Accounting and Financial

Analysis
(course ISF 6043-01)

Financial Analysis – Auto industry

Key earnings drivers
Capex and operating profit forecasts
Economies of scale, operating leverage, BE analysis

Professor Namuh Rhee

Yonsei University GSIS

May 4th and 11th, 2022

Readings

RP:
•  Page 342-360, Hyundai Motor Company, JP Morgan, Feb
25, 1994.

•  Page 283-292, The Automotive Industry, Financial

Statement Analysis, Car Manufacturing, CFA Institute.

•  Page 428-432, Initiation Report Guidelines, V. Earnings

Outlook, Samsung Securities, Research, August 2000.
Agenda
•  Key earnings drivers

•  Capex and operating profit forecasts

•  Economies of scale, operating leverage, and break-even

analysis

•  Homeworks
Key earnings drivers
•  Analyze 4 key drivers in the past three years:
1)  Volume
2)  Pricing
3)  Costs
4)  Change in capital structure

•  Combination of volume growth and higher ASP (average

selling price) creates explosion in revenue growth and
operating leverage kicks in (for capital-intensive
industries).

•  Ultimate objective – With help of the company’s

“guidance”, make 1) - 4) forecasts for the next 2-3 years.
Hyundai Motor earnings summary
(JP Morgan 1991-96E vs. 2016A)

2016A
4,860.0
-2.1% YoY
19,269
+4.0% YoY
93,649
+1.8% YoY

5,194
5.5% OP margin
(peak margin 9%)

5,720
6.1% NP margin
Top-line forecasts and cyclicality
•  Three factors determine a company’s sales growth:
1)  Market demand growth for existing products (cycle vs.
long-term growth);  
2)  the company’s market share for each product; and
3)  Market diversification or new product intro by company.

•  Clearly state the cyclicality, stage of cycles and next

peak/trough.
•  For cyclicals, indicate inventory levels and shipment growth.

•  Disclose key assumptions: Real GDP growth, FX (yen/$,

RMB/$ etc), global smartphone growth etc.
Alphabet (Google) quarterly sales growth
Cyclicality, stage of cycles, and
next peak & trough Next peak (E)

Previous peak

Current stage

2 Previous Previous trough

trough

T-36 T-24 T-9 T T+18 (E)

mos mos mos
Agenda
•  Key earnings drivers

•  Capex and operating profit forecasts

•  Economies of scale, operating leverage, BE analysis

•  Real-life case: Hyundai Motor investment thesis

OP is the most reliable indicator of a
company’s ability to survive and prosper
•  Operating profit (OP) reveals management’s capacity to
generate profits from the basic business of the company.
It’s usually dominant component of cashflow (CF) and
other measures of reported income.
•  OP is the product of sales and OP margin. A time
series analysis of GP margin and OP margins lies at the
heart of financial analysis. Important correlation between
OP margin and 1-2 factors is helpful.

•  OP is subject to relatively little consistent manipulation

•  The reliability of reported earnings deteriorates rapidly as

their “distance” from sales lengthens (on the income
statement).
KOSPI 200 Index OP aggregate
(Won  tr)  

Source:  Wisefn  
Samsung Electronics is the world’s biggest
spender in capex and R&D
Why sharp pick-up in 2017?
Capex and depreciation forecasts
•  Having projected future growth, capital investment (“capex”)
plan needs to be addressed.
•  Management typically discloses 1-2 year capex plan; degree
of match between forecast demand and management’s
expansion plan is an important topic.
•  Understanding: 1) relationship between capex and (non-
cash) depreciation and 2) capex as % of sales are
important.
Table: Apple capex and depreciation
(US$bn) 2014 2015 2016 2017 2018 2019
Capex 9.6 11.2 12.7 12.5 13.3 10.5
Depr 7.9 11.3 10.5 10.2 10.9 12.5
OP+depr 60.4 82.5 70.5 71.5 81.8 76.4

Table: Samsung Electronics capex and operating profit

(W tr) 2014 2015 2016 2017 2018 2019
Capex 23.4 25.5 25.5 42.8 29.6 25.4
(% of sales) 11.4% 12.7% 12.6% 17.8% 12.1% 11.1%
OP 25.0 26.4 29.2 53.7 58.9 27.8
Agenda
•  Key earnings drivers

•  Capex and operating profit forecasts

•  Economies of scale, operating leverage, BE analysis

•  Real-life case: Hyundai Motor investment thesis

Economies of scale ( = Scale economy)
•  Reduction in per unit cost that arise from large-volume
production. The reductions result largely from the
spreading of fixed costs (FC) over a larger number of units
than is possible for a smaller producer.
•  FC: R&D, depreciation, G&A expense (advertising, HQ
expense etc) and maybe labor cost in Korea.

•  Case: Let’s assume 65% of Apple’s 2016 R&D expenditure

of $10.05bn, or 5% of sales, was for iPhone. Apple sold
211.9mn iPhones in 2016. This translated into $31 R&D
cost per iPhone. Whereas, company XYZ spent $4.0bn
R&D on smartphones and sold 70mn units. Its R&D cost
per smartphone was $57.

=> Apple: ($10,045mn*0.65)/211.9mn units = $31 R&D cost for iPhone

=> Company XYZ: ($4,000mn)/70mn units = $57 R&D cost for XYZ
Capturing economies of scale
•  Merger of two firms with overlapping product lines, similar
corporate culture and in the same geographical region
could generate significant cost savings (per unit).
Ex) Hyundai Motor acquired Kia Motor in 1988 after
bankruptcy => Created large scale-economy; shared
platforms, developed infrastructure, power trains and selling
strategy together.

•  Consolidation of factories, R&D centers and top

management could reduce significant FC (per unit) such as
depr, R&D, advertising, and executive compensation costs.

•  If industries are not showing sustainable growth (ie,

banking, brokerage, steel, and cement), consolidation of IT
expense and back-office could yield cost savings.
Break-even analysis and operating leverage
•  Break-even analysis: The sales volume necessary to
cover total costs (incl both FC and VC) so that there’s zero
profit.

•  Operating leverage: The rate at which earnings pick up

once sales volume rises above the break-even rate. It’s
the degree to which FC exist in a company’s cost
structure.

•  Companies do not provide granular FC or VC breakdown

in general, thus financial statements provide only limited
insight into operating leverage.

•  Thus, you may have to make assumptions on cost

allocation within COGS and SG&A from time to time.
 Break-even analysis chart
•  Sales = FC + VC (=> Finding BE point
Dollar for sales volume)
(Revenue •  Sales price per unit * Volume =
or Revenue
FC + (VC per unit * Volume)
Costs) •  If the desired profit is P, then:
Sales = FC + VC + P
Profit

Total Costs

BE Point
(Rev=TC)

VC

FC
Loss

BE volume Volume
Hyundai Motor operating leverage analysis
(won billion)

Source: Hyundai Motor Company, JP Morgan, 2/25/1994

 HMC operating leverage continued..(won billion)

*Source: JP Morgan
BE analysis – Hyundai Motor case (1994)
•  Sales = FC + VC (=> Finding BE point for sales volume)
•  Sales price per unit * Volume = FC + (VC per unit * Volume)

7.670 * x = (396+458) + (4.966+0.732) * x

(7.670 – 5.698) * x = 854
1.972 * x = 854
x = 433,063 units for break-even or
35.9% of production capacity (at gross profit level)
It’s called BE-operating rate or capacity utilization rate.

•  BE analysis assumptions:
1) Selling price and VC per unit are constant; 2) Total FC is
constant; 3) Single product or a constant sales mix;
4) Manufacturing efficiency is constant.
The effects of operating leverage
•  Operating leverage vs. financial leverage
•  Operating leverage measures operating risk. (ie, how
much FC is in the cost structure)
•  High operating leverage magnifies changes in profit
caused by small changes in sales volume. It could work
both ways!
•  When high operating leverage is combined with highly
elastic product demand (ie, cyclical), earnings volatility
will magnify.
⇒  Auto, steel, chemical, semiconductor, shipping,
shipbuilding, airline etc.
•  Thus, high gearing (leverage) should be avoided in these
sectors. If not, bankruptcies are possible.
(Ex) Hanjin Shipping, Daewoo Shipbuilding
Stubborn labor costs in Korea
•  CASE: In the previous case, if we classify “labor”,
equivalent to Won795bn, as FC (as it should be in
Korea), BE point production level increases to
836,207 units or 69% operating rate. (vs. 433,063
units earlier)

⇒  Original FC/sales = 10.3%

⇒  New FC(incl labor)/sales = 19.8%
 GRADED Homework*: Calculation of Samsung
Electronics**, LG Electronics**, Intel and
Facebook profitability and R&D
•  Complete the following homework and send to my email
(cdc_advisor@yonsei.ac.kr) by May 15th (Sun).
1. Create a chart showing operating profit (OP) margin trend in
the past 5 fiscal years (FYs) ended FY2021 for the four
companies. Put 4 lines into one chart. Write 3-5 lines on your
observation regarding the profitability.

2. Create a chart showing annual R&D (in US$billion) in the past

5 FYs for the same four companies. Put 4 lines into one chart.

3. Create a table showing R&D as % of sales and R&D as % of

OP, respectively, for the same four companies in the past 5 FYs.

*Use consolidated financial statements.

**For Samsung Electronics and LG Electronics, convert all figures from KRW to US$ based
on the latest KRW/US$ exchange rate.