By William Trent, CFA of Stock Market Beat
For a book project we are working on we conducted a common size analysis of Total SA’s (TOT) financial statements. We figured it would be something worth passing along here.
Total’s common-size statements are presented below. The first step in conducting a common-size analysis is to review both the common-size income statements and common-size balance sheets to look for changes and trends that warrant further review. Once the trends are identified, explanations should be sought. Management’s discussion of financial performance and the financial statement footnotes are good starting points, provided the reader maintains a healthy skepticism of management’s explanations. These internal perspectives should be balanced by external sources such as industry reports, economic data, peer company financial statements and news reports. We present a common-size analysis of Total below including an initial assessment, income statement analysis and balance sheet analysis.
Exhibit 1: Horizontal Common Size Income Statement
Exhibit 2: Vertical Common Size Income Statement
Exhibit 3: Horizontal Common Size Balance Sheet
Exhibit 4: Vertical Common Size Balance Sheet
Initial Assessment
Total’s horizontal common-size income statement is presented in Exhibit 1. Revenues grew 22.8% in 2005 and 39.2% cumulatively between 2004 and 2006. Total’s horizontal common-size balance sheet is presented in Exhibit 3. Total assets increased by 22.3% in 2005 and declined slightly in 2006 for a cumulative increase of 21.3%. Assets grew at about the same rate as sales in 2005, but fewer assets produced a higher level of sales in 2006, indicating that Total used its assets more efficiently that year.
In Total’s Form 20-F filed with the U.S. Securities and Exchange Commission, management notes that the “average oil market environment in 2006 was marked by higher oil prices, with the average Brent oil price increasing 19% to $65.10/b from $54.50/b in 2005.” They further disclose that “Oil and gas production in 2006 was 2,356 kboe/d compared to 2,489 kboe/d in 2005, a decrease of 5% due principally to the impacts of the price effect (1) (-2%), shutdowns of production in the Niger Delta area because of security issues (-2%) and changes in the Group’s perimeter (-1%). Excluding these items, the positive impact of new field start-ups was offset by normal production declines at mature fields and shutdowns in the North Sea.” This explains the apparent productivity increase: rather than producing more petroleum with fewer assets the company produced less. However, due to higher oil prices the revenue from the production more than offset the decline in quantity. By comparing output rather than revenue we see that output declined 5% and assets declined less than 1%. By this measure, efficiency actually decreased rather than increased. Since management has control over production but not commodity prices, this may be a more appropriate measure.
Income Statement
An examination of Total’s vertical common-size income statement, presented as Exhibit 2, shows that the while the company was profitable the entire time net profit margin declined steadily from 9.5% in 2004 to 9.2%in 2005 and just 7.9% in 2006. Investors will want to know if this trend is more likely to continue or to reverse. To do this we analyze the components of the income statement.
Excise taxes declined steadily throughout the period, which increased net revenue available to the company. Whatever caused the decline in profit margin had to overcome this positive effect. Purchases offer a partial explanation. Rising crude oil prices hurt operating margins for the refining and retail businesses. However, while this expense grew substantially faster than sales during the three years (48.8% compared to net revenue growth of 39.2%) it does not account for the entire decline in net margins. In fact, Figure 5-1 shows that operating income as a percentage of sales increased in 2005 and the decline in 2006 still left the income from operations higher than it was in 2004. Instead, we see that the decline in net profitability was due to non-operating items: specifically “other income” and an increase in income taxes.
Turning to the 20-F for information, we learn that the biggest reason for the decline was a one-time gain recognized in 2004: “The gains (losses) on sales of assets included a pre-tax dilution gain on the Sanofi-Aventis merger of 2,969 M € in 2004.” Without the gain in 2004, other income would only have been 0.1% of sales, and the apparent decline in margins would not have occurred.
With regard to income tax, the effective tax rate has been rising relative to pre-tax income, with the major factor being the difference between French tax rates and foreign tax rates. In particular, “The Venezuelan government has modified the initial agreement for the Sincor project several times. In May, 2006, the organic law on hydrocarbons was amended with immediate effect to establish a new extraction tax, calculated on the same basis as for royalties and bringing the overall tax rate to 33.33%. In September, 2006, the corporate income tax was modified to increase the rate on oil activities (excluding natural gas) to 50%. This new tax rate will come into effect in 2007.”
Some expenses can be crucial to a company’s future success. For example, pharmaceutical companies rely heavily on research and development. Improved margins due to lower R&D spending may actually be bad news. For oil companies, the equivalent of R&D is exploration costs – expenses related to trying to find new sources of oil. Total’s exploration costs were fairly stable as a percentage of revenue.
Another industry-specific expense is depletion, which is the counterpart to exploration and the equivalent of depreciation for fixed assets. When new oil discoveries are made an estimate of the total available oil is added to assets. The depletion charge represents the amount used up each year from the resources.
For forecasting future net margins, we would probably want to use the more recent years as a guideline. Tax rate increases should be considered permanent, and the 2004 net gain appears to have been a one-time event.
Balance Sheet
Note that Total presents its balance sheet with long-term assets and liabilities above current assets and liabilities. This presentation is fairly common outside the United States.
Remember that revenues grew 22.8% in 2005 and 39.2% cumulatively between 2004 and 2006. Total assets increased by 22.3% in 2005 and declined slightly in 2006 for a cumulative increase of 21.3%. When reviewing common-size balance sheets, particular attention should be paid to individual items that are not in line with this trend.
Assets
Beginning with long-term assets, intangible assets rose faster than sales or total assets while tangible assets (property, plant and equipment) grew slower. By their nature intangible assets are difficult to value, and subjective judgment is involved. Investors should always investigate the composition of intangible assets. Looking at Note 10 in Total’s 20-F we find that the increase in 2005 was mostly due to acquired mineral rights. Assuming the valuation was performed appropriately this is a valid asset. In 2006 acquisitions of other companies resulted in the change. Rapidly growing intangible assets and slow-growing property and equipment indicates the company may be pursuing a “buy versus build” strategy. In aggregate, long-term tangible and intangible assets amounted to 43.9% of total assets in 2004, 42.3% in 2005 and 43.1% in 2006 – a fairly constant proportion. Equity and other investments also stayed fairly consistent as a percentage of assets.
Hedging instruments of non-current financial debt declined as a percentage of assets. However, looking further down the balance sheet we see that the non-current debt increased in both absolute and percentage terms. It is possible that the company reduced the amount of overall hedges, or that the hedges declined in value (which would normally be offset by a similar change in the fair value of the hedged liability.) The discussion in the 20-F reveals losses is limited to the change between 2005 and 2006, so it is necessary to refer to the 2005 20-F to learn about the large decline between 2004 and 2005. In doing so, we find that currency and interest rate swaps lost value. Currency and interest rate movements were of a favorable direction, so any currency and interest rate hedges were unfavorable. Although the amount of debt changed year/year it is possible to gauge the overall impact by comparing debt maturing in specific years. For example, in 2004 Total had $2,241 million of bonds issued that mature in 2008. In 2005, the amount of 2008 maturities was similar at $2,256. However, the fair value of interest and currency swaps on the 2008 maturities had fallen from $398 million to $117 million. Similar declines were seen across other maturity dates.
From 2005 to 2006 there was a decline in “other non-current financial assets.” Note 14 of the 20-F explains that the company used up some deferred tax assets during the year. As discussed in Chapter 3, deferred tax assets represent differences between earnings reported to shareholders and earnings reported to the tax authorities. Assets arise when book earnings are lower than tax earnings, frequently because of tax loss carry-forwards. As the company earns money in future periods it can use these carry-forwards to offset current period taxes. By contrast, deferred tax liabilities arise when the company’s reported book earnings are higher than reported tax earnings. This can be caused by use of accelerated depreciation for tax purposes, for example, and represents a tax payment that has been recognized in the income statement but not yet paid. Looking further down the balance sheet, we see that deferred tax liabilities grew in both years, though at a slower rate than either sales or total assets. As a result, they declined as a percentage of assets from 7.2% in 2004 to 6.8% in 2006. In aggregate, non-current assets declined from 62.0% of total assets in 2004 to 59.3% in 2006.
Turning to current assets, both inventories and accounts receivable grew faster than sales or assets in 2005, but declined in 2006. Over the entire two-year period inventories grew faster than total assets but slower than sales. Since sales are made directly from inventory and often result in accounts receivable, the comparison to sales indicates that working capital was efficiently managed in 2006.
Prepaid expenses and other current assets rose faster than assets and in line with sales for the entire period. Investors frequently devote special attention to the “other” category because changes there sometimes indicate earnings management since such assets arise when more earnings appear on the income statement than are collected in cash. Here the 20-F doesn’t help, as Note 16 provides a table breaking the category down further but the drivers of the change remain classified as “other.”
Cash and equivalents declined considerably. Half of the decline in 2006 was due to currency issues. Current financial assets were up sharply over the two years, which also contributed to the cash decline. According to the 20-F, “Certain financial instruments hedge against risks related to the equity of foreign subsidiaries whose functional currency is not the euro (mainly the U.S. dollar). They qualify as “net investment hedges”. Changes in fair value are recorded in shareholders’ equity. The fair value of these instruments is recorded under “Current financial assets” or “Other current financial liabilities”.” Given that the latter category declined considerably, favorable changes in the value of such hedges would seem to be a likely explanation for both shifts.
Liabilities
Total’s long-term liabilities grew just 7.1% in 2005 and declined in 2006. As a percentage of total assets they fell from 18.8% to 15.6%. The main driver of the overall decline was a reduced liability for employee benefits. Looking at Note 18 in the 20F, we find that the expected future obligation has been reduced by approximately €900 million between 2005 and 2006. Specifically, the reduction was due to actuarial gains and losses, which reduced the reported obligation by €1.15 billion but merely reflect actuarial estimates. In addition, currency translation adjustments reduced the expected future liability by €900 million. Investors might want to ignore these adjustments or make their own adjustments to reflect their arbitrary and possibly unsustainable nature. Without these two adjustments the liability would have increased rather than decreased. Non-current debt increased 25.6% cumulatively, which was faster than the growth in total assets but slower than the growth in sales.
Short-term borrowings increased substantially, particularly in 2006. This resulted from a larger portion of the non-current debt coming due in 2007.
Accounts payable ballooned in 2005 but were reduced in 2006 such that cumulative growth was in line with the growth in sales and assets. The large increase in 2005 could have been resulted from an unusually large amount of purchases late in the year. Other current liabilities grew at a slower rate than sales or assets in both periods.
Disclosure: Author is long UNITED STS OIL FD LP UNITS (USO) at time of publication.
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