Reading Annual Reports, Part II: What is Management Thinking?

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Yesterday, we began looking at the most vital pieces of information to extract from a company’s annual 10-K report when evaluating a potential investment.

We ended by noting that we’d need to dedicate a whole post to Item 7: the MD&A. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is where the annual report truly crosses the line from reporting into analysis. Management will explain the previous year’s results, outline financial expectations for the year ahead, and discuss major plans and projects for the coming year. These plans and projects in particular typically represent information that isn’t extensively represented elsewhere in the report.

This distinction between Item 7’s analysis and the “reporting” from the rest of the 10-K is more than organizational. Financial results elsewhere in the 10-K are subject to an audit requirement by the Securities and Exchange Commission (SEC). This requirement mandates that a CPA firm investigates and tests a firm’s reported financials to ensure that they are not “materially” incorrect. There’s no similarly objective standard for the discussion featured in the MD&A section. Since this area is designed as a forum for the thoughts and opinions of management, it can’t be held to the same standard as backward-looking financial data. This gives executives room to discuss more subjective factors in the firm’s performance but also gives unscrupulous management groups some legal leeway to mislead investors. While future prognostication can’t be audited, the SEC does monitor the MD&A section to ensure that companies accurately present critical information about current operations, capital, liquidity, etc.

Like other data points, we have to evaluate these ruminations with a curious but skeptical eye, and always verify management reasoning with data when available. Market reactions to previous annual reports from the same firm may provide some clues to deduce how much the market trusts the narratives propagated by a given management team. Unpersuasive reports aren’t necessarily dishonest; they can simply represent the dutiful optimism required of many executives until the moment the decision to sell or restructure is made.

The MD&A Section is roughly structured as follows:

  1. Executive Overview and Outlook: high-level overview of operations and performance, often discussed at a geographic or business-unit level. A few metrics intended as overall indicators of performance and financial health will be presented.
  2. Operational Results: review and explanation of performance and changes in various business units, especially in core operational metrics like sales, profit margin, changes in cost structure, or changes in tax exposure.
  3. Segment Results: discussion of results that attempt to abstract away from corporate level overhead and financial concerns and drill down to the efficiency of specific business units.
  4. Non-GAAP Financial Measures: here, management can provide figures used in internal decision making that don’t conform to standardized GAAP procedures.
  5. Liquidity/Capital: coverage of liquidity as determined by both cash flow and planned or past debt issuances. This section can be trivial or vital depending on the overall balance sheet health of the firm in question.
  6. Off-Balance Sheet Commentary: here, executives can describe potential financial liabilities that aren’t formally accounted for on the balance sheet. Many firms won’t report anything here at all, though this section can also become elaborate for firms in particular industries.
  7. Exposure to FOREX, Interest Rate, Commodity, Credit Market Risk: this section can be a bit hard to evaluate, as it asks managers to discuss the relationship of the firm to the entire broader macroeconomy. Depending on the firm’s business model, concerns like FOREX can be almost totally incidental or hugely determinative of ultimate earnings.
  8. Key Accounting Decisions: possibly the most vital section to review, management explains the major accounting decisions (often, by necessity, involving great leaps of estimation) that went into the annual report. These decisions offer a powerful window into how executives see the financial model of their own firm.

Indeed, this window onto the thinking of management is what the MD&A is all about. Like analysts, investors, and everyone else involved in evaluating stocks, management will always be making an educated guess about the future of their firm. The guidance provided in the 10-K may end up being almost perfectly on point; it could also end up being pie-in-the-sky optimism. Either way, it’s a rare opportunity to see the in-depth thinking of company management up close.

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