The True Value Creators of the DJIA Part II
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In a previous article, I selected four DJIA firms -- Intel (NASDAQ: INTC), IBM (NYSE: IBM), Wal-Mart (NYSE: WMT), and McDonald's (NYSE: MCD) -- for their higher-than-average residual earnings generation ability. As shown in this first article in the series, these firms not only grew their residual earnings nearly seven times as fast as all firms in the group collectively over the five-year test period, but they also generated significantly higher per share price appreciations.
The value creation framework illustrated below will be used to analyze these four firms with hopes of isolating a unique, value-generating quality that is inherent in each of their operations. In this article, we'll more closely examine Intel's residual earnings generation over the past five years.
As highlighted in the first article, Intel's residual earnings grew at an average compound growth rate of around 49% over the five-year period, and an investment held in the corporation to date since early January 2007 would have yielded an average return of around 7.5% per year thus far (not including dividends). This compares to about a break-even per share price appreciation for the entire DJIA over the same time period (actually a -0.2% CAGR since January 2007).
Intel's very successful operating history makes analysis of the corporation a simplified task. Over the study's five-year time frame, the corporation was able to drastically increase residual earnings through the simultaneous improvement of the two primary drivers -- a growth in net assets (common equity balance) and its return on those net assets (ROCE). Working behind the scenes to move these drivers was a multitude of small improvements in several of the business' other key metrics.
Primary Residual Earnings Drivers
In examining the growth in Intel's residual earnings compared to its growth in ROCE and equity balance, it can be determined that only an average of about 5% of the change in residual earnings was explained by the change in the corporation's net assets. Over the five-year period, INTC's common equity balance increased from $36.8 billion to $49.4 billion, or about 7.7% per year.
Although looking more closely at the firm's ROCE growth is arguably more important (it did have a greater impact on residual earnings expansion), it is still positive to note that the meaningful growth in shareholders' equity was due to a three-fold effect from sales, asset turnover, and net financial assets increases.
Sales increased at a 5.4% CAGR over the five-year period, and because asset turnover improved more than 14% over the study's duration, the corporation's efficient use of its assets turned sales into cash increasingly fast. This led to the utilization of minimal debt requirements, as most of the cost for daily operations was more than covered with working cash. As a result, Intel was able to maintain short and long term debt balances with relative stability (five-year CAGR of around 1% growth) while growing cash and equivalents by nearly 22% per year.
Whether the corporation will ultimately use this huge cash hoard to unlock further shareholder value in the future -- through an accretive acquisition, for instance -- is the topic of a different discussion.
As the growth in shareholders' equity accounted for about 5% of the change in residual earnings, return on those net assets (ROCE) was by far the primary driver of residual earnings growth over the five-year period. The corporation, as characteristic of most firms with sustainable competitive advantage, has historically generated very impressive returns on common equity. Intel's return of 25.2% in 2010, and even the higher 26.25% return in the past 12 months, is slightly more than the firm's 10-year average of around 15%.
ROCE Growth
The improvement in ROCE is attributable to several key factors. Intel hardly receives a financial leverage boost due to its minimal debt load, so the majority of the improvement in return can be directed to the efficient deployment of its core operating assets.
The firm's return on net operating assets (RNOA -- defined as post-tax operating income divided by net operating assets) increased in the most recent period to more than 38%. This is in comparison to the firm's 10-year RNOA average of 22%.
Around 60% of the improvement in RNOA over the five-year period can be explained by increasing margins. Gross margins over the past seven quarters have been well north of the 10-year average of 55% due to a multi-effect from increased volumes, selling prices, and the spreading of fixed costs (lower factory underutilization charges). The higher gross margins, and once again the spreading of fixed portions of SGA expenses, have led to 2010 operating margins that were 11% greater than the past 10-year average. Several SGA-to-sales percentage points were shaved off during the five-year period, with 2010's ratio of 14.5% comparing to the study's average of 16.6%.
Lastly, slightly improved asset turnover (increased 14.3% over the five-year period) explains about 40% of the improvement in return on net operating assets. This efficiency increase is no doubt due to not just the increase in sales on a comparable level of assets, but also the improvement in cash collection -- days sales outstanding improved 36%.
Likewise, the firm increased its ability to extract short-term credit from customers, allowing Intel to offset monies tied up in such accounts as inventory and better allocate investor funds to potentially higher-returning and value-creating projects. R&D spending, for instance, increased 16% in 2010.
What Gives?
For lack of a more creative adjective, Intel is simply a very good company. Huge barriers to entry, an unmatched level of economies of scale, and huge market share allowed the corporation to improve nearly all facets of its business despite the recent inclement economic environment. As will most likely be concluded with the other three DJIA firms in the study, Intel's ability to continuously generate returns above and beyond its cost of capital requirements can be primarily attributed to its sustainable competitive advantage.
In examining the corporation's unmatched historical success, there is no doubt that Intel's operations are surrounded by a huge competitive moat, which is further widened with huge economies of scale and a vast degree of customer captivity. With nearly 83.7% of the entire market's volume in Q3 2011, the corporation's ability to unlock value through scale operations, as well as its ability to capture customers through the industry's seemingly most attractive product on a price/quality continuum, is evident. Despite many advances made by its closest competitor, AMD (NYSE: AMD), Intel continues to steal small fragments of market share -- Intel's most recent market share reading is up from 80.9% in Q3 2010, and AMD slipped to 10.2% in Q3 2011 from 11.5% in the comparable quarter in 2010.
Without having examined the remaining three DJIA in the study, it has already become quite clear that only firms with wide competitive moats and sustainable advantages will have the ability to generate meaningful shareholder value over the long term through the growth of excess earnings. Stay tuned for the next article in the series to see how the remaining firms in the study have been able to stand out among their peers.
gibbstom13 has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines, Intel, and McDonald's. Motley Fool newsletter services recommend Intel and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
