© 2000 John Petroff

2)- Age of company and profitability

The age of a company has a major impact on profitability. The beginning and the end of a company's life have processes that are unusual by comparison to most normal operations. We look at two industries that are going through each of these processes.

a)- New growth industry: example of computer services

The first year, the company must become known to its customer, but sales rarely pick up enough to cover expenses. The longer the cash cycle, the longer it will take for the company to set up production, build up inventory, attract customers, and generate revenues. In Chapter 8, the cash cycle of six industries was calculated: retail and services had the shortest cash cycles of less than 10 days, manufacturing of pharmaceuticals and machinery had the longest cash cycles of over 90 days, wholesale and utilities had cash cycles somewhere in between. The cash cycle of computer services can be especially short.

Computer services which includes prepackaged software, computer data processing, information retrieval, computer programming, computer systems design and other computer services, is not a truly new growth industry. It has been around for at least a quarter century. But it had two bursts of growth: one in the early 1980's with the need for new software to use on PC's, and the second in the late 1990's with the need to place and retrieve information on the internet. Table T-13.14 presents the pattern of net margin and ROE for a number # of firms applying for loans during the two growth periods.

The table shows an increase in the number of loan applicants during each growth period in each of the industries that was emerging. It also shows a very high ROE of over 40% for each of the groups of companies involved in the expansion. The striking data in Table T-13.14 is the losses incurred by the majority of firms in 1999. Note however that data processing firms were not involved in expansion associated with the internet and they did not experience losses; moreover, their number actually decreased compared to the mid 1990's. The losses were incurred by the firms rushing to capture recognition on-line, and spending large sums of money to do that. For many new firms, especially small one, large losses resulted in negative net worth, as can be seen in the Pbt/Sales and NW/TA statistics arranged by size of sales in millions for eight computer service industries in Table T-13.15 below.

For the firms that were successful and avoided negative net worth, the returns were very high as can be seen in the ROE columns in table T-13.15. (Note that ROE statistics in tables T-13.14 are calculated differently from those in T-13.15: in T-13.14 an average of median values is shown, and in T-13.15 it is a median of median values. In both tables firms with negative net worth have been excluded to avoid gross distortion, and this biases both statistics upwards somewhat.)

The lesson from these statistics is that a new growth industry will experience a great deal of instability and dispersion. The potential for future earnings justifies incurring enormous losses by some firms. The losses are made possible by large sums of venture capital being poured into the industry. Firms that establish themselves quickly, become extremely profitable and accumulate free cash. The large number of entrants suggests that not all firms will survive. Some of the small firms will be acquired by the wealthy few, and the majority will fail. This is clearly a very risky industry, but also full of opportunity. With changes coming very fast, fortunes can turn in a matter of months, if not days. In an industry like this, financial analysis is usually too late to capture a new shining star, or avoid a burning comet. The real analysis requires gathering opinions of users of newly introduced products to determine if they can outperform existing products.

b)- Declining industry: example of leather shoes

The leather shoe manufacturers in the United States are unable to compete with imports.
Over the past 30 years, the industry has shrunk by two thirds. Table T-13.16 presents key statistics for the US shoe industry for selected years from 1980 to 1999.

If we look at ratios such as current, DSO, DSI, DPO, TIE, sales turnover, debt/equity in Table T-13.16, they are all in line with the manufacturing sector presented in Table T-10.13, Normalized average balance sheet of eight US sectors in 1999, except for profitability. Leather shoe industry ROE is only 5.7% compared to around 20% for other sectors.

Table T-13.16 reveals that compared to 20 years ago, all the ratios have deteriorated a little: current ratio went down from just above 2 to just below 2, DSI has stretched to over 100 days, equity declined from upper 40% to lower 40%, long term debt also decreased, but short term debt increased, and the combined debt went to twice the equity as opposed to one-for-one before, and consequently TIE deteriorated from over 4 times to about 2.5 times. All these are small signs of struggling firms. Even more telling is the worsening of profitability. The late 1990's was not a period of recession. Personal consumption expenditure was at an all time high. Yet ROE dipped below 6%. There is clearly no hope for an improvement. Owners compare this miserly return to what they can hope in alternative investments that generate at least twice as much (i.e. even utilities that have the lowest ROE, earn 12%). This is an industry that needs to reinvent itself. Firms have to find new products to take them into new growth markets.

See review questions Q-13D2.1 through Q-13D2.5.

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Last modified: Jun/01/01

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