In growing industries, competition is generally less fierce. When industry growth begins to slow, competitors fight for market share and, in some instances, will change the way they compete.
If customer-acquisition costs are increasing then a business is facing more competition.
A business is not threatened by foreign competition if its products cannot be shipped long distances, but if labor is a large component of the product cost, then the business will face threats from foreign competition.
Evaluate the Business’s Relationship with Its Suppliers
Good supplier relationships facilitate the flow of goods. If a business does not have reliable sources of supply, then it will generate more volatile earnings.
If the inventory-turnover ratio is increasing over time, then this is an indicator that the business’s supply chain is becoming more efficient.
A business with a diversified supplier network has less risk than one dependent on only a few suppliers.
Those businesses that are highly dependent on commodity resources—such as oil, steel, or chemicals—are difficult to forecast because you must assume a certain price for the commodity in the future.
aNote that in 2004, Sears merged with K-Mart; therefore, later years include K-Mart results.
1. Author’s interview with Pat Dorsey, March 31, 2011.
2. Western Union 2009 10-K and MoneyGram International 2009 10-K.
3. Evans, David S., and Richard Schmalensee, Paying with Plastic: The Digital Revolution in Buying and Borrowing, 2nd ed. Cambridge MA: MIT Press, 2005.
4. comScore Media Metrix (U.S. data).
5. Cardona, Mercedes M. “Affluent Shoppers Like their Luxe Goods Cheap.” Advertising Age, December 1, 2003.
6. Blackhurst, Chris. “La Belle Maison.” The Evening Standard, May 25, 2010.
7. Standard & Poor’s Capital IQ.
8. “Store Brands Surge.” MMR 27 (2010): 115.
9. “Private Label on the Attack.” Black Book—U.S. Household and Personal Products, August 2009.
10. LeVine, Steve. “IBM Piles Up Patents, But Quantity Isn’t King, “BusinessWeek, January 25, 2010.
11. Freedman, David. “Relax. Let Your Guard Down. Why Patents, Trademarks, and Other Intellectual Property Protections are Bad for Business.” Inc., August 2006, pp. 109–111.
12. Blackboard 2009 10-K.
13. American Apparel and Footwear Association. ShoeStats, 2008. Accessed May 11, 2011. http://www.apparelandfootwear.org.
14. Wubbe, Eileen. “TSL Profile.” Secured Lender, September 2010, pp. 39.
15. 2004 Four Seasons Annual Report and Time Value of Money, LP interviews with Four Seasons management.
16. Standard & Poor’s Capital IQ.
17. Ibid.
18. Ibid.
19. Steinberg, Richard M. “Merrill Lynch Failed at ERM, and Then Just Failed.” Compliance Week, August 2009, pp. 42–43.
20. Verschoor, Curtis C. “Who Should Be Blamed the Most for the Subprime Loan Scandal?” Strategic Finance, December 2007, pp. 11–12.
21. Tobin, Edward. “Cola Wars Soldiers March Toward Marketing Battle.” Reuters News, November 22, 1999; “Canadian Beverage Firm Cott Can’t Find Buyer Amid Pricing Pressures.” Dow Jones Online News, April 24, 1998.
22. Standard & Poor’s Capital IQ; Steverman, Ben. “Netflix Battle with Blockbuster Gets Ugly.” BusinessWeek, July 24, 2007.
23. Carroll, Paul B., and Chunka Mui. “7 Ways to Fail Big: Lessons from the Most Inexcusable Business Failures of the Past 25 Years.” Harvard Business Review, September 2008.
24. Standard & Poor’s Capital IQ.
25. Ibid.
26. Dalton, Matthew. “Risks to BP Revival Center in U.S.” Wall Street Journal, January 2, 2008.
27. Talley, Karen. “Retailers, Suppliers Tussle.” Wall Street Journal, February 11, 2009.
28. Porter, Michael E., and Mark R. Kramer. “Creating Shared Value” Harvard Business Review, January–February 2011.
29. Standard & Poor’s Capital IQ.
30. Hoover, Sandra, and Saul Bromberger. “Supply Chain Challenges: Building Relationships.” Harvard Business Review, July 2003, p. 70.
31. Schlangenstein, Mary, and Mary Jane Credeur. “Higher U.S. Airfares Loom as Oil Climbs Toward $100.” Bloomberg News, December 22, 2010.
CHAPTER 5
Measuring the Operating and Financial Health of the Business
After you’ve assessed the environment, industry, and competitive framework (covered in Chapter 4) that a business is operating in, you want to focus on evaluating the company itself. Essentially, you want to understand whether the company is operationally and financially healthy. This chapter starts by showing you how to review a company’s fundamentals and then how to measure its basic performance, using operating metrics. Operating metrics indicate improvement or deterioration of the business and allow you to compare the company to other companies. We’ll look at detailed examples from a couple of industries and then walk through the process of figuring out which operating metrics matter most, and how to find, track, and analyze them.
As we move beyond basic operational performance, this chapter will explore the other factors that affect business function and health. As we look at risk, inflation, balance sheet issues, and debt, I’ll focus on giving you tools to identify and evaluate the problems that are specific to the business you are considering investing in. For example, as we look at inflation, I’ll show you characteristics of businesses that have less to worry about when inflation rises.
Finally, we will look at a general measure of business quality by seeing how well the business generates a return on the money invested in it (ROIC). I’ll show you what ROIC is, how to calculate it, and where it matters most. Each of the sections in this chapter is designed to enhance your ability to recognize opportunities and avoid investment errors as you study individual companies.
21. What are the fundamentals of the business?
Fundamentals are the basic things a business must do in order to be successful: for example, an express delivery company has to deliver things on time; restaurants have to serve good food. Think of these as the blocking and tackling functions of the business.
Fundamentals also drive the value of the business. Said another way, the better a company executes its most important basic operations, the more valuable it is. For example, at a for-profit university, it is the quality of the academic faculty that creates employable students. In turn, employable students create demand for the for-profit university’s services, which increases the overall value of the for-profit university. Here’s another example: High employee productivity helps Southwest Airlines succeed, because that’s how it keeps fares low, which increases the value of the airline.
Determine whether the management team understands what increases the value of the business and whether that shapes their actions. If management deviates from these, then it is likely that profits will decline. For example:
Jeff Bezos, founder of online retailer Amazon.com, focuses on continually enhancing the customer experience by delivering orders in a timely manner and offering more products in order to enlarge the competitive advantage.
Larry Page and Sergey Brin, founders of Internet search business Google, focus on “organizing the world’s information and making it accessible.”
Christina Gold, former CEO of Western Union, focused on tying up the most desirable agents in the world in long-term contracts and then driving traffic to them. Agents are supermarkets, banks, or retail chains that offer Western Union’s services.
Robert Silberman, CEO of Strayer Education, focuses on academic quality, which drives good student outcomes.
Michael Bloomberg, founder of Bloomberg, focused on giving his company’s customers “the information they need—no matter what the information is—where and when they need it, in whatever form is most appropriate.”
In each of these cases, there are specific outcomes you can identify and evalua
te to understand if the company is successfully executing its fundamental operations. You can measure and track each of these: food quality or customer satisfaction, rate of on-time deliveries, employee productivity, graduate employment, or faculty quality. If a fundamental is deteriorating, then the value of the business will as well. If a fundamental is steady or improving, you can have more confidence in the business’s underlying value.
Watch for those managers who chase too many ideas or have continually changing vision statements. This can distract them from focusing on fundamentals. Before company founder Howard Schultz returned to Starbucks in 2008, the company pursued too many new ideas that were not central to their success. From March 31, 2005, until the time Shultz returned, Starbuck’s stock price declined from $26 per share to $19.86 per share.1 When Schultz returned as CEO, he refocused the company on the most important projects, canceling the ones that were less relevant to the core business. Schultz took out sandwiches that interfered with the aroma of coffee, and pulled the plug on products like Mazagran, a soft drink the company made with Pepsi. He also took out some of the in-store products such as books and CDs.2 Starbucks returned its focus to providing quality products in an inviting atmosphere, with exceptional customer service. The stock price increased from $19.86 per share when Schultz took over on January 8, 2008, to $32.48 per share on January 4, 2011.3
As an investor, identifying and tracking fundamentals puts you in position to more quickly evaluate a business. If you already understand the most critical measures of a company’s operational health, you will be better equipped to evaluate unexpected changes in the business or the outside environment. Such changes often present buying opportunities if they affect the price investors are willing to pay for a business without affecting the fundamentals of the business. Being able to recognize deteriorating fundamentals is equally beneficial, as you can avoid investment mistakes. If a negative news announcement causes the stock price of one of your holdings to drop, always ask, “What impact does the announcement have on the fundamentals of the business?”
For example, in the past, I invested in money-management firm W.P. Stewart. The fundamentals of a money-management firm include acquiring and retaining accounts. Certain accounts, called sticky accounts, have more of a long-term relationship with a money manager and tend to stick with the firm even when the firm’s funds are underperforming. Therefore, every time I listened to W.P. Stewart’s conference calls or monitored news releases, I watched for any information that might indicate that their accounts were no longer sticky. On one conference call, W.P. Stewart’s managers indicated that a large percentage of their accounts had shifted to consultant-related accounts. With these accounts, an intermediary determines whether to continue to invest in a money-management firm. These accounts are less sticky. I evaluated this deteriorating fundamental, and sold the stock. The stock dropped 80 percent over the next few quarters as the consultant-related accounts withdrew assets at an even faster pace. By recognizing which fundamentals were crucial to the value of the business and by closely monitoring them, I was able to avoid an investment mistake.
22. What are the operating metrics of the business that you need to monitor?
The best way to monitor whether the fundamentals of a business are improving or deteriorating is to measure and evaluate the operating metrics of a business. Operating metrics are measures that help you gauge the true performance of the underlying business, similar to taking your blood pressure to monitor your own personal health. You can begin to use these metrics to learn about the business, and then as you gain in-depth knowledge, you can use them to continually monitor the health of that business, which will alert you to potential problems. You need to do the following:
Identify the metrics for a particular industry.
Research the sources of metrics.
Monitor the metrics over time.
Determine if changes in metrics are lasting or temporary.
Compare the metrics of the business you are analyzing to those of competitors and identify the reasons for the differences.
The next sections cover each of these topics in depth.
Identify the Metrics for a Particular Industry
To determine which operating metrics are useful, first identify what you are trying to measure. The type of metric you use will depend on the industry or business you are analyzing. Below are a few of the most commonly used operating metrics in several industries:
Banks use efficiency ratio, return on assets, and average cost of funds.
Real estate uses occupancy rate, rent per square foot, and cost per square foot.
Airlines use available seat miles, load factor, traffic, and capacity.
Retailers use same-store sales, basket size, sales per square foot, and average ticket.
Internet firms use conversion rate and traffic counts.
Subscription-type firms use number of subscribers, average revenue per subscriber, average cost per subscriber, and customer churn.
Credit card firms use net charge-offs, delinquencies, and payment rates.
Hotels use occupancy, revenue per available room (RevPAR), and average daily rate (ADR).
Gaming businesses use slot-win percentage, table-win percentage, and average daily win per table per day (WPT).
Following are more detailed examples of two of the metrics listed that you can use as models for examining metrics in many industries. Let’s examine each to understand what the metric tells you, how it is calculated, and what its limitations are.
Efficiency Ratio (Used by Banks)
The efficiency ratio is defined as the ratio of noninterest expense to total revenues. It is used to indicate a bank’s ability to control its expense levels. The lower the efficiency ratio, the better a bank is at controlling its expenses. Smaller banks tend to have higher efficiency ratios compared to larger banks, because larger banks can spread their expenses over more products, and larger banks tend to generate higher earnings from fees.
Monitoring this key banking ratio over an extended period can help you understand the industry in greater depth. In the early 1990s, for example, a ratio of 60 percent was considered a good target for banks. By the late 1990s, the most efficient banks had ratios in the low to mid 50 percent range.4 The efficiency ratio reflects a fundamental industry change (increase in size and increase in fees) as banks continued to consolidate through the 1990s.
Same-Store Sales (Used in Retail)
If you are analyzing a retail business, same-store sales is one of the metrics you would look at to gauge the health of a retailer. Same-store sales are defined as the year-over-year sales changes for a store that has been open at least 12 to 18 months. It helps you understand if stores are maintaining their existing level of sales or if store sales are declining. If competitor sales are good, but the retailer you are studying has declining same-store sales, the retailer you are analyzing is losing market share.
Research the Sources of Metrics
Operating metrics are obtained from a variety of sources, including the Management, Discussion, and Analysis (MD&A) section found in the 10-K or 10-Q; industry primers and guides published for investors analyzing a certain industry; trade associations; company press releases; and articles written about the business. Let’s look at each of these sources in a bit more detail.
10-K and 10-Q Reports
The 10-K and 10-Q reports are a great starting point for identifying the key operating metrics of a business. In the business description section, look for the following information:
Number of transactions
Number of customers
Number of locations
Number of employees
Total square footage of operating locations
You can then take these operating numbers (such as the number of transactions) and divide by revenues and costs to calculate metrics such as these:
Revenue per transaction
Cost per transaction
Transactions pe
r location
Industry Primers
Useful sources for identifying the operating metrics typically used for an industry are industry primers, such as these:
Reuters Operating Metrics
Standard & Poor’s Industry Surveys
Fisher Investments guides
These are guides written for analysts who are researching specific industries. They are useful because they explain historical trends in operating metrics, and provide detail and additional information that helps you understand why a change in a metric took place.
Suppose you were researching telephone wireless carriers: Standard & Poor’s Industry Survey explains that one of the most important operating metrics for these businesses is average revenue per user (ARPU).5 The report goes on to describe historical changes in ARPU. For example, in an atmosphere of heavy competition for new customers, providers offered price cuts during the period from 1987 to 1998. This made ARPU decline. The report also explains why ARPU rose after that, citing data from the trade group CTIA—The Wireless Association. This data showed average local monthly bills rising from $39.88 in June 1998 to $49.57 in June 2009. The increase was driven by higher usage and data-related services. The report further notes that although rates went up after 1998, they’ve been flat since 2003, mainly because voice use decline has been offset by the increase in data use.
Internet Search and Books
A simple Internet search, using terms such as “industry metrics for [insert name of industry]” will help you begin to identify useful metrics. You can also search for metrics in accounting textbooks and other books written about an industry.
Trade Associations
Many trade associations and trade journals publish periodic statistics in the form of ratios. Often, the members of the trade association will send in confidential financial and operating reports to the trade association, which then compiles them in an industry study.
For example, the National American Retail Hardware Association published a 2007 report called the “Cost of Doing Business Study,” which outlines the average profit and the highest profit of hardware stores, home centers, and lumber/building material outlets. These types of surveys are useful when you are making comparisons because you can benchmark the business you are evaluating to the industry and also against the most profitable competitor. Many times, these reports will outline the reasons why a certain business within an industry has greater profitability.
The Investment Checklist Page 13