First Investments Case
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To: Head of Investment Analysis
Re: Basic Industries Analysis
With the exception of the strike years of 1989 and 1990, Basic Industries (BI) has maintained steady EPS growth since 1985. However, from 1993 to 1994, ROA and ROCE both dropped from 8.55% to 8.41% and 17.35% to 16.42% respectively. Dissecting ROA further, the fall comes from a reduced profit margin which appears to be from higher material costs. Breaking down the ROCE confirms the rise in material costs and also shows a higher interest expense to revenue ratio suggesting new debt has been issued. The capital structure ratio also increased from 2.47 to 2.53 over the period showing BI is more leveraged. Examining the balance sheet, long-term debt has increased by $278 million and PP&E has increased by about $255 million suggesting the new debt BI issued was to acquire new PP&E.
Looking at the evolution of BI from 1985 to 1994 through ROA and ROCE shows some continuing trends. First, the capital structure ratio has consistently risen from 2.04 in 1985 to 2.53 in 1994 giving BI more leverage. Both the ROA and ROCE profit margins have decreased from 6.16% to 5.88% and 5.71%% to 4.53% respectively. The main culprit in the decrease of profit margin seams to be from the rising interest expense shown by the interest expense to revenue ratio rising from 0.44% to 1.34%. The total asset turnover ratios have not changed significantly over the period. The cumulative effect of these changes has been a drop in ROA from 8.89% to 8.41% and a drop in ROCE from 16.85% to 16.42% from 1985 to 1994.
Given the limited information, it appears BI has issued debt to purchase PP&E in 1994. With the new PP&E, BI should have more production next year raising profit margin and in turn rising ROA and ROCE. However, they continue to grow EPS and ROCE through higher leverage and are not focusing enough on producing their product more efficiently. If BI faces adversity, the effects will be harder felt with the greater leverage. The following page shows the data used in this analysis.
Sincerely,
James Rambo
8.41%
8.55%
8.60%
8.26%
6.94%
6.04%
7.57%
8.15%
7.94%
8.89%