Someone who reads my blog emailed me this question:
“Do you listen (to) or read quarterlies? Do you find the management's spin and guidance helpful or detrimental to your investing?”
I do read earnings call transcripts. Sometimes I find them very useful. When Quan and I were writing the newsletter, Quan would start by collecting all the earnings call transcripts he could find on a company. Then he would take notes on those parts of the transcripts he thought were most important. Quan and I would then discuss his notes on the transcripts.
Yes, earnings call transcripts can be useful, but there are a few points to make here. One, we were always looking at transcripts going as far back into the past as possible. We were as interested in reading what the management of Frost (CFR, Financial) said in 2007, 2008 and 2009 as what it had to say in 2014. The last issue of Singular Diligence we did was on Bank of Hawaii (BOH, Financial). I think I used a quote in that issue from the early 2000s. I know I talked about Bank of Hawaii’s turnaround that started right around the turn of the millennium.
So we go back in time. We are interested in what management says in these transcripts that gives us an insight into the business. We aren’t interested in what management is guiding for next quarter, next year, etc. Personally, I’d prefer that management not provide any earnings guidance. There are some things it can be useful to provide guidance on. For example, giving hints about what debt levels the company is comfortable with, how much stock it plans to buy back, etc. We find those kinds of discussions useful. Longer-term discussions of the business’ possible growth can also be useful.
In the issues we wrote, I’m sure we cited management’s guidance on things like the total number of stores it hoped to one day have in a country. For example, Howden Joinery (LSE:HWDN, Financial) has something like 630 depots right now. In the past, it said it could one day reach 700 depots in the U.K. More recently, I think it has said that number could be 800 depots. Howden also gives information on the break-even point for a depot and the fully mature sales level of a depot. If you know the number of depots Howden hopes to one day have in the U.K. (800) and you know the “mature” sales level of a depot –Â 2.2 million pounds ($2.75 million) –Â you can calculate the total U.K. opportunity for Howden.
You could value Howden based on a sales ceiling of 1.76 billion pounds in U.K. sales. You’d need to think about what the operating margin might be at that time and how much of the operating profit could be converted into sales if the company stopped growing. That kind of “guidance” is very important. When a company is growing, it can be difficult to know what it would look like if it stopped growing.
Transcripts also include a lot of discussion of things like same-store sales growth, constant currency growth, breaking out organic versus acquired growth, etc. These are useful things to look at. But transcripts are generally too short-term oriented to interest us. Analysts almost never ask any of the questions that I’d ask. Analysts are mostly interested in knowing how to fill out their EPS models for the next quarter, year, etc. I’m more interested in what the company will look like in five years, what normalized earnings are, etc.
However, I do have to say that I’ve often heard useful tidbits from management during an interview. For example, I read an interview where the then-CEO of George Risk (RSKIA, Financial) – he has since died – made a useful comment about the company’s competitive position. It wasn’t an earnings call transcript. It was an interview with The Wall Street Transcript. It does some interviews with CEOs, chief financial officers, etc. – especially with executives at very small public companies.
Anyway, the CEO, Ken Risk, said that some competitors had prices that were lower than George Risk’s material costs. In other words, the company couldn’t compete on price. I knew it was successful in terms of market share, operating margin, etc. It had a good gross margin. This comment was important in getting me to consider whether price was as important a competitive factor as I originally thought it would be in the industry. I’m not sure I would have bought the stock – and I’m sure I wouldn’t have put as much into the stock – if I hadn’t read that comment.
The reason for this is odd. It’s a framing issue. I found George Risk as a net-net. So, I expected it to be a bad business. I did my usual long-term historical financials spreadsheet. And what I found was that George Risk’s profitability, predictability, etc. – everything but growth – were at levels associated with blue-chip companies rather than net-nets. And yet it had a net-net price.
I wasn’t sure the business was a good business until I read the interview. After reading the interview, I looked for some other information on the company and the housing market. And I concluded that during the housing boom, nobody in the industry had been raising prices. However, once the level of unit output dropped at a company like George Risk, the gross costs would rise.
Basically, George Risk was doing a lot of the same things in the same place. There was probably significant fixed cost absorption. If price was the main reason George Risk’s customers were customers – this wouldn’t be a good business in the bust. However, if price was not the reason George Risk’s customers were its customers, then the company could just raise prices to bring its gross margin to the same percentage level on a lower unit volume. The stock was a net-net either way. I’m not saying I wouldn’t buy it if I hadn’t read that interview, but I wouldn’t have put as much of my portfolio into the stock if I didn’t read the interview.
I am trying to think of other situations in which something that was said in an earnings call transcript, interview with management, etc., was important to an investment decision I made. Quan and I sometimes tried to talk to people who knew a lot about a company but were not part of the management team. We often got more useful information from competitors, branch managers and customers of a company than from the management of the company. For example, some information we got from insurance agents who sell Progressive (PGR, Financial) insurance as well as competing policies was useful. We talked to someone who knew a lot about Tandy’s (TLF, Financial) market power in the leather crafting accessories industry. The same was true of Wiley.
We didn’t quote heavily from these sources because we considered the conversations confidential. The information we got wasn’t the kind of information a lot of investors think they’ll get from doing “scuttlebutt.” Nothing anyone told us would be helpful in predicting next quarter’s earnings or next year’s earnings. But what we did get was confidence. I’m not sure we could have written about either Ekornes (OSL:EKO, Financial) or Hunter Douglas (XAMS:HDG) unless we spoke to dealers. The stores that sold Stressless and Hunter Douglas products made it clear to us that they could make more money selling those products than any competing products.
Hunter Douglas and Progressive were both interesting that way. We wouldn’t have understood how strong the distribution of these two companies was in the U.S. if we didn’t know how the “retailers” of Progressive’s independent channel and Hunter Douglas’ blind business in the U.S. felt about selling these companies’ products. It’s often easier to get information from the company’s perspective and from the end users’ perspective. It’s harder to get information explaining why a retailer chooses to stock one product over another product. We got a lot of quotes from agents who sold Progressive policies, a lot of stores that devoted most or all their blinds and curtain space to Hunter Douglas, etc.
Ekornes, Progressive and Hunter Douglas are somewhat unusual cases I guess. They all have somewhat limited distribution compared to the way investors think of competition. We tend to think that all end customers get to see all their options at one time and compare them. That’s rare. It’s very rare offline. A customer who buys a Stressless recliner, Hunter Douglas blinds or a Progressive insurance policy through an agent is only seeing a small number of other alternatives at the same time.
Distribution is often the most important aspect of a business that investors don’t really understand. How a product is sold and to whom is important. It’s also hidden from an investor’s view. Investors tend to focus on things like price and brand. Realistically, the reason why you buy a certain soda, razor, toothpaste, etc., is maybe 20% price, 20% your own preference and 60% where the product is stocked. You buy the product because the place you go to shop carries it.
The big question is: why does a retailer choose to carry one product over another? The simple answer is that one product is easier to sell than another. The more involved answer is that one product is likely to produce more gross profit per square foot of selling space. For insurance agents who sell Progressive, the three explanations they gave were: 1) Progressive gives them a quote on some clients for which other insurers don’t provide any quote; 2) Everybody knows the Progressive name so no client hesitates the way they sometimes do with a no-name regional insurer; 3) Progressive provides them with better systems and support than other insurers. Could we have guessed those were the three reasons without hearing insurance agents talk about Progressive? Maybe.
I’d say this issue of why someone who is not a member of the public but some sort of specialized businessman prefers one solution over another is the most important question we have to research. If we’re researching Southwest Airlines (LUV, Financial) or Greggs (LSE:GRG), we can easily model who the customers are and what factors go into their decisions to pick that company over a competitor. When we’re researching something like Breeze-Eastern (BZC), a maker of search and rescue hoists for helicopters, or Babcock & Wilcox (BW), a maker of boilers for coal power plants, we don’t have much insight into why the decisions maker at the client firm makes the decision he does.
For example, Breeze-Eastern and Babcock both make a ton of money in the aftermarket. They provide maintenance, replacement parts, etc., on original equipment they sold in the past. When they need maintenance, do clients always use the company that worked on the original project? Or do they go through another selection process?
That’s an important question that is rarely discussed in enough detail in 10-Ks. A 10-K will discuss competition. It will say that a client puts out a request for bids from a handful of qualified providers, etc. It may say what factors the client considers when deciding which bid to accept. For example, the 10-K will mention if clients are governments who must accept the lowest bid or if they are allowed to make the decision based on factors other than price.
Sometimes I have found earnings call transcripts useful. They are most useful when they are discussing the basis on which a typical customer chooses between the company and its competitors. However, I have never found earnings call transcripts to be as useful as talking to the purchasing people at the client firm, a branch manager, the agents and retailers who sell the company’s product to the public, etc. In almost all cases where we spoke to members of management (such as the chief financial officer) and to people closer to the customer, it was the front-line employees who were closest to the customer who provided the most useful information.
If I had the choice between spending an hour talking to Progressive’s CFO or spending an hour with a focus group of half a dozen independent agents who sell Progressive policies – I’d choose the agents every time. There’s nothing the CEO, CFO, etc., of Ekornes can tell us that is going to be more helpful than hearing from a dozen dealers who sell Stressless recliners.
Access to management is always less useful than “scuttlebutt.” I can’t think of a single situation in which something management said was more useful than something the company’s customers said.
Disclosure: Long George Risk, Frost.
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