Why reading the annual report isn't enough

Companies operates in complex industries with numerous competitors, suppliers and customers. To understand how they fit together, expand your research beyond the obvious.

You might assume company analysis is mainly reading annual reports. And it's true, if you're buying stocks then reviewing company documents will consume a chunk of your time.

But a company's annual report is only a small piece of the puzzle. It helps you understand a business's performance - or at least management's version of it - but a huge amount of relevant information won't be included.

Take the competitive landscape, for instance. ASX-listed company annual reports rarely reveal anything useful about competitors. Indeed it can be difficult to ascertain who a listed company's major competitors are. It's even harder to identify early-stage competitors that might represent threats down the track.

Detective work

Just because information about competitors is more difficult to obtain doesn't mean you should ignore it. Ferreting out industry and competitor information is not only vital, it can be rather enjoyable detective work.

Let's take a brief look at Tradelink, a competitor to plumbing supplies company Reece (ASX:REH), which we covered recently. There's little information available about Tradelink because it's a small division of New Zealand-based Fletcher Building (ASX:FBU) but enough can be gleaned to paint a picture.

Tradelink key statistics
$NZ 2016 2017 2018 2019E
Revenue ($m) 775 775 837 840
Revenue growth (%) (2) 0 8 0.3
Operating earnings ($m) 8 5 7 3
Operating margin (%) 1.0 0.6 0.8 0.4
Branches at year end 214 222 231 241
Branch openings 4 8 9 10
Branch openings - growth (%) 1.9 3.7 4.1 4.3
Source: Company reports, II estimates

The accompanying table contains some details about Tradelink collected from various Fletcher Building documents over several years (including our own estimates). So what does it tell us?

Well Tradelink appears to be having trouble growing revenue over the four-year period (the figures are in New Zealand dollars although the currency effect is minor). We estimate that its total revenue growth over the period is only 8%, which compares to Reece, whose Australasian revenues have risen about 28% over the same period.

What's particularly odd is that Tradelink is opening branches too. Over the four-year period the branch network has expanded by almost 13%.

But if a company's revenues are growing more slowly than the number of branches, there is an obvious conclusion - same-store sales are probably negative. That's not good for any wholesaler (or retailer) and it implies Tradelink is losing market share.

Tradelink's poor profitability is also evident from the table. The operating margin has languished at 1% or below over the four-year period. Compare that with Reece, whose operating margin has ranged between 11% and 13%. In 2017 Fletcher Building acknowledged Tradelink's poor profitability, writing down the goodwill associated with the business to the tune of NZ$153m.

Too far behind

Piecing all this together, it's clear that Tradelink is a much inferior competitor to Reece. While Tradelink appears to be fighting back with a branch-opening program - Reece has more than double the number of branches - it's going to be difficult to rebuild market share.

The key point is that competitor analysis such as this puts a company's performance into context. Listed companies don't operate in a vacuum; they're participants in an industry with competitors, suppliers and customers. Understanding the strengths and weaknesses of each participant helps build an overall picture of a company's business.

As the superior operator, Reece is far better placed to weather any downturn or shakeout. Its excellent market position partly explains why we upgraded the stock almost three years ago at a split-adjusted $6.77 a share despite a PER approaching 20 (the stock now trades at $9.99).

Understanding a company's context, then, gives you an edge. So spend as much time researching the competitors - and other industry participants - as you would the company itself.

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Join the Conversation...

There are comments posted so far.

If you'd like to join this conversation, please login or sign up here

Related Articles