Question 17.5: Core Operating Margin Warning Sign Based in Canada, NOVA Che...

Core Operating Margin Warning Sign

Based in Canada, NOVA Chemicals Corporation, together with its subsidiaries, engages in the production and marketing of plastics and chemicals. The company operates in three business units: Olefins/Polyolefins, Performance Styrenics, and STYRENIX. NOVA’s income statements and an associated note are presented below.

14. Restructuring Charges

During the past three years, NOVA Chemicals has undertaken several restructuring steps to reduce costs. As a result of these actions, the Company estimates it will reduce costs by about $100 million per year beginning in 2007. In addition to this, depreciation will be reduced by about $80 million per year in the three reportable segments within the STYRENIX business unit. In 2006, NOVA Chemicals recorded a restructuring charge of $985 million before tax ($861 million after tax) related to the following:

The Company recorded an impairment charge of $860 million related to the STYRENIX business unit assets. The STYRENIX business unit includes the Styrene Monomer, North American Solid Polystyrene and NOVA Innovene European joint venture segments. The STYRENIX business unit has not been profitable due to poor market conditions, and in recent years both NOVA Chemicals and the NOVA Innovene joint venture have reduced production capacity through plant closures. In July 2006, NOVA Chemicals announced it would investigate various alternatives for the STYRENIX business unit, including sale, formation of a joint venture with other producers, or spin out. NOVA Chemicals has assessed the recoverability of the STYRENIX assets and determined that the carrying value exceeded the estimated future cash flows from these assets. Based on this analysis, the fair market value of these STYRENIX facilities was determined to be $242 million.

NOVA Innovene permanently closed its Carrington, U.K., solid polystyrene facility in October 2006. The Company recorded a restructuring charge of $57 million related primarily to noncash asset write-downs of the plant including $8 million related to total expected severance and other departure costs. As of December 31, 2006, $5 million of the severance costs was paid to employees.

During 2006, NOVA Chemicals restructured its North American operations to better align resources and reduce costs. As a result, the Company recorded a $53 million restructuring charge related to severance, pension and other employee related costs. Of this amount, $10 million related to one-time pension curtailment and special termination benefits. Of the remaining $43 million, $22 million has been paid to employees by the end of 2006 with the majority of the remainder to be paid in 2007.

A $15 million charge was recorded related to the accrual of total expected severance costs for the Chesapeake, Virginia, polystyrene plant, which was closed in 2006. To date, $3 million has been paid to employees.

NOVA’s PP & E balance declined from $3,626 in 2005 to $2,719 in 2006. Net operating assets were $3,088 in 2005 and $2,349 in 2006.Based on the information given, address the following problems:

1. What was NOVA’s core operating margin in each of the three years ended 31 December 2006, 2005 and 2004?
2. What was NOVA’s balance-sheet-based accruals ratio in 2006?
3. Are there any warning signs related to NOVA’s earnings quality based on the information presented?