Recommendations to Better Evaluate Annual Reports

This is difficult to answer on account of the many potential motives for reading through an annual report. From my perspective, however, I am generally trying to understand what creates or destroys value.

If we share this objective then the challenge becomes one of knowing what to look for. I find that on the subject of value creation companies are quite content to let you know how brilliant they are. If the business is doing well, you don’t exactly have to read between the lines. Consider comments made by Under Armour CEO Kevin Plank on an earnings call:

We have started off our 20th year in business with impressive results. Our first quarter revenues grew 30% with the growth coming from every facet of the business. And to be clear, that 30 number was no accident. When Stephen Curry decided to average 30 points this season to take the scoring title while wearing the number 30, we thought that putting up 30% growth on our end was the best way for us to demonstrate our pride and support of Stephen and the Warriors.

The WSJ reported that “Mr. Plank invoked Mr. Curry’s name 14 times on an earnings conference…” emphasizing the positive impact of this relationship. Cause for excitement, no doubt.

So my advice would be to follow the investors and writers whose job it is to use all available data to understand why the market may be overly optimistic or overly pessimistic on a company’s valuation. Continuing with Under Armour, Jim Grant points out:

“We suggest that the company’s stock would be lower if analysts were more curious. The first quarter was the second consecutive quarter in which year-over-year growth in inventories and accounts receivable surpassed revenue growth by more than 10 percentage points; inventories leapt by 44%, accounts receivable by 43%.” - Grant’s Interest Rate Observer May 6, 2016

By focusing on working capital accounts like accounts receivable and inventory, Grant directs the reader’s attention to the company’s cash flow (more cash tied up in working capital = less cash flow). This is a frequently cited relationship, and in fact, most financial models project these accounts by linking them directly to sales or cost of goods sold. The more you are exposed to writers like Jim Grant, the more relationships you will be made aware of, which will help you navigate annual reports.

Examples can range from simple to complex. Howard Schilit covers the spectrum in his book Financial Shenanigans (which I highly recommend). One example on the simple end of the spectrum that I have always enjoyed pertains to revenue growth:

Enron ranked number seven in Fortune’s magazine’s list of the 500 largest companies in 2000 (ranked by total revenue), surpassing such giants as AT&T and IBM. In just five short years, Enron’s revenue had miraculously increased by an astounding factor of 10 (rising from $9.2 billion in 1995 to $100.8 billion in 2000). Curious investors might have questioned how frequently companies tend to grow their revenue from under $10 billion to over $100 billion in five years. The answer: never.

While it’s an entertaining example, you are not likely to identify many Enron-like disasters. But the hyperbole can be useful. With this knowledge you may dig a little deeper when evaluating another business with strong revenue growth. In a Barron’s interview Schilit identifies another revenue-growth-related example of smaller proportion:

Green Mountain Coffee Roasters (GMCR). In past quarterly statements, such as the third quarter of fiscal 2010, the company made a point of things like 11 consecutive quarters of 40% net sales growth and 24 quarters of double-digit growth. If you do some compounding, the numbers start to get enormous.

There were two important changes in the footnotes describing its accounting policies over the past five years or so. In 2007, Green Mountain recorded revenue when the product was delivered to the customer. Then, it gave rebates; For example, if you buy 1,000 of those little K-Cups, they may give you a 5% rebate. They accounted for rebates as a reduction from gross sales. Fine. Then, when they started having difficulty getting to that magical 40%—this is my interpretation—the revenue-recognition wording in the footnotes became longer; in some cases, revenue was recognized upon shipment. That's not the same thing. Then, instead of treating the rebates as a reduction to sales, in some cases it was treated as an operating expense. Now, my friendly auditor will say: 'They disclosed it all.' But investors would say: 'That stinks.' [1]

I like this passage because it directs the reader to focus on the footnotes, which is where most will argue the real information is “hidden.”

Continuing with more obscure examples. An article in Barron’s dating back to 2014 highlighted the significance of reviewing proxy statements:

Investors who toss proxy statements straight into the recycling bin take note: These documents, dry as they are, really do offer a window into what management is doing.

It was one such disclosure, buried on page 86 of Coca-Cola's most recent proxy, that has venerable value investor David Winters speaking out against this large and long-term holding in his $1.7 billion Wintergreen fund (ticker: WGRNX), which he launched in 2005 after nearly two decades managing money at Franklin Mutual Series.

The source of his ire is a plan to issue new stock for the purpose of compensating management. Winters says that the plan, which was passed by shareholders at Coke's April meeting, will transfer billions of dollars of stock to Coca-Cola (KO) management at the expense of existing shareholders. "We think this is a blatant attempt to pick the pockets of shareholders of one of the most widely held securities in America," says Winters, whose fund, despite a lackluster 2012 and 2013, has posted 15% annual returns over the past five years and 8% since its inception nine years ago. [2]

Any time investors disagree with management, look for the explanation. It is likely to be an education in where to look, which will help focus your attention on what is important. And always read the footnotes.

I have included a few books that provide plenty of detailed examples below.

More Suggested Reading / Resources:

Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports

Creative Cash Flow Reporting: Uncovering Sustainable Financial Performance

The Financial Numbers Game: Detecting Creative Accounting Practices

SeekingAlpha - Example: Netflix's Profitability Is An Illusion

Footnotes:

[1] A Financial Sleuth Finds a World of Abuses

[2] David Winters on Asia, the Consumer, and Coca-Cola

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