INTC: Financial Analysis through June 2007 (updated)

Intel's (INTC) preliminary financial results, reported in the form of press release, for the second quarter included only limited Cash Flow information. In our evaluation, we had to estimate Net Cash from Operations (CFO) from Net Income and other data.

The company subsequently submitted a Form 10-Q to the SEC with more complete financial statements. The 10-Q included the Cash Flow data missing in the original release.

We had estimated CFO at $2.728 billion for the quarter, and the correct figure was $2.417 billion. When we updated our analysis to use the lower CFO, the Profitability and Overall gauge scores were trimmed by one point each.

For completeness, we're providing the entire, updated analysis report.


Intel (INTC) manufactures integrated circuits for computers, servers, handheld devices, and communication products.

After a year in which Intel was the worst performer in the Dow Jones Industrial Average, the stock price started a significant recovery in April 2007. Outpacing the broader market, investors decided that rosier times were ahead for Intel. Favorable reviews given to Intel's newest products led to predictions that Intel will regain market share from steadfast competitor Advanced Micro Devices (AMD).

When we analyzed Intel after the first quarter, the Overall score was a dismal 18 points, indicating we saw no premonitions of the subsequent turnaround. Of the four individual gauges that fed into this composite result, Cash Management was the strongest at 7 points. Growth was weakest at zero points. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

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

• Cash Management: 10 of 25
• Growth: 3 of 25
• Profitability: 8 of 25
• Value: 1 of 25
  

• Overall: 20 of 100
  

Before we examine each gauge, let's compare the latest Income Statement to our expectations.

($M)		2Q-2007 (actual)	2Q-2007 (predicted)	2Q-2006 (actual)
Revenue		8680	8500	8009
Op expenses
	CGS	(4605)	(4250)	(3838)
	R&D	(1353)	(1360)	(1496)
	SG&A	(1284)	(1360)	(1593)
	Other	(88)	(84)	(10)
Operating Income		1350	1446	1072
Other income
	Investments	(1)	20	37
	Interest, etc.	180	207	144
Pretax income		1529	1672	1253
Income tax		(251)	(518)	(368)
Net Income		1278	1154	885
		0.22/sh	0.20/sh	0.15/sh

Revenue was 2 percent were higher than we expected, and 8 percent higher than the June 2007 quarter. We thought the Cost of Goods Sold (CGS) would be 50 percent of Revenue, and the actual value was 53 percent. In other words, the Gross Margin was 3 percent less than expected, mostly likely due to competitive pressures keeping prices in check. Research and Development (R&D) expenses were 15.6 percent of Revenue, a shade less than our 16 percent estimate. Sales, General, and Administrative (SG&A) expenses were 14.8 percent of Revenue, more than a point better than our forecast.

The higher CGS outweighed the better-than-expected Revenue, and the good control over R&D and SG&A expenses, resulting in lower-than-forecast Operating Income.

Non-operating income was $48 million less than expected. However, the Income Tax Rate was only 16.4 percent. Intel had predicted 31 percent. They now say that second quarter results benefited by $0.03/share for tax items, and they expect a tax rate going forward of 29 percent.

The low tax rate was the only reason that Net Income beat our prediction.


Cash Management. This gauge increased from 7 points in March to 10 points.

The measures that helped the gauge were:

• LTD/Equity = 5.0%, insignificant
  
• Current Ratio =3.0, returned to strength after a short weak spell
• Days of Sales Outstanding (DSO) = 29 days, less than the 32.6-day level one year earlier
• Working Capital/Market Capitalization = 9.2 percent, up from 7.3 percent
• Debt/CFO = .2 years, unchanged
  

The measures that hurt the gauge were:

• Inventory/CGS = 84.1 days, up from 81.9 days, and highest level since 1995
• Finished Goods/Inventory = 36 percent, up point from last quarter and last year
• Cash Conversion Cycle Time = 66.3 days, down from 67.5 days
  

Taken together, the two inventory ratios are worrisome.


Growth. This gauge increased from 0 points in March to 3 points.

• Revenue growth = -3 percent, down from +1 percent
• Revenue/Assets = 72 percent, down from 81 percent (efficiency suffering)
• Net Income growth = -15 percent, awful but better than recent quarters, driven by tax rate
• CFO growth = -7 percent, not as bad as last year's from -16 percent in a year
  

Profitability. This gauge increased from 5 points in March to 8 points now.

The measures that helped the gauge were:

• Accrual Ratio = -0.7 percent, down from +2.4 percent
  

The decreasing Accrual Ratio 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. This needs to be confirmed.

The measures that hurt the gauge were:

• ROIC = 14 percent, down from 19 percent
• FCF/Equity = 15.3 percent, down from 16.0 percent
• Operating Expenses/Revenue = 82 percent, up from 75 percent (ouch)
  

The big factor in the increase in operating expenses was the decrease in Gross Margin.


Value. Intel's stock price rose over the course of the quarter from $19.13 to $23.74. The Value gauge, based on the latter price, dropped to a weak 1 point, compared to 4 and 15 points three and twelve months ago, respectively.

There was no good news in the measures for this gauge.

• Enterprise Value/CFO is 12.0, up from 9.1 in June 2006
• P/E = 24.6, up from 16.7 hard to grow the multiple with so little growth
  
• P/E to S&P 500 average P/E = 48 percent premium, about double the average
  
• Price/Revenue ratio = 3.9, about the same as its long-term average.

The average P/E for the Semiconductor industry is a more expensive 28. The average Price/Sales for the Semiconductor industry is 5.2.


Now at a disappointing 20 out of 100 possible points, the Overall gauge stirred ever so slightly from last quarter.

NT: Financial Analysis through June 2007

We have analyzed Nortel Networks (NT) financial results, as reported to the SEC on Form 10-Q, for the quarter that ended on 30 June 2007. 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. For most of this decade, huge losses have been the norm at Nortel, resulting in an unfathomable accumulated earnings deficit of $35 billion (U.S.).

Tougher times also revealed shortfalls in the company's financial controls, resulting in numerous restatements, and allegations of fraud. The restatements, which only go back so far, complicate any financial analysis of Nortel.

Has Nortel turned the corner? Is it now profiting from global economic demand? No, Nortel has lost money in 9 of the last 10 quarters, including the most recent one. In the tenth quarter, a profit was due only to a $500 million legal settlement.

When we analyzed Nortel after the March quarter, the Overall score was an encouraging (for Nortel) 30 points. Of the four individual gauges that fed into this composite result, Cash Management was surprisingly the strongest at 17 points. Profitability was weakest at 4 points. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

Now, with the available data from the June 2007 quarter, featuring yet-another loss, our gauges display the following scores:

• Cash Management: 14 of 25
• Growth: 0 of 25
• Profitability: 5 of 25
• Value: 5 of 25
  

• Overall: 25 of 100
  

One has to ask, why are the scores not closer to zero? Do we need to adjust the scoring algorithms, or is there some good news hidden in the results?

Cash Management. This gauge decreased from 17 points in March to 14 points now.

The measures that helped the gauge were:

• Working Capital/Market Capitalization = 26 percent, up from 15 percent
• Current Ratio =1.7; not ideal, but much better than last year's 1.3
• Days of Sales Outstanding (DSO) = 84 days, less than the 94-day level one year earlier
• Finished Goods/Inventory = 35 percent, down from 38 percent a year ago
  

The measures that hurt the gauge were:

• LTD/Equity = 200%; highly leveraged, but down from 340 percent!
• Debt/CFO = N/A (CFO negative)
  
• Inventory/CGS = 120 days, compared to 113 and 103 days 3 and 12 months ago, respectively
• Cash Conversion Cycle Time (CCCT) = 146 days, up from 144 days, for this measure of efficiency
  

Growth. This gauge decreased from 7 points in March to 0 points.

None of the measures stirred the gauge:

• Revenue growth = 5.7 percent, down from 9.6 percent in a year
• Revenue/Assets = 60 percent, the same as last year
• Net Income growth = N/A
• CFO growth = N/A
  

Profitability. This gauge didn't change from last quarter's 9 points.

The measures that helped the gauge were:

• Operating Expenses/Revenue = 98 percent, down from 102 percent in a year
  

The measures that hurt the gauge were:

• ROIC = 0 percent
• FCF/Equity = -15 percent, it was worse last year
• Accrual Ratio = 2.1 percent, up from 1.8 percent in a year
  

Value. Nortel's stock price started and ended the quarter at $24.05. The Value gauge held at 5 points.

The measures that helped the gauge were:

• Price/Revenue ratio = 0.9
  

The measures that hurt the gauge were:

• 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 31. The average Price/Revenue for the industry is currently 5.

Now at 25 out of 100 possible points, the Overall gauge for Nortel has been in worse condition. But, we don't yet see an omen of better times ahead. There's also nothing to suggest that the company has slipped into critical condition, so management still has some time to find a better path forward.

CSCO: Reports on Tuesday

In this unsettled market, a good earnings report on Tuesday from Cisco Systems (CSCO) could be a stabilizing force. The quarter that ended in July was the fourth of Cisco's fiscal year, and by all indications it was an excellent year for the networking powerhouse.

As shown on this chart, Cisco shares began the fiscal year at $17.88 and ended July 2007 at $28.91. There was a short dalliance over $30.

Our calculations after the April quarter set the Overall gauge at a modest 40 points, but it was significantly higher than the two previous quarters. The Growth gauge was strong, and the Profitability gauge was steady. The double-weighted Value gauge was, however, keeping the Overall gauge in check. As fast as the company grew in the last year, the stock price increased faster for a time, and the Value gauge frowns on that. We were also a little concerned about Inventory levels after the April quarter. Total inventories were down -- we like lean and mean -- but Finished Goods/Inventory was up. It was almost as if the company was ratcheting down production, which didn't make a lot of sense.

Cisco indicated last May in a conference call that Revenue in the July quarter would be between $9.2 and $9.3 billion. By their reckoning, this would equate to year-over-year revenue growth of 15 to 16 percent. They must have updated the previous year's baseline, because our calculations show this to be a 22 percent increase over previously reported revenue figures. No matter, we're comfortable with the $9.25 billion estimate because it consistent with the trend line. We know that the fast-growing Scientific Atlanta segment has been an upward force on revenues.

As a result of competitive pressures, the Gross Margin has been tilting downward over the last few years from a peak of 70 percent to a still-admirable 64 percent. We would have assumed the lower value as our estimate for the last quarter, but Cisco's guidance, with ample caveats, was 64.5 percent. We'll use their number. Therefore, the forecast for Cost of Goods Sold (CGS) is 35.5 percent of $9.25 billion, or $3.3 billion.

Research and Development (R&D) expenses are usually about 13 percent of revenue, maybe a little more. This would equate to $1.2 billion in the last quarter, if the revenue estimate is achieved.

Similarly, Sales, General, and Administrative (SG&A) expenses tend to be around 25 percent of revenue, or about $2.3 billion for the fourth quarter. We wouldn't be surprised if the company could shave this by a half-percent of revenue, but we will be conservative.

Cisco usually reports various other operating changes, including payroll tax on stock options, amortization of deferred compensation, amortization of purchased intangible assets, and the mysterious in-process research and development. We don't know how to forecast these costs, but they have been averaging about $100 million per quarter. We'll assume $150 million because the final quarter of a fiscal year tends to be a magnet for extra charges.

These figures would result in Operating Income of $2.3 billion, compared to $2.0 billion in the year-earlier quarter.

Non-operating interest and other income has been around $200 million per quarter, and the company indicated that this is a reasonable estimate for the fourth quarter.

The effective income tax rate has dropped to about 25 percent, or a little lower. This is consistent with Cisco's guidance.

Therefore, we're looking to see Net Income in the fourth quarter of $1.88 billion. Depending on how active the company has been at repurchasing its shares, this would equate to about $0.30 per share.

($M)		July 2007 (predicted)	July 2006 (actual)
Revenue		9250	7984
Op expenses
	CGS	(3284)	(2839)
	R&D	(1203)	(1064)
	SG&A	(2313)	(1911)
	Other	(150)	(180)
Operating Income		2301	1990
Other income
	Investments	0	0
	Interest, etc.	200	156
Pretax income		2501	2146
Income tax		(625)	(602)
Net Income		1876	1544
		$0.30/sh	$0.25/sh

COP: Financial Analysis through June 2007 (updated)

ConocoPhillips's (COP) preliminary financial results, reported in the form of press release, for the second quarter did not include a Balance Sheet. The company subsequently filed a Form 10-Q with the SEC that filled this gap.

We updated our evaluation to incorporate the Balance Sheet for 30 June 2007, and the analysis results are reported below. For completeness, we're providing the entire analysis report. Information from our initial analysis that is still relevant is repeated.

The net effect of the current Balance Sheet on our results was to increase the Cash Management and Overall gauges by 3 points each.

With worldwide oil, gas, and chemical operations, ConocoPhillips is the third-largest integrated energy company based in the U.S. Among international energy giants, it ranks fifth by Revenue and eighth by Market_Capitalization.

Holding the sixth spot on the Fortune 500, Conoco's heft is the product of mergers and acquisitions. Conoco, Inc., and Phillips Petroleum combined in August 2002. The resulting behemoth purchased Burlington Resources for $33.9 billion in March 2006 for its extensive natural gas operations in North America.

Conoco's international holdings have become problematic, given the nationalistic trends in Russia, where it owns a chunk of Lukoil, and Venezuela. A disagreement with the Venezuelan government has caused Conoco to record in its second-quarter financial results "a complete impairment of its entire interest in its oil projects in Venezuela of approximately $4.5 billion, before- and after-tax." A $4.5 billion write-off for a company with $173 billion in assets is not a cause for panic, but it is worrisome.

Conoco shares have been surging, which must please super-investor Warren Buffett since the company he runs, Berkshire Hathaway, owns about 18 million shares of Conoco. Of course, $70 for a barrel of oil didn't hurt. A new $15 billion program to repurchase company stock through 2008 definitely helped the stock.

When we analyzed Conoco after the March quarter, the Overall score was a so-so 33 points. [We didn't foresee the impending big gain in the share prices. Was it because the surging price of oil outweighed all other consideration? Was it because the company's mergers have made historic data irrelevant?] Of the four individual gauges that fed into this composite result, Cash Management was the strongest at 15 points. Value was weakest at 3 points, which really worried us at the time. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

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

• Cash Management: 16 of 25 (3 points greater than the preliminary score)
• Growth: 3 of 25
• Profitability: 10 of 25
• Value: 0 of 25
  

• Overall: 27 of 100 (3 points greater than the preliminary score)

Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously announced expectations. In the table below, we have excluded the $4.588 billion charge for expropriated assets.

($M)		June 2007 (actual)	June 2007 (predicted)	June 2006 (actual)
Revenue (1)		47370	45000	47149
Op expenses
	CGS (2)	(33377)	(30150)	(32142)
	Depreciation	(2016)	(2025)	(1965)
	Exploration	(259)	(270)	(134)
	SG&A (3)	(5301)	(4950)	(5031)
	Other	0	(100)	(141)
Operating Income		6417	7505	7736
Other income
	Equity income (4)	1487	1000	1143
	Interest, etc. (5)	202	0	(197)
Pretax income		8106	8505	8682
Income tax		(3217)	(3742)	(3496)
Net Income		4889	4763	5186
		2.95/share	2.87/sh	3.09/sh

<sub>1. Revenue = Sales and other operating revenues.
2. CGS = Purchased crude oil, natural gas and products + Production and operating expenses
3. SG&A = SG&A expenses + Taxes other than income taxes
4. Equity income = Equity in earnings of affiliates - Minority interests
5. Interest, etc. = Other income - Interest and debt expense</sub>


Revenue was 5.3 percent above our estimate. We may have overweighted Conoco's guidance for the second quarter that maintenance and asset disposals would cut production, or maybe high oil prices are curative for many ills. We thought the Cost of Goods Sold (CGS) would be 67 percent of Revenue, and the actual value was 70.5 percent. Depreciation expenses were 4.3 percent of Revenue, a shade less than our 4.5 percent estimate. Sales, General, and Administrative (SG&A) expenses were 11.2 percent of Revenue, compared to our forecast of 11 percent.

The higher expenses outweighed the higher revenue to yield Operating Income 14.5 percent below the forecast value.

The gap was closed by Non-operating income $689 million greater than expected. The Income Tax Rate was 39.7 percent, instead of the predicted 44 percent. As a result, Net Income exceeded our prediction by 2.6 percent.

We find it a little worrisome that the out-performance was due to non-operating factors.

Of course, the $4.5 billion charge, not included above, wiped out most of the net income in the quarter.


Cash Management. This gauge increased from 15 points in March to 16 points now.

The measures that helped the gauge were:

• LTD/Equity = 25.6% manageable, and decreasing
• Cash Conversion Cycle Time (CCCT) = -0.9 days, down from 3.1 days, for this measure of efficiency
• Debt/CFO = 1.0 year compared to 1.0 and 1.4 years 3 and 12 months ago, respectively
  
• Working Capital/Market Capitalization = 0.3 percent, up from -3.8 percent

The measures that hurt the gauge were:

• Days of Sales Outstanding (DSO) = 27.5 days, substantially above the 20.3-day level one year earlier
• Current Ratio =1.0; weaker than we like, but matching the historic average

Note that the DSO change indicates the company is having more success getting its customers to pay their bills; rapid collection is a sign of efficiency because the payments received can be re-invested sooner.

Growth. This gauge decreased from 8 points in March to 3 points.

None of our measures helped the gauge that much.

• Revenue growth = -8.1 percent, down from 27 percent in a year
• Revenue/Assets = 104 percent, down from 120 percent in a year; sales efficiency is worsening
• Net Income growth = -32 percent, down from 52 percent in a year (killed by impairment charge)
• CFO growth = 15 percent; respectable, but down from 41 percent in a year

Profitability. This gauge decreased from 11 points in March to 10 points.

The measures that helped the gauge were:

• FCF/Equity = 12.3 percent, up from 7.5 percent in a year
• Accrual Ratio = 0.3 percent, down from +6.3 percent in a year
  

The decreasing Accrual Ratio tells us 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.

The measures that hurt the gauge were:

• ROIC = 10.5 percent, down from 13.5 percent in a year
• Operating Expenses/Revenue = 86.5 percent, down just a bit from 87.3 percent in a year.
  

The increase in Gross Margin was matched by increases in R&D and SG&A expenses, which is why operating expense were basically unchanged as a percentage of revenue.

Value. Conoco's stock price rose over the course of the quarter from $68.35 to $78.50. The Value gauge, based on the latter price, dropped to 0 points, compared to 3 points three months ago (and 5 points twelve months ago).

• Enterprise Value/Cash Flow = 6.4, very inexpensive, and down from 6.8 in June 2006
• P/E = 12, up from 7
  
• P/E to S&P 500 average P/E = 28 percent discount, compared to a 56 percent discount one year ago
  
• Price/Revenue ratio = 0.7, compared to 0.6 one year ago

The average P/E for the Integrated Oil and Gas industry is also 12. The average Price/Revenue for the industry is currently 1.2.

We're impressed that Conoco could take a $4.5 billion charge and still report an operating profit, albeit small, for the quarter. We're also in awe that company forged by mega-acquisitions has such a solid balance sheet. However, sagging revenues when the price of the underlying commodity is surging is a source of concern. One would also expect the profitability numbers to be better.

WPI: Financial Analysis through June 2007

We have analyzed Watson Pharmaceuticals' (WPI) preliminary financial results for the quarter that ended on 30 June 2007. Our evaluation will be updated after the company formally submits a complete 10-Q report to the SEC.

Watson develops, manufactures, and sells generic and, to a lesser extent, branded pharmaceutical products. In November 2006, Watson completed an all-cash, $1.9 billion acquisition of Andrx Corporation. [More than a quarter of this cost was later expensed as "in-process R&D."] Andrx made and distributed generic drugs, often controlled-release versions. Watson had been expanding beyond generic drugs into higher-margin branded pharmaceuticals. However, the Andrx acquisition reversed this strategy and generics became responsible for over 75 percent of revenues.

Investors collectively realized this year that many branded pharmaceutical products will soon lose their patent protection. When they did, stocks of generic drug manufacturers become a lot more attractive.

When we analyzed Watson after the March quarter, the Overall score was an encouraging 48 points. Of the four individual gauges that fed into this composite result, Growth and Profitability were strongest at 16 points each. Cash Management was weakest at 7 points. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

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

• Cash Management: 9 of 25
• Growth: 17 of 25
• Profitability: 17 of 25
• Value: 7 of 25
  

• Overall: 46 of 100

Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously announced expectations.

($ M)		June 2007 (actual)	June 2007 (predicted)	June 2006 (actual)
Revenue		603	650	510
Op expenses
	CGS	(360)	(419)	(331)
	Depreciation	(44)	(46)	(41)
	R&D	(36)	(39)	(311)
	SG&A	(97)	(104)	(71)
	Other	0	0	(67)
Operating Income		66	42	(30)
Other income
	Investments	0	0	0
	Interest, etc.	(8)	(5)	5
Pretax income		57	37	(25)
Income tax		21	14	(10)
Net Income		36	23	(15)
		0.31/share	0.20/sh	(0.15)/sh

Revenue was 7.2 percent below our estimate. We're still puzzled why revenue in the March 2007 was so high, $672 million, which led to us aiming way too high in the recent quarter. We expected Revenue to be an acquisition fueled 27.5 percent greater than in the year-earlier quarter, and the actual increase was a still-healthy 18.2 percent. (Forecasts after a major acquisition are especially challenging.)

Watson made excellent progress increasing their Gross Margin. We thought the Cost of Goods Sold (CGS) would be 64.5 percent of Revenue, and the actual value was 59.7 percent. Depreciation was 7.3 percent of revenue, compared to our 7.0 percent estimate. Research and Development (R&D) expenses were 6.0 percent of Revenue, exactly matching our estimate. Similarly, Sales, General, and Administrative (SG&A) expenses were 16.1 percent of Revenue, compared to our forecast of 16 percent.

Although we significantly underestimated revenue, Watson's progress on the cost side of the equation was so much better than we expected that it led to Operating Income 57 percent above the forecast value.

Non-operating expenses were a small $3 million greater than expected. The Income Tax Rate matched our 37 percent prediction. Net Income, driven by operating income, also exceeded our prediction by about 57 percent.


Cash Management. This gauge increased from 7 points in March to 9 points now.

The measures that helped the gauge were:

• Current Ratio =2.4; a sign of strength
• Days of Sales Outstanding (DSO) = 51 days, much less than the 65-day level one year earlier
• Cash Conversion Cycle Time (CCCT) = 78 days, down from 87 days, for this measure of efficiency
• LTD/Equity = 55%, up from 27 percent last year in wake of the Andrx deal, but already down from last quarter's 63 percent

The measures that hurt the gauge were:

• Working Capital/Market Capitalization = 13 percent, down from 40 percent
• Debt/CFO = 2.1 years, compared to 2.5 and 1.7 years 3 and 12 months ago, respectively
  
• Inventory/CGS = 109 days, compared to 102 and 110 days 3 and 12 months ago, respectively

Growth. This gauge increased from 16 points in March to 17 points now.

The measures that helped the gauge were:

• Revenue growth = 34 percent yr/yr, up from 6 percent in a year
• Revenue/Assets = 67 percent, up from 55 percent in a year; it's not surprising that more high-volume generic drugs in the product mix would have this positive effect on sales efficiency
• CFO growth = 38 percent yr/yr, up from -12 percent in a year

The measures that hurt the gauge were:

• Net Income growth was N/A because the enormous $500 million charge at the end of 2006 for in-process R&D causes net income for the trailing four quarters to be negative
  

Profitability. Coincidentally, this gauge also increased from 16 points in March to 17 points now.

The measures that helped the gauge were:

• FCF/Equity = 23.4 percent, up from 13.3 percent in a year
• Accrual Ratio = -23 percent, down from -7 percent in a year. Although negative values for this ratio are good, we're not used to value that this much negative. We need to explore this.

• ROIC = 9.3 percent, mediocre but up from 5.7 percent in a year
  

The measures that hurt the gauge were:

• Operating Expenses/Revenue = 91 percent, up from 89 percent in a year. This is also a consequence of the more lower-margin generic drugs in the product mix.
  

Value. Watson's stock price rose over the course of the quarter from $26.43 to $32.53. The Value gauge, based on the latter price, dropped to 7 points, compared to 10 points three months ago (and 11 points twelve months ago).

The measures that helped the gauge were:

• Enterprise Value/Cash Flow = 9.9, down from a five-year median of 11.4 (and a dirt cheap 6.4 in June 2006)
• Price/Revenue ratio = 1.6, lower than its five-year median of 2.3

The measures that hurt the gauge were:

• P/E = N/A
  
• P/E to S&P 500 average P/E = N/A
  

The average P/E for the Biotechnology and Drugs industry is 28. The average Price/Revenue for the industry is 8.

This was a very good quarter for Watson, primarily because it jacked up the Gross Margin. In addition, the measures of operating efficiency improved nicely. The gauge scores show these improvements, with the exception of Value. The negative trailing-year Net Income caused by the $500 million charge related to the Andrx deal throws the Value gauge out of whack.

However, what if, for the sake of the argument, the $500 million magically disappeared from Watson's financial history? The P/E ratio would be an expensive 34, and it would not help the Value gauge all that much. Watson is doing much better, but we still need to make sure we don't overpay for growth.

NOK: Financial Analysis through June 2007

We have analyzed Nokia's (NOK) financial results for the quarter that ended on 30 June 2007.

Nokia's finances changed radically during this quarter. Total Assets increased 38 percent, from €22.8 billion to €31.4 billion. So-called "other income" shot up from €335 million in the second quarter of 2006 to €1.988 billion in the second quarter of 2007. Despite all this income, the company paid next to nothing in income taxes during the quarter.

The explanation is that Nokia Siemens Networks, a 50/50 partnership with the German powerhouse, began operating on 1 April 2007. The results of the partnership, which would be considered a large-cap company if independent, are fully consolidated in Nokia's financial statements.

Nokia's latest results are, therefore, not directly comparable to the company's earlier results. And, this calls into question whether the GCFR methodology can be fairly applied to Nokia in its current form. Readers are strongly cautioned to consider the comparability question. In addition, readers should be aware of some facts about Nokia's financial reporting that distinguish it from companies based in the U.S. First, the financial statements are prepared in accordance with International Accounting Standards (IAS), rather than U.S. Generally Accepted Accounting Principles (GAAP). Second, the Euro is the currency used in Nokia's financial statements. Third, Nokia isn't required to file 10-Q and 10-K reports with the SEC.


Nokia, headquartered in Espoo, Finland, is a global seller of cellular phones and the equipment for mobile phone networks. Nokia once held a commanding, and quite rewarding, position in the mobile phone market. Today, consumers have many more choices, and the phones sport stylish designs can outshine their technical capabilities in the battle for popularity. Nokia's fortunes suffered at the onset of this sea change, and market share was lost to Motorola's (MOT) Razr. Nokia subsequently adjusted, and now their share of the mobile phone market is increasing.

Challenges remain, however, including Apple's (AAPL) iPhone and an increasingly contentious patent battle with Qualcomm (QCOM ). Nokia might, according to Fortune magazine, respond to the first threat by establishing their own online music service.

When we analyzed Nokia after the March quarter, the Overall score was a mediocre 36 points. Of the four individual gauges that fed into this composite result, Growth was the strongest at an impressive 19 points. Value, however, was weakest at a single, solitary point. [Note that recent algorithm tweaks led to minor changes in the previously reported scores.]

Now, with the available data from the June 2007 quarter, and subject to the limitations identified above, our gauges display the following scores:

• Cash Management: 3 of 25
• Growth: 14 of 25
• Profitability: 13 of 25
• Value: 3 of 25
  

• Overall: 29 of 100
  

Before we examine the factors that affected each gauge, let's compare the latest quarterly Income Statement to our previously announced expectations. This will help show how the new partnership changed the company's finances, since our prediction did not take the new corporate structure into account.

(€M)		June 2007 (actual)	June 2007 (predicted)	June 2006 (actual)
Revenue		12587	11290	9813
Op expenses
	CGS	(8671)	(7451)	(6573)
	R&D	(1716)	(1129)	(981)
	SG&A	(1669)	(1129)	(1019)
	Other	1828	(10)	262
Operating Income		2359	1571	1502
Other income
	Investments	453	(14)	(16)
	Interest, etc.	60	69	55
Pretax income		2872	1626	1541
Income tax		(44)	(406)	(401)
Net Income		2828	1219	1140
		€ 0.72/sh	€ 0.30/sh	€ 0.28/sh

Revenue was 11.5 percent above our estimate. We expected Revenue to be 15 percent greater than in the year-earlier quarter, and the actual increase was 28.3 percent. A major part of this increase can be attributed to new revenue from the businesses that Siemens contributed to the partnership. Of the joint venture's €3.438 billion of revenue, let's say that half, €1.719 billion, was from Nokia businesses (and, thus, part of the historical baseline) and half was from Siemens businesses (a new revenue stream to Nokia). If we subtract €1.719 billion from the reported €12.587 billion, we get a pro forma revenue figure of €10.868 billion. This is 10.75 percent about the revenue in the year-earlier quarter, and much closer to our expectation.

Maybe it is a result of the new partnership, or maybe it reflects changing business conditions, but Nokia's current operating costs as a percentage of revenue are much higher than Nokia's historic costs. We thought the Cost of Goods Sold (CGS) would be 66 percent of Revenue, and the actual value was 69 percent. Research and Development (R&D) expenses were 13.6 percent of Revenue, quite a bit more than our 10 percent estimate. Sales, General, and Administrative (SG&A) expenses were 13.3 percent of Revenue, compared to our forecast of 10 percent.

These additional costs, although major, were dwarfed in the opposite direction by the huge amount of partnership-induced "other income" Nokia recorded. It resulted in Operating Income 50 percent above the forecast value. The irony is that the Nokia Siemens partnership had a substantial loss in the second quarter. Some of the Nokia Siemens loss was due to restructuring charges, but €361 million can be attributed to business operations.

Non-operating income was €458 million greater than expected. The Income Tax Rate was a minuscule 1.5 percent, instead of the predicted 25 percent. The tax rate was low because much of the "other" income was the result of a non-taxable gain due to the partnership's formation. (Alchemy?) As a result, Net Income blew away our prediction by 132 percent.

Cash Management. This gauge decreased from 10 points in March to 3 points now.

The measures that helped the gauge were:

• LTD/Equity = 0.9%; insignificant
• Current Ratio =1.5; not bad, but down from 1.9 last quarter
  

The measures that hurt the gauge were:

• Debt/CFO = 0.1 years; insignificant, but up from last year
• Inventory/CGS = 27 days, compared to 21.6 and 23.1 days 3 and 12 months ago, respectively. (If sales are so good, why is inventory so high?)
  
• Days of Sales Outstanding (DSO) = 57 days, greater than the 48-day level one year earlier
• Working Capital/Market Capitalization = 6.9 percent, down from 9.3 percent

• Cash Conversion Cycle Time (CCCT) = 30 days, up from 25 days, for this measure of efficiency
  

Growth. This gauge decreased from 19 points in March to 14 points now, yet it was clearly helped by the new partnership.

The measures that helped the gauge were:

• Net Income growth = 43 percent (yr/yr), up from 20.8 percent in a year
• CFO growth = 39.6 percent (yr/yr), up from 8.4 percent in a year
• Revenue growth = 16.3 percent (yr/yr), good but down from 18.9 percent in a year
  

Net income benefited significantly from a change in the income tax rate from 26 to 14 percent

The measures that hurt the gauge were:

• Revenue/Assets = 141 percent, down from 185 percent in a year; sales efficiency worsened

Profitability. This gauge decreased from 15 points in March to 13 points.

The measures that helped the gauge were:

• ROIC = 41 percent (!), up from 39 percent in a year
• FCF/Equity = 42 percent (!), up from 32 percent in a year
• Accrual Ratio = 2.2 percent, down from 3.1 percent in a year (good cash flow)
  

The measures that hurt the gauge were:

• Operating Expenses/Revenue = 89.3 percent, up from 86.4 percent in a year
  

The increase in operating expenses was primarily the result of a decrease in Gross Margin.

Value. Nokia ADR's shot up from $22.92 to $28.11 over the course of the quarter. The Value gauge, based on the latter price, increased to a still-weak to 3 points, compared to 1 point three months ago.

None of the measures helped the gauge appreciably:

• Enterprise Value/Cash Flow = 17.8 down from 18.2 in June 2006
• P/E = 19, down from 20
• P/E to S&P 500 average P/E = 12 percent premium, compared to its five-year median of a 24-percent premium
  
• Price/Revenue ratio = 2.5, compared to its five-year median of 2.3

The average P/E for the Communications Equipment industry is currently a much more expensive 32. The average Price/Revenue for the industry is currently 5.

Now at 29 out of 100 possible points, the Overall gauge dropped despite the substantial increase in revenue and earnings in the recent quarter. This is because the stock surged in advance of the second quarter results, costs went up faster than revenues, and the earnings increase was driven by financial restructuring rather than core operations. The stock market reacted positively to the nice top-line and bottom-line numbers. We suggest that more attention be given to the numbers in between. It will probably take a year or so to distinguish operating changes from non-operating changes. In the mean time, caveat emptor.