PROBLEM 8–1 While you are an analyst at Investment Counselors, Inc., the senior portfolio manager at your firm makes a decision to increase sporting goods apparel manufacturer stocks in the firm’s managed funds. You are assigned to recommend one stock as an initial investment to meet this long-run objective. You diligently analyze and evaluate all communication stocks and narrow the decision to two athletic shoe manufacturing companies: Nike and Reebok.

The senior portfolio manager requests that you analyze the internal sources of earnings growth for each company. You decide to disaggregate and evaluate the internal growth components for each company to explain any trends in your variable of interest, return on common equity. You identify the key components driving ROCE and develop the following spreadsheet:

Nike Year 5 Year 4 Year 3 Year 2 Year 1 Return on equity (ROCE)................................. 21.6% 12.1% 18.1% 17.8% 18.5%

Return on net operating assets (RNOA).......... 19.2% 15.5% 14.2% 13.4% 13.3%

Financial leverage (LEV)................................. 14.4% 24.8% 32.8% 41.3% 46.0%

Spread............................................................ 16.6% 13.9% 11.9% 10.6% 11.3%

Sales growth ................................................. 14.55% 8.13% 4.26% 5.49% 2.49%

Gross profit margin ........................................ 42.9% 41.0% 39.3% 39.0% 39.9%

SG&A expense/Sales....................................... 32.7% 31.9% 31.4% 30.6% 31.5%

NOPAT/Sales................................................... 7.8% 7.1% 7.0% 6.6% 6.8%

Tax expense/Pretax income............................. 34.8% 34.1% 34.3% 36.0% 37.0%

NOA turnover .................................................. 2.44 2.19 2.03 2.02 1.96 Receivables turnover...................................... 5.83 5.50 5.78 5.95 5.79 Average collection period ............................... 62.62 66.33 63.19 61.37 63.09 Inventory turnover .......................................... 4.45 4.37 4.29 4.03 4.13 Average inventory days outstanding............... 82.07 83.50 85.04 90.54 88.37 Long-term operating asset turnover............... 6.56 5.46 4.67 4.47 4.18 Accounts payable turnover ............................. 10.48 11.72 12.83 11.86 10.62 Average payable days outstanding................. 34.84 31.13 28.46 30.78 34.36 Return on equity (ROCE)................................. 15.7% 15.1% 15.0% 13.4% 1.9%

Return on net operating assets (RNOA).......... 12.7% 12.3% 12.1% 10.1% 7.9%

Financial leverage (LEV)................................. 36.7% 44.5% 53.8% 78.8% 101.0%

Spread ........................................................... 8.2% 6.3% 5.4% 4.2% 6.0%

Sales growth .................................................. 11.43% 4.51% 4.45% 1.19% 10.07%

Gross profit margin ........................................ 38.4% 38.3% 36.7% 37.9% 38.5%

SG&A expense/Sales....................................... 32.2% 32.4% 31.8% 33.6% 35.2%

NOPAT/Sales................................................... 5.0% 4.8% 4.3% 3.8% 3.2%

Tax expense/Pretax income............................. 30.8% 31.0% 31.0% 36.1% 36.0%

NOA turnover .................................................. 2.55 2.59 2.84 2.66 2.50 Receivables turnover...................................... 7.31 7.77 7.42 6.81 6.20 Reebok Year 5 Year 4 Year 3 Year 2 Year 1 Average collection period ............................... 49.96 46.98 49.22 53.58 58.86 Inventory turnover .......................................... 5.71 5.06 5.01 4.40 3.76 Average inventory days outstanding............... 63.95 72.10 72.88 82.88 97.17 Long-term operating asset turnover............... 13.67 12.62 12.31 10.25 9.03 Accounts payable turnover ............................ 13.33 13.16 12.66 10.92 9.99 Average payable days outstanding ................ 27.37 27.74 28.83 33.43 36.54 Required:

a. Describe and interpret how the recent five-year trend in the components of ROCE determine the ROCE for both Nike and Reebok.

b. Recommend a “buy” on one of these companies based on your analysis. Support your recommendation with reference to your analysis in (a).