>> Hello, I'm Professor Brian Bushee, welcome back. In this video, we're going to continue our look at the performance of Vulcan Materials in 2010, with a look at their cash from operations. And a DuPont ratio analysis. Hope you enjoy the video. So if we look at our financial statement analysis roadmap, we are in the middle of answering the question, what was the company's performance this year? And we're moving on to look at, how did Vulcan do in generating cash from operating the business, so their cash from operations. One of the things we're going to look for are, what are the major differences between earnings and cash flows, because as we're gunna see they're, they're quite a bit different. What are the interpretations for these differences and after we look at the cash from operations we'll pull up the MD&A and see what the company says are the reasons for these differences. And then we'll try to think of, will these differences between earnings and cash flows persist into the future, again, thinking about the next step which would be forecasting. So here is the cash from operations for Vulcan. And as you can see in the top line we had net income, or net loss in 2010. And here we have cash from operations which is still pretty healthy, still pretty high and positive. >> You could certainly purchase a lot of tribbles with all of the cash flow. You have made it sound like Vulcan is having a terrible year, but look at all of this cash. You are such a downer! >> Yes, Vulcan could buy a lot of tribbles with this cash flow. Now, if you don't know what a tribble is, I suggest Googling it because they're really cute. But anyway, this highlights the fundamental discrepancy that you see in looking at the Volcan statements in 2010, is you see a negative earnings, but still a high positive cash flow. And what we're going to do is spend a lot of time talking about this, starting now with a breakdown of what causes earnings to be so different from cash flow for Vulcan in 2010. So looking at the items that cause earnings to be different from cash flows, we can see right away that earnings has some large non-cash items. And items related to property plan and equipment that get backed out of earnings to get the cash flow. And of course, the big one here, which we saw in the video with is the depreciation depletion. Which is 382 million. So basically, that 382 million doesn't affect cash flow. We still have cash coming in, but it affects earnings, and what it says with earnings is that we're not getting enough revenue to cover all of the cost of the heavy equipment and the land acquisition, that we use to deliver our product. We also see that there are some big swings in other assets. So, accounts receivable was a big drain on cash. And we'll look at accounts receivable a little bit more later. Other assets which, we don't know what those are, 'because those are other assets. We'd have to look into that further. But we did get some beneficial cash position from our trade payables. So it must mean that we're stretching our trade payables. We're not paying our suppliers as quickly. Which is helping our cash position. But again, it's questionable whether that is a sustainable long term strategy. But why don't we go ahead and bring up the MD&A section to see what Vulcan says about this year, in terms of their cash from operations. Okay, this is the MD&A, page 37. They have a section where they talk about their cash flows and cash flow from operating activities. Notice how they present their results in the, in the MD&A where they just have net earnings or loss, depreciation, goodwill, and then everything else. So obviously just reading the MD&A is not going to give you as much information as actually looking at the face of the cash flow statement given how they summarize things. So what they say is, lower net earnings caused the majority of the 250 million decrease in operating cash flows, so that makes sense. Earnings went down. Net cash went down. We continue to manage the business to generate cash as reflected in the year over year changes in our working capital accounts. Which generated 37.2 million of cash in 2010. Which, which we can't really see here cause it's lumped with everything else. We sort of have to take their word for it. Cash received associated with the sale of property plant equipment is presented as operating, or investing activities, which is correct, and accounts for 39 million of the decrease in operating cash flows. Although notice that what's happening is the gain is included in net income, and then has to be taken out to get to cash from investing activities. So, it really doesn't have anything to do with operating cash flows, it really has more to do with what happened to earnings. And, in fact, I would say from this, because it goes on to talk about '09 and '08. We really don't have much explanation for what's happened with these changes in accounts receivable or other assets that we saw caused this big swing. I guess most of it is the, the first order effects, really is the fact that earnings went down. Which drove the cash flow down as well. So anyway we have this picture of a company with still positive cash from operations but negative earnings. With the big difference being this depreciation charge which affects earnings but not cash flows. But there's some issues we have to keep in mind when we're interpreting cash flows. First of all, the cash flow statement is completely backward looking. It's susceptible to timing issues of when payments are made, whether, or cash received. So if cash payment is delayed one week past the end of the fiscal year, it won't affect this year's cash flow. It'll affect next year's cash flow. In the other hand with cash flow is that there's no estimates of future activities unlike earnings. So earnings is much more forward looking, than cash flow's, which is completely backward looking. >> What do you mean when you say that cash flow has no estimates of future activities, unlike earnings? When does earnings have estimates of future activities? I thought earnings was backwards looking as well. Jeez, it would be so much easier if we could mind meld with you instead of trying to figure out what you are saying. >> Well the part about cash flow being backward looking is easy to see. It's simply a measure of how much cash did we collect last year. Minus how much cash we paid last year. Earnings has some backward looking features as well. But it has a lot of forward looking information embedded in it. For example. Depreciation is a function of how long you intend to hold the asset in the future and what the salvage value will be in the future. So those future estimates affect the depreciation number. Any time you book revenue before collecting cash, you're making a future estimate. You're trying to estimate how much of this revenue you're going to collect in cash in the future. And you make adjustments for allowance for doubtful accounts. So basically, on the income statement, any time we recognize a revenue or expense before the cash flow,. Or any time that we take a cost and spread it out over time, we're embedding future estimates into the earnings number. And as a result of this forward-looking aspect, earnings tends to be a better predictor of future cash flows than current cash flows, which has been borne out by decades of academic research. The other problem with cash from operations is that there's no deductions for the cost associated with capital investment. So we see in earnings that there's this charge for depreciation which recognizes the property plant and equipment used this period. Whereas when you look on a cash basis the cash required for fixed assets shows up as cash from investing activities, not as part of cash from operations. And plus there's a mismatch in timing where it only shows up as the cash flow, obviously when you pay in cash. But then you may end up using that equipment for ten years without any future cash flow implications. But one of the ways we try to get around the fact that cash from operations doesn't have this deduction for the cost of capital investment, is look at Free Cash Flow. So page 27 of the Vulcan report, you can go look it up if you want, they provide this little chart which shows their free cash flow. And so we can see they have cash from operations of 202, which we saw before. They subtract purchases of property, plant, and equipment from the investing section. So that's their cost of investment in heavy equipment, in acquiring land and so forth. And once you take that out, they still have a positive free cash flow of 116.4. So, actually they're generating enough cash to cover their investment. >> Vulcan has a healthy free cash flow. I was talking to Ivy's sister from Hong Kong, and she said that positive free cash flow is the biggest driver of firm value. >> Professor, you really are a downer. >> Ivy's sister from Hong Kong. We haven't heard about her in a while. Hope she's doing okay. So yes, free cash flow is a big driver of a lot of valuation models. But its future free cash flows. Not necessarily historic free cash flows. And if you look at Vulcan's case. A lot of the reason that they have free cash flow so high, is that they've been dramatically cutting their investment in property planning equipment. And it's in question of whether you can have free cash flow in the future. Whether you can continue to generate a lot of operating cash flow if you're not maintaining your level of investment going forward. And we'll look more at this level of investment in the next video. But key thing to remember is it's all well and good to have high free cash flow historically but what really drives few, firm value is future free cash flow. And if you're drastically cutting investment for the future, I question whether you can have high free cash flow in the future. So to, to wrap up this discussion of earnings versus cash flows. Earnings are answering the question did the company earn enough revenue to cover all the costs of running the business during the year? And in the case of Vulcan, the answer was no. They didn't earn enough revenue to cover the cost of all the heavy equipment that they used and the land that they used to dig stones out of the ground to sell to customers. Cash from Operations answers the question, did the company collect more cash than it paid out during the period. And the answer for Vulcan is yes, they managed their cash in a way that they still had more cash coming in than going out, which is obviously something you need to do to maintain your business. Both numbers are useful. Don't think that one number is better than the other. Both have their advantages, both tell you something, both also have their disadvantages. So earnings are a much better predictor of future cash flows than past cash flows. But to get that better prediction, we allow managers to make all these estimates, we give them all this discretion. And that's where cash flows come in because cash flows are often a more objective measure of what actually happened during the period. But the bottom line is that Vulcan is really good at managing its cash position this year. So, they're still managing the business well from a cash point of view through the recession. But there won't be any cash to manage in the future unless they find a way to become profitable soon. Unless they find a way to raise selling prices or raise volume so that their revenue goes up enough to cover all the costs of that heavy equipment and the land that they have to run the business. >> Downer downer, you're such a frowner! >> Well, I prefer to think of myself as a realist as opposed to a downer for example, I really liked your poem. And as this course is winding down and you're looking for other things to do with your time, I would highly recommend the Coursera Course, Modern Poetry that's offered by one of my colleagues at Penn. Okay, now we're going to take a look at the DuPont Ratio Analysis for Vulcan. So remember the DuPont Analysis looks at return and equity, so for each dollar of investment from your shareholders, how much profit or return does the company generate. And that of course can be split into Return on Assets or Financial Leverage. Financial leverage is, levering up the company, how much debt you take on to buy more assets. Whereas ROA is how effective managers are at operating the business. Which further splits down into return on sales and asset turnover. So, the DuPont formula is that ROE equals profitability. So for each dollar sales how much net income does the company produce, times Efficiency, or Asset Turnover, which means for each dollar of assets the company has, how many sales does it generate. And Leverage, for each dollar of equity investment, how much Assets does it buy, in other words, how much debt does the company take on. So here are all of the DuPont Analysis ratios for Vulcan going back to 1999. In the first few set of rows, I have all the numbers that are used to calculate the ratios, so that you can see how the ratios are calculated if you want to check my work on your own. We look at ROE, which is sort of the first, ratio that we want to look at, bottom line, how much profit are you producing for your shareholders. And we can see that in the salad days of the mid 2000's, Vulcan was producing a really high ROE. And that has plummeted pretty dramatically since the financial crisis and the recession that's ensued, to the point where it's negative in 2010. Now that could be driven by return on assets or leverage. Return on assets were also good during the heyday of Vulcan, and now that's plummeted to almost zero. Leverage has actually gone up and that's the im, that's the outcome of the Florida Rock Acquisition where they took on a lot of debt. Now increasing leverage should increase ROE so the financial leverage is pushing ROE up, but it goes down because of the dramatic drop in ROA. And then of course ROA is split into return on sales and asset turnover, and we can see that profitability in the mid 2000s was around 16%. So that, that for every dollar of sales, there'd be 16 cents of profit. Now that same dollar sales gets you one cent of profit. So that's a precipitous decline in ROS. Asset turnover. So it used to that for every dollar of assets you generate 87 cents or 72 cents of sales. Now you're only generating about 30 cents of sales. So we see is that ROE is down due to lower return on assets, which is driven by both, lower profitability and lower asset turnover. Or lower efficiency, less sales per dollar of assets. >> I see a mistake. Vulcan had a net loss in 2010. But you show a positive return on sales. If return on sales is net income over sales, then how can it be positive? >> Good question. You can see that the return on sales and return on assets are based on de-levered net income, not net income. So, to take out the effect of financing to get a pure measure of operating performance and profitability. We back out the interest expense. And Vulcan's interest expense is so large that once we take out after tax interest expense it turns their loss into a profit, in terms of deal over net income, which means that return on sales and return on assets are both positive in this case. So just quickly to, to dig into the return on sales measures a little bit more. So we've got the breakdown of, gross margin, SG&A sales, operating margin. We saw all this before that gross margin used to be around 30%, and now it's plummeted to only 12%. So the markup over cost has dropped by, about 20%. And SG&A to sales. Which is around 9%, and now it's gone up to 13%. So higher SG&A expense per dollar sales. So what's happening is these sales have dropped and, and Volcan can no longer cover all the costs of pulling the stones out of the ground, so those, a lot of that's the depreciation of the heavy equipment and the depletion on the land. And they're not able to cover the period costs of things like the cost of the sales force administrative staff. Those costs fairly sticky, it's hard to cut those people really quickly in recession, so when your sales drop those costs stay pretty constant and as a result you SG&A goes up as a percent of sales. And then down below we have the breakdown in the asset turnover. So, we've got all the days measures and then the trade cycle. Remember the trade cycle is the number of days that we have to borrow from the bank. So in 2006 it was about 52 days that we'd have to borrow from the bank. That's gone up to about 77 days. The reason is primarily the inventory. So, what used to be that inventory we held for about 38 days. So from the minute we started incurring cost, pulling stones out of the ground, it was 38 days until we sold them. Now, it's almost 56 days that we have those stones in inventory. Meanwhile, receivables have stayed pretty constant in terms of days, and payables have gone down a bit, which does hurt the trade cycle. But the biggest effect is, we're pulling stones out of the ground but we have to hold onto them longer because there's no one there to buy them. And that's affecting our asset turnover. Last thing I want to talk about is the Allowance for Uncollectable accounts. So we saw on the statement of cash flows that accounts receivable going up was a drain on the cash flow. But on the other hand we saw that days receivable hadn't really changed much. So a way to sort of, get more insight into what's going on for receivables is to take a look at the allowances. So during a recession which is what Vulcan is facing in 2008, 2009, 2010. Collection receivables are obviously a big concern. We can try to measure the trends using either balance sheet numbers, so we'll divide the allowance by gross accounts receivable. Or income statement numbers we can use bad debt divided by net sales to get a sense for any kind of trends. So, this is information that I pulled from page 109 of the Vulcan 10k, so I'm not going to pull that up but you can go look at that at your leisure. So I have the allowance for uncollectibles, accounts receivable gross. Remember I had to take the net number on the balance sheet, add the allowance to get the gross allowance gross accounts receivable. And as we can see back in the salad days, the heydays of the mid 2000's, it was only about 1% of gross receivables were expected to be uncollected. That jumped up in 2008, and it stayed high since then. We see a similar thing if we compare bad debt expense to net sales. It was really small, I'm sorry it was a really small percentage basically zero in the mid 2000s, and now it's come up to two-tenths of a percent, and to one-tenth of a percent. So we see that the expected uncollectibles jumped in 2008 and have stayed high. But there's a little bit of good news. This is supposed to be forward looking. Right, how many of these receivables do you expect not to collect into the future, and the fact that Vulcan has lowered the estimate. Means that they're anticipating their collections are going to improve in the future. And so they've gone ahead and reduced the allowance. Or it could mean that they're trying to artificially raise their earnings by using their discretion to reduce their percentage. I don't think that's the case, normally I would be skeptical of that. Actually don't think that's the case in Vulcan's situation because they had a loss anyway, so it didn't really help them. So I think this is probably legitimate good news that they're expecting collections to improve in 2011, 2012. >> The bad debt expense is such a small percentage of sales, so, who cares? >> Well, I care. That's why I brought it up. So there are two reasons why you might care about the allowance for doubtful accounts. The first one is, even though it's a small percent of sales, it's still three or four or five million of expense per year. And if Vulcan was in a situation where they were really close to an earnings target, which, which didn't happen here, but if they were really close to an earnings target, cutting this expense by a million may help them put it over the top, and we want to be able to find that out. But the second reason, and this is the more important reason here is, as I mentioned, bad debt expense is forward looking. It's managers looking ahead to see how much of their receivables they're going to be able to collect, which reflects their information about the credit quality of their customers, and where the business is going. And so this is one place where we get a little insight into what managers are thinking about the future, without having to do a mind meld. And with another obscure Star Trek reference with the use of mind meld, that wraps up the video. What we're going to do now is in the next video move on to look at the investing and financing activities of Vulcan in the past few years. See you then. >> See you next video.
