sara lee equity analysis and valuation - mark e....
TRANSCRIPT
Sara Lee Equity Analysis and Valuation Valued at 1 April 1, 2007
Analysts: Todd L. Ehlers: [email protected]
Michael D. Estes: [email protected] Daniel W. Taylor: [email protected]
Joseph R. Torres: [email protected]
1
Table of Contents Page Number
Executive Summary……………………………………………………………………………………………… 2 Analysis Snapshot............................................................................................ 2 Company and Industry Overview…………………………………………………………………… 3 Accounting Analysis………………………………………………………………………………………. 3 Financial Ratio Analysis…………………………………………………………………………………. 4 Analysts Evaluations……………………………………………………………………………………… 4 Overview of Firm and Industry............................................................................... 5 Industry Overview and Analysis………………………………………………………………………….. 8 Rivalry Among Existing Firms…………………………………………………………………………. 8 Threat of New Entrants…………………………………………………………………………………. 15 Threat of Substitute Products………………………………………………………………………… 17 Bargaining Power of Buyers…………………………………………………………………………… 18 Bargaining Power of Suppliers……………………………………………………………………….. 20 Characterization of Industry…………………………………………………………………………… 20 Value Chain Analysis: Key Success Factors…………………………………………………………. 21 Competitive Advantage Analysis…………………………………………………………………………. 23 Cost Leadership……………………………………………………………………………………………. 24 Differentiation……………………………………………………………………………………………….27 Accounting Analysis……………………………………………………………………………………………… 30 Key Accounting Policies…………………………………………………………………………………. 30 Accounting Flexibility……………………………………………………………………………………..33 Accounting Strategies…………………………………………………………………………………… 36 Quality of Disclosure…………………………………………………………………………………….. 41 Manipulation Diagnostics………………………………………………………………………………. 43 Potential Red Flags………………………………………………………………………………………. 49 Undo Accounting Distortions………………………………………………………………………….. 51 Ratio Analysis and Forecast Financials………………………………………………………………… 51 Time Series Analysis/Cross-Sectional Ratios……………………………………………………. 52 Liquidity Ratios…………………………………………………………………………………………….. 52 Profitability Ratios………………………………………………………………………………………… 66 Capital Structure Ratios………………………………………………………………………………… 78 SGR and IGR Analysis…………………………………………………………………………………… 83
Forecast of Financial Statements……………………………………………………………………. 85 Cost of Capital………………………………………………………………………………………………………. 92 Valuations…………………………………………………………………………………………………………….. 95 Method of Comparables………………………………………………………………………………… 96 Discounted Dividends Model………………………………………………………………………….. 100 Discounted Free Cash Flow Model………………………………………………………………….. 101 Residual Income Model…………………………………………………………………………………. 102 Abnormal Earnings Growth Model………………………………………………………………….. 103 Long Run ROE……………………………………………………………………………………………… 105 Credit Risk Analysis……………………………………………………………………………………………… 106 Analyst Recommendation……………………………………………………………………………………..107 Appendix………………………………………………………………………………………………………………. 109 References……………………………………………………………………………………………………………. 132
2
Executive Summary
Investment Recommendation: Overvalued, Sell 4/1/2007
SLE- NYSE $16.92 52 Week Range $14.35 - $18.69 Revenue (2006) $15.9 Bil. Market Capitalization $12.96 Bil. Shares Outstanding 766,000,000 Dividend Yield 2.40% 3-Month Avg. Daily Trading Volume 3,654,200 Percent Institutional Ownership 69% Book Value Per Share (mrq) $3.22 ROE 22.7% ROA 3.8% Estimated 5-yr EPS Growth Rate 4.0% Cost of Capital Est. Beta R^2 Ke Ke Estimated 8.49% 10-year .652 .183 9.64% 7-year .648 .181 7.63% 5-year .650 .182 7.66% 1-year .655 .1845 8.29% 3-month .655 .1846 8.49% Kd 5.53% WACC 6.07% Altman Z-score 2.327
EPS Forecast 2006(A) 2007(E) 2008(E) 2009(E) EPS $0.72 $1.10 $1.14 $1.19 Method of Comparables SLE Industry Trailing P/E $21.59 $15.63 Forward P/E $22.25 $18.09 PEG $23.18 $19.28 P/B $4.98 $2.63 P/S $0.77 $1.70 D/P $0.49 $0.27 Valuation Estimates Actual Current Price $16.92 Ratio Based Valuations P/E Trailing $14.22 P/E Forward $13.02 PEG Forward $13.32 P/B $8.47 P/S $35.38 D/P $2.93 Enterprise Value $29.77 Intrinsic Based Valuations Discounted Dividends $11.24 Free Cash Flows $26.02 Residual Income $9.44 Abnormal Earnings Growth $7.29 Long-Run Residual Income Perpetuity $10.27
3
Company and Industry Overview and Analysis
Sara Lee is a major player in the packaged and processed foods industry.
Sara Lee started in Baltimore in 1939 as the C. D. Kenny Company. It adopted
its current name in 1985, and they are now based in Chicago. Sara Lee makes
products from bread all the way to sausage. Other major competitors include
companies such as Pepsico, Kraft, General Mills, and Unilever. Sara Lee operates
within a highly competitive and mature industry that leaves little room for
extraordinary profits. Cost leadership is the number one factor in competition in
this highly competitive industry with possible small benefits to be gained from
differentiation strategies. On the other hand there is little threat from substitute
products given that food is always going to be a needed commodity. We feel
that this industry will under go few changes in the foreseeable future.
Accounting Analysis
The information that we used to base our report on was mostly found in
Sara Lee’s 10-k report and their annual reports. The 10-k contains a plethora of
information, and after careful review can provide the reader with a vast
knowledge of how a company performs its operations on a day-to-day basis.
The 10-k provides all of the financial statements and other pertinent accounting
information.
We have found that Sara Lee usually stays on the conservative side of
accounting procedures when drafting its various reports to be sent to the SEC
and general public. Sara Lee is also a very well disclosed company. Sara Lee
breaks down its information and gives the reader lots of insight into the
operations of the company. The extensiveness of the 10-k made the job of
analyzing the company more productive and effective.
4
Financial Ratio Analysis
By analyzing Sara Lee’s financial ratios we were able to get a better
understanding of how Sara Lee stands within its respective industry. Sara Lee’s
liquidity standing is fairly comparable to its competitors showing that it is able to
remain liquid while profitably conducting business. The only anomaly was from
inventory levels which appeared to be inefficient at times, but improvement is a
major focus of recent restructuring activities. Sara Lee’s low level of inventory
turnover results in lower percentage of working capital. This is showing that
cash is being held in inventory. The profitability analysis shows mostly negative
traits for Sara Lee in 2005 and 2006 with low profit margins, which are due to
higher expense ratios. Even with these negative signs Sara Lee has maintained
a higher return on equity than its competitors. We feel that Sara Lee will correct
recent problems and return to its recent performances after restructuring takes
effect. Sara Lee demonstrates a capital structure that is made up heavily of
debt. It maintained an average of approximately 4 to 1 for debt to equity for the
past 5 years. This has proven to be an effective strategy, though, since Sara Lee
has been able to earn more than its cost of debt, which is shown again by a high
return on equity.
Analysis Evaluations
We used several different valuation models to determine whether Sara
Lee was fairly valued or not. The different models that we used were the
discounted dividends model, discounted free cash flows model, residual income
model, abnormal earnings growth model, long run ROE perpetuity, and method
of comparables. After careful evaluation of each model we arrive to the
conclusion that Sara Lee is overvalued. We believe the stock price per share
should be around $9.44. The residual income model gave us the best estimate
5
of value. Sara Lee’s current share price is $16.92, so Sara Lee is, in our opinion,
greatly overvalued and a sell opportunity.
Overview of Firm and Industry
Sara Lee Corporation is one of the largest global manufacturers of brand
name consumer products around the world. Over the past several years, Sara
Lee has been a major player in producing and providing customers with a
number of household and retail products. In 2006, Sara Lee disposed of a
number of their select businesses in order to help it focus on its key food,
beverage, and household product business (Sara Lee Corp 10-K). By doing this,
it allowed Sara Lee to organize the company into seven distinct business
segments: North American Retail Meats, International Beverage, International
Bakery, North American Retail Bakery, Foodservice Household and Body Care
and Branded Apparel. What is known today as Sara Lee Corporation was
originally organized in Baltimore, Maryland in 1939 as the C.D. Kenny Company,
and eventually adopted its current name in 1985. They currently hold many of
its main corporate offices in Chicago, Illinois and operate more than 440 facilities
and manufacturing plants across the United States, as well as internationally.
Sara Lee’s competitors include Unilever, General Mills Inc., Campbell Soup Co.,
ConAgra Food Inc., McCormick Co. Inc., and Kraft Foods Inc.
(yahoo.com/finance).
6
Sara Lee’s Sales Volume Fiscal Year End: June TTM = 12 Trailing Months
(MorningStar.com)
Sara Lee’s sales volume has increased steadily from 2002 to 2004, with a
slight decrease in sales in 2005 and 2006. This was mainly an effect of it selling
off a number of its companies, as well as a spin-off of one of its major American
and Asian apparel brands; HanesbrandsInc. Ending in year 2002, sales were
around 17.6 billion with a steady increase to around 19.5 billion in 2004. The
selling off of a large number of its companies dropped sales to around 15.9
billion over the next two years ending in 2006. Sara Lee’s market cap grew from
14.7 billion in 2002 to around 17.4 billion in 2004. Market cap has decreased
over the last two years to 12.84 billion in 2006; a 10% decrease. Sara Lee ranks
4th in market cap in the overall industry, with Unilever leading the industry with
a market cap of 76.49 billion.
7
Sara Lee continues to be a dominant competitor in the industry with a
positive change in sales growth of around 11% from 2002 to 2004. Net Sales for
the first quarter of fiscal 2007, ending September 30, 2006, were $2.9 billion,
which was an increase of 5% compared to $2.8 billion in the prior years first
quarter (MorningStar.com). Sara Lee’s stock price steadily rose from $18.74 to
$21.96 in 2002 to 2004, preceding a drop in price over the next two years;
$19.93 to $16.90 from 2005 to 2006. This could be a result of steadily reducing
its number of total assets while also increasing its total liabilities from 2003 to
2006. Sara Lee also issued an average dividend of around $0.164 each quarter
from 2002 to 2006. Starting in 2006 Sara Lee for the first time in over two years
was able to grow in all segments, helping it increase its sales in both of its North
American retail bakery and international beverage division by 8%. Sara Lee is a
highly diverse company that process and manufacturer a number of different
consumer based products, such as: meats, bakery goods, coffee and beverage
products, shoe care products, air freshener products, as well as body care
products. Because of this, Sara Lee is able to compete in a variety of markets,
where its drive is to lead the market as well as inspire repeat purchases on its
branded consumer packaged goods.
8
Industry Overview and Analysis: Five Forces
In order to analyze a firm properly an analyst must understand the factors
and forces that control the decisions made within the industry of the firm. The
five forces model contains items concerning competition and bargaining power.
The model can easily be seen by the chart below (Palepu).
Rivalry Among Existing Firms
The profitability of a firm often relies heavily on the profitability of firms it
competes with in its industry. Companies must always keep a close eye on their
competitors and watch how their competitors are doing business. They will
either compete aggressively or non-aggressively. The firms can compete on
price or other non-price strategies.
Rivalry Among Existing Firms
High
Threat of New Entrants Low
Threat of Substitute Products
Low
Bargaining Power of Buyers High
Bargaining Power of Suppliers
Low
Industry Profitability
Low
9
Industry Growth
Growth within an industry is always a concern for companies competing
against one another. If one company does not take advantage of possible
growth their competitor will. One of two characteristics can be used to describe
an industry in terms of growth. Either the industry is growing fast enough for
companies to freely expand or it grows slowly causing growth of a company to
be at the expense of another company. Sara Lee is a major competitor in the
processed and packaged goods industry. This market has many competitors
including around ten that make a great impact on the industry. Current
competitors of Sara Lee include companies such as Pepsico, Unilever, and
General Mills. Many of the main players in this industry stay between 10 and 15
billion dollars in market capitalization (far behind Pepsico and Unilever). Such
firms include Sara Lee. In order to insure its place among the top in its industry,
Sara Lee has developed a long-term transformation plan. This plan was
launched in February 2005. The company feels that this plan will give them
opportunity to ensure long-term growth. The plan as four key aspects: disposing
of unneeded businesses, reorganizing continuing operations, improving
operational efficiency, and to consolidate the North American and the European
operations to one central headquarter for each.
10
0
10000
20000
30000
40000
50000
60000
Ass
ests
(in
mill
ions
)
2002 2003 2004 2005 2006
Assets
Sara LeeUnileverKraft KellogsGeneral Mills
The graph above showing the asset levels of each major firm within the
industry gives a look at the amount of market share held by each one. Kraft and
Unilever hold approximately two and three times more assets respectively than
the other competitors shown. General Mills, Kellogs and Sara Lee have remained
at fairly equal rates from 2002 to 2006. The firm’s entire asset levels have
remained at consistent levels even with major differences in size within the
industry this shows a high level of industry competition with little chance for
growth.
11
0
10000
20000
30000
40000
50000
60000
Sale
s (in
mill
ions
)
2002 2003 2004 2005 2006
Sales
Sara Lee
UnileverKraft Kellogs
General Mills
The graph showing sales levels helps to further confirm the findings from
the asset chart. This indicates that sales are a steady trend within the industry.
The firms shown have little fluctuation over the 5 year period. This graph also
indicates that there is a strong correlation between the level of assets and the
level of sales. Asset turnover which shows the amount of sales dollars generated
by each dollar of assets seems to be at equal ratios further stressing high
competition levels and low ability to gain competitive advantages.
-0.2
-0.1
0
0.1
0.2
0.3
0.4
Sale
s (in
mill
ions
)
2002 2003 2004 2005 2006
Sales Growth
Sara Lee
UnileverKraft Kellogs
General Mills
The chart showing the sales growths of industry firms over the past 5
years also shows that sales growth in this industry is somewhat equal. In 2003
12
this trend varied somewhat with General Mills having an unusually high growth in
sales and Unilever also moderately higher than competitors. This trend again
varied in 2005 with Sara Lee and Unilever having steep declines in sale levels.
Another slight distortion in found in 2006 when Kellogs demonstrated a high
sales growth rate in comparison to the other firms. Even given these anomalies
the data overall indicates that sales growth is a somewhat common trend in the
packaged foods industry.
Overall, the processed and packaged goods industry is growing relatively
slow and we expect this trend will continue. Many of the companies are
reaching peaks in this well-saturated market. Companies like Sara Lee, can still
grow but only when they steal customers from their competitors. Company
strategies like the one described above can be used to gain a little ground
against giants such as Unilever.
Concentration
The concentration of a market is a key factor in how a company is able to
conduct business within its industry. High concentration results when there are
few companies in an industry, and low concentration results when there are
many companies in an industry. The difference in how these two industries
operate is significant. High concentration has far less competition and prices are
not near as significant as in low concentration. As mentioned before, Sara Lee
has many competitors. This means their industry has a low concentration. This
low concentration is represented in all of Sara Lee’s many product lines. As a
result, this low concentration forces companies in the processed and packaged
goods industry to compete heavily on price. Sara Lee and its counterparts alike
must keep constant watch on each other.
13
0%
20%
40%
60%
80%
100%
Mar
ket S
hare
2002 2003 2004 2005 2006
Market Share
Sara LeeUnileverKraft KellogsGeneral Mills
Market shares represented in the graph above confirm the data found in
the other charts showing that this industry is a relatively stagnant one. Of the
firms shown above, Unilever has consistently been the dominant firm when it
comes to the share of the market that it holds. While firms such as Kellogs and
General Mills have low market shares with little or no variation.
Differentiation and Switching Costs
Differentiation is how a company can distinguish its products from the
competitor’s products. The more differentiation a company has the less direct
competition the company will face. In Sara Lee’s industry, product differentiation
proves difficult. For example, a company’s bread is put on the shelf next to a
wide assortment of other breads. Such breads include Mrs. Baird’s, Sunbeam,
Wonder, and Pepperidge Farm. When so many options are available price
becomes the only way for a company to differentiate itself from the rest of the
competitors.
Switching costs is the amount that it costs a consumer to switch from one
company to another company. High switching costs will keep consumers with a
14
particular company, while low switching costs allow the consumers to easily
switch from one company to another. This industry produces breads, meats,
beverages, household products, and body care products that can be bought at
any major retailer right alongside all of their competition. Switching costs for
consumers are zero. Again, just like differentiation, switching costs force
companies in this industry to make price their main competitive edge.
Exit Barriers
Exit barriers are simply what stand between a company and its ability to
leave a particular market. Companies may leave one particular market to pursue
other ventures that may be more profitable. The common trend among
companies in the processed and packaged goods industry is to have many
product lines. Sara Lee, for example, has products from meat all the way to
insecticides. Unilever, McCormick, and others in the industry are not different.
For a company like Sara Lee to completely change industries would be
impossible. Although, Sara Lee could and has exited from individual product
lines it carries. One major example of this is when Sara Lee spun off its branded
clothing division into a completely separate company. In a process that was
completed within the last year, Sara Lee spun off popular brands such as Hanes
and Wonderbra. .Therefore exit barriers in this industry are low and an exit or
transformation can be done with little resistance.
The processed and packaged good industry demonstrates a high level of
rivalry among the existing firms. With little industry growth and high competition
there is not much chance of a firm quickly gaining more market than what it
currently has. In order for a firm to maintain or grow its position it will have to
remain highly competitive. This information indicates that this industry is mature
and has little potential for abnormal profits or chance of high growth.
15
Threats of New Entrants
In any industry, companies must be aware of the threat of new entrants
joining its particular market. The more companies that join an industry will, on
some scale, threaten or even damage the existing company’s earnings. The
threat of new entrants exist when markets look easy and attractive to join, low
startup costs for companies, low switching costs for customers, and any
abnormal profits or earnings. In this specific industry of processed and packaged
goods, it is difficult for new companies to join because of the competitiveness,
the advantage of the first movers, and the relationships already established with
suppliers and distributors of existing companies.
Economies of Scale
For companies new to this industry, economies of scale are important to
determine what types of things they must invest in to try to gain market share
with existing firms. Firms in this industry have extremely large asset bases, like
Unilever with 45 billion in assets; this allows them to operate with economies of
scale and would be hard for an entering firm to achieve. Even smaller firms such
as Sara Lee and General Mills maintain assets valued at 14 billion and 18 billion
respectively. Since most companies in this market sell to distributors, it’s a
bidding war to get your product to be included in the major distributor’s
inventory. This gives all the power to the distributors, which causes the industry
to be very competitive. When a new company comes around, they might need
to invest high costs in brand advertising to reach customers who are already
familiar with existing brands. A company like Sara Lee will not have to do this.
With such a strong presence of economies of scale and maturity in this industry
there is little chance of new firms being able to gain access to the market and
16
compete. This creates a very large barrier for new companies to join this
industry.
First Mover Advantage
First mover advantages in this industry are created when a company has
strong relationships with distributors and suppliers. Typically those companies,
like Sara Lee, have been around for a long time to establish those relationships.
The first mover advantages in this industry are very important to the success of
competing companies. The top companies (PepsiCo, General Mills, Kellogg, and
Sara Lee) have all been around at least 65 years, and customers are already
aware of their brands and products. Brand awareness is essential because
suppliers and consumers typically choose the brands they are familiar with, and
ones that are cheap. When a company has this first mover advantage, it makes
it easier to compete with prices because they don’t have to spend a lot on
marketing or advertising to get customers familiar with their brands. In order to
utilize the first mover advantage, companies have to try and find new ways to
make their brands as recognizable as possible so that customers can gain
familiarization and trust with certain brands. Sara Lee attempts this by
spreading their brands to many different markets such as food, beverage,
household, body care, and apparel (which was spun off recently). Low switching
costs, however, can actually make joining this industry easier for new companies
because with such a highly competitive market and with the products being sold
by these companies not having much difference with each other, a new company
might not have many problems making customers switch brands.
Distribution Access
The access to distribution probably poses the biggest difficulties to new
entrants. The distributors in the processed and packaged goods industry, such
17
as Wal-Mart, have a lot of power in deciding what brands they are going to
carry. It is a lot less risky for these distributors to carry a brand that they
already know about and that already has loyal customers that go to certain
distributors to buy their preferred brands. Sara Lee currently sells 15.6% of their
total Net Sales to Wal-Mart (their biggest customer). Establishing relationships
with these distributors in this industry takes time, and it would be difficult for
new companies to come and get access to the big distributors who already have
the brands that they usually buy from.
Overall, the threat of new entrants in the processed and packaged goods
industry is fairly low due to the difficulties to compete with the big, existing
companies. The most effective way to prove this is by showing that the leaders
in this industry have all been in business a very long time. Since Sara Lee has
been around since 1939, it has already had the opportunity to work with retailers
and gain a strong hold in the distribution channels. Firms trying to enter this
industry would find great difficulty trying to duplicate such distribution access.
Threat of Substitute Products
A substitute product is any product that can be consumed in the place of
another product. A substitute product does not have to be identical; it only has
to perform the same function. The threat of a substitute product is important
because a substitute product forces the industry to change and adapt to the
market. Without a substitute product the market is forced to change and adapt
to the industry. When the threat of a substitute product is high the industry
becomes a price taker and unless the food industry can cut cost in operations or
production they will see a reduction in their profit margin when competing with a
substitute products’ prices. A low threat of substitute products means there is
little or no competition and the industry does not have to conform to or compete
18
with the market and therefore is able to determine any market price for their
product. In this situation profit potential is unlimited and determined by the
industries price and the consumers’ willingness to purchase the industries
product.
The food industry produces a product that is a necessity for its customers
and consumers will always be willing to purchase. The only threat to the
processed and packaged foods industry in terms of substitute products would
come from sources such as restaurants and possibly organic foods. This threat
appears to be minimal since the even given the slight increase in organic food
sales which most likely is a fad. And competition with restaurants is long
established and unlikely to undergo any major changes. Therefore, the only
potential caps on profitability for the food industry are a moral obligation to its
customers and American or international government regulation. The food
industry supplies a product that its customers cannot live without and therefore
could be morally responsible to charge a price that is affordable at every income
level. As with every industry the government could place a cap on prices to
uphold the industries moral responsibility. The possibility that another industry
would be able to replicate the function of food without making a food product is
extremely unlikely if not impossible. There is a low threat of substitute products
to the food industry, because buyers’ have to have the product and the product
is extremely hard to replicate.
Bargaining Power of Buyers
Customers bargaining power in an industry is an important part of
determining industry profitability, because it relates to a firms ability to set prices
in the market, and determine what kind of class their industry is, ranging from
perfect competition to a monopoly. If customers set prices then the firm has
19
little chance for supernormal profits. There are two factors that determine
bargaining power of the customer. One factor is price sensitivity which is the
extent buyers will go to in order to bargain on price. If products are
undifferentiated then bargaining power is high, because buyers have many
options. The other factor contributing to the buyer's power is their relative
bargaining power which is ultimately the opportunity cost of one party not doing
business with the other party. Buyer's relative bargaining power will be high in a
market where the number of sellers is high in relation to the number of buyers.
If the market has many product alternatives then buyer's power will also be high.
Another consideration in assessing the customer’s power is their volume of
purchases. For example a mass retailer such as wal-mart has a great deal of
power over its suppliers do to their large amount of purchases.
In the processed and packaged good industry the buyers have a
relatively high bargaining power. This is due to the products offered generally
being undifferentiated giving customers the option to easily buy alternative
products. Also the brand-name consumer products industry is intensely
competitive with a large number of firms. In order to protect their existing
market share or gain new market share in a highly competitive retail
environment firms will have to be able to offer competitive prices on products to
meet the buyer's demands. Such pressures also may restrict the ability to
increase prices in response to raw material and other cost increases, which could
possibly lead to lower profit margins. Firms may try to offset these forces by
introducing new products to the market and by promoting their existing products
through advertising campaigns. Another way firms attempt to offset buyer's
power is by producing high quality products to try and gain customer loyalty and
repeat business. They also may try to cut cost through vertical integration by
owning and operating production and manufacturing facilities. Even with these
measures in place, customers have substantial bargaining power relative to the
firms in the processed and packaged good industry.
20
Bargaining Power of Suppliers
Bargaining power of suppliers is a mirror image of the bargaining power of
buyers. The power of suppliers directly relates to a firms ability to control cost
and ultimately profits. Firms will have buyer power if the number of suppliers
offering the same product is high due to the ease of switching suppliers with
little costs. Also, if a supplier sells large quantities to a single buyer then the
buyer will have the bargaining power. In the processed and packaged good
industry firms like Kraft or General Mills claim they mostly deal in commodities
either for the products or their packaging. This gives firms the bargaining power
since there are a large number of commodity suppliers offering identical products
or product substitutes. There are also little switching costs for firms, if sellers
try to raise prices they will likely be undercut and firms will choose to buy from
another supplier while incurring little or no cost. Another factor taking power
from suppliers is that they generally sell to firms in very large quantities and
cannot afford to lose the sale. Firms like Con Agra and Pepsico. buy huge
amounts of raw materials, like corn, flour and sweeteners every year. If a
supplier were to lose these huge sales due to a price war it would be devastating
to them. These facts show that the bargaining power of suppliers in this
industry is low. This gives firms the ability to control costs and maintain
profitability.
Characterization of Industry
In the profitability analysis of the Processed & Packaged Goods industry,
using the five forces model, we find many important points. The first is that
there is a high degree of rivalry among existing firms. This is illustrated by the
low industry growth rate and high concentration of firms, with most major firms
21
having fairly equal and unchanging market shares. Second with existing firms
having well established distribution access, good relationships with buyers, and
established scale of economies shows a low threat of new entrants to the
industry. Third the processed and packaged goods industry has a low threat of
substitute products given the need to offer low prices in order to maintain
market share. The bargaining power of buyers in the industry is also high due to
products generally being undifferentiated and offering low switching cost to
buyers. Also suppliers have a low level of bargaining power given the high
number of suppliers offering the same goods. The processed and packaged
goods industry is a highly competitive one with all firms having to fight for
market share. Given this information about the industry, firms have a fairly low
profitability potential. Firms that want to gain a competitive advantage will have
to implement some sort of cost leadership techniques or offer some level of
product differentiation, but they will most likely have to display a mixture of
both.
Value Chain Analysis: Key Success Factors
In order to be successful in an industry firms must be able to identify and
develop key success factors within its industry. By doing so, they will enjoy
greater profits and an established position among competitors. Given the Five
Forces model, showing a highly competitive industry and somewhat equal market
share, strategies for gaining competitive advantage in the processed & packaged
goods industry are a combination of cost leadership and differentiation with most
of the emphasis on cost leadership. Firms that can obtain cost leadership will be
able to earn greater profits by charging the same price as competition while
maintaining lower total costs. Another ability that a cost leader has is to cut
prices and gain market share or even force competitors out of the market. Firms
that implement the differentiation strategy will be able to increase sales by
22
offering a unique product that has greater value to consumers. The
differentiation strategy is primarily not used in industries like the processed and
packaged goods industries because most of these firm’s products are
commodities which use the Cost Leadership strategy.
Cost Leadership
To achieve cost leadership in this industry firms will want to develop
economies of scale and scope. Economies of scale are achieved by buying and
producing in mass quantities and still maintaining an efficient use of resources.
Since fixed costs such as plants and equipment are unchanged an increasing in
production quantity will spread these cost over a greater number of units and
lower average cost with the production of each additional unit. Economies of
scope will occur if a firm produces an increased number of different goods, while
keeping its asset base low to lower its average total cost and increase profits. If
production and storage facilities are used for more than one product then the
average cost is dispersed over more products. For example, if a firm is able to
produce numerous products cheaper than to separate firms then they exist in an
economy of scope. In the processed and packaged goods industry we see
success in firms that operate in economies of scale and scope. Another means
for gaining cost leadership is to develop efficient production means. By using
resources efficiently firms reduce unnecessary costs. Lowering input and
distribution costs are also important to become a cost leader. Buying goods in
large quantities can increase a firms bargaining power over its suppliers and
reduce the cost of inputs. Without having cost leadership firms would have few
ways to control costs and with their buyers having a lot of bargaining power they
would not be able to recuperate costs.
23
Differentiation
Differentiation in the processed and packaged goods industry can be
achieved by supplying a unique product at lower price premium than customers
are willing to pay. Superior product quality is another differentiation strategy
that will develop competitive advantage and increase profits. Customer will be
willing to pay more for a good of higher quality. Offering a variety of products to
customers can also create differentiation for a firm. Firms in the industry can
also invest in their brand image, creating favorable recognition with customers.
These strategies promote customer satisfaction, loyalty and repeat business
which will in turn generate more profits and give the ability to gain greater
market share. Differentiation can bring success to firms in the processed and
packaged goods industry since the products are generally the same.
Competitive Advantage Analysis
Usually a company will use one of two approaches: cost leadership or
differentiation. Cost leadership is used when a company is in a highly
competitive industry with products that are similar, and differentiation is used
when a company is in a less competitive industry with products that are
noticeably different. The processed and packaged good industry is a highly
competitive one with many large firms holding fairly equal market share. In
order for firms to be successful they must be able to identify and implement key
strategies to gain competitive advantage. When considering the processed and
packaged goods industry, Sara Lee obviously must compete with price against its
competitors, but price is not the only factor. Sara Lee tries to make its products
at a quality level higher than most of its competitors. This allows them to sell a
slightly higher-priced product without losing sales due to the higher price.
Although price is the main competing edge in this industry, a little differentiation
24
used by Sara Lee gives them a competitive edge. Sara Lee’s success from
previous year shows they demonstrate competitive advantage at some level in
their industry. Sara Lee corp. has chosen to strive for competitive advantage in
the areas discussed in this section.
Cost Leadership
Cost leadership in this industry can be gained through economies of scale
and scope, efficiency within the industry, and lowering input costs. Sara Lee has
substantial cost leadership in the processed and packaged good industry, which
is its main concern in regard to gaining a competitive advantage. Several
measures contribute to their strong stance in this area as we will discuss below.
Economies of Scale
Operating in an economy of scale will allow a firm to increase their
production, lower their average total cost and enjoy larger returns. Sara Lee’s
large size and sales volume allows them to be in an economy of scale. They are
continuously trying to transform their business in order to be better in this area.
As part of the transformation, Sara Lee is consolidating the headquarters of its
North American businesses to one location in the Chicago area and the
headquarters of its European businesses to one location in Utrecht, the
Netherlands (Sara Lee 10k). Also, due to the transformation Sara Lee is going
through, it is reducing the number of product lines it runs. This allows the
company to focus on a smaller number of product lines. This reduces costs and
allows for higher quality. Sara Lee is trying to focus mainly on the food sector in
the United States and Europe, and also household products in Europe. Currently
this transformation is causing loses for Sara Lee. This is shown by the $62
million dollar loss in the fourth quarter of 2006 (yahoo.com/finance). But in the
25
long run Sara Lee will be able to grow its main product lines to be profitable.
This transformation will help its economy of scale.
Economies of Scope
A firm in this industry able to operate in an economy of scope will enjoy
sales from a variety of products and lower average costs than a firm producing
only one product. Sara Lee offers a wide variety of goods produced within its
seven business sectors. North American Retail Meats, which operates in north
America, sells a variety of packaged meat products such as, hot dogs, corn
dogs, sausages and sandwiches, smoked and dinner sausages, premium deli and
luncheon meats, bacon, and cooked and dry hams. North American Retail Bakery
sells a wide variety of fresh and frozen baked products and specialty items to
retail customers in North America. Products include bread, buns, bagels, rolls,
muffins, specialty bread, frozen pies, cakes, cheesecakes and other desserts.
International Bakery sells a variety of bakery and dough products to retail and
foodservice customers in Europe and Australia. Products include a variety of
bread, buns, rolls, specialty bread, refrigerated dough, frozen desserts and ice
cream. Foodservice sells a variety of meats, bakery and beverage products to
foodservice customers in North America. Products include hot dogs and corn
dogs, breakfast sausages and sandwiches, smoked and dinner sausages,
premium deli and luncheon meats, bacon, meat snacks, cooked and dry hams,
bread, buns, bagels, rolls, muffins, specialty bread, refrigerated dough, frozen
pies, cakes, cheesecakes, roast, ground and liquid coffee, cappuccinos, lattes,
teas, and a variety of sauces, dressings and condiments. International Beverage
sells coffee and tea products in major markets around the world, including
Europe, Australia and Brazil. Household and Body Care sells products in four
primary categories: body care, air care, shoe care and insecticides. Body care
consists of soaps, shampoos, bath and shower products, deodorants, shaving
creams and toothpastes, which are sold primarily in Europe. The branded
26
apparel segment designs, manufactures, sources, and sells a broad range of
apparel essentials such as t-shirts, bras, panties, men’s underwear, kids’
underwear, socks, hosiery, casual wear and active wear. On September 5, 2006,
Sara Lee spun off the branded apparel segment into an independent, publicly
traded business named Hanesbrands Inc. (Sara Lee10k) Sara Lee displays strong
economies of scope is shown through their production of so many different
goods, this has helped create a cost leadership quality that will be valuable for
many years.
Efficiency in the Industry
Maintaining a high level of efficiency in this industry is essential in order to
keep costs low and attain competitive advantage. The Sara Lee Corporation has
taken several steps in order to increase their operating efficiency. One way the
firm strives to be efficient is that they reorganized their business operations in
the beginning of fiscal 2006. This reorganization is an attempt to steer focus
around distinct consumers, customers, and geographic regions. As a result, the
business is organized around seven business segments: North American Retail
Meats, North American Retail Bakery, Foodservice, International Beverage,
International Bakery, Household and Body Care and Branded Apparel. The
success of these actions has yet to be seen.
Sara Lee has also recently decided to change its business portfolio and
narrow its focus on its 3 key products businesses: food, beverage, and
household products. Their strategy for this was the disposal of certain
businesses. During fiscal 2006, Sara Lee disposed of its Direct Selling, European
Branded Apparel, U.K. Apparel, U.S. Retail Coffee, European Nuts and Snacks,
and U.S. Meat Snacks businesses. In August 2006, after the end of fiscal year
2006, Sara Lee completed the sale of its European Meats business. Additionally,
on September 5, 2006, Sara Lee completed the spin off of its Branded Apparel
27
Americas/Asia business, which was spun off as an independent public company
named “Hanesbrands Inc.”(Sara Lee 10k). Sara Lee claims to continuously
implement methods of improving their operational efficiency, by streamlining its
processes and centralizing its procurement and information technology across
the organization.
Low Input Costs
Sara Lee uses many different commodities for production in their various
businesses. They do exercise a level of bargaining power over suppliers do to a
large purchases volume. However, commodity prices are volatile and subject to
market fluctuations, weather, currency fluctuations and changes in governmental
agricultural programs. Sara Lee does use commodity financial instruments, such
as future contracts, in order to circumvent price increases but not at significant
levels (Sara Lee 10k). Sara Lee may be able to pass on some or all of an
increase in the price of raw materials to their customers by increasing their
prices, but this could lead to lower sales volume since customers bargaining
power is high in this industry. Sara Lee does not implement strong measures in
lowering input costs. An increase in commodity prices would increase raw
material costs and operating costs and may reduce profitability.
Differentiation
While the cost leadership method dominates most of Sara Lee’s
competitive advantage strategies, they also try to gain a little different
advantage over competition in this industry by implementing a few differentiation
strategies as well. Quality, brand names and others are among Sara Lee’s top
strategy for having competitive advantage.
28
Superior Product Quality
Consumers will be willing to pay more for goods with a high rate of
quality. A firm in this industry that offers goods products of superior quality will
be able to have higher asking prices than other firms. Sara Lee strives to
maintain the highest level of quality possible in the goods that it offers to its
customers. Advertising campaigns for Sara Lee’s many brands often tell of the
products high quality or quality guarantee. Their web site boasts, “You can trust
Sara Lee to use quality ingredients, so your family can enjoy great tasting meals
that fit today's busy lifestyles (SaraLee.com).” Sara Lee has decided that
product quality and perception of quality are strong factors in its profitability.
High quality is a key part of Sara Lee’s ability to attain differentiation in their
industry.
Superior Product Variety
Sara Lee offers a wide variety of products to customers all over the world.
Its food sector offers a wide variety of packaged meat products, bakery
products, coffees, and teas. Its household and body care sector sells body care,
air care, shoe care and insecticides. Its North American retail meats accounted
for 15.9% of revenues in 2006. Combined retail bakery products grabbed about
20% of revenues in 2006. The international beverage gained 14.7% of revenues
in 2006. In offering such a large product variety to customers Sara Lee is able to
satisfy more buyers in its industry. Also by reaching a vast amount of customers
it can gain more loyalty to its brand name.
29
Investment in Brand Image
A good brand image can cause customers to buy a product just because
of name and logo on it. Good brand names can also be a symbol of high quality.
Sara Lee owns approximately 28,000 active trademark registrations and
applications in countries around the world (excluding trademarks transferred to
Hanesbrands Inc. in connection with the spin off). Sara Lee feels that its brand
names are one of its biggest assets as it builds brands globally (Sara Lee10k).
Its brands includes registered names, but also proprietary trade secrets,
technology, know-how processes and other intellectual property rights that are
not registered but valued as an asset to the company. Sara Lee is confident that
its trademark registrations are well protected under the laws of all the countries
that it operates in (Sara lee 10k). The Sara Lee web site states, in the page
dedicated to brands, that, “At Sara Lee Corporation our business is brands.
Leading brands. Trusted brands. Great brands like Hillshire Farm, Jimmy Dean,
Senseo, Douwe Egberts, Ambi Pur, Kiwi and of course, our namesake, Sara Lee.”
Sara Lee’s strong brands in all sectors should be a valuable asset for the
foreseeable future.
Research and Development
For years, Sara Lee has ignored research and development of new
products. This had worked for the company for most of its existence. Starting
around 2005 the company began to noticeably take a turn in the wrong
direction. According to the Chicago Tribune, the stock price for Sara Lee has slid
23% since 2005, and earnings for 2006 were half of what they were in 2004 in
similar sales. Top company executives feel the lack of R&D is a major
contributor to the downturn. In response, the company is launching a
progressive R&D project. They have begun building a R&D campus near their
30
Chicago headquarters that will be completed in 2009, and they will increase R&D
employment by 50%.
The increase in the competitive advantage is slowly starting to appear.
The company has developed new products such as: Jimmy Dean Skillets,
Breakfast Bowls, Hillshire Farm Salad Kits, and Flavor Fusion Pies. Sara Lee must
maintain some sort of competitive advantage in the following years in order to
remain competitive. The most important strategy is cost leadership but
differentiation can cause a healthy profit margin. Sara Lee demonstrates a string
ability to keep costs low, competitive and also maintain a level of differentiation
above its competitors.
Accounting Analysis
Accounting analysis is a crucial step in understanding what key accounting
policies are being utilized by the company. It also allows investors and the
general public to view the current financial position of the firm, as well as make
future financial forecasts. As analysts it is beneficial for us to evaluate the
accounting procedures of Sara Lee. We have to ensure that Sara Lee has
accurately and effectively reported its financial information. We must determine
if there are any errors whether intentional or unintentional. If there are
inaccurate numbers we must revise the various accounting data to give us a
better portrayal of the value of Sara Lee.
Key Accounting Policies
When performing an accounting analysis, several steps and procedures
are essential in order to help one evaluate the firms’ accounting standards and
quality. The first step is to identify key accounting policies. When identifying the
31
key accounting policies, it is vital to pinpoint the key success factors of the firm
and evaluate whether or not Sara Lee is using these factors as value drivers for
the firm.
Sara Lee’s growth seems to be driven by marketing and advertising of
their products, offering products of highest quality at the lowest price possible,
customer excellence, customer driven innovation, efficient inventory
management, and geographic expansion. Sara Lee currently has numerous
operating leases for its manufacturing facilities, warehouses, office buildings,
vehicles, and operating machinery. This allows Sara Lee to not have to show
these facilities, warehouses, and machinery as assets on its balance sheet, as
well as to not have to disclose these as liabilities for the company. Sara Lee also
has contingent leases obligations, which represent leases that are operated by
others and only become a liability for the company if those other companies are
not able to meet their leasing obligations. The operating leases within the non-
contingent lease obligations constitute such a small portion of their non-
contingent liabilities that it is difficult to say that they play a part in any type of
manipulation or distortion of future forecasted liabilities.
Payments Due by Fiscal Year
In millions Total 2007 2008 2009 2010 2011 Thereafter
Long-term debt $4175 $368 $1369 $172 $38 $11 $2,217
Interest on debt obligations 1541 218 164 131 121 121 786
Operating lease obligations 616 136 110 87 71 60 152
Purchase obligations 2616 1711 352 228 192 106 27
Other long-term liabilities 624 232 67 25 19 17 264
Subtotal 9572 2665 2062 643 441 315 3446
Contingent lease obligations 188 26 24 23 20 16 79
Total $9760 $2691 $2086 $666 $461 $331 $3525
32
Inventory is recognized on the balance sheet at the lower of cost or
market. Damaged inventory, excess inventory, as well as obsolete inventory is
recognized at net realizable value on the balance sheet. Spoilage rates, historical
recovery rates, and forecasted marketing and sales plans help in determining the
amount of net realizable value for these types of inventory.
COGS/Inventory
0
1
2
3
4
5
6
7
2002 2003 2004 2005 2006
Year
Sara LeeGeneral MillsKraftConagra
The above graph demonstrates how Sara Lee is working toward becoming
a leaner and more efficient business. Sara Lee is reducing inventory in
comparison to the amount of goods sold. As inventory decreases the
COGS/Inventory ratio will increase. This is a good characteristic of a firm.
“[Managers of Sara Lee] have made dramatic progress in transforming Sara Lee
from a decentralized holding company into a smaller, integrated and more
efficient operating company.” (saralee.com). Sara Lee is pursuing this goal by
33
eliminating extra inventory and increasing shareholder value by issuing attractive
dividends and the repurchase of more than $500 million of its own shares, as
well as spinning off major brand names such as Hanesbrands Inc. (Hence, the
increase in the ratio from 2003-2006.) A corporation without extra inventory is a
more efficient corporation as a result. Not as much money is spent on holding
and maintaining inventory. Spinning off Hanesbrands will help Sara Lee. Sara
Lee will be able to lose distractions and focus on the core parts of their business
and do what they do best.
A portion of financial statements contain estimated numbers that are
based on historical and present information, which help decision makers make
critical determinations for the firms position in the future. For example, Sara
Lee, like many other companies, must estimate the amount of impairment
charges that it may undertake in the future. In order for goodwill to fall under
the “impairment charge” category, the fair value must be less than the carrying
value. This impairment charge decreases the value of goodwill to the fair market
value and symbolizes a “market-to-market” charge. Determining the fair value of
goodwill is as much an art as it is a science. This makes it difficult to forecast
impairment charges, because you can derive honest assumptions at different
valuations. The allocation process can also be manipulated in order to meet
management’s needs and preferences.
Accounting Flexibility
Sara Lee Corporation prepares its Financial Statements in accordance with
Generally Accepted Accounting Principles (GAAP). Since GAAP regulations can be
interpreted loosely in many areas, Sara Lee has flexibility in many areas of how
they report their operations on their financial reports. Flexibility of accounting is
highly affected by the policies that a corporation implements. Sara Lee’s policies
34
discussed in the previous section, such as reducing its inventory, play a major
part in how flexible Sara Lee is with its accounting strategy.
One example of flexibility that managers at Sara Lee have is how they
report their amounts of intangible assets, such as goodwill. According to GAAP
requirements, goodwill cannot be amortized, but is assessed for impairment
annually. Delaying the assessment of impairment can affect the value of long-
term assets that will make total assets for that period overstated (Sara Lee 2006
Annual Report). In order to get an accurate estimate of impairment values,
managers at Sara Lee must estimate the fair value of an asset and compare that
to its carrying value. They make this estimate by looking at operating results,
business plans, and present value techniques. While it is management’s job to
make these estimates as accurate as possible, it is still an estimate and
management might be tempted to put their own twist on the data that is used in
these estimates. If these estimates are manipulated, it is likely that earnings will
be overstated in following periods. According to their 2006 Financial Report,
Sara Lee performs its annual review for goodwill impairments in the 2nd quarter
of each year.
Another example of accounting flexibility that Sara Lee faces is how to
evaluate its inventory. Management has the option of using the LIFO method,
FIFO method, or the average cost method. Sara Lee chooses to state 98% of its
inventories using the first-in, first-out (FIFO) method and the remaining 2%
using the last in, first out (LIFO) method. The FIFO method lowers the
company’s cost of goods sold, which is an expense, and will result in a higher net
income. FIFO also can have the risk of overstating assets because of the
possibility of inventory being overstated. The decision of which method to use
does not have a large impact in this particular industry of consumer products due
to the short amount of time that inventory is received and sold, but it can still
make a slight difference in accounting numbers.
35
Another area of flexibility related to inventory is how management values
the cost of inventory. Sara Lee shows its inventory on the balance sheet at
lower of cost or market, which is required by GAAP. However, damaged or
obsolete inventory is valued at net realizable value, which is evaluated using
estimates made by management, and may involve uncertainties (Sara Lee 2006
Annual Report). Flexibility can also be shown if a company offers discounts or
rebates which might be due to surplus inventory. If managers over-buy or over-
produce in the current period, they are likely to have to offer customers
discounts to lower surplus inventories (Palepu 4-7). Sara Lee has the option to
offer discounts to vendors that relate to inventory. These discounts are a
reduction of costs of the items and are reflected in cost of sales. Discounts of
surplus inventory could be a result from delaying a write down from a current
asset (inventory) which would be overstating assets.
Pensions and other post-retirement plans are other examples of
accounting flexibility that management are faced with. In order to obtain the
values of pension obligations, management must estimate the projected value of
future pension payments using discount rates, salary growth, expected return on
plan assets, retirement rates, and mortality (Sara Lee 2006 Annual Report).
Manipulating these estimates can result in an understatement of benefit
obligations, which will cause expenses to be understated. This chart illustrates
the sensitivity of a 1% change in the discount rate, which is determined by
utilizing the yield on high-quality fixed-income investments that have an AA bond
rating and last as long as the average life of the pension obligations.
36
(In millions)
(Sara Lee 2006 Annual Report)
According to the chart a 1% change in the discount rate in the current
period of projections for pension benefit obligations can either overstate or
understate the following period’s costs by a $50 million understatement or a $98
million overstatement. This means there is a heavy influence on the estimation
of discount rates by the accounting managers within the firm. Just one percent
can make the difference in a conservative or aggressive approach.
Accounting Strategies
Accounting strategy is how managers implement their accounting
flexibility. Strategy can vary largely. Usually a firm is described as conservative
or aggressive. Conservative companies will show less net income and aggressive
companies will show more net income typically. Being on the far end of either
side of the scale is almost always considered to be a negative quality.
Increase/(Decrease) in
2007 Net 2006
Periodic Projected
Benefit Benefit
Assumption Change Cost Obligation
Discount rate 1% increase $(50) $ (828)
Discount rate 1% decrease 98 1,043
Asset return 1% increase (47) –
Asset return 1% decrease 47 –
37
According to the company’s 2006 annual report, Sara Lee uses lower of
cost or market values to value their inventory. Sara Lee uses the first in, first out
(FIFO) inventory method for 98% of its inventory to determine the cost of its
inventory. The remainder (2%) of their inventory is valued by the last in, first
out (LIFO) inventory method. This is standard with GAAP and the rest of the
industry.
When it comes to the potential of managers manipulating future
forecasted liabilities, it is important to consider the company’s pension plans.
Sara Lee happens to use defined benefit pension plans across its spectrum of
divisions, where the benefits that are provided by these plans are based on the
number of years of service provided by the employee and their level of
compensation. With a company as large as Sara Lee, pension expenses are a
significant cost to the company, making it an incentive for unethical managers
and top executives to manipulate these numbers to their liking. By using defined
benefit plans, Sara Lee must forecast the life expectancy of these plans, as well
as salary inflation. Sara Lee discloses that these obligations are estimated by
“using actuarial assumption, based on the current economic environment.” (Sara
Lee 10-K). This statement clearly represents the amount of flexibility that is
given when using this type of pension plan, as well as the potential to alter
liabilities for the future.
Summary of cash contributions
Continuing operations $326 $327 $104
Discontinued operations 5 21 8
Total $331 $348 $112
(Sara Lee 10-k)
When forecasting future pension plan liabilities Sara Lee’s managers are
required to offset employee working commitments with the assets that the firm
38
has committed in helping fund retirement and future pension benefits (Palepu 4-
27). Sara Lee must have enough funds set aside to cover its plan commitments.
If the funds set aside by the firm fall short of its commitments the plan is under-
funded, and vice versa for an over funding of pension reserves. When selling off
a business, such as its United Kingdom apparel business, Sara Lee must continue
to recognize the pension obligations that were related with that business. With
Sara Lee no longer having to incur these obligations, the cost is then recognized
in discontinued operations.
(in millions) 2006 2005
Projected benefit obligation $4265 $4281
Accumulated benefit obligation 4159 4080
Fair value of plan assets 3163 2916
(Sara Lee 10-K)
Sara Lee also breaks their benefit obligation plans into two categories:
accumulated benefit obligation and projected benefit obligation. Accumulated
benefit obligation are portrayed based on employee service and compensation.
This measurement differs from the projected benefit obligation plan because it
contains no forecasts or assumptions about future compensation. Sara Lee also
contributes to a number of investment objectives such as: equity securities, debt
securities, and real estate in order to help pension plans meet their full potential.
39
Pension Expense/SG&A Expense
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
2004 2005 2006
Year
Pension/SG&A
One noticeable factor that affects accounting strategy is that Sara Lee
offers high bonuses and/or incentives to high-performing employees within its
company. They are fairly aggressive in this area. These bonuses are based on
items such as profits, sales, cash flows, and individual achievement on projects.
There are five levels of achievement; the highest level of achievement receives
150% of the target bonus. This gives employees in top management positions a
strong incentive to have good accounting numbers for a particular period. It
would not be unforeseeable for managers to distort accounting policies to
achieve high sales or profits in order to receive higher bonuses. Sara Lee has
made recent changes to there performance measures used for bonuses. In
2006, Sara Lee added another level of performance and put sales goals on a
different measuring system. See charts below.
40
Performance Level 2006 Performance Goal Performance Payout Level
(Operating Profit, Goal as a % of
Cash Flow, Individual (Sales) Target Bonus
Objectives)
Level 5 Maximum 110% of Target 105% of Target 150 %
Level 4 Above Target 105% of Target 102.5% of Target 135 %
Level 3 Target Target 100% of Target 100 %
Level 2 Below Target 95% of Target 97.5% of Target 50 %
Level 1 Threshold 90% of Target 95% of Target 0 %
Performance Level 2005 Performance Goal Pay out Level as a %
of Target Bonus
Level 4 - Maximum 110% of AOP 150%
Level 3 - Target AOP 100%
Level 2 - Below Target 95% of AOP 50%
Level 1 - Threshold 90% of AOP 0%
Sara Lee appears to not use business transactions to achieve certain
accounting objectives. They are relatively conservative when they are concerned
about future losses from possible scenarios. In its 10-K report the company
mentions several factors showing this quality. In September 2006, Sara Lee
spun-off a section of its branded clothing division. In terms of short-term
success this move will actually hurt Sara Lee. Their 10-K reports that the move
actually will end up costing them more in taxes. The company also is investing
greatly in a transformation project. Significant amounts of money are being
spent on this transformation along with research and development. This project
is scheduled to last for three more years. Companies looking deep into the
future to achieve long-term profits make moves such as these exhibited by Sara
Lee.
One negative effect is currently taking place due to this transformation
that could possibly affect accounting strategy. Many internal management
41
positions are being moved, and new, different people are being placed in those
positions. This flow of new managers brings the threat of inconsistencies within
the accounting decisions made across this worldwide corporation. This means a
different perspective could arise in terms of accounting policies. The company
recognizes this potential problem in their 10-K, and is ready to tackle this
potential threat.
We feel that Sara Lee is not an aggressive firm in terms of accounting
strategy, but at the same time not too conservative. Sara Lee makes its
accounting decisions to fit whichever scenario is prevalent, and make sure that
the owners of the firm are accurately well-informed about the financial standing
of the company. Sara Lee is a highly disclosed company. Some analysts might
view this technique as a way to bog down information, but we feel that Sara Lee
wants the public to be fully informed about the company. To take a stance as
either conservative or aggressive, we must say that Sara Lee is conservative in a
healthy manner.
Quality of Disclosure
The quality level of a firm’s accounting disclosure is a main factor in
determining their true business reality. A high level of quality disclosure would
equate to a high level of transparency and can make it easier for analysts and
investors to determine the value of a company. A low level of disclosure may
cloud the true economic situation of a firm making analysis more time consuming
and possibly less accurate. Managers have the ability to alter the level of the
accounting disclosure and portray their company to be a better investment
choice than it truly is by choosing accounting methods that imply high earnings.
Top managers may try to appear as having earned lower income to save on
taxes or show steady signs of growth.
42
Qualitative
A firm’s disclosure can by considered in two categories, qualitative and
quantitative. Sara Lee appears to demonstrate a high level of qualitative
disclosure to the public, through its annual summary reports, letter to
shareholders and footnotes. These reports offer a clear view of their business
environment and a break down of performance by sectors and regions. Sara Lee
clearly explains their methods, procedures and strategies for success. In the
annual report found on the Sara lee website management discusses its goals for
growth and plans to attain it. Management also discusses accounting methods
such as the accounting of goodwill and what types of leases they use, as well as
give logical explanations for these decisions. Sara Lee’s annual report seems to
make no attempt to hide bad news or risks that it may face. Overall, their 10-k
gives good quality in-depth information of the company’s financials as well as
explanations of choices and unexpected events.
Quantitative
Quantitative information found in the 10k is another major factor in
determining a company’s level of disclosure. Although much of the information
has regulations and guidelines on how to account for certain transactions,
managers still have discretion over a significant portion. With this discretion,
managers can distort financial truths and make it difficult to assess a firm’s true
value. Due to incentives and pressures that top managers face each day to meet
earnings goals, analyzing quantitative accounting data over several years and
comparing it to firms within the industry is imperative. The following diagnostic
will attempt to analyze the firms accounting methods as well as some
competitors in the industry.
43
Manipulation Diagnostics
Ratio Analysis:
The following charts summarize accounting ratios for Sara Lee and two of
its major competitors: Kraft and General Mills. The ratios are broken down into
two categories: Revenues diagnostics and expense diagnostics. We selected
these ratios to screen in order to perceive any type of out of the ordinary ratios
that may stand out among possible trends over a five year period.
Revenue Diagnostics:
The revenues diagnostics indicate how much revenue is being generated
from sales, accounts receivable or inventory, depending on which ratio you are
interested in. These ratios are important because they show an important
linkage between revenues, sales, accounts receivable and inventory, which can
ultimately help reveal any signs of number manipulation.
44
Net Sales/Cash from Sales
0.980.990.991.001.001.011.011.02
2002 2003 2004 2005 2006Year
Sara LeeGeneral MillsKraft
The Net Sales/Cash from Sales ratio shows the relationship between
actual sales and the cash received for those sales. The industry is relatively
close to one another over the five year span. If a company were to have a ratio
of 1 in this category, it would indicate that all sales dollars were being collected
as cash. A firm could rise above this number without need for concern if they
are growing at a fast pace. The packaged goods industry ratio hovers around a
1, showing that there is a safe level of cash from sales. Sara Lee is an example
of a good ratio over the entire five year time frame. Sara Lee’s steady ratio of
around 1 conveys no level of concern or effort of trying to manipulate sales or
cash from sales. Their competitor’s ratio hovers around a 1 as well. This
indicates that Sara Lee seems to be keeping up with the competition when it
comes to collecting cash and limiting their risk of accounts receivable.
45
Net Sales/Acct. Receivable
0
2
4
6
8
10
12
2002 2003 2004 2005 2006Year
Sara LeeGeneral MillsKraft
A large ratio is good for Net Sales/Net Accounts Receivable. A large
number means a company collects a large portion of their sales; this quality
relieves the threat of uncollectible accounts. The industry is very consistent
except for General Mills up and down fluctuation of their ratio from 2002 to
2005. Sara Lee ranks last among the industry for the last five years, in which
they had been increasing their ratio until 2005 where they experienced a slight
decrease due to a drop in sales and increase in accounts receivable. Sara Lee’s
consistency of outputting a small (net sales/net accounts receivable) seems to be
caused by their lower sales and higher accounts receivable relative to the
competition. Sara Lee seems to maintain a steady ratio over the entire five
years, which causes no concern of any type of manipulation.
46
Net Sales/Inventory
0
2
4
6
8
10
12
2002 2003 2004 2005 2006Year
Sara LeeGeneral MillsKraft
The industry is not as consistent in this ratio as the previous two. A larger
sales/inventory ratio is more desirable. It means a company is moving their
inventory quickly and efficiently. Sara Lee is at the bottom of the pack compared
to General Mills and Kraft. Sara Lee’s ratio increased largely from 2004 to 2005,
but this was due to a decrease in inventory of nearly $600 million. Sara Lee’s
ratios seem to be consistent and straightforward, showing no evidence of
manipulation.
Expense Diagnostics:
The expense diagnostic ratios help one analyze how accurate a company
is reporting their expenses. A majority of these ratios indicate how much cash a
company is generating from assets, operating income, net operating assets and
change in sales. Like revenue diagnostics, expense diagnostics provide an
important linkage between cash and these other items, which ultimately help in
recognizing any type of manipulation that may occur.
47
Asset Turnover
0.00
0.20
0.40
0.60
0.80
1.00
1.20
2002 2003 2004 2005 2006Year
Sara LeeGeneral MillsKraft
The asset turnover ratio shows how much sales are generated from total
assets; the ratio is stated as Sales/Assets. Sara Lee uses operating leases which
could explain there relatively high ratio. The increase in Sara Lee’s ratio from
2003 to the end of 2005 can be explained by a larger increase in their sales
relative to their total assets. The industry shows little movement over the entire
five year period. Sara Lee stays quite constant as well and shows no signs of
manipulating sales or total assets.
48
CFFO/Operating Income
0
0.5
1
1.5
2
2.5
2002 2003 2004 2005 2006Year
Sara LeeGeneral MillsKraft
This ratio shows how much cash is generated from operating activities. A high
number means a lot of cash was created from operating activities. Sara Lee is
on top of the industry in this category. This is a good thing for the company.
This shows that Sara Lee is collecting cash on their operating activities, which in
turns shows that the expenses that Sara Lee projects are accurate. The
consistent increase in this particular ratio for Sara Lee is explained by their cash
flow from operations being consistently higher than their operating income.
Although CFFO did decrease from 2004 to 2006, operating income had a $4
billion decrease from 2005 to 2006. In this particular case, Sara Lee seems to be
disclosing their information accurately with no signs of manipulation.
49
CFFO/Net Operating Assets
00.10.20.30.40.50.60.7
2002 2003 2004 2005 2006Year
Sara LeeGeneral MillsKraft
CFFO/Net Operating Assets shows how much cash flow a company gets
out of its assets. There is lots of variance within the industry. Sara Lee has
declined in recent years, which means they are collected less cash for every
dollar of property, plant, and equipment they invest in. The large drop in Sara
Lee’s ratio is caused by a large decrease in their cash flow from operations from
2004 to 2006, relative to slight increases in their net operating assets. Although
their ratio dropped from 2004 to 2006, they seem to remain competitive and
accurate with their disclosures.
Potential Red flags
Even with guidelines such as GAAP, managers still have considerable
discretion in choosing accounting policy. Given their ability do distort numbers
and their incentive to do so identifying questionable accounting practices is an
important step in the analysis of a firms accounting and disclosure quality. Red
flags such as extreme changes in accounting policy or a high inconsistency of
financial numbers can reveal major changes to the way a firm is perceived in the
50
market. These red flags without proper justification will have an impact on the
firm’s financial status and therefore will require adjustments in order to fairly
value the company.
In the accounting analysis of Sara Lee we found a key item that
potentially could cause distortion in the firm’s financial reports. The first of
which is Sara Lee has a potential red flag concerning their fourth quarter net
incomes for 2005 and 2006. These numbers are more than likely not
intentionally distorted but do raise a legitimate concern. Please see the chart
below. The fourth quarter is highly irregular when compared to the numbers for
the first three quarters preceding. A reasonable answer to this irregularity
discussed in the firms 10k is the company transformation that Sara Lee is
undergoing. There is lots of restructuring and selling of company divisions
starting in 2005. These activities caused unusually high losses from discontinued
operations in 2005 and 2006 causing them to recognize after tax impairment
charges of 362 million and 256 million respectively (Sara Lee 10k). After
analyzing these unusual trends in the 4th quarter we found that legitimate
activities took place that justified the changes and we found no need for
adjustment.
Net Income By Quarter
2007 2006 2005 2004 2003 2002
Q1 $333 $67 $352 $230 $308 $242
Q2 -$62 $438 $326 $312 $348 $160
Q3 N/A $42 $189 $376 $269 $257
Q4 N/A $8 -$148 $354 $296 $351
Year $271 $555 $719 $1,272 $1,221 $1,010
(Sara Lee 10-K)
51
Undo Accounting Distortions
After reviewing the red flags found in our accounting analysis, we do not
believe any of them distort the accounting quality a significant amount. Also, we
feel that the low amount of operating leases used by Sara Lee do not distort the
company’s accounting numbers. Their operating leases total for all future years
was only $616 million. This is insignificant for a company that sales around $15
billion worth of product every year. Sara Lee does a superb job being well-
disclosed and thorough in their accounting practices. They have consistent
numbers that show good policies in regard to accounting. Any change large
enough to draw attention was either well explained by management or had a
beneficial impact on the company, and is due to the restructuring attempts Sara
Lee has implemented.
Ratio Analysis and Forecast Financials
In determining a firm’s value an analyst must consider its profitability and
growth rate to better assess the implementation and success of its chosen
strategy. The two main tools used in doing so is the ratio analysis and the cash
flow analysis. Ratio analysis shows how different line items on a firm’s balance
sheet relate to one another and cash flow analysis helps to determine how a firm
manages cash flows from all aspect of their business (Palepu). Comparing the
results of the ratio analysis with a firms previous years, it’s competitors and
against the industry average can give an in depth look at how a firm handles its
operating, financing and investment cash flows. By running and understanding
financial ratios of past and present performance for the firm and its competitors,
as well as understanding the industry and accounting environment an analyst is
able to build a good foundation in which to make forecasts of future conditions.
52
Trend (Time Series) Analysis/Cross Sectional Analysis
The following analysis of Sara Lee and its competitor’s, Kraft (KFT) and
General Mills (GIS) is broken down in three categories: liquidity, profitability, and
the structure of capital. Financial ratios are a set of ratios that we are going to
be discussing in this analysis. By computing these ratios over a period of five
years, we will be able to recognize trends within the industry as well as Sara Lee,
and the factors that contribute to the trends.
Liquidity Ratios
A firm’s liquidity relates to its ability to meet and maintain its current
liability obligations in the short term with that of its cash and equivalence assets.
A highly liquid firm means that it is able to easily meet debt obligations given it’s
high level of current assets in relation to it’s current liabilities. For example a
current ratio of 2 would indicate a highly liquid firm, but a firm could still face
short term liquidity problems if some of the current assets were not easily turned
into cash. Therefore we will break the liquidity analysis down into 5 ratios
consisting of current ratio, quick asset ratio, inventory turnover, receivables
turnover and working capital turnover.
53
Current Ratio
The current ratio is found by dividing current assets by current liabilities to
show the amount of current assets in relation to current liabilities. This is a
somewhat a broad look at a firm’s ability to meet its short term debts with on
hand cash and other assets perceived to be fairly easy to convert into cash.
Generally the higher the current ratio is, the better the ability for the company to
pay back its obligations. Current assets consist of cash and cash equivalents,
short term investments, net receivables, inventory, and other current assets.
Current liabilities consist of accounts payable, short term and current long term
debt, as well as other current liabilities. Current assets are assets that can be
converted into cash, usually within at least one year or one business cycle;
whichever is longest. Current liabilities are a company’s debt that is due within
one year. With a current ratio below 1, a company may not be able to meet its
current short term obligations if they were due at that point in time. If a firms
current ratio is greater than 1 than they have more current assets than liabilities
and they should have no trouble meeting their debt obligations as well as
obtaining further financing. On the other hand, a current ratio that is too high
may mean that the company is not operating efficiently, as well as an indicator
that the assets are not being utilized efficiently.
2002 2003 2004 2005 2006
Sara Lee 0.91 1.14 1.06 1.19 1.08
General Mills 0.60 0.92 1.17 0.73 0.52
Kraft 1.04 1.03 1.07 0.93 0.79
54
Current Ratio
00.20.40.60.8
11.21.4
2002 2003 2004 2005 2006
Years
Ou
tpu
t
Sara Lee
GeneralMillsKraft
IndustryAvg.
The above graph is a cross sectional analysis of Sara Lee’s current ratio
compared to General Mills and Kraft. In 2002, Kraft is the only company whose
ratio stays above a 1 due to their current assets being so much larger than their
current liabilities. In 2002, Sara Lee and Kraft were the only two in the industry
to maintain a current ratio above a 1; Sara Lees’ ratio being higher than Kraft’s
due their larger current assets relative to current liabilities. General Mills’ ratio
rises and surpasses everyone in the industry in 2004 due to a small increase is
current assets and a larger decrease in current liabilities of around $687 million.
Because of General Mills’ consistency of staying below a ratio of 1, this may
cause them to turn to alternative ways of financing their short term debt, which
is not good and may lead to bankruptcy in the long run. Sara Lees’ current ratio
seems to be very efficient over the entire 5 year time span. In 2002 the ratio fell
just below 1 due to a lower number of current assets compared to their higher
number of current liabilities. In 2005 their current ratio increased to a 1.19 due
to a decrease in their current liabilities of $397 million, followed by a smaller
increase in current assets of $207 million. The consistency of their steady
current asset ratio indicates that Sara Lee is definitely utilizing their current
assets to their fullest potential, as well as meeting their short term debt
obligations.
55
Quick Ratio
2002 2003 2004 2005 2006
Sara Lee 0.38 0.54 0.46 0.44 0.63
General Mills 0.35 0.49 0.64 0.38 0.28
Kraft 0.46 0.49 0.42 0.42 0.39
Quick asset ratio is found by dividing cash, accounts receivable and
securities by current liabilities and shows the relation of assets considered
extremely liquid to current liabilities. This ratio is important to consider in
respect to the current ratio since it does not take into account assets such as
inventory that may not be quickly converted into cash very quickly. A firm with a
high quick ratio shows the ability to cover its debts in an emergency situation
(Palepu). Sara Lees’ quick asset ratio increases by 0.25 from 2002 to 2006, due
to a substantial increase in cash, showing that Sara Lee is able to cover such
debts if needed.
56
Quick Ratio
00.10.20.30.40.50.60.7
2002 2003 2004 2005 2006
Years
Out
put Sara Lee
General MillsKraftIndustry Avg.
The above table and graph show the quick ratios for Sara Lee, General
Mills, Kraft and the industry average. This particular graph shows Sara Lee
staying above the industry average in all years except 2004 when they dropped
to .46, and 2002 when they were at .38. In 2006 Sara Lee’s numbers rose to
.63, well above its competitors. While current liabilities did rise in 2006, the
increase in cash of $1.7 billion from 2005 to 2006 enabled Sara Lees’ quick asset
ratio to rise. This indicates that they have a strong ability to cover their short
term debts. From 2002 to 2004 General Mills was able to increase it’s ratio to
0.64, due to a decrease in current liabilities of nearly $3 billion; following that
their ratio drops to 0.28 in 2006 due to a considerable increase in current
liabilities of nearly $2 billion. Kraft maintains a ratio close to industry level up
until around 2003. From 2003 to 2004 Kraft’s current liabilities increased around
$1.2 billion, followed by an even larger increase in current liabilities of around
$1.7 billion in 2005 to 2006; resulting in a drop in their quick asset ratio.
57
Inventory Turnover
2002 2003 2004 2005 2006
Sara Lee 3.59 3.49 3.55 4.66 4.66
General Mills 4.24 5.31 5.82 6.15 6.20
Kraft 5.03 5.39 5.62 6.26 6.00
Days Supply of Inventory
2002 2003 2004 2005 2006
Sara Lee 101.67 104.58 102.82 78.33 78.33
General Mills 86.08 68.74 62.71 59.35 58.87
Kraft 72.56 67.72 64.95 58.31 60.83
Inventory turnover allows an analyst to examine how productively the
three principal components of working capital are being used. In assessing the
overall liquidity of a firm an analyst must take into consideration the amount of
inventory that is held by the firm. We believe this is an important consideration
since inventory is part of current assets. Therefore even if a firm shows a
favorable current ratio it could be deceiving if the firm is holding to much
inventory or failing to write of unusable inventory. Inventory turnover is found
by dividing the cost of goods sold (COGS) by a firms amount of inventory on
hand. Since inventory is part of current assets, it is important to decipher
between inventory and other current assets. If a firms inventory is too high in
relation to it’s COGS then the ratio may indicate that inventory levels do not
meet the required level to sustain a profitable business. A lower ratio can be
detrimental in some cases, but may also indicate that the company is
overstocking its inventory or delaying inventory write-offs in order to keep there
58
current assets high. Although Sara Lee’s ratio is smaller than General Mills and
Kraft, we feel that Sara Lee is turning over their inventory at an efficient level by
keeping their cost of goods sold at an appropriate level, relative to their
inventory levels.
Inventory Turnover
01234567
2002 2003 2004 2005 2006
Years
Out
put Sara Lee
General MillsKraftIndustry Avg.
The graph above shows Sara Lees’ inventory turnover ratio compared to
the industry. Sara Lee has a lower inventory turnover ratio compared to General
Mills and Kraft over the entire five year time period. This is so, due to Sara Lees’
level of cost of goods sold staying quite constant at around $10 billion. Sara
Lees’ inventory levels also stayed quite constant around almost $3 billion over
the five year time period, causing the ratio to remain around an average ratio of
4.34. Kraft on the other hand has a high inventory turnover ratio due to an
increasing high level of cost of goods sold; while also maintaining a lower level of
inventory compared to Kraft and Sara Lee. General Mills is able to maintain a
ratio level above the industry average due to their low levels of inventory.
General Mills’ inventory ratio increases over the years due to an increase in cost
of goods sold. Since inventory turnover directly impacts working capital, Sara
59
Lees’ low levels of inventory turnover will ultimately result in a lower percentage
of working capital. This is not a positive outcome because it is showing that Sara
Lee is not turning it’s inventory into sales at a rate at which they should be;
displaying that cash is continuously being held in inventory, elongating the cash
to cash cycle.
Days Supply of Inventory
0
20
40
60
80
100
120
2002 2003 2004 2005 2006
Years
Oup
ut
Sara LeeGeneral MillsKraftIndustry Avg.
Compared to others in the industry, Sara Lee falls short of displaying a
prominent days supply of inventory. Days supply of inventory explains the
number of days that it takes a company to make an initial order of inventory,
until the time it takes to have to re-order a new batch of inventory. Along with
days receivables and days payables, days inventory is another way to evaluate
the efficiency of a firms working capital management (Palepu). The industry
average is high due to Sara Lees’ large numbers of days supply of inventory,
which is due to Sara Lee having smaller outcomes of inventory turnover than
General Mills and Kraft. This is showing that Sara Lee is not selling their
inventory quick enough, and is ultimately storing their inventory inefficiently.
60
Receivables Turnover
Days Sales Outstanding
2002 2003 2004 2005 2006
Sara Lee 44.46 43.71 42.44 38.18 40.07
General Mills 46.38 34.05 33.30 33.58 33.73
Kraft 38.26 39.67 40.15 36.14 41.10
Much like inventory turnover, receivables turnover is also a measure of
how effectively and efficiently a company is making use of their assets.
Receivables turnover is found by dividing sales by the accounts receivable
balance found on the balance sheet. If a firms ratio reveals a high number, then
the firm does not sell as much merchandise on credit and therefore could have
less risk of accounts defaulting. Whereas if the ratio is low, then the firm takes
on more risk of not collecting payments of goods sold on credit. This is
important to analyze in addition to sales volume alone since sales assumes that
accounts receivable will be collected. A firm with a consistent receivable
turnover ratio demonstrates the ability to collect on credit sales. But a firm with
a decreasing number shows that a growing amount of credit accounts is going
uncollected. Days sales outstanding is also much like days supply of inventory.
Days sales outstanding tells us the specific number of days that it takes to collect
cash from receivables. A lower ratio is considered more valuable, meaning that
2002 2003 2004 2005 2006
Sara Lee 8.21 8.35 8.60 9.56 9.11
General Mills 7.87 10.72 10.96 10.87 10.82
Kraft 9.54 9.20 9.09 10.10 8.88
61
the company is collecting cash faster, causing actual and forecasted bad debt
expense to remain lower.
Receivable Turnover
0
2
4
6
8
10
12
2002 2003 2004 2005 2006Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
As the table and graph above demonstrate, Sara Lee projects a lower
receivables turnover than others in the industry, including the industry average.
Sara Lee persistently maintains this lower ratio because of their lower sales,
while also maintaining receivables of a little over $1 billion. General Mills
revenues were much smaller in 2002 of around $7 billion, but increased to over
$11 billion in 2005; this enabled them to keep a higher ratio by allowing fewer
sales on credit, which in turn caused a lower accounts receivable. Kraft on the
other hand maintains a high ratio due to very high sales numbers and low
accounts receivable relative to their sales. While Kraft did have a higher
accounts receivable than both Sara Lee and General Mills, it only accounts for
about 10% of sales; Sara Lees’ remaining around 11% and General Mills only
around 9%.
62
Days Sales Outstanding
0
10
20
30
40
50
2002 2003 2004 2005 2006Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
Because days sales outstanding has an inverse relationship with
receivables turnover, it is obviously apparent that Sara Lee is going to have the
highest days sales outstanding in the industry, because of their lowest
receivables turnover in the industry. The above table and graph both
demonstrate that over the five years, it took Sara Lee an average of 41.77 days
to collect their receivables. With the average of the industry being 37.06 days,
this demonstrates that Sara Lee is not collecting receivables from sales on credit
in an efficient manner. Since Sara Lee is not collecting cash in an efficient
manner this affects the amount of cash that they could either re-invest in the
company or use to create more sales. This is obviously a downfall that Sara Lee
must deal with and must either decrease accounts receivable while holding sales
constant, or increase total sales relative to accounts receivable; if not this could
restrict them from potential sales in the future. General Mills maintains the
lowest average DSO ratio out of the industry due to their lower accounts
receivables relative to sales.
63
Working Capital Turnover
2002 2003 2004 2005 2006
Sara Lee -30.44 20.08 48.75 17.24 32.08
General Mills -3.44 -39.65 24.17 -9.96 -3.93
Kraft 103.56 117.91 49.96 -59.75 -15.48
Working capital explains how well a company is using it’s working capital
to create sales. Working capital is found by subtracting current liabilities from
current assets. Then dividing sales by working capital will give you the working
capital turnover. This reveals how well a firm’s investment in there working
capital is used to generate sales. A high ratio can mean that the firm is able to
generate more sales with a lower amount of working capital. But, this ratio can
be misleading since, the reason for low working capital can have different
effects. For instance, if working capital is lowered due to an unjustifiable
increase in current liabilities or decrease in current assets, then that would show
an unfavorable impact on the firm.
Working Capital Turnover
-100
-50
0
50
100
150
2002 2003 2004 2005 2006
Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
64
Sara Lee is able keep a moderate working capital turnover ratio from 2002
to 2004. In 2002, Sara Lee produced a negative working capital turnover due to
their current liabilities remaining larger than their current assets by $477 million.
The jump from 2002 to 2003 was due to an increase in both sales and current
assets, with also a decrease in current liabilities. From 2002 to 2003, sales
increased around $400 million, while total current assets increased around $989
million. On the other hand, the decrease of total current liabilities of around
$231 million helped increase Sara Lees’ working capital turnover by 50.52. Sara
Lee was able to maintain an increase in their WCT ratio from 2003 to 2004 for
different reasons than the year before. From 2003 to 2004, Sara Lee increased
their sales by $973 million and actually decreased their total current assets by
$176 million; with an increase in current liabilities of $241 million as well. While
sales did increase, this can have a negative affect on Sara Lee if they continue to
increase their current liabilities by larger amounts in the future. Kraft’s ratio
drops from 2003 to 2005 due to a large increase of current assets of around
$2.27 billion over that two year time period. General Mills’ ratio decreased
significantly from 2002 to 2003, due to current liabilities outweighing current
assets by $2.3 billion. Compared to others in the industry, Sara Lee seems to be
maintaining a more efficient WCT over the five year period, due to their steady
increase in sales as well as their steady increase in currents assets over their
current liabilities.
65
Liquidity Analysis
2002 2003 2004 2005 2006 Opinion
Current Ratio 0.91 1.14 1.06 1.19 1.08 Positive
Quick Ratio 0.38 0.54 0.47 0.44 0.63 Steady/Average
Inventory
Turnover
3.59 3.49 3.55 4.66 4.66 Negative
Days Supply
of Inventory
101.67 104.58 102.82 78.33 78.33 Positive
Receivables
Turnover
8.21 8.35 8.60 9.56 9.11 Positive
Days Sales
Outstanding
44.46 43.71 42.44 38.18 40.07 Steady
Working
Capital
Turnover
-30.44 20.08 48.75 17.24 32.08 Moderate
The liquidity analysis for Sara Lee was moderately positive, with only a
single factor in which we found to be negative. Sara Lee seemed to lead or rank
among the best with their current ratio, days supply of inventory and receivables
turnover. This shows that Sara Lee is able to meet their short term debt, as well
as collecting receivables at an efficient rate. Their days supply of inventory was
another positive aspect, which shows that the amount of time that it takes for
inventory to be ordered and re-shipped to customers is minimal, allowing them
to keep lower levels of stagnant inventory on hand. Sara Lee seems to have no
major problems with liquidity, but still contains room for improvement. Based on
66
the information provided, we believe that Sara Lee will continue to operate at the
same steady rate or possibly improve over the years to come.
Profitability Ratios
Profitability ratios help show the makeup of a firm’s overall ability to
generate earnings relative to their costs that they have incurred over a specific
time frame. These ratios break down into two categories. The first is operating
efficiency which is shown by gross profit margin, operating expense ratio, and
net profit margin. Operating ratios help show the amount of revenues generated
by a firm in contrast to the expenses incurred while conducting business. The
second category shows a firm’s return on its assets and equity as well as the
productivity of its assets. When comparing profitability ratios as a whole, you
must understand the type of industry that it is in and its possible seasonality
periods. For example, Sara Lee experiences higher revenues in the 2nd and 4th
due to the seasons of Christmas and summer. Since revenues tend to rise a
great deal during these time periods in a seasonal fashion, you would not
compare Sara Lee’s 2nd quarter profit margin to their 3rd quarter profit margin for
obvious reasons. Due to seasonality when dealing with profitability ratios, it is
apparent that one must compare the same time period to the year before in
order to help make a rational decision between the two time periods.
67
Gross Profit Margin
2002 2003 2004 2005 2006
Sara Lee 38% 38% 39% 37% 37%
General Mills 40% 42% 41% 39% 40%
Kraft 40% 39% 37% 36% 36%
Gross profit margin is found by dividing a firm’s gross profits by its total
revenues. This ratio is a good starting point in determining potential profitability
since it reveals the profitability of the products that a firm engages in selling,
given that gross profit only accounts for the cost of goods that are being sold as
an expense. Firms with a high gross profit margin will in turn have the potential
for high returns if they can keep there other costs low. Firms with a low gross
profit margin show that they engage in business with potentially low profits, and
may have a harder time in keeping expenses low enough to ultimately turn a
profit.
Gross Profit Margin
33%34%35%36%37%38%39%40%41%42%43%
2002
2003
2004
2005
2006
Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
68
The above graph and table compare gross profit margin between Sara Lee
and other competitors in the industry. General Mills illustrates that they have the
highest gross profit margin in the industry due their lower revenues relative to
gross profit. General Mills maintained an average gross profit of around $4.2
billion, which was somewhat close to Sara Lee’s of $5.9 billion. Sara Lees’ ratio
is consistently lower than General Mills’ because of their difference in sales; From
2002 to 2006 Sara Lee having average sales of around $15.5 billion and General
Mills having sales around $10.5 billion on average. Kraft on the other hand,
having average sales of around $32.3 billion and gross profit of around $12.1
billion, is not able to compete with Sara Lee and General Mills because of their
high denominator; which is sales. Kraft continued to experience a decrease in
their ratio because of a 15% increase in sales from 2002 to 2006. General Mills
experienced a decrease in their ratio from 2004 to 2006 due to a larger increase
in sales than gross profit. Sara Lee did not see this type of decline until the
middle of 2004, when it experienced a 4.8% decrease in gross profit and an
0.3% increase in sales from 2004 to 2006.
Operating Expense Margin
2002 2003 2004 2005 2006
Sara Lee 29% 28% 30% 29% 30%
General Mills 24% 23% 22% 22% 23%
Kraft 19% 20% 21% 21% 21%
Operating expense ratio relates sales to the selling, general and
administrative expense (SG&A) incurred by a firm. A high operating expense
ratio could be due to an inefficient use of money and poor management
decisions. Since SG&A is one of the largest expenses taking away from profits, it
69
is crucial that a firm keeps it as low as possible while still striving for growth.
Sara Lee maintains a high OEM ratio compared to General Mills and Kraft, due to
their lower sales compared to Kraft and higher operating expenses compared to
General Mills.
Operating Expense Margin
0%5%
10%15%20%25%30%35%
2002
2003
2004
2005
2006
Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
The above graph compares Sara Lee’s operating expense margin to
General Mills and Kraft, as well as the industry average. Sara Lee’s ratio stays at
such a high percentage because they maintained an operating expense near
Kraft’s of around $4 to $5 billion, while also maintaining around half of Kraft’s
sales of $14 to $16 billion. General Mills maintains both low operating expenses
and sales throughout the five year time period. The drop in General Mills’
operating expense margin from 2002 to 2004 was an effect of their SG&A
expenses increasing only around 26% compared to sales, which increased
around 39%. Kraft on the other hand is able to maintain the lowest operating
expense margin in the industry, solely due to their large revenues. Relative to
sales, Kraft’s SG&A expenses make up only 20% of their total revenues on
average; which is favorable when comparing them to Sara Lee, whose SG&A
70
expenses make up around 29% of their total sales on average, and General Mills,
whose SG&A expenses make up around 23% on average. Sara Lees’ high
operating expense margin signifies that a larger portion of their revenues are
going into their operating expenses, therefore leaving less cash to flow into net
income.
Net Profit Margin
2002 2003 2004 2005 2006
Sara Lee 7.0% 7.9% 8.0% 4.5% 3.5%
General Mills 5.8% 8.7% 9.5% 11.0% 9.4%
Kraft 8.5% 11.2% 8.3% 8.5% 8.9%
Net profit margin, or return on sales, shows the percentage of sales
revenues that are left after all expenses have been paid. It is calculated by
dividing net income by sales revenues. Firms with higher net profit margins than
competitors may have a cost leader or differentiation advantage in the industry
and therefore have a high potential for higher sustainable profits. Sara Lees
average net profit margin is around 6%, which mean that $0.06 of every dollar
of sales actually flows into net income. The above graph demonstrates that Sara
Lee contained a fairly high ratio in 2002 to 2004, but had a downfall after 2004.
71
Net Profit Margin
0.00%2.00%4.00%6.00%8.00%
10.00%12.00%
2002
2003
2004
2005
2006
Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
According to the cross sectional analysis graph above, Kraft manages to
have the highest net profit margin ratio up until after 2003. The decrease in
their ratio was due to a decrease in their net income of about 20%, and an
increase in their sales of 10%. From 2002 to 2005 General Mills continued to
experience an increase in both sales and net income. The cause for General
Mills’ decrease in their ratio from 2005 to 2006 was a decrease in their net
income of about 14%. Sara Lee experienced good growth in both net income
and sales from 2002 to 2004, after which they experienced a decrease in net
income of 56%. Due to this large drop in their net profit margin, Sara lee
became less and less of a competitor in cost leadership after 2004. The industry
average was quite stable up until 2003, after which it started to decrease rapidly,
resembling that of Sara Lee, Kraft and General Mills.
72
Asset Turnover
2002 2003 2004 2005 2006
Sara Lee 1.06 0.96 1.07 1.12 0.69
General Mills 0.48 0.58 0.60 0.62 0.64
Kraft 0.52 0.52 0.54 0.59 0.62
Asset turnover is computed by dividing sales by assets in order to
determine the productivity at which a firm utilizes its assets. This ratio shows
the amount of sales dollars generated by each dollar of assets. Sara Lee
maintains a both stable and high asset turnover over the entire five year period.
Sara Lee’s average asset turnover was a 0.98, which is much higher than any
single year produced by General Mills or Kraft. General Mills asset turnover
increased steadily over the entire five years, due to a larger increase in their
sales relative to their total assets. While Kraft did hold an increase in their ratio
at a steady rate of around 0.56, they are restricted in turning out a higher ratio
due to the average value of their total assets being $57.9 billion.
Asset Turnover
0.00
0.20
0.40
0.60
0.80
1.00
1.20
2002 2003 2004 2005 2006
Years
Ou
put
Sara LeeGeneral MillsKraftInustry Avg.
73
The above graph and table demonstrate the number of sales that Sara Lee
is able to generate off of each of their assets. For example, in 2005, Sara Lee’s
asset turnover is a 1.12, which indicates that for every asset they are able to
create $1.12 return in sales. The industry stayed quite steady over the entire
five years, not including 2002 to 2003, due to Sara Lee weighting the industry
down in their decrease from a 1.06 to a 0.96. This particular decrease was
caused by a large increase in their total assets of around $1.8 billion, relative to
their smaller increase in sales of $400 million. The graphs clearly demonstrate
that Sara Lee leads the industry in using their assets efficiently in order help
maximize the creation of sales dollars. Although Sara Lee did have a substantial
decrease in their asset turnover ratio from 2005 to 2006, which was caused by a
decrease in sales of 0.5% and an increase in total assets of almost 2%, they still
maintained a more efficient ratio than anyone in the industry.
Return on Assets
2002 2003 2004 2005 2006
Sara Lee 7.4% 7.6% 8.6% 5.0% 3.8%
General Mills 2.8% 5.0% 5.7% 6.9% 6.0%
Kraft 5.9% 5.9% 4.4% 5.0% 5.5%
The return on assets is a percentage that explains how much profit a
company returns for each dollar of its assets. A high return on assets is good for
a company. A firm should like to see a constant ROA or an increasing ROA.
74
Return on Assets
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
2002
2003
2004
2005
2006
Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
A decreasing ROA like Sara Lee has is not desirable. This means they are
not receiving the same value from each dollar of assets that they were in the
past. The rest of the industry is moderately strong in this area. The graph
shows how the other players in the industry are increasing and Sara Lee is
decreasing significantly. Sara Lee’s total assets have stayed relatively constant
over the past five years, so their net income is the factor in this ratio which is
ultimately hurting them. If they could raise their level of net income they may
be able to improve their ratio altogether.
75
Return on Equity
2002 2003 2004 2005 2006
Sara Lee 34.3% 56.4% 42.6% 26.3% 22.7%
General Mills 12.4% 20.5% 19.0% 18.2% 15.8%
Kraft 13.1% 12.2% 8.9% 9.8% 10.7%
Return on equity is the percentage of the equity that a firm is able to
produce. The basic formula is net income divided by owners equity, but can be
further decomposed as: net income/assets * assets/equity, or ROA multiplied by
financial leverage (Palepu). Firms with high returns on equity show the ability to
generate large profits with little investment from owners. Return on equity is
closely related to the return on assets, these numbers would in fact be equal if a
firm was financed through all equity (Palepu). A firm can increase its return on
equity by increasing its return on assets which will generate more profits to
equity holders, or by acquiring debt in order to finance the assets as long as it is
able to earn a higher return than the interest rate. Sara Lee has shown very
impressive returns on owner equity this is due to its extremely high debt ratio.
This allows them increase their asset base and also generate more profits
available to owners.
76
Return on Equity
0.00%10.00%20.00%30.00%40.00%50.00%60.00%
2002
2003
2004
2005
2006
Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
According to graph above, Sara Lee’s ROE outperforms everyone listed in
the industry. Sara Lee is able to maintain this advantage due to higher net
income in relation to General Mills. Kraft is unable to compete with Sara Lee due
to their large amounts of owners’ equity in relation to net income. While Sara
Lee did experience a large decrease in their ROE after 2003, their ability to
manage their money efficiently enables them to remain ahead of the game.
77
Profitability Analysis
2002 2003 2004 2005 2006 Opinion
Gross Profit
Margin
38% 38% 39% 37% 37% Steady
Operating
Expense
Margin
29% 28% 30% 29% 30% Steady
Net Profit
Margin
7.0% 7.9% 8.0% 4.5% 3.5% Negative
Asset
Turnover
1.06 0.96 1.07 1.12 0.69 Negative
Return on
Assets
7.4% 7.6% 8.6% 5.0% 3.8% Negative
Return on
Equity
34.3% 56.4% 42.6% 26.3% 22.7% Negative
Sara Lee’s profitability ratios have become quite negative over the five
year time period. There are only two ratios that have stayed steady over time,
(not improved), which are their gross profit margin and operating expense
margin. Since their profitability performance has declined over the years, this is
an indication that Sara Lee’s ability to generate revenues relative to their
expenses and other costs has decreased over the past five years. Based on the
information, we believe that Sara Lee will continue to fall behind in generated
revenues unless action is taken to revamp their numbers.
78
Capital Structure Ratios
Firms have two ways in order to finance their assets. One source of
financing is the use of equity which is capital provided by the firm’s owners. The
other available method of financing is through debt, which will be profitable and
increase the return on equity as long as the return on debt is higher than its
cost. Capital structure ratios analyze the way that a company structures the
financing its business, how these decisions effect profitability and the ability to
service its debt requirements. The three ratios we will use to analyze the capital
structure of Sara Lee and industry competitors are debt to equity, times interest
earned, and debt service margin.
Debt Service Margin
2002 2003 2004 2005 2006
Sara Lee N/A 3.897
14.586
16.071
5.155
General Mills 2.14 4.88 5.89 1.53 1.28
Kraft .83 4.05 4.76 4.47 2.81
The debt service margin is used to measure a firm’s ability to pay its debt
that is due within one year with its current cash flows. A margin of 5 for
example means that the firm as five dollars for every one dollar of debt due in
one year. An example of a bad margin would be Kraft’s numbers in 2002. With
the number less than one Kraft did not have enough cash flow to support their
payments on debt.
79
Debt Service Margin
02468
1012141618
2002 2003 2004 2005 2006Year
Sara LeeGeneral MillsKraft
Sara Lee has a healthy debt service margin for the last few years. They
are actually well above the industry except for the year 2003. Sara Lee saw such
large increase in this margin in 2004 due to both a drop in notes payable and an
increase in cash flow. In 2005, cash flow actually decreased but notes payable,
which were due that year dropped dramatically. Sara Lee’s strong credit rating
was shown in July 1, 2006, when they paid out a $0.79 dividend/share, which
happens to be $0.07 more than their net income per share at $0.72. This shows
that Sara Lee has no contingencies prohibiting them from paying more dividends
than earnings. Since Sara Lee demonstrates a strong ability to pay off their
debt, this implies that Sara Lee would be able to take on more debt if they
choose to do so.
80
Debt to Equity
2002 2003 2004 2005 2006
Sara Lee 3.65 6.42 3.98 4.23 4.93
General Mills 3.44 3.04 2.33 1.65 1.64
Kraft 1.21 1.08 1.00 .95 .95
The debt to equity ratio relates a firms debt to their equity to show a firms
credit risk (class handout). A firm with a high debt to equity ratio has a higher
credit risk since there debt is high or equity is low in comparison. If the ratio is
above one then a firm uses more debt than equity to finance its assets and may
become a credit risk or even default if they are forced to liquidate. Having a
high debt to equity ratio can be beneficial if the return on debt is greater than
the interest paid. This implies that Sara Lee will be able to borrow at lower
costs, causing them to have a low interest risk.
Debt to Equity
01234567
2002 2003 2004 2005 2006
Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
81
In the graph above Sara Lee shows to have a significantly higher debt to
equity ratio than their competitors. In 2003 their ratio shot up to 6.42 mainly
due to a large increase in the firms long term debt balance of $4.36 billion in
2002 to $5.16 in 2003. In 2004 there ratio came back to their normal levels
since it’s long term debt fell to $4.17 billion. In 2006 Sara Lee’s ratio increased
again from 4.23 to 4.93 because of large increases in short term liabilities mainly
notes payable. Sara Lee has continually maintained a higher margin than
general mills and Kraft foods. While alarming, this ratio can be justified by Sara
Lee’s higher return on assets and return on equity. This indicates that they
efficiently use debt financing to increase overall returns on equity. Kraft for
example has maintained a lower and more consistent debt ratio but also has
lower returns.
Times Interest Earned
Times interest earned show a firm’s capabilities to pay interest charges
from both current and long term debt with its operating income. This ratio is
calculated by dividing operating income by its interest expense. A ratio that is
high shows adequate income to pay interest expenses while a low ratio shows
that a firm is not generating enough income from operations in relation to their
interest charges and may be in danger of defaulting on loans or receiving higher
interest rates on borrowing.
2002 2003 2004 2005 2006
Sara Lee 7.02 4.29 4.09 3.44 2.96
General Mills 7.15 7.47 8.35 9.86 12.74
Kraft 14.05 17.95 17.60 18.92 23.37
82
Times Interest Earned
0
5
10
15
20
25
2002 2003 2004 2005 2006
Years
Ou
put
Sara LeeGeneral MillsKraftIndustry Avg.
The graph of times interest earned reveals that Sara Lee has a
substantially lower ratio than its competitors. Sara Lee’s ratio has also steadily
declined from 7.02 in 2002 to 2.96 in 2006. The very large decrease in 2006
was due to an increase in interest expense of $20 million from 2005 and a
decrease of operating income from $1.37 billion in 2005 to $911 million in 2006.
This drop in operating income is mainly accredited to the impairment charges of
$193 million incurred from its restructuring process. Kraft and General Mills
ratios are far higher than Sara Lee in 2006 with Sara Lee at 2.96, General Mills at
12.74 and Kraft at 23.37.
83
Capital Structure Analysis
2002 2003 2004 2005 2006 Opinion
Debt Service
Margin
N/A 3.897 14.586 16.071 5.155 Positive
Debt to Equity 3.65 6.42 3.98 4.23 4.93 Positive
Times interest
Earned
7.02 4.29 4.09 3.44 2.96 Negative
Sara Lee’s capital structure ratios have been quite positive over the years.
Sara Lee sees to have a very good credit rating by being able to pay back their
debts quickly. Although their debt to equity is higher than usual, Sara Lee is
financing their equity at an efficient manner. The only aspect that is negative is
their times interest earned. This was caused by decreases in their operating
income and increases in their interest expense. Overall, we believe that Sara Lee
is financing their operations in an efficient manner, allowing them lower their
borrowing costs and exceed their cost of capital.
Sustainable Growth Rate and Internal Growth Rate
The sustainable growth rate, commonly referred to as SGR, is defined as
being the rate at which a firm can grow while keeping its profitability and
financial policies unchanged (Palepu). This essentially means how much a
company can grow without taking on more equity. SGR equals the internal
growth rate multiplied by the difference of one and dividends paid divided by
equity (SGR=IGR(1-D/E)). The internal growth rate, commonly referred to as
IGR, is defined as being the rate at which a firm can grow without additional
financing (investopedia.com). IGR equals the return on assets multiplied by one
minus the dividend payout ratio (IGR=ROA(1-D/NI)).
84
SGR and IGR are positively related to one another. This means when IGR
goes up, SGR goes up and vice versa. SGR will also be higher than IGR due to
their mathematical relation. This is true except in the extremely rare instance
when IGR is negative. This occurred during year 2006 for Sara Lee. This
happened because the company paid more dividends than they had net income.
This causes the dividend payout ratio to be greater than one and thus causing a
negative IGR. For Sara Lee to pay more dividends than net income for that
particular year they had to reduce retained earnings. This practice allows a
negative growth rate to make sense. This also means that Sara Lee had to
acquire more debt to just have a 0% growth rate.
Sara Lee’s growth rates have dropped every year since 2003. This is not
a good quality. This means that the company must borrow more and more
money each year to keep a constant growth rate. This can be seen on the
company’s financial statements. They have the highest current liabilities in the
last five years for 2006, and their total liabilities are the highest since year 2003.
Sara Lee must improve this situation if they want to stay profitable. If they
continue with the decreasing growth rate trend they will spiral into massive debt.
The chart below shows the SGR and IGR for Sara Lee and its competitors.
85
IGR
2002 2003 2004 2005 2006
Sara Lee 3.84% 4.37% 3.75% 1.78% -0.76%
Kraft 4.27% 4.05% -0.94% 2.53% 2.69%
General Mills -4.29% -1.11% -0.40% 0.59% 2.90%
SGR
2002 2003 2004 2005 2003
Sara Lee 4.47% 5.41% 4.65% 2.08% -0.96%
Kraft 4.12% 3.90% -0.90% 2.41% 2.54%
General Mills -2.95% -0.83% 0.08% 0.49% 2.66%
As the chart shows, Sara Lee’s competitors have been improving their
growth rates while Sara Lee’s has been decreasing in the most recent years.
Obviously as shown by General Mills, a negative IGR and SGR does not mean
doom, but Sara Lee needs to stay away from negative years like they had in
2006.
Forecasted Financial Statements
In forecasting Sara Lee’s financial information we used industry averages
and financial ratios in order to accurately forecast this data. Most firms that
demonstrate a competitive advantage over competitors will tend to lose it and
revert to industry averages over time. Since this forecast is for 10 years we
made gradual adjustments to account for such circumstances. Also, some ratios
such as asset turnover tend to remain consistent over time and forecast have
been made to reflect these trends. The income statement and balance sheet
were forecasted to show dollar amounts as well as in common size form to show
86
percentages and better communicate the trends and make up of the firms
financial status.
Income Statement
In the forecast of the income statement we used trends set by Sara Lee
and its competitors to try to accurately predict future revenues and expenses.
To forecast future net sales we found an average sales growth of Sara Lee and
competitors for years 2002 through 2006. With this information showing that
sales tend to grow at an average rate of 4% per year, which is the rate that was
forcasted. We feel that this is a reasonable estimate given the highly
competitive nature of the industry and small chance to gain market share. The
previous financial statements indicated that the Hanes segment consistently
accounted for approximately 4 billion dollars of revenues a year. A major
adjustment was made to the starting forecast year to decrease sales in order to
account for the spin off of the branded apparel segment which had no effect on
2006 or previous years.
For future estimates of cost of goods sold we predict them to stay at a
constant rate of 61% of total sales revenue given that this was consistent trend
for the past 5 years. For the forecast of SG&A we started with a slightly lower
percentage of sales than average due to restructuring efforts which already
showed a slight decrease and is expected to take full effect in 2007 and continue
for the foreseeable future. At this point we have an operating income of 10.8%
of net sales. This percentage is consistent with industry averages and should
give accurate estimates given the maturity of this industry. We estimated that
the interest expense would stay at a constant rate of 2.1% of total liabilities and
that interest income would be 4.1% of accounts receivable, leaving the income
from operations, net of tax, at 9.5% of sales. We assumed a constant tax rate
of 35% which was the most logical choice given past information. Given all this
87
information we believe that Sara Lee will generate a net income of 7.2% of net
sales a slightly higher rate than it did in 2005 and 2006. We believe this to be a
logical conclusion given the recent restructure and trends to move toward
industry averages. We feel that based on analysis of competition, competitive
advantage and financials of the firm and industry that these are reasonable
estimates of future earnings.
INCOME STATEMENT
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
NET REVENUES 14519 14919 15892 16029 15944 11806 12278 12769 13280 13811 14364 14938 15536 16157 16804 4% growth rate
COGS 9001 9249 9684 10024 10023 7333 7626 7931 8249 8579 8922 9279 9650 10036 10437 62.1% of sales
GROSS INCOME 5518 5670 6208 6005 5921 4473 4652 4838 5032 5233 5442 5660 5886 6122 6367 37.9% of sales
SG&A 4245 4212 4811 4663 4843 3188 3315 3448 3586 3729 3878 4033 4195 4362 4537 27% of sales
OPERATING INCOME 1242 1458 1485 1369 911 1273 1324 1376 1432 1489 1548 1610 1675 1742 1811 10.8% of sales
INTEREST EXPENSE 177 340 270 288 308 214 222 231 240 250 260 270 281 292 304 2.1% of total debt
INTEREST INCOME 80 80 80 90 80 62 64 67 69 72 75 78 81 84 88 4.1% of A/R
INCOME PRE-TAXES 1022 1023 1295 1180 683 1122 1165 1212 1261 1311 1363 1419 1475 1534 1595 9.5% of sales
INCOME TAXES 126 (47) 244 99 273 392 408 424 441 456 477 496 516 537 558 35% tax rate
INCOME CONT OPS 896 1070 1051 1081 410 730 757 788 820 855 886 923 959 997 1037 6.2% of sales
NET INCOME 1010 1174 1272 719 555 841 875 910 946 984 1024 1065 1107 1151 1198 7.1% of sales
88
Balance Sheet
For forecasts of the balance sheet we started by predicting that Sara Lee
would maintain a return on assets of 6.8% this was found by taking averages of
Sara Lee and its competitors from 2002 to 2006. Sara Lee’s make up of
financing for assets has been comprised mainly of debt in years 2002 through
2006 causing them to have a much higher return on equity than their
competitors we forecasted that this would slowly decline back to industry norms
over the next 10 years. We used a starting point of 21.9% of assets financed
through equity and ended in 2016 with 36% of assets financed by equity as
shown on the common sized balance sheet. This number was forecasted by
adding the difference of net income and dividends paid to the previous book
value of equity. For current and long term assets and liabilities we set them
equal to the past averages of Sara Lee’s current ratios. We feel that these will
prove accurate since they have been somewhat constant and should remain
necessary in order to maintain sales volumes. Asset balances such as accounts
receivable were calculated at 12.5% percent of net sales. Inventories were
taken at a percentage of the cost of goods sold with an adjustment from 2007 to
2011 to bring Sara Lee’s inventory turnover margin from 4.9 to approximately 6
then kept steady after that. We feel that this decrease in inventory is justified by
industry norms and the recent restructuring efforts. Other small items within the
current and long term assets and liabilities that were thought to be forecastable
were also forecasted at a percentage of their larger account found within the
common sized statement.
89
BALANCE SHEET 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Assets:
Cash and equivalents 298 1004 655 533 2231 1476 1608 1744 1886 2030 2113 2198 2284 2377 2472 11.9% to 14%
Accounts receivable 1768 1787 1848 1677 1750 1476 1535 1597 1662 1727 1797 1869 1943 2022 2102 11.9%
Inventories 2509 2652 2728 2151 2153 1490 1478 1466 1454 1440 1499 1559 1620 1686 1753 12.1% to 10%
Other current assets 341 359 380 410 301
Assets of discont operations 7 110 125 1172 339
Total current assets 4923 5912 5736 5943 6774 4570 4754 4945 5146 5347 5564 5787 6015 6260 6509 36.9%
Other noncurrent assets 192 281 143 117 118
Deferred tax asset 4 453 281 53 91
Land 176 195 148 130 135 127 132 137 142 148 154 160 167 173 180
Buildings and improvements 1744 1895 2030 1712 1795 1552 1615 1680 1748 1816 1890 1966 2043 2126 2211
Machinery and equipment 4299 4872 5045 4367 4531 3929 4088 4252 4425 4598 4784 4976 5172 5382 5597
Construction in progress 320 289 382 204 258 236 246 255 266 276 287 299 311 323 336
Accumulated depreciation 3384 3939 4269 3577 3777 3251 3382 3517 3660 3803 3958 4116 4279 4453 4631
Property, net 3155 3312 3236 2836 2942 2573 2677 2784 2897 3010 3133 3258 3387 3524 3665 21.3%
Trademarks and intangibles, 2106 2058 1977 1395 1185
Goodwill 3314 3331 3354 3018 3052
Assets of discont. operations 0 149 152 938 360 2.2%
Total Assets 13694 15496 14879 14300 14522 12368 12868 13382 13926 14471 15059 15662 16279 16941 17618 assume 6.8% ROA
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Liabilities and Equity Notes payable 468 140 84 239 1784 435 445 454 463 470 477 483 487 490 491 Accounts payable 1359 1314 1293 1115 1226 1058 1082 1105 1126 1144 1161 1175 1185 1192 1194 Payroll and benefits 1147 1193 1150 929 996 Advertising and promotion 421 439 531 431 475 Taxes other than payroll 102 111 119 87 79 Income taxes payable 122 22 247 142 253 Other 1047 900 829 774 790 Current maturities lt debt 734 1004 1070 380 368 Liabilities of discont operations 0 46 87 916 306 298 305 311 317 322 327 331 334 336 336 Total Current Liabilities 5400 5169 5410 5013 6277 4646 4752 4850 4945 5024 5100 5161 5204 5235 5243 dec liab 17%
Long-term debt 4357 5157 4171 4112 3807 Pension obligation 220 1178 870 766 436 Other liabilities 1325 1496 1362 1410 1417 Liabilities of discont operations 0 18 7 206 68 Minority interest in subsidiaries 632 356 74 61 68 Total Liabilities 10746 13413 11894 11568 12073 9652 9851 10053 10249 10429 10614 10796 10950 11126 11272 Total Common Equity 2948 2083 2985 2732 2449 2716 3016 3229 3678 4042 4445 4866 5330 5815 6346 inc equity 17% Total Liabilities and Equity 13694 15496 14879 14300 14522 12368 12868 13382 13926 14471 15059 15662 16279 16941 17618
90
Statement of Cash Flows
After forecasting the balance sheet and income statement we used a
straight forward method of constructing the statement of cash flows from items
that we found forecast able in the other two statements. By using this method
in forecasting the operating segment of the cash flow statement we feel that we
have reached an accurate forecast of cash from operating activities. This is due
to the fact that Sara Lee has demonstrated a fair amount of consistency in their
operations over the analyzed years and we do not expect any major changes to
occur in this industry. We also feel that changes made to bring Sara Lee to
industry norms and reflect the recent restructuring attempts are accurate. Items
that were able to be forecasted have shown little impact in the past and should
not cause the forecasts to be greatly effected. Upon examining the investing
and financing sections of the statement of cash flows we determined that they
were to volatile for prediction, and any forecasts made could not be relied upon
to give an accurate view of future cash flows.
91
STAEMENT OF CASH FLOWS
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Net Income / Starting Line 1010 1187 1272 719 555 841 875 910 947 984 1024 1065 1107 1152 1198
less: contingent sale proceeds 0 0 -119 -117 -114
Depreciation & Depletion 471 525 561 570 541
Amoritization of Intangible Assets 111 136 173 181 160
Impairment 0 0 0 350 587
net gain on bussiness dispositions 0 -16 14 -69 -589
Deferred Income 21 5 166 186 112
other 0 42 149 60 57
Dec(Inc) In Receivables 93 94 -44 -199 -14 274 -59 -62 -65 -65 -70 -72 -74 -79 -80
Dec(Inc) In Inventories 304 -23 -45 8 108 663 12 12 12 14 -59 -60 -61 -66 -67
Dec(Inc) In Other Assets/Liabilities 7 -17 44 -9 -65
Inc(Dec) In act payable -- -126 45 0 -10 168 -24 -22 -22 -18 -17 -14 -10 -7 -2
Inc(Dec) In Other Accruals 27 0 -174 -330 -96
CFFO 1735 1824 2042 1350 1232 89 1600 1659 1694 1783 1711 1774 1839 1907 1978
Capital Expenditures 669 746 -530 -538 -625 251 -68 -70 -74 -74 -80 -82 -84 -90 -92
Net Assets From Acquisitions 1930 -10 0 -2 -78 369 -104 -107 -113 -113 -122 -125 -128 -138 -141
Disposal Of business investments 136 0 137 86 868 602 -159 -164 -173 -173 -187 -192 -196 -210 -215
CFFI 2475 -674 -184 -233 365 1222 -331 -340 -360 -360 -389 -399 -409 -438 -447
FCF 4210 1150 1858 1117 1597 1311 1269 1319 1334 1423 1322 1375 1430 1469 1531
Proceeds From Sale Stock 0 98 139 161 27
Com/Pfd Purchased 138 -555 -350 -396 -561
Long Term Borrowings 1362 1773 1 339 37
Reduction In Long Term Debt 503 -995 -1288 -1033 -467
Inc(Dec) In Short Term Borrowings 124 -359 -19 178 1528
Other Sources - Financing 0 0 0 0 33
Cash Dividends Paid - Total 484 -497 -714 -464 605
CFFF 470 -535 -2231 -1215 -8
92
Cost of Capital
There are three main areas of cost of capital: weighted average cost of
capital, cost of debt, and cost of equity. Cost of capital is crucial in estimating
the value of a firm. Models that use cost of capital information are the
discounted dividends, residual income, abnormal earnings growth, free cash
flows, and long run return on equity. In order for us to perform correct
estimations of the value of Sara Lee, it is crucial that we perform the cost of
capital calculations accurately.
WACC
WACC is the starting point for many valuation models. It is crucial to the
valuation process. The formula for WACC is as follows:
WACC= (Vd/Vf)(Kd)(1-T) + (Ve/Vf)(Ke)
The value of debt (Vd) is simply the book value of debt. Sara Lee’s total
liabilities are $12,073 million. The value of equity (Ve) is the market value of
equity. This is the market capitalization. Market capitalization is the number of
outstanding shares times the current price per share. Sara Lee’s market
capitalization is $12,359 million. The market value of the firm is found by adding
together the market values of the equity and debt. Sara Lee’s firm value is
$24,432 million. We chose to use a 35% tax rate for our valuations and
forecasting due to historical trends. When the numbers for the WACC are
inserted in a weighted average cost of capital of 6.07% is found. The cost of
debt and the cost of equity will be explained in the next two paragraphs.
93
Cost of Debt (Kd)
To find the cost of debt for Sara Lee we had to give discount rates to each
of the liabilities on the balance sheet. The long-term liabilities were broke down
well in Sara Lee’s 2006 annual report filed with the SEC. Using weighted
averages we calculated the long term discount rate. Below are a few examples
of how the long-term liabilities were broken down. The chart shows the type of
liability, interest rate on the liability, amount of the liability, and a its percentage
of total liabilities. (Please see the appendix for fully disclosed information on this
subject.) The short-term and current liabilities were broke down into categories
and given rates based on treasury bills. We found these rates on the St. Louis
Federal Reserve website. Then we used weighted averages based on the
percentage of each specific liability in the total debt to find the cost of debt. We
found the cost of debt to be 5.53%.
6.125% Notes 6.13% 759 1.22%
11.35% Mex. Pesos 11.35% 34 0.10%
5.6-6.95% medium
notes 6.28% 252 0.42%
2.75% Notes 2.75% 300 0.22%
7.05-7.40% Notes 7.23% 75 0.14%
6.5% Notes 6.50% 150 0.26%
Cost of Equity (Ke)
Cost of equity is essential in determining the residual income model,
discounted dividends, abnormal earnings growth, and the long run ROE
perpetuity. We had to run regressions on numerous data sets to determine the
accurate beta and risk free rate. To solve for cost of equity we used the CAPM
model. The CAPM model (with determined information) is as follows:
94
Ke = Risk Free Rate + Beta*Market Risk Premium
Ke = 5.16% + .6550(5.08%)
Ke= 8.488%
To get the necessary information for this model we had to use various
market data. We observed monthly pricing data for treasury bills and the
monthly share prices for Sara Lee. We compared these rates with the rates from
the S&P 500 index. We chose to use the 3 month Treasury bill to do our
observations with due to its high adjusted r squared figure. The higher the r
squared for an observation the more relevant it is to determining future values.
Based on our calculations we derived a market risk premium of 5.08%. We feel
this is a sound MRP for the market. The beta of .655 was found by comparing
stock performance of Sara Lee with that of the market. This beta is even
actually very close to other current estimates done by other analysts in the
market (e.g. yahoo.com/finance). This gives us even more confidence that the
beta is accurate. The tables below show a summary of this information.
Cost of Equity Estimations:
10 Year (Rf = 5.92%) 7 Year (Rf = 4.71%)
Months Beta R^2 Ke Months Beta R^2 Ke
72 0.3247 0.0485 0.0777 72 0.3217 0.0478 0.0616
60 0.6521 0.1831 0.0964 60 0.648 0.1814 0.0763
48 0.4693 0.0581 0.086 48 0.4659 0.0566 0.0681
36 0.5983 0.1078 0.0934 36 0.5929 0.1065 0.0738
24 0.6479 0.0986 0.0962 24 0.6456 0.0991 0.0762
95
5 Year (Rf = 4.71%) 1 Year (Rf = 5.05%)
Months Beta R^2 Ke Months Beta R^2 Ke
72 0.3225 0.0481 0.0617 72 0.3244 0.0488 0.0665
60 0.6496 0.1823 0.0766 60 0.6545 0.1845 0.0829
48 0.4677 0.0575 0.0683 48 0.4738 0.0602 0.0739
36 0.5973 0.1082 0.0742 36 0.6126 0.1141 0.0808
24 0.6444 0.0987 0.0764 24 0.6399 0.0958 0.0822
3 Month (Rf = 5.16%)
Months Beta R^2 Ke
72 0.3236 0.0485 0.068
60 0.655 0.1846 0.0849
48 0.4749 0.0604 0.0757
36 0.6136 0.1142 0.0828
24 0.6382 0.0947 0.084
Valuations
Several common models are used to determine the intrinsic value of Sara
Lee. We use the method of comparables, discounted dividends model,
discounted free cash flow model, abnormal earnings growth model, residual
income model, and the long-run ROE/RI model. These models all have various
components that include figures such as earnings, dividends paid, cost of equity,
weighted average cost of capital, and growth rates. The most reliable model is
the residual income model. It is most reliable because of the use of benchmark
earnings, also known as normal earnings. This gives the model stability in the
perpetuity. The dividend model and the cash flow model are not as reliable, so
we do not put as much value in their estimates for Sara Lee. The method of
comparables is more or less a good screening tool to get a quick snapshot of
Sara Lee. Overall, these models show that Sara Lee is an overvalued firm.
96
Method of Comparables
2006 PPS EPS BPS DPS
SLE 16.02 0.72 3.22 0.79
GIS 51.79 3.05 16.12 1.34
KFT 35.70 1.86 17.45 0.96
The Method of Comparables valuation method is quick and easy screening
tool, that helps explain the value of an asset based on the most recent historical
data. This particular valuation method can be somewhat unreliable, since the
accuracy of the comparables largely depends on the industry average. This can
be a problem because some of the figures are not applicable due to their
negative value, causing vital information to be left out in helping us value Sara
Lee. Although, in some instances, these valuation methods due provide
unreliable measures, they are still a valuable tool in comparing Sara Lee to its
competitors.
SLE SHARE PRICE
P/E 2006 $13.02 P/E 2005 $14.22 P/B $8.47 P/S $35.38 D/P $2.93 PEG $13.32
97
Forward P/E (2006)
PPS EPS P/E IND. AVG SLE PPS SLE $16.02 $0.72 $22.25 $13.02 GIS $51.79 $3.05 $16.98 KFT $35.70 $1.86 $19.19 $18.09
In estimating Sara Lee’s share price using the P/E valuation method, you
must start by multiplying the competitor’s price per share by their earnings per
share. After taking an industry P/E average, you then multiply this by Sara Lees
earnings per share. This calculation will in turn give us Sara Lee’s current
forward share price. In this instance, Sara Lee’s share price is $13.02. In
comparing it to their own price per share of $16.02, this implies that Sara Lee is
an overvalued company.
Trailing P/E (2005)
PPS EPS P/E IND. AVG SLE PPS SLE $19.65 $0.91 $21.59 $14.22 GIS $49.68 $3.34 $14.87 KFT $28.17 $1.72 $16.38 $15.63
In calculating the trailing P/E ratio, you use the same methods that you
used in calculating the forward P/E ratio. You start out by multiplying the
competitor’s price per share by their earnings per share. You then take an
industry P/E average and multiply this by Sara Lee’s earnings per share. The
only thing that different about the trailing P/E ratio and the forward P/E ratio, is
that for the trailing P/E ratio you use previous year data; hence “trailing” P/E.
This particular valuation insists that Sara Lee is undervalued by $5.43; actual
price being $19.65 and valued price being $14.22.
98
Price to Book P/B
PPS BPS P/B IND. AVG SLE PPS
SLE $16.02 $3.22 $4.98 $8.47 GIS $51.79 $16.12 $3.21 KFT $35.70 $17.45 $2.05 $2.63
In calculating price to book, you divide price per share by the book value
per share for each of the competitors. After this, you find an industry average in
which you will multiply by Sara Lee’s book value per share. This particular ratio
states that Sara Lee is overvalued, with a price at $16.02. The ratio indicates
that Sara Lee’s share price should be $8.47, which would be a reasonable price if
Sara Lee’s return of equity was not as high and more like the industry norm.
Price to Sales P/S
PPS SPS P/S IND. AVG SLE PPS
SLE $16.02 $20.81 $0.77 $35.38 GIS $51.79 $32.51 $1.59 KFT $35.70 $19.81 $1.80 $1.70
Calculating the price to sales ratio is much like calculating the price to
earnings and market to book ratio. You start out by dividing the competitor’s
price per share by their sales per share, and then add them up to take an
industry average. We then multiplied the industry average by Sara Lee’s sales
per share to get their estimated share price of $35.38. This ratio insists that
Sara Lee is undervalued by $19.36.
99
Dividend/Price D/P
PPS DPS D/P IND. AVG SLE PPS
SLE $16.02 $0.79 $0.49 $2.93 GIS $51.79 $1.34 $0.26 KFT $35.70 $0.96 $0.27 $0.27
The dividend to price valuation displays that Sara Lee’s estimated share
price should be $2.93. According to this Sara Lee is overvalued by $13.09, with
their actual price being $16.02. In finding D/P, you divide the dividend per share
by price per share, for all competitors. After taking the industry average we
divided Sara Lee’s dividends per share by the industry average in order to get an
estimated share price.
Price Earning Growth (P.E.G)
PPS EPS G PEG IND. AVG SLE PPS
SLE $16.02 $0.72 4.0% $23.18 $13.32 GIS $51.79 $3.05 7.5% $18.36 KFT $35.70 $1.86 5.0% $20.20 $19.28
In finding Sara Lee’s price earnings growth, we started out by finding the
competitor’s P/E ratio. After finding this, we divided their P/E ratio by
(1-growth rate). After taking an industry average we multiplied the industry
average by (1-growth rate), times Sara Lee’s earnings per share. With an
share value of $13.32, this valuation model suggests that Sara Lee is overvalued
at $16.02 per share.
100
Discounted Dividends Valuation Model
The discounted dividends model is a method to value the equity of a firm.
In this process the present value of all forecasted dividend payments is found to
be the current market value of shareholder equity. This valuation model is
relevant since all future dividends to shareholders in the form of cash payoffs
represent the value of equity relative to the firms cost of capital. In order to
forecast the future dividends for Sara Lee we reviewed dividend payoffs for the
previous 10 years, this revealed a steady trend in the amount of dividends paid
each quarter. From this we derived that in 2007 dividend payout would total
$575 million and increase $0.03 per share every other year until reaching a
perpetuity payment amount of $666 million in 2017.
After forecasting the dividends we used the cost of equity that we found
to be 8.4% to discount back forecasted dividend payments back to present value
terms. We found the present value of all forecasted dividends from 2007 to
2016 to be $4025 million. The present value of the perpetuity starting in 2017
has an estimated value of $4548 million. This value was found using an 8.4%
cost of equity capital and a dividend growth rate of 2%. This valuation gave an
intrinsic present value of $8573 million as of April 1 2007. This gives a per share
value of $11.24. This valuation would indicate that Sara Lee is overvalued given
that the market price per share of $16.92. In the sensitivity analysis of Sara lee
estimations of stock value ranged from $14.06 given a 0% growth rate and 6%
cost of equity, to $10.43 with a 2% growth rate and a 9% cost of equity. This
valuation does hold some validity in the estimation of stock price given the
consistency of payoffs Sara lee has maintained over the previous years. On the
other hand this model could be misleading given that it does not take into
account the amount of money that is reinvested into the firm in other methods
that could add value to the firm.
101
Discounted Dividends Sensitivity Analysis
g
0.00 0.01 0.02 0.03 0.04
0.06 $14.06 $15.68 $18.12 $22.17 $30.30
0.07 $12.00 $13.05 $14.54 $16.75 $20.35
Ke 0.085 $9.84 $10.45 $11.24 $12.33 $13.91
0.09 $9.27 $9.78 $10.43 $11.32 $12.54
0.10 $8.31 $8.68 $9.15 $9.75 $10.56
Undervalued
Overvalued
Discounted Free Cash Flow Valuation Model
In the cash flow valuation model for Sara Lee we forecasted out free cash
flows to the firm of $1311 million in 2007 through 2016 with a free cash flow of
$1531 million. Free cash flows are made to all of the firm’s assets whether
funded by debt or equity. Therefore we used Sara Lee’s weighted average cost
of capital (WACC) of 6.07% to discount future free cash flows back to present
value of ending fiscal year 2006. We found the value of forecasted cash flows to
assets from 2007 to 2016 to be $10,027 million. Then we found that the
perpetuity payment of $1608 in 2017 to grow at a rate of 2 % giving a present
perpetuity value of $21,910 million as of 2006. Then by adding our present
values together and taking out the value of debt we were able to derive a
intrinsic share price of $25.93 as of July 31, 2006 or $26.02 at April 1, 2007 in
which would indicate that Sara Lee is under valued with a stock price of $16.92.
Prices in the sensitivity analysis range from $140 per share to $8.37. Since, cash
flows are hard to predict, and this model does not do very well to explain
variations in stock price due to variations in the future free cash flows. The fact
102
that it shows the intrinsic value to be much higher than the value provided by
the discounted dividends and residual income models makes an argument that
this valuation method may not be accurate.
Free Cash Flows Sensitivity Analysis
g
0 0.01 0.02 0.03 0.04
0.04 $34.28 $46.11 $69.79 $140.84 N/A
0.05 $23.88 $30.33 $41.09 $62.63 $127.23
WACC 0.061 $16.57 $20.36 $26.02 $35.37 $53.75
0.07 $12.05 $14.60 $18.16 $23.52 $32.45
0.08 $8.37 $10.11 $12.45 $15.70 $20.58
Undervalued
Overvalued
Residual Income Valuation Model
The residual income valuation method measures net income against a
future benchmark of earnings to find the residual income, and then discounts the
residual income to a present value. For this valuation we used forecasted values
for net income from the income statement, the book value of equity from the
balance sheet, and our forecasted dividend values from the dividends model.
The benchmark earnings were found by multiplying the previous BVE by the cost
of equity, which was found to be 8.4%. The present value of forecasted earning
from 2007 to 2016 equaled $4,185 million. A perpetuity residual income $659
million with a negative growth rate of 30% revealed a present terminal value of
$336 million. Along with a current book value of equity of $2449 million the total
present value was $6,970 million. The intrinsic share price was found to be
$9.10 per share as of July 31, 2006 and $9.44 as of April 1, 2007. These values
103
indicate that Sara Lee is currently overvalued with a current market price of
$16.92. in the sensitivity analysis the values ranged from $8.90 to $11.40 all of
which indicating a substantial overvaluing in the market. We believe this to be a
fair estimate given its consistency with the discounted dividends and abnormal
earnings models.
Residual Income Sensitivity Analysis
g
(0.10) (0.20) (0.30) (0.40) (0.50)
0.06 $12.00 $11.47 $11.24 $11.11 $11.02
0.07 $11.10 $10.66 $10.46 $10.34 $10.27
Ke 0.085 $9.92 $9.59 $9.44 $9.34 $9.28
0.09 $9.56 $9.26 $9.11 $9.02 $8.96
0.1 $8.90 $8.65 $8.52 $8.44 $8.39
Undervalued
Overvalued
Abnormal Earnings Growth (AEG) Model
This valuation model is second only to the residual income valuation
model in terms of dependability. It does a good job at valuing a firm. It relies
on earnings and dividends to create a valuation. Like residual income,
benchmark earnings (also called normal earnings) are used as a basis in the
model. Normal income is found in this model by multiplying earnings by the one
plus the cost of equity. This creates a more reliable valuation than the free cash
flow and discounted dividends models that do not have any stable benchmark to
follow. Shown below is the sensitivity analysis we created when using the AEG
model.
104
AEG Sensitivity Analysis
g
(0.10) (0.20) (0.30) (0.40) (0.50)
0.06 $8.82 $7.92 $7.51 $7.28 $7.13
0.07 $8.61 $7.80 $7.42 $7.21 $7.07
Ke 0.085 $8.33 $7.63 $7.29 $7.09 $6.96
0.09 $8.24 $7.57 $7.25 $7.06 $6.92
0.1 $8.07 $7.46 $7.16 $6.98 $6.86
Undervalued
Overvalued
We used negative growth rates when performing the AEG model. This
provides a more reliable valuation than using positive growth rates. To use a
positive growth rate would be unrealistic and almost impossible to achieve in a
real world context.
As the chart above clearly states this model highly suggests that Sara Lee
is overvalued. The actual share price of Sara Lee is $16.92 as of April 1, 2007.
The closest estimation on the chart to $16.92 is $8.82, which is achieved with a
6% cost of equity and a -10% growth rate. That is a difference of $8.10 per
share. It should be noted that the original valuations we arrived at were valued
as of July 31, 2006, which is the fiscal year end for Sara Lee. To compensate for
the eight month gap between July 31 and April 1 we had to pull our numbers
forward appropriately. The chart above reflects these changes. Based on this
model Sara Lee is overvalued and the stockholder recommendation would be to
sell.
105
Long Run Return on Equity Perpetuity
This model is another valuable way to determine the worth a company.
The formula for the perpetuity is as follows.
Po = BVE(1 + (ROE-Ke)/(Ke-g))
As shown by the formula, the valuation this model provides is determined
by four components: book value of equity (BVE), return on equity (ROE), cost of
equity (Ke), and growth rate (g). Due to this fact we have ran the model using a
wide variety of different possibilities, with the only constant variable being the
book value of equity. The charts below show this strategy.
Ke
0.06 0.07 0.08488 0.09 0.10
0 12.18 10.44 8.61 8.12 7.31 Undervalued
0.01 13.97 11.65 9.33 8.73 7.76
g 0.02 16.66 13.33 10.27 9.52 8.33 Overvalued
0.03 21.14 15.86 11.56 10.57 9.06
0.04 30.11 20.07 13.42 12.04 10.04
*ROE=22.7%
ROE
0.10 0.15 0.227 0.25 0.30
0 3.79 5.69 8.61 9.48 11.38 Undervalued
0.01 3.87 6.02 9.33 10.32 12.47
g 0.02 3.97 6.45 10.27 11.41 13.90 Overvalued
0.03 4.11 7.04 11.56 12.91 15.84
0.04 4.30 7.89 13.42 15.07 18.65
*Ke=8.488%
106
Ke
0.06 0.07 0.08488 0.09 0.10
0.1 6.44 5.15 3.97 3.68 3.22 Undervalued
0.15 10.47 8.37 6.45 5.98 5.23
ROE 0.227 16.66 13.33 10.27 9.52 8.33 Overvalued
0.25 18.52 14.81 11.41 10.58 9.26
0.3 22.54 18.03 13.90 12.88 11.27
*g=2%
These charts clearly show that this model provides overwhelming
evidence that Sara Lee is overvalued. The actual share price of Sara Lee is
$16.92. There are only seven instances out of seventy-five instances that this
model gives an undervalued estimation. It should be also noted that those
seven instances are all at the extreme ends of the charts, which makes the
possibility of them being accurate very slim. Based on this valuation alone, Sara
Lee’s current stock price is overvalued, and the stockholder recommendation
would be to sell.
Credit Risk Analysis
2002 2003 2004 2005 2006
Altman Z-scores 2.517 2.283 2.762 2.748 2.327
One method used by financial institutions to analyze credit risk of different
companies is the Altman Z-score. The Altman Z-score is a model that was
originally used to try and predict bankruptcy for companies. The model uses
different ratios from the Balance sheet and the Income Statement and assigns
different weights to each of them to come up with a number. The formula for
the Altman Z-score = 1.2(Working Capital/Total Assets) + 1.4(Retained
107
Earnings/Total Assets) + 3.3(EBIT/Total Assets) + .6(Market Value of
Equity/Book Value of Liabilities) + 1(Sales/Total Assets). This number
theoretically represents how risky that company is for potential investors. A
score below 1.81 is said to predict bankruptcy, and a score between 1.81 and
2.67 is what is called the “grey area”. Scores above 2.67 are said to be a low
risk firm.
The Altman Z-score for Sara Lee at the end of 2006 was 2.33, which lies
in the “grey area”. For the past 5 years, Sara Lee has only come out of this
range twice and not by very much. Going by this particular model, Sara Lee has
historically been a fairly risky firm for investors. One thing that stands out
looking at their ratios is the consistency of working capital being low. With this
low Z-score, Sara Lee might have some trouble getting access to borrowing in
the future. Another thing worth pointing out is the fact that Sara Lee has one of
the lowest scores after 2006 in 5 years. This doesn’t show investors that they
are doing things to decrease their risk, even though their score isn’t low enough
to alarm investors of a potential bankruptcy.
Analyst Recommendation
After careful examination of Sara Lee, its competitors, and the industry
that Sara Lee operates in, we have acquired a vast knowledge of the multi-billion
dollar corporation. Sara Lee is in the highly competitive packaged and processed
food industry, where price is a major competitive edge for the firms involved.
Sara Lee does a good job competing in this industry. Sara Lee has a
recognizable name associated with high-quality products. The company
definitely has a future and its managers appear to be leading the corporation in
the right direction.
108
Despite all of Sara Lee’s good qualities and characteristics the company’s
share price is overvalued. Every valuation technique we ran on the company,
except one, showed the firm to be overvalued. The one model that did show
Sara Lee to be undervalued was the discounted free cash flows. This model is
usually unreliable, and we do not put much value in its estimates.
The current market price for Sara Lee is $16.92. We feel the proper value
of the firm is best shown by the residual income model. This model gives the
value of $9.44 at a -30% growth rate and a cost of equity of 8.49%. Given this
information, we conclude that Sara Lee is overvalued and should be sold.
109
Appendix
110
BALANCE SHEET 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Assets:
Cash and equivalents 298 1004 655 533 2231 1476 1608 1744 1886 2030 2113 2198 2284 2377 2472 11.9% to 14%
Accounts receivable 1768 1787 1848 1677 1750 1476 1535 1597 1662 1727 1797 1869 1943 2022 2102 11.9%
Inventories 2509 2652 2728 2151 2153 1490 1478 1466 1454 1440 1499 1559 1620 1686 1753 12.1% to 10%
Other current assets 341 359 380 410 301
Assets of discont operations 7 110 125 1172 339
Total current assets 4923 5912 5736 5943 6774 4570 4754 4945 5146 5347 5564 5787 6015 6260 6509 36.9%
Other noncurrent assets 192 281 143 117 118
Deferred tax asset 4 453 281 53 91
Land 176 195 148 130 135 127 132 137 142 148 154 160 167 173 180
Buildings and improvements 1744 1895 2030 1712 1795 1552 1615 1680 1748 1816 1890 1966 2043 2126 2211
Machinery and equipment 4299 4872 5045 4367 4531 3929 4088 4252 4425 4598 4784 4976 5172 5382 5597
Construction in progress 320 289 382 204 258 236 246 255 266 276 287 299 311 323 336
Accumulated depreciation 3384 3939 4269 3577 3777 3251 3382 3517 3660 3803 3958 4116 4279 4453 4631
Property, net 3155 3312 3236 2836 2942 2573 2677 2784 2897 3010 3133 3258 3387 3524 3665 21.3%
Trademarks and intangibles, 2106 2058 1977 1395 1185
Goodwill 3314 3331 3354 3018 3052
Assets of discont. operations 0 149 152 938 360 2.2%
Total Assets 13694 15496 14879 14300 14522 12368 12868 13382 13926 14471 15059 15662 16279 16941 17618 asume 6.8% ROA
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Liabilities and Equity Notes payable 468 140 84 239 1784 435 445 454 463 470 477 483 487 490 491 Accounts payable 1359 1314 1293 1115 1226 1058 1082 1105 1126 1144 1161 1175 1185 1192 1194 Payroll and benefits 1147 1193 1150 929 996 Advertising and promotion 421 439 531 431 475 Taxes other than payroll 102 111 119 87 79 Income taxes payable 122 22 247 142 253 Other 1047 900 829 774 790 Current maturities LT debt 734 1004 1070 380 368 Liabilities of discont operations 0 46 87 916 306 298 305 311 317 322 327 331 334 336 336 Total Current Liabilities 5400 5169 5410 5013 6277 4646 4752 4850 4945 5024 5100 5161 5204 5235 5243 dec liab 17%
Long-term debt 4357 5157 4171 4112 3807 Pension obligation 220 1178 870 766 436 Other liabilities 1325 1496 1362 1410 1417 Liabilities of discont operations 0 18 7 206 68 Minority interest in subsidiaries 632 356 74 61 68 Total Liabilities 10746 13413 11894 11568 12073 9652 9851 10053 10249 10429 10614 10796 10950 11126 11272 Total Common Equity 2948 2083 2985 2732 2449 2716 3016 3229 3678 4042 4445 4866 5330 5815 6346 inc equity 17%
Total Liabilities and Equity 13694 15496 14879 14300 14522 12368 12868 13382 13926 14471 15059 15662 16279 16941 17618
111
Common Size Balance Sheet 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Assets:
Cash and equivalents 2.2% 6.5% 4.4% 3.7% 15.4% 11.9% 12.5% 13.0% 13.5% 14.0% 14.0% 14.0% 14.0% 14.0% 14.0%
Accounts receivable 12.9% 11.5% 12.4% 11.7% 12.1% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9%
Inventories 18.3% 17.1% 18.3% 15.0% 14.8% 12.1% 11.5% 11.0% 10.4% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0%
Other current assets 2.5% 2.3% 2.6% 2.9% 2.1%
Assets of discont operations 0.1% 0.7% 0.8% 8.2% 2.3%
Total current assets 36.0% 38.2% 38.6% 41.6% 46.6% 36.9% 36.9% 36.9% 36.9% 36.9% 36.9% 36.9% 36.9% 36.9% 36.9%
Other noncurrent assets 1.4% 1.8% 1.0% 0.8% 0.8%
Deferred tax asset 0.0% 2.9% 1.9% 0.4% 0.6%
Land 1.3% 1.3% 1.0% 0.9% 0.9% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0%
Buildings and improvements 12.7% 12.2% 13.6% 12.0% 12.4% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6% 12.6%
Machinery and equipment 31.4% 31.4% 33.9% 30.5% 31.2% 31.8% 31.8% 31.8% 31.8% 31.8% 31.8% 31.8% 31.8% 31.8% 31.8%
Construction in progress 2.3% 1.9% 2.6% 1.4% 1.8% 1.9% 1.9% 1.9% 1.9% 1.9% 1.9% 1.9% 1.9% 1.9% 1.9%
Accumulated depreciation 24.7% 25.4% 28.7% 25.0% 26.0% 26.3% 26.3% 26.3% 26.3% 26.3% 26.3% 26.3% 26.3% 26.3% 26.3%
Property, net 23.0% 21.4% 21.7% 19.8% 20.3% 20.8% 20.8% 20.8% 20.8% 20.8% 20.8% 20.8% 20.8% 20.8% 20.8%
Trademarks and intangibles, 15.4% 13.3% 13.3% 9.8% 8.2% 11.1%
Goodwill 24.2% 21.5% 22.5% 21.1% 21.0% 21.5%
Assets of discont. operations 0.0% 1.0% 1.0% 6.6% 2.5% 2.8%
Total Assets 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Liabilities and Stockholders Equity
Notes payable 3.4% 0.9% 0.6% 1.7% 12.3% 3.5% 3.5% 3.4% 3.3% 3.3% 3.2% 3.1% 3.0% 2.9% 2.8%
Accounts payable 9.9% 8.5% 8.7% 7.8% 8.4% 8.6% 8.4% 8.3% 8.1% 7.9% 7.7% 7.5% 7.3% 7.0% 6.8%
Payroll and benefits 8.4% 7.7% 7.7% 6.5% 6.9%
Advertising and promotion 3.1% 2.8% 3.6% 3.0% 3.3%
Taxes other than payroll 0.7% 0.7% 0.8% 0.6% 0.5%
Income taxes payable 0.9% 0.1% 1.7% 1.0% 1.7%
Other 7.6% 5.8% 5.6% 5.4% 5.4%
Current maturities LT debt 5.4% 6.5% 7.2% 2.7% 2.5%
Liabilities of discont operations 0.0% 0.3% 0.6% 6.4% 2.1%
Total Current Liabilities 39.4% 33.4% 36.4% 35.1% 43.2% 37.6% 36.9% 36.2% 35.5% 34.7% 33.9% 32.9% 32.0% 30.9% 29.8%
Long-term debt 31.8% 33.3% 28.0% 28.8% 26.2%
Pension obligation 1.6% 7.6% 5.8% 5.4% 3.0%
Other liabilities 9.7% 9.7% 9.2% 9.9% 9.8%
Liabilities of discont operations 0.0% 0.1% 0.0% 1.4% 0.5%
Minority interest in subsidiaries 4.6% 2.3% 0.5% 0.4% 0.5%
Total Liabilities 78.5% 86.6% 79.9% 80.9% 83.1% 78.0% 76.6% 75.1% 73.6% 72.1% 70.5% 68.9% 67.3% 65.7% 64.0%
Total Common Equity 21.5% 13.4% 20.1% 19.1% 16.9% 22.0% 23.4% 24.1% 26.4% 27.9% 29.5% 31.1% 32.7% 34.3% 36.0%
Total Liabilities and Equity 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
112
STAEMENT OF CASH FLOWS
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Net Income / Starting Line 1010 1187 1272 719 555 841 875 910 947 984 1024 1065 1107 1152 1198
less: contingent sale proceeds 0 0 -119 -117 -114
Depreciation & Depletion 471 525 561 570 541
Amortization of Intangible Assets 111 136 173 181 160
Impairment 0 0 0 350 587
net gain on business dispositions 0 -16 14 -69 -589
Deferred Income 21 5 166 186 112
other 0 42 149 60 57
Dec(Inc) In Receivables 93 94 -44 -199 -14 274 -59 -62 -65 -65 -70 -72 -74 -79 -80
Dec(Inc) In Inventories 304 -23 -45 8 108 663 12 12 12 14 -59 -60 -61 -66 -67 Dec(Inc) In Other Assets/Liabilities 7 -17 44 -9 -65
Inc(Dec) In act payable 0 -126 45 0 -10 168 -24 -22 -22 -18 -17 -14 -10 -7 -2
Inc(Dec) In Other Accruals 27 0 -174 -330 -96
CFFO 1735 1824 2042 1350 1232 89 1600 1659 1694 1783 1711 1774 1839 1907 1978
Capital Expenditures 669 746 -530 -538 -625 251 -68 -70 -74 -74 -80 -82 -84 -90 -92
Net Assets From Acquisitions 1930 -10 0 -2 -78 369 -104 -107 -113 -113 -122 -125 -128 -138 -141 Disposal Of business investments 136 0 137 86 868 602 -159 -164 -173 -173 -187 -192 -196 -210 -215
CFFI 2475 -674 -184 -233 365 1222 -331 -340 -360 -360 -389 -399 -409 -438 -447
FCF 4210 1150 1858 1117 1597 1311 1269 1319 1334 1423 1322 1375 1430 1469 1531
Proceeds From Sale Stock 0 98 139 161 27
Com/Pfd Purchased 138 -555 -350 -396 -561
Long Term Borrowings 1362 1773 1 339 37
Reduction In Long Term Debt 503 -995 -
1288 -
1033 -467 Inc(Dec) In Short Term Borrowings 124 -359 -19 178 1528
Other Sources - Financing 0 0 0 0 33
Cash Dividends Paid - Total 484 -497 -714 -464 605
CFFF 470 -535 -
2231 -
1215 -8
113
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Net Income / Starting Line 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% less: contingent sale
proceeds Depreciation & Depletion Amortization of Intangible
Assets Impairment
net gain on business dispositions
Deferred Income other
Dec(Inc) In Receivables 9.2% 7.9% -3.5% -27.7% -2.5% 32.6% -6.7% -6.8% -6.9% -6.6% -6.8% -6.8% -6.7% -6.9% -6.7% Dec(Inc) In Inventories 30.1% -1.9% -3.5% 1.1% 19.5% 78.8% 1.4% 1.3% 1.3% 1.4% -5.8% -5.6% -5.5% -5.7% -5.6%
Dec(Inc) In Other Assets/Liabilities
Inc(Dec) In act payable 0.0% -10.6% 3.5% 0.0% -1.8% 20.0% -2.8% -2.5% -2.3% -1.8% -1.7% -1.3% -0.9% -0.6% -0.2% Inc(Dec) In Other Accruals
CFFO 171.8% 153.7% 160.5% 187.8% 222.0% 10.6% 182.9% 182.3% 178.9% 181.2% 167.1% 166.6% 166.1% 165.5% 165.1% Capital Expenditures
Net Assets From Acquisitions Disposal Of business
investments CFFI FCF
Proceeds From Sale Stock Com/Pfd Purchased
Long Term Borrowings Reduction In Long Term Debt
Inc(Dec) In Short Term Borrowings
Other Sources - Financing Cash Dividends Paid - Total
CFFF
114
INCOME STATEMENT
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
NET REVENUES 14519 14919 15892 16029 15944 11806 12278 12769 13280 13811 14364 14938 15536 16157 16804 4% growth rate
COGS 9001 9249 9684 10024 10023 7333 7626 7931 8249 8579 8922 9279 9650 10036 10437 62.1% of sales
GROSS INCOME 5518 5670 6208 6005 5921 4473 4652 4838 5032 5233 5442 5660 5886 6122 6367 37.9% of sales
SG&A 4245 4212 4811 4663 4843 3188 3315 3448 3586 3729 3878 4033 4195 4362 4537 27% of sales OPERATING INCOME 1242 1458 1485 1369 911 1273 1324 1376 1432 1489 1548 1610 1675 1742 1811 10.8% of sales INTEREST EXPENSE 177 340 270 288 308 214 222 231 240 250 260 270 281 292 304
2.1% of total debt
INTEREST INCOME 80 80 80 90 80 62 64 67 69 72 75 78 81 84 88 4.1% of A/R INCOME PRE-TAXES 1022 1023 1295 1180 683 1122 1165 1212 1261 1311 1363 1419 1475 1534 1595 9.5% of sales
INCOME TAXES 126 (47) 244 99 273 392 408 424 441 456 477 496 516 537 558 35% tax rate
INCOME CONT OPS 896 1070 1051 1081 410 730 757 788 820 855 886 923 959 997 1037 6.2% of sales
NET INCOME 1010 1174 1272 719 555 841 875 910 946 984 1024 1065 1107 1151 1198 7.1% of sales
COMMON SIZED INCOME STATEMENT 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
NET REVENUES 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
COGS 62.0% 62.0% 60.9% 62.5% 62.9% 62.1% 62.1% 62.1% 62.1% 62.1% 62.1% 62.1% 62.1% 62.1% 62.1%
GROSS INCOME 38.0% 38.0% 39.1% 37.5% 37.1% 37.9% 37.9% 37.9% 37.9% 37.9% 37.9% 37.9% 37.9% 37.9% 37.9%
SG&A 29.2% 28.2% 30.3% 29.1% 30.4% 27.0% 27.0% 27.0% 27.0% 27.0% 27.0% 27.0% 27.0% 27.0% 27.0% OPERATING INCOME 8.6% 9.8% 9.3% 8.5% 5.7% 10.8% 10.8% 10.8% 10.8% 10.8% 10.8% 10.8% 10.8% 10.8% 10.8%
INTEREST EXPENSE 1.2% 2.3% 1.7% 1.8% 1.9% 1.8% 1.8% 1.8% 1.8% 1.8% 1.8% 1.8% 1.8% 1.8% 1.8%
INTEREST INCOME 0.6% 0.5% 0.5% 0.6% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%
INCOME PRE-TAXES 7.0% 6.9% 8.1% 7.4% 4.3% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5% 9.5%
INCOME TAXES 0.9% -0.3% 1.5% 0.6% 1.7% 3.3% 3.3% 3.3% 3.3% 3.3% 3.3% 3.3% 3.3% 3.3% 3.3%
INCOME CONT OPS 6.2% 7.2% 6.6% 6.7% 2.6% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2%
NET INCOME 7.0% 7.9% 8.0% 4.5% 3.5% 7.1% 7.1% 7.1% 7.1% 7.1% 7.1% 7.1% 7.1% 7.1% 7.1%
115
Discounted Dividends Model 0 1 2 3 4 5 6 7 8 9 10 P 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Earnings $555 $841 $875 $910 $946 $984 $1,024 $1,065 $1,107 $1,151 $1,198 Dividends $575 $575 $597 $597 $620 $620 $643 $643 $666 $666 $666 PV Factor 0.922 0.850 0.783 0.722 0.665 0.613 0.565 0.521 0.480 0.443 PV Dividends $522 $475 $449 $408 $385 $350 $330 $300 $283 $257 Sum of PV Dividends $4,025 PV Terminal Value $4,548 Estimated Value $8,573 Estimated Value per share (7/31/06) $11.19 Estimated Value per share (4/1/07) $11.24 Actual Price $16.92 Growth 0.02 Cost of Equity (Ke) 0.08488 Sensitivity Analysis g 0.00 0.01 0.02 0.03 0.04 0.06 $14.06 $15.68 $18.12 $22.17 $30.30 0.07 $12.00 $13.05 $14.54 $16.75 $20.35 Ke 0.085 $9.84 $10.45 $11.24 $12.33 $13.91 0.09 $9.27 $9.78 $10.43 $11.32 $12.54 0.10 $8.31 $8.68 $9.15 $9.75 $10.56 Undervalued Overvalued
116
Abnormal Earnings Growth Model 0 1 2 3 4 5 6 7 8 9 10 P 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Earnings $555 $841 $875 $910 $946 $984 $1,024 $1,065 $1,107 $1,151 $1,198 Dividends $575 $575 $597 $597 $620 $620 $643 $643 $666 $666
Div Invested at 8.488% $49 $49 $51 $51 $53 $53 $55 $55 $57 $57
Cum-Dividend Earnings $924 $961 $997 $1,037 $1,077 $1,120 $1,162 $1,208 $1,255
Normal Earnings $71 $74 $77 $80 $84 $87 $90 $94 $98 AEG $852 $886 $919 $956 $993 $1,033 $1,071 $1,114 $1,157 $1,157 PV Factor 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 PV of AEG $729 $648 $574 $510 $453 $403 $357 $317 $282 $3,006 Core Earnings $555 Total PV of AEG $4,272
PV of Terminal Value $732 Sensitivity Analysis
Estimation $5,558 g Estimation per share (7/31/06) $7.26 (0.10) (0.20) (0.30) (0.40) (0.50) Estimation per share (4/1/07) $7.29 0.06 $8.82 $7.92 $7.51 $7.28 $7.13 Actual Price $16.92 0.07 $8.61 $7.80 $7.42 $7.21 $7.07 Growth (0.30) Ke 0.085 $8.33 $7.63 $7.29 $7.09 $6.96 Cost of Equity (Ke) 0.08488 0.09 $8.24 $7.57 $7.25 $7.06 $6.92 0.1 $8.07 $7.46 $7.16 $6.98 $6.86 Undervalued Overvalued
117
Residual Income Model 0 1 2 3 4 5 6 7 8 9 10 P 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Beginning BVE $2,449 $2,716 $3,016 $3,229 $3,678 $4,042 $4,445 $4,866 $5,330 $5,815 $6,346 Earnings $555 $841 $875 $910 $946 $984 $1,024 $1,065 $1,107 $1,151 $1,198 Dividends $575 $575 $597 $597 $620 $920 $643 $643 $666 $666 Ending BVE $2,716 $3,017 $3,329 $3,578 $4,042 $4,446 $4,867 $5,330 $5,815 $6,347 Normal Income $231 $256 $274 $312 $343 $377 $413 $452 $494 $539 Residual Income $610 $619 $636 $634 $641 $647 $652 $655 $657 $659 PV Factor 0.922 0.850 0.783 0.722 0.665 0.613 0.565 0.521 0.480 0.443 PV of Residual Income $563 $526 $498 $458 $426 $397 $369 $341 $316 $292 $292 BVE $2,449 Total PV of RI $4,185
PV Terminal Value $336 Sensitivity Analysis
Estimated Value $6,970 g
Estimated Value per share (7/31/06) $9.10 (0.10) (0.20) (0.30) (0.40) (0.50)
Estimated Value per share (4/1/07) $9.44 0.06 $12.00 $11.47 $11.24 $11.11 $11.02 Actual Price $16.92 0.07 $11.10 $10.66 $10.46 $10.34 $10.27 Growth (0.30) Ke 0.08488 $9.92 $9.59 $9.44 $9.34 $9.28 Cost of Equity (Ke) 0.08488 0.09 $9.56 $9.26 $9.11 $9.02 $8.96 0.1 $8.90 $8.65 $8.52 $8.44 $8.39 Undervalued Overvalued
118
Free Cash Flow Model 0 1 2 3 4 5 6 7 8 9 10 P 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Cash from Operations $1,232 $89 $1,600 $1,659 $1,694 $1,783 $1,711 $1,774 $1,839 $1,907 $1,978
Cash Provided by Investing $1,222 ($331) ($340) ($360) ($360) ($389) ($399) ($409) ($438) ($447)
Free Cash Flow $1,311 $1,269 $1,319 $1,334 $1,423 $1,322 $1,375 $1,430 $1,469 $1,531 $1,608 PV Factor 0.943 0.889 0.838 0.79 0.745 0.702 0.662 0.624 0.588 0.555 PV Free Cash Flow $1,236 $1,128 $1,105 $1,054 $1,060 $928 $910 $892 $864 $849
Sum of PV Free Cash Flow $10,027
PV Terminal Value $21,910 Sensitivity Analysis
Book Value Liabilities $12,073 g Estimation Value $19,865 0 0.01 0.02 0.03 0.04
Estimation Value per share (7/31/06) $25.93 0.04 $34.28 $46.11 $69.79 $140.84 N/A
Estimation Value per share (4/1/07) $26.02 0.05 $23.88 $30.33 $41.09 $62.63 $127.23 Actual Price $16.92 WACC 0.0607 $16.57 $20.36 $26.02 $35.37 $53.75 Growth Rate 0.02 0.07 $12.05 $14.60 $18.16 $23.52 $32.45 WACC 0.0607 0.08 $8.37 $10.11 $12.45 $15.70 $20.58 Undervalued Overvalued
119
Long Run Residual Income Model Ke 0.06 0.07 0.08488 0.09 0.10 0 12.18 10.44 8.61 8.12 7.31 Undervalued 0.01 13.97 11.65 9.33 8.73 7.76
g 0.02 16.66 13.33 10.27 9.52 8.33 Overvalued 0.03 21.14 15.86 11.56 10.57 9.06 0.04 30.11 20.07 13.42 12.04 10.04 *ROE=22.7% ROE 0.10 0.15 0.227 0.25 0.30 0 3.79 5.69 8.61 9.48 11.38 Undervalued 0.01 3.87 6.02 9.33 10.32 12.47
g 0.02 3.97 6.45 10.27 11.41 13.90 Overvalued 0.03 4.11 7.04 11.56 12.91 15.84 0.04 4.30 7.89 13.42 15.07 18.65 *Ke=8.488% Ke 0.06 0.07 0.08488 0.09 0.10 0.1 6.44 5.15 3.97 3.68 3.22 Undervalued 0.15 10.47 8.37 6.45 5.98 5.23
ROE 0.227 16.66 13.33 10.27 9.52 8.33 Overvalued 0.25 18.52 14.81 11.41 10.58 9.26 0.3 22.54 18.03 13.90 12.88 11.27 *g=2% Actual Price $16.92
120
Forward P/E Price to Sales
PPS EPS P/E IND. AVG
SLE PPS PPS SPS P/S
IND. AVG
SLE PPS
SLE $16.02 $0.72 $22.25 $13.02 SLE $16.02 $20.81 $0.77 $35.38 GIS $51.79 $3.05 $16.98 GIS $51.79 $32.51 $1.59 KFT $35.70 $1.86 $19.19 $18.09 KFT $35.70 $19.81 $1.80 $1.70 Trailing P/E Dividend to Price
PPS EPS P/E IND. AVG
SLE PPS PPS DPS D/P
IND. AVG
SLE PPS
SLE $19.65 $0.91 $21.59 $14.22 SLE $16.02 $0.79 $0.49 $2.93 GIS $49.68 $3.34 $14.87 GIS $51.79 $1.34 $0.26 KFT $28.17 $1.72 $16.38 $15.63 KFT $35.70 $0.96 $0.27 $0.27
Price to Book Price Earning Growth
PPS BPS P/B IND. AVG
SLE PPS PPS EPS G PEG
IND. AVG
SLE PPS
SLE $16.02 $3.22 $4.98 $8.47 SLE $16.02 $0.72 4.00% $23.18 $13.32 GIS $51.79 $16.12 $3.21 GIS $51.79 $3.05 7.50% $18.36 KFT $35.70 $17.45 $2.05 $2.63 KFT $35.70 $1.86 5.00% $20.20 $19.28
121
IGR 2002 2003 2004 2005 2006
Sara Lee 3.84% 4.37% 3.75% 1.78% -
0.76%
Kraft 4.27% 4.05%-
0.94% 2.53% 2.69%
General Mills -
4.29%-
1.11%-
0.40% 0.59% 2.90%
SGR 2002 2003 2004 2005 2003
Sara Lee 4.47% 5.41% 4.65% 2.08% -
0.96%
Kraft 4.12% 3.90%-
0.90% 2.41% 2.54%
General Mills -
2.95%-
0.83% 0.08% 0.49% 2.66%
122
Cost of Equity Estimations: 10 Year (Rf = 5.92%) 7 Year (Rf = 4.71%)
Months Beta R^2 Ke Months Beta R^2 Ke72 0.3247 0.0485 0.0777 72 0.3217 0.0478 0.061660 0.6521 0.1831 0.0964 60 0.648 0.1814 0.076348 0.4693 0.0581 0.086 48 0.4659 0.0566 0.068136 0.5983 0.1078 0.0934 36 0.5929 0.1065 0.073824 0.6479 0.0986 0.0962 24 0.6456 0.0991 0.0762
5 Year (Rf = 4.71%) 1 Year (Rf = 5.05%)
Months Beta R^2 Ke Months Beta R^2 Ke72 0.3225 0.0481 0.0617 72 0.3244 0.0488 0.066560 0.6496 0.1823 0.0766 60 0.6545 0.1845 0.082948 0.4677 0.0575 0.0683 48 0.4738 0.0602 0.073936 0.5973 0.1082 0.0742 36 0.6126 0.1141 0.080824 0.6444 0.0987 0.0764 24 0.6399 0.0958 0.0822
3 Month (Rf = 5.16%)
Months Beta R^2 Ke72 0.3236 0.0485 0.06860 0.655 0.1846 0.084948 0.4749 0.0604 0.075736 0.6136 0.1142 0.082824 0.6382 0.0947 0.084
123
Cost of Debt (WACC) % of Total Liabilites Interest Rate Computed Interest Rate Current Liabilities Notes Payable 1784 14.78% 5.16% 0.76% Accounts Payable 1226 10.15% 5.16% 0.52% Employee Benefits 996 8.25% 5.16% 0.43% Other 2271 18.81% 5.16% 0.97% Total Current Debt 6277 51.99% Long-Term Liabilities Long-Term Debt 3807 31.53% 6.03% 1.90% Other 1989 16.47% 5.74% 0.95% Total Long-Term Debt 5796 48.01% WACD 5.53% Total Liabilities 12073 100.00% WACE 8.49% MVD 12073 Tax Rate 35% MVE 12359 MVA 24432 WACC 6.07% Break Down of Long-Term Debt 6.125% Notes 6.13% 759 1.22% 11.35% Mex. Pesos 11.35% 34 0.10% 5.6-6.95% medium notes 6.28% 252 0.42% 2.75% Notes 2.75% 300 0.22% 7.05-7.40% Notes 7.23% 75 0.14% 6.5% Notes 6.50% 150 0.26% 7.26-7.71% Notes 7.49% 25 0.05% 6.25% Notes 6.25% 1110 1.82% 3.875% Notes 3.88% 500 0.51% 10% zero coupon notes 10.00% 9 0.02% 10-14.25% zero coupon notes 12.13% 39 0.12% 6.125% Notes 6.13% 500 0.80% 1.95% notes 1.95% 0 0.00% 4.625% euro notes 4.63% 0 0.00% 1.55% jap. Yen 1.55% 0 0.00% euro - euribor+.10% 4.13% 316 0.34% total long term liabilities 3807 Cost of Debt (long term) 6.03%
124
Forecasted Financial Ratios 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Liquidity Analysis Current Ratio 0.98 1.00 1.02 1.04 1.06 1.09 1.12 1.16 1.20 1.24 Quick Asset Ratio 0.32 0.34 0.36 0.38 0.40 0.41 0.43 0.44 0.45 0.47 Accounts Receivable Turnover 8.00 8.00 8.00 7.99 8.00 7.99 7.99 8.00 7.99 7.99 Days Supply of Receivables 45.63 45.64 45.64 45.67 45.63 45.66 45.66 45.64 45.67 45.66 Inventory Turnover 4.92 5.16 5.41 5.67 5.96 5.95 5.95 5.96 5.95 5.95 Days Supply of Inventory 74.18 70.75 67.44 64.33 61.27 61.31 61.31 61.28 61.32 61.31 Working Capital Turnover -155.46 4515.40 135.43 66.22 42.78 30.94 23.85 19.15 15.78 13.27 Profitability Analysis Gross Profit Margin 37.89% 37.89% 37.89% 37.89% 37.89% 37.89% 37.89% 37.89% 37.89% 37.89% Operating Expense Ratio 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% 27.00% Net Profit Margin 7.13% 7.13% 7.13% 7.13% 7.13% 7.13% 7.13% 7.13% 7.13% 7.13% Asset Turnover 0.95 0.95 0.95 0.95 0.95 0.95 0.95 0.95 0.95 0.95 Return on Assets 6.80% 6.80% 6.80% 6.80% 6.80% 6.80% 6.80% 6.80% 6.80% 6.80% Return on Equity 30.98% 29.01% 28.18% 25.73% 24.35% 23.03% 21.88% 20.77% 19.80% 18.87% Capital Structure Analysis Debt to Equity Ratio 3.55 3.27 3.11 2.79 2.58 2.39 2.22 2.05 1.91 1.78 Times Interset Earned 5.96 5.96 5.96 5.96 5.96 5.96 5.96 5.96 5.96 5.96 Debt Service Margin 0.20 3.60 3.65 3.66 3.79 3.58 3.67 3.77 3.89 4.03
125
Altman Z-score
2002 2003 2004 2005 2006
Working Capital -477 743 326 930 497
Retained Earnings 3,168 3,787 4,437 4,361 3,855
EBIT 1,119 1,283 1,485 1,378 911
Sales 14,519 14,919 15,892 16,029 15,944
Total Assets 13,694 15,469 14,879 14,300 14,522Market Value of Equity 16,202 14,402 18,258 15,504 12,271
Book Value of Equity 10,746 13,413 11,894 11,568 12,073
2002 2003 2004 2005 2006
Altman Z-scores 2.517 2.283 2.762 2.748 2.327
126
Multiple R 0.248 72 mo. 10 Year Regressions
R Square 0.062 Regression Statistics
Adjusted R Square 0.049 Standard Error 0.050
Observations 73.000 df SS MS F Significance F
Regression 1.000 0.012 0.012 4.672 0.034
Residual 71.000 0.181 0.003
Total 72.000 0.193
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.002 0.006 0.256 0.799 0.010 0.013 0.010 0.013
mkt prem. 0.325 0.150 2.161 0.034 0.025 0.624 0.025 0.624 mkt prem. 0.325 0.150 2.161 0.034 0.025 0.624 0.025 0.624
Regression Statistics 60 mo. Regression Statistics 48 mo.
Multiple R 0.443 Multiple R 0.279
R Square 0.197 R Square 0.078
Adjusted R Square 0.183 Adjusted R Square 0.058
Standard Error 0.047 Standard Error 0.039
Observations 61.000 Observations 49.000 df SS MS F Significance F df SS MS F Significance F
Regression 1.000 0.032 0.032 14.444 0.000 Regression 1.000 0.006 0.006 3.960 0.052
Residual 59.000 0.131 0.002 Residual 47.000 0.071 0.002
Total 60.000 0.163 Total 48.000 0.077
Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.000 0.006 0.002 0.998 0.012 0.012 0.012 0.012 Intercept 0.003 0.006 0.524 0.603 0.015 0.009 0.015 0.009
mkt prem. 0.652 0.172 3.801 0.000 0.309 0.995 0.309 0.995 mkt prem. 0.469 0.236 1.990 0.052 0.005 0.944 0.005 0.944 Regression Statistics 36 mo. Regression Statistics 24 mo.
Multiple R 0.364 Multiple R 0.369
R Square 0.133 R Square 0.136
Adjusted R Square 0.108 Adjusted R Square 0.099
Standard Error 0.031 Standard Error 0.032
Observations 37.000 Observations 25.000 df SS MS F Significance F df SS MS F Significance F
Regression 1.000 0.005 0.005 5.349 0.027 Regression 1.000 0.004 0.004 3.626 0.069
Residual 35.000 0.034 0.001 Residual 23.000 0.023 0.001
Total 36.000 0.039 Total 24.000 0.027
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.004 0.005 0.844 0.404 0.015 0.006 0.015 0.006 Intercept 0.012 0.006 1.864 0.075 0.025 0.001 0.025 0.001
mkt prem. 0.598 0.259 2.313 0.027 0.073 1.123 0.073 1.123 mkt prem. 0.648 0.340 1.904 0.069 0.056 1.352 0.056 1.352
127
Multiple R 0.247 72 mo. 7 Year Regression R Square 0.061 Regression Statistics Adj. R Square 0.048 Standard Error 0.050 Observations 73.000 df SS MS F Significance F Regression 1.000 0.012 0.012 4.615 0.035 Residual 71.000 0.181 0.003 Total 72.000 0.193 Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.001 0.006 0.230 0.819 0.010 0.013 0.010 0.013 mkt prem. 0.322 0.150 2.148 0.035 0.023 0.620 0.023 0.620 Regression Statistics 60 mo. Regression Statistics 48 mo. Multiple R 0.442 Multiple R 0.276 R Square 0.195 R Square 0.076 Adj. R Square 0.181 Adj. R Square 0.057 Standard Error 0.047 Standard Error 0.039 Observations 61.000 Observations 49.000 df SS MS F Significance F df SS MS F Significance F Regression 1.000 0.032 0.032 14.294 0.000 Regression 1.000 0.006 0.006 3.880 0.055 Residual 59.000 0.131 0.002 Residual 47.000 0.071 0.002 Total 60.000 0.163 Total 48.000 0.077 Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients St. Error t Stat
P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.000 0.006 0.067 0.947 0.013 0.012 0.013 0.012 Intercept 0.003 0.006 0.578 0.566 0.015 0.008 0.015 0.008 mkt prem. 0.648 0.171 3.781 0.000 0.305 0.991 0.305 0.991 mkt prem. 0.466 0.237 1.970 0.055 0.010 0.942 0.010 0.942 Regression Statistics 36 mo. Regression Statistics 24 mo. Multiple R 0.362 Multiple R 0.370 R Square 0.131 R Square 0.137 Adj. R Square 0.106 Adj. R Square 0.099 Standard Error 0.031 Standard Error 0.032 Observations 37.000 Observations 25.000 df SS MS F Significance F df SS MS F Significance F Regression 1.000 0.005 0.005 5.289 0.028 Regression 1.000 0.004 0.004 3.641 0.069 Residual 35.000 0.034 0.001 Residual 23.000 0.023 0.001 Total 36.000 0.039 Total 24.000 0.027 Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients St. Error t Stat
P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.005 0.005 0.944 0.352 0.015 0.006 0.015 0.006 Intercept 0.013 0.006 1.949 0.064 0.026 0.001 0.026 0.001 mkt prem. 0.593 0.258 2.300 0.028 0.070 1.116 0.070 1.116 mkt prem. 0.645 0.338 1.908 0.069 0.054 1.345 0.054 1.345
128
Multiple R 0.248 72 mo. 5 Year Regressions R Square 0.061 Regression Statistics Adj. R Square 0.048 Standard Error 0.050 Observations 73.000 df SS MS F Significance F Regression 1.000 0.012 0.012 4.640 0.035 Residual 71.000 0.181 0.003 Total 72.000 0.193 Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.001 0.006 0.216 0.829 0.011 0.013 0.011 0.013 mkt prem. 0.323 0.150 2.154 0.035 0.024 0.621 0.024 0.621 Regression Statistics 62 mo. Regression Statistics 48 mo.
Multiple R 0.443 Multiple R 0.278
R Square 0.196 R Square 0.077
Adj. R Square 0.182 Adj. R Square 0.057
Standard Error 0.047 Standard Error 0.039
Observations 61.000 Observations 49.000 df SS MS F Significance F df SS MS F Significance F
Regression 1.000 0.032 0.032 14.373 0.000 Regression 1.000 0.006 0.006 3.926 0.053
Residual 59.000 0.131 0.002 Residual 47.000 0.071 0.002
Total 60.000 0.163 Total 48.000 0.077
Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.001 0.006 0.095 0.925 0.013 0.012 0.013 0.012 Intercept 0.003 0.006 0.596 0.554 0.015 0.008 0.015 0.008
mkt prem. 0.650 0.171 3.791 0.000 0.307 0.992 0.307 0.992 mkt prem. 0.468 0.236 1.981 0.053 0.007 0.943 0.007 0.943
Regression Statistics 36 mo. Regression Statistics 24 mo.
Multiple R 0.365 Multiple R 0.369
R Square 0.133 R Square 0.136
Adj. R Square 0.108 Adj. R Square 0.099
Standard Error 0.031 Standard Error 0.032
Observations 37.000 Observations 25.000 df SS MS F Significance F df SS MS F Significance F
Regression 1.000 0.005 0.005 5.369 0.026 Regression 1.000 0.004 0.004 3.627 0.069
Residual 35.000 0.034 0.001 Residual 23.000 0.023 0.001
Total 36.000 0.039 Total 24.000 0.027
Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.005 0.005 0.963 0.342 0.015 0.005 0.015 0.005 Intercept 0.013 0.006 1.951 0.063 0.026 0.001 0.026 0.001
mkt prem. 0.597 0.258 2.317 0.026 0.074 1.121 0.074 1.121 mkt prem. 0.644 0.338 1.904 0.069 0.056 1.344 0.056 1.344
129
Multiple R 0.249 72 mo. 1 Year Regressions R Square 0.062 Regression Statistics Adj. R Square 0.049 Standard Error 0.050 Observations 73.000 df SS MS F Significance F Regression 1.000 0.012 0.012 4.692 0.034 Residual 71.000 0.181 0.003 Total 72.000 0.193 Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.001 0.006 0.169 0.866 0.011 0.013 0.011 0.013 mkt prem. 0.324 0.150 2.166 0.034 0.026 0.623 0.026 0.623 Regression Statistics 60 mo. Regression Statistics 48 mo.
Multiple R 0.445 Multiple R 0.282
R Square 0.198 R Square 0.080
Adj. R Square 0.185 Adj. R Square 0.060
Standard Error 0.047 Standard Error 0.039
Observations 61.000 Observations 49.000
df SS MS F Significance F df SS MS F Significance F
Regression 1.000 0.032 0.032 14.580 0.000 Regression 1.000 0.006 0.006 4.074 0.049
Residual 59.000 0.131 0.002 Residual 47.000 0.071 0.002
Total 60.000 0.163 Total 48.000 0.077
Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.001 0.006 0.186 0.853 0.013 0.011 0.013 0.011 Intercept 0.004 0.006 0.655 0.516 0.016 0.008 0.016 0.008
mkt prem. 0.655 0.171 3.818 0.000 0.312 0.998 0.312 0.998 mkt prem. 0.474 0.235 2.018 0.049 0.002 0.946 0.002 0.946
Regression Statistics 36 mo. Regression Statistics 24 mo.
Multiple R 0.372 Multiple R 0.365
R Square 0.139 R Square 0.133
Adj. R Square 0.114 Adj. R Square 0.096
Standard Error 0.031 Standard Error 0.032
Observations 37.000 Observations 25.000
df SS MS F Significance F df SS MS F Significance F
Regression 1.000 0.005 0.005 5.636 0.023 Regression 1.000 0.004 0.004 3.543 0.072
Residual 35.000 0.034 0.001 Residual 23.000 0.023 0.001
Total 36.000 0.039 Total 24.000 0.027
Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.005 0.005 1.021 0.314 0.016 0.005 0.016 0.005 Intercept 0.013 0.006 1.949 0.064 0.026 0.001 0.026 0.001
mkt prem. 0.613 0.258 2.374 0.023 0.089 1.136 0.089 1.136 mkt prem. 0.640 0.340 1.882 0.072 0.063 1.343 0.063 1.343
130
Multiple R 0.248 72 mo. 3 Month Regressions R Square 0.062 Regression Statistics Adj. R Square 0.049 Standard Error 0.050 Observations 73.000 df SS MS F Significance F Regression 1.000 0.012 0.012 4.673 0.034 Residual 71.000 0.181 0.003 Total 72.000 0.193 Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.001 0.006 0.157 0.875 0.011 0.013 0.011 0.013 mkt prem. 0.324 0.150 2.162 0.034 0.025 0.622 0.025 0.622 Regression Statistics 60 mo. Regression Statistics 48 mo.
Multiple R 0.445 Multiple R 0.283
R Square 0.198 R Square 0.080
Adj. R Square 0.185 Adj. R Square 0.060
Standard Error 0.047 Standard Error 0.039
Observations 61.000 Observations 49.000 df SS MS F Significance F df SS MS F Significance F
Regression 1.000 0.032 0.032 14.583 0.000 Regression 1.000 0.006 0.006 4.086 0.049
Residual 59.000 0.131 0.002 Residual 47.000 0.071 0.002
Total 60.000 0.163 Total 48.000 0.077
Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.001 0.006 0.213 0.832 0.013 0.011 0.013 0.011 Intercept 0.004 0.006 0.674 0.504 0.016 0.008 0.016 0.008
mkt prem. 0.655 0.172 3.819 0.000 0.312 0.998 0.312 0.998 mkt premium 0.475 0.235 2.021 0.049 0.002 0.948 0.002 0.948
Regression Statistics 36 mo. Regression Statistics 24 mo.
Multiple R 0.373 Multiple R 0.364
R Square 0.139 R Square 0.132
Adj. R Square 0.114 Adj. R Square 0.095
Standard Error 0.031 Standard Error 0.032
Observations 37.000 Observations 25.000
df SS MS F Significance F df SS MS F Significance F
Regression 1.000 0.005 0.005 5.642 0.023 Regression 1.000 0.004 0.004 3.511 0.074
Residual 35.000 0.034 0.001 Residual 23.000 0.023 0.001
Total 36.000 0.039 Total 24.000 0.027
Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Coefficients St. Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.005 0.005 1.050 0.301 0.016 0.005 0.016 0.005 Intercept 0.013 0.006 1.960 0.062 0.026 0.001 0.026 0.001
mkt prem. 0.614 0.258 2.375 0.023 0.089 1.138 0.089 1.138 mkt prem. 0.638 0.341 1.874 0.074 0.066 1.343 0.066 1.343
131
Screening Ratio Analysis
Sara Lee
2002 2003 2004 2005 2006
Net Sales/Cash from sales N/A 1.00 1.00 0.99 1.00
Net Sales/Net Accounts Receivable 8.21 8.35 8.60 9.56 9.11
Net Sales/Unearned Revenues N/A N/A N/A N/A N/A
Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A
Net Sales/Inventory 5.79 5.63 5.83 7.45 7.41
Asset Turnover (Sales/Assets) 1.06 0.96 1.07 1.12 1.10
CFFO/Operating Income 1.72 1.55 1.61 1.88 2.22
CFFO/Net Operating Assets 0.55 0.55 0.63 0.48 0.42
General Mills
2002 2003 2004 2005 2006
Net Sales/Cash from sales N/A 1.00 1.00 1.00 1.00
Net Sales/Net Accounts Receivable 7.87 10.72 7.87 10.87 10.82
Net Sales/Unearned Revenues N/A N/A N/A N/A N/A
Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A
Net Sales/Inventory 7.53 9.71 10.41 10.84 11.03
Asset Turnover (Sales/Assets) 0.48 0.58 0.60 0.62 0.64
CFFO/Operating Income 0.72 0.82 0.70 0.85 0.89
CFFO/Net Operating Assets 0.33 0.55 0.47 0.57 0.59
Kraft
2002 2003 2004 2005 2006*
Net Sales/Cash from sales N/A 1.01 1.01 1.00 1.01
Net Sales/Net Accounts Receivable 9.54 9.20 9.09 10.08 8.88
Net Sales/Unearned Revenues N/A N/A N/A N/A N/A
Net Sales/Warranty Liabilities N/A N/A N/A N/A N/A
Net Sales/Inventory 8.79 9.28 9.33 10.20 9.80
Asset Turnover (Sales/Assets) 0.52 0.52 0.54 0.59 0.62
CFFO/Operating Income 0.59 0.69 0.75 0.66 0.71
CFFO/Net Operating Assets 0.39 0.41 0.40 0.35 0.38 *The following charts illustrate and compare Sara Lee’s screening ratios to their major competitors.
132
References
1. Edgar Scan, www.edgarscan.com
2. Conagra Corporation, www.conagra.com
3. Kraft Corporation, www.kraft.com
4. Sara Lee Corporation, www.saralee.com
5. St. Louis Federal Reserve website
6. Yahoo Finance, www.yahoo.com/finance
7. CNBC, www.cnbc.com
8. General Mills Corporation, www.generalmills.com
9. Investopedia, www.investopedia.com
10. Morning Star, www.morningstar.com
11. Unilever Corporation, www.unilever.com
12. Kelloggs Corporation, www.kelloggs.com
13. Chicago Tribune, www.chicagotribune.com
14. Business Valuations and Analysis, Palepu Bernerd, Healy
15. Wall Street Journal www.wsj.com
133