Financial Analysis of SBC Communications Prepared by: Eric Hall, Eric Rems, Abby Alexander, Ben Brantmeier, & Laura Foster

Transcription

1 T-Squared Financial Financial Analysis of SBC Communications Prepared by: Eric Hall, Eric Rems, Abby Alexander, Ben Brantmeier, & Laura Foster 0

2 Analysis of SBC Corporation Report by T- Squared Financial: BB, ER, EH, AA, LF Investment Reccommendation: Buy SBC-NYSE (11/1/04) $25.97 EPS Forecast 52 Week Range $ FYE 12/ E 2005E 2006E EPS $2.56 $1.45 $1.36 $1.32 Revenue 40.8B Net Income 6.23B Market Capitalization 85.6B Ratios Firm Competitors Averages Shares Outstanding 3.31B P/E Ratio PEG Ratio Current Div. Yield 4.8 P/S Ratio Dividend Per Share 1.25 Valuation Predictions Book Value Per Share Actual Current Share Price $25.97 Return on Equity 15.85% P/E Valuation $30.42 Return on Assets 6.18% M/B Valuation $23.26 DPS/PPS Valuation $20.16 P/S Valuation $16.37 AEG Valuation $ Residual Income Valuation $68.94 Discounted Free Cash Flows $76.74 Discounted Dividends Valuation $20.92 Long Run Avg. of RI $61.32 % Change in SBC Share Price Compared to S&P 500: We Recommend SBC as a Buy as its current market price is significantly below our predicted market prices based upon our valuations. SBC has great future potential due to its focus on expanding into more prominent areas of interest, such as its acquisition of Cingular Wireless in the cellular services industry. With an increase in net income from 5.7 to 8.5B over the past 2 years, we feel that this growth will remain and increase. SBC s profitability ratios have indicated a turn around in their overall profitability throughout the past five years. 1

3 Business Summary Industry and Competitors With annual revenue of over 41 billion dollars, SBC is taking strides in becoming the current and new leader in the telecommunications industry. SBC is one of the largest and fastest growing telecommunications companies in the industry. They have built a diversified network of products and services that can be used for all of the consumer s communication needs. Focusing on service innovations, cost efficiency, customer relations, and service quality are SBC s four main success factors. These factors are used in order to sustain a competitive edge of their competitors. Because the telecommunications industry is difficult to enter, SBC needs to focus mainly on those already existing competitors. In order to gain market share over these competitors, SBC needs to direct their attention to a cost-leadership strategy. It is also important to drive costs down because of the high bargaining power that consumers possess. Although over the past few years SBC has done a poor job in organizing their cost structure, they recently have focused major efforts in this area of management. Another area where SBC has focused their attention is innovation. With the development of their new fiber optics network, they will be able to move forward while maintaining a cutting edge advantage over their competitors because of their growing size and ability to offer a wide variety of products and services. Overall, the telecommunication industry is a highly competitive market and SBC continues to be a leader in the industry. Accounting Analysis While doing the accounting analysis we identified the significant accounting policies in relation to SBC s key success factors. SBC s most important policies concern recognizing revenues, allowance for uncollectibles, directory accounting, depreciation accounting, goodwill and other intangible assets accounting, property, plant and equipment, and software costs. After assessing that SBC has some degree of accounting flexibility, we determined that its flexible policies are similar to industry norms. These policies and estimates were found to be reasonably accurate and realistic with no major 2

4 adjustments or illegitimate changes. SBC s quality of disclosure was observed to be clearly conveyed and adequately broken down into more understandable terms. While reviewing their policies and disclosure, no evidence of economic manipulation or distortion was found. Since no accounting distortion was revealed, it was not necessary to undo any distortions. Ratio and Forecast Analysis The ratio analysis is a very important aspect of the overall valuation of a company because it is a good indicator of how SBC compares to its major competitors in the industry. After evaluating SBC and comparing their results to those of their competitors and the averages of the industry, we found that, overall, SBC is fairly consistent with the industry averages. While SBC s liquidity ratios showed they did not have much ability to liquidate quickly and turn their assets to cash easily, their profitability ratios showed, for the most part, that they were consistently outperforming the industry averages. The capital structure ratios also show significant signs of outperforming the industry. We also used the EBITDA and PP&E turnover ratios because they are applicable to our industry. Sometimes outperforming the industry average and sometimes performing below the industry average, SBC is a solid company that has a track record of consistent performance in the marketplace and their industry. The forecasted revenues for SBC were estimated to steadily climb back to a sustainable growth rate. It starts in a lower dip, then increases in the next ten years; this is due to a slowly rising growth percentage which peaks at 5.50%. The rest of the income statement figures correspond directly with this growth rate; although, certain expenses were estimated to remain fairly constant through the forecast. The forecasted balance sheet consists of moving averages of historical figures. Total assets as well as total liabilities and stockholders equity remain very steady through the next ten years maintaining numbers around $95,000 (in millions). The statement of cash flows was determined to generate free cash flows that eventually start to increase steadily in the next four years to peak at approximately $5,000. Overall, SBC forecasted financials are estimated to steadily grow over the next ten years. 3

5 Valuation Analysis Throughout the valuation analysis we were able to estimate what SBC was actually worth and decide whether they under, over, or properly valued. After performing intrinsic valuations as well as the method of comparables, we determined that SBC is currently being undervalued. Almost all of the intrinsic valuations indicated that SBC is worth almost double what the market place is currently stating. This is possible because many of our valuations were based upon future growth which gives SBC the opportunity to expand. We found this to be accurate because of their recent merger with Cingular Wireless, and their aspirations for future growth. By instituting a sensitivity analysis we were able to vary SBC s growth rate and cost of equity. This gave us the opportunity to factor in errors in our WACC and cost of equity computations. After performing the analysis we felt more confident in our accusation that SBC is being under-valued because almost all reasonable growth rates and cost of equities, displayed SBC to be undervalued. Overall, we placed a buy on SBC s stock because of our estimations. 4

6 Company Overview SBC Communications is a telecommunications company based out of San Antonio, Texas, and through its subsidiaries provides communications products and services in about one third of the United States and holds investments in more than 25 countries. SBC offers a variety of products and services such as voice and data telecommunications products and services for consumers and businesses, local and long distance telephone service, DSL, and wireless, data networks, satellite television and directory. They currently serve more than 54 million access lines nationwide while employing about 168,000 people. In the 2003 year, SBC obtained $41 billion in revenue with $8.5 billion in net income. SBC offers its products and services to businesses, consumers, and other service providers of telecommunications services. The company s products and services are marked under several brands including SBC, Cingular Wireless, and SBC Yahoo, and just recently, AT&T Wireless Service. SBC is a Fortune 50 company that is one of the 30 stocks that make up the Dow Jones Industrial Average, and is currently sold on the New York Stock Exchange. Industry Overview The telecommunications industry has been a rapidly growing industry that has resulted from the existence of many small companies to the takeover and control of a few select larger powerhouse companies. Some of the major competitors of SBC Communications are MCI, AT&T, Cox Communications, AOL Time/Warner, and Verizon. Over the past 10 years, there have been a series of mergers and acquisitions that have increased the size of certain companies while reducing the current number of companies within the telecommunications business. The acquisition of AT&T and Yahoo by SBC has enabled them to become one of the stronger and faster growing companies within the telecommunications industry. The telecommunications current ratio industry average has been decreasing in the past five years while SBC s current ratio has been steadily increasing over the past five years. 5

7 Rivalry Among Existing Firms SBC Communications is one of the largest telecommunication companies in the world. They directly compete with many other firms in their various sectors of operation, although their main competition comes from other telecom powerhouses such as MCI and AT&T. Due to the high demand for their products and services, SBC and their competitors are seeing a rapid growth in the overall telecommunications industry, mainly due to the de-regulation of the industry and many new technological advancements. This rapid growth in the industry gives SBC a competitive advantage in gaining market share because of their extensive product bundling. In the telecommunications industry there are many competitors but only a few leaders. These leaders are able to dictate and set the overall prices for the others to follow. Product differentiation is limited, therefore, staying competitive with pricing and customer service is necessary to gain and maintain market share. Due to the infrastructure of the telecommunications industry as a whole, leaving the industry can be a costly venture because of its specialized equipment and expansive networks. This makes for an incentive for the companies to stay competitive in the industry by setting prices at a reasonable level and keeping their customers content. Threat of New Entrants Today, the telecommunications industry as a whole has a huge market opportunity but, due to the high costs of equipment, few companies are able to enter and compete effectively. Probably the biggest barrier to entry into the telecom industry is finding a source of financing. This is a capital-intensive industry where fixed costs are high and a lot of cash is a must. Because SBC was one of the first movers in the industry, they have been able to create a vast, loyal customer base, which makes it hard for new entrants to gain market share. However, because the switching costs are so low, SBC must provide a quality product and quality customer service in order to retain its customer base. Due to 6

8 the strong relationships between existing telecom firms and their customers, new entrants find it difficult to steal market share from these already dominant companies. Legal barriers are also a major factor in entering the telecom industry. The current FCC laws and licensing regulations make entering the industry a difficult and drawn out process because new, start-up companies must apply for both regulatory approval and licensing. Threat of Substitute Products SBC is in a very high-tech, fast moving industry that sees major changes and innovation in a short period of time. Because of this, SBC must always be worried about the threat of substitute products. Whether it is cable television over satellite or dial-up Internet over DSL, this industry is moving in directions in which nobody can predict. Cable companies have now become a threat to traditional telecom companies because they have their own direct line into the homes and offices of their customers, allowing them provide high speed, broadband Internet that can substitute for many businesses networking needs. Because price is such an important factor in customers choosing a service, SBC must always be watching out for their competitors developing new ways to produce a product or service at a lower cost. For example, fiber-optic technology is the newest innovation in the telecommunication industry and is replacing the old copper cables. Given that this is the new way to communicate, SBC just invested 6 billion dollars in their fiber-optics research and development in order not to lose customers to substitute products. Bargaining Power of Buyers Bargaining power of buyers is dependent upon the price sensitivity and the relative bargaining power. The services provided by SBC are widely treated as a commodity, and for the most part, do not vary much regardless of who is selling them, whether it be SBC or a competitor. Therefore, buyers have more bargaining power if the product between companies is similar, and the cost of switching service providers is low. In addition, relative bargaining power is associated with the cost of the consumer and the 7

9 cost of the supplier not doing business with each other. In other words, will either party be affected if business is done elsewhere? Within the telecommunications business, consumers have a high bargaining power over buyers. This means that at the highest level of bargaining power by the consumers, they have the ability to bargain for the best service provider and the cheapest cost of service while continuing to maintain similar products and services. However, in some areas of the telecommunications industry, consumers sign a binding agreement to remain with the service provider for a time of one to two years, and there is a high cost of switching service providers. At this point, consumers loose their bargaining power regarding price of the product and service from the company. Consumers also have a high relative bargaining power. In other words, there is a large quantity of consumers looking for a service, and only a few service providers. However, with the ability to provide an unlimited supply of service their relative bargaining power remains high. Because SBC s customer base ranges from residential consumers to big corporations and businesses some buyers may have less bargaining power over SBC than others, due to the amount of their switching costs. While residential consumers generally remain unaffected because of their low switching costs, corporations, universities, and other big organizations bargaining power can be greatly affected due to their need of highly customized products and services, which increases their switching costs. With this increase in switching costs the buyer will be less likely to switch service providers giving SBC an advantage in their bargaining power with their buyers. Bargaining Power of Suppliers With the way the telecom industry is set up, one might think that the suppliers would have considerable bargaining power over the telecom operators because without high-tech broadband equipment, fiber-optic cables, and various types of software, it would be vary hard for them to transfer information from place to place. But because there are so many makers and suppliers of equipment, for instance Nortel, Lucent Technologies, Cisco Systems, Nokia, and Ericsson, the bargaining power of these suppliers is dramatically reduced due to the fact that SBC has so many different options 8

10 from which to buy their supplies. This gives SBC, along with its competitors, a substantial advantage when dealing with their suppliers. Cost Competitive vs. Differentiation Based on our five forces model, SBC and the industry is classified as a competitive, cost leadership market. Their competitive advantage is generated from keeping service costs low and supplying a similar or better product and service. Throughout the telecommunications industry, the products and services offered by SBC and other companies are relatively the same. From wireless communications and local and long distance service to Internet and satellite TV, the products and services are nearly the same with no detectable differences. For this reason, the most important factor for SBC is keeping product and service costs low and maintaining efficient low cost production of the products and services they offer. Key Success Factors SBC s key success factors are service quality, service innovation, cost efficiency, and customer relations. SBC has made many recent moves in order to shore up their key success factors and allow them to maintain their competitive advantage. According to SBC s 2003 annual report, Cingular, a subsidiary of SBC, announced on February 17, 2004, that they would acquire AT&T Wireless Services by the end of the fiscal year. This acquisition will enhance Cingular s ability to compete by strengthening both its network coverage and quality. This along with their new interlata long-distance service in the mid-west and fiber-optic technology to transfer data faster and easier will greatly enhance SBC s service quality and service innovation, two of SBC s key success factors. According to the San Antonio Business Journal, SBC was recently recognized as a leader in customer relations by IDG s CIO Magazine. They were given this award for their commitment to provide e-business tools and data services to their customer along with a customer service program that is unmatched by anyone in the industry. Another way that SBC supports their customer relations is through philanthropy. According to the 9

11 Chronicle of Philanthropy and the Foundation Center, the SBC Foundation is consistently ranked among the nation s top corporate leaders in donations to charitable organizations. In 2003 alone the SBC Foundation contributed $45 million to programs that support enhancement of education and the community through technology. Another key success factor of SBC is that they are striving to become more cost efficient and thereby becoming a more profitable company. From 2001 to 2003, Verizon, SBC, and BellSouth have reduced their workforce by 25%. However, Verizon saw a slight reduction in actual operating expenses, but SBC and BellSouth actually saw an increase in actual operating expenses. The reason for this is that there is inefficiency within the operating process of SBC rather than within their high employee expenses. The operating costs are high because copper-based network infrastructures incur a large quantity of costs. For this reason, SBC is beginning to move towards a fiber optic infrastructure in order to reduce the high operating costs and become more cost efficient. By continuing and pressing SBC s goals to exceed these factors, SBC will continue to hold a strong competitive advantage over the remaining telecommunications industry. Strengths SBC Communications controls and maintains a large and diverse network of telecommunication products and services for consumers and businesses. Because of SBC s size and ability to reach nearly any consumer, they are able to focus and exceed their key success factors. Since SBC is such a large and diverse network of telecommunication products and services, they can offer higher service quality, newer service innovation, better cost efficiency, and closer customer relations. SBC is the first major telecommunications provider to offer a wide range of services such as satellite TV, combined with wireless, broadband, local and long distance phone services all in one monthly bill, SBC DISH Network. By offering a bundle of services, SBC can boost service quality and customer relations by giving their customers easier access to a one stop shopping communications provider. Another way SBC has expanded its bundle of services is by the recent acquisition of Cingular and its even more recent acquisition AT&T for 41 billion dollars**. SBC owns 60% of Cingular, which serves 25 million 10

12 people in the U.S. Long distance is one of the company s fastest growing areas serving 13.4 million access lines. This will complete the network and there will be one less competitor for SBC. SBC is a leader in data services with annual revenues of 10 billion. It is also the largest DSL provider to 4.3 million subscribers. Another way SBC is taking strides in becoming a leader in service quality, cost efficiency, and service innovation is through research and development. In the future SBC will spend up to 6 billion on new fiber optic technology. The new fiber optic technology will give customers better service quality, and reduce operating expenses for SBC and therefore help them become more cost efficient. This will be less costly and more capable for handling voice, video and data services. **See appendix for detailed information** Weaknesses SBC has a lot of strengths that are building them into a better company. However, there are some weaknesses that SBC needs to overcome. Over the past four years, SBC has had steadily increasing wireline cash expenses of 1.5%. In order to maximize a better cost efficiency, SBC should attempt to decrease their wireline cash expenses. Another weakness that is contributing to having adverse benefits with cost efficiency is that SBC is attempting to enter into other industries and is having trouble internally with understanding how to operate their company efficiently. They also have an out of date network that is hard to maintain. SBC needs a new infrastructure; most of their competitors have a lower cost structure. However, as stated above SBC is in the process of restructuring a fiber optics infrastructure so this will no longer be a weakness in the future. Opportunities With the growth of SBC Communications, small and even big companies are being forced to reduce in size or even back out of the market. This gives SBC the opportunity to take over more markets. SBC is going to have the ability, based on a 11

13 ruling from the Texas Public Utility Commission, to collect 2 to 3 cents from dial-up users for using SBC s phone lines for internet use. This will allow an increase in revenue from local internet providers. AT&T has withdrawn from its consumer long distance business, which is over crowded with competitors, giving SBC the opportunity to gain more customers. By SBC s recent gain of the market by AT&T, they can provide their customers with higher service quality and customer relations by increasing the bundle of products and services they provide. Threats AT&T has launched a new nationwide internet calling service which will be a threat to SBC s internet service. In order to maintain their customer base without loosing customers to AT&T s new internet service, SBC should boost customer relations and service quality to retain their customer base. With increasing competition, the product market is becoming more confusing for customers. Customers are having difficulty deciding on products based on their price and quality. This is another reason why SBC should emphasize on customer relations and service quality. Some companies, such as Skype Technologies, are entering into markets that SBC currently does not operate but could move towards in the future. Skype Technologies could be dominating a market before SBC even gets there. 12

14 Accounting Analysis Significant Accounting Policies These accounting policies were specifically chosen in accordance with SBC s key success factors, to supply evidence of the management of their economics. Revenue Recognition Revenues and expenses dealing with nonrefundable, activation services are deferred and recognized over the average customer life of five years. Revenues associated with telephone, data, and wireless services are billed monthly in advance and later recognized when services are provided. EITF became effective July 1, 2003 and has not had a significant effect on our consolidated financial statements. It addresses certain aspects of accounting for sales involving multiple revenue generating products/ services sold under a single agreement. Revenue policies are key to any company s success because sales alone are vital to the performance of the company. Revenues are important to SBC because its key success factors rely heavily on revenues. To supply quality service, cost efficiency, or innovative new services revenues are necessary funds. Allowance for Uncollectibles Estimation for bad debt allowances is primarily based on analysis of history and future expectations of their retail and their wholesale customers. Their estimates are based on their actual historical write-offs and the aging of accounts receivable balances for retail customers. The assumptions are reviewed quarterly and adjustments are made to their bad debt allowance. They use a statistical model based on their aging of accounts receivable balances for wholesale customers. Risk percentages and reserve balance 13

15 assumptions built into the model are reviewed monthly and the bad debt allowance is adjusted accordingly. Managing a well-balanced allowance for bad debt is essential to maintaining a productive consumer base. Since this account is a contra balance to accounts receivable, it is actually a part of sales. SBC reviews its write-offs and assumptions often so that the most accurate allowance can be accounted for in their books. Directory Accounting They changed their method of recognizing revenues and expenses related to publishing directories to the amortization method from the issue basis method. The amortization method has now become the more prevalent method used among significant directory publishers. Directories are a major subdivision of SBC s company, and this segment s income for 2003 is $2,301(in millions). Also, by changing the method of accounting for directories lowered their operating expenses; translating into a consolidated segment income increase of 5% from Directories. Depreciation Accounting Plant, Property, and Equipment are accounted for under the straight-line method. Certain subsidiaries follow composite group depreciation methodology, when a portion of their depreciable property, plant and equipment is retired in the ordinary course of business, the gross book value is reclassified to accumulated depreciation; no gain or loss is recognized on the disposition of this plant. Property, Plant and Equipment includes capitalized software costs that are amortized over three years. In addition, FAS 143 was adopted to change depreciation rates which lowered expenses in Depreciation methods are useful points of flexibility in a firm s financials. Most companies have choices in the method they employ. Different methods create different advantages to a company; SBC has chosen a simple straight-line method for its property, 14

16 plant and equipment, which gives the same sum for every year of depreciation and a capitalization policy for software. Goodwill and Other Intangible Assets They adopted the Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (FAS 142). As a result, they stopped amortizing goodwill, and at least annually they will test the remaining book value of goodwill for impairment. The impairments following the adoption of FAS 142 will be recorded in operating expenses. They also stopped amortizing goodwill recorded on their equity investments. SBC s goodwill is specifically tied to its recent purchase of Cingular Wireless. Goodwill is important to SBC because it increases the firm s value. In the telecommunications industry, acquisitions are integral to maintaining competitive advantages. Also acquiring goodwill, then determining how to account for it could be more profitable for the firm. Property, Plant, and Equipment Property, plant, and equipment are stated at cost. The cost of additions and substantial improvements to property, plant and equipment are capitalized. The cost of maintenance and repairs of property, plant and equipment are charged to operating expenses. Property, plant, and equipment are the core of the physical assets of a firm. These are the keys to generating revenues for SBC, which directly connect to its key success factors. 15

17 Software Costs Their policy is to capitalize certain costs incurred in connection with developing or obtaining internal use software. The software costs that do not meet capitalization criteria are expensed immediately. Software is the main tool used in SBC s business. This internal intelligence is the backbone of their services and the management of their services. Software relates to service quality and innovation. Assessment of Accounting Flexibility SBC has a degree of flexibility in choosing their accounting policies but are still strictly limited by FCC regulations. Through SBC s flexibility, their accounting information shows the reader some insight into the management of their economics. In determining methods used for depreciation and amortization, recognizing revenue and expense, capitalization, and directory accounting, the most beneficial method was applied. SBC uses the common method of straight-line depreciation for the property, plant and equipment, and they do not recognize any gain or loss on retired equipment. In respect to amortization, they stopped amortizing their goodwill and amortize their capitalized software over three years, which decreased operating expenses. Since customers are billed in advance, revenues are deferred and recognized when earned. Expenses are deferred and recognized over an average customer life determined by SBC. The company s capitalization policy includes software costs that are directly related to their internal use software. They changed their directory accounting policy to a more popular method, which decreased operating expenses. SBC s accounting flexibility is embedded in the policies above and related to their recent improvements in cost efficiency, as well as other success factors. 16

18 Evaluating Accounting Strategies SBC s accounting policies are similar to MCI, one competitor, in that both companies recognize revenues when earned. For both companies, most expenses are recognized when incurred. Like SBC, MCI also depreciates its long-lived assets over the straight-line method. Allowance for bad debt is periodically evaluated for adjustment as well as estimated using historical trends and known events. SBC and MCI are different in that MCI uses a less accelerated method of amortization on capitalized software costs. They maintain a software life of six years in comparison to SBC, who uses a three year life. In contrast AT&T, another competitor, uses a group depreciation method based on estimated useful lives of specific assets. AT&T also accounts for expenses during any recognized period. The managers within SBC face some incentive to use accounting discretion to manage earnings because they are a cost competitive firm. As noted before they have changed some accounting policies which have lowered their costs. They have also recently gone through restructuring in which they downsized the amount of employees. The company s policies and estimates have been realistic in the past. Looking through recent financial documents no changes in estimates have been stated, with the exception of changes in accounting policies handed down by FASB. No business transactions that have been reviewed have shown any evidence of being structured only to achieve certain accounting objectives. SBC has made a few changes in its policies and estimates (see appendix for the cumulative impact of these accounting changes). One of the significant policies that went through a change was in directory accounting. SBC changed their method of recognizing revenues and expenses related to publishing directory from the issue basis method to the amortization method. The decided to change methods in order to be more consistent with their quarterly income and the amortization method has now become the more prevalent method used among significant directory publishers. The change in directing accounting resulted in a non-cash charge of *$1,136, net of an income tax benefit of *$ 714. The reason behind this change was to increase consolidated pre-tax income and the directory segment income by *$80. 17

19 Another change they made was in depreciation accounting. On January 1 st 2003, SBC changed the way they account for the removal of long lived assets when those assets are no longer used in the company s business. The justification for the accounting change resulted when SBC adopted financial account standards number 143 because they were required to by the FASB. In connection with FAS 143, all existing accrued costs of removal for those plant accounts where SBC s estimated costs of removal exceeded the estimated salvage value were reversed. The non-cash gain from the reversal was *$3,684, net of deferred taxes of *$2,249. For these plant accounts, costs of removal are expensed as incurred; where previously the costs were recorded in their depreciation rates. Goodwill and other intangible accounting also went through changes. SBC stopped amortizing goodwill and will test the remaining book value of goodwill for impairment annually. They also stopped amortizing goodwill recorded on their equity investments. SBC made this change in accounting by adopting statement of financial accounting standards number 142, goodwill and other intangible assets. *All dollars are stated in millions. Evaluating the Quality of Disclosure SBC uses their Annual Report for shareowners in order to clearly convey its industry conditions, its competitive position, and their management s plans for the future. In this section of their annual report they use the Management s Discussion and Analysis of Financial Condition and Results of Operations and Notes to Consolidated Financial Statements to break down the complex terms and conditions discussed throughout the companies annual report. The footnotes in SBC s annual report clearly and adequately explain their key accounting policies. It also lists and explains the many changes in their accounting policies and how these changes have affected the company. The Management Discussion and Analysis section of the annual report does adequately explain its current performance. It goes into detailed summaries of each area of increases or decreases in 18

20 the financial statements and gives a valid explanation of the preceding events. SBC does provide adequate additional disclosure of the accounting rules and conventions to help understand how the factors are being managed. SBC uses a very segmented analysis of their separate departments. In the Management of Discussion and Analysis section, SBC gives a detailed explanation of the wireline segment, Cingular segment, Directory segment, and the International segment. SBC also includes the current position of these segments and the percent and numerical change within the segment. The management responds to bad news as quickly as possible. The quicker management responds to imperfections, the quicker they are able to recover from bad news. This also keeps their stock value from dropping considerably if they choose to not disclose bad news as soon as they are aware of it. SBC includes a section within the annual report that is specialized to summarize and clarify information for the shareholders interests. SBC also sends out the annual report routinely to the shareholders each year. Identifying Potential Red Flags The graph below illustrates different key ratios in determining a possible manipulation of sales. In observing the graph, the first four years remain fairly consistent in all ratios, but the most recent year has an increase in every ratio. The increase in the net sales/ net cash flow ratio is primarily due to an increase in net sales and a decrease in net cash flow. The rise in net sales/ net accounts receivable is due to a decrease in accounts receivable, and the increase in net sales/ unearned revenues is a result of the rise in net sales. The main component that has affected all of the ratios, the increase in net sales, is a combination of a decrease in taxes and a decrease in operating expenses. Because of the legitimate reasons for the accounting number shifts, the ratios were not evidence for a possible sales manipulation. 19

21 Sales Manipulation Diagnostics values year Net Sales/Net Cash Flow Net Sales/Net Accounts Receivable Net Sales/Unearned Revenues The graph below illustrates different key ratios in determining a possible manipulation of core expenses. The declining asset turnover, changes in cash flow from operations/ NOA ratio, and the other employee expenses/ selling, general, and administrative expenses ratio were all very consistent over the past five years. In addition, the pension expense/ S,G&A ratio decreased down toward the firm s norm. The only ratio to increase was changes in cash flow from operations/ operating income. This ratio has been steadily rising over the past three years as a result of a continual decrease in operating income. In review of the financial statements, the lower numbers come from a corresponding decrease in operating revenues. Because revenues in and of themselves are not affected by expenses, there is no evidence showing a manipulation of core expenses. 20

22 Core Expense Manipulation Diagnostics value Declining Asset Turnover Changes in Cash Flow From Opertions/Operating Income year Changes in Cash Flow From Operations/ NOA Pension Expense/SG&A Other Employee Expenses/SG&A Undo Accounting Distortions After evaluating both the quantitative and qualitative factors within SBC, we found no current red flags. There were no unexplained changes in accounting. SBC s profits decreased in the last year, so there were no were no unexplained transactions that could have possibly boosted profits. There also were no unusual increases in accounts receivable in relation to any increase in sales. The accounts receivable and sales were both decreasing. SBC has no inventories, so, there is no increase in inventories in relation to an increase in sales. The gap between both SBC s income in relation to its cash flow from operating activities, and also its income in relation to its tax income is decreasing from We found no large asset write-offs or large fourth quarter adjustments, therefore, the amount of assets remain fairly consistent. There was also no change in independent auditor or any transactions between related parties. Therefore, there is no need to undo any accounting distortions within SBC s annual report. 21

23 Introduction to Ratio and Forecasting Analysis The ratio analysis and forecasting section of a valuation analysis is very important to the overall valuation of SBC. The purpose of the ratio analysis is to identify past and current trends, not just with SBC, but with its main competitors also. These ratios identify the overall profitability, liquidity, and capital structure of all the main companies in the telecommunications industry. By finding these values, current and future investors of SBC can see just how their company has performed against their competitors and the industry average. These values are also important to the future valuation of the company by identifying past trends and using them to form a rough estimate of future trends. Another key component of a valuation analysis is forecasting the financial statements. By forecasting SBC s future balance sheet, income statement, and statement of cash flows current and future investors have a basis for future decisions and investment in the company. In order to find the various ratios for SBC and its five main competitors we used three main liquidity ratios (excluding inventory turnover and working capital turnover because they do not apply to this industry), six main profitability ratios, and three capital structure ratios. We also felt it was beneficial to use the EBITDA margin ratio and the PP&E turnover in order to get a better view of SBC and the overall industry. In regards to forecasting the future financial statements we used the moving average, random walk, and trend analysis methods. These methods were chosen because they best depict the way SBC operates. At the conclusion of this section of the valuation analysis we hope to provide investors with an accurate view of past trends and fluctuations throughout the industry as well as a reasonable estimate of SBC s future performance. 22

24 Ratio Analysis Years Liquidity: Current Ratio Quick Asset Ratio Receivable Turnover Day Sales Uncollected Days Days 80.2 Days 72 Days 69.1 Days Inventory Turnover * N/A N/A N/A N/A N/A Working Capital Turnover * N/A N/A N/A N/A N/A Profitability: Gross Profit Margin 59% 62% 43.50% 40% 40.70% Operating Expense Ratio 24.10% 22.20% 20% 21% 21% Net Profit Margin 20.80% 13.10% 15.70% 15.50% 16.50% Asset Turnover Return on Equity 22.23% 17% 22.30% 26% 30.50% Return on Assets 8.50% 5.90% 7.50% 8% 10% Capital Structure : Debt-to-Equity Ratio Times Interest Earned Debt Service Margin Other Relevant Ratios: EBITDA Margin 35% 40% 56.50% 60% 59% PP&E Turnover Sustainable Growth Rate 7.65% *Since SBC Communications is predominately a service company, they do not depend on having physical inventory in stock. This causes working capital to be a negative number which makes Inventory Turnover and Working Capital Turnover inaccurate. Along with using the 14 basic Liquidity, Profitability, and Capital Structure Ratios, we also used 2 other ratios that were important to SBC and our industry. EBITDA Margin is important for SBC and the telecommunications industry as a whole because it displays earnings without the subtraction of depreciation, and amortization as well as no interest or income tax subtraction. But most importantly, 23

25 with the deduction of depreciation and amortizations, the public receives a better overview of the company s true earnings. This is because many companies depreciate their assets differently over a certain amount of time. This way all of the companies being compared to SBC, as well as SBC by themselves will have a fair overview of their earnings. Also, PP&E turnover was used to show how well SBC is using there Property, Plant, and Equipment to generate sales. This is a very important ratio because in the telecommunications industry you carry little to no inventory because you use your Property, Plant and Equipment to help generate sales. With the use of the above Ratio Analysis for SBC Communications, we were able to analyze the overall Liquidity, Profitability, and Capital Structure of the company. To begin with, Liquidity Ratios were used to show the overall liquidity of SBC. Although, liquidity is not nearly as important in the Telecommunications Industry due to the low amount of current assets Telecom companies carry. The Current Ratio and the Quick Asset Ratio show how well SBC s short- term assets can cover their Liabilities. Both of these increased slightly over time, which shows that they are more able to cover their debt now, and then they have in the past. Another positive aspect in SBC s liquidity is their increase in Receivable Turnover. This shows that they have been collecting cash sooner as time carries on. This helps them increase the overall flow of cash into the business. We also used the PP&E Turnover to show how they are generating sales from their Property, Plant and Equipment. Over the past five years SBC has been experiencing a decrease in this ratio which leads us to believe that they are not generating sales well from the above assets. When looking at SBC s overall liquidity, we can see the increase that they have received over time, which leads us to believe that they are more able to pay their debt now then they have in the past. Another, probably more important, aspect is SBC s overall profitability. Gross Profit Margin is used to show the extent to which revenues exceed direct costs associated with sales. Although there was a decrease between 2003 and 2002, the overall Gross Profit Margin has been increasing over time. The Operating Expense Ratio, which deals with how SBC s operating expenses take over sales, has been 24

26 constantly increasing over the past five years. This is not a good aspect in SBC s profitability because operating expenses are eating up its sales. SBC just recently had a major increase in their Net Profit Margin over the most recent year. They managed to increase by 7% over the previous year, as well as a 5 % increase in the past five years. Return on Equity and Return on Assets show how well SBC uses its Assets and Equity to generate income. Recently, both of these have increased over the past year, but still are below where they were in the past. The recent increase in could be due to their recent purchase of Cingular Wireless, which would explain how they are using there assets more efficiently in another sector and how their asset base has grown relative to shareholders investment. Another Profitability Ratio we used, that was relevant to our company was the EBITDA Margin. Before looking at this ratio one might think SBC has been, for the most part, a profitable company. There has been a constant decrease in SBC s EBITDA Margin over the past five years which shows that their cash operations have been declining. This ratio can be misleading, but in the telecommunications industry it is an important ratio to look at because it takes out a lot of areas that do not involve cash related expenses. Overall, SBC s profitability took a dip a few years ago, but has recently been increasing over the past year. We must be skeptical though, because this recent increase good have occurred from their recent purchase of Cingular Wireless, which could have inflated its earnings. We must also watch out for their increase in operating expenses, because if those continue to increase, SBC is going to have a major problem in its profitability. The final area we covered was SBC s Capital Structure. Debt- to- Equity Ratio shows how much debt SBC carries in comparison to the amount of equity they are holding. SBC has been constantly decreasing this ratio which leads us to believe they have less debt then they have in the past in comparison to their equity. Also, SBC s Times Interest Earned has been steadily decreasing over the past five years. This shows that their interest expenses have been eating up their NIBIT. SBC has been experiencing an increase in their debt service margin steadily. This shows that their operating cash flow has been increasing comparatively to their current notes payable. Overall, we can see that SBC has been seeing an increase in its capital structure, which shows how well they have been covering there debt. 25

27 Liquidity Charts: Current Ratio 2.5 Value SBC AT&T Verizon AOL/TW Cox MCI IND AVG Year Over the past five years SBC has seen a rise in their current ratio. By raising their current ratio they are better able to cover their debts with their assets. In 1999 SBC was well below the industry average but in 2003 they were more than ten points over the industry average. 26

28 Quick Asset Ratio 7 6 Value SBC AT&T Verizon AOL/TW Cox MCI IND AVG Year As with their current ratio, SBC s quick asset ratio has followed a similar path. It was just below the industry average in 99, dipped well below the industry average at the turn of the century and climbed near the tops in the industry by This ratio is important because it shows how much of SBC s current liabilities and be covered by their quick assets: cash, accounts receivable, and securities. This is crucial because, in the event of an emergency where cash is needed quickly SBC can cover 82.5% of their current assets. 27

29 A/R Turnover Value SBC AT&T Verizon AOL/TW Cox MCI IND AVG Year Over the past five years SBC has consistently been below the industry average. A lower than average A/R Turnover ratio means that a company is not collecting their accounts receivable as fast as their competitors. This applies to SBC because they are below the industry average, therefore not collecting their money as fast as their competitors, which keeps them from reinvesting that money from their accounts receivable. Inventory Turnover Because of the nature of SBC and the telecommunications industry, neither SBC nor any of its main competitors had any significant measurable inventory. This is due mainly to the telecommunications industry being a service intensive industry. Working Capital The working capital ratio did not apply to SBC or its competitors because, for the most part, everyone in the industry had a negative working capital ratio. This is due to SBC and its competitors being in a service industry where it is not an asset intensive industry. 28

30 Profitability Charts: Gross Profit Margin % Value SBC AT&T Verizon AOL/TW Cox MCI IND AVG Year In 1999 SBC was well below the industry average but by the end of 2003 they raised their GP Margin by nearly 19% points to 59%. This is due SBC reducing their cost of goods sold in proportion to their revenue. This, in turn, gives them more available income to re-invest back into the company to generate future revenues. 29