretax income		314	332
Income tax		(100)	(66)
Net Income		214	266
Discontinued ops		(3)	22
		$0.65/sh	$0.81/sh

<sup>1. Total operating revenue.
2. Fuel + Purchased Power + Other Operation and Maintenance + Property and Other Taxes.
3. Depreciation, Decommissioning, and Amortization.
4. Provision for Regulatory Adjustment Clauses + Miscellaneous.
5. Equity in Income from Partnerships, etc., + Minority Interests
6. Interest and Dividend Income + Other Non-operating Income - Interest Expense - Other Non-operating Deductions - Dividends on Preferred Securities</sup>

Edison's Revenue in the recent quarter was up 4.7 percent over the year-earlier period. Cost of Goods Sold (CGS) was 72.2 percent of Revenue, much higher than 67.0 percent in the December 2006 quarter and the five-year median value of 68 percent. Depreciation was 10.2 percent of Revenue, up from the year-earlier value of 8.4 percent.

Other Operating Expenses, which in this case is "Net Provisions for Regulatory Adjustment Clauses," were almost $200 million less in the December 2007 quarter than in the year-earlier period. This figure fluctuates substantially from quarter to quarter. It is income in some quarters and an expense in others, as was the case in both of the two quarters being compared. We don't gain any insight into the company's operating performance from the swings in Net Provisions, but it can have a significant impact on quarterly results.

Despite a lower Net Provisions expense, higher CGS and Depreciation had a significant negative effect on profitability. Although Revenue increased nicely, Operating Income was only $10 million more in the quarter than the amount attained one year ago.

Non-operating expenses, predominantly interest, were $28 million more in the current quarter than in the year-earlier quarter.

The Income Tax Rate was 31.8 percent in the December 2007 quarter, which is fairly typical. Since the rate was an unusually low 19.9 percent in December 2006 quarter, it provided a boost to Net Income in the earlier quarter. Lacking that advantage in the more recent quarter, Net Income declined by 19.5 percent.


Cash Management. This gauge increased from 2 points in September to 7 points now.

The following measures contributed the most to the score:

• Cash Conversion Cycle Time (CCCT) = 6.9 days, down from 8.9 days, for this measure of efficiency.
• Days of Sales Outstanding (DSO) = 28.5 days, below last year's 32.3 days.
  

The following measures contributed the least to the score:

• Current Ratio =1.0; down from 1.3 last year and the five-year median of 1.2
• LTD/Equity = 96.3 percent; highly leveraged, but down from 105.5 percent a year ago
• Debt/CFO = 3.0 years, compared to 2.7 years in December 2006
• Working Capital/Market Capitalization = -0.1 percent, down from 4.8 percent
  

Growth. This gauge remained at a very weak 1 point.

Clearly, none of these measures contributed much to the score:

• Revenue growth = 3.9 percent year-over-year, down from 6.5 percent
• Revenue/Assets = 34.9 percent, essentially unchanged from last year's 34.8 percent
• CFO growth = -10.5 percent year-over-year, down from 58.8 percent
• Net Income growth = 1.6 percent year-over-year, up from -2.3 percent
  

Net income growth benefited significantly from a decrease in the effective income tax rate from 35.0 to 30.9 percent.

Profitability. This gauge decreased from 7 points in September to 5 points now.

The measures that helped the gauge were:

• ROIC = 10.9 percent, up from 9.9 percent in a year
• Operating Expenses/Revenue = 78.8 percent, down from 80.1 percent in a year
  

The measures that hurt the gauge were:

• FCF/Equity = 9.7 percent, down from 12.0 percent last year
• Accrual Ratio = 1.5 percent, up from 1.3 percent in 2006
  

As the result of a reader comment, we're experimenting with a different way to calculate the Accrual Ratio. We'll explain the details in a subsequent post, but the new approach provides a different view of the relationship between Net Income and Cash Flow. Low Accrual Ratios, preferably below 0, indicate 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. Edison's stock price slipped over the course of the quarter from $55.45 to $53.37. (It has dropped more significantly during the first two months of 2008.) The Value gauge, based on the year-end closing price, sunk to 0 points from 3 points last year.

• Enterprise Value/Cash Flow = 8.0, matching its five-year median value. The ratio was only 6.2 last year.
• P/E = 16.0, up from a median value of 13.1
• P/E to S&P 500 average P/E = 6 percent discount, compared to a more typical discount of about 20 percent
  
• Price/Revenue ratio = 1.3, higher than the median value of 1.1.
  

The average P/E for the Electric Utilities industry is currently a more expensive 16.3. The average Price/Revenue for the industry is currently 1.7.

At 13 out of 100 possible points, the Overall gauge for Edison remains very weak. We're not seeing much Growth, the Profitability picture is mixed, and most Value metrics suggest that the shares are expensive compared to norms.