Tag Archives: securities analysis

the Intel (INTC) 3Q12 preannouncement: studying operating leverage

September 12, 2012 By in Constructing a Portfolio, margins, operating leverage, Portfolio management Tags: , , , , , , , , , Leave a comment

the preannouncement

As I wrote about yesterday, INTC preannounced weaker than expected 3Q12 earnings.  The main culprit?  …worldwide general economic slowdown.

The company said it now expects revenues of $13.2 billion for the quarter, down by 7.7% from the $14.3 billion it guided to when it announced 2Q12 earnings two months ago.  The gross margin will come in at 62% instead of 63%.  Virtually all other cost items will remain the same.

looking at leverage

This isn’t much data.  But it’s enough for us to see two things about the company, manufacturing leverage and leverage on SG&A (Selling, General and Administrative) expenses.

manufacturing leverage

two kinds of costs

In the simplest terms, in every accounting period employees get paid and the accountants apportion costs for the use of the factory and the machinery in it, whether or not anything gets build.  So, in a sense these are indirect costs of manufacturing.  In the short run, they’re relatively fixed.

In addition, there’s the cost of the materials–electricity, gas, silicon, who knows what else–that get used up in making INTC chips.  These are direct costs.   Their total in any period is variable, depending on how many chips get made.

Accountants assign each chip a total cost that depends on two factors:  the out-of-pocket cash (variable cost) spent making it plus its share of indirect costs, a figure that depends on how busy the factories are.

gross margin

Total cost ÷ sales price = gross margin.

separating the two

Is there a way to find out how much of the total cost is variable and how much depends on how well sales are going in a given quarter?  In INTC’s case, yes.

Management has just told us that sales will be $1.1 billion less than anticipated and that this fact will lower the gross margin by a percentage point.  That’s not because the variable cost of making a chip has changed; it’s because the indirect (or fixed, or overhead) costs of running the factories are being distributed over a smaller number of chips.  (It’s a little more complicated than that, but not a worry in this case.)

Another way of saying this is that in order to get to the new, lower, sales and operating profit estimates, INTC has subtracted the sales price of the extra chips it won’t sell and only the variable cost of making those chips.  If we calculate the change in estimated gross profit and divide by the change in sales, we’ll get a variable cost margin for those “extra” chips.

Here we go:

$13.2 billion x .62  =  $8.18 billion in gross profit

$14.3 billion x .63  =  $9.01 billion in gross profit

The difference is $.83 billion, the gross profit lost from lower sales.   This gross profit   ÷ $1.1 billion in lost sales   =  75.5%.

Therefore, 75.5% is the profit margin from producing/selling an extra chip during the quarter.  That’s the manufacturing leverage INTC gets at current production levels for getting/losing additional sales.

Note, too, that the new operating profit is 9.1% less than the original estimate.  That compares with a 7.7% drop in sales.  So, while there is operating leverage in the manufacturing operation, but at current production levels it’s not huge.

SG&A leverage

INTC has two types of SG&A.  One is R&D.  The other is the typical SG&A that any industrial company has. The two items are roughly equal in size.  This quarter they’ll amount to $4.6 billion.

Let’s subtract that from both the original gross profit estimate and the new guidance.

$8.18 billion  -  $4.6 billion  =  $3.58 billion in operating income

$9.01 billion  -  $4.6 billion  =  $4.41 billion in operating income

Now calculate the percentage drop in operating income that our 7.7% decline in sales produces.

It’s 18.8%!

To recap, the 7.7% fall in sales produces a 9.1% drop in gross profits and an 18.8% contraction in operating profits.  Of the 11.1 percentage point differential, 1.4 comes from the manufacturing process, 9.7 from SG&A leverage.

In other words, the operating leverage at INTC is coming from SG&A, not manufacturing.  If INTC wanted to reduce costs in a way that would affect current reported profits the most, it would attack either R&D or “normal” SG&A.

operating leverage (II)

August 28, 2012 By in growth vs value, operating leverage Tags: , , , , , , Leave a comment

high fixed cost businesses

The most common and the most powerful type of operating leverage is present in companies with high fixed costs, or so-called capital intensive businesses.

(An aside:  Traditionally, the need to spend immense amounts of money on plant and equipment to be able to enter a business served as a big barrier against new competitors.  The major threat to the capital intensive firm is technological change.

Over the last forty years or so, change has been so rapid that capital intensity has suddenly turn into a millstone in many industries (think: Best Buy vs Amazon in retail).  Nevertheless, there are still many capital intensive businesses that remain attractive.)

Take a hotel as an example

How much do you think the out-of-pocket cost is for a hotel company to lodge a guest for one night?

It’s the cost of cleaning the room, changing the sheets and putting in new soaps.   Less than $20.  But the guest can easily pay $100 or $200 a night (in NYC, it’s more like $500) for his stay.

Having an “extra” (other jargony terms used:  marginal, incremental) guest in the hotel is almost pure profit.  After all, the hotel is open and staff are present, whether or not our guest is.  In practical terms, those costs are fixed.

Take an airline (please!)

Airlines have been a dreadful business for longer than I’ve been an analyst.  Same  question, though.  How much extra does it cost the airline to service one more passenger who is paying $5,000 in first class for an international flight?

It’s the cost of the meal(s).  The plane and the crew are going to be there whether our incremental passenger is on the flight or not.  So, again, he’s almost pure profit.

The trick with a capital intensive business is to sell at least enough of your product or service to cover your fixed costs.  The rule of thumb in the hotel business is that at 50% occupancy, you’re not making profits but are at cash flow breakeven (meaning you’re meeting all your out-of-pocket costs).  At 60%, you’re barely profitable.  At 70%, you’re making wheelbarrows full of money.

WSJ on airlines

Same thing with airlines.  Only the story here is a lot grimmer.  The Wall Street Journal had a really, really good article in June about air carriers’ cost structure, that was based on research by Oliver Wyman.  It concluded that on a 100-seat aircraft, the airline has to fill 99 to break even.  The carrier’s profits come from filling that last seat, where someone gets shoehorned in right next to the restrooms.

Think about it, though.  If the airline in the WSJ example could somehow scrunch the seats an inch and a half closer together, it might be able to fit in an extra row.  Assuming customers didn’t revolt, revenue would go up by 4% from the four extra passengers.  But profit would go up almost 5x!!!

That’s operating leverage.

don’t use percentages in analysis

If I have one criticism of the diagram “Decoding A Flight” in the article, it’s that it uses percentages, not actual figures.

I understand that this is the best (probably the only) way to illustrate the article’s point.  From years teaching securities analysis, however, I have a different perspective.  If you take the percentages shown and apply them to, say, a different airline or a bigger plane, profits will always be 1% of sales.  It’s because you’re using margin percentages, not the raw data.  Using percentages obscures operating leverage.

The article also gives a useful illustration of what securities analysts do all day.  They try to figure out, in as much detail as possible, the profit structure of the companies they follow.

a simple model

Let’s make up a company.  It builds a factory and puts machinery in it, at a cost of $40 million.  Assuming that everything will last for 40 years, each year the firm will enter a (non-cash–it has already spent the money) charge of $1 million on its income statement to represent recovery of this outlay.

That’s $250,000 each quarter.

Let’s say the company has a factory payroll of $100,000 each quarter.  So total costs are $350,000.

Finally, suppose the firm makes some item that uses $10 of raw materials and can be sold for $80.  That means each item earns an operating profit of $70.

Case 1.  The company breaks even in a quarter if it sells 5000 items.

Case 2.  What if it sells 4500?

Then sales are: $360,000

Costs are:  $350,000 + ($10 x 4500) = $395,000

Loss:  $35,000.

Case 3.  If it sells 6000, sales are $480,000 and profits are $70,000.

Case 4.  If it sells 7000, sales are $560,000, 16.7% higher than in case 3.  But profits are $140,000, or double those of case 3.

That’s operating leverage.

how do we find out what a company’s costs are?

Avenues to explore:

–the company’s 10-k, annual report and website

–the company’s investor relations department

–the industry trade association

–trade publications

–government offices

–the financial press–you might be incredibly lucky and see an article like the airline

–sell-side research, although most analysts don’t publish their detailed spreadsheets for fear their rivals will “borrow” the results.

Two other thoughts:

–look for a small company in the industry you’re interested in.  The firm’s structure might be simpler and more visible than is the case with a larger firm.  The small company’s IR department may be more willing to talk to investors, too.

–a quick and dirty approach.  If the company is highly seasonal, figure out the extra sales in the high revenue quarter and compare it with the extra profit those sales bring with them.  Sometimes, a year-on-year or quarter-on-quarter comparison can also yield useful information.

More tomorrow.

 

 

 

 

 

return on equity: a measure of management prowess

August 15, 2012 By in book value, return on equity Tags: , , , , , , , , Leave a comment

REITS  …eventually

I want to eventually write about the attractiveness of REITs and the increasing tendency of mature companies in the US to turn themselves–or at least part of themselves–into them.  This is the first in a series of posts to lay the foundation for that discussion.

a new company, a blank slate 

Imagine that we’re forming a new company.  On Day 1, the books and accounts of the new firm are just empty pages.

balance sheet

Then we inject some cash to get the firm going.  We get shares of stock, representing our ownership interest in the new firm, in exchange.  The balance sheet of the new firm will reflect this transaction by recording the cash inflow on the asset side, and the same value under “shareholders’ equity” on the other (the liabilities + equity side).

income statement

The new management of our company–maybe us, maybe professionals we’ve hired–invests the cash in (we hope) high-return projects that generate a lot of income.  We, or our accountants, will periodically create an income statement to record how much money we’ve earned (or lost) during a given period of time.  In real life, the money is coming in every day and being spent or invested almost simultaneously.

where the money goes

In the simplest conceptual terms, two things can happen to the money the firm earns.  It can be reinvested in the firm’s operations, in which case we can think of it as entering the balance sheet as cash (in + or – amounts) on the asset side (and then being invested in working capital or plant and equipment, which are other categories on the asset side) and as corresponding changes to shareholders’ equity on the other.  Or it can be paid out to shareholders as dividends.

If the firm makes a new stock offering to raise additional capital, the balance sheet activity will be similar to what happened at the firm’s birth:  cash is entered on the asset side of the balance sheet; shareholders’ equity rises by the same amount on the other.

One way of summarizing this process–the one we need today–is that shareholders’ equity represents the amount of money the management of our firm has to work with:  the initial capital, the proceeds from further equity issues, plus accumulated profits (minus any amounts paid out to shareholders).

measuring management’s skill

How do we measure management success?  One straightforward method, for both actual and potential shareholders, is to look at the income the firm produces with the money it has invested.  In other words:

–       annual profit  ÷  shareholders’ equity,    which is known as return on equity.

Astute readers will recognize that shareholders’ equity is also known as book value.  Regular readers may remember that I’m not particularly a fan of book value as a valuation metric.  True, but let’s put that aside for the moment.

return on equity

The virtue of using return on equity is its simplicity.  A return on equity of 3% a year is bad.   A return on equity of 15%+ is good.  In today’s world it’s very good.

stock market adjustment

For publicly traded companies, firms that consistently achieve only a 3% return on shareholders’ equity will probably trade at a huge discount to book value.  If Wall Street believes that a firm should be able to earn 10% a year on the money it has to work with, then the 3% company might trade at 1/3 of book (in reality, the market will likely expect either the company’s board of directors or an activist outsider to force a change of management.  So the discount won’t be as deep as it otherwise should be).

On the other hand, a firm that consistently earns 15% on equity will doubtless trade at a premium.

some caveats

Bad companies can sometimes have high returns on equity.  One of my favorite examples is Fotomat, which had kiosks in mall parking lots where it collected undeveloped camera film ad returned prints to customers the next day.  I remember a shareholder calling me up one day to criticize me about my negative view, citing the company’s current 15% return on equity.  I pointed out that the prior year the company had a mammoth loss, which cut its equity in half!!  Shrinking the denominator is not the best way to achieve good return numbers.

Suppose we invested $100/share in a gold exploration venture–and our geologists discover gold worth at least $1000/share.  The stock will trade at 5x, or 10x, or some higher x, book value–even though production hasn’t started (in fact, the Wall Street cliché is that the stock peaks the day the mine opens).  Other kinds of natural resource companies can experience this phenomenon, as well.

prisoners of the past?

If we imagine the assets of a company as being a collection of investment projects–some successful, some not–how do we deal with the clunkers?  In particular, what do we do  if we’ve just been hired to run a firm and see (from low historical returns on equity) that the company is filled with terrible past investment projects?  Or how do we keep the inevitable mistakes from tarnishing our record forever?

More tomorrow.

the future of professional investment research unfolding

June 13, 2012 By in hedge funds, Industry Analysis, Investment firms, securities markets, stock market Tags: , , , , , , Leave a comment

brokers’ post-recession adjustments…

It doesn’t seem that long ago that Guy Moszkowski, top-ranked analyst of brokerage house stocks on Wall Street, shocked his colleagues by leaving Salomon for Merrill.  This was during one of Merrill’s on-again, off-again attempts to build a competent research effort to complement its powerful Thundering Herd sales force.

Don’t get me wrong.  There are excellent analysts at Merrill.  But my take on the firm is that its heart has always been in sales.  Its attitude is that three so-so analysts are a better use of the firm’s money than one research star.

Mr. Moszkowski is now leaving Merrill, according to the Wall Street Journal.  Where is he going?   …to Autonomous Research, a UK-based independent research boutique specializing in banks.

He’s the latest in a long line of similar departures from the big sell-side firms, as Wall Street brokers dismantle the research departments they built up over the past fifteen years or so.  Brokers are convinced that research is a chronic loss maker they can no longer afford to subsidize in an austere post-Great Recession era.

…are causing problems for mid-sized money managers

A generation ago, equity money management firms all had large in-house staffs of securities analysts who supported their portfolio managers.  Having your own “proprietary” analysis was considered to be a vital point for selling services to both retail and institutional investors.

In reality, these buy-side research departments were:

–expensive

–very difficult to manage

–even more difficult to train and upgrade, and

–inevitably a mix of skilled and creative, along with mediocre and pedestrian.

During the 1990s, money managers discovered that they could lay off most (or all) of their own analysts and replace them with research bought from brokerage houses.  Figure–to pluck a figure out of the air–that it costs a firm $250,000 yearly to support one analyst.  Lay off 10 and the company saves $2.5 million a year that would otherwise come from the fees clients pay to their managers.

Better still, money management firms could “pay” for brokerage research with clients’ money–by letting the broker to charge higher-than-normal trading fees for specified transactions (a practice called “soft dollars,”  as opposed to “hard dollars,” i.e., payments in cash).  Best of all, clients didn’t seem to mind either the disappearance of in-house analysts or the fact that they, rather than the money manager, were now footing the bill for investment research.

So all but the largest money management firms did just that.  They eliminated, mostly or entirely, their own research departments.

But the brokerage research departments have been gutted over the past few years.  What do those money managers do now?

rebuilding in-house research?

I think that’s the only solution for money managers who want to stay in business for themselves.  But that’s much easier said than done.

I guess it’s possible to string together a “virtual” brokerage analyst network by doing business with a bunch of the little independent research boutiques that have sprung up recently.  But many of the best sell-side analysts now work for hedge funds, venture capital or private equity.  So there’s no guarantee you’d end up with enough coverage.  Also, there’s no reason to believe that your information network would stay together for long (a topic for another post).

Another issue:  money managers are paid a percentage of their assets under management as their fee for services.  For many traditional money managers assets under management are much lower than they were a half-decade ago.  Assets are also shrinking.  Institutional clients are taking money away from traditional managers and giving it to hedge funds.  Retail clients continue to fund their 401ks, but they’re shifting their taxable money and their IRAs to lower-cost  index funds and ETFs.

So where will the money for securities analysts come from?

Let’s say a small money management company has $2 billion in assets under management.  Let’s say it collects a management fee that averages 0.5% of assets.  That’s $10 million a year.  Take away $1 million a year for sales, general and administrative expenses.  That leaves $9 million, most of which will be split among the professional employees of the firm.

Let’s say the firm needs six securities analysts + a research director to create a bare-bones research department.  At $250,000 per analyst (including office space, travel …) and $500,000 for the research director, that comes to $2 million a year, reducing operating income by almost a quarter.  This implies everyone at the firm takes a 25% pay cut to get research up and running.  …which is a recipe for having the best talent abandon ship.

For a host of reasons, it’s probably better to merge with another comparably-sized management company.

what’s important for you and me

Don’t go to work for a small money manager expecting a job for life.

The quality of aggregate buy side research is going to get worse, not better.  This instability will mean continuing high market volatility as professionals end up reacting to news they didn’t anticipate.

Less efficient markets mean more scope for ordinary individuals like you and me to know more about specific stocks than professionals.  This means more chance of making market-beating gains.

 

dealing with hedge funds: …industry analysts

March 6, 2012 By in Industry Analysis, Investment firms Tags: , , , , , , , , 1 Comment

calling on customers

Two brokerage areas routinely call on corporations.  They are:

–investment bankers.  They’re somewhat like bank lending officers, in that they visits company to try to sell services.  In the investment banking case, that’s typically the possibility of stock or bond offerings, mergers and acquisitions advice or general consulting.

–securities analysts specializing in the company’s industry.  Analysts are members of the firm’s research department.  For smaller and privately held firms, the analyst will want to gather information that may be useful in his reports on publicly traded companies.  He’ll also want to set the stage for possible investment banking business with his firm as/when the company goes public.  For already publicly traded companies in the analyst’s coverage universe, the visit will be for updates–usually right before the analysts issues one of his periodic reports to clients.

Prior to 2000, securities analysts usually reported to the head of investment banking.  After the Internet Bubble-related scandals, where analysts were seen to have written inaccurate reports solely to stimulate demand for the stocks of companies their firms had brought public, that supervisory relationship has been broken.  I’m not sure there is a general rule about who supervises the research department today.

securities analysts

calling on clients

Securities analysts also spend a lot of time interacting with the firm’s brokerage clients, in the expectation that the client will trade with the firm–thus generating commission/spread profits–in return for the information provided.  This interaction may either be with the client’s own securities analysts, their buy-side counterparts, or with the client’s portfolio managers.  Communication may be by phone or e-mail or in person.

Like any other brokerage service, the appropriate institutional salesman will control/advise the analyst about the quality (phone or in person) and quantity of time he spends with a given client.  This will depend on the importance of the client to the firm, measured by the profitability of the relationship.

spreadsheets

Analysts or their assistants create spreadsheets to forecast company earnings.  They also write research reports that either analyze the company’s operations in detail, or highlight recent developments and their significance.  As well, they make buy, hold and sell recommendations for the company’s stock.

technical background?

In many cases, analysts will have worked in the industry they cover before moving to Wall Street.  They may also have relevant advanced technical degrees, such as in petroleum engineering for oil and gas analysts, or in electrical engineering for analysts covering technology hardware firms. (In my experience, such technical training can be a mild positive.  But it can also be a major hindrance, if the analyst mistakenly thinks this exempts him from having to do actual financial analysis of a company’s profit prospects.)

reliant on companies for information

No matter what their background, however, analysts remain very reliant on the companies they cover for industry and firm-specific information.  They’re also dependent on the continuing attractiveness of their industries to investors, whose commission business with the broker influences the analyst’s compensation.

In my experience, therefore, analysts tend to be a bit like home town sports announcers.  They’re highly reluctant to make negative assessments about their industries.  After all, that puts them out of work.  They also can be subject to considerable pressure from holders of large positions in a stock not to write anything negative about it.  Also, some companies may demand that analysts not only make positive statements but also adhere closely to company-issued earnings guidance.  Non-compliance can mean that the offending analyst is denied access to company management that’s routinely given to others.

Sounds crazy, doesn’t it?  But stuff like this happens.  The case of bank analyst Mike Mayo is perhaps the most famous recent case of this type.

A possible response to this pressure is for an analyst to give a “base case” in print, but to supplement this with a “whisper” number that’s noticeably different.  This will be disseminated to clients orally, with or without attribution to the analyst, but never put down on paper.

To be successful, analysts have to be good either at marketing themselves and their research to clients or at analyzing the companies they follow.  Of course, it would be better to excel at both, but in my experience that’s not necessary.  At one end of the spectrum there are (only a few) analysts who have completely pedestrian information, but are witty and know where a client likes to be taken to lunch.  For the majority who provide analytical insights, they come in several varieties:

–able to forecast earnings very accurately

–able to give a good qualitative appraisal of the industry and where all the companies stand within it

–able to say whether the stocks will go up or down.

These are all separate skills, and each worth paying for, I think.

 

 

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