Question

***PLEASE ANSWER WITH FORMULAS INCLUDED***

Newman Industries is a leading supplier of cosmetics.

In the letter to stockholders as part of the 2008 annual report, President and CEO Jennifer White offered the following remarks:

Fiscal 2008 was clearly a mixed bag for Newman, the industry, and the economy as a whole.

Still, we finished with revenue growth of 15 percent—and that’s significant. We believe it’s a good indication that Newman continued to pull away from the pack and gain market share. For that, we owe a debt of gratitude to our employees worldwide, who aggressively brought costs down— even as they continued to bring exciting new products to market.

The statement would not appear to be telling you enough. For example, Chauhan says the year was a mixed bag with revenue growth of 15 percent. But what about earnings? You can delve further by examining the income statement in Exhibit 1. Also, for additional analysis of other factors, consolidated balance sheet(s) are presented in Exhibit 2 on page 92.

1. Referring to Exhibit 1, compute the annual percentage change in net income per common share-diluted (second numerical line from the bottom) for 2005–2006, 2006–2007, and 2007–2008.
2. Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years. Begin with 2005.
3. What is the major reason for the change in the answer for Question 2 between 2007 and 2008? To answer this question for each of the two years, take the ratio of the major income statement accounts to net revenues (sales).

Cost of sales

Research and development

Selling, general and administrative expense

Provision for income tax

4. Compute return on stockholders’ equity for 2007 and 2008 using data from Exhibits 1 and 2.

Exhibit 1

Newman Industries Summary Consolidated Statement of Income (in millions)                                                                               2008             2007              2006				2005
	Dollars	Dollars	Dollars	Dollars
Net revenues ...............................................	$17,125	$14,610	$10,705	$8,751
Costs and expenses: Cost of sales .........................................	9,030	6,438	4,569	3,602
Research and development ..................	1,015	1,529	1,179	918
Selling, general and administrative ......	3,433	3,061	2,085	1,715
Goodwill amortization .........................	150	54	11	1
In-process research and development ..	66	9	75	106
Total costs and expenses .............................	13,694	11,091	7,919	6,342
Operating Income .......................................	3,431	3,519	2,786	2,409
Gain (loss) on strategic investments ...........	(80)	107	–	–
Interest income, net .....................................	252	69	75	37
Litigation settlement ...................................	–	–	–	–
Income before taxes ....................................	3,603	3,695	2,861	2,446
Provision for income taxes .........................	502	806	464	306
Cumulative effect of change in accounting principle, net .....................	(54)	–	–	–
Net income ..................................................	$    3,047	$ 2,889	$ 2,397	$   2,140
Net income per common share—diluted ....	$   1.32	$    1.27	$    1.10	$ 1.03
Shares used in the calculation of net income per common share—diluted ...........	2,316	2,268	2,171	2,079

5. Analyze your results to Question 4 more completely by computing ratios 1, 2a, 2b, and 3b (all from this chapter) for 2007 and 2008. Actually, the answer to ratio 1 can be found as part of the answer to question 2, but it is helpful to look at it again.

What do you think was the main contributing factor to the change in return on stockholders’ equity between 2007 and 2008? Think in terms of the Du Pont system of analysis.

6. The average stock prices for each of the four years shown in Exhibit 1 were as follows:
   2005. 11¼  
   2006. 16¾
   2007. 28½
   2008. 9½

1. Compute the price/earnings (P/E) ratio for each year. That is, take the stock price shown above and divide by net income per common stock-dilution from Exhibit 1.
2. Why do you think the P/E has changed from its 2007 level to its 2008 level? A brief review of P/E ratios can be found under the topic of Price-Earnings Ratio Applied to Earnings per Share in Chapter 2.

Answer 1

		2005	2006	2007	2008
A	Price per share	11.25	16.75	28.5	9.5
			48.9%	70.1%	-66.7%
B	Net income per share diluted	1.03	1.1	1.27	1.32
			6.8%	15.5%	3.9%
a.	P/E ratio =A/B	10.92	15.23	22.44	7.20

	2008	2007	2006
Net revenue growth	17.2%	36.5%	22.3%
Costs & expenses growth	23.5%	40.1%	24.9%
Net income growth	5.5%	20.5%	12.0%
Operating income growth	-2.5%	26.3%	15.6%

		2005	2006	2007	2008
Cost of sales	As a % of net revenue	41.2%	42.7%	44.1%	52.7%
Research and development	As a % of net revenue	10.5%	11.0%	10.5%	5.9%
Selling, general and administrative expense	As a % of net revenue	19.6%	19.5%	21.0%	20.0%
Provision for income tax	As a % of Income before taxes	12.5%	16.2%	21.8%	13.9%

		2005	2006	2007	2008
Net revenue		8,751	10,705	14,610	17,125
EBIT margin	As a % of net revenue	27.5%	26.0%	24.1%	20.0%
Net margin	As a % of net revenue	24.5%	22.4%	19.8%	17.8%

b. Net revenue grew by just 17.2% (=17125/14610-1) in 2008 versus 36.5% (=14610/10705-1) in 2007 and 22.3% (=10705/8751-1) in 2006. While total costs and expenses expanded by 23.5% (=13694/11091-1) in 2008 against 40.1% (=11091/7919-1) and 24.9% (=7919/6342-1) in 2007 and 2006 respectively. So the cost increase has exceeded the revenue growth for the corresponding years. Thus, operating income for 2008 has decreased by 2.5% in 2008 after growing by 26.3% and 15.6% in 2007 and 2006 respectively.

However, the interest income has also increased astronomically in 2008 compared to the erstwhile years partially offsetting the impact of the loss on strategic investments for 2008. The provision for taxes is also lower compared to 2007. Therefore, the revenue growth, interest income, and lower tax have helped the company post a 5.5% growth in net income for 2008 against 20.5% and 12% in 2007 and 2006 respectively.

The PE ratio for 2006 and 2007 had increased driven by the growth in price per share and net income per share. However, the stock price has also dipped by 66.7% in 2008 after gaining by 48.9% and 70.1% in 2006 and 2007 respectively. The dip in price was probably in response to the lower topline and bottom-line growth in 2008. As a result, the PE ratio declined in 2008.