For Simpson, selling, general, and administra- tive (SG&A) dropped from 21.4 percent of sales in 2004 to 19.4 percent in 2005 and 19 percent in 2006. This is a good performance, and proba- bly reflects economies of scale and effective management.
Normally, economies of scale should bring some decline in the percentage in the long run, as economies of scale allow for more business activity to occur per unit of headquarters cost, IT cost, and so on. In the short run, SG&A may increase more rapidly as marketing campaigns
or staff are added or new facilities are required.
That’s why a longer view is really needed to make a final determination of whether SG&A is on the right track.
Company comparisons are appropriate here, too.
But watch again for economies of scale.
Although Wal-Mart reports SG&A at 18.4 percent of sales, easily beating bookseller Borders at 24.3 percent, the sheer size of Wal-Mart suggests that its SG&A should be lower as a percentage.
Compare carefully.
Depreciation and amortization expenses are usually broken out on the earn- ings statement, but may also be buried in a consolidated SG&A or other oper- ating expense line.
Do you really want to know what a company wrote off for depreciation in a reporting period? Then refer to the statement of cash flows. This is jumping ahead a bit, but depreciation, a noncash expense, is a major source of differ- ence between accounting income and cash flow. So, accountants show depre- ciation as a separate add-back item on the cash flow statement.
What should you look for? The actual amount of depreciation is normally not that important. What is more important is the method and time period over which it occurs. Accelerated depreciation methods result in more conserva- tive earnings statements. Companies sometimes use straight-line methods for financial reporting and accelerated methods for tax purposes — giving rise to two sets of books and can contribute to the deferred taxes lines in the balance sheet. Watch for sudden changes in depreciation methods, and be careful when comparing especially capital-intensive companies to assure that they’re using comparable depreciation methods.
Impairments, investments, and other write-downs
When the value of an asset changes significantly in the eyes of management, a company can elect to take a write-down recognizing the change. The write- downshows up as a decrease in asset value on the balance sheet for the asset category involved and as a (usually) one-time expense somewhere on the earnings statement. The rules for when and how to take these write-downs are somewhat flexible.The rules for writing down investment losses are particu- larly complex and beyond the scope of this book. The good news is that write- downs are normally reported as a separate line and are well documented in the notes.
For value investors, knowing the detail or amount may not be as important as knowing the pattern. Are these write-downs really one-time adjustments, or does the company continually overinvest in unproductive technology? Are companies quick to recognize mistakes, or do they linger, pushing an ever- larger “bow wave” toward amortization and earnings oblivion? Write-down behavior provides insight into management behavior and effectiveness, as well as overall business consistency, and should not be ignored.
It is also critically important to understand write-offs and one-time charges when building intrinsic value models (more in Chapter 12). Many intrinsic value models base forward projections on the most recently reported net income numbers. Most financial portals and automated investment analysis tools simply take the latest year’s earnings figure from a database. If that figure was significantly reduced (or enhanced) by extraordinary items, a large (and compounded!) error in the intrinsic value assessment can occur.
Giving to goodwill
As presented in Chapter 7, intangible assets are long-lived assets that have no physical existence. Included are patents, copyrights, trademarks, fran- chises, and other legal protections. Also included — and attracting more interest from value investors — are goodwill assets obtained by acquiring other companies. These goodwill assets arise when more is paid for an acquired company than it is worth in hard assets. Acquired goodwill assets often have real value — brand equity, customer base, and so forth — but more often than not, the amount booked exceeds this value, and goodwill is used as a plug-in figure to account properly for the purchase.
The treatment of goodwill has changed — it has become more uniform. The deal that accountants struck with the corporate world calls for allowing goodwill to remain on the books forever — but it also subjects them to an annual review for impairment of the fair value of those assets (FASB Standard
# 142). Goodwill amortization involved quantitative methods that can be quite complex and beyond the scope of this book. And as stated in the Simpson annual report, “determining fair value of . . . an indefinite-lived purchased intan- gible asset is a judgment involving significant estimates and assumptions.”
Like depreciation and impairments, goodwill amortizations are accounting phenomena and don’t result in a cash transaction. Goodwill amortization affects earnings, not cash flow. Informative annual reports deconstruct impairment analysis for you and give estimates not only for current but also future asset impairment charges.
You can decide how you want to appraise goodwill, but conservative is usu- ally best. Ben Graham was particularly leery of goodwill and usually removed it entirely from company valuation, regardless of company policy. Buffett and other contemporary value investors recognize the value of patents, copy- rights, brand equity, customer base, and other intellectual property and allow it to stand in valuation, so long as it’s not in excess and is accounted for realistically.
Operating income
Now, finally, we can summarize how a company has performed at its basic business by examining operating income. Operating income is simply sales less cost of goods sold, less operating expenses. Because it includes noncash amortizations, it is a “fully loaded” view of operating performance in the business.
If you closely observe the effects of amortizations, special write-downs, and accounting changes, you can better understand operating income and oper- ating income trends. For Simpson, 2006 operating income (“Operating Income or Loss”) increased to $161.4 million from the previous year’s $153.7 million, a modest increase.
Interest-ed and taxed
Interest and especially taxes are the corporate world’s equivalent of the proverbial sure things. So not surprisingly, space is reserved for them on the earnings statement.
Companies invariably have some form of interest income or interest expense, and usually both. Interest income comes primarily from cash and short-term investments held on the balance sheet, while interest expense comes, not surprisingly, from short- and long-term debt balances. Interest reporting is usually done as net interest; that is, by combining interest income and expense into a net figure. Taxes are quite complicated, just as they are for individuals, and the details go beyond the scope of this book. There is nor- mally an income tax provision recorded as a single line item on the earnings statement, consisting of Federal, state, and local taxes put together.
You don’t need to pay too much attention to these areas except where inter- est expenses are disproportionately high and growing. In most situations value investors treat taxes as a given, unless the company has recently been through tough times and has a lot of write-offs to carry forward. If that’s the case, taxes can be artificially low for a while; investors must take into account when they will return to a normal level.
Income from continuing operations
What results from netting out interest and taxes from operating income is income from continuing operations.This figure gives a good picture of com- pany performance, not only from an operating but also a financial perspec- tive. A close look at interest costs tells, for instance, whether operating success (operating income) comes at a financial price (high interest
expense). If operating income is low or declining while financing cost (inter- est) is large or increasing, look out below!
Income from continuing operations tells shareholders, in total, what their investment is returning, after everyone, including Uncle Sam and his brethren, is paid. Income from continuing operations is a good indicator of total business performance, but be aware of truly extraordinary events dri- ving expenses or income.
Ordinary extraordinaries
Extraordinary items on an earnings statement are, according to accounting rules, to be tied to events that are unusual and nonrecurring. Unusual events aren’t related to typical activities of the business, at least going forward.
Nonrecurringevents aren’t expected to occur again.
Extraordinary items commonly result from business closures (“discontinued operations”) or major restatements due to changes in accounting rules. They may result from debt restructurings or other complex financial transactions.
They may result from layoffs and other employee transactions. Extraordinary items generally are notsupposed to include asset write-downs (such as receivables, inventory, or intangibles), foreign currency gains or losses, or divestitures. Some companies interpret the accounting rules and guidelines more strictly than others.
Our advice to you is to watch for extraordinary expenses that aren’t so extra- ordinary. For example, companies that routinely have some kind of write-off every year or reporting period aren’t doing as well as the investing commu- nity is being led to believe. If earnings are consistently a dollar a share each quarter with a consistent $4 write-off each year, the true value generated by the business is closer to zero than four.