"Sara Lee Equity Valuation"
Equity Valuation and Analysis Leanna Dennard: firstname.lastname@example.org Gavin Heckman: email@example.com Kristin King: firstname.lastname@example.org Michael Perrien: email@example.com Jason Sibley: firstname.lastname@example.org Table of Contents Executive Summary……………………………………………………………………………………………….4 Business and Industry Analysis……………………………………………………………………….……..9 Company Overview……………………………………………………………………………………..9 Industry Overview………………………………………………………………………….………….11 Five Forces Model…………………………………………………………………………………………….…12 Rivalry Among Existing Firms………………………………………………………………….….13 Threat of New Entrants………………………………………………………………………………19 Threat of Substitute Products……………………………………………………………………..22 Bargaining Power of Customers…………………………………………………………………..23 Bargaining Power of Suppliers…………………………………………………………………….25 Value Chain Analysis…………………………………….……………………………………………………..27 Firm Competitive Advantage Analysis…………………………………………………………………….30 Accounting Analysis ……………………………………………………………………………………………33 Key Accounting Policies …………………………………………………………………….………34 Accounting Flexibility …………………………………………………………………………………40 Actual Accounting Strategy ….…………………………………………………………………….41 Quality of Disclosure …………………………………………………………………………………42 Qualitative Analysis …………………………………………………………………………42 Quantitative Analysis ………………………………………………………….……………44 Sales Manipulation Diagnostic ……………………………………………..…44 Expense Manipulation Diagnostic …………………………………..….……50 Potential Red Flags ……………………………………………………..……………………………57 Undo Accounting Distortion ……………………………………………………………………….60 Financial Analysis, Forecast Financials, and Cost of Capital Estimation………………………61 Financial Analysis………………………………………………………………………………………61 Liquidity Analysis……………………………………………………………………………………….61 Profitability Analysis…………………………………………………………………………………..70 Capital Structure Analysis……………………………………………………………………………75 2 IGR/SGR Analysis………………………………………………………………………………………78 Financial Statement Forecasting………………………………………………………………….81 Analysis of Valuations………………………………………………………………………………………….88 Methods of Comparables……………………………………………………………………………89 Cost of Equity……………………………………………………………………………………………95 Cost of Debt……………………………………………………………………………………………..98 Weighted Average Cost of Capital……………………………………………………………….98 Intrinsic Valuations………………………………………………………………………………………………99 Discount Dividends Model…………………………………………………………………………..99 Free Cash Flows Model…………………………………………………………………………….101 Residual Income Model…………………………………………………………………………….103 Long Run Return on Equity Residual Income Model…………………………………….104 Abnormal Earnings Growth Model……………………………………………………………..106 Credit Analysis…………………………………………………………………………………………………..108 Analyst Recommendation……………………………………………………………………………………109 Appendix………………………………………………………………………………………………………….111 Heinz’s Ratios…..……………………………………………………………………………………..111 Campbell’s Ratios…………………………………………………………………………………….111 Sara Lee’s Ratios……………………………………………………………………………………..112 ConAgra’sRatios………………………………………………………………………………………112 Regression…..…………………………………………………………………………………………114 Cost of Debt……………………………………………………………………………………………131 Weighted Average Cost of Capital……………………………………………………………..131 Discount Dividends Model…………………………………………………………………………132 Free Cash Flows Model…………………………………………………………………………….133 Residual Income Model……………………………………………………………………………134 Long Run Return on Equity Residual Income Model……………………………………135 Abnormal Earnings Growth Model……………………………………………………………..137 Method of Comparables……………………………………………………………………………138 Reference Page…………………………………………………………………………………………………139 3 Executive Summary: Investment Recommendation: Overvalued, Sell as of 11/1/2007 HNZ Stock Price (11/1/07): $45.61 Altman's Z-Score: 52 Week Range: $42.04 - 48.15 2003 2004 2005 2006 2007 Revenue: 9.19B 3.024 2.917 2.809 3.241 3.308 Market Capitalization: 15.1B Shares Outstanding: 319.15M Valuation Estimates: Actual Price Percent Institutional Ownership: 62.50% (11/1/07): $45.61 Book Value per Share: 5.77 ROE: 40% Financial Based Valuations: ROA: 8% P/E Trailing: $54.82 P/E Forward: $36.76 Cost of Capital: D/P $14.37 Time Period (With 60 observation best) : R2: Beta: Ke: P.E.G.: $30.09 3-month: 0.1722 0.6588 8.5308% P/B: $30.79 1- year: 0.1872 0.6596 8.8368% P/EBITDA: $33.07 3-year: 0.1756 0.667 8.6822% P/FCF: $10.74 5-year: 0.17468 0.66286 8.9614% EV/EBITDA: $54.03 7-year: 0.17493 0.66365 9.1374% 10-year: 0.17524 0.66457 9.3543% Intrinsic Valuation: Discount Dividend: $19.76 Published Beta: 0.62 Free Cash Flows: $25.18 Ke: 11.293% Residual Income: $24.30 Kd (BT): 5.6492% LR ROE RI: $24.57 WACC (BT): 2.5342% AEG: $27.12 WACC (AT): 2.3728% 4 Industry Analysis: Heinz is a producer in the food industry and has many competitors that have great effects on their decisions and products. They are a leading processed foods manufacturer and own more than 68 factories world-wide and employing over 33,000 people. Heinz produces in Europe, Asia, and Australia. Food processing factories are scattered in order to keep shipping and distribution costs low. Some major competitors for Heinz include Sara Lee, ConAgra, and Campbell’s. These existing firms battle for more and more market share since the food industry mostly competes on quantity, not necessarily quality. Based on this high level of rivalry, the threat of new entrants are very moderate. Since most of the products produced in the food industry are very simple to recreate, the threat of substitute products is high, giving the buyer moderate power. Also, since there are a lot of places to receive the goods needed in the food industry, at least in the United States, the suppliers have a little power in demanding higher prices from such large companies. In order to gain a competitive advantage against their competition, firms in the food industry must continually find ways to save more and more money compared to the others. Efficient production, economies of scale, low-cost distribution, and product variety are all key success factors in the industry that a firm must achieve to have a chance at increasing its market share. Without these major success factors, the firm would not have the cost saving and product variation needed to stay ahead or even keep up with the rest of the industry. Accounting Analysis: It is very important that companies disclose proper financial statements. Their information not only portrays how their company is doing but is also shows investors how the company is doing. This is important for the companies to get loans. It is also important for the companies to disclose correct information so they do not get in trouble with GAAP. Heinz’s key success factors are economies of scale, cost leadership, and low-cost distribution. Economies of scale are used to measure its wealth and size relative to its competitors, and observe its relationships with its buyers. As the level of 5 disclosure continues to increase the level of transparency will also increase to provide solid information. Cost leadership is important in the food industry in order to get a position with buyers to supply the company’s products. The food industry is very price competitive and having a better priced substitutable product can increase sales versus having fewer sales due to the cheaper replaceable good. Heinz strives to have competitive prices and offer promotions on their products, such as coupons. This gives the buyer incentives over other substitute products. Low-cost distribution is the last of the key success factors. Since Heinz and the food industry have to compete on price, they have to make up costs some where. One way to decrease this risk is to go into long term contract with not only supplier, but also buyers. This will provide more stability for Heinz and less worry of the future. It will allow for them to allocate prices more effectively if they know their set price of transportation. Heinz strives to be cost effective, continue with a high level of research and development, price sensitivity, and product variety. They also disclose information in their 10-K’s that let shareholders and investors know where the numbers came from and what methods they used. Heinz does a good job of disclosing this information. We did not find any “red flags” through this process, but we did adjust for goodwill. This shows that Heinz has a fairly high level of transparency in their disclosures. Financial Analysis, Forecast Financials, and Cost of Capital Estimation: We have put together a number of ratios that compare Heinz with three competitors. We then used different financial information to project what Heinz’s share price should be and compared it to Heinz’s share price at November 1, 2007. Liquidity, profitability, and capital structure are the categories of the ratios we ran. We then used these ratios to construct a forecast for Heinz’s three financial statements. Then we ran regressions to see which beta was the best to use. Having this beta allowed us to calculate our cost of debt, cost of equity, and weighted average cost of capital all of which we would use to value Heinz. 6 The liquidity analysis shows that Heinz is a liquid firm. The quick asset ratio, inventory turnover, and working capital turn over all show this. Heinz is doing well when looking at the industry especially in the current ratio and days supply of inventory. The only concern we had with the liquidity analysis for Heinz was the days sales outstanding. This number is currently in 2007 ok with consideration of the industry but has come down from the highest number in the industry from the last four years. This shows that they are aware of the problem and trying to fix it. The profitability analysis shows that doing well in the food industry and most of the time at the top of the industry. This is with the exception of Heinz’s ROE. They have had a very unstable ROE over the past five years and have shown signs of improvement, but not consistency. The ratios that we ran were gross profit margin, operating profit margin, net profit margin, asset turnover ratio, ROA, and ROE. The last analysis was the capital structure analysis. Heinz showed good debt to equity, times interest earned, and debt service margin. They are in line or at the top of their industry. Although, Heinz can always improve on their ratios. We then forecasted Heinz’s financial statements for ten years, starting in 2008 using the last five years of statement information. After analysis of all financial information, we predicted an average growth rate of 5.4% of net income. We then forecasted out the balance sheet, income statement, and cash flows statement which will all help when we do our valuations of the firm. Valuations: The next step is to value the firm. We did this by first computing the cost of equity, cost of debt, and the weighted average cost of capital. To solve the cost of equity we used the CAPM model. We found the risk free rate and market risk premium and used the best beta we found during our regression analysis. After finding the cost of equity, we then found the cost of debt by taking all the liabilities on Heinz’s balance sheet for 2007 and multiplied them by their corresponding rates. We then added up all these numbers to get Heinz’s cost of debt. With these two numbers we found the weighted average cost of capital. We used the WACC equation with the value of 7 liabilities over the value of the firm times the cost of debt plus the value of equity over the value of the firm times the cost of equity. Then, we computed our method of comparables. This method would show what Heinz’s stock price should be. Each ratio gave us a different stock price. We ran P/E forward and trailing, D/P, P/B, P.E.G., P/EBITDA, P/FCF, and EV/EBITDA. We found a wide range of price from $10.74 from the P/FCF to $54.82 from the P/E trailing. These wide ranges show that these methods vary in efficiency and effectiveness. Our final valuation was the intrinsic valuation. This was made up of the discount dividend model, free cash flows model, residual income model, long run return on equity residual income model, and the abnormal earnings growth model. Heinz’s share price will be valued at each of these valuation models and compared to their actual share price from 11-1-07 which was $45.61. The discounted dividends model and free cash flows models are both inaccurate in their valuations. They valued Heinz at $19.76 and $25.18 respectively. These both showed large fluctuations where there was a change in variables. The residual income model valued Heinz at $24.30 and is a more stable model along with abnormal earnings growth model. And the long run return on equity residual income model comes up with $24.57 which is also a stable valuation. Over all, these valuations show that Heinz is an overvalued firm. 8 Business and Industry Analysis: Company Overview: H.J. Heinz Company, a multi-national corporation, is a major processed foods manufacturer. In 1869, Henry John Heinz and partner L.C. Noble started selling their first product, horseradish, to local grocers in Pittsburgh, Pennsylvania. After 31 years of selling condiments to local grocery stores, the H.J. Heinz Company became a legal corporation on July 27, 1900. Today, Heinz is a leading processed foods manufacturer owning more than 68 factories world-wide and employing over 33,000 people. “The company also owns and leases office space, warehouses, distribution centers and research and other facilities throughout the world (Heinz 2007 10K).” Food processing factories are located sporadically throughout the world to make distribution more efficient. The headquarters for the company still resides in Pittsburgh. Food Processing Factories Owned Leased North America 23 4 Europe 22 0 Asia/Pacific 14 2 Rest of World 9 3 Total 68 9 *Heinz 2007 10K 9 Heinz is included in the food sector of the major-diversified food industry. “Heinz Company and its subsidiaries manufacture and market an extensive line of processed food products throughout out the world including the following principal products: ketchup, condiments and sauces, frozen food, soups, beans and pasta meals, infant food and other processed food products” (Heinz 2007 10K). Heinz ketchup and Heinz 57 are the two leading products in the condiments sector. Acquiring new companies around the world helps the company to grow their product line and increase the shelf space allotted to them. Food processing plants dispersed throughout the world produce the ingredients needed to manufacture their products. Having plants in numerous major distribution areas help to keep shipping and processing costs low. Raw materials that cannot be made in the factories are either bought through contracts with farmers, or purchased in local markets. The consumer goods industry contains a large number of companies, but the main competitors of Heinz include the following: Sara Lee (SLE), Campbell Soup Co. (CPB), and ConAgra Foods Inc. (CAG). With a market cap of $14.77 billion, Heinz leads all of their major competitors. Heinz stock performance from 2003 to 2005 was relatively stable around $46. Although the stock performance of Heinz is not as great as that of Campbell Soup Co., Heinz net sales are far higher. Heinz stock price has improved from $33.87 in 2003 to $46.81 today (www.finance.yahoo.com). The S&P 500 has historically been higher than Heinz and their competitors, but Heinz continues to close the gap more and more every year. *www.Heinz.com 10 “The H.J. Heinz Company has been a pioneer in the food industry for 138 years and possesses one of the world’s best and most recognizable brands-Heinz. While the Company has prospered for a long time, we are constantly finding new ways to capitalize on emerging consumer trends and better methods of doing business (Heinz 2007 10K).” Heinz is constantly looking for ways to improve their current operations and expand into new factories as needed. With increasing net sales and overall company growth, Heinz will be incorporating more factories and distribution centers as they are needed. The increase in revenues and operations allows Heinz to grow their business all over the world. Also, over 100 new products were introduced within the past year and many more continue to be developed. A 24% increase in marketing and a 20% increase in research and development are both helping Heinz to grow their core portfolio. 2003 2004 2005 2006 2007 Total Assets 9,224,751 9,877,189 10,577,718 9,737,767 10,033,026 Net Sales 8,236,836 7,625,831 8,103,456 8,643,438 9,001,630 Sales Growth (8.5%) (7.42%) 6.26% 6.66% 4.14% *Numbers from Heinz 2003-2007 10K. Industry Overview: The consumer goods sector contains 32 different industries within its sector, including the Foods-major diversified industry, the industry which Heinz is classified. Heinz is placed in the major diversified food industry because not just one specialty item is produced; instead they manufacture numerous different types of processed foods. Having a wide variety of different products is beneficial to companies due to the fact that consumers have more to choose from and are more likely to pick one of their products versus one of their competitors. 11 Heinz relies on price competition to be able to keep up with their competitors. “The Company operates in the highly competitive food industry across its product lines competing with other companies that have varying abilities to withstand changing market conditions (Heinz 2007 10K).” Being able to consistently update products and development strategies is crucial for a company to remain competitive in their industry. Using a cost leadership strategy will help Heinz to sell their products over other companies. By having the lowest price for the highest quality good Heinz will be able to attract and keep more customers. Risk factors affect the percent of shares Heinz has in the market, and also their financial analysis. Heinz is a multi-national company and faces the challenge of currency exchange when totaling their sales and financial statements. Exchanging the currency to U.S. dollars can cause accounting and numerical errors that will have to be fixed on the financial statements. Five Forces Model: The five forces model is an analysis mechanism to help identify industry competition, power, and profitability. The degree of actual and potential competition is the first issue that the five forces model addresses. This competition among firms is a determinant for prices in the industry. It ranges from the perfect competition state, where a company’s prices are equal to the marginal costs, to a monopolistic state. Monopolies can charge any price for any item, hurting the buyer. The five forces model then examines rivalry amongst existing firms, threat of new entrants, and the threat of substitute products. These competitive forces are tied closely to firm prices, costs, products, and competitive moves with industrial firms. The second issue is the bargaining power of the firm. This is important to firms because it can be an insight to growth, income, or problems. It allows firm analysts to understand the position of the firm over the bargaining power to buyers and suppliers. 12 Food Industry: Competitive Force Level Rivalry Among Existing Firms High Threat of New Entrants Moderate Threat of Substitute Products High Power of Buyers Moderate Power of Suppliers Low Rivalry Among Existing Firms: Problems that firms encounter in the food industry are unpredictable growth, high industry competition, minimal differentiation, high fixed costs, and exit barriers. In this industry, there are very high competitive products and pricing pressures due to the large number of firms. Changes in business factors like pricing, product, or quantity could lead to major changes in a firm’s profit. As the retail grocery trade continues to consolidate, the food industry has to modify prices in relation to other firms and increase buyer relations to be able to remain profitable. Industry Growth Rate: A main factor in industrial growth is competition. Having a flat growth industry creates competition between firms for shelf space in a buyer’s store. A high growing industry would lead firms to compete highly where price equals marginal cost to stay in business. Being in a slow growth industry could possibly lead to the expectation of price wars between competing firms. Having a negative growth would lead to lowering prices below production costs which would cause a decrease in income. Each growth 13 scenario is directly affecting a firm’s income either positively or negatively. This is why it is important for an analyst to track and predict the growth of industries. Shown in the chart below, Heinz went from a negative growth to a positive and has steady sales growth since 2004. The industry shows volatile sales growth. Sara Lee and Conagra had major problems with their sales in a couple of years. Sales Growth: *Numbers from annual sales of each firm. Concentration of Competitors: The number of firms in an industry strongly influences how a company is run. With a high number of firms at any given level, a company will have to aggressively compete to get business and market share over competitors. Lowering prices, cutting costs, and changing product lines are possible actions that could be taken in a high concentration industry. Just the opposite is a low concentration industry where there are few companies that can agree to charge a high price and receive higher profits without advertising. This is called collusion. It can be very beneficial to firms and quickly increase profits and keep them high. It is also important that there is a high demand for products. The food industry has many firms that compete for the 14 customers’ needs or wants. The size of the firm is also very important in the competition. The smaller companies cannot compare to the larger companies with numerous product lines and international products. The chart below shows a range from 15% to 35% market share per firm. The greater a firm’s market share increases, the more it takes from others in the industry. Industry Market Share: Heinz percent of the market has been relatively stable for the past five years. Although, Heinz net sales have been higher than its competitors for every year. Having more diversified products than the other companies may reduce the percent of the market shares because consumers do not realize which products are all made by Heinz. % Market Share 40% 35% 30% Heinz 25% Campbells 20% Sara Lee 15% 10% Conagra 5% 0% 2003 2004 2005 2006 2007 *Percentages are from annual sales compared with total industry sales for each year. Differentiation and Switching Costs: Businesses in the food industry strive to differentiate themselves from their competitors by diversifying their product lines. However, there are many food substitutes for the consumer. Firms appropriate this issue and pursue innovative ideas to appeal to the customer’s desires. Competing companies fielding similar products compete primarily on price and shelf space. Having similar products and prices creates 15 low switching costs for consumers. Switching cost is the price that consumers are willing to pay to switch from one product to a similar product, usually to a cheaper substitute. Most consumers are indifferent between products and are quickly moved to switch their buying behavior. Since switching costs are low in this industry, businesses engage in greater price competition. Companies can also appeal to consumers by offering new, diversified, healthy products that catch the consumer’s attention. Economies of Scale: An economy of scale is a process where a firm increases their size of production and reducing long run average costs. Any size firm can experience economies of scales. Introducing businesses outside of the United States is one example of an economy of scale. Companies would increase the demand for their products and create more revenue while spreading out their costs. While going international, firms keep in mind diversity. Diversity is realizing and understanding the differences in multicultural life. Being diverse with products, advertising, tastes, and values will increase this success for a company. Industry Diversity- Gross Profit: U.S. Europe Asia/Pacific Rest of World Heinz $1,140,000 $1,240,000 $386,800 $610,722 Campbells $2,657,000 --- --- --- --- --- --- --- $150,000 Sara Lee $6,602,000 $5,458,000 $2,042,000 $3,728,000 Conagra $3,138,500 --- --- --- --- --- --- --- $179,000 * Numbers in thousands from 2007 annual reports. Gross Profit = Net Sales – COGS The Food Industry has a large market share outside of the United States. Heinz has shown that selling domestically can be profitable as well as foreign sales. Heinz’s percentage sold in the U.S. is about 34%, in Europe is 37%, in Asia/Pacific is 11%, and 16 the rest of the world is 18%. The major problems that comes up when selling outside of the U.S. is dealing with exchange rates which are unexpected and can be very unpredictable. Another major problem is that there are major cultural changes that have to be made when looking at other countries. People from different cultures might like a different type of spice in their food or lack of spice. Heinz would have to change their recipes in order to sell any of their products. Fixed and Variable Costs: Costs play a large role in all firms’ success in earning a profit. The larger the costs are, the less the company receives at the end of the year. Costs also provided analysts with insight into the future of a company in projecting profit/loss outcomes. A company ideally would like to have a small fixed to variable cost ratio. Firms should have incentives to lower prices to increase the capacity of their products. The chart below shows the food industry’s cost ratios. The average of Heinz fixed cost to variable cost ratio is about .44, which is the average of 2003 through 2007. This means companies have about double the variable costs to their fixed costs. This is not profitable, especially in a price competitive industry. Fixed Cost to Variable Cost Ratios: 2003 2004 2005 2006 2007 Heinz 0.4235 0.4635 0.4746 0.3645 0.4754 Campbells 0.3023 0.1952 0.1304 0.2769 0.1359 Sara Lee 0.4096 0.4124 0.4355 0.6756 0.4626 Conagra 0.3389 0.4412 0.4450 0.4337 0.4992 *Numbers from annual costs. Capacity: When considering the capacity of an industry, the optimal goal is to have demand greater than the company’s product supply. In the food industry, this is not 17 the case. Supply is greater than demand which is said to have excess capacity causing the firm to lower already low prices in order to increase demand. This creates a decrease in profits while costs are staying the same and the end outcome is less than expected. From 2005 to 2006, Heinz had an increase in investing which showed an effect on net income in 2007 which increase from 2006. Excess capacity in the food industry is just another indicator that new entrant firms will fail before they even get started. Exit Barriers: Exit barriers are anything that holds a company back from shutting down and leaving its industry. Regulations can be assigned to an industry that companies have to comply with before leaving. This is important for the company to consider if the regulations or barriers cost more than the companies fixed costs. It would not be reasonable to shut down if the company would have to pay more than could be earned staying in the industry. That is why exit barriers are important factors in a business’ life. The food industry has few exit barriers to none. Since they would not hold a lot of food in inventory, this would not take a long time. The most important issue would be to disperse or sell the entire company’s disposable inventory. Then, it would sell off the rest of the assets to pay off all costs and close books. Conclusion: The food industry is a highly competitive market. The competitiveness stems from the similarities between company’s products and prices. The industry has a gradual increasing growth rate, mostly concentrates on prices, competes on gaining market share domestically and internationally, and has minimal exit barriers. Because of high price competition, companies switch attention to the financials of costs and liabilities. By decreasing costs and liabilities, the company will increase its net income. 18 Threat of New Entrants: The threat of new entrants into the food industry is moderate. This industry has low prices because of competition, which would not attract many new entrants. It is comprised of many different types of firms ranging from large multi-product companies to single product small companies. The threat of new entrants depends greatly on the firm’s size. A billion dollar company would not have to be worried about new firm entry because of their sheer size, while a small company would suffer from the switching costs of customers. Economies of scale, first mover advantage, and barriers help determine new entries into an industry. Economies of Scale: When deciding to enter into any industry, there are many important factors to analyze and consider. The new entering company should compare its capital to the firms that have the greatest market share. By looking at competitor’s operations, what it buys and sells, how it invests, and other financial information, a new entrant can determine if entering would even be worth it. The entrant would start off at a disadvantage to the older companies. This is due not only to experience, but economies of scale. The older firms have a positive income, relations with customers and suppliers, innovations that took years to create, and the research to create new products. The chart on the next page shows one of the important parts of the balance sheet a new entrant should look at. Assets take a long time to posses and can add great value to the company. A lender looks at assets to see if the company can back up loans and the greater the assets, the greater the loans can be. If the assets are not large enough, the company would struggle to keep up with other big dogs in the industry. 19 Total Assets: 2003 2004 2005 2006 2007 Heinz $9,224,751 $9,877,189 $10,577,718 $9,737,767 $10,033,026 Campbells $6,205,000 $6,662,000 $6,776,000 $7,870,000 $6,754,000 Sara Lee $15,496,000 $14,879,000 $14,412,000 $14,660,000 $12,190,000 Conagra $15,185,600 $14,310,500 $13,042,800 $11,970,400 $11,835,500 * Annual total assets in thousands of dollars. First Mover Advantage: In most industries, the first mover has an advantage over all followers. This is due greatly to brand recognition, brand loyalty, and setting industry standards. The first mover could also enter into agreements, especially in the food industry. If there was a high demand for a product of a first mover, that company could negotiate with buyers and sellers so that odds are in the first mover’s favor. If the first mover keeps off new entrants long enough, it could gain revenues and grow to where other companies are discouraged to try and enter. In the food industry this is very important. A first mover could come out with a new idea or product and it is important for the companies to be the first one who do this to get customers. Research and development play a large role, especially in such a competitive industry as the food industry. Channels of Distribution and Relationships: The grocery stores have been consolidating recently which limits selling capacity in the industry. This could discourage any new entrants to enter the industry. Plus, the low product prices could possibly be a flag to an entrant that they would have trouble getting relationships with buyers and suppliers leading to no shelf space. Entry firms also have to consider the channel fluctuations in costs, such as energy and fuel costs, transportations costs, crop failures due to disease or insect infestation, weather conditions that affect crops, changes in food or drug laws, health and safety matters, 20 export and import restrictions, and currency exchange rates. These would all lead to a direct effect to the costs of production, transportation, and to an increase or decrease of profits. Barriers: In the food industry, there are strict barriers dealing with obtaining, creating, and selling a product that consumers put in their body. There is a strict health code that each firm has to follow throughout its productions process. These barriers differentiate healthy foods that consumers can trust and foods that could contain harmful ingredients. Also in the food industry, sometimes there is a recall on food due to ingredients or the production process. This is very costly to the companies who produce these defected goods. These companies lose production costs along with the profit loss and the cost of recalling all the products and disposing of them. These legal rules could discourage new firms from entering the market due to the threat of major capital lost. Conclusion: The foods industry has a low to moderate threat of new entrants. This is mainly due to the large number of aged firms already in the industry. Their economies of scale would be incomparable to a fresh firm. New firms would find difficulty if entered into the food industry for three main reasons. The first is the first mover advantage. The industry advantage usually always goes to the initial firm in any industry. The second reason is the capacity of shrinking distribution channels of suppliers and especially buyers. This makes it hard for entering firms to start out at equal to experienced firms already in the industry. The final reason is the high responsibility of legal barriers. These issues pose high income loss in extreme situations, but minimal in consideration that people will be consuming the products. All this information listed above points to limited entry into the foods industry in the near future. 21 Threat of Substitute Products: There will always be a high degree of competition between substitutes in the food products market. Due to the fact that there are many relevant substitutes for industry products in this market targeting the same customers, there is a serious threat of consumers switching to a competitively priced comparable product. The similarity between product lines with others on the market directly correlates with a low switching cost for consumers. Buyers’ Willingness to Substitute: Since many industry products are functionally as well as economically the same as many competitor products, buyers have an exceedingly low switching cost for most industry products. This further emphasizes the fact that the food products industry is a highly competitive industry. The one exception to this rule is when a particular company negotiates exclusive contracts with high visibility like restaurants, hotels, or hospitals. In this case, the respective company may only carry company specific condiments or food products. Presumably, these contracts are renegotiated on a routine basis, emphasizing the importance of maintaining solid business relationships with buyers. Relative Price and Performance: In light of the fact that in certain instances industry products have superior branding and name recognition, in some cases they do have a distinct competitive advantage. However, the industry is flooded with many large and small competitors, and substitute products remain a considerable threat directly affecting the company’s bottom line. Therefore, it is important for competitors to charge a similar amount for their products despite this competitive advantage. The industry’s business strategy is to continue to reduce costs to increase company profit margins. Industry competitors can also gain an advantage by having its various brokers and agents initiate new as well as 22 maintain existing relationships with its customers (www.finance.yahoo.com). Maintaining a loyal base of customers is of the utmost importance to the company. Conclusion: There are plenty of substitutes readily available and in close proximity in the food products industry. In this competitive environment, companies are concerned with losing market share to competitors. Combine these aspects with extremely low switching costs and it is easy to see why industry insiders focus their efforts on reducing costs and selling as much product as possible. These efforts coupled with sufficient brand recognition enable companies to stay ahead of the curve and maintain increasing profit margins. Bargaining Power of Customers: The amount of bargaining power consumers have greatly affects how a firm runs its operations. The main determinants of this are price sensitivity and relative bargaining power. Price sensitivity directly affects the amount of bargaining between buyers and sellers. Relative bargaining power directly affects the ends buyers’ decisions in which product they end up buying. Major retail supermarket chains, large scale grocers, hotels, and still smaller local stores are a sampling of the customers industry competitors sell their products to. Some companies in the industry also have a highly diverse international customer base, selling products to various food serving entities like sports stadiums or airlines. Price Sensitivity: Price sensitivity is essentially the price customers are willing to pay for the value they perceive in an item. The value for industry competitors in the food product industry is largely based upon consumer taste preferences and competitor pricing. This is mainly evidenced in products like steak sauce, where the recipe is unique and taste is 23 a vitally important factor. On the flip side, industry competitors have many products such as ketchup and mustard that contain the same basic ingredients as competing products. Due to the fact that these are also very popular items, there are a substantial number of imitators in the industry trying to chip away at various competitors’ market share. For these products in particular, brand recognition and price play more of a key role in sales. To have their products offered in places like Wal-Mart, companies have to compete on price. This is mainly due to outside pressure from Wal-Mart to maintain a cheap and affordable price for its customers. This is a double edged sword because keeping prices for buyers like Wal-Mart low means that companies must also fight to keep their costs of production low. Bargaining Power: Relative bargaining power relates back to an earlier discussion of switching costs. With low consumer switching costs, companies within the industry must advertise creatively to set themselves apart with things like television commercials, placing coupons in newspapers and other local periodicals, and setting up point of sale displays to further gain brand recognition. The effects to individual companies of potentially losing customers are also taken into account when discussing bargaining power. As was previously stated, customers in the food products industry generally have a low switching cost because the competition’s product can generally be found in the same store on the same shelf. Companies also must worry about their other set of buyers, stores they directly sell their products to. These are important negotiations because they determine in-store shelf space and prices as discussed in the previous section. Conclusion: The two most important factors determining customer bargaining power are price sensitivity and relative bargaining power. To a very large extent, companies construct their appropriate business strategies in accordance with these factors. 24 Bargaining Power of Suppliers: Relative bargaining power of suppliers is also a key component to companies maintaining their past success. This is relatively the same as the discussion above on bargaining power of buyers, except the focus is flipped around the other way now. If suppliers are highly leveraged with bargaining power, companies may be forced to comply with that supplier’s stipulations. This could potentially have the effect of increasing input costs and lowering profit margins. In this case, the firm is at the mercy of its suppliers. On the other hand, if there are many different suppliers to the company, then that organization has the more powerful position. With this power they can force suppliers to decrease their prices and perhaps even dictate more demanding shipping standards. Price Sensitivity: With the food products industry being so large, it has a position of power over its suppliers because there are a large number of commodities growers. Suppliers must adapt to the demands made by large companies within the industry because if they do not, other suppliers would be more than happy to take their place. There is generally a market rate for the raw materials that companies purchase for their products. In certain instances however, the company can be held hostage to the commodities markets it purchases supplies from. Companies buy commodities such as tomatoes, potatoes, dairy products, and meat to use in its food products. The availability or cost of such commodities may fluctuate widely due to government policy and regulation, crop failures or shortages due to plant disease or insect and other pest infestation, weather conditions, or other unforeseen circumstances (Heinz 2007 10K). These fluctuations in price and supply could have a detrimental effect on a company’s business. As an example, Heinz raised its prices this year to offset higher costs of dairy sweeteners and oils. “This was in response to the rising popularity of ethanol, which drove the price of corn to record high prices earlier this year (www.forbes.com).” 25 Bargaining Power: Due to the industry’s significant size, there is quite a bit of bargaining power with suppliers in the industry. The supply chain is still a critical part of the operations though. Any problem with the manufacturing or distribution sectors of a companies supply chain could inhibit a company’s ability to make and distribute its products. Keeping this in mind, it is important for companies to maintain a supply chain that can consistently and economically purchase raw materials, manufacture, distribute, and sell its products to customers in a timely manner. Conclusion: The bargaining power of suppliers to a very large extent determines how competitive a company is able to be within a given industry. Maintaining relationships conducive to consistent and cost effective means of production and delivery is essential to the survival of any firm in the food products industry. Companies must continue to find the right balance in maintaining relationships with its buyers and suppliers to stay relevant within its industry and fully utilize its production capacities in hopes of maximizing shareholder wealth. 26 Value Chain Analysis: In summary, the food industry in which Heinz is a primary competitor is characterized by high rivalry among existing firms, a moderate threat of new entrants into the market, a high threat of substitute products, moderate bargaining power of buyers, and low bargaining power of suppliers. The factors that contributed to these conclusions were unpredictable growth, high industry competition, minimal differentiation, high fixed costs, and exit barriers in the industry. For a firm seeking to be competitive in the industry, focus must be maintained on various success factors. Primary concern in the highly competitive food industry, with the variety of substitutes available to consumers, should be placed on cost leadership, rather than differentiation. It should be noted that no firm concentrates purely on cost leadership or differentiation, so a successful competitor will have a combination of both, but emphasis should be placed on cost leadership. Competitive Strategies: In an industry with high competition, many substitute products available, and little consumer loyalty, a firm competes by becoming a cost leader. Factors involved with becoming a cost leader include efficient production, low input costs, economies of scale, and low-cost distribution. However, as mentioned earlier, no firm should be purely cost-competitive, and in the food industry, firms who offer a great deal of product variety also prosper. Efficient Production: Efficiency is important for any firm in any industry. Getting maximum output at minimum cost is arguably the most important factor to meet in being competitive. In the food industry, however, it is very important. Many of the input costs are highly volatile for the firms in this industry, as they are based on agricultural commodities. This leads two primary dilemmas for a firm in the industry, the first being that a firm 27 must be able to keep costs down when commodity prices are high. This requires maintaining low costs for other inputs, and an efficient production set-up. The second dilemma is that all of the firms in the industry are typically getting their agricultural inputs at the same or very similar prices. For a firm to be competitive in this type of environment, it must be efficient in its production. To determine whether or not a firm is an efficient producer, one must monitor the costs of the firm. All costs should be minimized, and those not directly related to the production process should virtually be eliminated. Economies of Scale: Size matters in the food industry. In order for a firm to be competitive, it must be large enough to market its product to a wide range of customers. To do this it must be able to produce its products on a large scale, and distribute those products to many different locations, in many cases world-wide, while keeping costs as low as possible. This is difficult for smaller, younger firms to achieve, as it requires good relationships with buyers, and large amounts of capital. Therefore, in this particular industry, it pays to be big, wealthy, and established. Obviously, to measure an efficient economy of scale would be to measure its wealth and size relative to its competitors, and observe its relationships with its buyers. In this industry, the efficient economies of scale come from the bigger companies. Low-cost Distribution: Another way for a firm to be competitive is to keep its distribution costs down. This allows for higher profit margins down the line, which is critical in a cost-competitive industry. In this instance, it helps to be large and experienced, again. Firms that have the capital and the relationships with distributors have a better bargaining position than smaller, less wealthy firms and can better keep the costs low. To get a good measurement of this, one should measure how much the firm is spending on distribution relative to what its competitors are spending. 28 Product Variety: Product variety is not typically associated with a cost competitive market, as it is usually more expensive for a firm to produce a multitude of products. In the food industry, however, there are many different, closely-related products for a consumer to choose from, and since there is less customer loyalty in this market, it is easy for a consumer to choose one firm’s product over another’s. Therefore, the more products a firm can offer a consumer to choose from, the more likely a consumer is to purchase one of that firm’s products. Many firms in the industry do this either through various brands, or by using a spin-off product, and in order for a firm to compete, it must do the same. Efficiency in product variety can be measured the number of products produced by a firm and the amount generated by each of those products. Conclusion: This is a highly competitive industry, as demonstrated by the wide availability of substitute products, large number of competing firms, and volatility of inputs. Maintaining a competitive advantage requires that a firm keep its costs as low as possible. It must maintain efficient production, lowering as many of its input costs as it can down, keep its distribution costs down, and market to as many consumers as possible. It must also supply what the consumer is looking for, which requires offering many different types of products, and yet maintaining low prices. Consumer loyalty is extremely difficult to come by in this industry, so a firm seeking to be competitive must cater to whatever a consumer may want. 29 Firm Competitive Advantage Analysis: Heinz has been implementing a two year plan primarily to increase shareholder value, but has also, helped increase net sales and operating income. This plan aims to execute several key objectives in order to produce efficiently, grow economies of scale, lower the cost of distribution, and increase the company’s product variety. These are necessary for all companies in the food industry, and Heinz has made it a goal to lead the industry in these aspects in order to stay ahead of the competition in the food industry. According to Heinz’s most recent 10-K, thanks to the current two year plan, “The Company achieved its targets for Fiscal 2007 and is well positioned for continued growth in Fiscal 2008.” Efficient Production: In the food industry, it is essential to produce your product very efficiently to increase profit by reducing cost of goods sold. Heinz in the past year has closed or divested 16 plants in order to help lower production costs (www.heinz.com). This can be seen as a precursor to “reducing cost of goods sold by 90 basis points as a percentage of sales, and total gross profit exceeding the company’s expectations.” The recent development of a “Global Supply Chain Task force” by Heinz has reduced the cost of production in the recent fiscal year, and is expected to continue to help drive production cost down. Since inputs such as agricultural inputs are hard to judge and usually cost all companies in the food industry practically the same, Heinz is willing to discard unproductive plants in order to help drive costs that they can more easily control downwards, according to their most recent annual report. Economies of Scale: In this industry, being a large company is very important if you want to have bargaining power over your suppliers. As stated earlier, the power of the suppliers in this industry is low since most of the companies are large. For being one of the largest 30 companies in a large industry, Heinz is able to, for the most part, negotiate easily with suppliers (www.finance.yahoo.com). Since Heinz produces so many of so many different products, they can easily buy in massive quantities, which reduce the cost per item significantly. By doing this, the company greatly reduces costs, and receives a great, loyal supplier foundation. Staying with the same suppliers and signing long term contracts can easily keep costs down as long as they are able to trust these suppliers. Along with being a large company being able to “strong-arm” suppliers, Heinz, with its two year plan which includes increasing cash flow and capital, has the ability to buy certain suppliers so they can even supply some of their own necessities. In addition, with an acquisition such as of IDF Corp., they can pick up suppliers through acquisitions of competitors (www.heinz.com). Low-cost Distribution: In an industry that almost everyone receives the same products for the same price, cost reduction is a key component in order to maximize profit margins. Another way that Heinz is trying to achieve cost reduction is by lowering the cost of distributing their products. This is a daunting task for a company who sells hundreds of products in over 200 countries, but they understand they need to lower these costs in order to stay as profitable as possible. One major way that Heinz has been able to control distribution costs was by entering into “long-term agreement with ES3, LLC, a leading national third-party logistics and distribution company, to be its lead logistics provider of warehousing and distribution services for Heinz's ketchup, condiments and sauces businesses” (www.es3.com). By signing this agreement, Heinz effectively has given the task of distributing its goods to a large distribution company that has more distribution centers in the United States that Heinz products can leave from and find their ways to stores nationwide. Product Variety: In the food industry, firms must go beyond a simple one product in order to be competitive. Heinz is no different in that they sell not only items such as ketchup and 31 mustard, but also meals, snacks, and infant foods. Though their top 15 brands grew 8.5% on the year, nearly 100 new products were launched (Heinz 10-K 2007). Heinz’s current research and development teams are working on over 200 new products across these several markets. In order to continue at varying the products that they produce, Heinz has increased research and development nearly 20% in innovation and consumer insight. By increasing consumer insight, the company will be able to continue to research products that consumers actually want or need, making the whole innovation process less expensive in the long run. The company is looking into “incremental improvements in… convenience products like portable hand-held snacks… and microwavable soups in the UK, Australia and New Zealand.” Conclusion: Heinz has positioned itself to increase market share by continuing growth worldwide. By continuing to find ways to produce efficiently, increase economies of scale by growing at a safe rate, lower the costs of distribution, and research and develop new products, the company has established its future and put themselves in a great situation to continue to lower costs and increase profits. Halfway through the most recent two year plan, the numbers of the past year prove that Heinz has implemented a great plan in order to stay competitive. 32 Accounting Analysis: The balance sheet, income statement, and the statement of cash flows all show the current standings of the firm and what it plans to do in the future. The Management Discussions and Analysis section of the annual report provides insight into the company’s performances, business conditions, and decisions. Financial statements are important for numerous reasons. The main reason for presenting all necessary financial statements is to provide information to investors. Investors are an important part of any business. Without enough funding for operations, a company would be forced to leave the industry. Investors fuel the firms operations leading directly to profits. Another important reason to disclose financial statements is for shareholders. A firm’s optimal goal is to maximize profits for the shareholders. The statements give valuable insight to shareholders possibly creating a higher value for the company stock. These financial statements must be prepared very diligently and properly. There are many rules put into place so that firms cannot alter numbers or policies to make their company look better. Firms must follow General Accepted Accounting Practices (GAAP) that is put in place by the Securities and Exchange Commission (SEC). GAAP sets the standards, conventions, rules, and procedures that firms must follow when creating their financial statements. These rules also help investors to understand all of the financial statements of the company so that they can know what they are investing in. Accounting allows managers to have room to modify their firm’s financial statements to better fit the company. Having the ability to choose their own policies creates the opportunity for managers to adjust the correct numbers to different numbers that would make the company appear better off and have higher profits. An accounting analysis is necessary to look at the financial statements to see if there is purposeful wrong doings and correct them. Accounting analysis evaluates the degree to which a company’s financial statements capture its business principles. Analysts can follow these rules to evaluate 33 the firm’s financial statements and undo the mistakes. The first step is to identify key accounting policies. A company’s industry characteristics and strategies help to determine their key success factors. “One of the goals of financial statement analysis is to evaluate how well these success factors and risks are being managed by the firm (Palepu & Healy 3-7). The second step is to assess the degree of potential accounting flexibility. This step connects key accounting policies to potential accounting flexibility to see where the company can separate from the general structuring of financial statements. The third step is to evaluate actual accounting strategies. This is where the analysts can determine true performance from mistakes or changes in financial statements. The fourth step is to evaluate the quality of disclosure with a qualitative and quantitative analysis. This step shows how well the financial statements were put together and how close they are to the actual numbers. The fifth step is to identify potential red flags. A red flag is anything that the analysis cannot explain and is directly related to what was found in step four. Any red flags that are found are good indicators that the manager changed the numbers indicating no explanation. And the last step in accounting analysis is to undo the accounting distortions that were found in the previous steps. This is important so firms are transparent and not misleading to their investors or stockholders. When firms do unknowingly make mistakes they would be brought to the company’s attention and corrected at this point. Key Accounting Principles: When evaluating a company’s key accounting principles it is important to know the key success factors. Understanding these factors can help the company to decide which accounting principles to use to keep a competitive edge over their competition. As stated earlier in the five forces model, the key success factors of Heinz are economies of scale, cost leadership, and low-cost distribution. Heinz is in an industry with a large amount of product substitutes, and must go the extra distance to keep them ahead of their competitors. Setting the costs low will persuade consumers to purchase their product instead of a higher priced alternative. In order to keep the costs 34 low and maintain cost leadership, Heinz must be efficient in their production and purchasing of raw materials. When trying to keep the inputs as inexpensive as possible it allows Heinz to keep their prices low. Product variety is also very important for Heinz to be able to beat their competition. With so many different products to choose from in this industry, Heinz must have as many products on the shelves as possible to ensure success. The more products that Heinz can distribute the more likely the consumer is to purchase from their line of products. The key success factors help to establish the following key accounting policies used by Heinz. Sales Growth: Due to the highly competitive food processing industry, Heinz has to remain a cost leader to continue the growth of both the company and net sales. Through acquisitions and mergers, Heinz continues to expand their operations throughout the world, and better manage fixed costs. With larger companies it is easier to mass produce and distribute which keeps costs low. Since Heinz has food processing factories and distribution centers world-wide, distribution costs are lower. “Gross profit increased $299.8 million, or 9.7%, to $3.39 billion. These improvements reflect higher volume, productivity improvements and favorable foreign exchange, partially offset by commodity cost increases (Heinz 2007 10K).” Heinz is constantly trying to find ways to increase productivity and decrease costs to raise the gross profit. Over the past five years net sales of Heinz has been rising except for in 2006 where the sales were comparable with that of 2005. The net sales growth is shown in the table on the following page. 35 *Heinz 2007 10K Heinz continues to look forward to new mergers and expansions that will increase the net sales of the company. “In fiscal 2008, the Company will continue to invest in improved business systems in order to boost the efficiency of its promotional programs, particularly in Europe (Heinz 2007 10K).” Post-Retirement Benefit Plans: Heinz offers post-retirement health care and benefit plans for those employees that are eligible. Benefit plans make it difficult for any cost leadership company to keep their costs low while still following the key success factors. Heinz has to try to accurately estimate the liabilities and discount rates that will be utilized by their employees at a future date. It does become hard trying to keep the pension rates competitive with other companies while still keeping overheads low for the cost competition in the industry. Heinz has stated in the 2007 10K that “Several statistical and other factors that attempt to anticipate future events are used in calculation the expense and obligations related to the plans including assumptions about the discount rate, expected return on plan assets, turnover rates and rate of future compensation increases as determined by the Company, within certain guidelines.” Often times this 36 type of aggressiveness in accounting strategies can make it hard for the investor to see what is really true about the company. Pension Discount Rates 2003 2004 2005 2006 2007 Heinz 5.90% 5.80% 5.50% 5.30% 5.50% Campbell’s 6.39% 6.19% 5.44% 6.05% N/A* Sara Lee N/A* N/A* N/A* N/A* N/A* Conagra 7.25% 6.50% 6.00% 5.75% 5.75% *Numbers from 10K’s of companies The table above shows the pension discount rates of Heinz and their competitors. Decreasing rates means that the numbers are becoming more transparent to the company and investors. Keeping the discount rates relatively consistent shows that Heinz is confident in their key success factors. The key success factors are often used when setting these rates to help keep the costs low. Operating and Capital Leases: An operating lease is “A lease for which the lessee acquires the property for only a small portion of its useful life (www.investorwords.com).” Operating leases are not recorded on the balance sheet because they are not owned by Heinz, but are usually included in the income statement as an expense. This can cause the financial reports to not be transparent as it makes liabilities seem lower than they really are. Operating leases are utilized by Heinz to gain access to production and office facilities, warehouses, and equipment that are necessary in production and distribution of products. These lease obligations “amounted to approximately $104.3 million in 2007, $97.6 million in 2006, and $101.2 million in 2005 (Heinz 2007 10K).” This is a relatively small amount compared to the total liabilities. Capital leases are defined by www.investorwords.com as “A lease that meets one or more of the following criteria, meaning it is classified as a purchase by the lessee: the lease term is greater than 75% of the property's estimated economic life; the lease contains an option to purchase the property for less than fair market value; ownership 37 of the property is transferred to the lessee at the end of the lease term; or the present value of the lease payments exceeds 90% of the fair market value of the property.” Capital leases are used by Heinz, but not as often as operational leases. This type of lease is stated on the balance sheet and is amortized over the asset’s useful life. The table below illustrates the total long term debt versus operational and capital leases. < 1 year 1-3 years 3-5 years > 5 years Total Long Term Debt $538,236 $1,521,200 $1,873,122 $3,259,179 $7,191,737 Capital Leases $10,046 $19,423 $54,391 $33,581 $117,441 Operating Leases $67,002 $108,994 $71,476 $188,163 $435,635 *Heinz 2007 10 K (amounts in thousands) Operating and capital leases are important in a cost leadership industry. Most firms will want to keep most of their obligations classified as operating leases to make the financials more appealing to investors. Currency Rate Risk: International companies face numerous market risk factors due to the conversion of currency into U.S. dollars. Market risk numbers are not included on the balance sheet because they are not believed to have an affect on the financial situation of the company. The risks can be somewhat diversified since Heinz owns factories throughout the world and not just in one market. “The Company may attempt to limit its exposure to changing foreign exchange rates through both operational and financial market actions including entering into forward contracts, option contracts, or cross currency swaps to hedge existing exposures, firm commitments and forecasted transactions (Heinz 2007 10k).” Maintaining low costs is vital in following the key success factors. Although some market risks cannot be avoided, it is necessary for Heinz to try and decrease whatever risks they can. 38 Research and Development: Heinz is constantly looking for new and innovative products that can increase company value. This requires that a large amount of money be spent on research and development. R&D is reported in the income statement under the selling, general, and administrative expenses and not as an asset. Expensing this out ensures that the net income level is not temporarily higher than the real number. Recently, Heinz has set out a goal for the company to grow the core portfolio including the largest brands. The Heinz 2007 10K states that, “This strategy established targets for increased marketing spending of $50 million and double digit increases in research and development costs.” This was almost a 20% increase in research and development in 2007 alone. Continually increasing R&D costs can make it difficult to remain a cost leader, but Heinz expenses them which help to keep their fixed costs low. Heinz is very reliable about following the proper accounting methods of expensing these costs, and not recording them as an asset. Although this might not be the best option for cost leadership competition, it is the correct way to report R&D. This keeps the company in stride with the key success factors and investors. Conclusion: With the accounting policies constantly changing, it is important for any company to keep up with them and make sure that they are following their own key success factors. Having clear, transparent financial reports is the best way to achieve this. Heinz does a good job of disclosing all of the information necessary in reporting the firm’s position. The accounting policies above followed the Heinz’s key success factors of economies of scale, cost leadership, and low-cost distribution. As the level of disclosure continues to increase the level of transparency will also increase to provide solid information. 39 Accounting Flexibility: Firms provide financial statements so that investors can have an accurate assessment of the firm’s financial position when making investment decisions. The information provided should be dependable and consistent over time in accordance with Generally Accepted Accounting Principles (GAAP). The accounting flexibility given by GAAP allows firms to either accurately depict their current financial position or to disguise certain shortcomings. Operating & Capital Leases: Capital and operating leases are a major area where Heinz has accounting flexibility. With its operating leases, Heinz leases the right to use a particular property for operating its business. When the lease is up, Heinz then has the option to either renew the lease for an additional term or abandon the premises. “The monthly rent expenses associated with operating leases only show up on the income statement and not the balance sheet (http://pages.stern.nyu.edu).” This alludes to the fact that assets and liabilities can be understated by the company when using operating leases. This does not necessarily reflect the true financial state of the company. This is problematic because investors will be more inclined to invest if they perceive a company to be more profitable than it is in reality. “In a capital lease, the lessee assumes some of the risks of ownership and enjoys some of the benefits. In this case, the leases are listed as both an asset and liability on the balance sheet (http://pages.stern.nyu.edu).” Firms usually choose operating leases over capital leases since capital leases recognize expenses sooner. Since both lease type amounts are relatively small for Heinz, they maintain accounting flexibility when choosing which lease style to apply. Post-Retirement Benefits: Post-retirement benefits can be very large liabilities for firms. Heinz must determine the present value of future cash flows they will have to pay out to employees 40 with benefits through careful calculations based on employee base, the discount rate, expected asset returns, and future compensation rates. “The lower the discount rate, the more conservative the pension accounting; the higher the discount rate, the more aggressive (http://beginnersinvest.about.com).” Lower discount rates obviously represent higher assets for a company because expenses associated with pensions would be less. Lower discount rates will also cause higher rates of return, thus increasing the attractiveness of investment within a given company. Heinz has consistently maintained a lower discount rate than that of its competitors. This conservative style illustrates Heinz’ supreme confidence in the performance of their core portfolio of products and acquired businesses enables them to have the flexibility of lower pension discount rates. Conclusion: Accounting flexibility, as provided by GAAP, enables firms to best display their financial realities in a way they see relevant to their line of business. This power can also be used to disguise investors into thinking a firm is more valuable than it is in actuality. Heinz relays helpful insider information on its company in a way that contributes to the ability of investors to get a fair picture of its financial position. Actual Accounting Strategy: The leeway provided by GAAP will cause companies to resort to either aggressive or conservative accounting styles when making their financial statements. The style chosen depends upon whether the company wants to give a realistic or unfairly optimistic view of their current business setting. Heinz appears to have chosen a mix of conservative and aggressive accounting in formulating its financial statements. Heinz had $104.3 million worth of operating leases in fiscal 2007. While this number may seem high, it is a relatively small amount when compared with the company’s total liabilities. Treating this lease expense as an operating expense on the income statement enables Heinz to leave these leases off the balance sheet. This could 41 appear to be an aggressive accounting technique when considered on its own, but the amount is small relative to total liabilities and Heinz’s direct competitors within the industry use similar accounting methods. This bit of aggressiveness is also offset by the disclosure of these facts in the financials. Heinz has pension plans available to eligible employees. “The company sponsors pension and other retirement plans in various forms covering substantially all employees who meet eligibility requirements. Several statistical and other factors that attempt to anticipate future events are used in calculating the expense and obligations related to the plans (Heinz 2007 10K).” This is used with estimated pension withdrawal and mortality rates to estimate the company’s future benefits expenses. Heinz has used a discount rate consistently lower than its competitors, though competitor rates are essentially in the same ballpark. Heinz has kept its discount rate consistent between 5.3 and 5.9% for the last 5 fiscal years. This along with an overall lowering of industry rates when information is available can be seen in the pension discount rates chart above. “These lowering rates in the industry are viewed as a conservative accounting measure by respective firms because these lower discount rates will in effect cause pension costs to rise (http://beginnersinvest.about.com).” Quality of Disclosure: A firm’s management can make an outside analyst’s job more or less difficult when deciding to put together the financials. Managers have a certain amount of wiggle room in disclosing accounting policies. This makes management’s quality of disclosure in the financial statements an important part of the firm’s accounting policies. Qualitative Analysis of Disclosure: The quality of disclosure provided by the company should be adequate in giving a realistic view of the current business position without giving away information that could deplete a firm’s competitive advantage within its industry. The quality of the disclosed information is crucial for outside analysts to maintain their confidence in the 42 credibility of the company’s management. Misrepresented information, if discovered, can do unknown amounts of harm to the company in all undertaken future business endeavors. Heinz makes an effort to disclose and explain much of the information in its annual reports. Some things like the goodwill mentioned above, however, are not explained in a concise way that would give the average person a true understanding of Heinz’s financial reality. Post-Retirement Benefits: Heinz does a fairly good job of informing investors about the affairs of both existing and upcoming product lines and how these will directly affect the financials. Heinz proves its financial transparency by discussing at length the implications of its post retirement benefits. This is important to analysts who know that companies have a large amount of flexibility when it comes to distorting financial statements based on unsound handling of pension plan accounting. Heinz discusses the importance of setting the discount rate and summarizes the process of how post-retirement benefits are accounted for. The company also discusses the sensitivity of these assumptions and provides examples of how small changes in pension plan assumptions can greatly influence the expenses associated with the plan. This amount of disclosure is different with certain Heinz competitors who do not even disclose respective pension discount rates. Business Segment Breakdown: Heinz is also helpful in breaking down the sales of differing product sections by country. This is especially helpful to outside analysts since Heinz conducts business worldwide. The percentages on the following page represent fiscal year sales operating results for 2006 and 2007 taken from the 2007 Heinz 10K. 43 Business Segment Operating Results 2006 2007 North American Consumer Products $2.6B $2.74B U.S. Foodservice $1.6B $1.56B Europe $3.0B $3.08B Asia/Pacific $1.1B $1.20B Rest of World $330M $427.1M *Numbers from Heinz 2007 10K Quantitative Analysis of Disclosure: Quantitative analysis is used to evaluate a firm’s performance using ratios to put several different numbers into easy to understand ratios. Based on these ratios, analysts can gauge how a firm’s accounting policies are affecting their numbers and possibly misleading investors. Since managers are given flexibility with their accounting procedures, some numbers may be distorted to help further their personal goals. There are two different types of diagnostics to check for discrepancies. Analysts look at both sales manipulation and expense manipulation diagnostics. Comparing sales numbers such as net sales, inventory, and accounts receivables will show whether or not there are any uncommon increases or decreases in certain sales numbers which could overstate sales, while comparing expense diagnostics show whether managers have tried to understate expenses. Sales Manipulation Diagnostics: Since GAAP gives flexibility to managers who have incentives to try to increase profits, analysts use certain ratios to determine if there are large inconsistencies in a firms sales ratios. Analysts can look at companies based on their industry and competition to see if a firm’s performance and sales growth is questionable 44 according to their annual reports. The following sales manipulation diagnostics compare Heinz with their competitors, Campbell’s, ConAgra, and Sara Lee. Net Sales/Cash from Sales: Net Sales/Cash from Sales 1.1 1.05 Heinz Campbell's 1 ConAgra Sara Lee 0.95 0.9 2003 2004 2005 2006 2007 Year *Numbers from company’s 10Ks The ratio net sales to cash from sales are meant to show how much cash is being received from a company’s net sales. In a perfect situation, the ratio would be one, meaning that every dollar sold would be turned into cash. However, with companies being allowed a “tab,” or given sometime before they must pay the bill, the ratio can easily deviate from that perfect world situation. Since Heinz has kept this ratio consistently between .99 and 1, they have ensured that they might not lose a large portion of their sales due to companies not being able to pay them. This ratio is significant in that cash collection activity supports a firms selling activity. Since the ratio has remained somewhat constant, it can be said that Heinz has not overstated net sales based on cash from sales activity. 45 Net Sales/Net Accounts Receivable: Net Sales/Net Accounts Receivable 20 16 Heinz 12 Campbell's ConAgra 8 Sara Lee 4 0 2003 2004 2005 2006 2007 Year *Based on 10-K and Annual Reports of their respective companies The ratio net sales compared to net accounts receivable shows analysts just how much more net sales is compared to accounts receivable. For a specific company, their ratio would be hopefully at or slightly above the industry level. This would mean that their net sales would be larger compared to their accounts receivable then the rest of the industry. Heinz has the lowest net sales to net accounts receivable ratios for the industry based on these four companies. According to this ratio, Heinz has been increasing their ratio, trying to get away from accounts receivables since they can sometimes be risky. It is still troubling that they have the lowest ratio, but they seem to be gaining ground compared to the other competitors. 46 Net Sales/Inventory: Net Sales/Inventory 14 12 10 Heinz 8 Campbell's 6 ConAgra Sara Lee 4 2 0 2003 2004 2005 2006 2007 Year *Based on 10-K and Annual Reports of their respective companies The net sales to inventory ratio shows exactly how quickly inventory of a company is sold. A low ratio could indicate that the company has a higher inventory level, while a higher ratio could show a lower inventory. Inventory turnover shows how often inventory is sold off and replaced (www.investopedia.com). Since Heinz has kept a relatively consistent ratio, there is no indication that net sales are overstated based on their inventory levels. Net Sales/Unearned Revenues: No firms out of Heinz, Campbell’s, ConAgra, and Sara Lee have disclosed in their 10-K or their annual reports if they have any unearned revenues. It would be safe to assume that they do have some unearned revenues considering their large industry and the many companies they serve. However, this ratio cannot be determined without exact figures and those are not given to the analysts. 47 Net Sales/Warranty Liabilities: As with the above ratio, warranty liabilities are not disclosed for any of the competitors in this industry. Either analyst’s should assume that the companies do not provide warranties on their products since they can easily spoil, or the companies have just decided not to disclose this information. It is probably safe to say that the companies do not offer warranties for their products. The sales manipulation ratios for the above graphs are listed below for Heinz, Campbell’s, ConAgra, and Sara Lee. Conclusion: Overall, Heinz has been very forthcoming about their accounting numbers. Though they did not disclose unearned revenue or warranty liabilities neither did any of their competitors. Since their net sales compared to cash from sales, net accounts receivable, and inventory are consistent and lack any major volatility such as Sara Lee’s net sales/inventory ratio, Heinz does not manipulate their sales numbers. 48 Sales Manipulation Diagnostics 2003 2004 2005 2006 2007 Heinz Net Sales/Cash from Sales 0.99 0.99 1.00 0.99 1.00 Net Sales/Net Accounts Receivable 6.49 6.98 7.42 8.63 9.03 Net Sales/Inventory 6.56 6.59 6.45 8.05 7.51 Net Sales/Unearned Revenue n/a n/a n/a n/a n/a Net Sales/Warranty liability n/a n/a n/a n/a n/a Campbell’s Net Sales/Cash from Sales 1.00 1.01 1.00 1.00 1.01 Net Sales/Net Accounts Receivable 15.18 13.59 13.89 14.86 13.54 Net Sales/Inventory 8.84 8.52 9.39 10.09 10.15 Net Sales/Unearned Revenue n/a n/a n/a n/a n/a Net Sales/Warranty liability n/a n/a n/a n/a n/a ConAgra Net Sales/Cash from Sales 0.97 1.05 1.00 0.99 1.00 Net Sales/Net Accounts Receivable 16.55 8.38 9.03 9.75 10.00 Net Sales/Inventory 5.40 4.34 5.29 5.39 5.12 Net Sales/Unearned Revenue n/a n/a n/a n/a n/a Net Sales/Warranty liability n/a n/a n/a n/a n/a Sara Lee Net Sales/Cash from Sales 1.00 1.00 0.99 0.96 1.01 Net Sales/Net Accounts Receivable 8.35 8.60 6.77 9.42 9.39 Net Sales/Inventory 5.63 5.72 5.27 12.47 11.69 Net Sales/Unearned Revenue n/a n/a n/a n/a n/a Net Sales/Warranty liability n/a n/a n/a n/a n/a *Based on 10-K and Annual Reports of their respective companies 49 Expense Manipulation Diagnostics: Analyzing the following expense ratios over several years allows the analyst to view trends in the reporting of the firm, and identify potential accounting discrepancies in the year to year reporting. Using each firm’s own financial statements, we derived the following ratios and their respective graphs which show these reporting trends. Because these companies are within one industry, their respective graphs should follow a similar trend. Therefore, any significant volatility could signal a red flag in the firm’s reporting, especially of their expenses with respect to these specific ratios. Asset Turnover: 1.4 1.2 1 Heinz 0.8 Campbells 0.6 Sara Lee 0.4 ConAgra 0.2 0 2003 2004 2005 2006 2007 The asset turnover ratio shows the relationship between sales and assets. It is essentially a figure that reveals the sales per asset for a firm. Significant volatility in this graph, suggests inconsistencies between total sales and total assets, neither of which should sharply change in a short period of time. For instance, a sharp increase in the ratio would suggest that assets had been consistently overstated over time, and a sharp adjustment was necessary. Consistently overstating assets would also mean consistently overstated retained earnings through overstated net income. In essence, this ratio should be consistent over time, with no volatile jumps or drops. The above graph reveals that consistency is present in the industry. Heinz is especially consistent compared to its competitors, suggesting accurate reporting of their 50 income and assets over time, and indicating that no future major adjustments will be necessary, and therefore net income should remain fairly constant. Cash Flow from Operations/Operating Income: 3.5 3 2.5 Heinz 2 Campbells 1.5 Sara Lee 1 ConAgra 0.5 0 2003 2004 2005 2006 2007 This ratio shows the relationship between cash flow from operating activities and operating income. Essentially, this ratio tells how much cash is generated from one dollar of operating income. A low ratio is preferred as it suggests that more cash is generated from operating activities than from financing or investing activities, which is important as it means they are profitable in accomplishing their core business, and aren’t outweighed by their expenses. In the food industry, the ratio is fairly consistent across the board, as each of the firms have been in the business for a while, and have continuously improved their efficiency over time. This is especially true of Heinz, as it appears to be the most consistent over the last five years, suggesting that it is well practiced at managing its expenses and maintaining decent cash flow over time. 51 Cash Flow from Operations/Net Operating Assets: 0.7 0.6 0.5 Heinz 0.4 Campbells 0.3 Sara Lee 0.2 ConAgra 0.1 0 2003 2004 2005 2006 2007 This ratio reveals the relationship between the cash generated by operating activities and the net operating assets, which consist primarily of the firm’s plants, property, and equipment, or fixed assets. Typically, the higher the ratio, the greater the cash flow produced by these fixed assets. A low ratio might suggest that the firm is not capitalizing all of its fixed assets and expensing them instead, typically through an operating lease. The graph represents a fairly volatile industry with respect to this ratio, suggesting that some of the firms are not consistent in the way they capitalize fixed assets. Heinz, however, is consistent over time, and does not use any major operating leases, suggesting accurate reporting of its fixed assets and, therefore, expenses. 52 Total Accruals/Change in Sales: 10 8 6 4 Heinz 2 Campbells 0 Sara Lee -2 2003 2004 2005 2006 2007 ConAgra -4 -6 -8 This ratio shows the relationship between the total accruals and the change in sales from the previous year. Total accruals are the net income of the firm less the cash flow from operations, and consist of liabilities and non-cash assets, like goodwill, future tax liability and future interest expense. This ratio is essentially a measure of how much of your increase in sales will be needed to cover future expenses. The industry appears to be fairly volatile, suggesting that accruals for several of the firms in the industry are not consistent over time. This is a red flag for these firms, suggesting that much of their future sales will have to be spent on expenses they are accruing at the present, which is not a good practice. Heinz, however, is consistent, yet again, which is a good sign that they are controlling their expected future expenses, and most their sales will not already be spent for them. This means that Heinz will be able to allocate the revenue generated from their sales to increase efficiency, rather than to pay off accrued debt occurred in the past. 53 Pension Expense/Selling, General, and Administrative Expenses: 0.4 0.35 0.3 Heinz 0.25 Campbells 0.2 Sara Lee 0.15 ConAgra 0.1 0.05 0 2003 2004 2005 2006 2007 This ratio shows the relationship between the amounts spent on pension with respect to the administrative expenses. It is essentially a measure of the percentage of their total selling, general, and administrative expenses that is pension expense. Obviously a lower ratio would suggest lower spending on pensions, or employees who no longer work for the company, which is preferable. The food industry, being both old and large, has considerable pension expenses. The graph indicates, however, that the amount being spent on pensions is fairly low with respect to the total administrative costs. This means that future earnings for the firms will not be weighed down by high pension expenses. Heinz has decreased over time, signaling that less income is being spent on pensions, opening it up for investment in efficiency. Conclusion: In the industry as a whole, there are several discrepancies in the ratios that deserve attention and concern. However, Heinz demonstrated consistency in each of the ratios and graphs, which can be relieving for an analyst. Though there may be some minor discrepancies in their accounting and reporting, there is nothing that generates an immediate red flag, suggesting inaccurate reporting of expenses or net income. With the ratios and their respective graphs as guides, Heinz appears to use generally fair and honest reporting standards, and does not generate much concern. 54 Certainly, some skepticism should be exercised, but Heinz’s consistency throughout the past five years indicates to us that their numbers are not lying. The following table shows the amounts for the ratios used in the above graphs for each firm. 55 Expense Manipulation Diagnostics Heinz 2003 2004 2005 2006 2007 Asset Turnover 0.89 0.85 0.84 0.89 0.90 CFFO/OI 0.77 0.91 0.86 0.97 0.73 CFFO/NOA 0.46 0.61 0.54 0.57 0.53 Total Accruals/Change in sales -0.55 -2.51 -0.82 1.60 -0.77 Pension Expense/SG&A 0.13 0.12 0.04 0.04 0.02 Campbell’s Asset Turnover 1.08 1.07 1.04 0.95 1.22 CFFO/OI 0.72 0.61 0.81 0.97 0.49 CFFO/NOA 0.47 0.39 0.50 0.63 0.33 Total Accruals/Change in sales -0.51 -0.23 7.65 -1.69 0.34 Pension Expense/SG&A 0.02 0.03 0.03 0.03 0.02 Sara Lee Asset Turnover 0.64 0.75 0.78 0.78 1.01 CFFO/OI 2.31 1.95 1.43 3.00 0.88 CFFO/NOA 0.55 0.61 0.43 0.25 0.09 Total Accruals/Change in sales -1.31 -0.70 -6.92 -6.23 0.01 Pension Expense/SG&A 0.03 0.05 0.05 0.05 0.04 ConAgra Asset Turnover 1.10 0.99 0.89 0.96 1.02 CFFO/OI 0.45 0.42 1.00 1.20 0.77 CFFO/NOA 0.25 0.20 0.39 0.47 0.41 Total Accruals/Change in sales -0.02 -0.09 -0.97 -5.44 -0.33 Pension Expense/SG&A 0.31 0.32 0.36 0.36 0.28 *Based on 10-K and Annual Reports of their respective companies 56 Potential Red Flags: When firms create their financial statements, mistakes or purposeful errors can be made. This is the job of the analyst to find and correct these “errors.” They look at all the numbers in the statements, especially the previous data stated above. This gives in depth insight into the company and can also help to see how well the company is doing. Analysts should also look for numbers that do not make since or unexplainable. This is a very good indicator, or flag, that the numbers need to be corrected. When examining Heinz, we have looked at six years of moving data of 10-Ks to understand and compute possible errors that might be in the financial statements. Heinz has shown a conservative and aggressive mix in accounting policies. They comply with all of GAAP. The only issue that we found on the six years of financial statements is the inconsistency of numbers between each year’s statements. After discovering these errors, the first thing that we looked at was the financial notes to see if there was an explanation to this inconsistency. In our understanding, this could happen for several reasons. The first could be that the company changed their numbers from previous years to better project actuality in those years or if the company changed the type of accounting style of preparation of the statements. This is the less likely of the two due to rules from GAAP, which would force them to state the change in accounting methods, which indeed they did not. Leaving the conclusion that Heinz changed some of the numbers from previous statements because of adjustments. On the following page is an example from Heinz 10-K in 2007. 57 H. J. Heinz Company and Subsidiaries Consolidated Statements of Income Fiscal Year Ended May 2, 2007 May 3, 2006 April 27, 2005 (52 Weeks) (53 Weeks) (52 Weeks) (In thousands, except per share amounts) Sales $ 9,001,63 $ 8,643,43 $ 8,103,45 Cost of products sold 5,608,73 5,550,36 5,069,92 Gross profit 3,392,90 3,093,07 3,033,53 Selling, general and administrative expenses 1,946,18 1,979,46 1,752,05 Operating income 1,446,71 1,113,61 1,281,47 Interest income 41,869 33,190 26,939 Interest expense 333,270 316,296 232,088 Asset impairment charges for cost and equity investments — 110,994 73,842 Other expense, net 30,915 26,051 14,966 Income from continuing operations before 1,124,39 income taxes 9 693,461 987,515 Provision for income taxes 332,797 250,700 299,511 Income from continuing operations 791,602 442,761 688,004 (Loss)/income from discontinued operations, net of tax (5,856) 202,842 64,695 Net income $ 785,746 $ 645,603 $ 752,699 On the next page is the 10-K from 2005. Consider the numbers that are highlighted, related to the 10-K above, and notice that they are not the same. 58 H. J. HEINZ COMPANY AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Fiscal Year Ended -------------------------------------------- April 27, 2005 April 28, 2004 April 30, 2003 (52 Weeks) (52 Weeks) (52 Weeks) -------------- -------------- -------------- (In thousands, except per share amounts) Sales............................................ $8,912,297 $8,414,538 $8,236,836 Cost of products sold............................ 5,705,926 5,326,281 5,304,362 ---------- ---------- ---------- Gross profit..................................... 3,206,371 3,088,257 2,932,474 Selling, general and administrative expenses..... 1,851,529 1,709,000 1,758,658 ---------- ---------- ---------- Operating income................................. 1,354,842 1,379,257 1,173,816 Interest income.................................. 27,776 23,312 31,083 Interest expense................................. 232,431 211,826 223,532 Asset impairment charges for cost and equity investments..................................... 73,842 -- -- Other expense, net............................... 17,731 22,192 112,636 ---------- ---------- ---------- Income from continuing operations before income taxes and cumulative effect of change in accounting principle............................ 1,058,614 1,168,551 868,731 Provision for income taxes....................... 322,792 389,618 313,372 ---------- ---------- ---------- Income from continuing operations before cumulative effect of change in accounting principle........ 735,822 778,933 555,359 Income from discontinued operations, net of tax... 16,877 25,340 88,738 ---------- ---------- ---------- Income before cumulative effect of change in accounting principle............................ 752,699 804,273 644,097 Cumulative effect of change in accounting principle...................................... -- -- (77,812) ---------- ---------- ---------- Net income....................................... $ 752,699 $ 804,273 $ 566,285 After our considerations, Heinz 10-K from 2007 states that “The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.” By making these estimates, they find out at a later date that those estimates were wrong, they go back through the numbers and correct the previous year’s statements. This is why there was a difference in numbers for the year 2005 above. This shows that Heinz obeys and complies with all of SEC and GAAP rules. 59 Undo Accounting Distortions: If we were to find any mistakes in Heinz’s financial statements, here is where we would correct them. It would be impossible to correct all of the mistakes even with all the provided information by the firm. Analysts would focus on corrections that would have a major impact on the company and the understandings of investors. If the effect is minimal in terms of overall or long term picture, analysts would not mind the correction. Since Heinz has not shown any misstated material, we are unable to correct or “undo” any of the financial statements. Heinz’s financial statements have proven to be clear and transparent of it disclosures. This is represented mainly by the notes given about any numbers or change in numbers. The only thing Heinz would have to adjust for is goodwill because it is a distortion to total assets. Goodwill is the excess purchase price of another business over its true market value. This is an intangible asset that Heinz reassesses the value of annually. The company should amortize goodwill over five years. This allows for the assets to decrease creating lower liabilities. Goodwill for Heinz amounts to $2.8 billion out of the company’s total assets of $10 billion. This means that roughly 28% of the company’s assets are merely intangible assets. This is a high number that definitely distorts the true financial standpoint of Heinz. Heinz has also proven to be a moderately conservative and aggressive on their accounting policies, showing where they lead to lower reported earnings and sometimes to higher reported earnings. 60 Financial Analysis, Financial Forecasts, and Cost of Capital Estimation Financial Analysis: Evaluating a company’s financial statements is a critical step in valuing a firm, and has been made possible through ratio analysis. Ratio analysis allows for a complete view of the profitability of a firm while comparing it to the competitors in their industry. This analysis is a way to compare of all the financial statements of a company including their balance sheets, income statements, and statement of cash flows. Liquidity Ratios, Profitability Ratios, and Capital Structure Ratios are the three classifications of ratios that determine the overall value of the company. These ratios can be used to forecast a company’s future performance based on their own historical performance and that of their competitors. This portion of the report will show how Heinz performs relative to the competition. Liquidity Analysis: Liquidity ratios are a class of financial metrics that are used to determine a company's ability to pay off its short-terms debts obligations (www.answers.com). The credit risk of a company is often determined by the liquidity ratios associated with the company. Higher liquidity ratios are preferred because it shows the lender or investors that the company has the means to pay off their short-term debt if necessary. The liquidity ratios most commonly used include the following: current ratio, quick ratio, inventory turnover, receivables turnover, and working capital turnover. The inventory, receivables, and working capital turnover ratios also show how fast capital gets into the company and how fast it goes out. 61 Current Ratio: This ratio shows the difference between a company’s current assets (cash, cash equivalents, short-term investments, receivables, and inventory, and their current liabilities (short-term payables and debt)). A ratio of 1:1 would mean that for every $1 of current assets the company had $1 of current liabilities. This would mean that the company would be able to pay off all of their current liabilities immediately if that ever became necessary. In order for companies to make their current ratios better they would need to increase their current assets or decrease current liabilities. A higher ratio is wanted by companies because it shows that they are a more liquid company which is attractive to investors. Banks usually look for a 2:1 ratio just for this reason. The lenders are making sure that the company will have the loan covered by assets or capital. Heinz had a ratio that was strong in 2003, but has decreased through the years as it approached 2007 closing the gap between themselves and Sara Lee. They ended up a little about .6, which still is fairly high compared to its competitors and the industry. Campbells has the lowest ratio of around .3. Overall, the companies in this industry are all relatively close and can most likely pay off their debt. The choice of 62 more debt to finance the current debt might be a decision, or sell off assets. Heinz continues to stay in close proximity of their competitors and in line with the industry. Quick Asset Ratio: The quick ratio, also known as the acid-test, relates the current assets (cash, cash equivalents, short-term investments, and receivables) to the current liabilities. Inventory is not included in this calculation because it is hard to easily convert to cash. This ratio is usually more conservative than the current ratio, and shows the true shape of the firm if they needed to pay off short-term liabilities within fairly quickly terms. Heinz has been increasing their quick ratio over the years which will make it more difficult to pay off short-term debt if they needed to. This declining number of the competitors in the industry may be alarming to potential investors, but Heinz is within proximity of their competitors and could easily raise this number by increasing quick assets. This is a common problem among the processed foods industry due to the fact that they have large inventories. 63 Receivables Turnover: The receivables turnover ratio is the net sales divided by the accounts receivables at a specific year. This ratio tends to be higher if a company efficiently collects their accounts receivables, or collects most of their sales on a cash basis. The receivables turnover ratio assesses how proficiently the assets are being used by the company. A higher ratio means that the company is not collecting their accounts receivables in a timely manner. This would not be ideal, because the longer a company does not collect receivables, the higher the risk of uncollectable leading to lower end profits. A lower ratio would tell investors that the company is effectively collecting from their customers and closing receivable accounts. Heinz historically has an accounts receivables turnover ratio average of 7.8. This number has steadily increased over the five year period. This shows that Heinz has been collecting their receivables faster than previous years. This is very beneficial to Heinz because it could appeal to potential investors or potential stock holders. 64 Days Sales Outstanding: Days sales outstanding is a means of measuring how long it takes for a company to collect the money for the credit they extended. This ratio is the number of days in a year (365) over the receivables turnover from above. This ratio is also used in calculating the cash-to-cash cycle for the company. The typical range for days outstanding is 30 days to 90 days. Historically, the processed foods industry is much lower because of their large inventories and the quick turnover rate. These companies need to keep the shelves stocked in their retailer which requires a faster turn-around rate in all areas. Historically, Heinz has had a day’s outstanding ratio higher than that of their competitors. This could be higher due to numerous reasons; one being that Heinz is a bigger company than their competitors and will most likely have a higher accounts receivable number. Another reason could be that Heinz is a multi-national company and has a larger scale of operations than its competitors. But Heinz has started to decrease back down to the industry average which is better for Heinz. This normal return shows that Heinz can put the revenue back into the production merry-go- round. 65 Inventory Turnover: Inventory turnover is the difference between companies’ cost of goods sold and their inventory. This ratio measures how often a company sells and produces its inventory during a year. A high inventory turnover ratio means that the products are being sold quickly. A company wants a higher number for inventory turnover because this means that the products are selling and being replaced faster. The average for Heinz over the past five years has been 4.52:1. This number means that the company replaces its inventory about 4 ½ times per year. If Heinz wanted to be more productive they could find ways to increase this number which would make them more competitive. Selling products at a faster rate would increase this number, and make Heinz comparable to Sara Lee and Campbells. Conagra is the only company that is consistently lower than the other companies in the industry. Overall, Heinz is keeping up with the industry average but could increase their turnover to help lower costs and increase profits. 66 Days Supply of Inventory: The days supply of inventory ratio is calculated by taking 365 days in a year and dividing it by the previously mentioned inventory turnover ratio. A smaller ratio is sought after because this means that the inventory is not sitting in a warehouse or store a long time before it is sold. The standard ratio for this industry is between 90 and 120 days. Heinz has a days supply of inventory average of 81.52 days for the past five years. Heinz is consistently in the middle of the ratios of their competitors, but has been decreasing slightly in recent years. As seen in the graph this ratio for the food processing industry is very volatile. This ratio is also used to calculate the cash-to-cash cycle mentioned earlier. Taking the days supply of inventory ratio and adding it to the days sales outstanding yields this cycle. The cash-to-cash cycle is a metric that expresses the length of time, in days, a company takes in order to convert resource inputs into actual cash flows (investopedia.com). This number signifies how quickly a company can convert its inventory into cash through sales. 67 Working Capital Turnover: Working capital turnover is measured by taking the net sales divided by working capital. A company’s working capital is the current assets minus the current liabilities. Companies want a higher working capital turnover because it shows that the company has larger revenues than the money being used to create the sales. Heinz has been increasing their working capital turnover meaning that they are making more money through sales than they are spending on the products sold. The industry average for the past five years is 10.80. Although Heinz has not always had the highest working capital turnover, they have recently started increasing their turnover, making them the stable against their competitors. Currently, in 2007, Heinz is tied with Campbells for leading the food industry in the working capital turnover. 68 Cash-to-Cash Cycle: The cash-to-cash cycle measures how many days it takes for a company to convert their products into a cash flow. Investopedia.com says “that this cycle attempts to measure the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sale to customers.” This cycle is calculated by adding the account receivables turnover in days and the inventory turnover in days. A shorter cycle shows that the company can turn over products faster and get cash to reinvest in more products quicker. Heinz is around the industry average for number of days in the cash conversion cycle. If Heinz wants to have more money to put back into new products they will need to decrease their cash cycle. Conclusion: Overall, the liquidity ratios of Heinz show that they are a liquid firm. They have the highest current ratio amongst their competitors and a quick asset ratio comparable with their competitors. Heinz continues to remain in step with their competitors in the other ratios including inventory turnover, receivables turnover, working capital turnover, and the cash-to-cash cycle. 69 Profitability Analysis: Profitability analysis uses gross profit margin, operating expense ratio, net profit margin, return on assets, return on equity, and asset turnover to evaluate a firm’s efficiency in generating profits. These measure the firm’s operating efficiency and productivity of the firm. Gross profit margin: “A financial metric used to assess a firm's financial health by revealing the proportion of money left over from revenues after accounting for the cost of goods sold. Gross profit margin serves as the source for paying additional expenses and future saving (www.investopedia.com).” Gross profit margin is computed by taking the company’s gross profit (sales- COGS) and dividing it by sales. Companies prefer a higher gross profit margin, because it means that the company will have more money left in retained earnings. Over the past five years Heinz has averaged a gross profit margin of 36.89%. This number appears to be consistent with the industry average over the same time period. The one exception to this is Conagra, which has an unusually low ratio. 70 Operating profit margin: Operating profit margin is the ratio between operating income and net sales. Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales (www.investopedia.com). This relationship is important because it allows investors to see if expenses are decreasing and net sales are increasing. Ideally, firms would prefer to have a higher operating margin. Heinz’s profit margin has been around 15.04% along with Campbells. The other extreme is Sara Lee and Conagra’s low margin. This splits the industry in two. And Sara Lee’s lower than normal average due to a negative operating income in 2007 gives a possible future hazard. Heinz has remained at the upper end of the industry average in recent years but could improve their operating profit margin ratio to be more competitively aligned. 71 Net profit margin: Net profit margin is derived by placing net income over sales. This assesses the amount of each dollar of sales preserved in earnings. When this number is compared with the industry average, it can give an analyst keen insight into the profitability of the firm. Heinz’s profit margin of 8.58 has been relatively high compared to industry standards. But again we see an industry split occurring between Heinz and Campbells and Sara Lee and Conagra. Asset turnover ratio: 72 The asset turnover ratio shows the relationship between assets and revenue. It is the ratio of revenue to total assets. As evidenced by the graph above, Heinz’s five year asset turnover ratio of .84 is clearly lower than the industry average, but has increased in the last three years. “Companies with high profit margins usually have low asset turnover thus indicating pricing strategy (www.investopedia.com).” This is consistent when Heinz’s cost competitive strategy is taken into account. ROA: Return on assets is the ratio of net income to total assets of the previous year. This percentage ratio gives an idea of how profitable a company is in comparison to its’ assets. Heinz’s five year average ROA is 7.17%. It is at the upper end of the industry along with Campbells. This shows that Heinz management has done a fair job of utilizing its assets to generate earnings. 73 ROE: Return on equity is the ratio of net income to shareholder equity. This ratio shows the firm’s profitability attained with the money invested by shareholders. Most of the companies in the industry have had a sharp decline in ROE over the last five years. These changes are connected with interest rates. The one exception is Conagra, who has actually had a rise in ROE. Over the past fiscal year, ROE did climb back substantially higher for Heinz to about 40%. The high industry ROE levels from five years ago would be difficult to sustain for long periods. The recent levels of ROE have been more realistic for sustainability by companies in the food products industry. Conclusion: When comparing all the Heinz profitability ratios with others in the industry, it’s clear that Heinz is at or near the top next to Campbell. All measures have maintained relative stability except of course for ROE as stated above. Heinz’s superior performance in profitability analysis demonstrates that company management has implemented successful business strategies over the past five years. 74 Capital Structure Analysis: Capital structure analysis focuses on a company’s ability to cover debt with shareholder’s equity. Debt to equity, times interest earned, and debt service margin all provide insight into how well a company is accomplishing this task. Heinz is compared to its industry competitors below. Debt to Equity: The debt to equity ratio is total liabilities to shareholder equity. “This ratio indicates what proportion of equity and debt the company is using to finance its assets. A high ratio means that a company has been aggressive in financing its growth with debt (www.investopedia.com).” Heinz is near the top of the industry average in this respect, especially in 2007 when they had the highest ratio for the industry. The chart indicates Heinz has had a high debt to equity ratio over the past 5 years when compared to the industry average. 75 Times Interest Earned: Times interest earned is used to measure a firm’s ability to meet its debt obligations. “It’s calculated by taking earnings before interest and taxes and dividing it by the total interest payable on bonds and other contractual debt (www.investopedia.com).” This shows how many times a company can cover its interest charges before taxes. Heinz’s average of 4.93 over the past five years is around the middle of the pack for its industry. This number has been down from around 6 over the past couple of years. A low number would indicate the company may be at risk of bankruptcy because they may not be able to cover their interest charges to debtors. On the flip side, too high of a ratio would indicate a lack of debt. “The rationale is the company would yield greater returns by investing earnings into other projects and borrowing at a lower cost of capital than what it is currently paying for its debt to meet debt obligations (www.investopedia.com)” This ratio indicates that Heinz has plenty of earnings to support its interest payments to debt holders. At the same time the number is not at a level that would indicate an unwanted lack of debt. 76 Debt Service Margin: Debt service margin shows how well a firm pays debt service with cash flows from operations. The higher the margin, the better it is for the company. Heinz has a debt service margin a bit above the industry average of about 1. Heinz is much lower than Conagra and only marginally greater than Sara Lee in this respect. This says that Heinz can cover its current notes payable and have cash left over at year’s end. But they can always increase to be the leader of the industry. Conclusion: After taking into consideration Heinz capital structure ratios with the averages of the industry, it’s clear that Heinz is better than average in most cases. This indicates Heinz’s favorable ability to pay debt to its creditors and would not raise any red flags in analysis. In any case, Heinz can always improve. 77 IGR/SGR Analysis: Growth rate analysis is valuable to a company by showing the amount of profits they can expect in the future if continued at current rates. Obtaining these rates give an idea of the possible profits and financial influence the firm has. Using the previously stated return on assets, the debt-to-equity ratio, and the dividend payout ratios this analysis can be computed. Internal Growth Rate: “Internal Growth Rate (IGR) is the highest level of growth achievable for a business without obtaining outside financing (www.investopedia.com).” This involves finding ways to increase the total assets without having to use external financing. Being able to finance future projects without having debt in the capital structure is valuable for any company. The internal growth rate is found by multiplying the return on assets by one minus the dividend payment. A higher IGR is wanted by companies and also shows that they are able to grow the company while maintaining low debt levels. Year 2003 2004 2005 2006 2007 Heinz IGR 1.425% 1.673% 1.581% 1.288% 1.552% 78 Heinz has an IGR much lower than the average of the competitors of their industry. This number shows that Heinz finances mostly through external financing and not their own assets. Averages of the competitors could also be higher than Heinz because both Sara Lee and Conagra have not paid dividends within the past five years. This number could also be lower because our net income forecasting is too progressive compared to our dividend growth rate. This would cause a smaller ROA and therefore a smaller IGR. Overall, Heinz would need to increase their IGR by using more internal financing to keep in line with their competitors. Sustainable Growth Rate: Sustainable Growth Rate (SGR) allows the company to evaluate the maximum growth rate possible without adding debt to their existing capital structure. SGR is determined by using the IGR and adding the debt-to equity ratio to it. This rate should remain at the same growth rate as the IGR since it is used in the calculation. “The SGR is a measure of how much a firm can grow without borrowing more money. After the firm has passed this rate, it must borrow funds from another source to facilitate growth (www.investopedia.com).” If the maximum SGR is surpassed then the company will 79 have to use leverage to keep their current growth level. Therefore, the higher the IGR is the higher the SGR will be. Year 2003 2004 2005 2006 2007 Heinz SGR 6.697% 4.257% 3.098% 3.777% 4.481% Heinz has a SGR that is competitive with the industry, and in recent years Heinz has increased their growth rate to above the average. Although the SGR has been decreasing, this is not a big concern for the company because of the mergers and buyouts that they often have. Heinz is constantly growing their company and this would cause for a lower SGR. Conclusion: Heinz has an IGR below the industry average but an SGR that is better than average. These rates determine the amount of debt a company will need to finance future projects. External financing could affect the level of profitability the firm is able to make. If a firm has to increase their debt it will ultimately decrease the profits due to the increase in liabilities. Heinz has a low IGR which means that projects are financed more through external sources versus internal sources. To help increase future profits the IGR needs to increase by reducing the financing through debt. The 80 SGR rate is in-line with the industry and Heinz needs to keep up the ratio growing. An increasing SGR would relay to investors that Heinz is a forward looking company and wants to improve the numbers now for the future. Also, the sales growth average we used to forecast the growth was based off of the SGR because it has been increasing in the last few years and is sustainable over time. Financial Statement Forecasting: When analyzing a firm, it helps to get a general idea of where that firm may be going in the future. Using historical information as starting point, one can predict a company’s future performance. We assumed a general stability in performance for Heinz, as demand for its products is relatively stable, and it is practiced in its operations due to its age. Under this assumption, and using its historical performance derived from its previous five years of financial statements, we were able to come up with forecasts for Heinz’s income statement, balance sheet, and statement of cash flows for the next ten years. Income Statement Analysis: Our income statement forecasting method consisted of analyzing the historical average growth rates for Heinz, and comparing those numbers to the averages for the food industry. First, we derived the common size income statement by setting all of the numbers as a percent of net sales. This revealed some noticeable trends in Heinz’s numbers. We then set about finding the averages for all of the percentages over the past five years, and calculating the growth rate between each year. We determined that the growth rate for net sales for Heinz will be approximately 5.4% per year for the next 10 years. Since this average growth rate is just above the SGR and well below the IGR, we felt that this average would be fairly accurate, especially since the SGR has steadily increased over the past 3 years. We excluded some of the percentages from our forecasts, as they appeared to be one or two time occurrences, or they showed no trend. We compared the averages 81 we found for Heinz to the averages of the industry, and assumed a value between the two, but closer to the Heinz value. We did this for two reasons: first, because the values were so close together, and second, since over time we assume they will head towards the industry average. For example, we assumed that the net income for each of the forecasted years was about 8% of the net sales that we forecasted out based on the 5.4% sales growth rate per year for the next 10 years. 82 Ind. 2003 2004 2005 2006 2007 Avg. Avg Assume 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Net Sales $8,236,836 $7,625,831 $8,103,456 $8,643,438 $9,001,630 $9,488,064 $10,000,785 $10,541,212 $11,110,843 $11,711,256 $12,344,114 $13,011,171 $13,714,274 $14,455,373 $15,236,519 Cost of Goods Sold $5,304,362 $4,733,314 $5,069,926 $5,550,364 $5,608,730 65.5% 63.11% 64.00% $6,072,361 $6,400,502 $6,746,376 $7,110,939 $7,495,204 $7,900,233 $8,327,149 $8,777,136 $9,251,439 $9,751,372 Gross Profit $2,932,474 $2,892,517 $3,033,530 $3,093,074 $3,392,900 34.16% 36.89% 36.00% $3,415,703 $3,600,282 $3,794,836 $3,999,903 $4,216,052 $4,443,881 $4,684,021 $4,937,139 $5,203,934 $5,485,147 Selling, Administrative and General Expense $1,758,658 $1,616,428 $1,752,058 $1,979,462 $1,946,185 23.5% 21.74% 22.00% $2,087,374 $2,200,173 $2,319,067 $2,444,385 $2,576,476 $2,715,705 $2,862,458 $3,017,140 $3,180,182 $3,352,034 Operating Income $1,173,816 $1,276,089 $1,281,472 $1,113,612 $1,446,715 10.2% 15.15% 13.00% $1,233,448 $1,300,102 $1,370,358 $1,444,410 $1,522,463 $1,604,735 $1,691,452 $1,782,856 $1,879,198 $1,980,747 Interest income $31,083 $24,547 $26,939 $33,190 $41,869 -0.3% 0.38% 0.00% Interest Expense (Note 14) $223,532 $211,382 $232,088 $316,296 $333,270 2.2% 3.14% 3.00% $284,642 $300,024 $316,236 $333,325 $351,338 $370,323 $390,335 $411,428 $433,661 $457,096 Asset Impairment Charges for Cost & Equity Investments $0 $0 $73,842 $110,994 $0 0.44% 0.00% Other Expense, net $112,636 $21,686 $30,915 $26,051 $14,966 0.50% 0.00% Income from Continuing Operations before Taxes $868,731 $1,067,568 $987,515 $693,461 $1,124,399 9.0% 11.45% 10.00% Provision for Income Taxes $313,372 $352,117 $299,511 $250,700 $332,797 2.7% 3.74% 3.25% Income from Continuing Operations $555,359 $715,451 $688,004 $442,761 $791,602 6.3% 7.71% 6.75% (Loss)/Income from Discontinued Operations $88,738 $88,822 $64,695 $202,842 ($5,856) 0.4% 1.06% 1.00% Income before Change in Accounting Principles $644,097 $804,273 $752,699 $645,603 $785,746 8.77% 8.00% Cumulative Effect of Change in Accounting Principle ($77,812) $0 $0 $0 $0 0.00% 0.00% Net Income (Loss) $566,285 $804,273 $752,699 $645,603 $785,746 7.0% 8.77% 8.00% $759,045 $800,063 $843,297 $888,867 $936,900 $987,529 $1,040,894 $1,097,142 $1,156,430 $1,218,922 Ind. Common Size Income Statement 2003 2004 2005 2006 2007 Avg. Avg Assume 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Sales Growth Percent -7.42% 6.26% 6.66% 4.14% 5.40% 5.40% 5.40% 5.40% 5.40% 5.40% 5.40% 5.40% 5.40% 5.40% 5.40% 5.40% Net Sales 100.00% 100.00% 100.00% 100.00% 100.00% Cost of Goods Sold 64.40% 62.07% 62.56% 64.21% 62.31% 65.5% 63.11% 64.00% 64.00% 64.00% 64.00% 64.00% 64.00% 64.00% 64.00% 64.00% 64.00% 64.00% Gross Profit 35.60% 37.93% 37.44% 35.79% 37.69% 34.16% 36.89% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% 36.00% Selling, Administrative and General Expense 21.35% 21.20% 21.62% 22.90% 21.62% 23.5% 21.74% 22.00% 22.00% 22.00% 22.00% 22.00% 22.00% 22.00% 22.00% 22.00% 22.00% 22.00% Operating Income 14.25% 16.73% 15.81% 12.88% 16.07% 10.2% 15.15% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00% Interest Income 0.38% 0.32% 0.33% 0.38% 0.47% -0.3% 0.38% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Interest Expense 2.71% 2.77% 2.86% 3.66% 3.70% 2.2% 3.14% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% 3.00% Asset Impairment Charges for Cost & Equity Investments 0.00% 0.00% 0.91% 1.28% 0.00% 0.44% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Other Expense, net 1.37% 0.28% 0.38% 0.30% 0.17% 0.50% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Income from Continuing Operations before Taxes 10.55% 14.00% 12.19% 8.02% 12.49% 9.0% 11.45% Provision for Income Taxes 3.80% 4.62% 3.70% 2.90% 3.70% 2.7% 3.74% Income from Continuing Operations 6.74% 9.38% 8.49% 5.12% 8.79% 6.3% 7.71% (Loss)/Income from Discontinued Operations 1.08% 1.16% 0.80% 2.35% -0.07% 0.4% 1.06% Income before Change in Accounting Principles 7.82% 10.55% 9.29% 7.47% 8.73% 8.77% Cumulative Effect of Change in Accounting Principle -0.94% 0.00% 0.00% 0.00% 0.00% -0.19% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Net Income (Loss) 6.88% 10.55% 9.29% 7.47% 8.73% 7.0% 8.58% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 81 Balance sheet analysis: We analyzed the balance sheet in much the same way as the income statement. We derived a common size balance sheet for Heinz, calculated averages for the last five years, and compared the numbers to those of the food industry. We then assumed a value between the two, but closer to Heinz. Again, this was because the two numbers were so similar and because we wanted to adjust for Heinz eventually meeting the industry average. To forecast our total assets out 10 years, we divided the net sales we found from the income statement forecasts by our average asset turnover of 0.84, since the asset turnover was very consistent for Heinz. Once we had calculated total assets, we were able to compute current and non-current total assets by multiplying the total assets we found by the averages we computed in our initial analysis, as we found about 33% of assets were current and 67% were noncurrent. We also forecasted our receivables, cash and cash equivalents, total inventories, and net property, plant and equipment based on their percentages of total assets, as these values appeared to be the most consistent over the previous five years. Once we had found the total assets, we set our total liabilities and stockholder’s equity equal to the total assets. Since Heinz appears to be consistent over time with its dividend payout and growth, we forecasted dividends by steadily increasing the dividends, and multiplying the DPS by the shares outstanding currently. With the dividends forecasted out, in order to find retained earnings we added last year’s retained earnings, subtracted the dividends from the current year, and added the current year’s net income in order to get the current year’s retained earnings. Then, for total stockholder’s equity, we took the retained earnings we just forecasted, subtracted the last year’s retained earnings and added that to the total equity of last year and that gave us the total equity for the current year. After stockholders equity was found, we subtracted the total equity from the total liabilities and equity, which gave us the total liabilities. Then we assumed that 35% of total liabilities were current and 65% were noncurrent. Then we forecasted out accounts payable as well as long term debt by approximately how much the averages 82 of the last 5 years on the common sized balance sheet were compared to total liabilities. 83 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2001/12/31 2002/12/31 2003/12/31 2004/12/31 2005/12/31 Assets Current Assets: Cash and cash equivalents $801,732 $1,140,039 $1,083,749 $445,427 $652,896 $960,102 $1,011,984 $1,066,670 $1,124,311 $1,185,068 $1,249,107 $1,316,607 $1,387,754 $1,462,746 $1,541,791 Short-term investments $0 $40,000 $0 $0 $0 Receivables $1,165,460 $1,093,155 $1,092,394 $1,002,125 $996,852 $1,186,008 $1,250,098 $1,317,651 $1,388,855 $1,463,907 $1,543,014 $1,626,396 $1,714,284 $1,806,922 $1,904,565 Inventories: Finished goods and WIP $902,186 $897,778 $974,974 $817,037 $943,449 Packing material and ingredients $250,767 $259,154 $281,802 $256,645 $254,508 Total Inventories $1,152,953 $1,156,932 $1,256,776 $1,073,682 $1,197,957 $1,581,344 $1,666,797 $1,756,869 $1,851,807 $1,951,876 $2,057,352 $2,168,528 $2,285,712 $2,409,229 $2,539,420 Prepaid expenses $147,656 $165,177 $174,818 $139,714 $132,561 Other current assets $16,519 $15,493 $37,839 $42,987 $38,736 Total Current Assets $3,284,320 $3,610,796 $3,645,576 $2,703,935 $3,019,002 $3,727,454 $3,928,880 $4,141,190 $4,364,974 $4,600,850 $4,849,473 $5,111,531 $5,387,751 $5,678,896 $5,985,775 Property, plant and equipment: Land $61,870 $65,836 $67,000 $55,167 $51,950 Buildings and leasehold improvements $752,799 $796,966 $844,056 $762,735 $788,053 Equipment, furniture and other $2,598,184 $2,864,422 $3,111,663 $2,946,574 $3,214,860 Less accumulated depreciation $1,454,987 $1,669,938 $1,858,781 $1,863,919 $2,056,710 Total property, plant and equipment, net $1,957,866 $2,057,286 $2,163,938 $1,900,557 $1,998,153 $2,372,016 $2,500,196 $2,635,303 $2,777,711 $2,927,814 $3,086,028 $3,252,793 $3,428,569 $3,613,843 $3,809,130 Other non-current assets: Goodwill $1,849,389 $1,959,914 $2,138,499 $2,822,567 $2,834,639 Trademarks, net $610,063 $643,901 $651,552 $776,857 $892,749 Other intangibles, net $134,897 $149,920 $171,675 $269,564 $412,484 Other non-current assets $1,388,216 $1,455,372 $1,806,478 $1,264,287 $875,999 Total Non-Current Assets $5,940,431 $6,266,393 $6,932,142 $7,033,832 $7,014,024 $7,567,861 $7,976,816 $8,407,871 $8,862,220 $9,341,120 $9,845,900 $10,377,958 $10,938,767 $11,529,881 $12,152,938 Total Assets $9,224,751 $9,877,189 $10,577,718 $9,737,767 $10,033,026 $11,295,315 $11,905,696 $12,549,062 $13,227,194 $13,941,971 $14,695,374 $15,489,489 $16,326,517 $17,208,777 $18,138,713 Liabilities Current Liabilities: Short-term debt $146,838 $11,434 $28,471 $54,052 $165,054 Portion of long-term debt due w/in one year $7,948 $425,016 $544,798 $917 $303,189 Accounts Payable $938,168 $1,063,113 $1,181,652 $1,035,084 $1,181,078 $1,194,605 $1,240,479 $1,291,243 $1,346,826 $1,407,153 $1,472,142 $1,541,710 $1,615,768 $1,694,222 $1,776,974 Salaries and wages $43,439 $50,101 $76,020 $84,815 $85,818 Accrued marketing $210,945 $230,495 $260,550 $216,267 $262,217 Other accrued liabilities $387,130 $361,596 $365,022 $476,683 $414,130 Income taxes $200,666 $327,313 $130,555 $150,413 $93,620 Total Current Liabilities $1,926,134 $2,469,068 $2,587,068 $2,018,231 $2,505,106 $3,216,244 $3,339,750 $3,476,424 $3,626,071 $3,788,488 $3,963,460 $4,150,759 $4,350,145 $4,561,368 $4,784,160 Long-term debt and other liabilities: Long-term debt $4,776,143 $4,537,980 $4,121,984 $4,357,013 $4,413,641 $4,594,634 $4,771,071 $4,966,319 $5,180,102 $5,412,126 $5,662,086 $5,929,655 $6,214,493 $6,516,240 $6,834,514 Deferred income taxes $183,998 $313,343 $508,639 $518,724 $463,666 Non-pension postretirement benefits $192,663 $192,599 $196,686 $207,840 $253,117 Minority interest $415,559 $104,645 $114,833 $120,152 $98,309 Other liabilities $531,097 $365,365 $445,935 $466,984 $457,504 Total Non-Current Liabilities $6,099,460 $5,513,932 $5,388,077 $5,670,713 $5,686,237 $5,973,025 $6,202,393 $6,456,215 $6,734,132 $7,035,764 $7,360,711 $7,708,552 $8,078,841 $8,471,112 $8,884,869 Total Liabilities $8,025,594 $7,983,000 $7,975,145 $7,688,944 $8,191,343 $9,189,269 $9,542,143 $9,932,639 $10,360,203 $10,824,253 $11,324,171 $11,859,311 $12,428,987 $13,032,479 $13,669,029 Shareholders' Equity Capital Stock: Third cumulative preferred $106 $94 $83 $82 $77 Common stock $107,774 $107,774 $107,774 $107,774 $107,774 Additional capital $376,542 $403,043 $430,073 $502,235 $580,606 Dividends paid ($521,611) ($379,926) ($398,869) ($408,151) ($461,237) -$494,683 -$542,555 -$590,428 -$638,300 -$686,173 -$734,045 -$781,918 -$829,790 -$877,663 -$925,535 Retained earnings $4,432,571 $4,856,918 $5,210,748 $5,454,108 $5,778,617 $6,042,980 $6,300,487 $6,553,357 $6,803,924 $7,054,652 $7,308,136 $7,567,112 $7,834,464 $8,113,232 $8,406,618 Less: Treasury shares $2,879,506 $2,927,839 $3,140,586 $3,852,220 $4,406,126 Unearned compensation $21,195 $32,275 $31,141 $32,773 $0 Accumulated other comprehensive loss $817,135 $513,526 ($25,622) $130,383 $219,265 Total Shareholders’ Equity $1,199,157 $1,894,189 $2,602,573 $2,048,823 $1,841,683 $2,106,046 $2,363,553 $2,616,423 $2,866,990 $3,117,718 $3,371,202 $3,630,178 $3,897,530 $4,176,298 $4,469,684 Total Liabilities and Shareholders’ Equity $9,224,751 $9,877,189 $10,577,718 $9,737,767 $10,033,026 $11,295,315 $11,905,696 $12,549,062 $13,227,194 $13,941,971 $14,695,374 $15,489,489 $16,326,517 $17,208,777 $18,138,713 84 2003 2004 2005 2006 2007 Avg. 2001/12/31 2002/12/31 2003/12/31 2004/12/31 2005/12/31 Assets Current Assets: Cash and cash equivalents 8.69% 11.54% 10.25% 4.57% 6.51% 8.31% Short-term investments 0.00% 0.40% 0.00% 0.00% 0.00% 0.08% Receivables 12.63% 11.07% 10.33% 10.29% 9.94% 10.85% Inventories: 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Finished goods and WIP 9.78% 9.09% 9.22% 8.39% 9.40% 9.18% Packing material and ingredients 2.72% 2.62% 2.66% 2.64% 2.54% 2.64% Total Inventories 12.50% 11.71% 11.88% 11.03% 11.94% 11.81% Prepaid expenses 1.60% 1.67% 1.65% 1.43% 1.32% 1.54% Other current assets 0.18% 0.16% 0.36% 0.44% 0.39% 0.30% Total Current Assets 35.60% 36.56% 34.46% 27.77% 30.09% 32.90% Property, plant and equipment: Land 0.67% 0.67% 0.63% 0.57% 0.52% 0.61% Buildings and leasehold improvements 8.16% 8.07% 7.98% 7.83% 7.85% 7.98% Equipment, furniture and other 28.17% 29.00% 29.42% 30.26% 32.04% 29.78% Less accumulated depreciation 15.77% 16.91% 17.57% 19.14% 20.50% 17.98% Total property, plant and equipment, net 21.22% 20.83% 20.46% 19.52% 19.92% 20.39% Other non-current assets: 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Goodwill 20.05% 19.84% 20.22% 28.99% 28.25% 23.47% Trademarks, net 6.61% 6.52% 6.16% 7.98% 8.90% 7.23% Other intangibles, net 1.46% 1.52% 1.62% 2.77% 4.11% 2.30% Other non-current assets 15.05% 14.73% 17.08% 12.98% 8.73% 13.72% Total Non-Current Assets 64.40% 63.44% 65.54% 72.23% 69.91% 67.10% Total Assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Liabilities Current Liabilities: Short-term debt 1.83% 0.14% 0.36% 0.70% 2.01% 1.01% Portion of long-term debt due w/in one year 0.10% 5.32% 6.83% 0.01% 3.70% 3.19% Accounts Payable 11.69% 13.32% 14.82% 13.46% 14.42% 13.54% Salaries and wages 0.54% 0.63% 0.95% 1.10% 1.05% 0.85% Accrued marketing 2.63% 2.89% 3.27% 2.81% 3.20% 2.96% Other accrued liabilities 4.82% 4.53% 4.58% 6.20% 5.06% 5.04% Income taxes 2.50% 4.10% 1.64% 1.96% 1.14% 2.27% Total Current Liabilities 24.00% 30.93% 32.44% 26.25% 30.58% 28.84% Long-term debt and other liabilities: 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% Long-term debt 59.51% 56.85% 51.69% 56.67% 53.88% 55.72% Deferred income taxes 2.29% 3.93% 6.38% 6.75% 5.66% 5.00% Non-pension postretirement benefits 2.40% 2.41% 2.47% 2.70% 3.09% 2.61% Minority interest 5.18% 1.31% 1.44% 1.56% 1.20% 2.14% Other liabilities 6.62% 4.58% 5.59% 6.07% 5.59% 5.69% Total Non-Current Liabilities 76.00% 69.07% 67.56% 73.75% 69.42% 71.16% Total Liabilities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Shareholders' Equity Capital Stock: Third cumulative preferred 0.01% 0.00% 0.00% 0.00% 0.00% 0.01% Common stock 8.99% 5.69% 4.14% 5.26% 5.85% 5.99% Additional capital 31.40% 21.28% 16.52% 24.51% 31.53% 25.05% Dividends paid -43.50% -20.06% -15.33% -19.92% -25.04% -24.77% Retained earnings 369.64% 256.41% 200.22% 266.21% 313.77% 281.25% Less: Treasury shares 240.13% 154.57% 120.67% 188.02% 239.24% 188.53% Unearned compensation 1.77% 1.70% 1.20% 1.60% 0.00% 1.25% Accumulated other comprehensive loss 68.14% 27.11% -0.98% 6.36% 11.91% 22.51% Total Shareholders Equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 85 Statement of Cash Flows Analysis: On our forecasted statement of cash flows, we derived our common size cash flow statement by setting everything as a percentage of cash flow from operations. We then took the net income that we previously forecasted on the income statement and divided it by the average of the industry average percent net income to the company specific average percent net income over the past five years. This calculation gives us the forecasted cash flow from operations, which we carried forward 10 years. We also forecasted depreciation by multiplying the previous year’s value by the average percent depreciation with respect to CFFO. When deriving our common sized statement of cash flows averages for the past five years, we excluded the numbers from 2003, since in that year, Heinz had negative cash flows from operations, severely distorting the percentages. 86 Ind. Operating activities: 4/30/2003 4/28/2004 4/27/2005 5/3/2006 5/2/2007 Avg. Assume 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Net income 566,285 $804,273 $752,699 645,603 785,746 74.46% 70.14% $759,045 $800,063 $843,297 $888,867 $936,900 $987,529 $1,040,894 $1,097,142 $1,156,430 $1,218,922 Adjustments to reconcile net income to (88,738) cash provided by operating activities: Depreciation 477,547 210,158 227,187 227,454 233,374 19.88% $215,167 $226,795 $239,050 $251,968 $265,584 $279,936 $295,063 $311,008 $327,815 $345,529 Amortization 23,785 25,265 36,384 32,823 Deferred tax provision/(benefit) 97,542 53,857 (57,693) 52,244 (Gains)/losses on disposals and impairment 194,328 100,818 48,023 (1,391) charges 20,434 (26,338) Other items, net 133,320 (105,559) 43,989 39,066 11,066 Changes in current assets and liabilities, excluding effects of acquisitions and divestitures: 77,812 Receivables 177,979 97,228 45,851 115,583 10,987 Inventories (133,696) 77,636 (25,315) (47,401) (82,534) Prepaid expenses and other current assets (5,161) 2,633 13,555 14,208 Accounts payable 46,525 8,140 56,545 56,524 Accrued liabilities 53,177 (39,751) 25,077 57,353 (4,489) Income taxes 66,351 68,669 (99,408) (59,511) (46,270) Cash provided by operating activities (1,665) 1,249,007 1,160,793 1,074,961 1,062,288 $1,082,250 $1,140,733 $1,202,376 $1,267,351 $1,335,836 $1,408,023 $1,484,110 $1,564,309 $1,648,842 $1,737,943 Cash flow from investing activity 961,088 -301,102 -264,054 -451,817 -326,244 -423183 -446051 -470155 -495561 -522341 -550567 -580319 -611679 -644733 -679573 CFFO/sales -0.02% 16.38% 14.32% 12.44% 11.80% 11.41% 11.41% 11.41% 11.41% 11.41% 11.41% 11.41% 11.41% 11.41% 11.41% CFFO/OI -0.14% 97.88% 90.58% 96.53% 73.43% 87.74% 87.74% 87.74% 87.74% 87.74% 87.74% 87.74% 87.74% 87.74% 87.74% CFFO/NI -0.29% 155.30% 154.22% 166.50% 135.19% 142.58% 142.58% 142.58% 142.58% 142.58% 142.58% 142.58% 142.58% 142.58% 142.58% Avg. Net income 64% 65% 60% 408% 74% 2252% 66% Adjustments to reconcile net income to cash provided by operating activities: Depreciation 17% 20% 21% 117% 22% 666% 20% Amortization 2% 2% 3% 21% 3% 98% 3% Deferred tax provision/(benefit) 8% 5% -5% -83% 5% -60% 3% (Gains)/losses on disposals and impairment 9% 4% 0% 4% charges -2% 0% 0% -1% Other items, net -8% 4% 4% -4% 1% 19% 0% Changes in current assets and liabilities, excluding effects of acquisitions and divestitures: Receivables 8% 4% 11% 14% 1% -256% 6% Inventories 6% -2% -4% -5% -8% -804% -2% Prepaid expenses and other current assets 0% 0% 1% -66% 1% -341% 1% Accounts payable 4% 1% 5% -112% 5% 62% 4% Accrued liabilities -3% 2% 5% -291% 0% -1616% 1% Income taxes 5% -9% -6% 102% -4% 81% -3% 87 Cash provided by operating activities 100% 100% 100% 100% 100% 100% 100% Conclusion: When comparing Heinz to the industry average, one can see that Heinz is very close to the mark in each respect. Our forecasted sales and income, which steadily increased over time, appear to indicate that, provided there are no unexpected, disastrous events, Heinz will continue to grow steadily along with its competitors in the food industry. Analysis of Valuations: With the method of comparables (valuations), the main goal is to back into the price for the firm using industry averages. This is a ratio based valuation of the food industry. It uses pricing on averages and provides and uses no fundamental understanding. Also the degree of desirability is measured. The models have variance of usefulness and the relevance needs to be determined. The relevant information excluded negative numbers or possible large outliers and excludes the firm that is being analyzed when computing averages. These model help determine if a firm is correctly valued, overvalued, or undervalued. The intrinsic models are better at truly valuing the firm better than price per share to earnings per share (forward and trailing), price per share to book value per share, and dividends per share to price per share. The intrinsic models are price per share to earnings per share over the one year ahead earnings growth rate, price per share to earnings before interest, taxes, depreciation, and amortization, price per share to future cash flows per share, and enterprise value to earnings before interest, taxes, depreciation, and amortization. 88 Method of Comparables: 2007 Actual Price $45.61 P/E Trailing $54.82 P/E Forward $36.76 P/B $30.79 D/P $14.37 P.E.G. $30.09 P/EBITDA $33.07 P/FCF $10.74 EV/EBITDA $54.03 In order to compute these ratios, we first had to get the data for Heinz and their competitor’s earnings, book value, dividends, and price and put them in a per share basis. This allows us to compute the following ratios. We also had to consider negative or not applicable numbers in our calculations. Forward Price to Earnings P/E Forward Heinz Ind. Share Company PPS EPS P/E Avg. Price Heinz 45.61 2.38 19.16 15.45 $36.76 Campbells 36.42 2.22 16.38 Sara Lee 16.06 0.696 23.09 Conagra 23.29 1.75 13.29 To compute the forward price to earnings ratio, which uses forecast future earnings and an industry average to back into a price for a firm, one needs the competitors average forward price to earnings to compute the industry average, and a forecast for future earnings. We took the forward price to earnings ratios for Campbell’s, Sara Lee, and ConAgra and took their average. We then took this average 89 and multiplied it by the future earnings we forecasted previously for Heinz to derive a current estimated price per share of Heinz at $36.76. This estimation is open to being highly inaccurate in that it relies on an average computed on estimated future earnings, and estimated future earnings for Heinz itself. Nonetheless, using the forward price to earnings ratio alone, Heinz is overvalued. Trailing Price to Earnings P/E Trailing Heinz Ind. Share Company PPS EPS P/E Avg Price Heinz 45.61 2.46 18.53 22.28 54.82 Campbells 36.42 2.22 17.27 Sara Lee 16.06 0.696 33.33 Conagra 23.29 1.75 16.25 The trailing price to earnings ratio is the least consistent of the theories. It uses actual past earnings in its computation, rather than estimates of future earnings. To compute this ratio, we took the trailing price to earnings ratio for the same three competitors to compute the industry average. We then multiplied this average by Heinz’s previous year’s earnings per share to derive an estimated price of $54.82. This is much closer to Heinz’s actual price per share of $45.61, but still may contain some degree of error, since it is relying on past performance of the firm, rather than looking at what the firm is doing at the present. Using this ratio, we find that the share price for Heinz is undervalued. 90 Price to Book P/B Heinz Ind. Share Company PPS BPS P/B Avg. Price Heinz 45.61 5.77 7.90 5.34 30.79 Campbells 36.42 3.37 10.80 Sara Lee 16.06 3.61 4.45 Conagra 23.29 9.41 2.48 The price to book ratio compares the price of the share to the book value of equity from the firm’s financial statements. We backed into our price estimate using the price to book ratio in a similar way as the previous two methods. First we took the price to book industry average of our competitors. We multiplied that industry average by our book value per share, computed by taking our total shareholder’s equity from the balance sheet and dividing it by the total number of shares outstanding. This yielded an estimated per share price of $30.79 for Heinz. The fallacy in this price estimate lies in the fact that the market value of a company, which is determined by the market, is not often directly linked to its shareholder’s equity balance, which is an accounting ‘snap-shot’ at a particular point in time. And also, the average of the industry is priced against something that does not exist in the industry. Using this ratio, however, Heinz’s price per share is overvalued. Dividends to Price D/P Heinz Ind. Share Company DPS PPS D/P Avg Price Heinz 1.49 45.61 0.033 0.026 14.37 Campbells 0.84 36.42 0.023 Sara Lee 0.40 16.06 0.025 Conagra 0.73 23.29 0.031 91 The dividends to price ratio compares the dividends per share to the price per share of a firm, and relies on the theory that dividends play a large role in determining the price of a stock. To derive this for Heinz, we computed the ratio for the competitors and took the average. This time, however, instead of multiplying, we divided the $1.49 dividend per share of the previous year by this industry average to back into a per share price of $14.37. This ratio, like the trailing price to earnings ratio, relies on what Heinz has done in the past, rather than what it is doing at present, which can lead to some degree of error. It also relies heavily on the thought that the price of a share of stock is highly correlated with the dividends paid on that stock, which is not necessarily true. For instance, many firms do not even pay dividends, but maintain relatively high prices per share. Also when using this ratio, if you compute 1/ (P/D), this shows how long till a company gets investments of dividends back which is a very useful number for a lender. Heinz has a ratio of .0327 and 1/.0327 equal 30.6 years till Heinz would get back their invested dividends. Using the dividends to price ratio, the current price per share of Heinz stock is, yet again, highly overvalued. Price Earnings Growth P.E.G. Heinz Ind. Share Company PPS EPS P.E.G. Avg. Price Heinz 45.61 2.46 2.45 2.34 30.09 Campbells 36.42 2.22 2.6 Sara Lee 16.06 0.696 2.42 Conagra 23.29 1.75 2 The P.E.G. ratio is price per share over earnings per share over the one year ahead earnings growth rate. This ratio shows a scale of growth opportunities for the firm. If the P.E.G. ratio is greater than one, the firm is overvalued. If the P.E.G. ratio is equal to one, then the firm is fairly valued. If the P.E.G. ratio is less than one, the firm is undervalued and is in an ideal state to buy. The P.E.G. ratio should be scaled between one to ten in order to determine this. We calculated our P.E.G. ratio by taking the industry average from Campbell, Sara Lee, and Conagra, then multiplying it by 92 Heinz’s earnings per share to get their share price which equals $30.09. The industry all showed overvalued firms. This also shows that Heinz is overvalued. Price to EBITDA P/EBITDA Heinz Ind. Share Company PPS EBITDA P/EBITDA Avg. Price Heinz 45.61 1.76 25.91 18.79 33.07 Campbells 36.42 1.15 31.67 Sara Lee 16.06 1.37 11.72 Conagra 23.29 1.8 12.94 *EBITDA stated in Billions of Dollars This ratio is price per share to earnings before interest, taxes, depreciation, and amortization. This ratio shows how money creates values for the firms. For each dollar of earnings creates value for the stockholders. We calculated our P/EBITDA by taking the three competitors P/EBITDA and averaging them to get an industry average, where we then set Heinz equal to the industry average times Heinz’s EBITDA to get the prices per share which came out to be $33.07. $33.07 is under the share price of $45.61 where we are valuing Heinz meaning that they are overvalued. The rest of the industry also shows an overvalued trend when comparing their P/EBITDA to their actual stock prices. Price to Future Cash Flows P/FCF Heinz Ind. Share Company PPS FCF P/FCF Avg. Price Heinz 45.61 4.46 10.24 2.41 10.74 Campbells 36.42 3.96 9.20 Sara Lee 16.06 -0.09 -187.68 Conagra 23.29 0.86 26.99 *Future Cash Flows are stated in Millions of Dollars This ratio is price per share to future cash flows of the firm. Free cash flows are calculated by taking the cash flows from operations and adding the cash flows from 93 investing. A company must have cash flows to drive value of the firm. This ratio shows how the cash flows are related to the stock price. We calculated Heinz’s P/FCF by taking the industry average of Heinz’s competitors which was 2.41. Then we set Heinz’s share price equal to the industry average times Heinz’s FCF. We got that Heinz’s share price should equal $10.74. Heinz is very overvalued in the P/FCF ratio. Enterprise Value to EBITDA EV/EBITDA Heinz Ind. Share Company EV EBITDA EV/EBITDA Avg. Price Heinz 19.63 1.76 11.1534091 9.97 54.93 Campbells 16.73 1.51 11.0794702 Sara Lee 14.05 1.37 10.2554745 Conagra 15.46 1.8 8.58888889 *EBITDA is stated in Billions of Dollars This ratio is the enterprise value to earnings before interest, taxes, depreciation, and amortization. Enterprise value is found from the market value of equity (price per share times the number of shares outstanding) plus the value of liabilities minus the total of cash and financial investments. A company would want the EV/EBITDA to be less than ten, because it would be a better buy. Having an EV/EBITDA greater than ten would be over paying for a firm’s stock. We calculated Heinz’s EV/EBITDA by taking three competitors and averaging them to get the industry average. We then set Heinz’s share price equal to the industry average times Heinz’s EBITDA and we got that Heinz’s share price equals $54.93. This shows that according to the EV/EBITDA ratio, Heinz’s stock price is undervalued. Conclusion: These ratios have shown there is a vary inconsistency between the different ratios. The prices vary from about $10 to about $55. Most of the ratios show that Heinz is overvalued, but with EV/EBITDA and P/E trailing show that Heinz is undervalued. These valuations will be taken into consideration as a broad view but the 94 next set of valuations will provide a better evaluation for the firms share price and the value of the firm. Cost of Equity: The cost of equity, Ke, is the return to the shareholders of the company. The model used in computing the cost of equity is the capital asset pricing model (CAPM). This model states that the cost of equity equals the riskless rate of return plus the beta risk times the market risk premium. We first ran regressions in order to get the betas that would be used for the computations. We got the S&P 500 closing monthly prices for the past seven years. Then we computed the returns on the S&P 500 monthly prices by subtracting the current month’s price by its previous month’s closing price then dividing both of them by the previous month. This gave us the returns of the S&P 500 for those seven years. We then computed the interest rates for the related series. We got this information from the St. Louis Fed Fred 2 data base (research.stlouisfed.org/fred2). From here we calculated our market risk premium by subtracting the interest rates from the S&P 500 returns. We then ran a regression between this market risk premium and Heinz market return computed from monthly stock prices with dividends taken into consideration. We ran these regressions for five time periods. 72, 60, 48, 36, and 24 month time periods. These five regressions were run six times for different time periods of interest rates. The time periods were three months, one year, three years, five years, seven years, and ten years treasury bonds. We did this to see which regression to see which time period gave us the best beta. From these regressions, we chose the highest adjusted r squared. This is because adjusted r squared shows how much is explained by beta. The ideal beta is the highest. We had a constant high beta in the 60 month regression over the six time periods it was ran. This shows that our beta that we ran was constant over time. We then computed the cost of equity. We used the constant 6.8% plus Heinz’s market value premium of .7 for the size premium. For the risk free rate, we used treasury bonds from each corresponding time period (finance.yahoo.com). The market 95 risk premium, beta, and the risk free rate are how CAPM was computed for all of the episodes. “Firms whose earnings and cash flows are less sensitive to economic changes will have betas lower than one (8-3, Palepu & Healy).” The related beta found on yahoo finance is .62, which is close to the beta numbers that we computed. The best beta found was .6596 from the one year treasury bonds interest rate, with a risk free rate of 3.89%, and a given adjusted r squared of .1872. This CAPM gave us a cost of equity of 8.84%, which means that it only measures 8.84% of the firm’s risk. These results were to low so we decided to approach the answer from a different strategy. We took the price to book ratio and set it equal to one plus the ROE minus the cost of equity over the cost of equity minus the growth rate. We then got that the cost of equity equal 11.29%. We decided to use this cost of equity because it better represented our market. 96 Regression analysis: 72 60 48 36 24 3 month Beta 0.4158 0.6588 0.6153 0.5910 0.3730 R2 Adj 0.0963 0.1722 0.1101 0.1286 -0.0041 Ke 6.7086% 8.5308% 8.2048% 8.0224% 6.3872% RF 3.59% 3.59% 3.59% 3.59% 3.59% 72 60 48 36 24 1 year Beta 0.4156 0.6596 0.6179 0.5936 0.3753 R2 Adj 0.0965 0.1872 0.1116 0.1300 -0.0035 Ke 7.0067% 8.8368% 8.5240% 8.3423% 6.7044% RF 3.89% 3.89% 3.89% 3.89% 3.89% 72 60 48 36 24 3 year Beta 0.4197 0.6670 0.6252 0.6020 0.3763 R2 Adj 0.0985 0.1756 0.1144 0.1076 -0.0035 Ke 6.8276% 8.6822% 8.3692% 8.1951% 6.5023% RF 3.68% 3.68% 3.68% 3.68% 3.68% 72 60 48 36 24 5 year Beta 0.41633 0.66286 0.62217 0.59753 0.37708 R2 Adj 0.09753 0.17468 0.11369 0.10651 -0.0029 Ke 7.1125% 8.9614% 8.6563% 8.4714% 6.8181% RF 3.99% 3.99% 3.99% 3.99% 3.99% 72 60 48 36 24 7 year Beta 0.41683 0.66365 0.62304 0.59856 0.37758 R2 Adj 0.09784 0.17493 0.11405 0.10689 -0.0028 Ke 7.2863% 9.1374% 8.8328% 8.6492% 6.9919% RF 4.16% 4.16% 4.16% 4.16% 4.16% 72 60 48 36 24 10 year Beta 0.41737 0.66457 0.62392 0.59984 0.37843 R2 Adj 0.09808 0.17524 0.11442 0.10738 -0.0027 Ke 7.5003% 9.3543% 9.0494% 8.8688% 7.2082% RF 4.37% 4.37% 4.37% 4.37% 4.37% 97 Cost of debt: The cost of debt, Kd, is calculated by taking all liabilities for the most recent year and comparing them to their corresponding interest rates. We found the interest rates from Heinz’s 10-K. For the interest rates for accounts payable, accrued marketing, and other current liabilities we used 4.63%. This number comes from St. Louis Fed Fred data base. The percent is a three month non-financial commercial paper rate. And for deferred taxes we used 4.14% which is the risk free rate. With all of these rates, which were multiplied by the percentage of total liabilities to compute the value weighted rate. Those totals were then added up with taxes in consideration. We computed this total with and without taxes so that we would have the appropriate number to plug into the WACC equation. We also state a net of tax cost of debt because it is after tax cash flows that are being discounted (8-2, Palepu & Healy). To get this after tax number, we tax one minus the tax rate, which is 35%, and multiply it by the net of tax number. Our cost of debt before taxes was 5.65% and cost of debt after taxes was 3.67%. Knowing these debt numbers allows the analysts to see if the company has enough cash or assets to back up the next year of debt and the rest of the future debt plus possible extra debt that the company will have. It is also important to know that both of the cost of debt percentages will change overtime because the fluctuating interest rates of the market. Weighted Average Cost of Capital: The weighted average cost of capital (WACC) is computed to value the firm’s assets by using the cost of equity and debt. We used the values of equity and debt from above and also pulled the numbers for the value of debt, value of equity, and the value of the firm from Heinz’s 10-K. We used with the average cost of equity of 11.29% and we used the cost of debt before taxes of 5.65%. We calculated the WACC before tax and after tax. WACC before tax was 2.53% and WACC after taxes was 2.37% and was calculated similarly to WACC before tax but the cost of debt was multiplied by one minus the tax rate of 35%. 98 Weighted Average Cost of Debt: Liabilities Current Liabilities: 2007 TL Percent of TL Rates Value Weighted Rate of Debt Short-term debt $165,054 2.01% 5.40% 0.10881% Portion of long-term debt due w/in one year $303,189 3.70% 6.14% 0.22726% Accounts Payable $1,181,078 14.42% 4.63% 0.66758% Salaries and wages $85,818 1.05% 0.0% 0.0% Accrued marketing $262,217 3.20% 4.63% 0.1% Other accrued liabilities $414,130 5.06% 4.6% 0.2% Income taxes $93,620 1.14% 35.00% 0.4% Total Current Liabilities $2,505,106 30.58% Long-term debt and other liabilities: Long-term debt $4,413,641 53.88% 6.14% 3.30834% Deferred income taxes $463,666 5.66% 4.14% 0.23434% Non-pension postretirement benefits $253,117 3.09% 6.10% 0.18849% Minority interest $98,309 1.20% 0% 0.0% Other liabilities $457,504 5.59% 11.00% 0.614373% Total Non-Current Liabilities $5,686,237 69.42% Total Liabilities $8,191,343 100.00% Total Kd before taxes: 5.649193% Total Kd after taxes: 3.67198% = 5.649193% * (1-.35) *Rates are from Heinz 10-k and from St. Louis Fed Fred 2 Intrinsic Valuations: Intrinsic valuations utilize the forecasts and analysis derived above to assess the true value of a firm. The discounted dividend model, the free cash flows model, the residual income model, and the long run return on equity residual income model are the four main models used in firm valuations. These models look at all aspects of the business to estimate the true value of a firm. A detailed description of the methods used and the valuation results for Heinz are explained below. Discounted Dividend Model: Dividends can be good insight into a company for potential investors. Whether or not a company distributes dividends can be a deciding factor when choosing investments. This model takes the future dividends and discounts them back to the 99 present value to calculate the value of a company. Due to the fact that dividends are only given out four times a year it makes this model very unreliable in valuing the firm. Volatility cannot be accurately measured because of the estimation of both profits and dividends. Dividend models often times undervalue the firm too much and may not show a true picture of the firm. The values necessary to find the future discounted dividends are the earnings per share, dividends per share, book value of equity per share, and cash flow from operations and investments. The following is the discounted dividend model for Heinz. Sensitivity Anaylsis: Growth 0 0.03 0.054 0.07 0.09 ost of Equity 0.07 $31.74 $43.88 $86.36 N/A N/A 0.09 $24.76 $30.04 $40.59 $61.70 N/A 0.11293 $19.76 $22.26 $26.09 $31.02 $46.85 0.13 $17.17 $18.73 $20.86 $23.23 $28.85 0.15 $14.88 $15.83 $17.02 $18.21 $20.59 Overvalued = <38.77 Actual PPS (11/1/07) - $45.61 Fairly Valued = within 15% Undervalued = > 52.45 It is necessary to forecast dividends to be able to use this model. Our average increase in dividends was 15 cents annually and this is what we used in the dividend model. After the dividends were calculated the numbers were discounted back to present value. The sum of the present values is multiplied by the perpetuity equation to find the number for any amount of years. This perpetuity equals $6,087.70 and when valued back to present value it was calculated to be $2,088.21. To find the value of the company we added the present value of the perpetuity and the present value of the firm. We found that the value of Heinz as of November 2007 was $18.73 per share. The fiscal year end for Heinz is May 1, so the value found had to be increased to a time consistent price of $19.76. The published share price of $45.61 per share means that 100 Heinz is overvalued. This proves that the discounted dividend model is not an accurate estimate of the price per share because of all the estimations used in calculating the price. Calculated prices are much lower than they actually are. Our sensitivity analysis showed that if Heinz wanted to be fairly valued they could do a few things. One is to decrease both their cost of equity and growth rate. Another option would be to either increase the growth rate or decrease the cost of equity. This growth does not currently seem attainable based on the past trends of Heinz. We believe that Heinz would have a hard time increasing their growth rate or decreasing the cost of equity that much due to their past dividend trends. The discounted dividend model shows that Heinz is overvalued compared to the current share price of $45.61 and that this model would not be the best to use when valuing a firm with small dividends. Free Cash Flows Model: The future cash flows model shows the difference between the accounting earnings and the free cash flows to the firm. This calculation uses the weighted average cost of capital mentioned earlier and compares it to the perpetuity growth rate. This model is often inaccurate due to the fact that the number is based off of the present value of future cash flows and the terminal value of the perpetuity. The inputs needed to find the future cash flows model are the same as those used in the discounted dividends model plus the before-tax weighted average cost of capital. The WACC used for Heinz was 2.534% and the growth rate was set at 5.4% per year. Sensitivity analysis on the next page shows how the numbers for Heinz changed when the WACC and growth rate were manipulated. 101 g 0 0.02 0.054 0.07 0.09 0 N/A N/A N/A N/A N/A 0.01 80.23 N/A N/A N/A N/A WACC 0.0253 25.24 162.37 N/A N/A N/A 0.03 19.59 81.02 N/A N/A N/A 0.04 11.97 35.12 N/A N/A N/A Overvalued = <38.77 Actual PPS (11/1/07) - $45.61 Undervalued = > 52.45 Annual free cash flows are the first thing that needed to be calculated by taking the cash flow from operations minus the investing cash flows. Then the free cash flows are multiplied by the present value factor to bring them to the value they would be today. The sum of the total present value of dividends and the present value of the terminal perpetuity yield a value of the firm of $16,128. The value of the firm minus the book value of liabilities equals the market value of equity. This market value of equity is then divided by the number of shares outstanding to get an estimated share price of $24.87. Like the discounted dividend model, this number also has to be time consistent with the fiscal year end value which is $25.18. Many of the numbers calculated in the sensitivity analysis came up negative or were unable to be calculated. This could be due to the fact that the WACC used was too low or the growth rate estimated was too aggressive. The results that did work show that Heinz needs to have a small growth rate and a higher WACC in order for this model to be reliable. This model shows that Heinz is once again overvalued as of November, 2007. 102 Residual Income Model: The residual income model is based off of the earnings of the firm versus the perpetuity used in the last two models. This model is more accurate than the other models because the earnings are usually better estimated than the perpetuity. Residual income is a good indicator of the value of the firm. Results from the residual income model for Heinz are shown below. 0 0.02 0.054 0.07 0.09 Ke 0.07 40.88 48.07 101.5 N/ A N/A 0.09 31.17 34.26 47.36 68.95 N/ A 0.11293 24.29 25.66 30.13 34.68 49.29 0.13 20.77 21.57 23.90 25.9 30.67 0.15 17.68 18.13 19.31 20.22 22.03 Overvalued = <38.77 Actual PPS (11/1/07) - $45.61 Fairly Valued = within 15% Undervalued = > 52.45 To find the values used in the residual income we started with the earnings minus the benchmark earnings, which are found by multiplying the book value of equity for the previous year by the cost of equity. This equals the annual residual income and it needs to be grown back to present value. Residual income tells whether the company is adding or destroying the value of their firm. Eventually the PV of residual incomes should get closer to zero because not many firms can keep their growth at a rate higher than the market for long periods. The present value trends of Heinz are shown below. PV 0 1 2 3 4 5 6 7 8 9 10 Annual 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 RI 495.21 453.99 418.21 386.88 359.20 334.51 312.28 292.07 273.56 256.45 After finding the residual income, the initial book value of equity, the PV or annual residual income, and the PV of terminal value perpetuity are all added together 103 and divided by the total number of shares outstanding to give the estimated price per share of $23.04. The time consistent price per share is $24.30. By using sensitivity analysis it further shows that Heinz is overvalued. In this model the company would have to decrease both the cost of equity and the growth rate to have a chance at being fairly valued. Heinz would have to have a drastic change in both the growth rate and the cost of equity to bring the share value closer to what it really should be. The residual income model is thought to be one of the best of all the intrinsic valuation models in determining the market price of stock and it says that Heinz is overvalued at a stock price of $45.61. Long Run Return on Equity Residual Income Model: The long run return on equity residual income model is also a very good model for valuing a firm. A perpetuity value from the residual income model is used to derive the valuation. This model is very effective due to the fact that it compares the long run return on equity, the long run growth rate of equity, and the cost of equity. The results for Heinz are listed below. ROE = .2919 g 0 0.03 0.054 0.07 0.09 Ke 0.07 $24.73 $38.80 $88.04 N/A N/A 0.09 $19.41 $26.10 $39.49 $ 66.26 N/A 0.1129 $15.63 $19.08 $24.38 $ 31.19 $ 53.09 0.13 $13.68 $15.95 $19.05 $ 22.49 $ 30.67 0.15 $11.96 $13.41 $15.21 $ 17.02 $ 20.63 104 g = .054 ROE 0.25 0.27 0.2919 0.31 0.33 Ke 0.07 $73.11 $80.58 $88.74 $ 95.50 $ 102.96 0.09 $32.80 $36.14 $39.81 $ 42.84 $ 46.18 0.11293 $20.25 $22.31 $24.57 $ 26.44 $ 28.51 0.13 $15.82 $17.43 $19.20 $ 20.66 $ 22.27 0.15 $12.63 $13.92 $15.33 $ 16.50 $ 17.79 Ke = .1129 g 0 0.03 0.054 0.07 0.09 ROE 0.25 $13.48 $16.15 $20.25 $ 25.52 $ 42.47 0.27 $14.55 $17.62 $22.31 $ 28.36 $ 47.78 0.2919 $15.73 $19.22 $20.25 $ 31.46 $ 53.60 0.31 $16.71 $20.55 $24.57 $ 34.03 $ 58.40 0.33 $17.79 $22.02 $28.51 $ 36.87 $ 63.71 Overvalued = <38.77 Actual PPS (11/1/07) - $45.61 Fairly Valued = within 15% Undervalued = > 52.45 We started by calculating the long run return on equity by dividing the book value of equity of the previous year by this year’s earnings. The ROE for Heinz is shown in the table below. ROE 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 41.21% 37.99% 35.68% 33.97% 32.68% 31.67% 30.88% 30.22% 29.67% 29.19% The ROE for Heinz has been steadily decreasing very little every year. Knowing the ROE helps to get a better picture of what the long run return on equity will be. The 105 next step is to find the percentage growth of the book value of equity. This can be found by taking the current year BVE divided by last year’s BVE and subtracting one from the total. Heinz has a BV percent growth that is decreasing every year until it gets to 2014 where it starts to slow down around 7%. BV % 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 14.35% 12.23% 10.70% 9.58% 8.75% 8.13% 7.68% 7.36% 7.15% 7.03% Growth After both the book value percentage growth and the return on equity are calculated they are used to estimate the current share price. This number is then divided by the number of shares outstanding to give Heinz and estimated share price of $23.29. When this price is time consistent to May 1st it equals $24.57. This model also shows that Heinz is overvalued. Sensitivity analysis showed that there are a few ways that Heinz could be fairly valued, but for the most part there is not much they can do to change the undervalued stock price. Heinz would need to increase both the return on equity and the long run growth rate while decreasing their cost of equity in order to make this happen. We do not believe that all of this would be possible based on the past trends of Heinz. This model like that of all the others proves that Heinz is overvalued as of November, 2007. Abnormal Earnings Growth Model: The AEG model is a complex valuation method that relates capitalized forward earnings with any added extra value from abnormal earnings growth to calculate the intrinsic market price for a share. It is a fairly complex calculation, but tends to provide fairly accurate results, and directly correlates to residual income, making it easier to justify. To compute AEG, we first found DRIP income by multiplying the previous year’s dividend by the cost of equity. Then, we calculated cumulative dividend income by adding DRIP income to forecasted earnings. We calculated normal income by taking 106 the previous year’s earnings and multiplying by one plus the cost of equity. Finally, to find annual AEG we subtracted normal income from cumulative dividend income, and discounted our findings back to the present and added them together to provide the value. We ran a sensitivity analysis using several different combinations of cost of equity and growth rates, to get a broad sense of how Heinz may perform under different situations. This resulted in a broad range of valuations, from $19 to over $50. Using the growth rate of 5.4% and the cost of equity of 11.293% from our calculations, the value of Heinz was estimated, through this model, at $27.12, which suggests a current overvaluation of Heinz. Using a 7% cost of equity and a growth rate below our computed 5.4%, the valuation is much more favorable of Heinz’s current market price, however we do not feel that these are actual realizable rates. Although Heinz is a fairly well established company, the cost risk of its inputs are just too large to justify a cost of equity much less than our calculated 11.293%, as it relies heavily on volatile agricultural products. Even under high growth with the cost of equity that we found, the price still did not reach $30. Under this model, it is difficult to justify a share price much higher than $28. Sensitivity Growth 0 0.03 0.054 0.07 0.09 Ke 0.07 $56.59 $65.48 $96.58 N/A N/A 0.09 $38.48 $41.06 $46.22 $ 56.54 N/A 0.11293 $27.59 $28.37 $29.56 $ 31.10 $ 36.05 0.13 $22.61 $22.95 $23.42 $ 23.94 $ 25.18 0.15 $18.58 $18.71 $18.87 $ 19.04 $ 19.36 Overvalued = <38.77 Actual PPS (11/1/07) - $45.61 Fairly Valued = within 15% Undervalued = > 52.45 107 Credit Analysis: We derived Heinz’s credit worthiness from the Altman Z-score, a model combining 5 different financial ratios using 8 variables from the income statement and balance sheet. In general, the lower the score for a particular company, the higher the probability that company will go bankrupt. Companies with Z-scores of 3 or above are considered safe and unlikely to go bankrupt. Z-scores between 1.8 and 3 are considered to be in jeopardy of bankruptcy. For Z-scores below 1.8 bankruptcy is considered imminent. “Studies measuring the effectiveness of the Z-score have shown the model is often accurate in predicting bankruptcy with 72 to 80% reliability (http://www.valuebasedmanagement.net)” This model effectively rates the credit of companies like Heinz that have a relevant history of financials to properly compute a Z- score. The Altman Z-score is computed from the following: Z-score = 1.2(Working Capital/Total Assets) + 1.4(Retained Earnings/Total Assets) + 3.3(Earnings Before Interest and Taxes/Total Assets) + .6(Market Value of Equity/Book Value of Debt) + 1.0(Sales/Total Assets) Altman Z-score 2003 2004 2005 2006 2007 3.024 2.917 2.809 3.241 3.308 The current Z-score for Heinz is very healthy at 3.3. The company has a fairly consistent Z-score right around 3 over the past 5 years. 108 Analyst Recommendation: After having rigorously analyzed virtually everything having to do with Heinz, through an industry analysis, accounting analysis, financial analysis, credit analysis, several different valuation models, and forecasting future financial statements, we have come to the conclusion that in the current market, Heinz is overvalued. Therefore, we give it a sell rating. To analyze the industry, we took what we believed to be the three largest competitors of Heinz, based on size and maturity in the market. Campbell’s, ConAgra, and Sara Lee, we decided, best fit the profile for firms with the right cost efficiency, size, and experience in the market. We used there financial statements along with Heinz’s to derive the current status of the food industry, and discover what the norms were among the firms in the industry. In our accounting analysis, we found that Heinz was very consistent over time, more so than its competitors. We analyzed its performance, and the competitors’, with respect to several sales and expense diagnostic ratios designed to detect potential errors or hidden items in their financial statement reporting. What we found was that Heinz was fairly consistent in each of the diagnostics, which led us to little concern over its reported financials. In the financial analysis ratios, Heinz appeared to closely follow the industry trends, which we took to mean that its performance was as good as can be expected from an industry with such volatile costs. Our forecasts of Heinz’s future financial statements were based on five years of the company’s own previous financial statements, plus the financial statements of its competitors compiled show industry trends. In many cases, we assumed that Heinz would steadily grow to meet certain industry averages, while in other cases, we noticed trends in its performance over the past five years and chose to carry those forward. In the end, we feel our forecast is thoughtfully based on solid financial information and financial theory. When we began to use our forecasts to compute various valuations, from the less reliable methods of comparables to the highly complex intrinsic valuation models, 109 we continually ran into the fact that our valuations were not consistent with those of the market. We have confidence in our forecasts and in our valuation methodologies, and therefore must come to the conclusion that the market’s valuation of Heinz is erroneous. Our valuation of Heinz, even when we allowed for excessively optimistic growth, was still less than the value assigned by the market. It is for this reason we recommend that Heinz stock be sold. The markets over enthusiasm may be a result of strong consumer spending over the past several years; however, even under these circumstances we do not believe Heinz has the kind of growth potential necessary to make the market’s valuation plausible. We feel the stock price must inevitably go down. 110 Appendix: Heinz's Trend Analysis 2003 2004 2005 2006 2007 LIQUIDITY Current Ratio 1.71 1.46 1.41 1.34 1.21 Quick Asset Ratio 1.02 0.92 0.84 0.72 0.66 A/R Turnover 7.07 6.98 7.42 8.63 9.03 A/R Days 51.65 52.32 49.20 42.32 40.42 Inventory Turnover 4.60 4.09 4.03 5.17 4.68 Inventory Days 79.34 89.21 90.48 70.61 77.96 Working Capital Turnover 6.06 6.68 7.66 12.61 17.52 PROFITABILITY Gross Profit Margin 35.60% 37.93% 37.44% 35.79% 37.69% Operating Profit Margin 14.25% 16.73% 15.81% 12.88% 15.52% Operating Expense Ratio 1.50 1.27 1.37 1.78 1.42 Net Profit Margin 6.88% 10.55% 9.29% 7.47% 8.73% Asset Turnover 0.89 0.77 0.77 0.89 0.90 Return on Assets 5.51% 8.14% 7.12% 6.63% 8.07% Return on Equity 32.95% 67.07% 39.74% 24.81% 38.35% CAPITAL STRUCTURE Debt to equity ratio 6.69 4.21 3.06 3.75 4.45 Times interest earned 5.25 6.04 5.52 3.52 4.34 Debt service margin 2.75 1.68 15.62 2.24 1.46 Campbell's Trend Analysis 2003 2004 2005 2006 2007 LIQUIDITY Current Ratio 0.63 0.63 0.76 0.73 0.78 Quick Asset Ratio 0.22 0.22 0.27 0.40 0.32 A/R Turnover 13.63 14.51 13.89 14.86 13.54 A/R Days 26.78 25.16 26.27 24.56 26.96 Inventory Turnover 4.79 5.35 5.34 5.87 5.90 Inventory Days 76.26 68.17 68.30 62.19 61.88 Working Capital Turnover 7.78 8.29 14.43 9.55 17.40 PROFITABILITY Gross Profit Margin 43.02% 41.10% 40.91% 41.81% 41.90% Operating Profit Margin 16.55% 15.68% 16.01% 15.67% 16.44% Operating Expense Ratio 0.26 0.25 0.25 0.26 0.25 Net Profit Margin 8.91% 9.10% 10.00% 10.43% 10.86% Asset Turnover 1.00 1.07 1.04 0.95 1.22 111 Return on Assets 8.91% 9.71% 10.43% 9.89% 13.25% Return on Equity 68.08% 74.03% 55.67% 43.33% 65.95% CAPITAL STRUCTURE Debt to equity ratio 6.64 6.62 4.34 3.38 3.98 Times interest earned 5.94 6.41 6.15 6.98 Debt service margin Sara Lee's Trend Analysis 9/22/20 9/3/200 9/2/200 9/14/20 8/29/20 03 4 5 06 07 LIQUIDITY Current Ratio 1.15 1.06 1.17 1.08 1.31 Quick Asset Ratio 0.55 0.47 0.52 0.54 0.89 A/R Turnover 1.18 1.31 0.79 0.78 1.01 A/R Days 308.31 277.64 463.63 466.92 362.38 Inventory Turnover 4.09 4.32 2.52 7.64 7.19 Inventory Days 89.30 84.41 144.71 47.75 50.75 Working Capital Turnover 24.26 60.58 13.46 23.10 9.15 PROFITABILITY Gross Profit Margin 39.58% 38.58% 40.11% 38.70% 33.15% Operating Profit Margin 9.20% 8.81% 8.34% 3.68% -0.81% Operating Expense Ratio 3.30 3.38 3.81 9.51 -41.70 Net Profit Margin 6.68% 6.50% 6.34% 4.84% 4.10% Asset Turnover 1.18 1.31 0.79 0.78 1.01 Return on Assets 7.90% 8.55% 4.99% 3.79% 4.13% Return on Equity 59.50% 43.15% 24.47% 22.66% 19.27% CAPITAL STRUCTURE Debt to equity ratio 6.51 4.05 3.91 4.99 3.66 Times interest earned 6.61 7.54 4.73 4.15 1.86 Debt service margin 0.35 0.49 0.33 0.33 0.18 Conagra Trend Analysis 2003 2004 2005 2006 2007 LIQUIDITY Current Ratio 2.51 2.21 2.21 1.49 1.49 Quick Asset Ratio 1.08 1.01 1.10 0.94 0.27 A/R Turnover 1.00 1.00 1.00 1.01 1.07 A/R Days 364.91 364.08 364.67 362.57 340.56 Inventory Turnover 4.66 2.87 3.67 3.87 3.83 Inventory Days 78.29 127.28 99.50 94.42 95.31 Working Capital Turnover 2.61 2.98 2.93 5.61 5.96 112 PROFITABILITY Gross Profit Margin 20.49% 25.53% 24.59% 23.63% 26.09% Operating Profit Margin 2.43% 3.54% 1.61% 2.87% 3.42% Operating Expense Ratio 1.24 1.28 1.56 1.55 2.50 Net Profit Margin 1.65% 3.71% 2.07% 4.35% 5.70% Asset Turnover 0.91 0.96 0.95 0.94 0.92 Return on Assets 1.70% 3.56% 1.96% 4.07% 5.27% Return on Equity 7.41% 13.42% 7.34% 18.44% 19.64% CAPITAL STRUCTURE Debt to equity ratio 2.28 1.93 2.02 3.53 2.73 Times interest earned 5.41 3.96 3.75 3.14 5.46 Debt service margin 21.86 21.60 36.39 125.56 94.34 113 Summary Output for 3 month Regressions: Regression Statistics 0.33014575 Multiple R 7 0.10899622 R Square 1 Adjusted R 0.09626759 Square 6 0.04162928 Standard Error 5 Observations 72 ANOVA Significance df SS MS F F 0.01483979 0.014839 8.56307 0.00462247 Regression 1 3 8 9 1 0.12130981 Residual 70 4 0.001733 0.13614960 Total 71 6 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 0.00353533 0.00493294 0.47595 - Intercept 4 6 0.716678 7 0.00630312 0.013373785 -0.006303117 0.013373785 0.41581988 0.14209875 2.926273 0.00462 0.13241284 X Variable 1 1 8 9 2 8 0.699226914 0.132412848 0.699226914 0.65877180 0.18080081 3.643632 0.00057 0.29685964 X Variable 1 1 7 9 5 8 1.020683955 0.296859648 1.020683955 SUMMARY OUTPUT Regression Statistics 0.43158144 Multiple R 9 0.18626254 R Square 7 Adjusted R 0.17223259 Square 1 0.03638345 Standard Error 5 Observations 60 ANOVA Significance df SS MS F F 0.01757426 0.017574 13.2760 0.00057538 Regression 1 2 3 6 4 0.07677783 0.001323 Residual 58 4 8 0.09435209 Total 59 6 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 0.00485879 0.00487730 0.996205 0.32328 - Intercept 5 1 6 8 0.00490418 0.014621774 -0.004904184 0.014621774 0.65877180 0.18080081 3.643632 0.00057 0.29685964 X Variable 1 1 7 9 5 8 1.020683955 0.296859648 1.020683955 Regression Statistics 0.35863644 Multiple R 1 114 0.12862009 R Square 7 Adjusted R 0.10299127 Square 6 0.03377150 Standard Error 2 Observations 36 ANOVA Significance df SS MS F F 0.00572375 0.005723 5.01857 0.03172141 Regression 1 4 8 3 5 0.03877748 0.001140 Residual 34 7 5 0.04450124 Total 35 1 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 0.00641588 0.00581946 1.102487 0.27799 - Intercept 8 4 8 3 0.00541069 0.018242461 -0.005410685 0.018242461 0.59098269 0.26380599 2.240217 0.03172 0.05486441 X Variable 1 9 6 1 1 6 1.127100982 0.054864416 1.127100982 Regression Statistics 0.19898610 Multiple R 3 0.03959546 R Square 9 Adjusted R - Square 0.00405928 0.03843242 Standard Error 4 Observations 24 ANOVA Significance df SS MS F F 0.00133970 0.001339 0.90701 0.35125515 Regression 1 6 7 4 8 0.03249512 0.001477 Residual 22 6 1 0.03383483 Total 23 2 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% 0.01190824 0.00826791 1.440296 0.16386 - Intercept 7 5 2 4 0.00523836 0.029054853 -0.00523836 0.029054853 0.39161707 0.952372 0.35125 - X Variable 1 0.37296545 1 8 5 0.43919864 1.185129543 -0.439198644 1.185129543 115 Summary Output for 1 year Regression: Regression Statistics Multiple R 0.33043278 R Square 0.10918583 Adjusted R Square 0.09645991 Standard Error 0.04162486 Observations 72 ANOVA df SS MS F Significance F Regression 1 0.014865607 0.01486561 8.57980033 0.004584871 Residual 70 0.121283999 0.00173263 Total 71 0.136149606 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - Intercept 0.00363162 0.004929059 0.73677697 0.46372023 -0.006199081 0.01346231 0.006199081 0.013462315 X Variable 1 0.41555599 0.141870127 2.92912962 0.00458487 0.132604948 0.69850703 0.132604948 0.698507032 SUMMARY OUTPUT Regression Statistics Multiple R 0.43262613 R Square 0.18716537 Adjusted R Square 0.17315098 Standard Error 0.03636327 Observations 60 ANOVA df SS MS F Significance F Regression 1 0.017659445 0.01765944 13.3552275 0.000555993 Residual 58 0.076692651 0.00132229 Total 59 0.094352096 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.00499059 0.004864175 1.02598982 0.30915646 -0.00474611 0.0147273 -0.00474611 0.014727297 X Variable 1 0.65956936 0.180482388 3.65448047 0.00055599 0.298294614 1.02084411 0.298294614 1.020844112 SUMMARY OUTPUT Regression Statistics Multiple R 0.36118966 R Square 0.13045797 Adjusted R Square 0.11155489 116 Standard Error 0.03451341 Observations 48 ANOVA df SS MS F Significance F Regression 1 0.008220793 0.00822079 6.90141084 0.011661768 Residual 46 0.054794084 0.00119118 Total 47 0.063014878 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - Intercept 0.00542167 0.005136319 1.05555574 0.29668376 -0.004917203 0.01576055 0.004917203 0.015760546 X Variable 1 0.617868 0.235194282 2.62705364 0.01166177 0.144446468 1.09128952 0.144446468 1.091289523 SUMMARY OUTPUT Regression Statistics Multiple R 0.36061431 R Square 0.13004268 Adjusted R Square 0.1044557 Standard Error 0.03374392 Observations 36 ANOVA df SS MS F Significance F Regression 1 0.005787061 0.00578706 5.08237715 0.030725213 Residual 34 0.03871418 0.00113865 Total 35 0.044501241 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.00650142 0.005803187 1.12031963 0.27042907 -0.00529207 0.01829492 -0.00529207 0.018294918 X Variable 1 0.59364462 0.263325607 2.25441282 0.03072521 0.058502607 1.12878664 0.058502607 1.128786641 SUMMARY OUTPUT Regression Statistics Multiple R 0.2003706 R Square 0.04014838 Adjusted R Square -0.0034812 Standard Error 0.03842136 Observations 24 ANOVA df SS MS F Significance F Regression 1 0.001358414 0.00135841 0.92020924 0.347844763 Residual 22 0.032476418 0.0014762 117 Total 23 0.033834832 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.01192293 0.008255068 1.44431675 0.16274194 -0.00519703 0.0290429 -0.00519703 0.029042897 - X Variable 1 0.37525802 0.391189048 0.95927537 0.34784476 -0.436018408 1.18653445 0.436018408 1.186534448 118 Summary Output for 3 years Regression: Regression Statistics Multiple R 0.33342359 R Square 0.11117129 Adjusted R 0.09847373 Square 7 0.04157844 Standard Error 2 Observations 72 ANOVA Significance df SS MS F F 0.01513592 0.0151359 8.75533186 Regression 1 7 3 9 0.004208904 0.12101367 0.0017287 Residual 70 9 7 0.13614960 Total 71 6 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - 0.00257862 0.00497019 0.5188171 0.60552461 - 0.01249137 0.00733412 0.01249137 Intercept 4 8 5 4 0.007334123 1 3 1 0.41967605 0.14183319 0.00420890 0.70255343 0.13679867 0.70255343 X Variable 1 5 5 2.958941 4 0.136798672 8 2 8 SUMMARY OUTPUT Regression Statistics 0.43536422 Multiple R 3 0.18954200 R Square 6 Adjusted R 0.17556859 Square 3 0.03631006 Standard Error 6 Observations 60 ANOVA Significance df SS MS F F 0.01788368 0.0178836 13.5644739 Regression 1 6 9 8 0.00050795 0.0013184 Residual 58 0.07646841 2 0.09435209 Total 59 6 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - 0.00320077 0.00500351 0.6397047 0.52488343 - 0.01321640 0.00681485 0.01321640 Intercept 3 7 2 7 0.006814854 1 4 1 0.66695586 0.18109047 3.6829979 1.02944784 1.02944784 X Variable 1 6 9 6 0.00050795 0.30446389 2 0.30446389 2 SUMMARY OUTPUT 119 Regression Statistics 0.36508140 Multiple R 7 0.13328443 R Square 4 Adjusted R 0.11444279 Square 1 0.03445727 Standard Error 5 Observations 48 ANOVA Significance df SS MS F F 0.00839890 7.07392849 Regression 1 2 0.0083989 6 0.010728361 0.05461597 Residual 46 5 0.0011873 0.06301487 Total 47 8 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - 0.00351387 0.00534326 0.51405508 - 0.01426930 0.00724155 0.01426930 Intercept 7 4 0.6576274 5 0.007241555 8 5 8 0.62522819 0.23507596 2.6596857 0.01072836 1.09841155 0.15204483 1.09841155 X Variable 1 4 2 9 1 0.152044833 5 3 5 SUMMARY OUTPUT Regression Statistics 0.36487364 Multiple R 9 R Square 0.13313278 Adjusted R 0.10763668 Square 5 0.03368394 Standard Error 1 Observations 36 ANOVA Significance df SS MS F F 0.00592457 0.0059245 Regression 1 4 7 5.22169301 0.028666845 0.03857666 0.0011346 Residual 34 7 1 0.04450124 Total 35 1 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - 0.00432255 0.00609191 0.48281764 - 0.01670282 0.00805771 0.01670282 Intercept 5 8 0.7095558 5 0.008057711 1 1 1 0.60201934 0.26345398 2.2851024 0.02866684 1.13742226 0.06661642 1.13742226 X Variable 1 5 9 1 5 0.066616425 5 5 5 SUMMARY OUTPUT Regression Statistics 0.20024667 Multiple R 1 120 0.04009872 R Square 9 Adjusted R Square -0.00353315 0.03842235 Standard Error 3 Observations 24 ANOVA Significance df SS MS F F 0.00135673 0.0013567 0.91902372 Regression 1 4 3 8 0.348149241 0.03247809 0.0014762 Residual 22 8 8 0.03383483 Total 23 2 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% 0.00887570 1.1729651 0.25335392 0.02881796 0.02881796 Intercept 0.01041089 2 9 7 -0.00799619 9 -0.00799619 9 - 0.37630349 0.39253184 0.9586572 0.34814924 - 0.43775771 X Variable 1 8 2 5 1 0.437757715 1.19036471 5 1.19036471 121 Summary Output for 5 year Regression: Regression Statistics 0.3320197 Multiple R 6 0.1102371 R Square 2 Adjusted R 0.0975262 Square 2 0.0416002 Standard Error 9 Observations 72 ANOVA Significance df SS MS F F 0.00438182 Regression 1 0.01500874 0.01500874 8.67264587 7 0.12114086 0.00173058 Residual 70 6 4 0.13614960 Total 71 6 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - - 0.0039553 0.00491646 0.80450308 0.00585027 0.00585027 Intercept 1 8 6 0.42383044 3 0.0137609 3 0.0137609 0.4163288 0.14137111 2.94493563 0.13437304 0.69828463 0.13437304 0.69828463 X Variable 1 4 7 1 0.004381827 1 7 1 7 SUMMARY OUTPUT Regression Statistics 0.4343632 Multiple R 5 0.1886714 R Square 3 Adjusted R 0.1746830 Square 1 0.0363295 Standard Error 6 Observations 60 ANOVA Significance df SS MS F F 0.01780154 0.01780154 0.00052505 Regression 1 5 5 13.48768383 8 0.07655055 0.00131983 Residual 58 1 7 0.09435209 Total 59 6 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - - 0.0053803 0.00483173 1.11355055 0.00429138 0.01505215 0.00429138 0.01505215 Intercept 8 6 5 0.270065675 8 4 8 4 0.6628582 0.18048950 3.67255821 0.30156921 0.30156921 X Variable 1 1 3 3 0.000525058 6 1.0241472 6 1.0241472 SUMMARY OUTPUT 122 Regression Statistics 0.3640733 Multiple R 7 0.1325494 R Square 2 Adjusted R Square 0.1136918 0.0344718 Standard Error 8 Observations 48 ANOVA Significance df SS MS F F 0.00835258 0.00835258 0.01096374 Regression 1 5 5 7.028957399 7 0.05466229 0.00118831 Residual 46 2 1 0.06301487 Total 47 8 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - - 0.00510546 1.11157308 0.00460167 0.01595186 0.00460167 0.01595186 Intercept 0.0056751 6 3 0.272097852 2 9 2 9 0.6221678 0.23467245 2.65121809 0.14979671 1.09453902 0.14979671 1.09453902 X Variable 1 7 9 7 0.010963747 8 2 8 2 SUMMARY OUTPUT Regression Statistics 0.3633691 Multiple R 7 0.1320371 R Square 6 Adjusted R 0.1065088 Square 4 0.0337052 Standard Error 2 Observations 36 ANOVA Significance df SS MS F F 0.00587581 0.00587581 Regression 1 7 7 5.172183749 0.02938054 0.03862542 0.00113604 Residual 34 4 2 0.04450124 Total 35 1 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - - 0.00578975 1.12954687 0.00522640 0.01830601 0.00522640 0.01830601 Intercept 0.0065398 9 9 0.266573568 2 1 2 1 0.5975265 0.26273637 2.27424355 0.06358195 1.13147107 0.06358195 1.13147107 X Variable 1 1 8 5 0.02938054 6 4 6 4 SUMMARY OUTPUT 123 Regression Statistics Multiple R 0.2016909 0.0406792 R Square 2 - Adjusted R 0.0029262 Square 7 0.0384107 Standard Error 3 Observations 24 ANOVA Significance df SS MS F F 0.00137637 0.00137637 0.34461081 Regression 1 5 5 0.932892187 8 0.03245845 0.00147538 Residual 22 7 4 0.03383483 Total 23 2 Standard Lower Upper Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0% - - 0.0118638 1.43512920 0.00528032 0.02900797 0.00528032 0.02900797 Intercept 3 0.00826673 6 0.165315371 3 3 3 3 - - 0.3770760 0.39040304 0.96586344 0.43257032 1.18672238 0.43257032 1.18672238 X Variable 1 3 4 1 0.344610818 8 4 8 4 124 Summary Output for 7 years Regression: Regression Statistics Multiple R 0.3324827 R Square 0.1105447 Adjusted R Square 0.0978382 Standard Error 0.0415931 Observations 72 ANOVA Significance df SS MS F F Regression 1 0.015050619 0.01505062 8.699852584 0.004324125 Residual 70 0.121098987 0.00172999 Total 71 0.136149606 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.0040547 0.004913173 0.82526785 0.412023183 0.005744331 0.013853699 0.005744331 0.013853699 X Variable 1 0.4168339 0.141321135 2.94955125 0.004324125 0.134977818 0.698690043 0.134977818 0.698690043 SUMMARY OUTPUT Regression Statistics Multiple R 0.4346462 R Square 0.1889173 Adjusted R Square 0.1749331 Standard Error 0.0363241 Observations 60 ANOVA Significance df SS MS F F Regression 1 0.017824741 0.01782474 13.5093522 0.00052017 Residual 58 0.076527355 0.00131944 Total 59 0.094352096 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.0055178 0.004821982 1.14429281 0.257202748 0.004134486 0.015170006 0.004134486 0.015170006 X Variable 1 0.6636547 0.180561412 3.67550707 0.00052017 0.302221813 1.025087676 0.302221813 1.025087676 SUMMARY OUTPUT Regression Statistics Multiple R 0.3645577 R Square 0.1329023 Adjusted R Square 0.1140523 125 Standard Error 0.0344649 Observations 48 ANOVA Significance df SS MS F F Regression 1 0.008374821 0.00837482 7.05053793 0.010850112 Residual 46 0.054640056 0.00118783 Total 47 0.063014878 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.0057642 0.005096683 1.13096721 0.263931022 0.004494909 0.016023271 0.004494909 0.016023271 X Variable 1 0.6230428 0.234642549 2.65528491 0.010850112 0.150731872 1.095353766 0.150731872 1.095353766 SUMMARY OUTPUT Regression Statistics Multiple R 0.3638731 R Square 0.1324036 Adjusted R Square 0.1068861 Standard Error 0.0336981 Observations 36 ANOVA Significance df SS MS F F Regression 1 0.005892126 0.00589213 5.188729985 0.029139883 Residual 34 0.038609115 0.00113556 Total 35 0.044501241 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.0065737 0.005784493 1.13642674 0.263724715 0.005181851 0.018329156 0.005181851 0.018329156 X Variable 1 0.5985578 0.262769886 2.2778784 0.029139883 0.064545191 1.132570502 0.064545191 1.132570502 SUMMARY OUTPUT Regression Statistics Multiple R 0.2019222 R Square 0.0407726 Adjusted R Square -0.0028287 Standard Error 0.0384089 Observations 24 ANOVA Significance df SS MS F F Regression 1 0.001379533 0.00137953 0.935124048 0.344046128 126 Residual 22 0.032455299 0.00147524 Total 23 0.033834832 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.0118681 0.008263963 1.43613257 0.165032745 0.005270264 0.029006557 0.005270264 0.029006557 - - X Variable 1 0.3775847 0.39046293 0.96701812 0.344046128 0.432185821 1.187355279 0.432185821 1.187355279 127 Summary Output for 10 years Regression: Regression Statistics Multiple R 0.33283841 R Square 0.11078141 Adjusted R Square 0.09807828 Standard Error 0.04158756 Observations 72 ANOVA Significance df SS MS F F Regression 1 0.015082845 0.0150828 8.72080108 0.004280236 Residual 70 0.121066761 0.0017295 Total 71 0.136149606 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.00414008 0.004910615 0.8430871 0.4020514 0.005653837 0.013933989 0.005653837 0.013933989 X Variable 1 0.41737099 0.141333161 2.9531002 0.00428024 0.135490895 0.699251089 0.135490895 0.699251089 SUMMARY OUTPUT Regression Statistics Multiple R 0.43498746 R Square 0.18921409 Adjusted R Square 0.17523502 Standard Error 0.03631741 Observations 60 ANOVA Significance df SS MS F F Regression 1 0.017852746 0.0178527 13.5355301 0.000514329 Residual 58 0.07649935 0.001319 Total 59 0.094352096 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.00564822 0.004812767 1.1735917 0.24535547 0.003985576 0.015282022 0.003985576 0.015282022 X Variable 1 0.66456822 0.180635014 3.6790665 0.00051433 0.302987961 1.026148486 0.302987961 1.026148486 SUMMARY OUTPUT Regression Statistics Multiple R 0.36505652 R Square 0.13326626 Adjusted R Square 0.11442422 128 Standard Error 0.03445764 Observations 48 ANOVA Significance df SS MS F F Regression 1 0.008397757 0.0083978 7.07281569 0.01073412 Residual 46 0.054617121 0.0011873 Total 47 0.063014878 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.00585903 0.005087653 1.1516172 0.25542894 0.004381885 0.016099942 0.004381885 0.016099942 X Variable 1 0.62392236 0.234603442 2.6594766 0.01073412 0.151690132 1.09615459 0.151690132 1.09615459 SUMMARY OUTPUT Regression Statistics Multiple R 0.36453186 R Square 0.13288347 Adjusted R Square 0.10738005 Standard Error 0.03368878 Observations 36 ANOVA Significance df SS MS F F Regression 1 0.00591348 0.0059135 5.21041637 0.02882772 Residual 34 0.038587761 0.0011349 Total 35 0.044501241 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.00661857 0.005777625 1.1455518 0.25998012 0.005122978 0.018360114 0.005122978 0.018360114 X Variable 1 0.59983644 0.262782616 2.2826336 0.02882772 0.065797916 1.133874966 0.065797916 1.133874966 SUMMARY OUTPUT Regression Statistics Multiple R 0.20229437 R Square 0.04092301 Adjusted R Square -0.0026714 Standard Error 0.03840585 Observations 24 ANOVA Significance df SS MS F F Regression 1 0.001384623 0.0013846 0.93872155 0.343138657 Residual 22 0.032450209 0.001475 129 Total 23 0.033834832 Standard Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% - - Intercept 0.0118796 0.008258076 1.4385428 0.16435543 0.005246605 0.029005795 0.005246605 0.029005795 - - X Variable 1 0.37842671 0.390583046 0.9688764 0.34313866 0.431592945 1.188446365 0.431592945 1.188446365 130 Cost of Debt: P/B = 1 + (ROE – Ke/ Ke – g) 33.874/5.77 = 1 + (.4 – Ke/Ke - .054) Ke = 11.293% Weighted Average Cost of Capital- WACC: • WAAC (Before Tax) = Vd/Vf * Kd + Ve/Vf * Ke o = $8,191,343/$10,033,026 * 5.649193% + $1,841,683/$10,033,026 * 11.293% = 2.5342% • WAAC (After Tax) = Vd/Vf * Kd (1-T) + Ve/Vf * Ke o = $8,191,343/$10,033,026 * 5.649193% (1-.35) + $1,841,683/$10,033,026 * 11.293% = 2.3728% 131 Discounted Dividends Model: Discounted Dividends Approach WACC(BT) 2.5342% Kd 3.67198% Ke 11.2930% 319.15 0 1 2 3 4 5 6 7 8 9 10 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Earnings 785.75 759.04 800.06 843.30 888.87 936.90 987.53 1040.90 1097.14 1156.43 1218.92 Dividends $461.24 $494.68 $542.56 $590.43 $638.30 $686.17 $734.05 $781.92 $829.79 $877.66 $925.54 687.48 Book Value of Equity $1,841.68 2106.04 2363.55 2616.42 2866.99 3117.71 3371.20 3630.18 3897.53 4176.30 4469.68 Cash From Operations- in millions $1,082.25 $1,140.73 $1,202.38 $1,267.35 $1,335.84 $1,408.02 $1,484.11 $1,564.31 $1,648.84 $1,737.94 Cash Investments- in millions- outflow 423 446 470 496 522 551 580 612 645 680 PV Factor 0.899 0.807 0.725 0.652 0.586 0.526 0.473 0.425 0.382 0.343 PV Dividends Year by Year 444.487 438.034 428.315 416.058 401.878 386.292 369.731 352.554 335.056 317.479 Total PV of Annual Dividends 3889.88 Continuing (Terminal) Value Perpetuity $6,087.70 PV of Terminal Value Perpetuity $2,088.21 Estimated Price per Share (end of 2007) 18.73 Time Consistency- Imp as of 5/1/07 $19.76 Observed Share Price $45.61 Initial Cost of Equity 0.11293 Perpetuity Growth Rate (g) 0 OUR ASSUMPTIONS: WACC(BT) = 2.5342%, Kd = 3.67198%, Ke = 11.293%, 319.15 million SHARES OUTSTANDING, HAVE A DIVIDEND INCREASE OF 15 CENTS PER YEAR Sensitivity Analysis: Growth 0 0.03 0.054 0.07 0.09 Cost of Equity 0.07 $31.74 $43.88 $86.36 N/A N/A 0.09 $24.76 $30.04 $40.59 $61.70 N/A 0.11293 $19.76 $22.26 $26.09 $31.02 $46.85 0.13 $17.17 $18.73 $20.86 $23.23 $28.85 0.15 $14.88 $15.83 $17.02 $18.21 $20.59 132 Free Cash Flows Model: WACC(BT) 2.5342% Kd 3.67198% Ke 11.2930% 0 1 2 3 4 5 6 7 8 9 10 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Earnings 785.75 759.04 800.06 843.30 888.87 936.90 987.53 1040.90 1097.14 1156.43 1218.92 Dividends $461.24 $494.68 $542.56 $590.43 $638.30 $686.17 $734.05 $781.92 $829.79 $877.66 $925.54 Book Value of Equity $1,841.68 2106.04 2363.55 2616.42 2866.99 3117.71 3371.20 3630.18 3897.53 4176.30 4469.68 Cash From Operations $1,082.25 $1,140.73 $1,202.38 $1,267.35 $1,335.84 $1,408.02 $1,484.11 $1,564.31 $1,648.84 $1,737.94 Cash Investments 423 446 470 496 522 551 580 612 645 680 Book Value of Debt and Preferred Stock $8,191.42 Annual Free Cash Flow $659 $695 $732 $772 $813 $857 $904 $953 $1,004 $1,058 $845 PV Factor 0.899 0.807 0.725 0.652 0.586 0.526 0.473 0.425 0.382 0.343 PV of Free Cash Flows $592 $561 $531 $503 $476 $451 $427 $405 $383 $363 Total PV of Annual Free Cash Flows $4,693 $ Continuing (Terminal) Value Perpetuity 33,334 $ PV of Terminal Value Perpetuity 11,434 Value of Firm $16,128 Book Value of Liabilities $8,191.42 g Estimated Market Value of Equity $7,936 Number of Shares 319.15 0 0.02 0.054 0.07 0.09 Estimated Price per Share (end of 2007) $24.87 0 N/A N/A N/A N/A N/A FV of Time consistent model $25.18 0.01 80.23 N/A N/A N/A N/A WACC 0.0253 25.24 162.37 N/A N/A N/A Observed Share Price $45.61 0.03 19.59 81.02 N/A N/A N/A Initial WACC 2.5342% 0.04 11.97 35.12 N/A N/A N/A Perpetuity Growth Rate (g) 0.0% 133 Residual Income: WACC(BT) 2.534% Kd 3.672% Ke 11.293% 0 1 2 3 4 5 6 7 8 9 10 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Earnings 785.75 759.04 800.06 843.30 888.87 936.90 987.53 1040.90 1097.14 1156.43 1218.92 Dividends $461.24 $494.68 $542.56 $590.43 $638.30 $686.17 $734.05 $781.92 $829.79 $877.66 $925.54 Book Value of Equity $1,841.68 2106.04 2363.55 2616.42 2866.99 3117.71 3371.20 3630.18 3897.53 4176.30 4469.68 Cash From Operations $1,082.25 $1,140.73 $1,202.38 $1,267.35 $1,335.84 $1,408.02 $1,484.11 $1,564.31 $1,648.84 $1,737.94 Actual EPS 759.04 800.06 843.30 888.87 936.90 987.53 1040.90 1097.14 1156.43 1218.92 "Normal" (Benchmark) Earnings 207.926 237.772 266.844 295.393 323.683 351.990 380.608 409.847 440.031 471.504 Residual Income (Annual) 551.114 562.288 576.456 593.477 613.217 635.540 660.292 687.293 716.399 747.416 634.349 PV Factor 0.899 0.807 0.725 0.652 0.586 0.526 0.473 0.425 0.382 0.343 PV of Annual Residual Income 495.205 453.990 418.213 386.882 359.198 334.508 312.279 292.074 273.558 256.449 Total PV of Annual Residual Income 3582.356 Continuing (Terminal) Value Perpetuity 5618.681 g 5618.681 PV of Terminal Value Perpetuity 1927.849 0 0.02 0.054 0.07 0.09 Initial Book Value of Equity $1,841.68 Ke 0.07 40.88 48.07 101.5 N/A N/A Book Value of Liabilities 8191.34 0.09 31.17 34.26 47.36 68.95 N/A Estimated Price per Share $23.04 0.11293 24.29 25.66 30.13 34.68 49.29 Time Consistent $24.30 0.13 20.77 21.57 23.90 25.9 30.67 0.15 17.68 18.13 19.31 20.22 22.03 Observed Share Price $45.61 Initial Cost of Equity 0.1129 Perpetuity Growth Rate (g) 0 134 Long Run Return on Equity Residual Income Model: Book Value of Equity 5.77 Long Run Return on Equity 0.2919 Long Run Growth Rate in Equity 0.054 Cost of Equity 0.11293 Estimated Price per Share (end of 2007) 23.29 Time Consistent Price 24.57 Observed Share Price $45.61 WACC(BT) 0.02534 Kd 0.0367 Ke 0.11293 0 1 2 3 4 5 6 7 8 9 10 2007 2008 2009 2010 2011 2012 2013 2014 205 2016 2017 Earnings 785.75 759.04 800.06 843.30 888.87 936.90 987.53 1040.90 1097.14 1156.43 1218.92 Dividends $461.24 $494.68 $542.56 $590.43 $638.30 $686.17 $734.05 $781.92 $829.79 $877.66 $925.54 Book Value of Equity $1,841.68 2106.04 2363.55 2616.42 2866.99 3117.71 3371.20 3630.18 3897.53 4176.30 4469.68 Return on Equity 41.21% 37.99% 35.68% 33.97% 32.68% 31.67% 30.88% 30.22% 29.67% 29.19% BVE Growth 14.35% 12.23% 10.70% 9.58% 8.75% 8.13% 7.68% 7.36% 7.15% 7.03% Average ROE 33.32% Average BE Growth 9.30% 135 g 0 0.03 0.054 0.07 0.09 Ke 0.07 $24.73 $38.80 $88.04 N/A N/A $ 0.09 $19.41 $26.10 $39.49 66.26 N/A $ $ 0.11293 $15.63 $19.08 $24.38 31.19 53.09 $ $ 0.13 $13.68 $15.95 $19.05 22.49 30.67 $ $ 0.15 $11.96 $13.41 $15.21 17.02 20.63 ROE 0.25 0.27 0.2919 0.31 0.33 $ $ Ke 0.07 $73.11 $80.58 $88.74 95.50 102.96 $ $ 0.09 $32.80 $36.14 $39.81 42.84 46.18 $ $ 0.11293 $20.25 $22.31 $24.57 26.44 28.51 $ $ 0.13 $15.82 $17.43 $19.20 20.66 22.27 $ $ 0.15 $12.63 $13.92 $15.33 16.50 17.79 g 0 0.03 0.054 0.07 0.09 $ $ ROE 0.25 $13.48 $16.15 $20.25 25.52 42.47 $ $ 0.27 $14.55 $17.62 $22.31 28.36 47.78 $ $ 0.2919 $15.73 $19.22 $20.25 31.46 53.60 $ $ 0.31 $16.71 $20.55 $24.57 34.03 58.40 $ $ 0.33 $17.79 $22.02 $28.51 36.87 63.71 136 Abnormal Earnings Growth Model: 1 2 3 4 5 6 7 8 9 Perp Forecast Years 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 EPS 785.75 759.04 800.06 843.30 888.87 936.90 987.53 1040.90 1097.14 1156.43 1218.92 DPS $461.24 $494.68 $542.56 $590.43 $638.30 $686.17 $734.05 $781.92 $829.79 $877.66 $925.54 DPS invested at 15% (Drip) 55.865 61.271 66.677 72.083 77.490 82.896 88.302 93.708 99.114 Cum-Dividend Earnings $855.925 $904.571 $955.547 $1,008.983 $1,065.020 $1,123.796 $1,185.442 $1,250.138 $1,318.034 Normal Earnings $844.758 $890.411 $938.534 $989.250 $1,042.704 $1,099.052 $1,158.449 $1,221.040 $1,287.026 Abnormal Earning Growth (AEG) $11.17 $14.16 $17.01 $19.73 $22.32 $24.74 $26.99 $29.10 $31.01 $21.80 PV Factor $0.899 $0.807 $0.725 $0.652 $0.586 $0.526 $0.473 $0.425 $0.382 PV of AEG $10.033 $11.432 $12.342 $12.862 $13.070 $13.022 $12.764 $12.363 $11.838 Residual Income Check Figure $11.17 $14.17 $17.02 $19.74 $22.32 $24.75 $27.00 $29.11 $31.02 Core EPS $759.04 Total PV of AEG $109.73 Continuing (Terminal) Value $193.07 PV of Terminal Value $73.71 Total PV of AEG $183.43 Total Average EPS Perp (t+1) $942.47 Capitalization Rate (perpetuity) 0.11293 Intrinsic Value Per Share (end 1987) $26.15 time consistent implied price 27.59 Nov 1, 1988 observed price $45.61 Ke 0.11293 G 0 Sensitivity Actual Price per share $45.61 Growth 0 0.03 0.054 0.07 0.09 Ke 0.07 $56.59 $65.48 $96.58 N/A N/A 0.09 $38.48 $41.06 $46.22 $ 56.54 N/A 0.11293 $27.59 $28.37 $29.56 $ 31.10 $ 36.05 0.13 $22.61 $22.95 $23.42 $ 23.94 $ 25.18 0.15 $18.58 $18.71 $18.87 $ 19.04 $ 19.36 137 Methods of Comparables: 2007 Company EPS BPS DPS PPS share size Heinz 2.46 5.77 1.49 45.61 319.15 Campbells 2.22 3.37 0.84 36.42 384.11 Sara Lee 0.70 3.61 0.40 16.06 724.53 Conagra 1.75 9.41 0.73 23.29 487.25 Company P/E Forward P/E trailing P/B D/P P.E.G. Heinz 19.16 18.53 7.90 0.03 2.45 Campbells 16.38 17.27 10.80 0.02 2.60 Sara Lee 23.09 33.33 4.45 0.02 2.42 Conagra 13.29 16.25 2.48 0.03 2.00 EBITDA P/EBITDA FCF P/FCF EV EV/EBITDA 1.76 25.91 4.46 10.24 19.63 11.15 1.15 31.67 3.96 9.20 16.73 11.08 1.37 11.72 -0.09 -187.68 14.05 10.26 1.80 12.94 0.86 26.99 15.46 8.59 2007 Actual Price $45.61 P/E Trailing $54.82 P/E Forward $36.76 P/B $30.79 D/P $14.37 P.E.G. $30.09 P/EBITDA $33.07 P/FCF $10.74 EV/EBITDA $54.03 138 References: 1. Heinz Website: www.heinz.com 2007 Annual Report 2003-2007 10K 2. Campbell’s Website: www.campbells.com 2003-2007 10K 3. ConAgra Website: www.conagrafoods.com 2003-2007 10K 4. Sara Lee Website: www.saralee.com 2003-2007 10K 5. Business Analysis and Valuation- Fourth Edition by Palepu and Healy 6. Investor Words: www.investorwords.com 7. http://beginnersinvest.about.com 8. http://pages.stern.nyu.edu 9. Yahoo Finance: www.finance.yahoo.com 10. ES3 LLC.: www.es3.com 11. www.investopedia.com 12. www.answers.com 13. research.stlouisfed.org/fred2 139