Harnischfeger Corporation

Financial Statement Analysis and Business Valuations.

Presented By - Group VAmber Saxena – 008Pavan Pratihast – 029Pranav Kumar – 031Pankaj Masand – 026Ratnesh Kumar - 033Uday Narayan Singh -049

Agenda

Case Facts

Strategy Analysis

Accounting Analysis

Case Facts

Machinery Equipment 2 Segments-Heavy Equipment &

Industrial Technologies Group (ITG) Expected growth in material handling

& engineering services Financed rapid growth in 70’s through

debt – leads to problems when market shrinks in 80’s

Continued..

Company ends up in violation of debt covenants

Recovery plan Change in management Cost Reductions Reorientation of Company’s business Debt restructuring and recapitalization

Strategy AnalysisIndustry Analysis: Porter’s 5 Forces

Rivalry Among Existing Firms: High Low growth for cranes & mining equip. Higher growth for ITG Concentration - Few firms Switching cost - High High fixed to variable costs - less for ITG High exit costs – less for ITG Conclusion: Rivalry is High - less for ITG

Strategy AnalysisIndustry Analysis: Porter’s 5 Forces

Threat of New Entrants: Low High cost of establishing economies of scale High capital investment required Access to distribution channels is difficult Threat of new entrants is higher for ITG

Treat of Substitute Products: Low Similar price and Performance Consumers willingness to switch products -Low

Strategy AnalysisIndustry Analysis: Porter’s 5 Forces

Bargaining Power of Buyers: Low Switching costs – High Alternative products – Few Importance of quality – High Importance of cost – High

Bargaining Power of Suppliers: Low Switching cost – Low Alternative products – Many Quality and Cost considerations -High

Strategy AnalysisIndustry Analysis: Porter’s 5 Forces

Overall: The market for cranes and mining machinery is less attractive than the market for ITG products & services

The income statement of Harnischfeger will likely show losses or low profitability for the near future

Therefore, Harnischfeger needs to be a low cost producer to survive

Strategy Analysis:Context for Accounting Analysis

Short term factors for success Maintaining financing/liquidity

-Look for accounting to improve revenue, cash flow, expense reduction,

reported earnings• Ex. Policy changes: revenue recognition,

inventory, depreciation Estimates: allowances for reserves,

pension forecast, depreciation

Strategy Analysis:Context for Accounting Analysis

Long Term factors for success Industrial Technologies Group:

- Growing high tech materials handling and systems business

-Manufacturing firms continued emphasis on cost reduction programs

Secure R&D funding, innovation, strategic alliances, skilled staff, etc.

Questions of Case. Ques-1. Identify all the accounting policy

changes and accounting estimates that Harnischfeger made during 1984. Estimate, as accurately as possible, the effect of these changes on the company’s 1984 reported profits.

Harnischfeger Consolidated SO

(in $1000s except per share figures)1984 1983 1982 1984 1983 1982

Total revenues 405,775 324,121 452,670 100% 100% 100%Cost of sales 315,216 261,384 366,297 78% 81% 81%Operating income 90,559 62,737 86,373 22% 19% 19%Less: R&D and SG&A 72,196 85,795 113,457 18% 26% 25% Interest expense - net 12,625 9,745 18,873 3% 3% 4% Provision for plant closing 23,700 5%

5,738 (32,803) (69,657) 1% -10% -15%Provision (Credit) for income taxes 2,425 (1,400) (1,600) 1% 0% 0%Inc. (Loss) before equity items and cum effect of acctg chgs 3,313 (31,403) (68,057) 1% -10% -15%Equity items 858 (3,227) (8,474) 0% -1% -2%Inc. (loss) bef. cum effect of acctg changes 4,171 (34,630) (76,531) 1% -11% -17%Cumulative effect of change in depr method 11,005 3% 0% 0%Net income (loss) $15,176 ($34,630) ($76,531) 4% -11% -17%

Harnischfeger CorporationConsolidated Statement of Operations

Year Ended October 31 Year Ended October 31

Accounting ChangesDepriciation Method.

Depreciation is a method that reduces the value of capital assets over time

Switch from accelerated to straight line retroactively

RevenuesLess: Depreciation Expense= Net Income

Depreciation method – add $11M Depreciation estimate – add $3.2M

Accounting Changes

Depreciation Expense (Straight Line)

= Capital Cost / Economic Life

If the Economic Life is increased then depreciation expense is lowered resulting in higher net income

Accounting Changes Pension Gain and rate of return

Components of Pension Expense:Current Service Cost+Interest on Accrued Pension Liability-Expected Earning on Assets+Amortization of start up costs+Amortization of prior service cost from

amendments+/- Amortization of actuarial gain/loss

Accounting Changes Higher expected earnings produce a lower

pension expense resulting in higher net income

Expected earnings tied in to general market conditions

Pension gain & rate of return assumption for pension – add $3.9M and $0.1M

Accounting Changes LIFO Liquidation

LIFO (Last In First Out) is a method of valuing inventory where the latest costs of raw materials are used in determining cost of goods sold (it is assumed that the last unit added to inventory is the first sold)

Since inventory is liquidated at lower cost than current cost, COGS is lower and Net Income is higher

LIFO liquidation – add $2.4M

Accounting Changes Provision for doubtful debt.

Bad debt reserve is an estimate of accounts receivable that will not be collected.

In 1983, this reserve was estimated at 10% of accounts receivable. In 1984, an estimate of 6.7% was applied resulting in higher accounts receivable and thus higher net income

Provision for doubtful accounts – add $2.6M

Harnischfeger

Harder to determine for these changes Fiscal year change for subsidiary – 15

months in 1984, insignificant change to net income, sales increase by $5.4M

R&D expense – reduced expenditures to below Kobe reimbursement

Included sales from Kobe Steel – why? Help build topline

Question cont.. Ques-2.What do you think are the

motives of Harnischfeger’s management in making the changes in its financial reporting policies? Do you think investors will “see through” these changes?

Incentives:

Boost stock price to raise new capital Meet earnings targets for compensation Avoid violating debt covenants Improve image with customers, suppliers,

etc. Internal pricing tied to external reporting

numbers. Accelerated depreciation makes cost appear too high.

Investors see through

Considerable evidence in finance and accounting that capital markets are generally efficient

For stock prices to reflect reality in an unbiased manner, not necessary to have everyone see through; marginal investors are the price setter.

From the management side - why manage earnings

Investors didn’t adjust their original conservative accounting

Unpleasant experience with debt covenant Interaction between mgmt accounting and

external accounting.

Harnischfeger management’s perspective

Harnischfeger management’s perspective on earnings management: In accounting there is no such thing as

absolute truth. The same underlying reality can be accounted for using a range of assumptions. The earlier philosophy of this company was to choose the conservative alternative whenever there was a choice. Now we have decided to change this. We would like to tell the world that we are alive and well. We wish to tell the truth but do not want to be overly conservative in doing so.

Harnischfeger management’s perspective

Harnischfeger management’s perspective on earnings management: As a company you have to put the best foot

forward if you want to raise capital, convince customers that you are a viable company, and attract talented people to work for the company. I feel that the financial reporting should help rather than hinder the implementation of our operating strategy. In my opinion, the changed accounting format highlights the effectiveness of our strategy better than the old policies do.

Harnischfeger management’s perspective

Harnischfeger management’s perspective on earnings management: When the outside world compares our financial

performance with that of other companies, they may or may not take the time and effort to untangle the effects of the differences in financial policies that various companies follow. My own belief is that people adjust for the obvious things like one-time gains and losses but have difficulty in adjusting for ongoing differences. In any case, these adjustments impose a cost on the user.

Harnischfeger management’s perspective Harnischfeger management’s perspective

on earnings management: If people adjust for the differences in accounting

policies when they compare us with other companies, then it should not matter whether we follow conservative or liberal policies. But suppose they do not adjust. Then clearly we are better off following the more liberal policies than conservative policies. I am not sure whether people make the adjustments or not, but either way we wish to present an optimistic version of the picture and let people figure out what to do with the numbers.

Question cont..

Ques-3.Assess the company’s future prospects given your insights from questions 1and 2 and the information in the case on the company’s turnaround strategy.

Turnaround Strategy

Assessing their turnaround strategy: Changes in top management Cost reductions to lower the company’s

breakeven point Reorientation of the company’s business Restructuring the company’s finances to

facilitate the implementation of the reorientation strategy

Turnaround Strategy

Subsequent events: 1985:

Changed accounting for the cost of duration patterns and tooling, from expensing to capitalizing

Reported a net profit of $0.74 per share for fiscal 1985. The accounting changes described above contributed $0.24 per share to the reported profits.

Raised $147M by issuing preferred stock.

Future Prospects The accounting changes increase net income and

Harnischfeger hopes that this will encourage investors to boost the stock price

Investors may also believe that the changes are part of the entire forward looking business strategy, and thus stock prices may increase

An increased stock price may help raise capital in the future However, if investors have been making adjustments

all along to compare Harnischfeger to other firms in the industry, there may be no change in stock price

Future Prospects Investors may see that the changes have

no cash flow implications, or be as a result of management incentives

Company went through difficult negotiations with their lenders to make the possibility of bankruptcy more unlikely in the future

The company may want to promote itself in a good light with their suppliers, customers, and employees

Future Prospects The company may want to match external

vs. internal reporting standards. Internal operations seem to be based on industry

accounting choices, but external reporting was extremely conservative

This may make internal operations more efficient Same accounting methods as the industry

may be necessary since investors may want more information

The drop in R&D – Improves short-term finance but could possibly impair future prospects for company

Questions ? ?

Thanks for being a serene listener.