Financial Metrics: Part 2 smartwomansecurities November 7, 2007 MORGEN PECK EQUITY RESEARCH ANALYST FIDELITY INVESTMENTS These materials are made for educational.

Financial Metrics: Part 2

smartwomansecuritiesNovember 7, 2007

MORGEN PECKEQUITY RESEARCH ANALYST

FIDELITY INVESTMENTS

These materials are made for educational purposes and should not be distributed. All materials are for SWS members’ use only

Announcements• Business Overview section of

Investment Project due today!• Competition section is due next

Wednesday (11/14)• NO seminar on Wednesday 21st

because of Thanksgiving Break!• Investment Project Mentors

In This Seminar:

• Recap of last week• Understand cash flows • How earnings’ season affect stocks• Valuation (yes, again)• Case study

Recap From Last Week

• Financial statements are critical to making investments

• Income Statement gives us information on profitability over time– Revenues – expenses = profit– Important metrics: revenue growth, EPS growth,

operating profit– We use EPS for valuation (P/E)

• Balance Sheet gives us information about financial health at point in time– Assets = Liabilities + Equity– Important metrics: Return on Equity, Return on Assets,

Debt/Equity, Current Assets/Current Liabilities

Questions From Last Week

• Don’t we want liabilities to go down over time?– Liabilities are NOT a bad thing, they

are a necessity for a firm and they should increase as the firm grows• Firm owing its suppliers money because of

strong demand for the firm’s product is a good thing

– We only worry when liabilities growing faster than assets. That is a bad thing

Questions From Last Week

• Revenues – cost of goods sold – selling, general & administrative expenses (SG&A)

= operating profit

• Another way to think of operating margin is:– For every $1 the firm makes in revenues,

operating margin is the % of that $1 that the firm keeps after operating expenses

• If firm has operating margin of 30%, for every dollar of revenue, it “costs” firm 70c to produce that dollar & they can keep 30c as profit

Mistake from last week

• In bread example, your company does not “borrow” money from mutual funds like Fidelity – Fidelity gives money to the firm in

exchange for shares and the firm does not have to ever pay back Fidelity

– Firm does have to pay back money borrowed from banks

SWY example: P/E & EPS growth drive stock price

StockVal®SAFEWAY INCORPORATED (SWY) Price 32.961997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 20081997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

PRICE15

20

25

30

40

50

65

HI 63LO 17ME 33CU 33GR 1.2%

10-31-199711-02-2007

PRICE / YR-FORWARD EPS ESTS5

10

15

20

25

30

35

HI 33.7 LO 6.7 ME 15.4 CU 14.9

10-31-199711-02-2007

EARNINGS-PER-SHARE YTY % CHANGE-40

-20

0

20

40

60

HI 41.0 LO -26.0 ME 13.8 CU 18.4

12-31-199709-30-2007

PFE: P/E compression & EPS growth deceleration hurt stock

priceStockVal®PFIZER INCORPORATED (PFE) Price 23.67

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 20081997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

PRICE20

24

28

32

36

44

52

HI 49LO 21ME 33CU 24GR 0.0%

10-31-199711-02-2007

PRICE / YR-FORWARD EPS ESTS7

14

21

28

35

42

49

HI 55.9 LO 10.0 ME 17.9 CU 10.2

10-31-199711-02-2007

EARNINGS-PER-SHARE YTY % CHANGE-26

-13

0

13

26

39

52

HI 56.9 LO -23.3 ME 16.6 CU -23.3

12-31-199709-30-2007

My contact info if you ever have questions

• [email protected]• 617-563-0042

Statement of Cash Flows

Cash Flows• Statement of cash flows provides relevant

information about a company’s cash inflows and outflows

• Net Income ≠ Cash generated!!– Net income is a function of accrual accounting

which smoothes cash flow– Cash can’t be manipulated

• Cash flows help investors (and creditors) assess– Future funding needs– Liquidity (cash to run daily/annual operations)– Long-term solvency (ability to pay bills and

service debt)Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

Income Statement vs. Cash Flow Statement

• Income statement uses accrual accounting to smooth cash flow, which tends to be lumpy.– Revenue recognition

• Does a company recognize revenue when end product has been produced, when it’s shipped, when customer receives it? Orders often placed at end of the quarter.

– Cost recognition• Does a company recognize cost when the end product has

been produced, when it receives payment for the product?– There is a LOT of discretion by the CFO in terms of how

s/he can account for items in the income statement

• Cash flow is literally the cash being generated and used by the company over a certain period of time

Cash Flows

• 3 sections of the cash flow statements – Operating Activities

• How much cash do the firm’s core operations generate?

– Investing Activities • How much cash firm is spending on long term assets

to grow (capex) or on acquisitions

– Financing Activities• How much cash firm is spending to finance its

growth (debt borrowed & equity issued) • How much cash firm is returning to shareholders

(dividends, share repurchases)

Cash Flows from Operating Activities• Inflows

– Cash received from customers (remember accounts receivables)

• Outflows– Buying inventory (remember accounts

payables)– Paying salaries and wages– Paying suppliers (also accounts payable)

Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

Reconciling Net Income and Operating Cash Flow

Operating cash flow statement takes Net Income and makes adjustments so investors can see how much cash the business generated

INCOME STATEMENT CASH FLOW STATEMENTRevenues Operating Cash Flows:- CGS (includes Depreciation & Amortization) Net IncomeGross Profit + Depreciation & Amortization- Selling, General & Administrative Costs + Amortization on Research & Development- Research & Development + Changes in A/R, Inventory, A/P- Other Operating Expenses Operating Cash FlowOperating Income - Interest Expense-TaxesNet IncomeEarnings Per ShareDiluted Shares Outstanding

Cash Flows from Investing Activities• Inflows

– Cash received from sales of PP&E (selling an plant the firm doesn’t need anymore). Pretty infrequent.

• Outflows– Purchasing long-term assets (PP&E)

= capital expenditures (aka capex) (building a new plant)

– Acquisitions of other companiesSources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

Cash Flows from Financing Activities• Inflows

– Cash received from borrowing (i.e. firms borrow cash from banks to make acquisitions)

– Cash received from issuing stock (i.e. firm issues shares to raise money)

• Outflows– Repaying debt (i.e. firms eventually have to

pay back what they borrowed from the bank)– Paying dividends to shareholders– Repurchasing stock

Sources: Intermediate Accounting; Spiceland., Sepe, Tomassini; 3rd edition; Irwin/McGraw-Hill Publishing Company, 2001

How To Read Cash Flow Statements

• Its usefulness– You can actually see where cash is going and

how the company spends it– Changes in the B/S can be explained by looking

at CF statement– Get a better understanding of a company’s

investing and financing activities because these aren’t obvious in the I/S

• Its limitations– When companies make acquisitions, it is often

difficult to fully reconcile all of the cash inflows and outflows w/ the B/S

Source: ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton

Most Important Metric from CF statement: Free Cash Flow

• Free Cash Flow = Operating Cash Flow – Capital Expenditures: Represents the cash that a company has left over after paying money required to maintain/expand its asset base

Sources: Vince Hanks, Motley Fool, fool.com; Investopedia

INCOME STATEMENT CASH FLOW STATEMENTRevenues Operating Cash Flows:- CGS (includes Depreciation & Amortization) Net IncomeGross Profit + Depreciation & Amortization- Selling, General & Administrative Costs + Amortization on Research & Development- Research & Development + Changes in A/R, Inventory, A/P- Other Operating Expenses Operating Cash FlowOperating Income - Capital Expenditures- Interest Expense FREE CASH FLOW-TaxesNet IncomeEarnings Per ShareDiluted Shares Outstanding

Other Helpful FCF Metrics

– FCF/Net Income = quality of earnings (the higher the better)

– YoY growth in FCF

•Negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, free cash flow should turn positive some day

Cash Flows (AEOS)In Millions of USD (except for per share

items)  2Q06   1Q06   4Q05

 Net Income/Starting Line   72.10   64.16   107.54  Depreciation/Depletion   21.71   19.23   19.15  Amortization   -   -   -  Deferred Taxes   -10.68   3.12   -5.13  Non-Cash Items   10.04   11.49   5.20  Changes in Working Capital   180.15   -43.75   142.01  Cash from Operating Activities   273.31   54.26   268.77  Capital Expenditures   -71.44   -31.71   -21.79  Other Investing Cash Flow Items, Total   -27.61   22.93   -247.15  Cash from Investing Activities   -99.05   -8.78   -268.94  Financing Cash Flow Items   2.62   3.24   -  Total Cash Dividends Paid   -16.88   -11.21   -11.14  Issuance (Retirement) of Stock, Net   4.35   -1.71   -19.94  Issuance (Retirement) of Debt, Net   -0.30   -0.17   -0.19  Cash from Financing Activities   -10.20   -9.86   -31.27  Foreign Exchange Effects   -1.27   2.42   1.62  Net Change in Cash   162.79   38.04   -29.83  Cash Interest Paid, Supplemental   -   -   -  Cash Taxes Paid, Supplemental   56.46   43.16   46.09 

From Google Finance

Lynch’s Views on Cash• In 1988, Lynch owned 5 million shares of Ford

which was at $38 a share• He saw in Ford’s B/S statement that it had

$16.30 in net cash/share– Net cash/share = (cash – debt)/diluted shares

outstanding

• So he saw it as buying a company not for $38, but for $21.70– This made its PE ratio something like 3.1– (Current stock price – net cash/share)/EPS

• Ford went up 40% after he decided to hold his shares of Ford

valuation

Valuation

• From looking at financials, we get information that we use in valuation

• We use either EPS or FCF in valuation – EPS >> use P/E– FCF >> use discounted cash flow (DCF)

• Because FCF can be lumpy, this is often why many investors use P/E analysis for valuation

Discounted cash flow (DCF)• Discount the profits (dividends, earnings, or

cash flows) that the firm will generate over time– Estimate yearly cash flows– Estimate the discount factor based on the risk (10%

is a safe assumption, but use a higher rate for riskier cash flow)

• Determine the “intrinsic value” of the business– Expect a business to make $1000 at the end of

each year and then fold after 3 years, estimating a discount rate of 10%• DCF = $1000/(1.1)+$1000/(1.12)+ $1000/(1.13) = $2,487• You should only pay $2,487 for this business. So if there

are 100 shares outstanding, a fair price for the stock would be $24.87

DCF & Comparables = 2 Good Valuation Techniques

• Research analysts typically create models and perform DCF valuation– Compare estimated value with actual

stock price (if value > stock price, stock is a good buy)

• Comparable analysis: – To determine if company is under or

overvalued compared to peers or to the company’s EPS growth rate• P/E Ratio

how earnings affect stocks

Earnings• Quarterly earnings

– How much profit a company made or lost during the past quarter

– Given in EPS• Usually company also holds an earnings call where they

discuss their earnings and company financial performance• Earnings seasons

– Differ by company, but typically they come in the month after the end of the quarter

• Earnings vs. consensus– Consensus from Wall Street analysts on what EPS will

be– If the company beats estimates, the stock tends to go up– If the company falls short, the stock tends to go down

• However, other aspects may also cause stock to move (management earnings call, announcement about part of the business, etc.)

Implications for Investors• More volatility in the markets during

earnings season• Earnings can paint a picture of an industry or

a market as a whole– For example, 3Q07: all financials stocks are

missing estimates right now

• Even if companies beat estimates, still depends on investors’ opinions– For example, earnings may beat estimates but

future-looking guidance may be below analyst expectations

3Q Earnings Disasters

• ALGN guided 4Q07 revenues 4% below expectations: stock down 35% in one day

AMMD: Another earnings disaster

• AMMD lowered 4Q guidance because of operational problems: stock off 35%

WCG: Another disaster (fraud, not earnings)

• FBI raids company HQ: stock down 70% in one day

ABAX: Good 3Q EPS

• 3Q EPS came in slightly ahead of estimates, stock +20% in one day

Looking at Financial Statements

Income Statement I Like

• Relatively consistent high teens revenue growth

• High GM that are improving over last 3 years

• High & improving operating profit margins

• Always profitable

• Very fast EPS growth

2000 2001 2002 2003 2004 2005 2006Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06

FY FY FY FY FY FY FYINCOME STATEMENT Net Sales 57.1 56.5 59.1 65.9 79.6 93.0 108.4Cost of Sales 21.7 25.8 24.5 27.6 33.9 38.2 43.7Gross Profit 35.4 30.7 34.6 38.3 45.7 54.8 64.7R&D 2.3 3.4 2.9 3.9 4.4 3.9 4.8Selling & Marketing 12.3 11.0 9.7 10.6 12.5 15.0 16.5General & Admin. 10.8 11.5 10.8 11.0 14.1 15.7 16.5EBITDA 15.0 9.6 14.9 16.6 18.7 24.5 32.2EBIT 10.2 4.9 11.2 12.8 14.7 20.2 26.9Interest Income 0.4 0.2 0.0 0.0 0.0 0.0 1.1Pretax Income 7.7 2.5 9.5 11.6 13.2 19.6 28.1Provision for Income Taxes (0.2) (4.6) 3.2 4.6 4.0 7.0 9.7Tax Rate -2% -187% 34% 39% 30% 36% 35%Net Income 7.9 7.1 6.2 7.0 9.2 12.6 18.3EPS 0.24$ 0.22$ 0.19$ 0.21$ 0.27$ 0.35$ 0.46$ CY EPS 0.07$ 0.19$ 0.22$ 0.28$ 0.38$ 0.50$

Mgmt GuidanceFirst Call Estimates

Diluted Weighted Average Shares 33.0 32.8 33.2 33.6 34.3 36.3 40.2GROWTH & MARGINSGROWTH (YoY)

Revenues -1% 5% 11% 21% 17% 17%EBITDA -36% 55% 11% 13% 31% 31%EBIT -52% 130% 14% 15% 38% 33%EPS -10% -13% 11% 28% 30% 32%MARGINS

Gross 62.1% 54.3% 58.5% 58.1% 57.4% 58.9% 59.7%R&D 4.0% 5.9% 4.9% 5.9% 5.5% 4.2% 4.4%S&M 21.5% 19.4% 16.5% 16.1% 15.7% 16.1% 15.2%G&A 18.9% 20.3% 18.2% 16.7% 17.7% 16.9% 15.2%EBITDA 26.2% 17.0% 25.3% 25.2% 23.5% 26.3% 29.7%EBIT 17.8% 8.6% 19.0% 19.4% 18.4% 21.7% 24.8%Incremental EBIT 927.4% 245.6% 23.4% 13.6% 41.6% 43.1%Net 13.9% 12.6% 10.6% 10.7% 11.5% 13.5% 16.9%

MERIDIAN BIOSCIENCEVIVO

Income Statement I Don’t Like

• Totally inconsistent revenue growth that has been bad recently

• Look how low their gross & operating margins are!!! Pathetic!

• They are not always profitable (negative EPS in FY06)

2000 2002 2003 2004 2005 2006FY FY FY FY FY FY

Sep-00 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06

INCOME STATEMENTTotal Revenue 7410 23367 24549 26432 26014 25559CGS 6453 21550 22805 24550 24266 24626Gross Profit 957 1817 1744 1882 1748 933SG&A 609 877 831 880 939 935EBITDA 348 1354 1295 1463 1310 527Operating Income 348 887 837 973 809 10Interest Expense 116 305 296 275 227 229Pre-Tax Income 234 593 661 683 564 -211Income Taxes (benefit) 83 210 235 256 199 -73Tax Rate 35.5% 35.4% 35.5% 37.5% 35.3% 34.5%Net Income 151.0 386.5 281.0 482.1 364.8 -138.3

EPS 0.67$ 1.09$ 0.80$ 1.36$ 1.02$ (0.40)$

CY EPS 1.08$ 0.97$ 1.14$ 1.02$ (0.35)$

YoY EPS growth 125.5% -26.7% 69.3% -24.7% -138.8%

Diluted Shares Outstanding 224.9 354 351 356 357.3 348.75Street Estimates 1.09$ 0.74$ 1.30$ 1.06$ (0.04)$ Mgmt Guidance 1.26-1.33 0.95-1.08 -14c to 1 c

GROWTH & MARGINSGROWTH (YoY)

Revenues 122% 5% 8% -2% -2%

SG&A 49% -5% 6% 7% 0%

EBITDA 68% -4% 13% -10% -60%

EBIT 88% -6% 16% -17% -99%

EPS 126% -27% 69% -25% -139%MARGINS

Gross 12.9% 7.8% 7.1% 7.1% 6.7% 3.7%

SG&A as % Sales 8.2% 3.8% 3.4% 3.3% 3.6% 3.7%

EBITDA 4.7% 5.8% 5.3% 5.5% 5.0% 2.1%

EBIT 4.7% 3.8% 3.4% 3.7% 3.1% 0.0%

Net 2.0% 1.7% 1.1% 1.8% 1.4% -0.5%

TYSON FOODS TSN

Balance Sheet I Like• Growing cash & equivalents• PP&E not growing too fast >> not capital

intensive business• Very high ROE & ROA

2000 2001 2002 2003 2004 2005 2006Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06

FY FY FY FY FY FY FYBALANCE SHEET Cash & Equivalents 5 5 3 2 2 33 40A/R, net 14 13 13 15 18 17 20Inventories 16 12 13 14 14 17 18PP&E, net 18 17 18 18 17 17 18TOTAL ASSETS 85 66 65 66 69 111 121Current Debt 8 8 4 1 1 1 0Accounts Payable 3 2 2 2 3 3 4Long Term Debt 27 24 24 22 17 3 2TOTAL LIABILITIES & EQUITY 85 66 65 66 69 111 121ROIC 5.7% 15.0% 14.7% 18.6% 17.5% 17.9%ROE 23.9% 26.4% 27.1% 30.4% 21.5% 20.5%ROA 9.4% 9.5% 10.7% 13.5% 14.0% 15.8%Debt/Cap 51.5% 49.2% 43.9% 34.2% 3.1% 1.9%Net cash/share (0.84)$ (0.74)$ (0.62)$ (0.46)$ 0.82$ 0.96$

MERIDIAN BIOSCIENCEVIVO

Balance Sheet I Don’t Like

• Cash is going down• PP&E is HUGE % of total

assets >> capital intensive business

• They have a lot of debt• Terrible ROA & ROE.

They are negative in FY06 because NI is negative.

2000 2002 2003 2004 2005 2006FY FY FY FY FY FY

Sep-00 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06

BALANCE SHEETCash/ Equivalents 43 51 25 33 40 28Accounts Receivable 508 1101 1280 1240 1214 1183Inventories 965 1885 1994 2063 2062 2057PP&E 2141 4038 4039 3964 4007 3945

TOTAL ASSETS 4841 10562 10486 10464 10504 11121Current Debt 185 254 490 338 126 992Accounts Payable 333 755 838 945 961 942Total Debt 1542 3987 3604 3362 2995 3979

TTL LIAB + EQUITY 4841 10372 10543 10464 10504 11121ROA 3.6% 2.7% 4.6% 3.5% NMROIC 7.8% 7.5% 8.4% 7.1% NMROE 10.9% 8.8% 10.3% 8.2% NMDebt/ Total Capital 41% 50% 44% 41% 38% 40%

TYSON FOODS TSN

FCF Statement I Like• Net change in working capital

(change in A/R, inventories, A/P) is not big

• Capex = D&A • FCF and FCF/share is increasing• FCF as % of NI is >100%• VIVO pays a dividend (and it’s

growing)

2000 2001 2002 2003 2004 2005 2006Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06

FY FY FY FY FY FY FYFREE CASH FLOW Net Income 7.9 7.1 6.2 7.0 9.2 12.6 18.3Depreciation 2.0 2.3 2.3 2.4 2.6 2.6 2.7Amortization 2.8 2.5 1.4 1.4 1.5 1.7 2.6Net Change in WC (7.6) 3.3 2.3 (0.4) (1.7) 1.5 (2.2)Capital Expenditures (4.0) (1.9) (3.6) (1.8) (2.4) (2.6) (3.1)FREE CASH FLOW 2.0 24.2 9.1 10.5 10.3 15.6 19.0FCF/Share 0.06$ 0.74$ 0.27$ 0.31$ 0.30$ 0.43$ 0.47$

FCF YieldFCF as % of NI 24.9% 339.9% 145.4% 150.2% 111.8% 124.1% 103.9%Dividend 3.4 3.7 4.0 5.0 5.8 7.2 11.1

MERIDIAN BIOSCIENCEVIVO

FCF Statement I Don’t Like• Net Income is negative some years• Capex>D&A >> capital intensive

business• Change in working capital is very

volatile• FCF is very volatile, sometimes

negative

2000 2002 2003 2004 2005 2006FY FY FY FY FY FY

Sep-00 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06

FREE CASH FLOWSNI 459 281 482 365 (138) +D&A 467 458 490 501 517 -Cap Ex (632) (402) (486) (571) (531) - Change in WC 294 51 (158) 186 (19)FCF 530 334 279 426 (226)FCF/ share 1.50$ 0.95$ 0.79$ 1.19$ (0.65)$ FCF Yield 13% 7% 4.9% 7.4% -4.0%

FCF as % of NI 137% 119% 57.9% 116.7% NM

TYSON FOODS TSN

Key Points

• Use balance sheets to assess a company’s financial position at a point in time– Look at key ratios to analyze a company’s business

• Income statements measure profitability– Look at the company’s profitability over time in terms

of gross & operating profit, gross & operating margins

• Use statement of cash flows to follow the cash– Look at where cash is going; free cash flow is a key

metric!

• Valuation: comparisons to other companies & for one company across time

Next Seminar

• Synthesis: Putting it all together to make an investment recommendation– Putting it all together– How to make stock pitches– Case studies

Q&A

appendix

Sarbanes-Oxley• In 2002, President Bush signed the Sarbanes-Oxley Act into

law to "re-establish investor confidence in the integrity of corporate disclosures and financial reporting.“– Financial fraud cases (such as those of Enron,

WorldCom, Tyco, Adelphia, AOL, and others) – End of the "boom" years for the stock market.

• Requires all public companies to submit both quarterly and annual assessments of the effectiveness of their internal financial auditing controls to the Securities and Exchange Commission (SEC). – Each company's external auditors must also audit and report on the

internal control reports of management and any other areas that may affect internal controls.

• The details of the Sarbanes-Oxley Act address many of the tactics companies have used to "cook the books" over the years.