Walt Disney Company Walt Disney Company (Disney) is a diversified international

ID: 2729624 • Letter: W

Question

Walt Disney Company Walt Disney Company (Disney) is a diversified international entertainment company with operations in three business segments. Revenue and operating income data for the three segments are shown below. images Page 499The profitability of the leisure-time industry is influenced by various factors including economic conditions, the amount of available leisure time, oil and transportation prices, and weather patterns. Disney management has been very aggressive in raising theme park admission prices. For the 10-year period ending in Year 13, admission prices increased at an annual rate of 8–9% compared to less than 4% for U.S. consumer price inflation. Disney’s Film Entertainment business has grown rapidly because of increasing acceptance of The Disney Channel and, importantly, management efforts to exploit the expanding distribution opportunities available for its extensive video library. Disney’s Consumer Products revenue has also grown meaningfully as the company has moved its product mix aggressively toward direct publishing and direct retail and away from higher-margined licensing and royalty income sources. During the fourth quarter of fiscal Year 13 (ending September 30, Year 13), Disney wrote off the full carrying value of Euro Disney. The charge was $350 million ($218 million after tax). images Page 500Required: a. Calculate and disaggregate Disney’s return on common equity for each of the two fiscal years ending September 30, Year 9, and September 30, Year 13 (use year-end figures for any ratio computations typically using averages). b. Drawing only on your answers to a and the data available, identify the two components that contributed most to the observed change in Disney’s return on common equity between Year 9 and Year 13. State two reasons for the observed change in each of the two components.

Case 8-2 (75 minutes) a. Computation and Disaggregation of ROCE Year 13 Year 9 ROCE 13.34% 23.09% NOA 5,527 3,243 NFOA 497 199 Equity 5,030 3,044 LEVB 0.10 0.07 NOPAT 654 677 NFEC 17 26 Net income 671 703 RNOA 11.82% 20.87% NFRD -3.52% -13.17% SpreadE 15.34% 34.04% A NOA - Equity B NFO/Equity C Net income-NOPAT D Negative amount indicates net income vs. expense E RNOA-NFR Computations Year 13 Year 9 ROCE $671/$5,030 = .133 $703/$3,044=.231 NOA $363+$1,390+$609+5,228+$2,272-$2,821-$1,514=$5,527 $381+$224+$+909+3,397+$1,084-$1,262-$1,490=$3,243 NOPAT ($8,529-$6,968-$515)x(1-($403/$1,074))=$654 ($4,594-$3,484)x(1-($450/$1,153)=$677 1 Ending assets are used because information is unavailable to compute average assets. b. Disney’s profit margin on sales decreased substantially from Year 9 to Year 13. Some reasons for this change include: • Disney experienced above average growth in the film entertainment business, which has the lowest operating margin of any of its business segments. • Disney experienced deterioration in consumer product margins as the business mix shifted away from licensing and royalty income. • Euro Disney losses and reserve provision (write-off) hurt Year 13 results, as compared with no effect in Year 9. • Disney experienced deterioration in the theme park margins because of lower attendance—this, in turn, stemmed from a slower economy and more expensive admission prices. • The profit margin on sales is offset, to some extent, by the favorable effects of financial leverage as the return on financial assets (other current assets) exceeds borrowing costs.

I have the answer, but can you tell me in your own words what is going on here?

Explanation / Answer

Ans:

Case 8-1 (120 minutes)

a. Computation of Return on Invested Capital Measures:

2005

(1) Return on net operating assets [a]............ 73.9%

(2) Disaggregated RNOA:

Oper. Profit margin [a].......................... 5.9%

NOA turnover [a]................................... 12.49

(3) Return on common equity [b].................... 47.7%

(4) Disaggregated ROCE [c]:

RNOA ............................................. 73.9

LEV ............................................. -38.3%

Spread.................................................. 68.6%

Computation notes:

[a] NOPAT

Average net operating assets

= ($4,254 x (1-[$1,402/$4,445])) / (($1,9301+$5,9502)/2) = 73.9%

1 2005: $23,215 - $5,060 - $14,136 - 2,089 = $1,930

2 2004: $19,311 - $835 - $10,896 - $1,630 = $5,950

Disaggregated:

2005 profit margin: ($4,254 x (1-[$1,402/$4,445])) / $49,205 = 5.9%

2005 net operating asset turnover: $49,205 / (($1,930+$5,950)/2) = 12.49

[b] Net income [11] - Preferred dividends

Average common equity

2005: [$3,043 - $0] / [($6,485 + $6,280)/2] = 47.7%

[c] 2005 NFO = $505 - $5,060 = -$4,555

2004 NFO = $505 - $835 = -$330

LEV = Avg. NFO = (-$4,555 - $330)/2 = -38.3%

Avg. Equity ($6,485 + $6,280)/2

NFE = NOPAT - Net income = $2,912 - $3,043 = -$131

NFR = NFE / Avg. NFO = $-131 / (-$4,555 - $330)/2 = 5.3%

Spread = RNOA – NFR = 73.9% – 5.3% = 68.6%

Case 8-1—continued

b. Computation of Asset Turnover Ratios:

2005

(1) Accounts receivable turnover.................................. 12.23

Average collection period.......................................... 29.85

(2) Inventory turnover....................................................... 102.26

Average inventory days outstanding....................... 3.57

(3) Long-term operating asset turnover....................... 6.56

(4) Accounts payable turnover....................................... 4.96

Average payables days outstanding....................... 73.61

The fact that ROCE is lower than RNOA results from the use of relatively high cost equity capital to finance investment in marketable securities. The company could eliminate this “problem” by repurchasing stock with its marketable investments, and has, indeed, repurchased a considerable amount of stock over the past 3 years. Since it operates in a fast changing industry, the additional liquidity is probably warranted. Dell’s ROE of 47.7% is still considerably greater than the 12% median for publicly traded companies.

Case 8-2 (75 minutes)

a. Nike’s ROCE, currently at 21.6%, has been steadily increasing over the 5 year period, while Reebok’s has remained at a constant level for the past 3 years, and is currently 15.7%.

ROCE = RNOA + LEV x Spread.

The computation of ROCE, based on its disaggregated components is as follows:

NIKE: 19.2% + 0.144 x 16.6% = 21.6%

Reebok: 12.7% + 0.367 x 8.2% = 15.7%

The recent 5-year trend in the ROCE components is as follows:

NIKE (NKE)

Reebok (RBK)

Sales growth

NKE’s sales growth has increased significantly in the past 2 years

After suffering sales declines 5 and 4 years ago, RBK’s growth has improved and is significant in the current year

Gross Profit

NKE’s gross profit margin has increased by 3.5 percentage points in the past 3 years and is currently 4.5 percentage points higher than RBK’s.

RBK’s gross profit margin increased by 1.6 percentage points in year 4 and has leveled off.

SG&A exp %

NKE’s SG&A percentage has increased by 2.1 percentage points from its trough and is currently 0.5 percentage points higher than RBK’s.

RBK’s SG&A percentage is 3 percentage points lower than 5 years ago and has leveled off in the recent 2 years.

NOPAT/Sales

NKE’s NOPAT% has increased by 1 percentage point form 5 years ago and is currently 2.8 percentage points higher than RBK’s.

RBK’s NOPAT% has also increased over the 5 year period, and is currently 1.8 percentage points higher than in year 1. It is currently significantly lower than NKE’s.

TAX exp. %

NKE’s tax expense has been increasing and is currently higher than RBK’s.

RBK’s tax expense has been decreasing over the 5 year period.

NOA turnover

NKE’s NOA turnover has increased significantly over the 5 year period, but is currently lower than RBK’s.

RBK’s NOA turnover has decreased form its high in Year 3, but has leveled off in the past 2 years.

Receivables turnover

NKE’s receivables turn has fluctuated within a constant band over the past 5 years and the average collection period currently stands at 63 days.

RBK’s receivable turn is significantly higher than NKE’s, and has remained fairly constant during the past 3 years. Its average collections period is 50 days.

Inventory turnover

NKE turns its inventories 4.45 times a year, for an average inventory days outstanding of 82 days.

RBK turns its inventories 5.71 times a year for an average inventory days outstanding of 64 days.

L-T oper. asset turn

NKE has been turning its long-term operations assets more quickly over the past 5 years, but only half as fast as RBK does.

RBK’s long-term operating asset turnover rate is twice that of NKE and has been increasing steadily over the past 5 years.

Accts. Pay turn

NKE’s accounts payable turnover rate has slowed over the past 3 years, increasing its average payable days outstanding to 35 days.

RBK’s accounts payable turnover has increased over the past 3 years, reducing its average payable days outstanding to 27 days.

Case 8-2—concluded

b. NKE’s operating performance is better than RBK’s. Its NOPAT margin is 2.8 percentage points higher, driven by a significantly higher gross profit margin. It appears that NKE is able to use its brand recognition and effective advertising to command higher unit selling prices for its products.

The NOA turnover is roughly comparable to the two companies. Most of the assets are current and NKE working capital turnover rate (not listed) is 3.89 times, compared with RBK’s of 3.14. The higher turnover of the more significant working capital accounts more than offsets NKE’s slower long-term operating assets turnover rate.

Based on this analysis, NKE appears to exhibit superior operating performance. Whether the stock is a “buy” depends on two factors: 1. is NKE’s higher profit margin sustainable, and 2. has the market already impounded the superior operating performance into NKE stock price.

Case 8-3 (75 minutes)

a. Computation and Disaggregation of ROCE

Year 13

Year 9

ROCE

13.34%

23.09%

NOA

5,527

3,243

NFOA

497

199

Equity

5,030

3,044

LEVB

0.10

0.07

NOPAT

654

677

NFEC

Net income

671

703

RNOA

11.82%

20.87%

NFRD

-3.52%

-13.17%

SpreadE

15.34%

34.04%

A NOA - Equity

B NFO/Equity

C Net income-NOPAT

D Negative amount indicates net income vs. expense

E RNOA-NFR

Computations