The Industry: Seagate Technology dominated the disk-drive industry in 1988 with sales of over $1. 3 billion. Other competitors like Computer Memories, Necropolis, Maxtor, Quantum and Prima were minor industry players with combined sales of less than $1 billion. There were other new competitors who entered the industry in 1987 and 1988. The industry was frequently embroiled in heated price wars because competition for sales was intense. This resulted in over supply, and the average cost of a megabyte of memory dropped roughly 25% during the first 10 months of 1988.
Research firm Data Quest estimated the over capacity at over 17 million disk drives. Out of this lot, only an estimated 14 million would be purchased in 1988. Because of this, it was expected that write-off of inventories would be high. The market’s preference was changing from 5 IL-inch to 3 h-inch disk drives. Although Inscribe controlled the growing 3 h-inch market, the rapid technological change put too much pressure on the company to turn their inventory into sales as quickly as possible.
Other possible threats to the established firms and industry leaders were the new entrants who signed disk-drives with less parts and thus lower cost. Finally, the industry faced the challenge of a forecasted decline in the US PC market to 29%, 17% and 9% for 1987, 1988 and 1989, respectively. This forced Inscribe to actively look for niche customers who could produce demand for smaller disk drives. The disk drives could potentially be installed in fax machines, laser printers and photocopiers.
Due to Inscribe Corporation’s record of consecutive quarterly increases in revenue and profits, it became one of Wall Street’s favorite stocks, and was recommended by any investment analysts and firms in Wall Street, including the prestigious brokerage firm of Alexander ; Ferris. However, in light of intense competition, overcapacity issues, the forecasted decline in the US PC market, and rumors that Inscribe was experiencing cash flow and inventory problems, Alexander ; Ferris deemed it necessary to re-evaluate Inscriber’s financial position and performance.
Research analyst Paula Perry of said brokerage firm was requested by her manager to analyses Inscriber’s latest financial results and recommend whether to retain Inscribe Corporation on its ‘Buy recommendation list or not. The group studied Inscriber’s history from its inception in July 1980 up to early October 1988, the time the protagonist, Paula Perry, must make a recommendation to remove or retain Inscribe in Alexander and Ferris’ ‘Buy recommendation list.
The group started by summarizing the firm’s story using the DuPont formula. From the three components of the DuPont formula, the group identified potential areas for concern, and subsequently coaxed more data out of those aspects for further analysis. The group took note of important milestones in Inscriber’s history that had the most profound effects on its current performance, considering the firm’s uncial history, changes in top management, operational changes and strategic direction.
The group also reviewed the disk-drive industry status from 1987 to 1988 along with analysts’ forecasts of the industry growth in 1989. Both the qualitative and quantitative data provided by the two background studies above are instrumental in providing support information for the financial statements analysis and, ultimately, in looking at Inscriber’s future growth (which should be Pula’s basis for her recommendation). The group then constructed a Statement of Cash Flows using the unedited interim Consolidated Income Statement and Consolidated
Balance Sheet. The three financial statements are then examined using vertical and horizontal analyses, to discover key areas that have the most significant effect on Inscriber’s financial condition. The ‘red flags’ gleaned from this exercise served to focus the group’s further investigation. The group then calculated financial ratios on the liquidity, solvency, profitability, stability and efficiency of the firm, and compared them with the industry averages.
Finally, after summarizing the results of the analyses and putting the results in the context of Inscriber’s historical background, rent condition and the trends in the industries where it operates, the group synthesized its findings to come up with the basis for making its decision. Given the firm’s data over the last three quarters, we started with a DuPont analysis to identify potential areas of concern. The DuPont formula elements were computed by quarter. Net margin increased significantly from IQ to Q but dropped in Q.
Similarly, Asset Turnover increased in Q but dropped in the third quarter. Financial Leverage was flat on the first two quarters, but increased significantly on the third quarter. The crease in Asset Turnover from Q to Q was caused by a huge increase in assets that didn’t translate to sales; also, the huge rise in financial leverage was caused by the rise in assets financed by debt: The graphs made it clear that the resulting increase in ROE from IQ to Q were due due to slight decrease in PM and the huge decrease in AT, which were slightly offset by the increase in FL.
The DuPont analysis suggested that we take a close look into the increasing assets financed by debt, especially because these assets do not help increase sales. Income Statement Next, the Income Statement is processed using vertical analysis. Profitability Ratio Using Vertical Analysis Based on the vertical analysis of the Income Statement, there seems to be no problem if we look at each line item in the Income Statement as a percentage (%) of Sales. Comparing each line item from period to period, no deviation is noticeable.
Looking at the horizontal analysis illustrated below, a 4% increase in Sales and an 8% increase in Gross Profit is seen from the quarter ending September; however, this was almost offset by the 9% increase in SO&A. By the third quarter of 1988, heavy spending on research and development was undertaken by Inscribe, causing a 22% increase (amounting to $940 thousand) in research and development expenses. As we can recall, the company has been investing a great deal in research with a 131 . 7% increase in 1987 and this is continuing to 1988.
