Calculating the value drivers

Source: own creation based on Copeland et. al.

I adapted the previous scheme to the Philip Morris case, because their financial statements are slightly different than those in Copeland's textbook.

The abbreviations used, stand for: COGS is cost of goods sold. In one of the other box there is other expenses less other incomes. OWC means operating working capital, net PPE is net property, plant and equipment.

For control purpose, I included ROIC, computed in the backward way (as multiplying of pretax ROIC and one less cash tax rate) as well. If the computations are correct, then the ROIC has to be exactly the same like the one computed in the beginning of this chapter.

+

+

EBIT/ Revenues

1-+

Pretax ROIC X

OWC/ Revenues

ROIC X +

1-1/

+ COGS/

Revenues Distribution exp./

Revenues Administrative exp./ Revenues

Other exp.-other inc./ Revenues

Net PPE/

Revenues Cash tax rate on

EBIT Revenues/

Invested capital

Other assets/

Revenues

Source: own computations

Notice that in 2005 there are missing few different components. The reason is that the cost structure in the Annual Report for 2005 was different and it would be impossible to obtain comparable figures.

When we start our analysis from the bottom, we can see that the first line has a rising trend. It can be explained by rising level of intangible assets, while the revenues had decreasing trend until 2008.

The second line, where there are net PP&E compared to revenues, has similar levels. It is because the net PP&E does not differ that much over the years. It changed few percentage points according to the level of revenues over the years.

When we moved to the third figure, OWC divided by revenues, we can see huge differences, starting as low as 14% and reaching around 70%. These results are mainly connected with huge changes in OWC. OWC is composed of operating current assets (OCA) less operating current liabilities (OCL). OCA are affected from the major part by the level of inventories and trade and other receivables. Level of these two items is really different over the years. In the recent years, there is a positive trend, when the level of both these items is decreasing.

The key part of OCL, which counts for more than three thirds of the total amount, is other tax liabilities. But this fact is derived from the nature of Philip Morris' business that is highly influenced by taxes.

The level of this driver differs in accordance with the points mentioned above.

2,009 2008 2007 2006 2005

ROIC 44.21% 19.49% 26.19% 47.13% 41.95%

Pretax ROIC 56.13% 25.09% 34.77% 63.59% 57.95%

Cash tax rate on EBIT 21.24% 22.31% 24.68% 25.89% 27.62%

EBIT/Revenues 27.43% 23.53% 25.33% 25.73% 32.20%

Revenues/Invested capital 2.05 1.07 1.37 2.47 1.8

COGS/Revenues 54.73% 58.28% 54.47% 49.02% n/a

Distribution exp./Revenues 10.57% 12.14% 13.65% 16.92% n/a

Administrative exp./Revenues 7.90% 7.28% 7.64% 8.81% n/a

Other exp.-other inc./Revenues -0.62% -1.23% -1.08% -0.48% n/a

OWC/Revenues 27.11% 70.08% 49.41% 14.29% 33.05%

Net PPE/Revenues 20.66% 22.72% 23.00% 25.77% 22.12%

Other assets/Revenues 1.09% 0.98% 0.42% 0.40% 0.38%

Now we will move to the next group of drivers. The first driver is other expenses less other incomes divided by revenues. I will not analyse this driver as its amount is negligible. The next driver is Administrative expenses. The level remains more or less the same, somewhere around 8%, over the years. Then, the next driver is Distribution expenses. Level of this driver is decreasing every year. It means that the Distribution expenses that are necessary in order to generate revenues are reduced from year to year.

Unfortunately, we cannot state the same about COGS driver. Its level in the beginning rose and only in the last year it went down.

Now we will continue with the next level drivers. Firstly, with the capital turnover, which measures how effectively Philip Morris employs its invested capital. It reveals the revenue per one money unit, in our case one CZK, of invested capital. It measures the ability of invested capital to generate revenues. The higher the result, the better. In 2005 the figure was 1.8 then it went up for one year, then it went to the value close to 1. Nevertheless, in 2009 the figure rose up to 2.05. To put this in another way, it means that 0.49 CZK⁵⁷ of invested capital was used in order to generate one CZK of revenues.

Operating margin reveals the profitability of each one CZK of revenues. It indicates the ability of the company to generate earning for a particular level of revenues. The results for Philip Morris show downtrend. The figure started at 32% in 2005, then there was downtrend until 2008 with the result 23.5%, when there was reversion and the result was more then 27%

in 2009. it reached around 47%. But the difference in operating margin over the years are quite high. Unlike the capital turnover, the trend does not reverse over the year.

Relationship between operating margin and capital turnover can be demonstrated by the next graph (likely position of Philip Morris in the graph is denoted by the circle with letters PM inside):

57 The value was computed as: 1/2,05=0,49

Source: own creation based on Holečková, p. 72

Philip Morris is in a capital intensive field of business, with tough competition and entry barriers. These companies have to reach high operating margin in order to attract sufficient funds. They operate under the capacity constraint, meaning that high capital intensity creates constraint for certain level of capital turnover.

The last but one figure is cash tax rate on EBIT. This driver follows clear downtrend. The reason is the decreasing corporate tax rate in the Czech Republic.

The main figure is ROIC. In the Philip Morris case we can see huge differences over the years. In the beginning ROIC is almost 42%, then rising to 47% and falling down to around 26% and 19% and in the last year rising to more then 44%. The results are good. The differences over the years count mainly for changes in the capital turnover.

ROIC and its components differs across industries, depending on their economic characteristics, and across firms within an industry depending on the design and implementation of their strategies.⁵⁸

I will try to explore more deeply the differences in ROIC over the years. According to Stickney (p.207) there are three elements that account for differences in ROIC over the time:

1) Operating leverage. Shortly can be defined as process of operating with high

58 Stickney et.al, p. 205

proportion of fixed costs. The problem with this point is that companies do not publish the portion of fixed costs versus variable costs. But we can assume that Philip Morris has higher portion of fixed costs as it is a manufacturing company and from the composition of a cigarettes' price we can conclude that the production itself is quite cheap (when we disregard from the taxes).

Companies with higher operating leverage experience higher variability in ROIC, because they incur more risk and therefore should earn higher returns.

2) Cyclicality of sales. This does not apply to the tobacco industry in general. As described in the previous chapters, the demand for cigarettes is stable regardless of the state of economy. Nevertheless, some distortions may happen, for example, before anticipated rise in excise taxes, retailers are likely to stock up their inventories.

3) Product life cycle. Products move through different phases. Cigarettes are no exception. Philip Morris is well aware of this fact. As Daniel Gordon said: ”Philip Morris closely monitors customer behaviors and preferences and thus provide adult smokers with more than fifty cigarette variants across different taste and price segments. As an example, we recently upgraded Marlboro Gold, introduced L&M Link and R&W Super Slims. So we indeed follow consumers’ expectations and adjust our strategy accordingly.”⁵⁹

When we conclude the previous elements, we can state that all of them affect changes in ROIC over the time. However, the most significant point is connected with operational leverage. Company has big portion of fixed costs and when they cannot use them appropriately the diseconomy of scale applies. The second and third point contribute to the changes as well, but only from the minor points.

More comprehensive analysis should include benchmarking with similar companies from the industry. But, as the scope of the thesis is limited, I will not include this. Moreover, it would be really problematic to find similar company in the Czech and Slovak market. Especially due to the fact that Philip Morris' market share is more than 50% and because other tobacco companies do not publish their financial statements.

59 http://www.patria.cz/Rozhovor/1617988/financni-reditel-philip-morris-cr-daniel-gordon-na-patriacz---prave-online.html

The reason why I disregard from traditional figures like return on assets or return on equity is that they do not distinguish between operating and non-operating activities. Return on equity mixes operating performance with financial structure, making peer group analysis or trend analysis less focused. The return on total assets is inadequate because it includes a number of inconsistencies between the numerator and the denominator.⁶⁰

In a valuation perspective distinction of operating and non-operating activities is essential in order to calculate the right value of a company.