Priceline's Return On Equity Decreased Because Of A Decreasing Asset Turnover Value

Summary

The decreasing ROE was a result of decreasing asset turnover, but also profit margins.

The company reported earnings last week, but the guidance portion of the call disappointed investors.

I'd like to see Priceline increase the equity multiplier number a bit by reducing some of its equity either through share buybacks or a dividend.

Most investors take a look at return on equity as a measure of how well a company is doing with respect to net income as a ratio to shareholders' equity on the balance sheet. Companies such as IBM (NYSE:IBM), Boeing (NYSE:BA), or Altria (NYSE:MO) even have huge returns on equity. Typically, a high return on equity value is pretty nice to have, but not all returns on equity are equal.

Although it is a straight ratio as suggested, it is a bit more complex than that. Not many investors know this, but return on equity can actually be decomposed into three parts, made popular by DuPont back in the 1920s. The decomposition of return on equity tells us three things:

1. Operating efficiency, which is measured by profit margin
2. Asset use efficiency, which is measured by total asset turnover
3. Financial leverage, which is measured by the equity multiplier

Prepare yourself for some algebra; I promise it will be pretty easy. We already know that profit margins are dictated by the equation of profit/sales. Total asset turnover is dictated by the equation of sales/assets and the equity multiplier is dictated by the equation of assets/equity. So when we multiply them all together we get the following proof:

 Profit * Sales * Assets = Profit = ROE Sales Assets Equity Equity

I for one am looking at return on equity in a much different manner now after learning this method. The part of the proof above that got me to investigate ROE more intently is the equity multiplier portion. Depending on how a company chooses to finance its assets (by debt or by equity), the equity multiplier can be really huge, causing the overall return on equity to be high. Personally, I don't like a whole lot of debt on the balance sheet. But for capital structuring reasons, debt can be used as a tax shield as taxes are calculated after interest payments.

I've chosen to evaluate Priceline (NASDAQ:PCLN) today, because since I've been writing about the company, the return on equity has been steadily decreasing with the following profile:

 Date ROE (%) 24Apr14 32.7 24Jun14 30.0 24Nov14 30.6 22Apr15 30.0

Operating Efficiency

As mentioned earlier, operating efficiency is the profit divided by the sales. This in essence tells us how efficiently the company is operating from an operations, financial, and tax perspective. From the table below, we see that the profit margin decreased by 2.2% for the company from the prior quarter. We see that net income has increased and sales increased over the period at a higher clip. Nonetheless, profit margins decreased, which means the decrease in ROE was partially due to the decreasing profit margin.

 1Q15 4Q14 % Change Q/Q Net Income (NYSE:TTM) \$2,423 \$2,421 0.1% Sales \$8,641 \$8,442 2.4% Profit Margin 28.0% 28.7% -2.2%

Total Asset Turnover

From the equation I showed above, the total asset turnover ratio is defined by sales divided by assets. Total asset turnover gives us the big picture of how well the company is transforming all of its assets into sales. From the table below, we see that the total asset turnover actually decreased from the prior quarter. Total sales increased while average assets increased at a higher clip. This portion of the equation tells us that the ROE decrease was related to the company's ability to make less money on their assets when compared to what they've done in the past.

 1Q15 4Q14 % Change Q/Q Sales \$8,641 \$8,442 2.4% Average Assets \$14,642 \$13,135 11.5% Total Asset Turnover 0.59 0.64 -8.2%

Equity Multiplier

The equity multiplier is the part of the ROE equation that I don't like. It's with this portion of the equation that a company can choose to get risky or play it safe. It completely depends on how the company manages its debt, equity, and on how well the cash flows are coming in to pay those debts. From the previous portions of the equation, we pretty much determined that the ROE has decreased, thanks to the decrease in profit margin and asset turnover, but we still have to look at the equity multiplier.

An equity multiplier number of 1.74 is pretty good for my taste. But it isn't until we break it out like I did in the tables below that we can see if it is a good thing or a bad thing. As we can see, assets have increased and equity has increased, but at a lower clip, causing the equity multiplier to increase.

 1Q15 4Q14 % Change Q/Q Average Assets \$14,642 \$13,135 11.5% Average Equity \$8,439 \$8,083 4.4% Equity Multiplier 1.74 1.62 6.8%

If we dig a little further, we see that the equity value increased over the past year primarily because of an increase in retained earnings over the past year.

 Stockholders' equity 1Q15 4Q14 3Q14 2Q14 1Q14 Common stock \$0 \$0 \$0 \$0 \$0 Additional paid-in capital \$4,927 \$4,923 \$4,849 \$4,703 \$4,650 Retained earnings \$6,974 \$6,641 \$6,189 \$5,126 \$4,550 Treasury stock -\$3,046 -\$2,738 -\$2,233 -\$2,085 -\$2,084 Accumulated other comprehensive income -\$225 -\$260 -\$72 \$78 \$93 Total stockholders' equity \$8,630 \$8,567 \$8,733 \$7,824 \$7,209

In Other News

The company reported first-quarter earnings a week ago that beat expectations on both the top and bottom lines by reporting \$8.12 per share on the bottom line and \$1.84 billion in revenue versus \$7.72 per share on revenue of \$1.8 billion. On the surface, someone would think that the stock price jumped up on the announcement, but it actually didn't, and that was in no thanks to the guidance part of the conference call. The company guided conservatively for the coming quarter with only an increase in bookings by 0% to 7%. Hopefully, if the euro begins to strengthen during the quarter, Priceline can report another blowout as it gets a lot of its business from across the pond.

Conclusion

Priceline's return on equity is decreasing from the prior quarter and it is primarily decreasing because of the decreasing asset turnover number. When you multiply all the numbers together, you get an ROE of 28.7%, a decrease of 4% from the previous quarter. This ROE makes Priceline the 9th highest in the business services industry (out of 85 companies). I'd like to see Priceline increase the equity multiplier number a bit by reducing some of its equity either through share buybacks or a dividend.