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Digging Deeper Into Key Areas

Strictly Financials

Jan. 3 , 2014

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Donald W. Reynolds National Center For Business Journalism At Arizona State University

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n  James K. Gentry, Ph.D. n  Clyde M. Reed Teaching Professor n  School of Journalism and Mass Communications n  University of Kansas n  jgentry@ku.edu

n  Gary Trennepohl, Ph.D. n  ONEOK Chair and President’s Council Professor of Finance n  Oklahoma State University n  Trustee, Oklahoma Teachers Retirement System n  Member, OSU Foundation Investment Committee

n  gary.trennepohl@okstate.edu

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Topics n  Goodwill, impairment n  Pro forma n  Bank financials n  Comparing companies n  And a “disruptive technology”

Goodwill, Impariment

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Goodwill n  Difference between what a firm pays to buy

another company and the book value (total assets minus total liabilities) of that company.

n  Has been written off over time, typically 40 years

n  No longer amortize n  Other intangible assets will continue to be

amortized over useful lives

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Impairment n  Instead of writing off over time, now use “impairment testing”

n  The impairment is expensed on the income statement

Examples n  Crocs n  McClatchy n  Gannett n  New York Times

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Pro Forma

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Pro Forma Results n  Critics: Selectively defined earnings n  Expenses against earnings are not

standardized across an industry n  SEC’s Regulation G (1/03) states that

non-GAAP numbers used in an earnings release must be accompanied by, and reconciled with, the “most directly comparable GAAP number”

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Pro Forma Results

n  Recommendation: GAAP results should precede pro forma results in earnings releases

n  Headlines should show GAAP earnings n  Companies say pro forma has value n  Common form: EBITDA. Also, OIBDA n  “As a matter of form”

Examples n  Sprint n  Lowe’s

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Bank Financial Statements

1.  The business of a bank 2.  The balance sheet 3.  The income statement 4.  Some key financial ratios 5.  Sources of bank data

The Business of a Bank

n  Banks are a “financial intermediary,” taking in money from “savers” and loaning it out to “investors” - they buy and sell money.

n  For most banks, the majority of their earnings come from interest income on loans, and interest earned on securities.

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The Business of a Bank n  Banks also earn fee income for

services. n  Banks’ two main risks are:

n  interest rate risk n  “credit risk”

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“CAMELS” and Banks n  Most bank analysis is based on the

“Camels” acronym: n  Capital adequacy n  Asset quality n  Management quality n  Earnings n  Liquidity n  Systematic risk

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The Income Statement Net interest Income

- Provision for loan losses = Net Income after PLL +/- Net non-interest income = Net Income Before Taxes - Taxes (many small banks are S corps) = Net Income

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Assets = n  Cash +

n  Fed Funds loaned

n  Securities n  U.S. Governments

n  Loans n  Real Estate n  Commercial n  Consumer

n  Premises- Fixed Asset

n  Misc. Assets

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Liabilities + Capital

Primary Reserve

Secondary Res.

n  Deposits n  Demand Deposits n  Savings Deposits n  Now/Money Market Accts. n  CDs, Time Deposits

n  Non-deposit Borrowings n  Fed Funds purchased n  Repo agreements

n  Long term debt n  Equity Capital

The Bank Balance Sheet

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Three Key Ratios n  Return on Assets = Net Income/Avg. Total Assets

n  Typically runs around 1.0% to 1.5% n  Averages 4 quarters of total assets for the

denominator to smooth effect of asset swings n  Return on Equity = Net Income/Equity capital

n  Will be different for publicly traded banks versus private banks

n  Capitalization Ratio = Equity/Total Avg. Assets n  Tier 1 Capital should be ≥10%

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The Texas Ratio n  Texas Ratio = (non-performing loans+OREO)

n  Think of it as the ratio of troubled loans to “capital” n  OREO is Owned Real Estate Owned n  Early warning system to measure a bank’s potential for

failure. n  Banks tend to fail as TR approaches 100% (troubled bank) n  Don’t get a mortgage loan from a troubled bank n  Data to calculate at http://www2.fdic.gov/sdi/main.asp. Use “non-performing assets and bank real estate owned/equity and loss reserves”

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Equity + Loan loss Reserves

Key Issues for Banks in 2014 n  True form and impact of Dodd/Frank Bill

n  CFPB begins life January 2013 and most rules still being written

n  CFPB answers only to Fed n  Banks are either OCC; Fed or State/FDIC regulated. How

will these regulators interact with CFPB?

n  Basel III - More new and complicated rules for calculating “risk based” capital.

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Sources of Banking Data n  The Uniform Bank Performance Report

(UBPR) is provided by U.S. Federal regulators so analysts can compare bank performance against peer groups.

n  Web link: n  www.ffiec.gov

n  Another source for large banks is: n  www.BankRegData.com

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Comparing Companies n  Common size analysis is an excellent

tool for comparing companies, regardless of size.

n  Companies in the same industry might have similar or widely differing statements. Common size brings out those similarities and differences.

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The “Traditional” Companies n  CVS Caremark n  Walgreen n  Rite Aid n  They’ve been evolving

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Model is Changing n  The business model for pharmacies has

been changing for several years. Now, a somewhat new entrant poses a bigger threat.

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A “Disruptive Technology”? n  Express Scripts n  How will it change and how will its

model change the business? n  Is this an example of a “disruptive

technology” in the Clayton Christensen sense?

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