Littelfuse, Inc. (NASDAQ: LFUS) generated an above average return on equity of 10.2% over the past twelve months, while the Information Technology sector returned 2.9%. Even though Littelfuse’s performance is impressive relative to its peers, it’s useful to understand what’s really driving the company’s healthy ROE and how it’s trending. Understanding these components may change your views on Littelfuse and its future prospects.
Littelfuse’s Return On Equity
Return on equity represents the percentage return a company generates on the money shareholders have invested. Return on equity or ROE is defined as follows:
ROE = Net Income To Common / Average Total Common Equity
A higher return on equity suggests management is utilizing the capital invested by shareholders efficiently. However, it is important to note that ROE can be “manufactured” by management with the use of leverage or debt.
Littelfuse’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
It appears that the return on equity of Littelfuse has generally been increasing over the last few years. ROE increased from 11.0% to 13.4% in fiscal year 2016, increased to 13.7% in 2017 and decreased to 10.2% as of LTM Mar’18. So what’s causing the general improvement?
What’s Driving Littelfuse’s Improving Return On Equity
The DuPont analysis is simply a separate way to calculate a company’s ROE:
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
Created by the DuPont Corporation in the 1920s, the analysis is a useful tool that helps determine what’s responsible for changes in a company’s ROE. It highlights that a firm’s ROE is affected by three things: profit margin, asset turnover, and its equity multiplier or financial leverage.
Analyzing changes in these three items over time allows investors to figure out if operating efficiency, asset use efficiency or the use of leverage is what’s causing changes in ROE. Strong companies should have ROE that is increasing because its net profit margin and/or asset turnover is increasing. On the other hand, a company may not be as strong as investors would otherwise think if ROE is increasing from the use of leverage or debt.
So let’s take a closer look at what’s driving Littelfuse’s returns.
Littelfuse’s Net Profit Margin
The net profit margin of Littelfuse has generally been declining over the last few years. Margins increased from 9.3% to 9.9% in fiscal year 2016, decreased to 9.8% in 2017 and decreased again to 8.6% as of LTM Mar’18.
Therefore, the company’s ROE improvement is not as a result of its net profit margin performance which has generally been decreasing. Then could the increasing ROE be a result of improving efficiency?
Littelfuse’s Asset Turnover
It appears that asset turnover of Littelfuse has generally been declining over the last few years. Turnover increased from 0.81x to 0.83x in fiscal year 2016, decreased to 0.76x in 2017 and decreased again to 0.65x as of LTM Mar’18.
source: data explorer – asset turnover
Therefore, the company’s ROE improvement is not as a result of its asset turnover performance which has generally been decreasing.
Finally, the DuPont constituents that make up Littelfuse’s ROE are shown in the table below. Note that the table also compares Littelfuse to a peer group that includes AVX Corporation(NYSE: AVX), Vishay Intertechnology, Inc. (NYSE: VSH), Belden Inc (NYSE: BDC) and Amphenol Corporation (NYSE: APH).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Littelfuse’s general improvement in return on equity is the result of a worsening net profit margin, a declining asset turnover ratio and increasing leverage. Therefore when looking at the core operations of the business, Littelfuse shareholders should not be too excited due to the company’s general decline in profitability along with a general decline in operational efficiency and increasing leverage.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. However, it doesn’t necessarily tell the whole story. For example, how do the company’s ROE trends compare to its peers or sector? How about in absolute returns? I recommend that investors continue to research Littelfuse to gain a better understanding of its fundamentals before making an investment decision.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.