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Author: lostpros Two stars, 250 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 129  
Subject: The Five Minute Test Date: 4/21/2004 9:18 AM
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The following is The Five Minute Test as advocated in It's Earnings That Count. The author, Hewitt Heiserman, writes that the test provides “a rough-mesh screen to help you sift out the obvious losers in order to focus your analytical efforts exclusively on the highest-probability winners.” (SeaPickle and Formorears first advocated using this test on these boards. I am using SeaPickle's format and language and just inserting Reebok's numbers. In other words, SeaPickle and Heiserman are the brains behind this and I am simply the robot).

If you go by the book, the perspective company must pass all of the tests. Then it is time to move on to the next step which is to build the defensive and enterprising income statements. I will do this in future posts if people on these boards express such an interest – since based on my review below I believe RBK passes this test. As always, I welcome any thoughts or comments.

After they are completed however, then next step is to graph the results on Heiserman's Earnings Power Chart.
http://boards.fool.com/Message.asp?mid=20191765
http://boards.fool.com/Message.asp?mid=20157676

Overstock.com sells the book for $16.69.
http://www.overstock.com/cgi-bin/d2.cgi?PAGE=PROFRAME&PROD_ID=572570


=====

Sources Referenced

Reebok 10k; Moneycentral; Yahoo Finance


=====

Results of Tests
1 Auditor's Opinion => PASS
2 Lawsuits => PASS
3 Unusual Losses => PASS
4 Restatements => PASS
5 Intangible Assets Ratio => PASS
6 Debt to Equity Ratio => PASS
7 Revenue Growth => FAIL (BUT SEE BELOW)
8 Stock Based Compensation Ratio => PASS
9 Short Ratio => PASS
10 Defensive Profit => PASS
11 Enterprising Profit => PASS

=====================================================================
Analysis

Test 1: Auditor's opinion
If a company does not get a clean bill of health from it accountant, ditch it. (source: 10K Notes)

Independent Auditors Ernst & Young give a positive report about RBK consolidated
financial statements. (Page 76 of annual report)

PASS
______________________________________________________________________________
Test 2: Lawsuits
Many companies are defendants in some sort of lawsuit nowadays. But it is the serious cases that you are looking for here. If there is a lawsuit which could drastically harm or even put the company out of business if lost, then proceed at your own peril. (sources: Yahoo, Google, 10K Notes)

The Company is a party to a number of legal proceedings. The company does not believe that any of the lawsuites will result in a material change. Nothing is included in the notes. These lawsuits appear to be the typical cost of doing business and nothing more.

PASS
______________________________________________________________________________

Test 3: Unusual Losses
If there is a history of unusual losses, it may be a red flag. These include bad debt, worthless inventory, machinery that has outlived it useful life, and severance payments to laid-off workers. (source: Multex, 10K)

There is no recent history of unusual losses.

PASS
______________________________________________________________________________

Test 4: Earnings Restatements
Part 1: Heiserman states that almost every major financial collapse over the past few years has been preceded or precipitated by an earnings restatement. Check the last several years for such an occurrence. If more than 1 in last 3 years, drop it.

RBK has had no earnings restatements over the past 3 years.
PASS

Part 2: Heiserman also looks to see if the Audit Committee is independent of the company (no executives on the audit committee) and has regular meetings. This is forward looking to ensure you that all audits will be independent.

RBK has four members of the board of directors on the audit committee; none of whom are executives of the company. In addition, RBK had six audit committee meetings in the past year. See Proxy page 11.

PASS
______________________________________________________________________________
Test 5: Intangible Assets Ratio
Heiserman recommends a ratio less than 20%. (Balance Sheet)
(all figures in thousands)

Intangible assets ratio = (Goodwill + Other Intangibles) / Total Assets

RBK = (24,690 + 42,296) / 1,989,742 = 3.3%

PASS

As a variation calculate the companies tangible book value. If negative, drop it.


______________________________________________________________________________

Test 6: Debt-To-Equity Ratio
The lower the ratio, then the higher a firm's credit-worthiness. Avoid companies with a ratio over 75%. (source: 10K Balance Sheet)
(all figures in thousands)

(Debt-To-Equity Ratio = Debt / Shareholder Equity)

RBK = 398,262 / 1,033,710 = 36%

PASS
______________________________________________________________________________

Test 7: Revenue Growth
It takes a top line growth rate of at least 30% over the last 5 year period to pass this test. Not only is it important to calculate the figure but also to determine the source of the revenue growth. Revenue growth from an increase in units sold in great. Revenue growth from acquisitions is not so great. (source: 10K)
(all figures in millions)

(5 yr Growth Rate = (Year 5-Year 1) / Year 1) X 100

RBK = (3485.3-3224.6) /3224.6 = 8%
FAIL

But, note that sales increased 11% from 2002 to 2003 and only 8% from 1999 to 2002. There was a drop off from 1998 to 1999. After that sales began climbing slowly. With 11% this past year, RBK seems back on track.
_____________________________________________________________________________

Test 8: Stock-Based Compensation Ratio
This is a stock option issue. There are 2 big reasons why a ratio over 15% is bad. First, they can be viewed as a hidden expense that overstates a firm's profitability. Second, when the shares are exercised they dilute shareholder equity. (source : 10K Notes (Page 55))

(Stock-Based compensation % accrual profits = Stocked-Based Compensation / Accrual Profits)

RBK had stock based compensation of 10,414 and accrual profits of 157,214 (as always numbers in 000s). Thus, the stock based compensation ratio is 6.6%.

PASS
______________________________________________________________________________
Test 9: Short Ratio
It is recommended that if the Short Ratio is more than 15%, then take your time to find out why.
(Yahoo)

(Short Ratio = Shares Short / Float)

RBK = 5.1% as of 03/08/04

PASS
______________________________________________________________________________

Test 10: Defensive Profits
Can the company self-fund? The purpose of this test is to determine if the company is producing more cash than it is consuming. Until a company produces a Defensive Profit, it is essentially living on borrowed time. A positive number means a Defensive Profit. (source: 10K Cash Flow Statement)

Operating cash flow–capital spending–acquisitions-nonoperating sources of cash

135.4 - 44.5 - 0 - 35.0 (issuance of stock) = 55.9 (million)

PASS
______________________________________________________________________________

Test 11: Enterprising ProfitsIs the company creating value? The purpose of this test is to determine if the company is able to produce a return on capital that is greater than the cost of that same resource. A result over 18% means the company probably has and Enterprising Profit.

EBIT / Debt + Shareholders Equity

252,400 / 1,286,934 = 18.2%

PASS

====================================================================

What does failing a test mean?

Some test are more important that others. Ideally, you want to find a company that will pass all of the tests or have a good reason if it does not.

If the company fails the following test then drop it:
Test 1: Auditor's opinion
Test 2: Lawsuits

Failing Test 3: Unusual Losses, may mean management does not know what they are doing.

Heiserman finds no reason in spending time with companies that fail the following tests unless there is a very good reason:

Test 4: Earnings Restatements
Test 5: Intangible Assets Ratio
Test 6: Debt-To-Equity Ratio
Test 9: Short Ratio

If the company fails Test 7: Revenue Growth find out why. If it is because the product being sold is losing popularity or no longer needed in the marketplace, drop it and move on.
This is the only test RBK technically fails. Based on their recent revenue growth, aggressive strategy, etc. I believe that this is not a problem in the future. Any contrary thoughts are welcome.

====================================================================
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