How To Read Annual Reports

When I read an annual report, I search for anything that may compromise (or, if I get lucky, enhance) the value of a company’s common stock that would otherwise not be known by merely looking at a balance sheet. 

Since it is better to be more specific than to generalize, I’ll give an example. I recently noticed that XPO Logistics (XPO) has received heavy investments from its management and staff (who own 18.7% of the stock), Orbis Investment Management (that owns 22.3% of the stock), Jacobs Private Equity (17.3% of the common stock), and Spruce House Investment (13.9% of the common stock). 

In the case of Spruce House Investment, a New York hedge fund, 33% of the $2.7 billlion that it manages is allocated into shares of XPO Logistics. The big dog owners of this stock not only own a large percentage of the company overall, but the success-or-failure of their “investment score” in the eyes of all who observe them is going to be determined by the success or failure of this trucking and freight brokerage firm. 

When looking at the annual report, I also tend to focus on the section about “Notes” (i.e. debt) and preferred stock and other issuances. This section will often tell you whether the cash flows generated by the core business operations will flow to you as a common shareholders or will go to someone else that has a superior claim in the priority line to those cash flows. 

With XPO, I noticed from the balance sheet alone that there was a major disparity between the cash flows reported on the balance sheet and the profits that are attributable to shareholders. For instance, in 2020, XPO is expected to generate $13.80 per share in cash flows but only generate $4.75 per share in profits per share. Why such a disparity?

Part of the answer can be found on page 77 of the company’s most recent annual report where the company discloses debt totaling $7.3 billion, with some senior debentures requiring payouts with 10.34% effective interest rates through 2034. Adding up all of XPO’s debt obligations, this means that XPO throws off cash in the amount of $1.2 billion annually but only $430+ million remains for shareholders as net profit.

In addition, on page 86, XPO reveals that it created $75 million in preferred stock (back in 2011) that can be converted to common stock at a price of $7 per share. The company indicates that there are 10 million shares outstanding subject to this type of conversion. Since XPO stock currently trades in the $70s, and has 91 million shares outstanding, XPO stock will be diluted 11% and will only have $75 million to show it. In other words, XPO will be giving up $750 million for $75 million because it needed to borrow some money nine years ago under the terms of its Series A Convertible stock offering.

This is why you have to read an annual report. When a corporation sells more stuff than is expensed, what is leftover is cash that can be considered profit if there are no intervening claims on those funds. 

But with most businesses, there are intervening claims on those funds. Some times it is interest and such flowing from debt agreements that must be paid. Other times, shareholders must bear the cost of dilution (where future stock is offered to obtain operational funds) which means each dollar of profit has to be shared across a broader base, leaving you with less. None of these facts necessarily disqualify an investment from consideration, but it is your job to spot all of these “intervening claims” and figure out how it will affect the potential profit that will accumulate to shareholders over the subsequent five, ten, fifteen years. 

On the upside, the annual report also serves an important because it tells you whether the company owns its real estate, equipment, and other real and personal property that are necessary to effectuate the company’s business purpose. When I read the McDonald’s and Wal-Mart annual reports, it is clear that both companies are sitting on vast real estate holdings that have billions of dollars in value that are (at best) indirectly referenced in the company’s annual balance sheets. 

Every stock calculator can access a company’s balance sheet. “Hidden value” can be located by paying attention to the things that a company owns and carries value but whose value is somehow understated when looking at the balance sheet. On the other hand, you can spot many companies that carry debt and other obligations that will impair profits and help you adjust the price at which you would be interested in purchasing shares accordingly. 

Typically, that is the information that I seek from an annual report. Sometimes, I do find tidbits here and there about the company’s strategy, but such information is usually disclosed on the firm’s website and other presentation materials. But the annual report (and SEC filings in general) are the one place where the bad news must be disclosed. And “bad news” almost always means intervening claims that prevent the company’s profit from being attributable to you. 

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