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How to Read a 10-K

How to Read a 10-K. Alexander Motola, CFA. Quality of Earnings, Ch. 2. Auditors are essentially consultants, hired by the company they are auditing (see pg. 17 – “opinion shopping”)

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How to Read a 10-K

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  1. How to Read a 10-K Alexander Motola, CFA Alexander Motola, 2013

  2. Quality of Earnings, Ch. 2 • Auditors are essentially consultants, hired by the company they are auditing (see pg. 17 – “opinion shopping”) • DBL suggested taking the audits at face value; DBL went bankrupt in 1990 due to illegal activities in the junk bond market • Many examples in the book of clean audits where the company was out of business or had massive restatements shortly thereafter • Pg. 17 – “How much is 2+2?” Alexander Motola, 2013

  3. 10-K: Why Read It? • We are looking for things that are material, that as investors we want more clarity on, that might give us an advantage versus other investors • It is not fraud free nor hyperbole free, but it is the “cleanest” source of primary information we will get • “K” has much more detail than the “Q” or the press releases • There is an art and a science to this; experience helps, and being alert helps – you are basically a detective or an investigative reporter Alexander Motola, 2013

  4. 10-K: What is it? • SEC filing, delivered to SEC within a specific time from the FYE (for your companies it is 75 days for the K, 40 for the Q) • It is NOT reviewed in most cases by the SEC; just made available to the investing public • Required of US based (Domicile) companies; some companies are TRADED in the US, but not headquartered here – those companies file an abbreviated document called a 6-K • It covers specifically the just completed fiscal year (Annual Report), but has comparable data in it from prior years • There is actually a different document which is referred to as the “Annual Report” (technically the “Annual Report to Shareholders”) • SEC filing are available in many places, but always on EDGAR (sec.gov) Alexander Motola, 2013

  5. 10-K: Cover Page • Not much here • Name & HQ location • Fiscal Year End date • At the bottom of page, the number of shares outstanding as of the filing date • Useful if there’s a lot of dilution • Useful if there’s an aggressive buyback program Alexander Motola, 2013

  6. 10-K: Part I • Business/Overview • Very generic discussion of what they do, where they do it Alexander Motola, 2013

  7. 10-K: Part I • Segments – what they are Alexander Motola, 2013

  8. 10-K: Part I • Segments – % of revenue (not useful to us, we will calculate our own • Products and Services – description • Important • More details – always be the lookout for something unusual Alexander Motola, 2013

  9. 10-K: Part I • In Part I, the company lays out the factors that impact their industry • Regulation, competition, environmental, etc. • There is some clarity on specific industry terms, standards, etc. • Read all of this, it is important • Forward Looking Statements should be read once (for your edification, it’s largely boilerplate, and I always skip it) Alexander Motola, 2013

  10. 10-K: Part I – RISK FACTORS • A mix of boilerplate & extremely important information • They must disclose issues and concerns they face, if somewhat opaquely • First listed issue for CTL: “Increasing competition, including product substitution, continues to cause access line losses, which has adversely affected and could continue to adversely affect our operating results and financial condition.” – this means landlines are being lost to people using cell phones as their only phone Alexander Motola, 2013

  11. 10-K: Part I – RISK FACTORS • Collective bargaining risks with the labor force – 38% (and when) • Discussion of specific risks from acquisitions (unlike the rosy press releases) – substantial integration expenses, etc. • Regulatory Risks • Liquidity, Capital, and Div Risks • $20B in debt • For the IAC: you can’t present them all, but figure out what’s important, and drill down Alexander Motola, 2013

  12. 10-K: Part I – Legal Proceedings • Extremely important • Mgmt. tends to be dismissive of litigation, either they will win or they are insured, reserved, etc. • Legal cases can be quite serious • You will want to understand what is serious and what is not, you will be asked (IAC) Alexander Motola, 2013

  13. 10-K: Part II – MD&A • First comes “Selected Financial Data” – the purely financial information isn’t important (you will get better data later in the filing), but the “metrics” are important, so highlight them MD&A “Management’s Discussion and Analysis” • Overview – more description. In this overall section, they are going to breakdown the events of the year – this is the more important qualitative info you will have about last fiscal year • For CTL, the focus in on their acquisitions and the revisions to their segment reporting Alexander Motola, 2013

  14. 10-K: Part II – MD&A • We get some idea of the acquisitions and their impact. Notice the dates the acquisitions closed. Alexander Motola, 2013

  15. 10-K: Part II – MD&A • Did they really grow in 2011 (internally or organically)? We are going to try to figure that out… - Clearly access lines are declining, and it’s hard to gauge the rate of growth in broadband subs without more data… Alexander Motola, 2013

  16. 10-K: Part II – MD&A • Tons of revenue information • 4 categories, 4 segments, impacts to categories of the acquisitions (CTL core business is NOT growing) • Expense and margin information about each segment, and qualitative info about what’s happening in each segment • More detail on each expense line item above and below the line • If you get all this revenue detail in a spreadsheet, you can calculate your own % of revenue for each item, growth rates of each item, etc. Alexander Motola, 2013

  17. 10-K: Part II – MD&A • Critical accounting policies • Most don’t read this; I always do (and changes show up in BLACKLINE) • Beyond the scope of this class • Pensions are often discussed in detail here, which can often be a hugely understated liability based on their assumptions • Debt detail, future obligations, Cap Ex detail, OBS (essentially B/S and SCF detail) • Auditor’s statement (QoE, Ch. 2) Alexander Motola, 2013

  18. 10-K: Part II – Financials, etc. • Basic Financials, plus comprehensive income, Statement of Shareholder’s Equity, etc. • Footnotes • Revenue Recognition – this is extremely IMPORTANT. It tells what can be recognized as revenue, and when “We recognize revenue for services when the related services are provided. Recognition of certain payments received in advance of services being provided is deferred until the service is provided. These advance payments include activation and installation charges, which we recognize as revenue over the expected customer relationship period, which ranges from eighteen months to over ten years depending on the service.” Alexander Motola, 2013

  19. 10-K: Part II – Footnotes We know that SG&A includes advertising… We can analyze SGA-ads, we can look at ads as a % of revenue, and we can wonder why advertising declined YOY from FY11 to FY12 Alexander Motola, 2013

  20. 10-K: Part II – Acquisitions • Lots to examine here • This is what they reported… • This is what it would look like if they owned the new companies all along… • Is CTL REALLY growing? Alexander Motola, 2013

  21. 10-K: Part II – Footnotes • A/R is discussed • Foreign Currency impact should be normalized and analyzed (for CTL it is di minimis). Company may also hedge. • Debt Schedule • Credit Facilities and Covenants • More Pension details, including actuarial assumptions • Tax detail • Reclassification of revenues or expenses Alexander Motola, 2013

  22. Summary • Must read the key SEC filings • The format for the K (and Q) are always similar for every US company, but what is in there will vary by company, industry, etc. • Always look to mine information – everyone knows most of the data, you are looking for more and better information Alexander Motola, 2013

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