(This report is part of our occasional Other Voices format, as we run across interesting investment ideas or practices from outside our firm. Today’s piece is written by David Zion, founder of the Zion Research Group, an independent research firm focused on accounting and tax issues, and his colleagues Ravi Gomatam and Ben Wechter. This report is excerpted in part from Zion’s annual 10-K Checklist, which includes tricks of the trade, potential red flags, questions to ask and common-sense tips to help you navigate the 10-K filings.)

They aren’t fun to read, but SEC documents are crucial to a complete understanding of the company whose shares you are considering.  Buying a stock without reading the 10-K is like driving to an unknown destination without a map.  You can do it, but it’s better with navigation. Zion Research Group is expert at deciphering corporate SEC filings.  To help you navigate this thicket, we are running excerpts from Zion’s reports about 10-Ks. This is the third of three.

Footnotes

Financial statements are a good place to start your analysis, but you need to dig deeper to make sense out of them and that’s where the footnotes come in to provide more context and detail. Remember that when you are going through the footnotes, keep asking yourself if the company’s disclosures are clear and in plain English or are they confusing and complex. If a company wants a premium valuation, it needs to provide you with premium disclosures.  The following is what to look for.

Significant Accounting Policies:  We’ve started year three of the “Three Great Years of Accounting Changes”. Revenue recognition (2018), leases and hedge accounting (2019), followed by credit losses (2020). As companies get closer to applying a new rule, they should provide better info (i.e., SAB 74 disclosures) about the potential impact.

In our view, the biggest impact of an accounting rule change is the potential changes in behavior it can spark. Investors may gain some new insight about the risks, growth and claims on future cash flow, which could change how they view the underlying economics of the business and how they value the company. Corporates might do things differently, too.

Watch out for changes in accounting policy… Of course, companies may change how they account for things even when not forced to by the FASB. Pay extra close attention to these types of changes: did the company get more/less aggressive, did they pull closer/farther away from their peers, will their results more/less closely track the underlying economics?

Red Flag: Not understanding a footnote after reading it three times. Instead of ignoring accounting rule changes, we’d suggest asking yourself eight questions, The Ocho. (See below.)

1. Does the new rule better reflect the underlying economics? Does that affect how you view the business?  2. What adjustments (if any) do you need to make to your model? Are you looking at minor tweaks or a major rebuild?  3. Were you already factoring this issue into your analysis (e.g., leases)? Does the new rule change your approach?  4. Will non-GAAP numbers change as a result? Will the Street look at the company any differently?  5. Do you need to fix your quant screen so that it’s not sending misleading signals?     6. Does the change make it easier/harder to compare companies both within the U.S and around the world?    7. What changes in corporate behavior do you expect because of the new rule (are those good business decisions or just meant to paint a prettier picture)? Will that change the underlying economics of the business?   8. Are the debt covenants based on frozen GAAP or floating GAAP? If a change in GAAP sparks a covenant default (possible under floating GAAP), would it create an event of default or does it require the covenant to be renegotiated?

Below is an abbreviated list of potential footnote items that Zion Research Group recommends that investors study closely.  Space doesn’t allow us to list them in their entirety, but readers can get the full picture at http://www.zionresearchgroup.com

Tax Are today’s low tax rates sustainable? Probably not.

How to value NOLs. Post TCJA, the net operating loss (NOL) related tax shield is less valuable due to the lower tax rate.

How does the company make money? You need to determine if the revenue recognition pattern matches up with how the company does business with its customers.   

Questionable Judgement Calls: New revenue recognition rules provide plenty of room for management judgment which could be used to manage earnings. Do those judgments match the economics of the business?.

Financial Instruments When stock prices fall, there’s some accounting consequences. For example, changes in the fair value of equity securities (typically less than 20% stakes) now run through earnings.

Foreign Currency FX risk, FX hedging, FX accounting are all complex. Focus on two things (1) impact of FX on business fundamentals and (2) impact of FX on the value of the business.

Leases Most leases are now on balance sheet but they might present surprises.

Pensions/OPEB When analyzing pensions, take three steps: (1) Health (2) Cost  and (3) Risk.

M&A There are lots of games companies can play with purchase accounting. For example, watch out for large chunks of purchase price allocated to goodwill, is that what they are buying or an attempt to make the transaction appear more accretive.

Derivatives & Hedging Hedging costs are worth keeping an eye on.

Stock Comp Make sure you capture two things in your analysis: (1) options and restricted stock are a claim and (2) future grants are a cost of doing business. Don’t ignore the stock comp cost, especially when management tells you to.

Shareholder’s Equity Buying back stock to offset earnings dilution is not always a great idea. In theory, companies should buy back stock when it’s cheap, but in reality, they tend to buy back the most shares when stock prices are at their highs.

EPS There are a few different share counts. If you are looking for the shares outstanding, check the front page of the 10-K. Keep in mind that’s not the same as the basic share count, which is the weighted average of the shares outstanding for a period (quarter, year). The company will provide a table that takes you from basic to diluted shares.

Inventory  Companies don’t disclose too much about inventory nowadays. We’d suggest monitoring the components (raw materials, work-in-process, finished goods). For example, rising finished goods might signal an expected increase in demand or the company is stuck with inventory it can’t sell.

PP&E Don’t ignore impairment charges. Sure, there’s no impact on current period cash flows, but it does reflect management’s expectations for lower future cash flows (does that change your expectations?).

Prior “Signals”

    
DateTopicSubject / TickerThe Signal
8/19/20Stock10-K Filings Part 2Other Voices: Why Reading 10-K Filings Is Crucial; Part 2
8/6/20StockTruist Financial (TFC)Never Heard of Truist? This Bank Stock Could Rise Up to 30%
7/29/20StockWeight Watchers (WW)Weight Watchers Can Continue to Outperform Post COVID-19
7/22/20StockXilinx (XLNX)If EPS Rises to Pre-Covid-19 Level, XLNX Could See Old Highs
7/15/20StockMarket ConcentrationNarrow Mkt Rally Fuels Worry; We Expect Cyclicals To Join
7/8/20StockSEC FilingsOther Voices: Why Reading 10-K Filings Is Crucial; Part 1
7/1/20StockSimply Good Foods (SMPL)Post-COVID-19, Simply Good Foods Stock Looks Appetizing
6/24/20StockLam Research, Applied MaterialsLam Research, Applied Materials Set to Reap IoT Harvest
6/17/20StockNordic Semiconductor (Nod.NO)Continued IoT Growth Good News for Nordic Semiconductor
6/10/20StockHelmerich & Payne (HP)Helmerich & Payne Stock Could Energize Your Portfolio
6/3/20OptionsVan Hulzen Asset ManagementFor Income Seekers, Why Covered Calls Top Junk Bond ETFs
5/27/20StockJP Morgan Chase (JPM)Why JPMorgan Chase Belongs in Portfolios Post-COVID-19
5/20/20StockHorizon (HZNP)Horizon Therapeutics Is Inexpensive; 2 Drugs Show Promise
5/13/20StockBank OZK (OZK)‘Plain Vanilla’ Bank OZK Could Be Long Term Opportunity

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