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Mike Farkas
EIF- Fall 2014
Final Paper
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Table of Contents:
Pages:
3-18: Economic Analysis
19-29: A&D Industry Analysis
30-59: LMT Company Analysis
60-67: LMT Valuation
68-75: Medical Supplies (N/I) Industry Analysis
76-101: BSX Company Analysis
102-126: BAX Company Analysis
127-133: BAX and BSX Valuation
134: Review
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Economy Analysis
Economy Overview
The economy as of the past year has seen GDP rise to a 4.2% annual rate for quarter two of
2014, up from the -2.1% pace in quarter one of 2014. GDP for the third quarter again rose at an
annual rate of 3.9%. The increase is related to the sharp increase in inventory accumulation and a
moderate rebound from the first quarter’s domestic final sales. Domestic final sales show that
consumer demand rose at a 3.1% annual rate for quarter two versus the 0.7% in quarter one of
2014. This also shows us that consumers are spending which is supported by a 2.2% annual rate
increase in CPI. Economists believe this is due to gradual spending on motor vehicles. Real
estate is performing at a mediocre level, and homebuilding has risen at a 5.5% rate, which is up
from last year as well.
If we look back from our recovery in 2009, what makes this recovery different is the
decline in governmental policies. Minimizing the military budget through sequester cuts, which
have also decreased government spending in other areas, alleviated burdens from local, state, and
federal governments, resulting in a significant impact on our economy’s recovery. The economy
has seen the unemployment rate steadily decrease from 6.6% in quarter one to a lower figure of
6.1% the past quarter. Although this rate has decreased over time, economists believe long-term
unemployment, underemployment, and average wages are slacking.
Janet Yellen says Fed policymakers are naturally “shifting to questions about the degree of
remaining slack, how quickly it is taken up, and believes we should begin dialing back our
extraordinary accommodations because “they are unambiguous” she says. Due to this, interest
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rates remain generously low but Yellen believes short-term interest rates will be raised before the
end of the quarter. Consumer price inflation and inflation itself is due to remain the steady and
slightly creep up with interest rates next year. The soft global economy should keep commodities
stable throughout as gold and copper are essentially pretty quiet right now. In regards to oil, due
to increased domestic production, energy prices are facing downward pressures.
The stock market continues to seen an all-time highs with the DJIA and S&P performing
well over the past couple of years. The market recovered well from the 10% correction we saw in
October 2014 and by November was witnessing new highs. The world’s most influential central
banks remain actively engaged in attempts to support the financial markets, however, we still see
a valuation gap between emerging markets and the developed world. This gap, based on future
corporate earnings estimates, has not been this wide since 2005.
Interest Rates
10yrs ago9/2/2004
5yrs ago9/2/2009
3yrs ago
9/2/2011
9mo ago12/2/2013
6mo ago6/2/2014
3mo ago9/2/2014
Current12/1/2014
90 Day T-Bill 1.71 0.11 0.02 0.03 0.02 0.02 0.03
10yr T-Bond 4.12 3.31 1.92 2.72 2.53 2.34 2.28
30yr T-Bond 4.89 4.05 2.91 3.56 3.36 3.08 3.00
Corporate Bond
5.90 5.49 4.49 4.58 4.36 4.18 3.83
Fed Funds 2.00 0.02 0.08 0.04 0.03 0.05 0.13
Prime Rate 4.75 3.25 3.25 3.25 3.25 3.25 3.25
*Baseline
As of December 1, 2014, 90-day T-bill yields 0.03%. If we compare this rate to the 5-
year, 10-year, and 30 year rates we see an increasing short term yield. This yield has been
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consistently low since the recession in 2009. Compared to that point in time in 2011, the yield
curve appears even stronger, with higher 2 year 5 year, 7 year and 10 year yields in relation to
the 20 year and 30 year yields, which suggest a steady economic growth for the time being.
Looking back to our previous report which dated 9/2/2014, the 90-day rate increased by only one
basis point, which is not a significant jump.
Yield Curve vs S&P 500 August 31, 2011
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Yield Curve vs S&P 500 December, 2 2014
If we look at 10-year and 30-year Treasury bonds, the yields are 2.28% and 3.00%
respectively, slightly lower than 9/2/2014 figures, suggesting rates are still decreasing. Compared
to a 10 year AAA corporate bond, as noted on Yahoo Finance, the yield is 3.83%. The 3.83%
yield has decreased from a 3.92% yield last week, which was relatively at the same rate level for
last month as well. Last week's effective Fed Funds rate was 0.09%, increasing to today's latest
rate of 0.13%. The target range is currently 0 to 0.25%, a range which has been in effect since
December 16, 2008. The target rate in 2007 and 2008 ranged from 1.00-5.25%, suggesting the
Fed's goal over the course of the past 6 years was, and still is, to stimulate the economy with its
lower interest rates. Are bonds decreasing in yields because of higher interest rates? If we ignore
the Fed Funds rate and look at the 3-month treasury rates, they have generally decreased since
July 1st of this year.
Let us step back and question the continuation of a low fed funds rate. For 6 years, the
Fed Funds rate has been relatively low compared to previous periods. Can we honestly expect
this low rate to continue forever? With the S&P 500 reaching record heights, and a fairly new
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Chairman leading the Fed, how long can we expect rates to remain low? In our opinion, it's only
a matter of time before rates will increase, pushing discount and prime rates even further, putting
the brakes on the flow of easy money. The Fed’s current plans are to begin a slow and deliberate
increase in interest rates starting in mid 2015.
As a result of a low Fed Funds target and a discount rate of 0.75%, the current prime rate
in the United States is 3.25%. According to the Wall Street Journal, Canada has a prime rate of
3.00%, Japan a rate of 1.475%, and the Eurozone a rate of 0.05% (a decrease of 0.10% basis
points), suggesting one can receive cheaper funding not only overseas, but also in neighboring
Canada. Overall, we do not believe that interest rates will remain as low as they are now for
another 6 months. Despite treasury rates remaining low as they are right now, we believe that
Fed Chairman Yellen will increase the Fed Funds rate, resulting in increased discount and prime
rates, ultimately calling for a moderate correction in market prices through 2015.
Stock Market Indices Analysis
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Historical Stock Indices
Index10
Years09/03/04
5 Years09/03/09
3 Years09/03/11
1 Year09/03/13
6 months06/03/14
3 months09/03/14
Current12/02/14
DJIA 10,260 9,345 11,240 14,834 16,722 17,067 17,880
NASDAQ 1,844 1,983 2,480 3,612 4,252 4,598 4,756
S&P 500 1,114 1,003 1,174 1,640 1,924 2,002 2,067
NIKKEI 225 11,022 10,215 8,950 13,978 15,068 15,728 17,663
FTSE 100 4,551 4,797 5,292 6,468 6,836 6,874 6,742
*Yahoo finance
Thousands of securities are traded every day on various exchanges around the world.
Several economic and geopolitical influences work to set the direction of the market. Before we
discuss the details of those possible determinants of market trends, important stock market
indices, their compositions and temporal trends will be examined in the paper. There are five
stock indices that have been considered for the present discussion: Dow Jones Industrial Average
(DJIA), NASDAQ composite, S&P 500, London FTSE and Tokyo Nikkei 225.
The Dow Jones Industrial Average is the oldest index and includes 30 large publicly
owned companies based in the United States. The average is calculated by using price-weighted
method. Due to stock split of component stocks, the current divisor is less than one, and that is
why the value of index is greater than the sum of component prices. DJIA was originally
compiled to measure the performance of American industrial sector.
The S&P 500 has been popularly used to compare the level of stock prices. It is
segmented in S&P 500 Stock Composite Index, the 425 Stock Industrial Index, the 50 Stock
Utility Index, and the 25 Stock Rail Index. The index recorded one of the highest closing on
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December 2nd, 2014 at 2066.55 and saw its bottom in the recent recession on March 9, 2009 at
676.53.
The NASDAQ was the world's first electronic stock market and began as a provider of
quotation but did not perform trade. The stocks registered at this site are usually technology
stocks.
The London FTSE 100 includes companies with the highest market capitalization. The
list of companies are determined quarterly. The constituents of FTSE represents more three
fourth of entire market capitalization of London Stock Exchange.
The Nikkei 225 is a stock market index for the Tokyo Stock Exchange. It is a price-
weighted index. Unlike London FTSE, its components are reviewed once a year, in September.
However, if a company found ineligible to trade at this index, delisting can take place any time.
In the course of last three months, almost all the stock indices have gone up in total value.
However, the FTSE 100, closed 2% below its value, in the month of September 2014.
Previously, the stock index experienced increase towards the end of June 2014, but a significant
decline was observed in beginning of August. Worldwide surprise of geopolitical events (e.g.
Ukraine crisis) may have had a role to influence this trend. The European stock index such as
FTSE experienced negative return during this period. In the beginning of year 2014, there was
sharp decline in Nikkei 225. However, Nasdaq (IXIC) experienced the highest return.
In the last three years, the Nikkei 225 saw its worse performance in the middle of 2012,
but showed its highest returns in the month of June in 2013. However, in the beginning of 2014
the NASDAQ performed better than the rest of indexes compared here. Over the last five years,
if we compare these stock indices, the Nikkei reached really low levels during 2011-2012.
Japanese internal affairs may have been a determining factor. The total average of the entire
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stock index was picking up after the 2001 slowdown. But another recession during 2009 led to
the weakest performance in the market, resulting into significantly low value of all the indices.
The table 1 illustrates the 10 -year performances of these five indices. It shows their
opening and closing price for the convenience in the comparison. On December 2, 2014 all the
indices opened at their historical highs. S&P 500 reached its all-time high open price of 2,067
points. DJIA experienced approximately 100% growth in prices as compared to 2009 (economic
slowdown period). Almost all the stock index traded at their minimum price level during last
recession. This indicates that economy do impact stock market. When people buy less due to
income, unemployment or other reasons, then there seem to be overall decline in the trade
volume.
Exchange Rates
9/3/2004 9/3/2009
9/3/2011 9/3/2013 6/3/2014 9/2/2014
12/2/2014
EUR 0.83 0.70 0.70 0.73 0.73 0.76 0.81
GBP 0.56 0.61 0.62 0.60 0.60 0.61 0.64
CAD 1.30 1.08 0.99 1.11 1.09 1.09 1.14
CHF 1.27 1.06 0.79 0.88 0.90 0.92 0.97
CNY 8.28 6.83 6.39 6.15 6.25 6.14 6.13
JPY 110.49 93.02 77.09 101.44 102.54 104.93 119.23
Indirect Quotes: 1USD
Overall, the USD looks to have lost a significant amount of value during the seven years,
from September 2004 through September 2011. The only exchange rate that the USD improved
on over that period was against the British Pound. In regards to the other currencies, the USD
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lost anywhere from 15-30% of its value from late 2004 to 2011. The effect of a weaker dollar is
recognized as a positive opportunity for U.S. based companies that export goods to countries
with currencies which have strengthened in comparison to the USD. For example, our goods
would be cheaper for consumers in Japan where the USD dropped roughly 30% compared to the
Yen from 2004 to 2011. In return, goods imported into the U.S. will now be more expensive for
U.S. based consumers purchasing goods with the USD. This would encourage consumers to buy
domestic goods over a comparable imported goods.
When looking at the past three years, the USD has regained some of the value lost in
previous years. This is another indicator that the U.S. has been a leader in the world’s economic
recovery since 2011. The strengthening USD has the opposite effect from what was previously
mentioned regarding exports, as imports are now becoming cheaper. If the USD continues to
strengthen, it will become more difficult for U.S. companies to export their goods to other
countries where their currency has depreciated in respect to the USD. This is great for consumers
in the U.S. who can choose to buy relatively less expensive imports. However, this may also
have a negative impact on the revenue growth in U.S. companies that export goods if the USD
continues to strengthen as it has done over the past year.
Key Commodities
Oil is currently trading at a its lowest level since the recession. As of December 2nd,
Brent Crude went as low as $69.92 a barrel. Consumers are traveling more for the holidays, but
the price per barrel has continued to decrease in the past six months down over 30% for the year.
The oil prices outlook will be driven mainly by the rise in non-Organization of the Petroleum
Exporting Countries (OPEC) such as the US and Canada. The OPEC’s supply growth in the
latter of 2014 and beginning of 2015 is expected to outpace the growth in global oil demand.
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Geopolitical risks will also continue to play an important role in determining global oil
prices. Geopolitics has played a significant role in influencing prices since the Arab Spring in
2011. In 2014, we look at the events in Iraq, Libya, Russia and Ukraine. Although, the recent
risks have been quieter in those countries, there is a high chance that these risks will return. At
that time, we can expect risk premiums to be added if the Ukraine and Russia situation escalates,
the political crisis in Libya erupts suddenly, and the ISIS led operations in Iraq start to disrupt oil
production.
Given OPEC’s recent agreement to not cut back oil production, we expect to see a
continued fall in oil prices. Saudi Arabia plans to gain back market share that has been taken by
the unexpected high growth American Shale production. Saudi wants to price American Shale
production out of the market and American Shale is estimated to break even at $42 a barrel. With
the recent developments in the energy markets, analyst expect oil to fall into the $40 range
before prices stable around $70.
With the US dollar at a two-year highs, analysts expect the dollar to weaken and
comment that only gold can truly store value. Despite everything that’s been thrown gold’s way,
the precious metal has managed to hold its own, falling below $1,200 per ounce level over the
past month and looking to end the year above $1,200. There are not many reasons for gold to be
more volatile in the coming 6 months to a year and we expect gold to maintain a price from
$1,200-$1,300. In the past six months, gold has been as high as $1,338 in July and as low as
$1,143 in November.
Copper is by the far the worst performer amongst precious and base metals year to date.
It is currently down 10% in 2014, and continuing its downward trend. Prices for copper are
lingering around $2.90 a pound, which has not been seen in the past 6-12 months. Over the past
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5 years, Copper has been as high as $4.49 a pound, and as low as $1.25 in 2008. Needless to say
copper is not going to provide investors with the same opportunities as gold but is a solid
investment as prices are currently very low. In global news, China’s fraudulent metal backed
financing has pushed copper down even lower. Futures and options traders are shorting copper
showing us that money managers believe this commodity may continue to fall.
Other Macroeconomic Indicators
Real GDP Quarterly Growth
The total output of goods and services produced by labor and property located in the
United States is defined as Real Gross Domestic Product. The Real GDP graph above shows that
the growth of RGDP was -2.1% for first quarter of this year and showed a significant
improvement of 4.2% in the second quarter, due to rise in demand of goods and services.
However, the revised figure for the second quarter was 4.6%. Recent release by B.E.A, as on
November 24, 2014 reported the final figure for the third quarter real GDP growth was 3.9%.
This clearly indicates that the economy has been making progress as compared to the growth rate
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in the beginning of this year. The reason for improvement was cited as positive contribution from
fixed income investments, federal government spending and exports etc.
Unemployment Rate (October 2012-14)
The number of unemployed saw consistent decline since second quarter of 2012. The
figure shows that in the recent end of third quarter of 2014, it was just over 6 percent of the total
workforce. And this trend continued as the end of October figure of unemployment dropped
below 6%. This seems to have reflected in the buying behavior of the consumers. The Bureau of
Labor Statistics reported that over the last twelve months, the consumer price experienced an
increase.
% Change in CPI for Urban Consumers
The index for gross domestic purchases rose by very small fraction. Compared to a
month earlier, each measure was up just 0.1% (see figure 3). There was a rise in food and shelter
by 0.4 percent but due to the decline in energy index, overall rise in CPI was affected.
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If we compare some prices, such as for personal consumption expenditure, only 1.5%
increase was registered. Thus, as report shows inflation continues to run below the 2% target and
the PCE price index has run below 2% for 27 consecutive months. The Bureau of Labor
Statistics report suggests that percentage change in CPI was minimal from the month of
(http://www.bls.gov) September to October.
6 Month Economic Forecast
One part of the economy that we definitely see changing within the next six months are
interest rates. Interest rates are at historical lows, and we believe that these low levels will simply
not last. Within the next six months, we see treasury rates jumping. How much is up to the Fed to
decide, but one thing we know for sure is that interest rates are so low, they must eventually
come back up. According to the Raymond James weekly economic commentary, Dr. Brown
mentions that as inflations decreases, real interest rates may actually decrease. It is this low
inflation which delays the Fed from raising rates. However, Dr. Brown also states that nominal
interest rates cannot be lowered. Speaking on the subject of nominal interest rates, we believe
that these rates will be increased in the foreseeable future.
According to estimates made by Kiplinger, consumer prices for 2015 will increase just under
2%, with core inflation rising only 1.8%. The reason for consumer prices to increase at a low rate
is because of the issue with oil prices. With oil prices being at the low levels that they are right
now, consumer prices are limited from increasing at faster rates. Factoring out food prices which
are expected to remain high, but eventually decline over 2015, core inflation is expected to grow
at 1.8%, slower than consumer prices. One of the main drivers for core inflation is the 3%
expected increase in rent. As far as business expenditures are concerned, because oil is at the low
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price it is right now, rail transportation, aircraft and automotive and general manufacturing
overall will see increased activities.
Briefly pacing back two paragraphs, backwards onto the topic of interest rates, this
information we have gathered on inflation is one of the main reasons why we believe interest
rates will increase. Given inflation is expected to increase at a low rate, but still faster than 2014,
we would like to reiterate that interest rates will be increased by the Fed.
We like mentioning the interest rate hike because we believe this is will be on of the biggest
factors that will influence the future international economic climate in the next five years. We
also believe that the low price of oil will be a big player in the future, however, it will be more
short term than the interest rate hike, and therefore place a higher significance on rising interest
rates.
One of the reasons why we can say that consumer spending was low was because of weak
average wages. However, it is believed that the job market will tighten as more jobs are filled. As
this unemployment is quenched with fresh jobs, falling from 5.7% this year to 5.3% exactly one
year from now, jobs filled by a large number of tuition indebted college students (which also
plays a large role in consumer spending), consumer spending is expected to improve. Housing
sales are also expected to remain at least the levels they are at right now, according to Kiplinger,
with the possibility that housing sales activities may exceed this year’s levels given estimated
housing prices are estimated to decrease.
When looking at other fundamental economic forecast figures, according to the Wall Street
Journal’s website, GDP is expected to drop from 4.0% for Q2 of 2014, to 3.2% for Q3, and drop
down further to 2.7% growth for the final quarter of 2014. 2015 supposedly looks like GDP will
hang on at roughly the same GDP growth, at 2.8% for periods Q1-Q3 of 2015.
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Keeping in mind that interest rates have an inverse relationship with equity markets, it seems
that stocks may suffer a blow if interest rates increase, which we believe will happen. How
detrimental will this increase in interest rates be? We believe that the blow will not be as big on
the US market. Dr. Brown explains that the reason is because the Eurozone is still not as
prepared as the US, and while stocks in the US will still suffer a recoverable blow, the increase
in interest rates will have a more magnified effect on the European market. This makes sense, as
the economic environment in the US, overall, seems to be strengthening.
Raymond James Economic Commentary:
http://www.raymondjames.com/monit1.htm
Kiplinger:
http://www.kiplinger.com/tool/business/T019-S000-kiplinger-s-economic-outlooks/
Wall Street Journal Economic Forecast Survey:
http://projects.wsj.com/econforecast/#ind=tenyear&r=16
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Aerospace and Defense Industry
Life Cycle
According to Baseline, Lockheed Martin's beta is 0.68 in respect to the S&P 500. Having
said that, the aerospace and defense industry is an industry that follows its own cycle more so
than the business cycle, as seen in the graphs of Lockheed Martin's performance in respect to the
S&P 500 and the Real GDP of the United States over the past ten years. However, the industry is
also fairly stable given that the industry depends mainly on government spending, which further
explains the 0.68 beta, since there is always some space reserved for defense spending in the
budget. The reason the A&D industry still follows the business cycle to some extent is because it
is also involved in the business of commercial aircraft. The commercial aircraft side is more
sensitive to the business cycle since its customers are mainly the airline companies, as opposed
to governmental entities who are bigger players on the defense side of the A&D industry.
Overall, the A&D industry is a semi-defensive, semi-cyclical stock, given it follows the business
cycle at a slight level, while having its own independent growth factors, as well as the steady
spending from government customers when the industry is not experiencing as much growth in
times of low military conflict.
External Factors
Technology: Technology is important in the aerospace and defense industry. However, its
operations are based on contracts. Even though tech does play an important role, its sales are
somewhat secured by the contracts the company wins from governmental entities, lessening the
pressure for innovation during periods fulfilling a contract. Having said that, the industry’s
upstream portion of the value chain will always be existent, since it is reasonable to assume that
governments will still exist in the next 20 years. In other words, businesses in the A&D industry
operate on a contractual basis. Innovation is pushed when companies fight for the security of a
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contract assigned by government entities. But it’s during the actual performance and act of
fulfilling the contract where companies have to focus not only on innovation, but on fulfilling
those contracts as well, contracts which have the risk of being withdrawn by the issuing party.
Nevertheless, innovation is critical in this industry. Technology does provide threats to
businesses operating in this industry. However, it also presents many attractive opportunities. For
example, in the industry report done by Deloitte, there are many profitable technologies that are
revealing themselves, particularly the ISR (Intelligence, Surveillance, Reconnaissance)
technologies. Although I am no expert on such technologies, one can assume there is a lot of
profitability in such technologies because, for one, building heavy military hardware, such as
Lockheed Martin's state-of-the-art F-35, requires not only massive amounts of research and
development costs, but it also requires the cost of manufacturing, because this industry is, in fact,
classified under the industrials sector. But building technologies in these other segments, such as
intelligence, requires less of these direct costs, because products, such as cyber security systems,
are more valuable today than ever, and require hardly the same amount of raw materials and
physical manufacturing time as, say, an advanced fighter plane. Products like cyber defense
systems appear to be fairly valuable, because demand is growing more and more over the years,
as technological safeguards become more necessary to protect intellectual properties and keep
important systems, such as the energy infrastructure in the US, less vulnerable from a growing
presence of foreign cyber threats. Perhaps acquisitions of such businesses will occur more in the
future by these defense companies.
Government: Government is a major player in this industry. There many contracts available, for
example Lockheed Martin holds government contracts in all of its complexly layered business
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segments. However, there are many of competitors. Because government is the biggest player in
this industry, since they are the largest customers of the industry's goods and services, they
provide the largest threats and opportunities. A big threat provided by government entities is a
decreasing military budget. The US, for example, is the largest spender in the global defense
industry. It spends nearly as much on its defense budget as do the next largest 15 countries in the
world, with a whopping figure totaling $1.7 trillion. From that figure, we can calculate the
governmental market totals about $4.2 trillion in total. Having said that, again, a threat the US
brings to this industry is its decrease in military spending. According to a report from Deloitte,
the US sequestration cuts in 2013 resulted in $37 billion reduced military spending. Even more
so, the US is planning to cut $52 billion every year for the next nine years. However, the report
also indicates that spending will increase in other areas of the globe, particularly in the Middle
East, India, China, Russia, South Korea, Japan, and Brazil. A major factor of this decline in US
spending is simply due to the sheer size of the budget itself and the fact that the US government
has other priorities it must provide to its constituents, domestic affairs such as healthcare. The
reason also stems from the costs of products these defense companies pass onto their customers.
Products, such as the $116 million F-35 (c), are expensive, and with affordability being an issue
for many governments in making their purchases, businesses operating in this industry must
address this issue of affordability if they want to succeed. Governments also provide
opportunities in military contracting. For example, the United Kingdom nearly implemented an
innovation known as the Government Owned Contractor Operated (GOCO) model, where the
Ministry of Defense would purchase military equipment, but have contractors operate them.
Unfortunately, governments are also opportunities for businesses operating in the A&D
industry because we live in a world of conflict. Usually, before there is a conflict, there grow
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tensions, and with growing tensions, there comes a time of military spending by those nations
which feel vulnerable or insecure. For example, with China's growing presence and rising want
to be a world power, the nation will need the military hardware to reach their status as a world
power. This includes, but is not limited to, naval and air superiority. We also see unfortunate
events, such as the Crimean conflict between Russia and Ukraine, and the situation with ISIS as
an opportunity for the defense industry because of the increased demand for military hardware.
Social Changes: Social changes do indirectly affect the performance of the A&D industry. Its
influences may not be as obvious as technological and governmental influences, but that does not
make this external factor any less worth the time to take into effect when making investments in
this industry. Social changes that need to be taken into effect are the emotions of a nation's
population, or in other words, political views. This may seem a bit odd to say but ask yourself
this question: how would’ve a company, like Lockheed Martin, performed over the past 10
years, had the political views of Americans been more diluted and less sensitive than the events
that unfolded on September 11, 2001? It is an insensitive question to ask, associating tragic
events with profits, but companies in this industry would have not profited as much as they have
over the past ten years had citizens fought George W. Bush's insistence on invading Iraq and
growing the US's presence in the Middle East. Had the public voiced strongly different actions
by forcing Congress to impeach the President, on the grounds of illegally creating a propagandist
war campaign misleadingly tying the 9/11 tragedy as a means for the Iraqi invasion (as well as a
number of other questionably constitution-undermining acts), or have the President pursue other
actions, the defense industry would not have profited as much as it did. It may be naïve and
frankly a debatable issue as to think whether today's public has such a strong influence on the
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affairs of government, more so than the lobbyists, but nevertheless, it is still important to monitor
the emotions of a public.
Demographics: Demographics play a large part on the A&D Industry, mostly on the Aerospace
part. Today's growing population implies a greater demand in basic demands in a 21st century
society. There is a greater demand for water, food, electricity, internet, and so on. Where the
A&D industry is affected is more on its Aerospace side because of a growing demand for
transportation. A larger population means more air traffic, and more air traffic suggests more air
vehicles. A growing population is an opportunity. Demographic threats and opportunities also
include the distribution of wealth across the population. America's growing income inequality,
where more money is flowing into the pockets of the rich rather than finding its way into the
pockets of the middle classes, can be seen as a threat, since air travel is becoming more
expensive relative to people’s incomes, or also as an opportunity since people with private
wealth can more easily purchase private planes rather than 1st class tickets on a public airline.
Not only does this apply to the A&D industry, but also to the commercial airline industry as
well.
Demographics also play a role in the defense side of the A&D industry. Monitoring
demographics in different regions may predict tensions which may flare up into conflict. For
example, seeing an increased presence of one ethnic group’s size or power in a relatively
unstable region may increase tensions which may lead to conflicts, as we've seen with the Balkan
crisis in the 1990's, where the US air force used one third of its worldwide cruise missile supply,
manufactured by Boeing, worth a total of $150 million, in only a week of campaigning in 1999
(Schmitt, 1999).
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Foreign influence: As you can see, the A&D industry is very much influenced globally, which
is why I decided to describe the industry thus far from a global perspective. In summary, global
competition stemming from superior or more affordable technologies, changing demographics as
well as changing political powers and policies, all affect the industry. A couple other ways
foreign factors influence the industry in the US, as we’ve also explained before, includes military
tensions and conflict, which increases demand, a growing global population, which also
increases demand, and international competition, which increases supply.
Demand analysis: The demand analysis is fairly simple for the A&D industry. Because demand
stems mainly from government entities, demand will always be present for the products of the
A&D industry. Demand increases when tensions of nations build, for example, the tensions
between Japan and South Korea versus China and North Korea. Another example is the growing
tension between the US and China in regards to cyber-attacks. Conflicts also increase the
demand for products in this industry. As noted before, the Second Gulf War during the Bush
campaign; and the War on Terror the US has been fighting ever since have inflated the market
for this industry at an all-time high which is now deflating with US sequestration cuts. Overall
demand in this industry will start decreasing, assuming the US will keep cutting its spending,
regardless of whether other governments will increase their spending since the US has the
biggest net effect potential, being the military spending giant that it is.
Supply Analysis: The A&D has a lot of moving parts to it. Lockheed Martin is an epitome of
this diverse industry, as the company has five different business segments which all do vastly
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different operations. One of the biggest material inputs would be metals. Just as an F-35 needs
metals for its avionics, so does a laser-guided missile, so does a littoral ship, and so does the
infrastructure of a newly installed security system, drone, or surveillance system. Copper is a
cheap conductor that is used in vast amounts of common circuitry found in these products. So is
aluminum in the frameworks of fighters even though specially engineered plastics are also
emerging as substitute materials used for metals such as aluminum and even steel. Who knows if
these materials, called carbon nanotubes, will one day be used in the production of lighter and
faster naval ships as well. Nanotechnology is certainly one technology to keep an eye out for in
this industry, as well as for other investment opportunities. Computer technologies are also used
as inputs, such as chips and integrated network software that allows the fluid communication
between those operating the military hardware. Technology does cheapen over time, according to
Moore’s Law, but state-of-the-art military hardware always requires top technology, which
makes Moore’s Law less relevant to this industry since top-quality technological inputs are
usually used as inputs. Oil is also a large material player that affects the performance of
aerospace products. This is a threat to the A&D industry, as we all know today that oil reserves
will not last forever, meaning that oil driven products, chiefly fighter jets, will be more expensive
to maintain, thus increasing a government customer’s hesitancy in choosing such military
hardware. In the long term, this may also be an opportunity, since governments will probably ask
companies in the A&D industry to develop new hardware that is powered by alternative fuels.
However, another resource that is a threat to the A&D industry is labor. With decreasing military
budgets, companies operating in a saturated market have to streamline in order to survive. This
streamlining requires the use of automated machines. Another threat labor brings is the limited
capacity levels companies can operate in, since it’s common for A&D companies to have large
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amounts of backlog. This again is a threat (as well as a weakness), since governments can cancel
contracts while inventories are still in work in process. Overall, supply is at a moderate level
because even though there are a good number of suppliers, backlog still is a common in this
industry. The nature of these types of inventory produced for their customers stem from the
nature of the contracts that are issued by the customer. In other words, contracts are tailored for
the customer, increasing the significance of being able to satisfy the customer through product
differentiation strategies. In that respect, products are not as capable of being mass produced as
are products such as civilian vehicles, for example.
International competition: Very briefly, international competition is high in this particular
industry because of the limited number of contracts that are awarded to a greater number of
companies. However, demand will always be present, as it is reasonable to assume today that
governments will always be issuing contracts to keep their militaries sharp and up to date, but
companies that want to survive further into the maturity phase of this industry's life should
carefully streamline where excess costs are being cut in a shrinking market, but still able to keep
supplying the current demand and getting rid of backlog both effectively and efficiently.
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Porter’s Five Forces
Threat of New Entrants:
The threat of new entrants in the A&D industry is low. Barriers to entry are relatively
high in the United States according to the rest of the world. The reason is because in the airline
industry, manufactured parts need to be approved by the Federal Aviation Administration (FAA).
On the defense industry’s side, you also have the US government requiring employees to pass
security clearance. Capital expenditures, and cost structures are also very high. Both sides of this
industry require high research and development costs. Economies of scale, as well as product
differentiation are also present. You have the mass production of aircraft as well as the heavy
expenditures used to research products to be top quality. Overall, switching costs are high, as
some defense products are heavily intertwined with military operations, and switching between
products would be very inconvenient in most cases.
Bargaining Power of Suppliers:
Supplies are ordered on a contractual basis. There are more suppliers than there are A&D
businesses, meaning that bargaining power is low. But bargaining power also varies considering
the availability of a certain part. If a part is in high demand, and supply is low, the supplier has
increased their bargaining power. If the product in demand is also widely available, then the
bargaining power of the supplier remains unchanged. Switching costs from supplier are not high,
since the products the supplier has to offer are tangible goods that can be manufactured by other
suppliers. The threat of forwards integration by the supplier is also low. In fact, businesses in the
A&D industry tend to integrate backwards, as seen with the production process of Boeing. As a
result, suppliers tend to have a low bargaining power.
Bargaining Power of Buyers:
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The bargaining power of buyers is high. Commercial aircrafts are primarily sold to big
airline companies, while defense products are sold to governmental entities, the US government
being the largest customer. Airline industries, such as American or Delta Airlines, also do not
have the financial capacity to acquire or even operate companies such as Boeing, or Lockheed
Martin, because not only are their market capitalizations three times to two times larger
respectively, but they would not have the earnings to invest effectively in research and
development.
Threat of Substitute Products:
The threat stemming from substitute products are moderate. Airline industries do not
provide other services of transportation. The substitute products of air travel, however, include
cruises, train and automobile transportation. Although not direct, these products can be viewed as
indirect substitute products. The threats stemming from substitute products are a lot more
dynamic in the defense industry, in terms that defense products are replaceable by a wider range
of influences. The reason being is that defense product are part of the complete pie of a
governmental entity’s budget. The portion of a country’s budget allocated to defense products
can be replaced by larger section of other parts of the pie, such as education, highways, social
programs, healthcare, and so on. Overall, threats stemming from substitute products are moderate
for the A&D industry.
Intensity of Rivalry:
The level of rivalry in the A&D industry is very high. Competitors all have to compete
for a limited number of contracts made available by governments, and the spending of large
airline businesses. Companies in this industry have to be efficient to be affordable to their
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customers, and innovative, so that they may secure government contracts. Overall, the intensity
of rivalry is very competitive.
Conclusion: Given the conditions, Porter’s Five Forces show us that the A&D industry is risky
but profitable. The threat of new entrants is low, as is the bargaining power of suppliers, but the
intensity of rivalry is high, as is the bargaining power of buyers. The issues do not stem from
supplier or barriers of entry, but maintaining all four pillars of value, quality, efficiency,
innovation, and customer responsiveness. The issues companies need to be aware of are the high
bargaining powers of buyers, and high levels of rivalry. Very briefly, this means companies need
to address the four pillars of value in order to achieve success through the means of securing the
limited numbers of government contracts available in the defense contracting market, and
securing the limited financial resources of large airline businesses.
Sources:
http://www.valueline.com/Stocks/Industries/Industry_Analysis__Aerospace_and_Defense.aspx
http://www.nytimes.com/1999/03/31/world/crisis-balkans-bombing-bad-weather-hampers-bombers-effectiveness-us-says.html http://www.flightglobal.com/news/articles/lockheed-martin-reveals-f-35-to-feature-nanocomposite-357223/ http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/us_AD_GlobalAandDOutlook_01022014.pdf
Holtzman E. The Impeachment of George W. Bush. (cover story). Nation [serial online]. January 30, 2006;282(4):11. Available from: MasterFILE Premier, Ipswich, MA. Accessed October 18, 2014
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0.0000100.0000200.0000
LMT Closing Prices
(Baseline)
2004-10-01
2005-02-01
2005-06-01
2005-10-01
2006-02-01
2006-06-01
2006-10-01
2007-02-01
2007-06-01
2007-10-01
2008-02-01
2008-06-01
2008-10-01
2009-02-01
2009-06-01
2009-10-01
2010-02-01
2010-06-01
2010-10-01
2011-02-01
2011-06-01
2011-10-01
2012-02-01
2012-06-01
2012-10-01
2013-02-01
2013-06-01
2013-10-01
2014-02-0112000.0
14000.0
16000.0
Real US GDP
(http://research.stlouisfed.org/fred2/series/GDPC1)
38230 38442 38656 38868 39082 39294 39507 39721 39933 40147 40359 40574 40786 40999 41213 41425 41639 418510
5001000150020002500
S&P500 Close
(Baseline)
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Lockheed Martin Company Analysis
General Company History
The Lockheed Martin Company’s history is a story of two companies. The first part of
the present day Lockheed Martin company was founded by Alan and Malcolm Lockheed in
1912, which was then named Alco Hydro-Aeroplane Company. Also in 1912, the other
completing half of present day Lockheed Martin Company, Glenn L. Martin Company, is
incorporated in Los Angeles. In 1914, Martin makes its first order to the US military, providing
its Model TTs. In 1916, the Lockheed brothers established Loughead (changed to Lockheed in
1920) Aircraft Manufacturing Company in Santa Barbara. In the same year, Martin comes out
with its Wright-Martin Model R, its first reconnaissance plane. 1916 is also a year where you
start to see aeronautic instruments arise, such as the altimeter, the angle of attack and the stall
warning instruments. In 1917, with the help of investors, the company moves to Ohio.
In 1918, Martin makes its first sale of HS-2L flying boats to the Navy, and creates the
first twin engine bomber, the MB-2. Then in 1924, Lockheed's SC-1 torpedo-scout bomber are
built for the US Navy. In 1926, due to the fall of the original company, Allan Lockheed, the
original co-founder, moves the company to Hollywood, California, and forms the Lockheed
Aircraft Company. Martin incorporates in Maryland during 1928.
The year of 1930 brings the two companies many new planes, as pre-World War II
tensions escalate. However, Lockheed faces problems in the early 30's. Robert Gross ended up
saving the company from receivership, and as a result, according to the website, becomes known
as the visionary that pushes the company to become the aerospace giant it is. In 1937, the first P-
38, the first US Army Air Forces plan to shoot down a Nazi aircraft, is built by Gross's
energized Lockheed company. In the same year, Martin creates the first powered-operated
rotating gun turret.
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In 1940, Lockheed maintains its focus in the A&D industry while Martin scales back, and
re-focuses on commercial planes and enters into the missile, rocket, and modern weapons
production business. In 1943, the secret operation, known as the Skunk Works operation, is
started in California by the Lockheed company. 1947 brings the Vought Regulus, by Heritage
company, the first jet-powered guided missile for the US military.
In 1950, Lockheed prepares for the Korean Conflict and launches its Missile Systems
Division. The first C-130 Hercules is flown in 1954, and with other planes still in production, it
is the longest running military airlifter program in the world. In the following year, Lockheed's
first U-2 Reconnaissance Aircraft is flown as well. Three years later, in 1958, the company
makes the first FAA approved black box, which is standard equipment on both commercial and
military transports. Jumping ahead to 1974, the notorious SR-71, by Lockheed, beats a world
record for speed, as it travels from Los Angeles to London in just 3.75 hours. In 1979, Lockheed
launches its first Trident Missile. In 1988, the US discloses the F-117 stealth fighter, on of the
creations of Skunk Works. The Hubble Telescope, built by Lockheed, is deployed. 1991 marks
the beginning of the development of the F-22. The project is a collaboration between Lockheed,
General Dynamics, and Boeing.
Finally, in 1995, Lockheed and Martin Marietta merge together to form one of the world's largest
aerospace and defense companies in the world. Lockheed's focus is broadened to
telecommunications and information systems. In 2000, Lockheed Martin is chosen to modernize
the architecture for NORAD (the North American Aerospace Defense Command), and in 2001,
it won the contract to develop the F-35II for the US Navy, Marines, and UK's Royal Air Force
and the US's Navy. In 2004, the company acquires a naval electronics company to keep its
competitiveness in naval warfare. In 2006, NASA selected Lockheed Martin's Orion Crew
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Exploration Vehicle to transport explorers with destination ranging from the International Space
Station to Mars. In 2008, the company begins working on the FBI's Next Generation
Identification System, which is a biometrics system for federal, state, and local law enforcement.
Then, in 2013, Marillyn Hewson becomes the present CEO of Lockheed Martin.
*Overall, the merger that resulted in the unified Lockheed Martin enabled a company, focused
primarily on defense, to expand further into space, as Martin Marietta brought rockets, space and
transportation vehicles to the newly established company's portfolio.
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General Company Overview:
Lockheed Martin is a company with five business segments, and it's these 5 business segments
which give the company a lot of complicated moving parts. There's the Aeronautics segment, the
Information Systems and Global Solutions segment, the Missiles and Fire Control segment, the
Mission Systems and Control segment, and the Space Systems segment. In each of the following
paragraphs, I will briefly go over what each segment does, and include a segment from the
company's most recent 10-k (Fiscal Year End December 31, 2013).
The Aeronautics segment is concerned with the value chain regarding the business of
military aircraft and adjacent technologies. "Aeronautics is engaged in the research,
design, development, manufacture, integration, sustainment, support, and upgrade of
advanced military aircraft, including combat and air mobility aircraft, unmanned air
vehicles, and related technologies."
The Information Systems and Global Solutions segment focuses on technological and
management systems, as well as services for these systems. "IS&GS provides advanced
technology systems and expertise, integrated information technology solutions, and
management services across a broad spectrum of applications for civil, defense,
intelligence, and other government customers. In addition, IS&GS supports the needs of
customers in data analytics, cyber security, air traffic management, and energy demand
management. IS&GS provides network-enabled situational awareness, delivers
communications and command and control capability through complex mission solutions
for defense applications, and integrates complex global systems to help our customers
gather, analyze, and securely distribute critical intelligence data. Also, IS&GS is
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responsible for various classified systems and services in support of vital national security
systems."
The Missiles and Fire Control segment is focused on missile defense systems, military
operation support services, and ground vehicles. "MFC provides air and missile defense
systems; tactical missiles and air-to-ground precision strike weapon systems; logistics and
other technical services; fire control systems; mission operations support, readiness,
engineering support, and integration
services; and manned and unmanned ground vehicles."
The Mission Systems and Control segment focuses on naval vessels and weapon
systems , mission systems and sensors, and defense systems. "MST provides ship and
submarine mission and combat systems; mission systems and sensors for rotary and fixed-
wing aircraft; sea and land-based missile defense systems; radar systems; the Littoral
Combat Ship (LCS); simulation and training services; and unmanned systems and
technologies."
The Space Systems segment is focused on larger scale missile defense systems,
satellites, and space transportation. " Space Systems is engaged in the research and
development, design, engineering, and production of satellites, strategic and defensive
missile systems, and space transportation systems. Space Systems is also responsible for
various classified systems and services in support of vital national security systems."
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Corporate, business, and Functional-Level Strategies:
Lockheed Martin's corporate strategy is focused on vertical integration, although the
company does expand through actions of related diversification, such as the acquisition of
Industrial Defender (a cyber-defense company) in May of 2014. However, the main theme of the
company's corporate strategy is related diversification, since acquiring related companies enables
Lockheed Martin to accumulate expertise that allows for development or reinforcement of
certain projects, for example, the company gaining more expertise, an less competition, in cyber
security with its acquisition of Industrial Defender. Lockheed's corporate strategy also includes
divesting certain operations that are not as profitable.
Lockheed Martin's business strategies in all of its segments are focused on the concept of
product differentiation. The nature of the entire industry is set in this tone. You can't just make
an amazing super-military aircraft and market it at your own desired price. The nature of all the
this industry is to work on an awarded contract with a client, usually a governmental entity, and
satisfy the demands set by the client. Not every contract is alike, and in that respect, Lockheed
Martin's business level strategies are all centered around product differentiation.
However, even though cost leadership is not a primary strategy, it is still an important
concept to consider. Although Lockheed Martin does not focus on cost leadership, it still has to
spend at least part of its attention on cost efficiency to remain among the dominant players in the
industry, because with a shrinking US defense budget, the company has to adopt to this external
change internally through processes such as automated labor, cheaper materials, energy efficient
operations, and innovative technologies that reduce production costs. The company does strive to
run cost efficient operations. Some examples of these cost efficiency pursuits include the
company's 14 out of 50 ranked status on the EPA's National Top 50 Green Power Leadership
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List in the company's 2013 Sustainability Report, and substituting metal frames with cost-
efficient nanocomposites on the F-35 fighter jet and the Juno spacecraft.
Regarding functional-level strategies, the company's source of value is its innovation, a
major value factor in the A&D industry, customer service, given there are very few customers
and demands must be met pleasantly so that more orders may occur in the future, and its highly
competitive level of quality, for example, the PAC-3 missile system being among the most
advanced missile defense systems yet. Cost efficiency is also a factor, however, it is not a major
value-added player since the company's major challenge it faces lies in reducing costs of its
products since the US defense budget is decreasing. With the budget decreasing, it is critical to
improve the company's cost efficiency, because being more cost efficient will address the
affordability problems governmental customers are facing, meaning an improvement in
efficiency will add value to the company's products in the eyes of the purchaser.
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Life Cycle:
I believe the company is transitioning from a late mature phase into a decline phase.
Although the aerospace and defense industry itself is more weighted towards a declining phase,
as the US's military budget decreases, I still believe that the company is on the border of a
maturity-decline phase because there opportunities with new technologies emerging that might
strengthen the company's performance, and on the flip side, three out of the five business
segments are experiencing a decline in sales. But not all of the company's three declining
segments are experiencing a proportional decrease in profit margins. The Aeronautics segment,
for example, performed with the same profit margin, despite its 5% decline in net sales. There is
also a possibility that tensions around the world will increase, as China continues to grow and
assert itself as a world power, and ISIS continues its attempts to fill the power vacuum in the
Middle East, but the nature of the industry itself is a technological arms race, and with
technologies such as nano-technology replacing metals with lighter, cost-efficient composite
materials, I believe such technologies will continue to surface in the coming years and keep the
industry from declining at a faster rate the average market expects.
I have also calculated Lockheed's beta to the S&P 500 since November 1st, 2007, and the
resulting figure was .68, meaning the company is not as closely correlated to the economy. The
reason being is because the company is mostly affected by geopolitics, and the actions of the US
government as opposed to the general market, which makes the company more of a defensive
stock than a growth stock (even though you can argue it as both), despite its significant gains
over the past 52 weeks.
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Product Lines, Major Products, and Marketing:
Product Lines and Products
As mentioned before, Lockheed Martin contains a lot of moving parts to it. Operating in five
business segments, the company creates fighter jets, its own combat ship, combat ground
vehicles, ground and aerial drones, defense systems, mission support, and even information
systems.
In the Aeronautics segment, Lockheed Martin's main products are the F-35 Lightning II JSF,
the C130J Hercules, the F-16 Fighting Falcon, F-22 Raptor, and the C-5M Super Galaxy.
In the Information and Global System segment, the company provides many relatively
smaller contracts to civil, defense, intelligence, and other government customers. The major
programs in this segment include providing energy infrastructure to the Department of
Energy (Hanford Mission Support contract), integrating the US's Ballistic Missile Defense
System (C2BMC), the automating of the Federal Aviation Administration's infrastructure
(ERAM), and providing operations and support for the Department of Defense's global data
network (DISA Global Information Grid Services Management-Operations contract).
In the Mission and Fire Controls segment, products include missile defense systems,
logistics services, fire control systems, operations for the US military, and ground vehicles.
Major programs include the PAC-3 advanced missile system, the Javelin missile program,
the Hellfire missile program, LANTIRN weapons targeting capabilities for the US Army's
Apache helicopters, and special forces logistical contractor services.
Missiles Systems and Training products include the TPQ-53 radar system which identifies
and neutralizes enemy mortar and rocket threats, the Aegis Combat System which is a fleet
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based missile defense system, avionics for the MH-60 Sikorsky Helicopter used by the US
Navy, and the rapid missile firing MK-41 Vertical Launching System for naval carriers.
Space Systems products include the infamous Trident II D5 Missile, the Orion Multi-Purpose
Crew Vehicle, Advanced Extremely High Frequency satellite communications system for the
US Air Force, and the Space Based Infrared System which enables the US Air Force to
detect and track missile launches.
Marketing
All of these products are mainly aimed at government entities, mainly the US government
military branches and agencies, as well as international governmental entities.
Marketing strategies for developing such products would include maintaining relationships
with government entities, or in other words, creating special interest groups to lobby for the
company.
In general, because Lockheed Martin, like the rest of the companies in this industry, has to
compete for contracts, there really are no conventional marketing and advertising methods that
we see with the majority of other companies in industries such as retail, auto, and airline
industries. Therefore, Lockheed Martin's marketing strategy is one of maintaining a positive
public relations image, and maintaining good relations with its government customers, which
includes maintaining special interest groups that lobby for the company's interests. According to
opensecrets.org, a website that tracks political contributions activities, Lockheed spent
$7,175,197 in Lobbying (ranked 14 out of the 4,213 other entities), and $403,868 in political
contributions(ranked 228 out of 14,641 other entities) (as of 9/29/2014), compared to the total
$14,466,226 spent on lobbying in 2013. The site also indicates that more than half of Lockheed
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Martin's 110 lobbyists previously held government jobs, which gives a rough picture of how
competent the Lockheed Martin lobbying team is.
*As of the end of 9/29/2014, Lockheed Martin now has political contribution totaling
$3,420,868, which is a $3,017,000 jump within a 24 hour period. The company jumped from
228th place out of the 14,641 entities, to 28th place.
**Lockheed Martin contributed $10,000 to Illinois’s 6th District’s Congressman Peter Roskam-
Republican.
Here is a picture showing Illinois’s 6th District:
***The individual Lockheed Martin backed most with political contributions is Senator John
Cornyn- Republican of Texas, who received $97,200 in contributions from LMT.
Distribution
Lockheed Martin's system of distributing its products is slightly more complicated due to
government regulations that maintain oversight and control of military transactions. The
company has two methods of distributing its products to the original customer, either through
Foreign Military Sales (FMS) or Direct Commercial Sales (DCS).
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In a FMS, the US government (more specifically the Department of Defense) acts as an
intermediary between the defense contractor and the customer purchasing the military
equipment. In an FMS transaction, the Department of Defense orders the military equipment
from the contractor, which in this case is Lockheed Martin, through the Defense Contractor
Management Agency, which holds such military equipment for the DOD. The purchaser also has
the ability to give a smaller down payment than in the other DCS transaction scenario, and also
has the ability to receive funding through the Foreign Military Financing program, which helps
the purchaser with financing arrangements. Finally, in a FMS transaction, the government is
responsible for shipping, delivering, and assisting with the installment of equipment. As you may
have noted, in the FMS transaction, the government pays the contractor (Lockheed Martin), as
opposed to the customer paying the contractor directly.
In a DCS transaction, the contractor (Lockheed Martin) is able to handle the contract with
the customer purchasing military equipment, directly, with the oversight of the US Government
(the State Department which authorizes shipment, and Congress which authorizes a license to
transactions where the military equipment is valued over $14 million). In this case, usually no
FMF can be used to help finance the transaction (even though there are foreign governmental
entities [e.g., Israel, Yemen, etc.] that are exceptions to this financing arrangement regulation)
and the paying customer has to provide a larger down payment. In a DCS, the contractor
(Lockheed Martin) holds responsibility over shipment and other support services disclosed per
the contract, besides the US government.
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Operations:
Integration
Lockheed Martin is fairly integrated. It has control over research, production, sales, and
service. However, production is not as vertically integrated because the company still orders its
raw materials and major components through other suppliers via contracts, as opposed to
acquisitions, which seems reasonable since acquiring suppliers has its negative drawbacks, such
as these acquired subsidiaries become less inefficient, and a changing industry would expose
Lockheed Martin to more risk. But there still is a drawback to have contractors as opposed to
your own division, since the purchaser of supplies (Lockheed Martin) has less control over such
operations. A risk associated with both supplier-contracted orders and subsidiary-owned orders is
the risk of cyber-attacks, as stated in the 10-k.
Labor
As stated in the 10-k, Lockheed Martin is constantly in need of labor that is not only
skilled, but also has an acceptable security clearance. The major challenge associated with
maintaining Lockheed Martin's human capital includes containing the knowledge and expertise
that leaves the company through retired personnel, and personnel lost due to wage competition
from competitors. Having a competent and skilled labor force is a critical factor which affects the
success of Lockheed Martin, currently demand for such employees exceeds supply. Competitors
for such valued employees are not only in the A&D industry, but also in other technology
companies.
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Important Expenditures
Because this is an industry where companies mainly focus on product differentiation,
prices for products are highly priced. However, with a shrinking US Defense budget, Lockheed
Martin has to start planning and implementing strategies that will reduce the cost of its products,
increasing the affordability of its customers. Such efforts have already started, with the example
of Lockheed Martin decreasing its F-35 by 4%.
Because a skilled and competent workforce is key in maintaining Lockheed Martin's
competitiveness in the A&D industry, the most important expenses include Research and
Development, which is a measurement of the utilization of competent scientists and engineers,
and Cost of Goods Sold, which is a measurement used in determining efficiency in the labor
force. As stated in the notes of the 10-k, Research and Development isn't explicitly shown in the
financial statements (the reason is because a different amount of costs are reimbursed by
customers in a material portion from contractual agreements), but it is allocated among the Cost
of Sales section of the company's Consolidated Statements of Earnings.
Competition
The competition Lockheed Martin experiences is high given there are only a limited
number of contracts in the market, and numerous competitors trying to get awarded those
contracts as well, with major competitors being Boeing, Raytheon Company, Northrop
Grumman Corporation, and General Dynamics. Contracts are usually awarded to trustworthy
companies, with a financially sound record, who also bid to do the contract for a more attractive
price range for the customer. Competition is also increasing due to the fact that new competitors
are being formed in emerging markets.
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Management
Lockheed Martin's management seems to be in good shape. Over the years, since the
merger back in 1995 that formed the company, Lockheed Martin has been able to secure
significant contracts, including the F-35 JSF program, which is well-recognized for its record as
being the largest single defense program in the history of the world. More recently, the company
has been awarded a $146 million contract to produce its D5 Trident II nuclear missiles for the
US Navy, and provide services to the missiles already deployed, for both, US and British naval
military branches. Contracts are awarded to companies that are in healthy financial standings and
provide a high level of reliability. Every contract won is a reflection of management being able
to keep a company running efficiently, which results in the company's healthy financial standing,
and that operations are running smoothly, that reliability and effective allocation of capital keeps
the company attractive.
The company has received a new CEO in 2013, due to an ethical dilemma which surfaced
in 2012, where investigations found that CEO Chris Kubasik had "a close personal relationship"
with a subordinate who had already left. Violating the company's code of ethics, Kubasik
resigned, and left with a $3.5 million separation payment.
As a result of the resignation, to take his place on January 1st of 2013 was Marillyn
Hewson, a Lockheed Martin veteran who had been with the company since 1983. Hewson was
promoted based on her merit as a well-performing manager who is well-known for her
performance and well-liked by the employees she manages. Especially considering sales have
fallen, and the company has been able to hold on to its profit margin, I believe that Ms. Hewson
is doing a satisfactory job in keeping the company running well.
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As for public information, the company's audit report by Ernst and Young has
communicated with external users the issuance of an unqualified opinion. Furthermore, the
company uses conservative accounting methods, such as its lower of cost or market method to
value inventories, uses financial derivatives only for the purpose of minimizing risks from global
exchange rates, and provides clear information disclosed in its financial statements, and notes to
those financial statements.
Overall, I would say that Lockheed Martin's management is placing a higher emphasis on
the value of the company rather than the price of its stock, meaning the company's management
is in order.
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Comparative Financial Statement Analysis and Basic Financial Information:
Basic Financial Information
LMT Exhibit 1
Comparative Analysis
For this section, please refer to LMT Exhibit 5, located at the last page of the LMT
section.
This comparative analysis has been structured around the way the authors of the Hooke Chapter
7 reading assignment presented the topic in Exhibit7.12, on page 15 of the text.
LMT Exhibit 2
CompanyBeta
P/E 2012% Growth
2013Gross Profit
Avg Tax Rate
Prof. Margin
LMT 0.68 18.2 $47,182 -4% $45,358 9% 29% 7%BA 0.99 18.8 $81,698 6% $86,623 15% 26% 5%GD 0.83 17.7 $31,513 -1% $31,218 12% -31% 8%NOC 0.77 14.9 $25,218 -2% $24,661 13% 32% 8%RTN 0.68 17.4 $24,414 -3% $23,706 12% 29% 8%
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Beta and all of the ratios were calculated manually. Beta was calculated by using the COVAR/VAR equation in Excel, where Yahoo! Finance daily historical prices were used for the calculation. The period for the calculated was from November 1st, 2007, about 1 year before the subprime mortgage crisis hit, to November 10th, 2014. The 2013 10-k report was used to obtain Sales, Net Income, and calculate the Profit and Gross Margins, ROA, and ROE. The P/E was obtained by using the 10-k Basic Earnings Per Share, and the 12/3/2014 closing day LMT price traded on the New York Stock Exchange.
Financial Measurements
LMT
Beta 0.68P/E 18.1908ROA 8.20%ROE 61%Net Sales 2013 $45,358Net Sales 2012 $47,182Net Inc 2013 $2,981Net Inc 2012 $2,7452013 Profit Margin 6.57%2012 Profit Margin 5.82%2013 Gross Profit 9.23%2012 Gross Profit 8.89%
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Looking at sales, Lockheed places second place out of five, with Boeing dominating with
nearly twice as much total revenue than Lockheed Martin. However, Boeing scores the lowest in
its profit margin, with Lockheed Martin scoring nearly 1.3 percentage points higher and
Raytheon scoring 1.9 percentage points more than Lockheed. However, when it comes to ROE,
Lockheed clearly takes the lead, given it has a significantly lower amount of equity than all other
4 competitors. But Lockheed Martin also performed better on its ROA, 1.5 times better than
Boeing. Moving into backlog, Lockheed Martin has 82.6 billion in backlog, 1.6 times more than
the Boeing, which is the second highest company with backlog (in the it’s A&D industry
segment). Lockheed’s backlog actually increased a third of a percent, while all other companies
experienced an average of a 9% decrease in backlog, a significant difference. This slightly
positive increase in backlog is due to an increase in the THAAD (Terminal High Altitude
Defense) program (which is an easily transportable missile defense system), the Littoral Combat
Ship program, AEGIS integration and sensors, and more significantly due to the Orion program.
Amidst a decreasing US Defense Budget, Lockheed Martin seems to standout due to its
slightly positive backlog growth, compared to the 6%-10% negative growth range all other 4
competitors experienced. This positive growth can be a result of many things. I believe that it is
the result of the company’s innovative capabilities and political endeavors.
One last measurement I would like to point out is LMT’s percentage change in revenue
over its percentage change in cash. In 2013, the company’s sales decreased by $10 for every $1
gained. BA resulted with a $50 decrease for every $1 gained, but RTN experienced the largest
negative result, with a $86 decrease in sales for every $1 increase in cash.
General Information
BSX had the second highest P/E among all four competitors.
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o Its P/E was 18.2, while the closest competitor with the highest P/E was BA, with a
P/E of 18.8. o This shows us that buying a share in LMT’s earnings is relatively more expensive
than buying a share in other competitors’ earnings. Looking at sales from 2012 to 2013, LMT experienced a 4% decline in its sales.
o While the top line has eroded, this trend is normal in the industry as the US
budget decreases. Three other companies also experienced the same trend, with BA being the only company out of those four experiencing a positive growth, sine half of its sales also are generated from commercial aircraft.
If we look at operational performance in terms of retaining sales from expenses from operations, BSX has a fair profit margin.
o Its gross margin is 9%, the lowest of all four other competitors. BA has the
highest gross profit margin of 15%. However, LMT’s gross profit margin only decreases by 2 basis points, resulting in a profit margin of 7%, a number that is two basis points higher than BA.
o Investors should monitor the profit margin. Although it is common sense that
investors would want a company with a nice profit margin, at this time in LMT’s industry’s lifecycle, it is important to see this figure, as well as the gross margin, increase, resulting in a leaner, more adaptive company.
Efficiency
LMT Exhibit 3
Company
ROA ROEInventory Turnover
A/R Turnover
A/P Turnover
LMT 8.2% 61% 26.2 7.3 29.5BA 7.8% 24% 200.9 14.3 8.3GD -0.7% -2% 38.1 7.3 12.3NOC 10.4% 19% 12.7 8.9 17.4RTN 12.8% 29% 6.5 5.0 17.6
LMT has a fair ROA and very high ROE figure. o The company’s ROA is 8.2%,
o The company’s ROE is 61%.
o Normally this would indicate that management is doing a fair job in managing
assets, but in my opinion, the reason why these figures are lower than companies like NOC and RTN is because of LMT’s heavy expenditures on R&D poorly is because of the fact that there are random items that are negatively affecting earnings.
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o The only sensible reason why LMT would have such a high ROE is because it is
highly financed by debt. In the previous fiscal year, the company had less than a percent of its financing supported by equity. For that reason, this ratio may not be as material as the ROA figure.
LMT has the highest total assets turnover.o Its total assets turnover figure is 125%, with the closest competitor being NOC at
118%.o This shows that LMT is generating the most sales per its total assets, an excellent
indication of management. In other words, more sales are generated from $100,000 of equipment under LMT’s management than Boeing’s management. Looking from the perspective of the top line, rather than the assets, it could also mean that LMT secures more sales from the government per assets it has, than its competitors.
LMT also has a fair accounts receivable turnover and inventory turnover.o A/R turnover is 7.3, the same as GD, and its inventory turnover is 26.2, less than
GD’s figure of 38.1.o This shows that LMT is performing fairly well when it comes to selling its
inventory and collecting its receivables from its clients. However, investors should be aware that sales are generated by awarded contracts, so inventory turnover is more dependent on the case of government purchases, a difference worth noting in comparison to more commercial industries that sell more openly to the public in everyday operations.
Liquidity and Solvency
LMT Exhibit 4
Company
LTD/OE
Quick Ratio
A/P TurnoverOCF/Liabilities
Times Int. Earned
LMT 4.1 0.76 29.5 14.5% 11.9BA 1.7 0.30 8.3 10.5% 16.1GD 0.6 0.80 12.3 14.8% 41.9NOC 0.9 1.35 17.4 15.8% 11.1RTN 0.8 1.41 17.6 16.1% 13.1
LMT has the highest long-term debt to equity ratio,o Its LTD/OE ratio is 4.1.
o The dividend investor would find this unattractive since LMT is focused on
pleasing the creditor more with interest payments than the equity holder with dividend payments.
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o As mentioned before, this high liability is due in part to the high loss (increase in
obligations) the company’s employee benefit program experienced in the fiscal year of 2012.
o This is likely to change when interest rates start to increase over the next couple
of years. LMT has the second lowest quick ratio.
o Its quick ratio is .76, with BA having the lowest quick ratio of .3.
o The reason why this is, is because LMT has high inventory levels. It is involved
in the world’s most expensive military project, and producing expensive products such as the F-35. The quick ratio doesn’t count inventory in the numerator when dividing against current liabilities. If we included LMT’s inventory in the ratio computation, we would get a current ratio figure of 1.2, which is acceptable. However, the quick ratio is something to consider for a company such as LMT when purchase withdrawals take place, since the company is left with illiquid inventory which wouldn’t help in paying off its current liabilities.
LMT has the highest accounts payable turnover ratio.o Its A/P turnover ratio is 29.5, with RTN having the second highest figure of 17.6.
o This shows us that LMT is on top of paying off its creditors, a plus for creditors.
o Because LMT pays off its creditors fairly quickly, this means it spends less on
interest expense, a risk other companies, besides BA, do not have to worry as much about.
LMT has the second lowest operating cash flows to liabilities ratio.o Its operating cash flow figure for 2013 is 14.5% of its total liabilities.
o Remember that LMT also has the highest LTD/OE ratio, meaning the company
has a higher debt financing, meaning it’s not surprising that this OCF/L ratio is as low as it is. This doesn’t make the ratio irrelevant, however, it is useful to keep this in mind while viewing the OCF/L ratio.
LMT also has the second lowest Times Interest Earned ratio.o LMT’s figure is 11.9, while BA, the company with the lowest ratio figure, is 16.1.
o Once again, one of the biggest factors as to why this is, is because LMT is heavily
financed by debt. o Being heavily financed by debt, the company is more exposed to risk when sales
are slowing, and interest is accumulating. Especially considering LMT’s quick ratio, which is less than 1, investors should monitor this side of the company’s performance. But considering the company’s A/P turnover is high, it shows that the company is able to pay off its debts quickly. If this ratio slows down, investors should monitor sales, and if sales drop as well as the A/P turnover ratio, then the company may start to face difficulties as its interest naturally starts to build.
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Financial Statement Analysis
Income Statement:
Comparing Lockheed Martin’s 4 competitors, we make several notes on operations.
Regarding tax efficiency, Lockheed Martin has never been one of the 5 companies used in this
comparison that paid the least average tax rate, however, it was not the worst either. Compared
to the averaged figure of all 5 companies, Lockheed Martin still ended paying about .8
percentage points less.
If we break up sales into products and services, LMT receives about 79% of its sales
from its products, and 21% from its services. LMT’s product revenue composition is about 8
percentage points lower than BA, meaning LMT receives a smaller percentage from its products
than BA, but an equal amount of 8 percentage point amount of revenues higher from its services.
But overall, LMT gets more revenue from its products than its services in comparison to the
averaged figure of all 5 companies.
Moving on to operations, LMT experienced a sales growth of 2.4% from 2011 on to
2012. It then experienced a 5.6% decline in sales. However, its net income still increased by
$236 million in that period as sales dropped $2.1 billion, meaning there was an improved profit
margin of three quarters of a percentage point. Even though BA improved its sales by $5.6
billion, its net income only increased by $685 million, meaning its profit margin improved by
only by .52 percentage points. Looking at the 5 year company averaged figures for profit margin,
it seems that LMT performed on a less than normal level, since the range for the gross profit
figure from 3 out of the 5 companies (excluding LMT and BA) was 7-8%. Still, LMT as well as
Raytheon (RTN), were the only companies with a 3 year consecutive increase in its profit
margin.
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If we look further up the bottom line, at the gross margin percentages and operating
incomes, LMT and Northrop Grumman (NOC) were the only two companies with increasing
gross margin rates. Boeing is the company with the highest gross margin rate in all three years,
however, its rate has been decreasing since the beginning of 2011, where its most significant
drop happened in the 2012-2013 period. Boeing also has the highest operating income, since its
revenues are, by far, the largest of any of the other 4 companies.
Also concerning operations and profitability, LMT has had the highest ROA of 8.2% in
2013, and a ROA performance of 7.1% back in 2012. In both cases, the company outperformed
BA by an average of 3% points over the two year period. ROE would not be an appropriate
comparison measure, given LMT is the most leveraged company.
Balance Sheet:
One very alarming fact seen on LMT’s balance sheet is the level of ownership the
company had in 2012. The company was almost 100% financed by debt, which is due mainly to
the accumulated and other comprehensive losses which stemmed from the company’s $15 billion
unfunded defined benefit pension plan.
LMT has the lowest amount of cash on hand, the second highest amount of accounts
receivable, and second highest in non-current assets. LMT’s Cash increased by 38%, but General
Dynamics (GD), saw the highest increase in cash, which was about a 61% increase. LMT’s
accounts receivable decreased the most, by about 11%, compared to BA, who had the highest
increase of about 17%. All five companies experienced a decrease in non-current assets. LMT
also has the third lowest inventory turnover rate for 2012 and 2013. The company’s inventory
turnover tells us inventory was sold every 12 days in 2012, and every 26 days in 2013. However,
these aren’t appropriate measurements since inventory is sold per contract. F-35’s are not like
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T.V’s at a Best Buy, where people freely walk in and purchase mass produced electronics. Such
products are not like the missiles, fighter jets, and combat ships LMT sells in its extremely
different market environment.
Moving on to liabilities and equity, LMT has the lowest amount of working capital,
which is no surprise given it has the least amount of cash. As mentioned before, LMT was also
the highest leveraged company in 2012, being nearly 100% financed by debt, but its leverage
ratio dropped from 991 in 2012 to 7 in 2013, which still places the company 5th out of 5 in being
most debt financed. The company’s current ratio was about 1.2 in 2013, but its quick ratio
brought the seemingly harmless figure, down to .76, which is 9% (not 9 percentage points)
higher than last year’s ratio. The 2013 ratio is still more attractive than BA’s .3 2013 quick ratio
figure.
Cash Flows
Operating Activities
The top two positive items from LMT’s cash flows statement operating activities are
Depreciation and Net Receivables. Depreciation was $990 million, 33% of Net Income, and
changes in Net Receivables amounted to $767 million, 26% of Net Income.
The top two negative items from LMT’s cash flows statement operating activities are
Changes in Accounts Payable and Post Retirement Obligations. The A/P activity was $(647)
million, -18% of net income, and Post Retirement Obligation activities totaled $(375) million, -
13% of net income.
Investing Activities
The top two negative items for major investing activity items were Capital Expenditures
and Acquisitions. Capital Expenditures decreased, from $942 million in 2012 to $836 (-18% of
operating cash flows) in 2013. Acquisition activities increased, from $259 million in 2012 to
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$269 million in 2013 (-6% of operating cash flows). This shows that the company is slowing its
operating activities to compensate for acquisitions which may further diversify the company,
securing future growth as opposed to more short term sales generation. In an industry that is
decreasing in size, this is a good strategy since focusing on short term sales may inhibit more
future sales from being generated.
*There were no positive activities in the LMT’s investing activities.
Financing Activities
Proceeds from Stock Option Exercises was the largest positive and significant item. $827
million came from this activity, which is 28% of net income.
Repurchasing Common Stock was the company’s most negative financing activity. This
activity totaled $(1,762) million, -59% of net income. Dividend payments were the second most
negative activity, totaling $(1,540), which is -52% of net income. This suggests that LMT is
repurchasing its shares so that it may be able to continue affording to pay for its generous
dividend payments. This makes dividend payments more affordable because if LMT buys back
more shares, it can pay more dividends per share while still being able to pay the same total
distribution amount.
Sources:
Company Historyhttp://www.lockheedmartin.com/us/100years/timeline.html
Difference between FMS and DCS.http://lmdefense.com/foreign-military-sales/fms-vs-dcs/
PAC-3 Missilehttp://www.lockheedmartin.com/us/products/PAC-3.html
Marillyn Hewson and Managementhttp://online.wsj.com/news/articles/SB10001424127887324894104578109344076574924
Political Contributions
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http://www.opensecrets.org/orgs/summary.php?id=d000000104
Most recent Value Line (September 12th) and 10-k Reports (FYE December 31, 2013) for LMT, BA, GD, NOC, and RTN.
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LMT Exhibit 5:
Dec. 31 2012-2013 Data
Company
Annual Sales ($millions)
Annual Sales Growth(%)
Estimated 4 yr. Sales Growth (%)
Profit Margin (%) ROE ROA 2013 Backlog
% Change in Backlog
LMT $ 45,358 -4.02% 1.6% 6.6% 60.6% 8.2% 82,600 0.36%
BA $ 86,623 5.69% 5.8% 5.3% 30.8% 4.9% 49,681 -9.78%
GD $ 31,218 -0.94% 1.4% 7.6% 16.3% 6.6% 46,005 -10.29%
NOC $ 24,661 -2.26% 2.4% 7.9% 18.4% 7.4% 37,033 -9.25%
RTN $ 23,706 -2.99% 1.1% 8.5% 18.0% 7.8% 33,685 -6.90%
5Company Sales 2013 Sales 2012 NI 2013
Total Equity
Total Assets
Estimated Sales 5 year Backlog 2013
Backlog 2012
LMT 45,358 47,182 2,981 4,918 36,188 49,000 82,600 82,300BA 86,623 81,698 4,585 14,875 92,663 115,000 49,681 55,068GD 31,218 31,513 2,357 14,501 35,448 33,500 46,005 51,281NOC 24,661 25,218 1,952 10,620 26,381 27,700 37,033 40,809RTN 23,706 24,414 2,013 11,197 25,967 25,000 33,685 36,181
*5 Year Sales Projections Provided by Value Line** Boeing's Backlog Refers to its A&D Industry's Backlog, Not its Total Backlog
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Income Statement
DEC DEC DEC DEC DEC2013 2012 2011 2010 2009
Revenue 45358 47182 46499 45803 45189Cost of Goods Sold 40181 41998 41998 41126 40215 Gross Margin 0.1141364 0.1098724 9.68E-02 0.1021112 0.110071Selling, Gen'l & Admin. 0 0 0 0 0Depreciation & Amort. 990 988 797 841 854OPERATING INCOME 4187 4196 3704 3836 4120 Operating Margin 9.23E-02 8.89E-02 7.97E-02 8.37E-02 9.12E-02Interest Expense 350 383 354 345 305Other Expenses (Income) -318 -259 -281 -335 -469INCOME BEFORE TAXES 4155 4072 3631 3826 4284 EBT Margin 9.16E-02 0.0863041 0.0780877 8.35E-02 9.48E-02Income Taxes 1205 1327 964 1181 1260INCOME AFTER TAXES 2950 2745 2667 2645 3024 Net Profit Margin 6.50E-02 5.82E-02 5.74E-02 5.77E-02 6.69E-02GAAP EPS (as reported) 9.04 8.35871 7.85 7.18165 7.775Baseline EPS 10.01 8.780001 7.74 7.26 7.8 Adjusted for Restatements, Unusual and Extraordinary ItemsWeighted Avg. Shares Outstanding ('000) 326500 328400 339900 368300 388900
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Statement of Cash Flows
DEC DEC DEC DEC DEC2013 2012 2011 2010 2009
Net Income (Loss) 2981 2745 2655 2926 3024Depreciation & Amort. 990 988 797 841 854Net Changes - Assets/Liabilities -5 -3317 832 -130 102 (Increase) Decrease in Receivables 767 -460 -363 -15 -719 (Increase) Decrease in Inventories -60 -422 -74 -227 -233 (Increase) Decrease in Other Current Assets 104 162 247 -209 593 Increase (Decrease) in Payables -647 -236 609 -364 -21 Increase (Decrease) in Other Current Liab. -169 -2361 413 685 482Other Adjustments, Net 580 1145 -31 -90 -807 CASH FROM OPERATIONS 4546 1561 4253 3547 3173Capital Expenditure -836 -942 -987 -820 -852Acquisitions -269 0 0 -148 0Sale of Property, Plant & Equipment 0 0 0 798 0Investments (Increase) 0 -304 -649 -171 0Cash In (Out) Flow -16 24 823 22 -666 CASH FROM INVESTMENTS -1121 -1222 -813 -319 -1518Issuance of Capital Stock 827 440 0 0 40Repurchase of Capital Stock -1762 -990 -2465 -2420 -1851Debt Increase (Decrease) -150 0 1348 0 1222Dividends -1540 -1352 -1095 -969 -908Other Cash In (Out) Flow -81 -121 93 26 21 CASH FROM FINANCING -2706 -2023 -2119 -3363 -1476Effect of Exchange Rates 0 0 0 5 44 NET CHANGE IN CASH 719 -1684 1321 -130 223
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Income Statement
DEC DEC DEC DEC DEC2013 2012 2011 2010 2009
Cash & Cash Equivalents 2617 1898 3582 2261 2391Short Term Investments 0 0 3 516 346Accounts Receivable 5834 6563 6064 5757 6061Inventories 2977 2937 2481 2378 2183Other Current Assets 1901 2457 1964 1939 1496Total Current Assets 13329 13855 14094 12851 12477Net Fixed Assets 4706 4675 4611 4554 4520Other Long Term Assets 7805 9757 9055 8057 7855Goodwill & Intangibles 10348 10370 10148 9605 10259TOTAL ASSETS 36188 38657 37908 35067 35111Accounts Payable 1397 2038 2269 1627 2030Short Term Debt 0 150 0 0 0Other Current Liabilities 9723 9967 9861 9530 8673Total Current Liabilities 11120 12155 12130 11157 10703Long Term Debt 6152 6158 6460 5019 5052Other Liabilities 13998 20305 18317 15183 15227TOTAL LIABILITIES 31270 38618 36907 31359 30982Preferred Equity 0 0 0 0 0Common Equity 4918 39 1001 3708 4129 Retained Earnings 14200 13211 11937 12372 12351STOCKHOLDERS' EQUITY 4918 39 1001 3708 4129TOTAL LIAB. & EQUITY 36188 38657 37908 35067 35111Shares Outstanding ('000) 321430.3 321000 323570 349855.2 372900
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Valuation of LMT
Statement:
Lockheed Martin appears to be undervalued. Latest price and other fundamental information
were used as of 12/4/2014 (the day of our last class session). The conclusion was reached using
the P/E method, which is indicating that the stock is undervalued by 20%.
Introduction
P/E:
If we look at the company's different P/E ratios, the last price I checked LMT to be at was
$189.73. The TTM EPS is $10.23 a share. From these two numbers, the TTM P/E ratio is 18.5x.
Looking ahead into future periods, ValueLine has estimated EPS for the year end performance of
2015 to be $11.4 a share. Using the TTM P/E multiplier only as a starting point, we multiply
18.5x times by the estimated 2015 EPS figure of $11.4 to get a justified price of $210. Because
the leading P/E is larger than the current TTM P/E, LMT is undervalued in that respect, but we
will elaborate further on the P/E method since this is assuming the current P/E is fairly valued.
Price Per Sales:
The next measure of valuation used was price per sales (P/S). Looking in previous
periods, ValueLine indicated that sales per share were increasing from 2009 to 2012, with sales
per share dipping 3% in 2013. Because of the nature of the A&D industry, it is not always easy
to predict sales, since sales are generated from contracts awarded, in most part, by government
entities. Sales estimates are therefore not always accurate. Nevertheless, sales are still easier to
predict than earnings because earnings has to take into effect a lot more factors, such as
operating costs and tax efficiency.
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In my opinion, sales according to ValueLine seem to be too optimistic. The reason is
because sales, as a whole, overall have been decreasing as the US defense budget is decreasing.
However, there are still other programs run by LMT that will continue to generate sales into the
future, such as the Trident Missile program, the Aegis Missile Defense System program, and
other contracts that make switching costs inconvenient for the US military.
Regarding the valuation results, if we divide the current price per share by sales per share
in 2013, we receive a figure of 1.3x. ValueLine predicts sales per share for 2014 and 2015 to be
$145.15 and $148.85. The intrinsic value is therefore $189 for the end of 2014, and $194 for the
end of 2015. These figures are more conservative than the justification price derived from the
leading P/E ratio calculation. Because the market has valued LMT at a low of about $185.51 per
share this month, I feel that using the more conservative figures from the P/S calculation to be
more conservative in the valuation. However, I believe EPS has a larger voice than sales in the
reflected price of LMT since sales for the industry are expected to decrease due to continued
budget cuts.
*Again, the P/S ratio is assumed to be valued fairly, however, it is still being used as a basic
reference point and for convenience purposes.
Comparative P/E Figures and PEG:
Let's move on to comparative companies, and the industry in which LMT operates in as
well. For this analysis, four competitors were used, including Boeing (BA), General Dynamics
(GD), Northrop Grumman (NOC), and Raytheon (RTN). In comparison to the competitors, LMT
ranks 3rd highest in its TTM P/E (18.4x), lagging behind BA (19.8x) and GD (20.2). The other
two companies fall within a 15 to 18x range, with NOC having the lowest P/E of 15.1x and. But
overall, the industry's overall P/E is 17.7x, hinting that half of the more expensive competitors
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are slightly to moderately overvalued to the extent of their P/Es. As far as PEG is concerned,
LMT’s PEG has actually declined over the past two months, from the ugly figure of 1.61 to 1.48.
In comparison, BA and RTN have increased their 5 year expected PEGs, from 1.37 to 1.48 for
BA, and 1.23 to 1.69 for RTN. NOC and GD both have PEGs in the 1.80s. This suggests that
LMT, despite its P/E becoming more expensive, is actually becoming cheaper per its 5 year
growth rate, making it appear more attractive than its competitors. In relations to the industry,
LMT seems to have a slightly higher P/E in that regards. However, LMT is a leader in its
industry, so it is no surprise it is more expensive than the industry average.
We can make a quick calculation of LMT's price based off of the industry's P/E of 17.7x.
By multiplying 17.7x by LMT's TTM EPS of 10.23, we get a figure of $181 per share. In
comparison to the current price of $189.73. But is the industry correctly valued? The A&D
industry’s P/E was 19.2 two months ago. It seems that the price is finally settling a bit to a more
reasonable area. However, whether the pricing of this industry shrinks some more is based on
future politics, geo political events, and budgets
Price Per Books:
Price per book measurements weren't used because the LMT's total equity to total assets
was .1% for the fiscal year end in 2012. Using this figure would produce less meaningful
numbers since P/B would fluctuate too widely to consider in the valuation.
Valuation Methods
Gordon Growth Model:
The Gordon Growth Model was one of three methods used to assess the value of LMT.
This assessment has resulted in the discovery that LMT is overvalued.
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The following is a process looking at how the Gordon Growth Model was executed. The
company's dividend payment history shows that the first three quarters of the 2013 fiscal year
paid $1.15 a share for each of those three quarters. The fourth quarter experienced an increase
from $1.15 a share to $1.33. Dividends per share then jumped to $1.50 a share with the issuance
last week in November.
The incremental growth we see with every dividend payment increase since 2001 has
always been positive, and at least 9%. Because the present value of the dividends were taken
quarterly as opposed to annually, the dividend growth rate used was the compounded, quarterly
rate, which rounded to 2.2%. Dividends for the next three quarters are expected to remain at
$1.50. Then, for the next four quarters, using the 9% increase in payments, the dividend payment
will jump up to $1.78. This will continue for the next 13 quarters, where the final 20th dividend
payment used in this valuation will end up being $2.36. The sum of the present values of all the
dividends will end up totaling $29.31. Feel free to view Figure 1 to gain a more complete
understanding.
Using ValueLine as a professional source for the projection of Lockheed Martin’s ending
price for 2019, the research firm expects the price for the company to be anywhere from $160 to
$200 a share. Using the 5 year geometric EPS growth rate of 4.75%, the present value range of
low and high prices for the 5 year ending period until 2019 starts from $127 on the low end and
ends at $159 a share on the high end. Because of how LMT is currently performing, factoring in
how the company is making its operations more efficient and also factoring in its very
impressive innovative capabilities and how these capabilities match with future opportunities, the
high end price was used in the valuation. Thus, adding the present value of the high end price
and the present value of the 5 year projected dividends, the value comes to $188.
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With LMT priced at the closing price of $189.73, and the Gordon Growth Model valuing
the stock at $188, LMT is fairly valued.
Figure 1.
Quarters PV
1 1.501.46802
9
2 1.501.43673
9
3 1.501.40611
74 1.64 1.5
5 1.641.46802
9
6 1.641.43673
9
7 1.641.40611
78 1.78 1.5
9 1.781.46802
9
10 1.781.43673
9
11 1.781.40611
712 1.94 1.513 1.98 1.5
14 1.981.46802
9
15 1.981.43673
9
16 2.161.53266
717 2.16 1.5
18 2.161.46802
9
19 2.161.43673
9
20 2.361.53266
7PV of Div
29.30753
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Figure 2.
5 Year Proj. Geom. GrowthProjected Price: High end 200 1%Projected Price: Low end 160 -3%Projected Price: Average 180Current Price 189.73EPS Growth 4.75%
Figure 3.
PV of Price +
PV of Div Total PV
High end
158.57143 +
29.30753 187.879
Low end
126.85714 +
29.30753
156.1647
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Justified P/E:
As you can see from Figure 4., LMT has one of the higher growths to risk ratios, with its
12/4/2014 P/E being 18.2. Boeing has a P/E of 18.8 and has a higher growth to beta. However,
stocks like GD, NOC, and RTN have lower P/Es, but much lower growth to risk figures. With
that said, there was a mathematical computation that was used in assisting with the assessment of
what LMT’s P/E figure should be. The following is a list of steps used in that mathematical
computation of a justified P/E, as well as the corresponding justified price, given the parameters
in Figure 4:
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Figure 4.
Price EPS P/E Beta
5 year EPS Growth
Growth to Beta
LMT $ 189.73 10.43 18.2 0.68 4.8% 0.0699BA $ 131.32 6.99 18.8 0.99 7.1% 0.0711GD $ 144.88 8.20 17.7 0.83 1.2% 0.0148NOC $ 139.84 9.38 14.9 0.77 1.9% 0.0251RTN $ 110.00 6.32 17.4 0.68 7.0% 0.1022
Before we get into the
Justified P/E, let’s gather some
preliminary information. The
following is a table with LMT and
its other four competitors used as
benchmarks for the justified P/E
valuation:
Figure 5.
Steps1 Average P/E 17.19
2
Avg
Growth:Beta 5.3%
3
LMT
Growth:Beta 0.070
4 Step 1/ Step 2 327.18
5 Justified P/E 22.87
6Step 5 X LMT EPS 238.51
* Step 5 shows the justified P/E
Step 6 shows the corresponding justified price
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This process assumes that the relationship between growth, risk, and the dependent
variable, price, to be linear. However, the results provide some frame of reference. 22.87x seems
a bit high for a justified P/E in the A&D industry. Although LMT as a company is excellent, as
communicated in the attached Company Analysis section, it would seem more reasonable to
adjust the P/E at a lower, figure. 22.00x seems appropriate.
But even with the adjustment, LMT is greatly undervalued. Multiplying the justified P/E
of 22.00x by the $10.43 EPS figure, the justified price ends up valuing $229. Compared to the
current price per share of $189.73, that’s a 20% undervaluation opportunity.
Conclusion:
In conclusion to this stock's valuation, I have to first say that the company is in an
advantageous position. It is currently engaged in the most expensive military project in the
world, the F-35 Joint Strike Fighter program. As the company's ValueLine report states, this
product is one that will contribute a significant portion to future earnings. However, there are
more products that the report had failed to include in its summary. LMT has other projects that
are also deeply significant for the military of the United States, the company's, as well as the
entire industry's largest customer. The nation's Trident missile system is of crucial importance to
its national security, being that is the only one of its kind in its scale of operation. From more
micro PAC-3 missile defense systems, to the larger Aegis missile defense system, to integrating
and updating NORAD's command systems, LMT has a very distinct advantage over its
competitors, being that it is already so intertwined with the US military. Even by reading the
company's history, one is able to see just how significant LMT is in the US's global military
dominance. But as pretty as the company's status may be, some external factors cloud that
attractive rhetoric which seems to be over valuing the company's stock price. The US budget is
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shrinking; there is no denying that fact. There is also no denying the fact that the company has
doubled its price within 18 months. This doubling in size is not sustainable, and because of that, I
believe that the stock is getting closer to becoming overvalued.
However, this doesn’t mean that LMT has no more room to grow in price. $229 seems
like a reasonable price projection. Beyond that threshold, I believe the company will become
overvalued, again, the reason being the price has already accelerated so much in the past couple
months.
* The P/E method was given more precedence than the dividend growth model. The reason
is simply because dividends are very likely to continue increasing, and the spotlight is more
focused on the company’s earnings. With the spotlight being more focused on earnings, the
stock’s price is more sensitive to headlines regarding this figure than dividends. It is also very
likely that dividends will not decrease, and remain at least at that conservative growth rate of 9%.
Sources:
ValueLine
BaseLine
Yahoo! Finance (A&D Industry P/E)
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Medical Supplies- Non Invasive
Industry Analysis
Life Cycle
The Healthcare industry is a growth industry. According to Investopedia, a growth industry is
characterized by "experiencing a higher-than-average growth rate […] often associated with new
or pioneer industries that did not exist in the past and their growth is related to consumer demand
for the new products or services offered by the firms within the industry." The medical supplies
industry is very much defined by that statement. Although the industry has been around far too
long to be a pioneer phase, and is not as new as say the Internet or the mobile market, it is still
powered by consumer demand for innovative products that help address health problems that still
exist today.
http://www.valueline.com/Stocks/Industries/
Industry_Analysis__Medical_Supplies_Invasive_and_Non_Invasive.aspx
External Factors
Technology:
Tech is a big factor in this industry. Companies always strive to surpass their competitors
with equipment that is better designed. Not only is design one of the focuses of competition, but
innovative technologies which health problems with no solutions is another venue in which
competitive interests clash. This is mostly looking at the product differentiation strategy, even
though technology can still affect cost-leadership organizations. If for example, a needle-less
injection takes a hold of the majority of the demand in the syringes market, companies focused
on producing needle-pointed syringes will have to adjust their operations in lieu of running their
organizations to the ground by producing products that collapsed under no supporting demand.
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R&D expenditures tend to be float around 10-15%, with companies like Johnson and Johnson
spending about 11% of their sales on R&D, while companies like Pfizer spend 13%, and
companies like Baxter International spend about 8%.
Government:
The medical supplies industry is one that is regulated by the FDA in the U.S, and various
other agencies for sales taking place internationally. As mentioned by Nira Maharaj in her
ValueLine article, government regulation is not a factor to overlook, because regulations affect
strategies. One obvious example is complying with government regulations. This is critical
because a business may not access certain markets unless regulations for those markets have
been met. In the US, the FDA has three levels in which it classifies certain products. These three
different product classifications (I, II and III) are subject to different rules by the FDA. If a
product falls in Level I, it is a low-risk product, and because it is a low risk product, no FDA
approval is necessary. On the other hand, products under Level II and III are higher risk
products, and require approval.
Legislation is another way strategies and operations may be altered. For example, the
recent additional tax which entities in the medical supplies industry now have to pay, affects
operations in that lower amounts of income trickle down to the bottom line. Obamacare is a
factor that affects strategies of companies in this industry, since having more people insured will
increase the utilization of health clinics and hospitals. With an influx of health facilities usage,
there is a higher importance placed on equipment, resulting in an increased demand on such
products.
http://www.who.int/medicines/areas/quality_safety/regulation_legislation/ListMRAWebsites.pdf
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http://www.valueline.com/Stocks/Industries/
Industry_Analysis__Medical_Supplies_Invasive_and_Non_Invasive.aspx
https://research.valueline.com/secure/api/report?documentID=2185-
VL_20140822_VLIS_Industry_MEDIC1_01-4SDMQGQONAEM4UOT9F1DGIE9PE
Social:
Social factors are minimal, however, I believe that these social factors compound and
magnify over time. I believe that lifestyles of generations will have a large impact on long term
future performance. For example, during the 50's and on before the millennials were born, there
has been this unawareness of the health risks associated with deep fried food. Being a millennial,
I would say that a larger portion of the population today (strictly speaking about the US), is more
health conscious than past generations, and part of that has to do with the unawareness past
generations had about certain health issues. Of course, no generation is perfect, and with the
millennials such as myself being more conscious about the consequences of fats and sugars, we
still may be unaware of other health concerns we are oblivious to, for example, the overexposure
to electronics. With more mobile devices, video games, social media, and other entertainments
that affect our lifestyles, who knows what unique health concerns my generation will face in the
future (poor eyesight, increased levels of arthritis in the hands, etc).
Although these lifestyle factors are very low today, though they still exist, they will
compound and magnify over time, and companies willing to address these opportunities (poorer
vision with more electronics exposure from earlier ages), as well as threats (leveling obesity
levels), will be at a strategic advantage.
http://www.usatoday.com/story/news/nation/2013/10/17/obesity-rate-levels-off/2895759/
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Demographic:
Demographics are important factors as well. Factors such as increasing or decreasing
wages may affect the utilization of health facilities. If people have more money, they can afford
going to the dentist or the doctor's office. Another factor is population growth. As population
increases, so does the base for disease distribution. In other words, hemophilia, for example,
according to hemophilia.org, 1 in 5,000 in the US are diagnosed with hemophilia, which is a
genetic disorder, meaning the statistic should remain constant as populations rises. For example,
whether the US has 400 million, or 500 million individuals, in both cases, the 1 in 5,000 rate
should remain the same, unless along comes a technology which will eliminate this genetic
defect (a possible opportunity for companies in this industry). As far as race is concerned, with
an increasingly mixing global population, who knows if no other genetic diseases may surface.
http://www.hemophilia.org/Bleeding-Disorders/Types-of-Bleeding-Disorders/Hemophilia-A
Foreign:
Foreign factors include a mix of international demographic, government, tech, and social
factors in this industry. Foreign governments may change legislations or tax structures which
affect foreign companies. These tax structures may make business I that area more attractive, as
research and development may be more deductible or credit-generating than domestically
speaking. Foreign demographics, such as an increase or decrease in wages of a particular region
may make a strategy towards one region more or less attractive. An increase in education in
certain regions may also provide for a more competitive and talented work force.
Demand Analysis:
Demand in this industry is affected by consumer demand, however, as noted in the
ValueLine article, it is also affected by the overall health of the economy, because institutions
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which purchase medical supplies need to be in good enough conditions in order to make such
purchases. Customers include health institutions, such as hospitals, doctor/dentist offices, and
health clinics. Consumers include both doctors and patients, since the supplies and equipment
allow the doctor to render the service and the patient to receive the service. Healthcare services
and insurance are a compliment to this industry.
Supply Analysis:
The inputs of this industry include a wide variety of commodities, from copper wiring, to
the rubber in gloves. However, the backbone of this industry is the educated employee who
designs and develops the product. Education is a crucial commodity in this industry, given the
extensive research and development that labels this industry as a growth industry, and enables
products to push through the expectations of health regulators such as the FDA.
International Competition:
As noted in Baxter International's 2013 FYE 10-K, international competition is high and
continuing to grow. Consolidation in the in the industry leads to more powerful competitors,
even though domestic acquisitions will be affected with the recent tax inversion legislation,
which will make such offshore acquisitions less tax beneficial. The results of competition affect
all two dimensions of value addition in the industry, as foreign manufactures have prices which
are regulated by the governments and are growing in scale, which affects the cost dimension.
The price dimension is also being affected as product differentiators are competitively pushing
innovation and competing for marketing distribution channels.
Porter's Five Forces:
Barriers to Entry:
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Threat of new entrants in the medical supplies industry is low. There exist economies of scale,
stemming from large scale manufacturers, and product differentiation, stemming from large
amounts of expenditures in research, development, and design. Capital requirements and
government regulation however vary. For companies in the business of producing Level I
products, as discussed above in the 'Government' section, no FDA approval is needed. Rubber
gloves are a low-risk Level I product, and therefore can be produced without the fear of
consequences from the FDA. Capital expenditures vary in this sense as well. Rubber gloves
production requires low-levels of capital expenditures since the manufacturing process is not
complicated. However, the production of more sophisticated, and implicitly more regulated,
products, have higher barriers of entry. Pricing is also regulated in certain areas of the world
where government involvement imposes cost containments, which means that expected
retaliation of competitors lowering prices is high, since competitors want to sell their products to
the government. In places like the US, where government cost containment is not as huge of a
player, retaliation is only slightly lower, because public lists of recommended products are not
published for purchasers.
Bargaining Power of Suppliers:
The bargaining power of suppliers is low. The number of suppliers is high, and prices are set in
advance by contracts. Switching costs are low, and risks of forward integration are low, given
suppliers do not have the business models to pursue such strategies. The primary reason forward
integration is not likely is that suppliers usually have a cost-leadership strategy, meaning there
are low amounts of capital that are able to match the level of research and development
expenditures as the business entities further ahead in the value chain. One benefit that suppliers
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do have in such an industry is that they are not solely reliant on the medical supplies and
equipment industry, and have other purchasers who buy raw materials.
Bargaining Power of Purchasers:
Areas with publicly-funded healthcare will have a very low ratio of purchasers to suppliers
would be fairly low, given the government is the single largest entity that would be interested in
purchasing medical supplies and equipment. Governments also have a variety of products to
choose from, because suppliers publicly state the price of their products in a bid-to-sell structure.
In such regulated areas, the government is the largest purchaser of medical supplies and
products, meaning purchase orders are also fairly large. Certain products have a high switching
cost, since some products require special training. Other less sophisticated products have little to
no switching costs. In the rubber gloves example, the government will have no switching costs,
and therefore will most likely choose the lower-priced offers.
In less regulated geopolitical areas, the ratio of buyers to suppliers is much larger, since the
government no longer is the sole purchaser of medical products. A much larger number of
hospitals, offices, and clinics, with smaller purchasing powers, are added to the picture, and the
power of the purchaser is greatly reduced.
In both cases, it is not feasible for hospitals or governmental entities to operate on a profitable or
effective scale as the large businesses in this industry, meaning backwards integration is not
likely.
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Threat of Substitute Products:
The threat of substitute products vary. Again, if the company is in the business of
manufacturing low-regulated products, switching costs will most likely be low. High-risk
products are more likely to have higher switching costs, and therefore the threat stemming from
switching costs are lower for high-risk products as opposed to low-risk products. The threat of
substitute products is higher for low-risk products in geopolitical locations with governments as
the sole purchasers. The threat of substitute products for high-risk products is lower in such
geopolitical regions since the sole purchaser will be more invested towards using a certain high-
risk product, and therefore have a higher switching cost, whereas in a less regulated geopolitical
region, there are more, smaller purchasers with lower switching costs.
Intensity of Rivalry among Competitors:
Although the level of competition varies among different regions, competition is heavy,
as cost leaders heavily focus on maintaining their strategies as cost leaders and product
differentiators must focus on high level of research and development expenditures in order to
create break-through technologies.
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Boston Scientific Company Analysis
General Company History
1970s:
Boston Scientific was founded in 1979. The company was a holding company that was
formed by John Abele and Pete Nicholas to purchase a company known as Medi-Tech, a
company with innovative products such as the lung cytology brush (a bronchoscopy product) and
steerable catheters.
1980s:
The 80s were seen as a growth period for the company. A top competitor was acquired in
the gastro-intestinal and pulmonary endoscopic field. Entry in urology grew with the
introduction of a urological stent. A manufacturing facility was added in Europe, as well as
subsidiaries in France and Germany, as well as another subsidiary in Japan.
1990s:
Boston Scientific finally went public in 1992. Nine additional competitors were acquired,
raising revenues to $1.8 billion. Boston Scientific became a key player in coronary angioplasty (a
procedure used to unclog clogged arteries in the heart) and non-vascular therapies. A
manufacturing facility was constructed in Ireland. 1999 also marked a change in co-founder
management, as the co-founder, Pete Nicholas, retired.
2000s:
A coronary stent system product, named TAXUS, was launched and became one of the
most successful products in the history of the entire industry (however, no sales figures for 2004
were given on the company’s 10-K reports). An acquisition also gave the company an entry into
the neuromodulation business.
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2010s:
The company continues to show some innovative edge (not as much as Baxter
International), with four new products launched, one product being an implantable defibrillator,
another product being a device managed asthma treatment device, the third product being
another stent system, and a rechargeable chronic pain management system being the fourth
launched product. Expansion is targeted in China and India (which sounds risky because of other
companies expanding into these regions, including Baxter International).
General Company Overview:
Boston Scientific has seven core businesses. These segments include Interventional
Cardiology, Cardiac Rhythm Management, Endoscopy, Peripheral Interventions, Urology and
Women’s Health, Neuromodulation, and Electrophysiology. The following is brief description of
these segments.
The Interventional Cardiology segment is concerned with coronary stent systems,
intraluminal ultrasound imaging, structural heart therapy, and other core coronary
technologies.
Coronary Stent Systems: “[…]Coronary stents are tiny, mesh tubes used in the treatment
of coronary artery disease, which are implanted in patients to prop open arteries and
facilitate blood flow to and from the heart.[…] We market a broad portfolio of internally-
developed and self-manufactured drug-eluting stents.[…]”
Intraluminal Ultrasound Imaging: “We market a family of intraluminal catheter-directed
ultrasound imaging catheters and systems for use in coronary arteries and heart chambers
as well as certain peripheral vessels.”
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Structural Heart Therapy: “Through the acquisition of Sadra, we have developed a fully
repositionable and retrievable device for transcatheter aortic valve replacement
(TAVR) to treat patients with severe aortic stenosis.[…] In March 2011, we completed
the acquisition of Atritech, Inc. (Atritech). Atritech developed a novel device designed to
close the left atrial appendage in patients with atrial fibrillation (AF) who are at risk for
ischemic stroke.[…]”
Core Coronary Technologies: “We market a broad line of products used to treat patients
with atherosclerosis, a principal cause of coronary artery obstructive disease which is
characterized by a thickening of the walls of the coronary arteries and a narrowing of
arterial openings caused by the progressive development of deposits of plaque. Our
product offerings include balloon catheters, rotational atherectomy systems, guide wires,
guide catheters, embolic protection devices, crossing and re-entry devices for the
treatment of chronically occluded coronary vessels and diagnostic catheters used in
percutaneous transluminal coronary angioplasty (PTCA) procedures.”
The Peripheral Interventions segment designs and sells medical devices that deal with
other medical conditions relating to cardiac problems. “We sell various products
designed to treat patients with peripheral disease (disease which appears in blood vessels
other than in the heart and in the biliary tree), including a broad line of medical devices
used in percutaneous transluminal angioplasty (PTA) and peripheral vascular stenting.
[…]”
The Rhythm Management segment focuses on designing, manufacturing, and selling
products that deal with monitoring and maintaining normal heart rates. “We develop,
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manufacture and market a variety of implantable devices that monitor the heart and deliver
electricity to treat cardiac abnormalities […]”
The Endoscopy segment deals with marketing products that treat digestive (stomach,
small and large intestines, etc…) and respiratory (lung) issues. “We market a broad
range of products to diagnose, treat and ease a variety of digestive diseases, including those
affecting the esophagus, stomach, liver, pancreas, duodenum, and colon.[…] We market
devices to diagnose, treat and ease pulmonary disease systems within the airway and lungs.
[…]”
The Urology and Women’s Health segment deals with the design, production, and
selling of products that address urinary issues. “Our Urology and Women’s Health
division develops, manufactures and sells devices to treat various urological and
gynecological disorders.”
The Neuromodulation segment deals with the selling of pain management system
products. “Within our Neuromodulation business, we market the Precision® and Precision
SpectraTM Spinal Cord Stimulator (SCS) systems, used for the management of chronic
pain.[…]”
The Electrophysiology segment deals with developing products that relate to regulate
to identifying and treating cardio-rhythmic issues. “Within our Electrophysiology
business, we develop less-invasive medical technologies used in the diagnosis and
treatment of rate and rhythm disorders of the heart.”
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Corporate, business, and Functional-Level Strategies:
Boston Scientific’s corporate strategy is focused on related diversification. Going back to
the company’s history, much of the company’s acceptable levels of performance have been
partly due to its acceptable levels of innovation, but mainly through its acquisitions, for example,
the move into the neuromodulation field in the 2000s. With its limited research and development
capabilities, the company is able to add value to those products through its innovative strengths,
although it is by no means as effective in R&D as a competitor like Baxter Inernational.
Boston Scientific’s business strategies in both of its segments are focused on the concept
of product differentiation. Heavy research and development expenditures are focused on
innovative technologies, as seen with the launch of the asthma treatment device and the
subcutaneous defibrillator. Research and development costs have totaled $861 million in 2013, in
comparison with Baxter’s 50% larger expenditure of $1.25 billion. Considering that Boston’s
net sales for 2013 are about half of Baxter’s, that is a major commitment to innovation.
As mentioned in the previous company analysis on Baxter, even though cost leadership is
not a primary strategy, it is still an important concept to consider, even though it is more difficult
for a company like Boston (in comparison with Baxter), to do. With the Healthcare industry
changing in ways where more heavily government-controlled economies are awarding orders to
the more reasonably priced suppliers, and a similar situation unfolding in the US as the
Affordable Care act is forming consolidated hospitals with larger market powers, Boston should
better control its costs so that less costs are being eaten by the hospitals. Again, this is harder for
Boston to do since it spends such a large portion of its revenue on R&D expenditures, meaning
that there are less free cash flows that can be used on operation efficiencies.
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Regarding functional-level strategies, the company's source of value is by far, its
innovation, a major value factor in the medical supplies industry. The asthma product mentiond
before, is the only one of its kind, as is the subcutaneous defibrillator which is also the only one
of its kind. Its these innovations which make Boston Scientific seem like a great company to
invest in. Without its innovation, Boston would probably be a company focused on cost
leadership, but who knows if the company would still be around to day since that strategy is
perhaps more demanding than the prior strategy mentioned. When it comes to the quality of
products, one can argue that Boston’s products are perceived as lesser quality than Baxter’s since
the company also faces litigation issues, but is half the size of Baxter.
Life Cycle:
I believe Boston is closer to the declining phase than is Baxter, and is more of a volatile
growth stock than can be said about Baxter. Although the industry it operates in is moving
forward, Boston’s sales are slumping, and Net Income for the 2011-2013 period are, for the most
part, not at all impressive but concerning, with only one fiscal year (2011) having a positive
profit margin of only 6%. The company is highly reliant on its innovations, which do add to the
company’s top line growth, however, costs associated with such top line growth need to be cut in
order for the company to remain profitable. Technologies do surface from time to time, and more
areas of the market are uncovered as a result of the company supplying unmet clinical needs
(moving Boston Scientific’s lifecycle status to a younger stage), but costs are keeping the
company from generating a competitive level of returns. Such actions are not sustainable, and if
the company keeps operating the way it has been, it will not survive.
For that reason, I place the company is in a decline phase. Even though Boston Scientific
can still cut its costs and improve its bottom line, placing the business’s lifecycle in a more
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attractive stage, which it has over the past recent quarter, as noticed by ValuLine’s financial
analyst, Nira Maharaj, the company is still in a decline phase.
I have also calculated Boston’s beta to the S&P 500 since October 27th, 1988, and the
resulting figure was 0.92, meaning the company is slightly less correlated to the economy,
especially with an r squared of 0.14. The reason being is because the company is mostly affected
by the introduction and demand of products it develops, which results in more independence
from the economic business cycle of the US. That is not to say that the business cycle has no
effect on the company. The phase of the economy is still important, as it affects whether
hospitals and other purchasers spend or hold on to their financial resources, and whether or not
they are able to continue financing their purchases from Baxter.
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Product Lines, Major Products, and Marketing:
Product Lines and Products
Boston Scientific’s business is focused on three product families; Cardiovascular, Rhythm Management, and MedSurg.Here is a list of the product families, along with the 2013 net sales (in millions) of their associated segments:
In the Cardiovascular family (total net sales of $2,786), Boston’s segments include: Interventional Cardiology: $1,997
o Coronary Stents: TAXUS Element, Promus Element, Ion, SYNERGY, PREMIER Peripheral Interventions: $789
o Peripheral stents, catheter balloons, embolization devices, vena cava filters
In the Rhythm Management family (total net sales of $2,041), Boston’s segments are: Cardiac Rhythm Management: $1,886
o Implantable cardio defibrillators (ICDs), implantable cardiac resynchronization therapy defibrillators (CRT-D), implantable arrhythmia-monitoring pacemakers which include cardiac resynchronization therapy pacemaker (CRT-P) systems.
Electrophysiology: $155o Radio frequency (RF) generators, steerable RF catheters, intracardiac ultrasound
catheters, diagnostic catheters, delivery sheaths, and other accessoriesIn the MedSurg family (total net sales of $2,258), Boston’s segments are:
Endoscopy: $1,300o Gastroenterology: Radial Jaw, RX Biliary System, Spyglass Direct Visualization
Systemo Interventional Bronchoscopy: Alair Bronchial Thermoplasty System
Urology and Women’s Health: $505o Ureteral stents, wires, lithotripsy devices, stone retrieval devices, sheaths,
balloons and catheters Neuromodulation: $453
o Precision® and Precision SpectraTM Spinal Cord Stimulator (SCS) systems
$2,786
$2,258
$2,041
2013 Product Family Sales
Cardiovascular
MedSurg
Rhythm Management
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Figure 1.
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Marketing
All of these products are mainly aimed at healthcare facilities, such as hospitals, as well
as smaller sized clinics and doctor offices, just like Baxter International.
Boston’s marketing strategies for developing such products and bringing them to market
would include maintaining relationships through its own direct sales force in significant areas,
and through networks of dealers and distributors in less critical areas. But the company has a
direct sales force for all of its business segments.
Although the company is not dependent on single institutions, large purchasing
organizations, as well as hospital networks, are becoming more and more important.
Because of the nature of the products Boston offers, it strives to maintain and form new
relationships with physicians, who are the ultimate consumers of the products. These
relationships drive the demand of its products.
Operations:
Integration
Baxter International has a scattered integration structure. As briefly mentioned before,
some segments do not include all steps of the value chain. For example, the neuromodulation
segment does not manufacture its own products. The segment was a result of an acquisition in
the 2000s, and all Boston does is design and market the products. The company is therefore, not
completely integrated, even though some segments are nearly completely integrated (raw
materials are not controlled by the organization and are purchased by suppliers). Two examples
of nearly fully integrated segments are the Rhythm Management, and the Urology and Women’s
Health segments.
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Labor
Labor depends on segment. Employees in R&D require formal education. Workers in
manufacturing usually require at least a high school diploma. The company also offers finance,
IT, and legal compliance positions. For the most part, Boston Scientific’s employees have four
year college degrees, with the exception of manufacturing jobs requiring only a high school
diploma.
Important Expenditures
The top two important expenditures for Boston Scientific are Cost of Goods Sold and
Research and Development costs. These two costs are essential to the company’s success
because COGS need to be controlled, so that customers may afford to purchase Boston’s
products. Research and Development costs are also important because this is where the
company’s growth comes from. COGS is what makes the products attractive on the consumer
end, and profitable on Boston’s end, while R&D enables the growth of sales, and with the
growth of sales comes the expenditures on COGS. Still, the company should make sure that it
controls R&D expenditures, so that it doesn’t invest too heavily in products which may
ultimately fail.
Competition
Each of Boston’s seven business segments face competition. Because these seven
segments cover such a broad area in the industry, the company faces a lot of competition that
come from various angles. Neuromodulation faces competition from companies like Medtronic
and St Jude Medical. Interventional cardiology experiences competition from companies like
Abbott Laboratories. Rhythm Management also faces competition from Medtronic, while
Electrophysiology also faces competition from St. Jude Medical, and Biotronic.
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International competition is also increasing, due to the increasing saturation international
competitors have in marketing and distribution, as well as their growing manufacturing
capacities.
Customers are also consolidating, which results in the increasing bargaining power of
purchasers, meaning prices can be reduced easier by the power of the purchaser upstream of the
value chain. The probability of securing sales also decreases since there are less customers, and a
relatively higher number of competitors to satisfy those scarcer purchasers.
The following is a list of Boston Scientific’s competition, provided by BaseLine:
CompetitorsSymbol
Current Market Cap. (Billions)
2012 Sales (Mill)
Sales Growth
2013 Sales(Mill)
Johnson & Johnson JNJ 290.9 67,224 6.1% 71,312Pfizer Inc, PFE 184.6 58986 -12.5% 51,584Abbott Laboratories ABT 63.8 37874 -42.3% 21,848Baxter International BAX 39.3 13,893 9.8% 15,259
Management
Baxter’s corporate governance consists of a board with five committees, including audit,
executive compensation and human resources, nominating and governance, finance, and
compliance and quality committees.
The audit committee is a committee responsible for overseeing internal audits of the
company, discussing financial statements, and setting the policy for hiring internal auditors. It
also has various other activities that harmonize with other committees. For example, the audit
committee also works with the finance and compliance/quality committee to ensure financial
compliance.
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The executive compensation and human resources committee is responsible for deciding
how much to compensate the company’s officers, as well as overviewing incentive
compensation, benefit plans, and setting corporate goals and objectives relative to the
compensation of the CEO and his or her performance for attempting to achieve those goals.
The nominating and governance committee is responsible for organizing and maintaining
the structure and member ship of the board of directors, and reviewing the performance of its
members.
The finance committee is responsible for recommending financial decisions, such as
opinions on divestitures, dividends, reviewing pension assets, and the company’s investment
policies.
The compliance and quality committee is concerned with reviewing regulations and
compliance with laws, as well as reviewing government affairs in the healthcare industry. It is
also responsible for overviewing product development and product quality, ensuring quality of
products do not deviate from company standards.
Overall, the company’s board of directors show a promising level of guidance over
corporate policies.
The company’s CEO is Michael Mahoney. He has served as Worldwide Group Chairman
for Johnson and Johnson’s DePuy franchise, from January to September in 2011. In this position,
Mr. Mahoney managed 50,000 employees and seven franchises. Prior to his time with DePuy,
Mr. Mahoney served as CEO of Global Healthcare Exchange from 2001 to 2007, adding to his
experience with the supply chain of hospitals, manufacturers, and distributors, a very valuable
experience given the importance of distribution in this industry. 10% of his pay is fixed, 11%
comes from a bonus, and the remaining 79% income item comes from stock options and
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performance share units. While the allocation of the CEO’s compensation sources seems
appropriate, the $10.9 million total compensation size for 2013 seems to be excessive. Even
though Boston Scientific had a gross profit of $4.97 billion in 2013, an increase from 2012, the
company still had a net loss on the bottom line for both of those years. Having an average of a
$10.8 million salary during those years, in my opinion, is nearing excessive levels. Mr.
Mahoney’s 2013 compensation was .41% of total marketing and administrative expenditures, not
material enough to hinder performance, but still, a bit excessive considering the company’s
bottom line status. In comparison to other companies, it is a normal occurrence to have a
compensation of this size, however, I still disagree with the fairness of the compensation figure.
Total Compensation for non-employee directors for the end of fiscal year 2013 was
$2,741,585.
Here is an image indicating the CEO’s compensation consistence as well as the board’s:
When it comes to recent headlines, there have been a couple of issues worth noting. One
is a Transvaginal Mesh lawsuit, where a woman who suffered from gross negligence of the
installation of the product was awarded $73 million in compensatory damages. There are 23,000
lawsuits pending for this product. Over the years, Boston Scientific has seen a sizeable increase
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of litigation charges as seen on the company’s 2011-2013 income statements, starting at $48
million of expenses in 2011, to $221 million in 2013.
Here is a brief comparison of management measures, provided by csimarket.com:
Overall, management seems to be working effectively. Much more pressure should be put
on the compliance and quality committee to keep these huge litigation losses from continuing.
ROA, ROE, and ROI seem to be performing poorly against the industry and Boston’s
competitors, but so many litigations, and random items which I believe to be unusually frequent
(ex: $4 billion impairment of goodwill for 2012), affect the bottom line in such negative ways
that I believe those measures are less useful than in the analysis of the other companies analyzed
in this report.
2014 Transvaginal Mesh Lawsuit and Manufacturer Lawsuithttp://www.reuters.com/article/2014/09/09/bostonscientific-mesh-verdict-idUSL1N0RA2BB20140909 2013 10-khttps://www.sec.gov/Archives/edgar/data/885725/000088572514000005/a2013form10-k.htm#sBB53F6B0E69BD9565EDE95EB71B4059D
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2013 DEF14Ahttps://www.sec.gov/Archives/edgar/data/885725/000104746914002942/a2219226zdef14a.htm
Management Measures:http://csimarket.com/stocks/BSX-Management-Effectiveness-Comparisons.html
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Comparative Financial Statement Analysis and Basic Financial Information:
Basic Financial Information
BSX Exhibit 1
Financial Measurements BSX
Beta0.75306
7
P/E14.4276
9ROA 0.59399
ROE1.79813
8Net Sales 2013 15259Net Sales 2012 14190Net Inc 2013 2012Net Inc 2012 2326
2013 Profit Margin0.13185
7
2012 Profit Margin0.16391
8
2013 Gross Profit0.49773
9
2012 Gross Profit0.51451
7
Comparative Analysis
For this section, please refer to the following tables:
BSX Exhibit 2- General Information
Company Beta P/E 2012% Growth 2013
Gross Profit
Average Tax Rate
Profit Margin
ABT 0.60
20.28
$ 37,874 -42%
$ 21,848 58% 21% 12%
BAX 0.63
14.43
$ 14,190 8%
$ 15,259 50% 11% 13%
BSX 0.92
26.20
$ 7,249 -1%
$ 7,143 73% 27% -2%
JNJ 0.61
17.91
$ 67,224 6%
$ 71,312 74% 5% 19%
PFE 0.81
18.13
$ 58,986 -13%
$ 51,584 85% 46% 43%
91
Beta and all of the ratios were calculated manually. Beta was calculated by using the SLOPE equation in Excel, where Yahoo! Finance daily historical prices were used for the calculation. The period for the calculated was from May 20th, 1992, to 10/3/2014. The 2013 10-k report was used to obtain Sales, Net Income, and calculate the Profit and Gross Margins, ROA, and ROE. The P/E was obtained by using the 10-k Basic Earnings Per Share, and the 10/3/2014 closing day BAX price traded on the New York Stock Exchange.
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BSX Exhibit 3- Efficiency
Company ROA ROEInventory Turnover
Latest AR Turnover (TTM)
A/P Turnover
ABT 6.0% 10.2% 8.112885258 3.77 5.676939426BAX 7.8% 23.7% 4.360960274 5.72 1.802695418BSX -0.7% -1.9% 7.963210702 5.66 7.9833JNJ 10.4% 18.7% 9.052043666 6.2 3.078614533PFE 12.8% 28.8% 8.365877392 4.75 2.23493095
BSX Exhibit 4- Liquidity
Company
LTD/OE
Quick Ratio A/P Turnover
OCF/Liabilities
ABT0.32875
12.02450
8 5.676939426 0.186930604
BAX1.35246
31.69387
1 1.802695418 0.183972847
BSX1.25523
81.65076
8 7.983263598 0.107854864
JNJ0.44501
92.19696
2 3.078614533 0.29701518
PFE0.94916
62.40708
7 2.23493095 0.185450028
Boston Scientific was compared amongst four other competitors, along a four year period, from years 2010 to 2013.
General Information
BSX had the highest P/E among all four competitors. o Its P/E was 26.2, while the closest P/E ratio from a competitor was ABT, with a
P/E of 20.3. o This shows us that buying a share in BSX’s earnings is relatively more expensive
than buying a share in other competitors’ earnings. Looking at sales from 2012 to 2013, BSX experienced a 1% decline in its sales.
o Its decline in sales was 1%, with PFE the closest behind with a -13% decline.
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o Only 2 other competitors experienced positive growth rates in sales.
If we look at operational performance in terms of retaining sales from expenses from operations, BSX has one of the highest 2013 gross margins.
o Its gross margin is 73%. PFE holds the highest gross profit margin of 85%, 70%
larger than BAX, but only 16% larger than BSX.o To get a more complete picture, BAX has $7.6 billion dollars after operational
expenses. BSX has $5.2 billion, an amount which has a lesser purchasing power. Although BSX has a larger gross margin percentage figure, it’s profit margin is the
weakest out of all other four competitors. o Its profit margin is -2%. Again, I believe that the reason is due to material,
random items that occur frequently which I truly believe should be less frequent in nature.
Efficiency
BSX has the lowest ROA and ROE figures. o The company’s ROA is -.7%,
o The company’s ROE is -1.9%.
o Normally this would indicate that management is doing a poor job, but in my
opinion, the reason why these figures are doing so poorly is because of the fact that there are random items that are negatively affecting earnings.
BSX has the third highest accounts receivable turnovero Its receivables turnover figure is 5.66, outperformed by BAX (A/R turnover 5.72)
Liquidity and Solvency
BSX has the second highest long-term debt to equity ratio,o Its LTD/OE ratio is 1.26.
o The dividend investor would find this unattractive since BSX is focused on
pleasing the creditor more with interest payments than the equity holder with dividend payments.
BSX has the lowest quick ratio.o Its quick ratio is 1.65, with the next highest quick ratio figure coming from BAX
(quick ratio 1.69). BSX has the highest accounts payable turnover ratio, by far.
o Its A/P turnover ratio is 7.98, with ABT having the second highest figure (A/P
turnover ratio 5.68).o This shows us that BSX is on top of paying off its creditors, a plus for creditors.
BSX has the lowest operating cash flows to liabilities ratio.o Its OCF/L ratio is .11.
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o Remember that BSX also has the highest LTD/OE ratio, meaning the company
has a higher debt financing, meaning it’s not surprising that this OCF/L ratio is as low as it is. This doesn’t make the ratio irrelevant, however, it is useful to keep this in mind while viewing the OCF/L ratio.
BSX is the only company out of five that has a negative times interest earned ratio. o This is simply terrible. The company does not have enough EBIT to even cover
its interest expense that is accruing.
Financial Statements:
Balance Sheet:
When looking at BSX’s left side of the balance sheet, assets seem to be indicating that
the company is still performing fairly, but barely. A/R seems to be up from 2012, but has been at
relatively the same level since 2009. Inventory has actually decreased a couple of times
throughout the 5 year period, and growth is not as strong as a highly-demanded-product-
providing company should be. Cash has also significantly decreased over the past 5 years, from
$864 million to 2013’s cash figure of $217 million. This is very alarming. Over the past years,
cash funds have plummeted, but there have been no significant increases in other asset accounts,
such as inventory, or A/R.
The company’s left side adds no optimism to this report. While cash has plummeted by
roughly 75%, and there have been no significant increases in complimentary accounts such as
inventory or A/R, liabilities are actually staying at the same level, but in relations to BSX’s total
assets, liabilities have been increasing faster than equity financing. This mean less earnings are
bread-crumbing down to the shareholders, which is not good at all, considering the company that
doesn’t even pay its investors any dividends.
Overall, the balance sheet does not give a good impression.
Income Statement:
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Starting with the top-line and going down, sales have decreased 13% (linearly), since
2009. While cost of goods sold have decrease, gross margin has improved by only 2%. The
company is streamlining itself, but not effectively. In a time when sales should be increasing, due
to a large aging population, BSX’s sales are actually decreasing, with its gross margin only
improving by 2% since 5 years ago. In general, the top line isn’t performing well.
If we look at operations, one of the most important items is R&D. R&D is what is
responsible for generating future sales. Looking at the figures, R&D has been decreasing, which
is good for the bottom line, but not for future top lines. The reason as to why these expenditures
have been decreasing seems to stem from the top line, which has been deteriorating, as we
previously discussed. As we look at Marketing and Administrative figures, these expenditures
have been increasing, yet there has been no growth in the top line. This shows that marketing,
and management seem to be dragging the company even further down.
All these activities have led to operating income decreasing as well. With operating
income decreasing, and interest expense slightly moving up and down, the investor should be
concerned with the company’s solvency. The company is heavily financed by debt, yet its
performance isn’t compensating as much as is appropriate for that risk.
Overall, the income statement does not provide a positive image of the company.
Statement of Cash Flows:
Operating Activities
The top two positive activities in this section include Goodwill Impairment Charges, and
Depreciation. Goodwill Impairment Charges totaled $4,350, -3600% of net income (BSX has a
net loss), with Depreciation being $683, or -5600% of net income.
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The top two negative activities in this section include Deferred Income Tax, and Accrued
Expenses. Deferred Income Tax totaled $(166) million, 137% of net income, and Accrued
Expenses totaled –(131) million, or 108% of net income.
Investing Activities
Acquisitions of PPE and Payments for Business Acquisitions were the two most negative
activities in this section. Business Acquisitions totaled $(366) million, -33% of cash flows from
operations, and Acquisitions of PPE totaled $(226) million, -1.5% of cash flows from operations.
Disposal of PPE was the only positive activity, totaling $16 million, or 1.5% of cash
flows from operations.
Financing Activities
The major negative activity for this section was the Acquisition of Treasury Stock, which
is $(600) million, or 496% of net income.
The major positive activity for this section was Borrowing Credit, which totaled $371
million, or 307% of net income.
Summary
After viewing the statement of cash flows, it seems that BSX is generating cash flows
mainly from securing debts from credit lenders. What the company does with this cash is spend
equal amounts on business acquisitions as it does so in capital expenditures. If a company has
declining sales, ineffective marketing and management, and negative earnings, it seems
desperate for the company to spend half of what it spends on capital expenditures on
acquisitions, in hopes that future growth might keep the company just barely going.
Overall, Cash Flows seems to give a negative picture of this company, as does the
Balance Sheet, as does the Income Statement.
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Conclusion
BSX seems to have a very high P/E ratio. Looking back at the previously discussed
financial figures, there are a couple reasons the company is expensive, compared to its
competitors. One reason is that it has very low earnings due to the random items repeated a
couple times over the past couple pages.
BSX also has terrible efficiency ratios. Its ROA is the lowest in the table, as is its ROE.
Its 2012-2013 sales growth was negative, as was its bottom line.
But there are a couple of attractive aspects to this company. BSX does collect its
receivables at a fair level. It has been able to pay off its creditors at a fast rate, since it has the
highest A/P turnover compared to its competitors. BSX also has a great amount of purchasing
power it has left over from its gross margin, enabling the company to spend relatively more
heavily in marketing and R&D. It’s these R&D and marketing expenditures that cause future
sales to occur, as innovation is what enables companies to address unmet clinical needs in the
medical supplies industry.
There is also a great opportunity the company has with its cardiac products, as a recent
headline indicated that the first “Dead Heart” transplant was performed in Australia, indicating a
new unfilled market for new cardiac products. Boston does have the ability to use its innovative
skills to create products that can be associated with this significant surgery.
But overall, the negative outweigh the positives with this stock. Sales are decreasing,
indicating that the company is in the decline phase, indicating marketing and R&D are not
functioning effectively. While random negative events are detrimental to the bottom line, with
items like lawsuits and goodwill impairment absolutely destroying the bottom line, this could be
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an indication of poor responsiveness to detrimental factors, for example, not addressing quality
issues as seen with the Transvaginal Mesh.
Whether the company gains a stronger foothold in the expanding cardiac segment of the
medical supplies market is a matter of speculation. Although the company has done well in the
past, it is not at all certain that the company will create new successful products to meet this new
demand. However, I believe that this speculation is one of the few reasonable, foreseeable top-
line growth additions the company has for the next few years, given the blow the company is
experiencing for its public image and deceleration in its innovative products.
The company has also never paid a single dividend in the past 10 years, even though the
company has been around since the 70’s! Having accumulated that age, but not the appropriate
retained earnings level to pay a dividend suggests that something is wrong from my point of
view.
That said, my recommendation is to not buy BSX since it has very high P/E, and few
signs for an appropriate future growth. Even by looking at the numbers on the financial
statements, there are signs of imminent, if not already occurring, desperation. As you will see in
the valuation section, my opinion is also supported by the valuation methods used to value this
company.
Dead Heart Surgery:
http://www.huffingtonpost.com/2014/10/29/dead-heart-transplant-surgeons-australia_n_6062374.html
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5 Year Financial Statements (2013-2009) * Provided By BaseLine
Balance Sheet
DEC DEC DEC DEC DEC2013 2012 2011 2010 2009
Cash & Cash Equivalents 217 207 267 213 864Short Term Investments 0 0 0 0 0Accounts Receivable 1307 1217 1246 1320 1375Inventories 897 884 931 894 920Other Current Assets 590 714 661 1188 902Total Current Assets 3011 3022 3105 3615 4061Net Fixed Assets 1546 1564 1670 1697 1728Other Long Term Assets 371 306 281 287 253Goodwill & Intangibles 11643 12262 16234 16529 19135TOTAL ASSETS 16571 17154 21290 22128 25177Accounts Payable 246 232 203 184 212Short Term Debt 3 4 4 504 3Other Current Liabilities 1575 1536 1600 1921 2807Total Current Liabilities 1824 1772 1807 2609 3022Long Term Debt 4237 4252 4257 4934 5915Other Liabilities 3971 4260 3873 3289 3939TOTAL LIABILITIES 10032 10284 9937 10832 12876Preferred Equity 0 0 0 0 0Common Equity 6539 6870 11353 11296 12301 Retained Earnings -8570 -8449 -4381 -4951 -3757STOCKHOLDERS' EQUITY 6539 6870 11353 11296 12301TOTAL LIAB. & EQUITY 16571 17154 21290 22128 25177Shares Outstanding ('000) 1322296 1355712 1449056 1520780 1510750
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Cash FlowsDEC DEC DEC DEC DEC2013 2012 2011 2010 2009
Net Income (Loss) -121 -4068 441 -1065 -1025Depreciation & Amort. 689 683 717 816 834Net Changes - Assets/Liabilities 155 256 -237 -1362 922 (Increase) Decrease in Receivables -101 37 42 52 1 (Increase) Decrease in Inventories -7 66 -54 -5 -92 (Increase) Decrease in Other Current Assets 91 -96 -60 143 273 Increase (Decrease) in Payables -37 -131 -271 -1148 462 Increase (Decrease) in Other Current Liab. 209 380 106 -404 740Other Adjustments, Net 359 4389 87 1611 104 CASH FROM OPERATIONS 1082 1260 1008 0 835Capital Expenditure -289 -248 -304 -278 -362Acquisitions -274 -366 -377 -211 -527Sale of Property, Plant & Equipment 83 26 1456 5 5Investments (Increase) 0 0 5 4 0Cash In (Out) Flow 5 9 -11 0 91 CASH FROM INVESTMENTS -475 -579 769 -480 -793Issuance of Capital Stock 74 21 21 31 33Repurchase of Capital Stock -500 0 -492 0 0Debt Increase (Decrease) -10 -19 -1250 -527 -853Dividends 0 0 0 0 0Other Cash In (Out) Flow -160 -746 0 0 0 CASH FROM FINANCING -596 -744 -1721 -496 -820Effect of Exchange Rates -1 3 -2 325 1 NET CHANGE IN CASH 10 -60 54 -651 -777
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Income StatementDEC DEC DEC DEC DEC2013 2012 2011 2010 2009
Revenue 7143 7249 7622 7806 8188Cost of Goods Sold 1895 2061 2363 3112 2296 Gross Margin 0.7347053 0.715685 0.6899764 0.6013323 0.7195897Selling, Gen'l & Admin. 2814 2688 2659 2765 2826Depreciation & Amort. 689 683 717 816 834Research & Development 861 886 895 939 1035OPERATING INCOME 884 931 988 174 1197 Operating Margin 0.1237575 0.1284315 0.1296248 2.23E-02 0.1461895Interest Expense 324 261 281 393 407Other Expenses (Income) 783 4777 65 844 2098INCOME BEFORE TAXES -223 -4107 642 -1063 -1308 EBT Margin 8.42E-02Income Taxes -102 -39 201 2 -283INCOME AFTER TAXES -121 -4068 441 -1065 -1025 Net Profit Margin 5.79E-02GAAP EPS (as reported) -0.09 -2.89 0.29032 -0.70167 -0.679Baseline EPS 0.72 0.6 0.5 0.39 0.5 Adjusted for Restatements, Unusual and Extraordinary ItemsWeighted Avg. Shares Outstanding ('000) 1341200 1406700 1519000 1517800 1507900
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Baxter International Company Analysis
General Company History
1930s:
Baxter International was originally founded in 1931, when its primary business was
manufacturing intravenous solutions (IV). The demand for its IV products forced the company to
expand into the Midwest, so the company acquired property that was to be used for
manufacturing in Glenview, IL. With management changed in 1935, a research and development
branch was added to the company, a valuable play by management since four years later, the
Transfuso-Vac container was developed, revolutionizing the way blood is stored with technology
that increased blood storage time by more than 2000% from a few hours to 21 days.
1940s:
As a result of Baxter being the only company to meet US Armed Forces standards,
temporary plants opened in 1941 to increase demand from the interference of World War II.
Later on during the year, Baxter was also able to formulate a container which was able to
separate the different components of blood. Three years later in 1944, the company came up with
the first dialysis device known as the drum kidney. With sales exploding in the $1.5 million
range, headquarters moved to Morton Grove, IL.
1950s:
In 1950, the company created another manufacturing facility in Cleveland, MS, aiming to
expand internationally as an increasing demand made the company increase its capacity. 1952
brought the company’s acquisition of Hyland Laboratories, now enabling the company to
provide human plasma commercially available. In the decade the company started looking
overseas, the company finally acquired its first international office in Belgium. 1959 brought
another acquisition of a company by the name of Fenwal Laboratories, which enabled the
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company to develop the VIAFLEX plastic IV bag, a flexible, plastic container system which
made possible Baxter’s development of CAPD (continual ambulatory peritoneal dialysis).
*Overall, the merger that resulted in the unified Lockheed Martin enabled a company, focused
primarily on defense, to expand further into space, as Martin Marietta brought rockets, space and
transportation vehicles to the newly established company's portfolio.
1960s:
Baxter ended its long-term relationship with American Hospital Supply, who helped in
distributing Baxter’s products since the 1930s, and replaced the relationship with the company’s
own internally based sales team. The company began trading on the NYSE in 1961, and in 1962,
the company made open-heart surgery possible with its new blood oxygenator product. Six years
later in 1968, Baxter created factor VIII concentrate which treated hemophilia. In 1969, a
research facility was added in Round Lake, IL.
1970s:
1970 was the year the previously mentioned VIAFLES flexible plastic IV container was
developed. A major plant, that is still among the largest of its kind, was also constructed in
Marion, NC. 1971 is when Baxter made it into Fortune Magazine’s list of 500 largest American
corporations, with sales reaching $242 million. 1975 is when the company moved to its present-
day headquarters in Deerfield, IL. 1978 brought the home use dialysis system, the CAPD. Sales
that year went over $1 billion. 1979 brought the company its first automated blood-cell separator.
1980s:
Management changed in the year of 1980. Three years later, the heat-treated VII
concentrate for hemophilia was developed, reducing the risk of viral contamination to its
consumers. In 1985, the former long-term relationship with American Hospital Supply
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Corporation was re-energized with an acquisition. The acquisition aided in product distribution
as well as medical technologies development. 1988 brought the HEMOFIL M, a VII product
which was purified through new technological processes.
1990s:
This decade is populated with heavy activity. Two acquisitions happened in the late 90s,
and five products have been developed throughout the entire decade, one which was a needleless
system for IV therapy, and the rest relating to renal and hemophilia activities. There is also a lot
of international activity, as a manufacturing plant opened in Singapore and China, in 1994 and
1995 respectively. A number of products also passed health regulations in Europe and in the US,
with a stem-cell separator being approved in Europe in 1995, and a cost efficient IV pump, a
homeostasis/wound-healing product, as well as a chamber bag product for parenteral nutrition
being approved in the US in the years 1996 and 1998 respectively.
2000s:
This decade is also riddled, more so than the 90s decade, with innovative products, more
regulatory approval of products, and more international activities, as well as three acquisitions.
Examples of new products being introduced included FLEXBUMIN in 2005, which is the first
albumin in a flexible, plastic container, and the first needle-less IV connector with an
antimicrobial coating in 2007. Examples of international expansion include the launch of
OLIMEL triple-chamber system for parenteral nutrition in France and Switzerland. The
acquisitions were of the manufacturing of prefilled injectable drugs, and the assets of pertaining
to plasma-based therap.
2010s:
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2010 brought the regulatory approval of the seasonal flu vaccine in Austria and the Czech
Republic. In the same year, a new research and development facility was built in Belgium. In
2011, five events worth noting occurred. First, the company launched Baxter Ventures to invest
$200 million in early stage products and therapies. Second, the company entered into an
acquisition agreement to purchase an automated, compounding, parenteral nutrition systems
manufacturing company, Baxa Corporation. Thirdly, the KIOVIG product, a multifocal motor
neuropathy treatment, passed European approval. Fourthly, GAMMAGARD LIQUID, a product
used for patients with immunodeficiency, passed approval. Finally in the year of 2011,
NEXTRONE, a product used to treat cardiac arrhythmias, was introduced in the US. 2012
brought the beginning construction phase of a plasma-derived therapies facility in Georgia, in
anticipation of rising demand. The year also brought approval to its European approved product
GAMMACARD LIQUID. Finally, the company announced partnerships in China and Brazil
which increased exposure to dialysis and hemophilia products. Lastly, 2013 was dominated with
regulatory approvals of hemophilia treatments and products in both the US and the European
Union.
General Company Overview:
Baxter International is a company with two business segments. There's the BioScience and the
Medical Products segment. In the following paragraphs, I will briefly go over what each segment
does, and include a segment description from the company's most recent 10-K (Fiscal Year End
December 31, 2013).
The BioScience segment is concerned with the processing of bio-materials to treat
acute and chronic health conditions, as well as the processing of certain medical
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goods. "The BioScience business processes recombinant and plasma-based proteins to treat
hemophilia and other bleeding disorders; plasma-based therapies to treat immune
deficiencies, alpha-1 antitrypsin deficiency, burns and shock, and other chronic and acute
blood-related conditions; biosurgery products; and select vaccines"
The Medical Products segment manufactures medical devices, as well as providing
goods and services to drug-related businesses and treatment of kidney-related disease.
"The Medical Products business manufactures intravenous (IV) solutions and
administration sets, premixed drugs and drug-reconstitution systems, pre-filled vials and
syringes for injectable drugs, IV nutrition products, infusion pumps, and inhalation
anesthetics. The business also provides products and services related to pharmacy
compounding, drug formulation and packaging technologies. In addition, the Medical
Products business provides products and services to treat end-stage renal disease, or
irreversible kidney failure, along with other renal therapies, which was enhanced in 2013
through the acquisition of Gambro AB (Gambro). The Medical Products business now
offers a comprehensive portfolio to meet the needs of patients across the treatment
continuum, including technologies and therapies for peritoneal dialysis (PD), in-center
hemodialysis (HD), home hemodialysis (HHD), continuous renal replacement therapy
(CRRT) and additional dialysis services. "
Corporate, business, and Functional-Level Strategies:
Baxter International’s corporate strategy is focused on related diversification. Going back
to the company’s history, much of the company’s success has been through its horizontal
movement to related areas in its industry, for example, the move into the renal field in the 40’s,
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and the movement into hemophilia as well. With its research and development abilities, the
company is able to add value to those products through its innovative core competency. The
company’s corporate strategy in the past also included the spin-off of certain areas of its
business, including a medical products distribution business in 1996, known as Allegiance
Corporation, and a cardiovascular business in 2000, known as the publicly traded company
Edwards Lifesciences, a publicly traded stock which has gained 1315% since the spin-off (as of
10/25/2014). But overall, the company focuses on related diversification because as stated in the
company’s 10-K, “no single company competes with Baxter in all of its businesses”
Baxter’s business strategies in both of its segments are focused on the concept of product
differentiation. Heavy research and development expenditures are focused on innovative
technologies, in order to keep up with competition and provide reliable products.
However, even though cost leadership is not a primary strategy, it is still an important
concept to consider. With the Healthcare industry changing in ways where more heavily
government-controlled economies are awarding orders to the more reasonably priced suppliers,
and a similar situation unfolding in the US as the Affordable Care act is forming consolidated
hospitals with larger market powers, Baxter should better control its costs so that less costs are
being eaten by the hospitals.
Regarding functional-level strategies, the company's source of value is by far, its
innovation, a major value factor in the medical supplies industry. Without its innovation, Baxter
would not be able to maintain its competitive edge by maintaining its top line. Quality is another
strategy, as the reputation of Baxter’s brand name is well respected.
Life Cycle:
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The company is in an early mature, late growth phase, as is the industry it operates in, and a
growth stock as well. Highly demanded technologies are continuing to surface, and sales are
progressing, and still expected by sources like ValueLine and Baseline, to grow. Because of
these technologies that surface from time to time, you have the businesses in this industry,
including Baxter, moving from mature stages, to growth stages as these new technologies are
developed, approved through government regulation procedures, and brought to markets.
I have also calculated Baxter’s beta to the S&P 500 since October 1st, 2010, and the
resulting figure was 0.82, meaning the company is not that closely correlated to the economy,
especially with an r squared of 0.43. The reason being is because the company is mostly affected
by the introduction and demand of products it develops, which results in more independence
from the economic business cycle of the US. That is not to say that the business cycle has no
effect on the company. The phase of the economy is still important, as it affects whether
hospitals and other purchasers spend or hold on to their financial resources, and whether or not
they are able to continue financing their purchases from Baxter.
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Product Lines, Major Products, and Marketing:
Product Lines and Products
Baxter International’s business is straightforward. Operating in two business segments, the
company researches, designs, and manufactures medical supplies, as well as provide medical
services to its companies. Here is a list of the company’s top grossing divisions by segment:
In the BioScience segment, Baxter’s main divisions are:
Hemophilia
o The Hemophilia division, as labeled in the name, is related in producing solutions
for patients with Hemophilia, including blood clotting proteins, and inhibitor
therapies.
o “Hemophilia includes sales of recombinant factor VIII products and plasma-
derived hemophilia products (primarily plasma-derived factor IX, factor VIII and
inhibitor therapies). Recombinant and plasma-based hemophilia products were
previously reported in separate product categories.”
BioTherapeutics
o The BioTherapeutics division deals with antibody and plasma-based therapies.
o “BioTherapeutics includes sales of the company’s antibody-replacement
immunoglobulin therapies and other plasma-based therapies, such as albumin and
alpha-1 antitrypsin products. Antibody therapies and other plasma-based products
were previously reported in separate product categories.”
BioSurgery
o The BioSurgery division deals with medical equipment used for tissue repair,
sealing, and homeostasis.
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o “BioSurgery consists of biological products and medical devices used in surgical
procedures for hemostasis, tissue sealing, adhesion prevention and hard tissue
repair, as well as soft tissue repair and microsurgery products.”
Vaccines.
o The Vaccines division deals with vaccines for meningitis C and flu shots.
o “Vaccines consists primarily of vaccines for meningitis C and tick-borne
encephalitis, as well as ongoing collaborations for the development of seasonal
and pandemic influenza vaccines.”
In the Medical Products segment, Baxter’s main divisions are:
Fluid Systems
o The Fluid System division deals with intravenous (IV) products
o “Fluid Systems principally includes IV therapies, infusion pumps, administration
sets and premixed and oncology drug platforms. IV therapies were previously
reported with nutrition products in IV Therapies, and Infusion Systems and
Global Injectables were previously reported in separate product categories.”
Renal
o The Renal division deals with dialysis products.
o “Renal consists of therapies for PD, HD, HHD and CRRT. Effective September
2013, the Renal franchise includes the results of Gambro. Refer to Note 4 for
additional information.”
Specialty Pharmaceuticals
o The Specialty Pharmaceuticals division deals with anesthetics and nutrition.
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o “Specialty Pharmaceuticals principally includes nutrition and anesthesia
products. Nutrition products were previously reported within the IV Therapies
product category and anesthesia products were previously reported as a separate
product category.”
BioPharma Solutions
o The BioPharma division deals with pharmaceutical partnerships and drug
preparation.
o “BioPharma Solutions principally includes sales from the pharmaceutical
partnering business and pharmacy compounding services, which were previously
reported with the Global Injectables product category.”
Marketing
All of these products are mainly aimed at healthcare facilities, such as hospitals, as well as
smaller sized clinics and doctor offices.
Baxter’s marketing strategies for developing such products and bringing them to market
would include maintaining relationships through its own direct sales force, through independent
distributors, and drug wholesalers.
Because Baxter is the respected company that it is, it must maintain that image by
maintaining its customer service. Customer service in the healthcare industry is important,
because it is one of the factors which play important roles in sales generation. For example, if a
hospital buys a complicated piece of machinery, say a certain type of surgery equipment, the
hospital is placing a trust in Baxter that its products will provide smooth operations for the
certain procedures in the hospital the surgical product will be used for. If the equipment proves
unreliable, or poor product training leaves the doctor clueless in the middle of an operation, then
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the hospital faces liabilities over malpractice, whether it’s due to the failure of the equipment or
the performing doctor. High-risk products have to give purchasers confidence in their purchase
of the equipment, not only with high quality performance, reliability, and services, but also with
great customer service that enables Baxter’s reputation to add value to its image.
Operations:
Integration
Baxter International is a highly integrated company. It develops, manufacture, and markets its
products, while also providing customer service, hitting all four stages of the value chain,
excluding the phase of generating raw materials.
Labor
The company requires properly educated individuals who may add to the innovation, quality, and
cost effectiveness of the company. Going on the company’s career page, a variety of fields are
available. Fields requiring less formal education are manufacturing and sales, even though sales
requires you have three years of experience in the related field of healthcare sales. The quality of
labor varies from region to region. For example, in Suzhou, China, an operator 1 position
requires high school completion as the minimum education level. In Los Angeles, besides
experience, the lead operator requires a bachelor’s in engineering or some scientific discipline.
Important Expenditures
The top two important expenditures for Baxter are Cost of Goods Sold and Research and
Development costs. These two costs are essential to the company’s success because COGS need
to be controlled, so that customers may afford to purchase Baxter products. Research and
Development costs are also important because this is where the company’s growth comes from.
COGS is what makes the products attractive on the consumer end, and profitable on Baxter’s
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end, while R&D enables the growth of sales, and with the growth of sales comes the
expenditures on COGS. R&D costs for 2013 were 8.2% of net sales, while COGS was 50.2% of
net sales.
Competition
As mentioned before, no company competes with Baxter in all areas of its business, but that does
not grant the company immunity from other entities. Regardless of the company’s BioScience
segment advantages in innovation and customer relations, and the Medical Product’s advantage
in range of product availability, both of its segments still deal with a lot of competition. The
company’s BioScience segment experiences competition from pharmaceutical and biotech
organizations. The company’s Medical Products segment faces competition from medical device
manufacturers, as well as pharmaceuticals.
International competition is also increasing, due to the increasing saturation international
competitors have in marketing and distribution, as well as their growing manufacturing
capacities.
As mentioned before, customers are also consolidating, which results in the increasing
bargaining power of purchasers, meaning prices can be reduced easier by the power of the
purchaser. The probability of securing sales also decreases since there are less customers, and a
relatively higher number of competitors to satisfy those scarcer purchasers.
The following is a list of Baxter’s competition, provided by BaseLine:
CompetitorsSymbol
Current Market Cap. (Billions)
2012 Sales (Mill)
Sales Growth
2013 Sales(Mill)
Johnson & Johnson JNJ 290.9 67,224 6.1% 71,312Pfizer Inc, PFE 184.6 58986 -12.5% 51,584Abbott Laboratories ABT 63.8 37874 -42.3% 21,848Boston Scientific Corp. BSX 17.2 7,249 -1.5% 7,143
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Management
Baxter’s corporate governance consists of a board with six committees, including audit,
compensation, corporate governance, finance, public policy, and science/technology.
The Audit committee is a four-person committee responsible for overseeing internal
audits of the company, discussing financial statements, and setting the policy for hiring internal
auditors.
The compensation committee is responsible for deciding how much to compensate the
company’s officers.
The corporate governance committee is responsible for organizing and maintaining the
structure and member ship of the board of directors, and reviewing the performance of its
members.
The finance committee is responsible for recommending financial decisions, such as
opinions on divestitures, dividends, reviewing pension assets, and the company’s investment
policies.
The public policy committee is concerned with reviewing regulations and compliance
with laws, as well as reviewing government affairs, and community relations (including
charitable contributions).
Lastly, the company’s science and technologies committee deals with the oversight of
research and development, reviewing technology platforms, and trends in the world of science
and technology.
Overall, the company’s board of directors show a promising level of guidance over
corporate policies.
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The company’s CEO is Robert L Parkinson. He has served as CEO for Abbott
Laboratories, a pharmaceutical and healthcare company from 1976, to the time he retired in 2001
as Abbott’s Chief Operating Officer. 12% of his pay is fixed, 18% comes from a bonus, and the
remaining two 35% income items come from stock options and performance share units. The
size of compensation does not seem to be excessive, given the company’s gross margin for 2013
was $7.595 billion, and Parkinson’s total salary was $0.016 billion, an amount which was .44%
of total marketing and administrative expenditures.
Despite growing sales, there have been a couple of issues worth noting. One is a flu
vaccination recall in 2011 where 300,000 flu vaccines were tainted. The other, more serious
issue, was a 2008 recall on Heparin, a blood-thinning product, which resulted in 81 deaths in the
US. This issue was linked to counterfeit ingredients being used in the drug, something which
may have been avoided if the company had more controls in place. The issue was resolved with
compensating the families of the victims, and performing evaluations on its Chinese operations.
More recently, there was a worldwide recall on IV solutions. The products seemed to be unclean,
and because of what these products are used for, them being unclean could have resulted in
various reactions, from allergic reaction to more severe reactions, given the patients using this
product are very diverse. But the actions of management were quick enough that no adverse
cases were reported.
Overall, management seems to be working effectively. Overseas operations should be
monitored more strictly, especially regarding operation controls, so that there may be less recalls,
and Baxter’s valuable brand image may be maintained.
2008 recallhttp://news.medill.northwestern.edu/chicago/news.aspx?id=220861
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2014 recallhttp://www.fda.gov/Safety/Recalls/ucm405469.htm
2013 10-Khttps://www.sec.gov/Archives/edgar/data/10456/000119312514061654/d596470d10k.htm
2013 DEF14Ahttps://www.sec.gov/Archives/edgar/data/10456/000119312514109172/d664387ddef14a.htm
Comparative Financial Statement Analysis and Basic Financial Information:
Basic Financial Information
BAX Exhibit 1
Financial Measurements BAX
Beta0.75306
7
P/E14.4276
9ROA 0.59399
ROE1.79813
8Net Sales 2013 15259Net Sales 2012 14190Net Inc 2013 2012Net Inc 2012 2326
2013 Profit Margin0.13185
7
2012 Profit Margin0.16391
8
2013 Gross Profit0.49773
9
2012 Gross Profit0.51451
7
117
Beta and all of the ratios were calculated manually. Beta was calculated by using the SLOPE equation in Excel, where Yahoo! Finance daily historical prices were used for the calculation. The period for the calculated was from May 20th, 1992, to 10/3/2014. The 2013 10-K report was used to obtain Sales, Net Income, and calculate the Profit and Gross Margins, ROA, and ROE. The P/E was obtained by using the 10-K Basic Earnings Per Share, and the 10/3/2014 closing day BAX price traded on the New York Stock Exchange.
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Comparative Analysis
For this section, please refer to the following tables:
BAX Exhibit 2- General Information
Company Beta P/E 2012% Growth 2013
Gross Profit
Average Tax Rate
Profit Margin
ABT 0.60
20.28
$ 37,874 -42%
$ 21,848 58% 21% 12%
BAX 0.63
14.43
$ 14,190 8%
$ 15,259 50% 11% 13%
BSX 0.92
26.20
$ 7,249 -1%
$ 7,143 73% 27% -2%
JNJ 0.61
17.91
$ 67,224 6%
$ 71,312 74% 5% 19%
PFE 0.81
18.13
$ 58,986 -13%
$ 51,584 85% 46% 43%
BAX Exhibit 3- Efficiency
Company ROA ROEInventory Turnover
Latest AR Turnover (TTM)
A/P Turnover
ABT 6.0% 10.2% 8.112885258 3.77 5.676939426BAX 7.8% 23.7% 4.360960274 5.72 1.802695418BSX -0.7% -1.9% 7.963210702 5.66 7.9833JNJ 10.4% 18.7% 9.052043666 6.2 3.078614533PFE 12.8% 28.8% 8.365877392 4.75 2.23493095
BAX Exhibit 4- Liquidity
Company
LTD/OE
Quick Ratio A/P Turnover
OCF/Liabilities
ABT0.32875
12.02450
8 5.676939426 0.186930604BAX 1.35246 1.69387 1.802695418 0.183972847
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3 1
BSX1.25523
81.65076
8 7.983263598 0.107854864
JNJ0.44501
92.19696
2 3.078614533 0.29701518
PFE0.94916
62.40708
7 2.23493095 0.185450028
Baxter International was compared amongst four other competitors, along a four year period, from years 2010 to 2013.
General Information
BAX had the lowest P/E among all four competitors. o Its P/E was 14.4, while the closest P/E ratio from a competitor was JNJ, with a
P/E of 17.9. o This shows us that buying a share in BAX’s earnings is relatively cheaper than
buying a share in other competitors’ earnings. Looking at sales from 2012 to 2013, BAX experienced the highest percentage growth in
its sales.o Its P/E is 8%, with JNJ the closest behind with a 6% growth (JNJ still has about
5x the amount of sales than BAX). o All 3 other competitors experienced negative growth rates in sales.
If we look at operational performance in terms of retaining sales from expenses from operations, BAX has the lowest 2013 gross margin.
o Its gross margin is 50%. PFE holds the highest gross profit margin of 85%, 1.7x
larger than BAX. o To get a more complete picture, BAX has $7.6 billion dollars after operational
expenses. PFE has $43.8 billion, an amount which is about 5.8x than BAX’s figures.
Since BAX lags behind its competitors’ gross margin figures, we can give an educated guess that its profit margin will also be the lowest, which it is.
o Its profit margin is 13% (BSX has negative earnings and therefore has a negative
profit margin).o This gross profit percentage shows us that BAX is most likely an R&D-centered
company. Unlike a company in this industry which would have a cost leadership strategy and a narrower profit margin, BAX has a sizeable profit margin. This of course means that the company has to make sure that its R&D expenditures are being spent as effectively as possible since innovative products are the main generator of the company’s sales.
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Efficiency
BAX has the third highest ROA and the second highest ROE. o The company’s ROA is 7.8%, outperformed by JNJ (ROA 10.4%), and PFE
(ROA28.8%). o The company’s ROE is 23.7%, outperformed only by PFE (ROE 28.8%).
o This shows us that BAX’s management is performing fairly well.
o Having the third highest ROA, Baxter seems to be utilizing its assets at a fair
level. This also shows that there is less net income left over, which could indicate that the reason why this figure is so low is because the company spends its gross margin on R&D. However, this is not the case since the company only spends about 8% of its sales on R&D. The company should therefore either effectively increase R&D focuses, or improve operation efficiency.
o Having the second highest ROE shows that the company utilizes its capital well.
However, the company has high debt levels in comparison to its competitors, so it’s no surprise that ROE is high.
BAX has the highest total assets turnovero Its total assets turnover figure is 59%, with the closest competitor being JNJ at
54%.o This shows that more sales are being generated per assets. BAX is, so far, doing
an excellent job by utilizing its assets. BAX has the second highest accounts receivable turnover
o Its receivables turnover figure is 5.72, outperformed by JNJ (A/R turnover 6.2)
o This means that BAX collects its receivables quickly, which is a good thing. It
shows that its credit policy is not too strict, where it would have a lower turnover, and its credit policy is not the most risky, where just anyone will be able to place a credited sales order (which would result in a higher turnover rate).
Liquidity and Solvency
BAX has the highest long-term debt to equity ratio,o Its LTD/OE ratio is 1.35, followed by BSX with a ratio of 1.26.
o The dividend investor would find this unattractive since BAX is focused on
pleasing the creditor more with interest payments than the equity holder with dividend payments.
BAX has the second lowest quick ratio.o Its quick ratio is 1.69, with the next quick ratio figure coming from ABT (quick
ratio 2.02). BAX has the lowest accounts payable turnover ratio.
o Its A/P turnover ratio is 1.8, with PFE having the second lowest figure coming
from PFE (A/P turnover ratio 2.23).
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BAX has the second lowest operating cash flows to liabilities ratio.o Its OCF/L ratio is .18.
o Two other companies (ABT and PFE) nearly tie with BAX, having OCF/L ratios
of .19 (due to rounding). BAX has an acceptable times interest earned ratio.
o Its times interest earned is about 20.
o JNJ has the largest times interest earned figure of about 32.
o Although BAX doesn’t have as high a times interest earned ratio as JNJ, it is
because the company is more heavily financed by debt. Even so, this is an acceptable level since it shows that BAX is able to pay off the interest of its debt effectively and in a timely manner.
Financial Statements
Income Statement:
Comparing Baxter to its competitors, we make several notes on operations. Regarding tax
efficiency, Baxter usually pays a higher tax rate than JNJ and ABT, However, it was not the
worst either. Compared to the averaged figure of all 5 companies, Pfizer still ended paying about
6 percentage points more.
If we take a look at Baxter’s 5 year sales, sales have increased on average, 4% annually.
This 5 year growth was taken measured with a recession as the starting year, meaning it is
natural for sales to have increased since that recession period. However, sales figures still appear
to be strong. During those five years, gross margin has stayed in the 50%s range, with the 2013
gross margin ending at a slightly more efficient figure than the beginning year in 2009.
Moving on to operations, we can see that R&D expenses are increasing, while net income
is decreasing due to these expenditures. While it is good to focus on R&D, it is also important to
control R&D expenditures, so that there is still a healthy bottom line which may be used to
finance other activities, such as updating equipment. Baxter
Balance Sheet:
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One of the advantages with issuing debt today as a means of financing operations, is that
interest rates are very low. Baxter is able to use this to its own advantage, being that it is more
heavily financed by debt.
The company also has a healthy level of cash, however, it has no short term investments.
Having short term investments is beneficial because it grows cash funds that are not being
utilized and helps ease the burden of debt, more specifically lessening the burdens of interest
rates
Accounts receivable and inventory balances seem to be growing, as well as the status of fixed
assets. Fixed assets are continuing to increase, showing the company is investing in new
equipment as well.
Overall, the company’s left hand side of the balance sheet looks healthy. The growth in
current and noncurrent assets shows very obviously that the company is still growing.
Looking at the right hand side of the balance sheet, we see a sizeable jump in the
company’s short and long term debts. Baxter is acting on the advantage of leveraging its
operations using low interest rates. Of course, interest rates will not last for a very long time, as
indicated in the economic report, so it seems reasonable that Baxter is using this opportunity to
secure cheaper leverage.
Cash Flows
Operating Activities
The top two positive items from BAX’s cash flows statement operating activities are
Depreciation and Pension Benefit charges. Depreciation was $823 million, 41% of Net Income,
and Pension Benefit Charges amounted to $381 million, 19% of Net Income.
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The top two negative items from BAX’s cash flows statement operating activities are
Inventories and Deferred Income Taxes. The Inventories activity was $(311) million, -15%
of net income, and Deferred Income Taxes was $(224) million, -11% of net income.
Investing Activities
The top two negative items for major investing activity items were
Acquisitions/Investments of Net Cash, and Capital Expenditures. Acquisitions/Investments of
Net Cash jumped by about 260% to $(3,636) million, showing the company has big plans for its
corporate strategy. Capital Expenditures totaled $(1,525), 76% of net income.
The only positive income from investing activities was $14 million from
Divestitures, .4% of cash flows from operations.
Financing Activities
Issuance of Debt was the largest positive and significant item. $3,636 came from this
activity, 113% of net income, a good strategy since interest rates are so low.
Cash Dividends was the largest negative activity, totaling $(1,023) million, -32% of net
income.
Conclusion
BAX seems to have a relatively low P/E ratio. Looking back at the previously discussed
financial figures, there are a couple reasons the company is cheap, compared to its competitors.
One reason is that it is more finance by debt, having the highest LTD/L ratio. Secondly, as a
result of being leveraged more so than its competitors, its cash flows have to be spent more on
liabilities than reinvestments.
For example, ABT has the second highest P/E ratio, meaning it’s the second most expensive
security in the table. Despite having the most negative sales growth from 2012 to 2013, it is the
lowest in the table that is financed by debt. Contrarily to BAX’s financial situation, this provides
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more of an opportunity for stockholders, because their interests are the main focus, rather than
the creditors.
However, BAX has good efficiency ratios. Its ROA is the third highest in the table, and
its ROE is the second highest. Its 2012-2013 sales growth was also the highest. It also collects
from its receivable more quickly than its competitors. While having the lowest positive gross
profit may seem bad to investors, it indicates that BAX spends a good chunk of its sales on
R&D. These R&D and marketing expenditures are what cause future sales to occur, as
innovation is what enables companies to address unmet clinical needs in the medical supplies
industry. Seeing that a company has a low gross profit, as in the case of BAX, should not be
viewed negatively since these operational expenditures are necessary to continue growing sales
and market share. Seeing BAX’s high sales growth is no surprise, given it spends 50% of its
sales on operations which include R&D and marketing.
Although dividend investors may not view this as attractively as growth investors, there
is still a sense of security in investing in a company, such as BAX, that places an emphasis on
innovation.
That said, my recommendation is to buy BAX, since it has a low P/E, but also shows good signs
of future growth, as well as a healthy financial standing. More is discussed in this company’s
Valuation section.
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Baxter’s 5 Year Income Statement
DEC DEC DEC DEC DEC2013 2012 2011 2010 2009
Revenue 15259 14190 13893 12843 12562Cost of Goods Sold 6841 6177 6177 6200 5480
Gross Margin 0.55167440.564693
5 0.55538760.517246
7 0.5637637Selling, Gen'l & Admin. 3681 3324 3154 2907 2731Depreciation & Amort. 823 712 670 685 638Research & Development 1246 1156 946 915 917OPERATING INCOME 2668 2821 2946 2136 2796
Operating Margin 0.1748476 0.198802 0.21204920.166316
3 0.222576Interest Expense 128 87 54 87 117Other Expenses (Income) -9 -155 115 166 -65INCOME BEFORE TAXES 2549 2889 2777 1883 2744
EBT Margin 0.1670490.203594
1 0.19988480.146616
8 0.2184366Income Taxes 537 563 553 463 519INCOME AFTER TAXES 2012 2326 2224 1420 2205
Net Profit Margin 0.13185660.163918
3 0.16008060.110566
1 0.1755294GAAP EPS (as reported) 3.66 4.18 3.88 2.39057 3.591Baseline EPS 4.66 4.53 4.31 3.98 3.8 Adjusted for Restatements, Unusual and Extraordinary ItemsWeighted Avg. Shares Outstanding ('000) 549000 556000 573000 594000 614000
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Baxter’s 5 Year Balance Sheet
DEC DEC DEC2013 2012 2011
Cash & Cash Equivalents 2733 3270Short Term Investments 0 0Accounts Receivable 2911 2425Inventories 3499 2803Other Current Assets 861 762Total Current Assets 10004 9260Net Fixed Assets 7832 6098Other Long Term Assets 1534 1716Goodwill & Intangibles 6499 3316TOTAL ASSETS 25869 20390Accounts Payable 1103 766Short Term Debt 1040 350Other Current Liabilities 3763 3643Total Current Liabilities 5906 4759Long Term Debt 8126 5580Other Liabilities 3374 3113TOTAL LIABILITIES 17406 13452Preferred Equity 0 0Common Equity 8463 6938 Retained Earnings 11852 10888STOCKHOLDERS' EQUITY 8463 6938TOTAL LIAB. & EQUITY 25869 20390Shares Outstanding ('000) 543037.9 546213.6 560970.5
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Baxter’s 5 Year Cash Flows Statement
(P) DEC DEC DEC DEC DEC2013 2012 2011 2010 2009
Net Income (Loss) 2012 2326 2256 1427 2215Depreciation & Amort. 823 712 670 685 638Net Changes - Assets/Liabilities -246 -297 -753 -289 -416 (Increase) Decrease in Receivables -36 -41 -229 -122 -167 (Increase) Decrease in Inventories -311 -129 -315 20 -60 (Increase) Decrease in Other Current Assets 230 138 40 -182 -59 Increase (Decrease) in Payables 329 18 98 -5 -85 Increase (Decrease) in Other Current Liab. -125 -283 -347 -79 -130Other Adjustments, Net 609 365 644 1180 472 CASH FROM OPERATIONS 3198 3106 2817 3003 2909Capital Expenditure -1525 -1161 -960 -963 -1014Acquisitions -3851 -515 -590 -319 -156Sale of Property, Plant & Equipment 14 107 123 0 0Investments (Increase) 0 0 0 0 0Cash In (Out) Flow 0 0 0 18 24 CASH FROM INVESTMENTS -5362 -1569 -1427 -1264 -1146Issuance of Capital Stock 508 512 0 0 0Repurchase of Capital Stock -913 -1480 -1583 -1453 -1216Debt Increase (Decrease) 3096 765 733 91 473Dividends -1023 -804 -709 -688 -632Other Cash In (Out) Flow -23 -108 422 334 363 CASH FROM FINANCING 1645 -1115 -1137 -1716 -1012Effect of Exchange Rates -18 -57 -33 -124 -96 NET CHANGE IN CASH -537 365 220 -101 655
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Valuation of BAX & BSX
Statement
BAX seems to be undervalued BSX seems to be overvalued
Price to Earnings:
BAX’s price, as of the closing trading day of 11/7/2014, was $70.61 a share. The
company’s Trailing-Twelve Month EPS is $4.84 a share. The resulting P/E is 14.6x.
BSX’s price, as of the closing day of 11/7/2014, was $13.24 a share. The company’s
Trailing-Twelve Month EPS is $0.50 a share. The resulting P/E is 26.5x.
The same competitors were used to value both BAX and BSX. Three competitors were
used in the valuation, including Johnson and Johnson (JNJ), Abbott Laboratories (ABT), and
Pfizer (PFE). Here is a table of the competitors’ P/E, Growth (Projected EPS growth by
ValueLine), and Risk (Beta) as well as BSX and BAX.
Company Beta Growth P/EBAX 0.63 5.7% 14.6BSX 0.92 5.7% 26.5PFE 0.81 5.2% 18.7JNJ 0.61 3.6% 18.7ABT 0.60 7.1% 20.9
To make the decision process more straightforward, I came up with a ratio that measured
the relativity of pricing between the companies, by multiplying P/E by the ratio of Growth per
Beta. The logic behind this ratio is that Growth has a direct theoretical relationship with pricing,
while risk has an inverse theoretical relationship with pricing.
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Here is a table which illustrates the process:
CompanyGrowth/Beta
P/E per Growth/Beta
BAX 0.090 1.315BSX 0.062 1.644PFE 0.064 1.203JNJ 0.059 1.097ABT 0.118 2.460
Because we now have the relationship of P/E to Growth per Risk (G/R), we can now get
a mathematical feel for the pricing of BAX and BSX. Here is the process for finding the justified
P/E and afterwards, the justified price.
Step 1. Find the Average P/E : 19.4
Step 2. Find average G/R : 1.59
Step 3. Find company’s G/R : BAX:1.32 BSX:1.64
Step 4. (Avg PE/ Avg GR) : 12.23
Step 5. Step 4 * Company GR : BAX:16 BSX:20.1
*Step 5 Results in Justified P/E
Step 6. Step 5 * TTM EPS
BAX: 16 Justified P/E * 14.84 TTM EPS
Justified Price: $79.8
15% Error Range: $67.80 to $91.73
BSX: 20.1 Justified P/E * .5 TTM EPS
Justified Price: $10.65
15% Error Range: $9.06 to $12.25
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Current Price (11/7/2014) Justified Price (% Difference from current price)
BAX $70.61 $79.80 (+13%)BSX $13.24 $10.65 (-20%)
According to the P/E valuation method, it appears that BAX is undervalued by 13% of its current market price.
It also appears that BSX is overvalued by 20% of its current market price.
I agree with these valuations. Baxter has a good growth that does seem reasonable. It is a
very innovative company that has been around thirty years before Boston Scientific. It
has grown to a very competitive size, and continues to display advantages in its
innovative capabilities. I agree that this is a fair valuation of the company.
Even though Boston scientific has been around for a while, it still hasn’t displayed the
innovation Baxter has shown in its history. Although BSX has brought innovative
technologies to the medical industry, such as steerable catheters, and stents, ValueLine
talks about its present growth coming from its POLARIS imaging product, as well as its
recent acquisitions, not to mention the industry itself is growing. That said, I believe that
the growth ValueLine has shown is reasonable, and that the market is too excited for this
stock. Thus, such optimistic anticipation is what I believe to be the cause of its inflated
pricing.
Dividend Discount Model
Using the Dividend Discount Model, it appears that BAX is, again, undervalued. Because BSX has not paid any dividends since its IPO, the Dividend Discount Model
cannot be used for the Valuation of BSX.
CAPM model used to calculate BAX’s ROR:
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CAPMExpected Rate of Return 9%Risk Free Rate 2.30%Beta 0.629Required Rate of Return 6.5%
Being an accounting major, it’s in the nature of my education that makes me value things
conservatively. That said, I have viewed the dividend payment history of BAX. Dividend growth
tends to happen every 4 quarters. Since 12/12/2001, the company has deviated from its normal
tendency to increase dividend payments every four quarters, 4 out of 9 times. Dividend payment
growth also seems to increase during each of those periods when per share dividend payment
increases. There have been 2 instances out of 9 dividend growth changes that were negative, but
they happened during the crashes of 2001 and 2007.
I chose to calculate the value of BAX by using a conservative, constant growth rate. Even
though Baxter isn’t your typical mature company judging by the fluctuations in its dividend
growth rates, but that is mainly due to the fact that Baxter is also a company focused on
innovation, which may affect the bottom line differently during different business periods, which
affects dividend payments. That is why I define Baxter as a mature company.
I used the conservative growth rate of 6.12% as the average 4 quarter dividend growth
rate. Sure, there may be economic periods that will hit Baxter hard, such as the Internet bubble
Baxter experienced in 2001, and right before the subprime mortgage crash of 2008, but I expect,
at the bare minimum, over time, that there will be at least a 6.12% growth rate.
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Using the next expected dividend payment of $0.52, which I am 43% confident (5/9 *
7/9) will occur, and dividing that figure by the difference between the rate of return (6.5%) and
by the growth rate (6.12%), we get a value of $133.
But because the required rate of return and the growth rate are very close together, the
valuation may be too optimistic. 6.12% is the bare minimum I expect dividend payments will
grow at. That implies that I expect periods where the growth rate will surpass the required rate of
return, making the Dividend Discount Model less irrelevant for the use of the company’s stock
valuation.
While I believe that BAX is undervalued, I believe that the P/E method is more
relevant.
o If I would weigh the valuation methods, with the P/E method assigned a
75% weight and the DDM a 25% weight, the valuation would be $85
([$80 * 90%] + [134 * 10%]), which seems more reasonable.
Price to Cash Flows Method
Using the Price to Cash Flows Method rather than the Dividend Discount Model, BSX
appears to be overvalued.
The same thinking process was used in this method, except instead of using Beta as risk, I used
Long Term Debt to Equity, and instead of using EPS growth, I used the growth resulting from
multiplying retention rate by calculated projected ROIC.
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Here is a table with all the necessary values:
Companies
CF per Share P/CF LTD/E Growth
Growth/Debt:Equity
BSX 1.10 12.04 1.26 8.0% 0.064BAX 6.70 10.54 1.35 7.2% 0.053PFE 2.65 11.29 0.95 1.8% 0.019JNJ 7.60 14.24 0.45 6.0% 0.135ABT 3.00 14.46 0.33 7.0% 0.214
Step 1. Find the Average P/CF : 13.3
Step 2. Find average G/R : 0.12
Step 3. Find company’s G/R : 0.06
Step 4. (Avg PCF/ Avg GR) : 108.42
Step 5. Step 4 * Company GR : 6.91
*Step 5 Results in Justified P/CF
Step 6. Step 5 * 5 year leading CFPS
6.91 Justified P/CF *$1.5 5 year leading CFPS
Justified Price: $10.36
15% Error Range: $8.81 to $11.92
Current Price (11/7/2014) Justified Price(% Difference from current price)BSX $13.24 $10.36 (-22%)
The results speak for themselves; BSX is overvalued by 22% of its current market price.
Compared to the valuation of BAX, it makes sense. BSX nearly had the same statistics as BAX.
BSX was slightly less riskier, and had a 10% higher projected growth, but its P/CF was about
20% higher than BAX. It’s no coincidence why we see BSX being roughly that amount
overvalued. It should be at a relatively close P/CF to BAX since the two stocks are nearly
similar, but as mentioned before, the market is too optimistic about this stock.
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Conclusion:
Looking strictly at the numbers, BAX is undervalued and BSX is overvalued. BAX looks
like a better investment than BSX. For that reason, I recommend to buy BAX stock and keep
BSX out of the investment fund. However, this is strictly looking at the numbers.
We should still be sensitive to headlines in the biotech industry. For example, BSX is into
cardiology, and with the first “dead heart” transplant occurring in Australia earlier on this year in
October, this may be a significant growth opportunity for BSX the company acts on it. But as of
now, I still feel BSX is overvalued, and do not recommend buying its stock.
Studying BAX’s business, I have been impressed with the company’s achievements in the past.
Innovation is a key player for the company, but it is also a concern. Having BAX grown to the
size that it is, it must continue to develop its products and generate sales, and keep performing as
it has done in the past, by bringing revolutionary products to market. It has been acquiring
companies, which is a good investment strategy, to spread itself in a growing industry, but it
must make sure that its management effectiveness and innovative processes are not diluted
throughout time. Regardless, I still believe that BAX is a great company to invest in, and agree
with its justified pricing.
Buy Baxter International.
Do not buy Boston Scientific.
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ReviewLockheed Martin- Undervalued- Buy
Baxter International- Undervalued- BuyBoston Scientific- Overvalued- Don’t Buy
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