During the last couple of weeks it’s been icky weather — dark, cold, rainy. I’ve been indoors, looking at a several companies’ financial filings, connecting the pro-forma dots in an attempt to understand the companies’ fundamentals and make a judgement on whether I think they will remain viable concerns. The job is much easier with public companies because they’re required to regularly file with the SEC.
The most useful filing is the 10-K. Think of this as a hyper-detailed version of the annual report, without the snazzy graphics and positive spin. It includes a description of the business, a description of any legal proceedings, a list of executives and their compensation, and a detailed set of risks for the company. The 10-Q is the quarterly version. It, too, has a lot of detail, though the results are unaudited and it’s often limited in scope. I prefer to compare them with each other and the 10-K to track predictions.
10-Qs have to be filed within 40 days of the close of a quarter. Occasionally a company will not file in time. This often means there are “anomalies.” For example, Krispy Kreme failed to file their 10-Q last week, citing “ongoing analysis related to the accounting treatment of certain franchise matters in the company’s fiscal third quarter, primarily concerning the company’s consolidation of KremeKo Inc., its area developer for Central and Eastern Canada.” Translation: the bean counters can’t count the donuts. Or “bad news.”
There is a lot of data to pore through in these documents. I first flip to the “Management Discussion and Analysis,” because it should tell me a lot about the business and give me a clues about how management thinks. Unlike the annual report, management is inclined to be factual in a slightly pessimistic way. If they’re too optimistic, and someone loses money on the company’s stock, management gets sued. I also look for a lucid explanation with enough supporting detail. If they’re cagey or invoke the phrase “we can’t tell you because that’s competitive information,” I view that as a negative. (My theory: at this level, the competitors already know this stuff; a company should have enough confidence in the plan and worry more about its execution.)
As I read the filings, I tally up the number of good and bad karma points to get an overall feel for the business. For example, Company U has three major product lines. They choose not to disclose the amount of revenue contributed by each, lumping them into one bucket. One of their product lines is a “cash cow” in a declining market. It’s quite possible 99.94% of their revenue is from the “cash cow” and the other two ventures are too unestablished to be viable. This lack of transparency is a concern. Indeed, with this particular company, I was able to trace back far enough in previous filings to confidently estimate the numbers they wouldn’t provide, supporting my theory that they’re in a weaker position than they’d care to admit.
In contrast, their competitor, Company E, has four product lines and provides a nice breakdown of the number of customers, contribution margin, and changes from the previous quarters. Company E is not only forthcoming about how the cash cow product’s market is changing, but they also provide believable estimates and show how they’ve anticipated this and are reacting. In other words, they appear to have their shit together.
Sometimes a company will have an explicit section labeled “Risk Factors.” This can be fun reading because it’s the polar opposite of the marketing spiel. The section really should be called “All the Reasons You Should NOT Invest in this Company Unless You Truly Want to Lose It All.” It’s management’s way of absolving themselves in advance. Many of the reasons enumerated are common sense like “Our business could be shut down or severely impacted by a catastrophic event.” Yeah, meteor hitting the data center certainly could be a risk factor. A very small one.
Or, they’re are unlikely. I’d just wish they’d come out and say what’s really on their minds and move on. However, I suppose after they write the chirpy, poodles-dancing-on-the-ceiling press releases, they come down from their high.
SVP #0 What if all of our software vendors are lying about their applications’ functionality as much as we are and, in fact, their software doesn’t work. We should explicitly name all the vendors.
SVP #1 (looking excited) What if Alan Greenspan woke up and … saw his shadow. The US Dollar might rebound, hurting our exports. (But my vacation to France would be cheaper.)
SVP #2: Ooh! Ooh! I got one. If the sun exploded, the power grid would be disrupted and our server farm might crap. That would adversely affect business.
(heads nod in unison; it gets put in the filing)
Somewhere in the mix are the big three sheets in tabular form. Following the management discussion and analysis are the number broken out into tabular form. I start backwards, reading all the footnotes. You’d be surprised what’s buried in footnotes.
Next, I look at the Cash Flow statement. There are business school cases built around companies that were “profitable” a but “ran out of cash” because they got too extended. Cash is king, baby. I like to see a positive cash flow from operations. If a company is buying back stock, overall cash flow can be negative provided there’s still cash left.
I’ll then ping-pong between the income statement, the footnotes (again), the cash flow statement (again), the footnotes, the balance sheet, and finally, the footnotes. By this point, I’ll have about as good a view of the company as I’m going to get and the 10-Q and 10-K look like I’ve been cramming for an exam.
By their nature, private companies are very hard to get information on. (I’m a private company. I like it that way.) If they are large enough to have capital equipment needs, they’ll likely have to register for a DUNS number, which may give me some self-reported revenue and employee count. Local business journals are also useful in this regard because smaller companies like the free press — we’re all human (Except for link spammers) — as do the businesses they deal with. For example, if General Business Properties reports that Company X just signed a 3 year lease for 100,000 square feet of office space, Company X is no longer a two-person operation.
So, after all this analysis, I think very highly of Company E and its management team. The 10-Q is well-written, management’s discussion is lucid and they’re calling out true, plausible risks and addressing them honestly. I am pessimistic about Company U’s prospects. While their cash flow looks good, the management discussion isn’t inspiring confidence. I put their numbers through the grinder and think they’re going to see a decline this coming quarter, not 2006 as everyone else says, spooking the market. Company A, which I hadn’t mentioned, is in deep doo-doo.