TN6_The_Financial_Detective_2005.doc

Case 6 The Financial Detective, 2005

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THE FINANCIAL DETECTIVE, 2005 Teaching Note Synopsis and Objectives Suggestions for complementary cases on financial ratio analysis and performance assessment: “Deutsche Brauerei,” (Case 11); “The Battle for Value 2004: FedEx vs. United Parcel Service, Inc.,” (Case 4)

The case presents the student with financial ratios for eight pairs of unidentified companies and asks them to mate the description of the company with the financial profile derived from the ratios. The primary objective of this case is to introduce students to financial ratio analysis—in particular, the range of ratios and the insights each one affords. This case presumes that students have already been introduced to the definitions of various financial ratios through other readings or lectures. The structured exploration of pairs of companies within an industry affords a number of important insights into strategy and financial performance. First, the economics of individual industries account for significant variations in financial ratios because of differences in technologies, product characteristics, or competitive structures. Second, financial performance results from managerial choices: within industries, the wide variation in financial ratios is often a result of the differences in corporate strategy in marketing, operations, and finance. For those reasons, this case is a good springboard into subsequent classes, which deal with the interaction of strategy and financial performance. Suggestion for Advance Assignment to Students The problem in this case is self-explanatory so no formal assignment questions are required. Depending on the level of the students, however, the instructor may choose to assign different subgroups of the class to deal with specific industries. In addition, the students may benefit from suggested textbook readings that define and discuss the various financial ratios. There are no supporting computer spreadsheets associated with this case.

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Hypothetical Teaching Plan Discussion leadership of this case can be fairly straightforward. One could simply proceed through the eight industries. There are, however, several teaching tactics that could enhance the success of the learning experience: 

Call on a different student to resolve the question in each industry. This case is an excellent vehicle for bringing out the quiet or less confident student through a “cold call.” The task is objective, so the student’s personal exposure is limited. If one asks the students to choose the industry that they wish to address, the easier pairs (computers, retail, books and music, and beer) tend to be dispatched first, while the harder pairs (health products, paper, newspapers, and tools and hardware) will be dealt with later in the discussion. The teacher might anticipate this by saving the “cold calls” until later in the class for students suspected to be a little stronger than those that were called upon earlier. The result is good pacing. The easier comparisons build upon the students’ confidence to tackle the harder comparisons, and the harder comparisons lay the groundwork for closing comments by the instructor.

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Format the chalkboards in advance of class, writing the industry names as column headings, with the company letters below them. During the class discussion, the instructor can record the salient characteristics of the companies mentioned by the students in the various columns. When the student exhausts the important observations, the instructor can ask the student to identify the company in each pair.

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Before asking students to cite the pertinent numbers, it may be useful to first ask them to discuss the salient qualitative features of each company and the differences between the pairs. Then ask them to describe what they would expect to see intuitively in the data based on their prior observations. That approach tends to focus the discussion on the key issues and discourages a mind-numbing recitation of the numbers. Indeed, one of the important objectives of this case is to encourage students to focus on deriving practical insights rather than on giving an “elevator analysis” (for example: this figure is up or that figure is down). If the instructor is dealing with novices in finance, repeated encouragement toward substantive conclusions may be necessary.

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Maintain suspense. Students often ask for the correct answers as each industry is discussed. By deferring the correct answers until the end, however, the instructor can use the answers as a platform on which to give some general summary comments on the nature of ratio analysis.

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Manage your time carefully. The early (easy) industries can absorb more time than they objectively require. The harder industry comparisons deserve more time because through them, the students learn more about the limitations of ratio analysis. Moreover, since the case raises many mechanical and substantive issues, it is worth leaving 15 minutes at the end of class to survey the issues and get closure on them.

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Case Analysis Comparisons among industries This case is primarily about the effects of managerial strategy on financial ratios, but it also affords several insights about the effect of industry differences on financial ratios. For instance, differences in asset intensity can produce dramatically different asset structures (for example, compare the percentages of inventory and net property, plant, and equipment [PP&E] for paper products with computers). The rate of technological change can manifest itself in several ways including the reinvestment rate required to stay competitive (for example, compare dividendpayout ratios for newspapers, and books and music). Industry structure is believed to affect the profitability through the pricing power of the firm. The newspaper industry can be characterized as locally oligopolistic (in some areas, however, monopolistic); the discount retail industry is much more competitive in structure. The gross profit margins of the two industries differ substantially. The general insight for students must be that, in conducting the financial analysis of a firm, one must understand the nature of the industry. Comparisons of pairs of companies within industries Table TN1 and Exhibit TN1 summarize the identities of the 16 firms. I usually withhold the identities until the conclusion of the class period so that students will reason from the financial data, rather than from other knowledge that they may have about those companies. Table TN1 also highlights the industry pairs that have proven to be relatively easier and harder 1 for the students to sort out.

1 It might be possible to produce pairwise comparisons that were equally easy. The point of this exercise, however, is to stimulate reflection on the uses and possible abuses of financial ratio analysis. The fact is that ratio analysis of some companies will leave the analyst as puzzled as before—the instructor could emphasize that if this happens, the analyst has not necessarily failed. Thoughtfully done, good ratio analysis should generate questions for further analysis. Thus, puzzlement and closure are not necessarily the measures of effective analysis; reasoning and inquiry are.

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Case 6 The Financial Detective, 2005

Table TN1. Summary of the identities of the firms.

IDENTITIES OF PAIRS OF COMPANIES Health products

A = Johnson & Johnson

B = Pfizer Inc.

Beer

C = Anheuser-Busch Companies

D = The Boston Beer Co.

Computers

E = Dell, Inc.

F = Apple Computer, Inc.

Books and music

G = Amazon.com

H = Barnes & Noble, Inc.

Paper

I = International Paper Company

J = Wausau Paper Corp.

Hardware and tools

K = Black Corporation

L = Snap-on Inc.

Retailing

M = Wal-Mart Stores, Inc.

N = Target Corporation

O = Lee Enterprises

P = The New York Times Co.

Newspapers

&

Decker

LEVEL OF CHALLENGE Middling Easy Middling Easy Middling Difficult Easy Difficult

Turning to the pairs of comparisons, we seek to impress upon the students the impact that different business strategies will have on the financial ratios of the companies. Health products: companies A and B Company A is Johnson & Johnson (J&J): a diversified manufacturer of prescription pharmaceuticals, over-the-counter drugs, health and beauty aids, and medical devices. Company B is Pfizer Inc., which develops, manufactures, and markets patented pharmaceuticals such as Lipitor (for high cholesterol) and Celebrex (for arthritis pain). The most significant strategic differences between those firms lie in their product mix and their customer focus: J&J sells many of its products directly to consumers while Pfizer sells almost exclusively to institutions and doctors. Intangibles percentage: Firm B shows a proportion of intangibles nearly twice as large as firm A, which may reflect firm B’s higher investment in research and development. Firm B may also have higher intangibles from its ownership of patents and its investments in licensing arrangements. Gross margin: Company B’s gross margin is more than 12% higher than company A’s, which reflects the higher input costs for company A’s medical diagnostics and devices product segment, as well as the higher prices that company B can charge on ethical prescription pharmaceuticals.

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Inventory turnover: Company A turns over its inventories far more quickly than company B. Company A markets its consumer products to retailers, which have high-turnover orientations, while company B sells almost exclusively to institutions and pharmacies, which may take longer to exhaust their supplies. Net profit margin: Many of company A’s products are branded consumer products that command a price premium. Company B’s patented products also command a price premium. Company B’s premium is higher than company A’s, reflecting the benefits of patent protection on prescription pharmaceuticals, and the additional returns needed to support company B’s large research and development (R&D) efforts. Beer: companies C and D Company C is Anheuser-Busch Companies Inc.: a producer and marketer of a number of mass-market beers such as Budweiser, Michelob, and Busch. Company D is The Boston Beer Company, the seller of the popular Sam Adams line of beers. Boston Beer’s products are part of a category of niche beers called “microbrews.” Cash & short-term investments percentage: Company D’s extraordinarily higher proportion of cash and cash equivalents illustrates the firm’s highly conservative approach to its financial management. Net fixed assets: Company C shows a relatively high level of property, plant, and equipment (PP&E), which is consistent with its status as a major brewery. Company D has much lower net fixed assets since much of N’s brewing operation is outsourced. Company C’s higher fixed assets are also due to its other holdings such as theme parks. Gross profit versus net profit: Company D has higher gross profit, consistent with the premium pricing of its specialty brews versus the mass-marketing approach that was taken by company C. Conversely, company C’s net profit margin is almost three times greater than company D’s. This may reflect the economies of scale that company C can achieve through its large size, relative to company D. Current ratio: Company D’s current assets to current liabilities ratio is three times greater than company C’s, whose current ratio is less than one, illustrating a careful financial approach. Debt to assets and equity: Again, the relatively low level of debt may demonstrate the company’s commitment to financially conservative policies. (An alternative explanation is that, as a younger firm, company D has had less access to debt financing than would a more mature company.) Inventory turnover: Consistent with company C’s mass-market approach, C’s inventory turnover is significantly higher than D’s turnover.

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Case 6 The Financial Detective, 2005

Asset turnover: Due to the relatively low level of assets required (because of outsourcing), company D’s asset turnover is much higher. C’s lower turnover is consistent with a firm that owns its manufacturing facilities as well as asset-intensive theme parks.

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Computers: companies E and F Company E is Dell, Inc.: a worldwide manufacturer and direct marketer of built-to-order computers and related equipment. Company F is Apple Computer, Inc., a manufacturer of a highly differentiated group of personal computers, software, and consumer electronics. The essential differences that motivate our conclusions here are in the price and volume goals of each company. Company E seeks to sell a relatively high volume of lower-margin products, while company F attempts to sell an adequate volume of higher margin products. Cash and short-term investments percentage: The computer and software industry is notoriously volatile. Company F, led by its charismatic founder, has recently emerged from a particularly turbulent period, which could have resulted in the firm’s demise. Therefore, company F’s extremely large holdings of cash and cash equivalents may represent the company’s efforts to insure itself against any future difficulties. Accounts payable percentage: Company E, an assembler of built-to-order computers, has a high percentage of accounts payable, which may reflect a higher degree of supplier financing. Cost-of-goods-sold percentage: Company F has a lower cost-of-goods-sold percentage, reflecting both its premium pricing and the lower costs associated with software production. Company E’s cost-of-goods-sold percentage is higher, reflecting its strategy of making money on volume rather than from individual product margins. Gross profit versus net profit: Company F has higher gross profit, consistent with the premium pricing of its highly differentiated product designs versus the commodity-product approach of company E. Conversely, company E’s net profit margin is almost twice as large as company F’s, which reflects company E’s low-cost focus. SG&A percentage: Company E has a lower SG&A percentage, consistent with its lowcost mail-order strategy. Company E’s higher SG&A reflects the costs associated with its unique retail store concept. Receivables turnover: Company F has a higher receivables turnover, reflecting the fast payments made by consumers in the form of credit card purchases. Fixed asset turnover: Company E’s turnover is more than twice as large as F’s. This might reflect E’s strategy as an assembler of components that have been manufactured by its suppliers. Books and music: companies G and H

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Company G is Amazon.com: the on-line retailer of books and music, plus a variety of other consumer goods. Company H is Barnes & Noble, Inc., the largest bookseller in the United States, with more then 800 brick-and-mortar bookstores. The key differences between those two firms primarily derive from one being an established, traditional retailer and the other being a relatively new, on-line business. Cash and short-term-equivalents percentage: Company G has more than half of its assets in cash and cash equivalents, which may reflect the firm’s readiness for implementing its acquisition strategy. (Alternatively, this conservative position may illustrate the carefulness that is required in the volatile on-line retail business.) Inventories percentage: Company H’s proportion of inventories is significantly higher than company G’s, because company H must maintain stocks of books, CDs, and videos at all of its traditional stores, whereas company G can keep a more limited inventory at its distribution centers. Net fixed assets percentage: Company G, an on-line retailer, needs far fewer fixed assets than company H, the bricks-and-mortar bookseller, to sell its merchandise. Company G’s percentage of net fixed assets is, therefore, significantly higher. Long-term-debt percentage: More than half of company G’s percentage of total liabilities & equity is comprised of long-term debt. This may be because company G, unable to raise capital in a post dot-com bust environment, sought financing through the debt market to fund its acquisitions. Beta: Company G’s beta is more than three times higher than company H’s, which illustrates the relatively higher risk of company G, which only recently began to post positive net income. Inventory turnover: Given its ability to keep relatively low inventories, it is not surprising that company G would also be able to manage a high turnover ratio. Since company H must maintain high stocks of merchandise, it has a correspondingly lower inventory turn. Net profit margin: Company H has a lower net profit margin than company G, which reflects company H’s regular discount strategy.

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Paper products: companies I and J Company I is the International Paper Company: a large, vertically integrated paper products manufacturer. Company J is the Wausau Paper Corporation, a small, specialty-papers operation. The financial distinctions between the firms arise primarily from their scale and scope. Inventories percentage: Company J, the smaller, specialty producer of papers, carries inventories at twice the rate of company I. This may occur because company I’s smaller scale requires the firm to carry a higher proportion of inventory in order to satisfy its demanding customers. Cost-of-goods-sold percentage: Company I has a markedly lower percentage of cost of goods sold (and a correspondingly higher gross profit) than company J, even though the raw materials for each company’s goods are essentially the same. This illustrates not only company I’s ability to negotiate lower volume-prices, but also the benefits of having its own forests and lumber operations (versus company J, which purchases raw materials on the open market). SG&A expense percentage: Company I’s selling, general, and administrative expense are higher than company J’s, which may reflect the higher costs associated with being a large company. (Note how those higher SG&A costs flow through the income statement, such that company J’s net profit margin is ultimately higher than I’s.) Hardware and tools: companies K and L Company K is the Black and Decker Corporation, which manufactures and markets a broad range of power tools, primarily for consumer use. Company L is Snap-on Inc., also a manufacturer of tools and other hardware, but the company is known for its high quality merchandise and for its direct sales to professional mechanics and commercial technicians. Receivables percentage: Company L has a higher percentage of receivables compared to company K. This result occurs because company K markets directly to professional end-users and provides financing, which may cause delays in repayment. Company L, on the other hand, primarily sells its merchandise to large retailers, which may have more regular payment schedules. Gross profit percentage: Company K sells lower-priced products intended for the consumer market, whereas company L markets higher margin precision tools for the commercial customer. As such, company L’s gross profit percentage is measurably higher than K’s. SG&A expense percentage: Company L has a higher level of selling, general, and administrative expenses, which corresponds to the costs associated with maintaining its large direct sales force. (This flows through the income statement, leading to a lower net profit margin and a lower return on equity for company L versus company K). Dividend payout ratio: Company L’s payout ratio is more than four-and-a-half times greater than K’s, which may suggest its need to maintain a high rate of reinvestment to remain competitive.

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Case 6 The Financial Detective, 2005

Case 6 The Financial Detective, 2005

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Retailing: companies M and N Company M is Wal-Mart Stores, Inc., and Company N is the Target Corporation: Wal-Mart is well known for the breadth of its merchandise and its “everyday low prices” strategy. Target is also a discount retailer, but Target appeals to its customers’ more upscale tastes. The essential differences here are product focus (breadth versus depth) and pricing strategy. Receivables percentage: Receivables at company N are much higher than at company M, reflecting N’s substantial credit activities. Inventories percentage: Company M has higher relative inventory levels, which may reflect the company’s commitment to providing a vast selection of goods. Cost-of-goods-sold percentage: Company N has a relatively lower cost-of-goods-sold percentage, reflecting its relatively fuller price for proprietary, designer-made products. Company M offers low prices, which, all else being equal, would result in a higher COGS/sales percentage. Receivables turnover: Company M has a higher receivables turnover, due to its lower use of credit sales. Newspapers: companies O and P Company O is Lee Enterprises: the owner of a number of small newspapers in the Midwest. Company P is The New York Times Company. The strategic difference between those two entities is along the centralization/decentralization dimension. Company P has a centralized, well-managed inventory system, whereas company O corresponds to the profile of a decentralized publisher. Net fixed assets: As a largely centralized operation, company P has a significantly higher level of net fixed assets than company O; in addition, this reflects company O’s recent investment in a large corporate headquarters. Intangibles percentage: Company K bears some of the features of a decentralized operation, perhaps built by acquisition, since its intangibles comprise almost 77% of total assets, which suggests the existence of substantial goodwill created by acquisitions or equity interests in unconsolidated subsidiaries. Cost-of-goods-sold percentage: Company P’s level of cost of goods sold is lower than company O’s, which may suggest that as a larger centralized company, company P may be in a better position to negotiate for volume discounts on inputs, such as newsprint. SG&A expense percentage: Although the case states that firm O is decentralized (suggesting, for instance, duplicative editorial and business functions at its many small newspapers), the SG&A percentage is slightly lower for this firm. One possible explanation is that high prices may be masking a relatively high SG&A expense. A way to determine this would be to examine performance ratios such as subscriptions or advertising revenue per employee

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Case 6 The Financial Detective, 2005

(unfortunately, the case does not present these data). This is a learning point for the student: how ratio analysis begets more questions and analysis. Price-to-earnings ratio: Company O’s price-to-earnings (P/E) ratio is higher than company P’s, which may indicate the expectations of growth for company O, which has been able to increase earnings through acquisitions. As the dominant market player on a larger scale, company P may be unable to grow through strategic acquisition. Net profit margin: Company O’s net profit margin is higher, which may reflect the “local monopolies,” or at least less intense competition outside of the major metropolitan newspaper markets. Some Closing Points After surveying the industries and revealing the identities of the firms, a useful closing for the instructor is to summarize the determinants of the big differences between firms in the same industries: Market positioning/customer focus 

Consumer versus institutional (health products)

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Discount versus full price (retail, computers)

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Single high-profile versus diversified low-profile (newspapers)

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On-line versus bricks-and-mortar (books and music) Product mix

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Specialty versus full line (retail, paper)

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Mass market versus niche (beer, tools) Asset mix

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Asset intensity versus service intensity (books and music) Financial policy

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Debt versus equity (paper, beer, tools)

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Off-balance-sheet financing (retail, beer)

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It is important for students to observe that all those elements are based largely on decisions that managers make, as opposed to luck or the dictates of the environment. To grasp the relationship between managerial choice and financial performance is to lay the groundwork for understanding the rich range of alternatives at management’s disposal for achieving financial goals. At the end of class, the instructor can also make a number of observations about the art of ratio analysis. For instance: 

Ratio analysis is only as good as the financial statements that underlie it. In particular, one needs to understand the accounting policies that generated the statements. The various treatments of goodwill, lease obligations, and equity interests in subsidiaries appear in the discussions. In addition, the absence of data can frustrate ratio analysis.

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Frameworks such as the DuPont system of ratios and categories of ratios (activity, profitability, liquidity, and leverage) are useful organizing schemes for an analysis.

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Naïve ratio analysis can absorb considerable time, as one seeks to find a pattern (any pattern) in the blizzard of numbers. Effort is economized by thinking first about the underlying business that generated the ratios.

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Exhibit TN1 THE FINANCIAL DETECTIVE, 2005 Case Exhibit 1, with the Names of the Companies Revealed