Reading a 10-K can be daunting for those without official training. It’s tough to figure out where to start. My goal of this post is to detail the first 5 things I do when I read a 10-K.
I’ll be using Fastenal as as an example given I recently used them as a case study in my Competitive Strategy series.
Unfortunately, if you want to read a 10-K to get better at investing or understanding how companies work, you can’t just read a 10-K in a vacuum. You must put the knowledge and information you glean into context.
If you were moving to a new city and needed to purchase a home, would you look at one home and determine you had enough information? Probably not. You’d probably want information on that home as well as several others and weigh the pros and cons of each (how are the schools, how much room am I getting for the price & is it a good trade off, do I need to pay city taxes, etc.).
Same is true for investing in companies. I want to read about this company, understand how it works, determine if I think it is good or not, and then go read about its competition. Is the competition even better? Maybe the customer is actually the better business or its supplier.
As you can probably tell, this creates a web of information you need to understand, but can be worth it in the end.
Also in the context of not reading a 10-K, I almost never open up a 10-K without opening up the company’s latest investor presentation (typically on their investor relations site), and then also typically plan on reading the latest earnings calls as I get more interested.
Ok – let’s dive into what I do when I first open a 10-K.
“How does this business actually make money” – Read the Business Overview Section and Understand How that Flows Through to the Income Statement
Nowadays, there are links upfront in a 10-K that can help you jump to the sections you want. First thing I do is click on the Business Overview section.
From there, I jump ahead to where the company has the opportunity to describe what it does.
I can’t tell you how much I respect companies that really take the time to help investors understand what they do. Sometimes companies leave it ambiguous which is super frustrating. Especially when covering small caps and I also look at private companies, the amount of times I’ve heard investors think an a company does one thing, when in reality they do not actually understand how they make money, is alarming.
As a quick aside, I once had a company describe themselves like this: “[Company’s] performance resins and surface overlays are ubiquitous in products used in residential and commercial applications and are increasingly displacing traditional building material through value-adding attributes. [Company] is a highly profitable, vertically integrated provider of these products.
Very hard to even determine what they were doing. Turned out, they would saturate paper with a formaldehyde-based resin and sell it into various building products. That’s the importance of diligence.
I have to commend Fastenal on how well they describe their business in 7 sentences. It gives some history, what customers they target, how many branches they have, and what their general strategy is.
So right off the bat, I can generally tell how Fastenal makes money. They sell fasteners. Their business description actually continues on for several pages, which I’ll let you read as opposed to pasting here. It’s a good read.
But as soon as I read this description, I start to have questions pop into my head. I’m trying to understand the value chain. Do manufacture themselves or buy from suppliers? What industries do they target? How do they differentiate themselves? The reason why I ask these is because the answers will start to tell me things about the business.
If they manufacture themselves, it’s probably a unique offering that they can charge a higher margin for, but it will be more capital intensive (need machines, plants as well as branches). If they just buy from China and sell in the US, maybe others can do the same so I’d expect their margins to be lower, but not much capital is really needed.
Turns out, Fastenal mostly buys from third-party suppliers, but as you’ll see later, its margins are surprisingly high. Fastenal is a rare company where it actually provides some detail on this. As I said in my competitive strategy series, looking just at the numbers doesn’t tell the whole story. We need to understand why a company may have high margins or not and if that is OK.
To understand a business and get better at investing, you have to know how a business works. If the above snippet doesn’t make a ton of sense to you, then you need to map it out.
Here is a quick snapshot of what I typically do. I first just try to make a made-up model of the company. I just say, “Hey, I understand selling fasteners, widgets, what-have-you, means buying fasteners in inventory and selling them for a profit. Let’s assume I sell 100k fasteners for $5 – how does that look here for Fastenal?” Note, these numbers are made-up, but the margins are about what Fastenal has.
Hopefully from the notes above, you can see I’ve also made attempts on how the cost structure of the business works. Is this a highly variable cost business or not? I would say it is highly variable. If my sales go down, I’m not just going to keep buying fasteners and keep paying bonuses to sales staff (I’m going to incentivize them to get sales up).
Contrast that to an automotive company like Ford or GM. They typically have unionized workforce, so I’m not sure how many people they can actually cut in a downturn. They also have huge manufacturing plants that are hard to just turn off and turn back on without expenses associated with it. Contrast that to Fastenal, whose branches are very basic stores with shelves. That’s one reason why automotive companies and airlines go bankrupt so often. They are highly competitive, highly cyclical, highly fixed cost businesses – demand going down hurts the bottom line a lot more.
I digress. Back to Fastenal.
Let’s now see an impact of what happens with more fasteners being sold – what impact does that have on the bottom line (using EBITDA here for now)?
As you can see, a 4% increase in fastener sales actually leads to a ~7% increase in EBITDA. The main reason is that, while COGS went up by a similar amount to sales, SG&A stayed relatively flat. This is important to understand because you may say, “Ok Fastenal is a mature business. Maybe it should only grow with growth in industrial production, manufacturing, or GDP in the long term. Well if that is 2-3% growth, earnings probably will grow at a faster clip than that, which is important for valuation.
This is a simplistic example and view (for example, more detailed models will have store branches modeled out, how many fasteners each branch sells, what the sales impact and cost impact will be of adding a new branch) but hopefully shows in more detail of how I examine a business and how it makes money.
“Show me the money!” or, uh, Free Cash Flow – Examine the Cash Flow Statement; Understand Drivers
Ask any investment banker which financial statement is the most important and my guess is most will say the cash flow statement. It makes sense for many reasons.
First, the income statement doesn’t capture everything. Net income does not equal free cash flow that we use to value a business. It may capture depreciation which can be used as a proxy for capex in a mature business, but for a fast growing business, capex will likely exceed depreciation. The income statement doesn’t capture the working capital investment needed to grow the business. It also doesn’t tell us where the free cash flow is going (M&A, dividends, share buybacks, debt paydown, just sitting on the balance sheet?).
I also focus on the cash flow statement next because frankly I am trying to find good businesses. If after examining the business overview and parts of the income statement, I see that the cash flow statement is a mess, I may or may not decide whether or not it’s worth my time. Sometimes I like to dig into a messy cash flow statement because people who do simple stock screens will miss opportunities. Other times I’ll decide it’s best to drive on.
To find the cash flow statement, I typically search the document for “Operating activities” which will allow me to jump to “Cash Flow from Operating Activities” part of the cash flow statement. If you don’t know, free cash flow = cash flow from ops minus capital expenditures. This is typically the cash leftover to the business that it can use for other discretionary items.
So I do some quick math and try to determine FCF for Fastenal.
They generated around $600MM of FCF last year, which was a nice jump from $500MM the year before despite what clearly was a big increase in capex. You probably want to figure out why to see if it is sustainably higher. Very quickly, I can see that net income increased (+$39MM), depreciation & amortization increased slightly (+$11MM) which is non-cash so added back, and I have to do some math, but I can see changes in working capital also benefited them in that it looks like they didn’t need to invest as much there, as you can see the increases in inventory and accounts receivable are down a lot Y/Y (total W/C benefit +$141MM Y/Y).
After figuring this out, you need to understand why these occurred. Does the company say anything in its earnings calls about this? Investor presentations? Why is capex up so much? New branches? Is that what drove net income higher? But if they opened new branches, why didn’t working capital increase? Is it a new type of branch that doesn’t require as much of an upfront investment?
After figuring out FCF and whether the past few years look sustainable, I take a look at where the cash is going. It looks like from above Fastenal paid down some debt (as payments are larger than issuance of debt) and paid a big dividend, which has been consistent in size.
However, one red flag I immediately see is that 2019’s dividend is nearly identical to 2018’s FCF… do they have enough FCF to cover the dividend? Yet ANOTHER reason why focusing on net income and payout ratios that are thrown around never makes much sense to me.
Anyway, looking at the cash flow statement provides a lot of clues as to how good the business is. Frankly, I only really need to Income Statement and Cash Flow statement to get an idea if the business generates a good return on capital.
Management’s Discussion & Analysis
This section of the 10-K is when management teams can really explain what drove business results over the past few years. Look at how much detail Fastenal provides in just one section. This doesn’t even really get into cost of goods or operating expenses.
This section really should help an investor with the detective work needed to understand the business. It certainly helps me model companies and think about drivers for the future.
Obviously, there are many more things to study when evaluating an investment, but wanted to share my starting point for how I read a 10-K.