July 2017 – Focused Compounding

Geoff Gannon July 27, 2017

How to Read Between the Lines of a 10-K

Question

“I have read some of your Singular Diligence content and one of the most interesting parts of the reading are the notes that you and Quan used and published in those reports.

So one of the most remarkable things that I have noticed in the notes is that you did not use a lot of information in the annual reports. And this sounds intriguing to me since I am a regular reader of your blog and you have always emphasized how important it is to read (the) 10-K, annual reports, (and) quarterly reports. Having said that, it would be good to understand why did you not use more info from those sources. Moreover, I was actually curious how do you allocate your time when doing research? I am currently also doing research so I was looking to see which sources you prioritize?”

Answer

It depends on what you mean by prioritize? If a top priority is the thing you read first, then I make 10-Ks a top priority. If a top priority is the thing you spend the most time on, then SEC filings are a low priority. And then, if a top priority is something you quote a lot – as you mentioned – SEC filing are a very low priority for me.

I’ve said before that I always read the newest 10-K and the oldest 10-K of a stock I’m researching. So, imagine I am researching a U.S. stock that has been public for a long time. The SEC’s database of company filings – which includes 10-Ks (annual reports), 10-Qs (quarterly reports), and “going public” or spin-off documents if the company has any of those. If the company has been public in its current form for a long time, the oldest annual report (10-K) will be something from maybe 1994-1996. That’s around the time companies started being required to file electronic copies of their 10-Ks with the SEC. As a rule, a U.S. company that has long been public will now have about 20 years of annual reports for you to read in full.

Don’t do that. I just read the 2016 (last year’s) annual report and then the 1994 or 1995 or 1996 – or whatever the oldest report you can find is – annual report. I want to get a sense of how the business has changed.

The 10-K – when read on its own – is of limited value when making an investment. All of the financial data that Quan and I used to create the “datasheet” of a Singular Diligence comes from the 10-K. So, the financial statements – especially the income statement, the balance sheet, and the cash flow statement – are useful. The datasheet we presented was usually a 15-25 year history of a company’s finances. It’s by far the most important thing in those reports. It may be possible to make an investment based purely on the financial statements if you have both income statement and balance sheet data for …

Geoff Gannon July 26, 2017

Guesses About My Next Purchase

In an earlier post, I mentioned I MIGHT be buying a new 20% position this week. Here is what you guys guessed that position would be:

Blog readers emailed me guessing I would buy one of four stocks this week: Howden Joinery, Omnicom, Hunter Douglas, or MSC Industrial.

The stock I am considering is not among those four.

Richard Beddard’s Share Sleuth portfolio, however, did buy Howden Joinery. Read the post explaining why here.

Geoff Gannon July 23, 2017

I MIGHT Buy a New 20% Position This Week

It’s very possible I will purchase a new 20% position this week (29% of my portfolio is in cash and 6% is in a stock I’d happily eliminate).

If I do buy the stock, I’ll announce it on the paid site (Focused Compounding) first and then mention the stock’s name here a week or two later.

Anyone who wants to guess what the stock is can email me at [email protected]

There are no prizes for a correct guess. But, it might be a fun exercise.…

Geoff Gannon July 17, 2017

How to Judge a Company’s Bargaining Power With its Customers and Suppliers

A Focused Compounding member asked me this question:

“…what are the factors we should be thinking about when assessing the bargaining power of a given business relative to its customers and suppliers?”

In an earlier memo, I talked about “market power”. My definition of market power is the ability of a company to make demands of its customers or suppliers without fearing that such demands will end their relationship. Why would a supplier or customer agree to demands without considering ending the relationship?

Dependency.

Recently, it was reported that Wal-Mart will start fining suppliers for delivering early as well as delivering late. Wal-Mart wants to manage inventory in their stores. So, they want to make sure that orders arrive on-time and in-full. Many suppliers to a retailer like Wal-Mart don’t have a good track record when it comes to making sure 100% of the order is there on the scheduled day. This causes problems for retailers. For example, I was at Costco last week and picked up the very last box of Eggo waffles available in that store. A few days later, there were several dozen boxes of Eggos – all containing 72 waffles each – stacked sky high. Everyone who came to Costco after I did was either looking for their usual supplier of frozen waffles and didn’t get them – or they have no idea Costco even sells Eggo products. Getting a supplier to deliver on time and in full sounds like a small thing, but a business model like Wal-Mart depends on keeping inventory at the right level. Wide selection in store is Wal-Mart’s main advantage. In most of the towns Wal-Mart is in it’s the offline “everything store” that Amazon aspires to be online. It is the only place to make a true one-stop shopping trip. If shelves are bare of any items at all – shoppers go away disappointed. Too much inventory obviously causes problems for shareholders – it ties up more capital and lowers free cash flow for the year – but it’s also a problem for employees. Because of the way Wal-Marts are run, employees spend a lot of time in areas shoppers don’t see. Sometimes, those areas aren’t the most pleasant places to work. When they are overcrowded with inventory, they became very unpleasant places to work.

Wal-Mart has a lot of bargaining power with some suppliers. Mostly, these seem to be suppliers that have gradually become dependent on Wal-Mart over time. This could happen for a few reasons. One of the most common reasons you see is chasing high growth in slow growth industries. So, if a company was in the soda business or the cereal business and Wal-Mart was quickly expanding around the nation during the 1970s, 1980s, 1990s, and early 2000s – such a company might have tried to grow faster than its category by selling a greater share of its product to faster growing retailers like Wal-Mart. This sounds like a good idea at the time. It allows …

Sebastian Schrick July 16, 2017

Merkur Bank (XETR: MBK)

Merkur Bank (MBK) is a small regional bank located in Munich, Germany. In 1986, MBK was acquired by a group of private investors led by Mr. Siegfried Lingel. At this time MBK had total assets of €14 million and 7 employees. Mr. Lingel refocused the bank’s business on financing residential real estate developers in Leipzig, Berlin and, to a lesser extent, Munich. In 1995, the bank extended its business to the financing of leasing companies and SMEs. In 1999, MBK went public on the Munich stock exchange. In 2002, Mr. Lingel’s son, Mr. Marcus Lingel, joined the company’s management team and, after a six-year transition phase, he finally became CEO. Mr. Lingel refocused MBK’s real estate business to Munich (beginning in 2002) and, in 2005, to Stuttgart. MBK operates five branch offices and since 2009 the company has also been offering online retail banking solutions to its clients. Currently, MBK has total assets of approximately €1 billion and 200 employees.

The following are the main arguments for investing in the company:

MBK’s business model is easy to understand.

MBK could serve as a text book example of how banks used (?!) to operate. MBK collects deposits from its clients and uses these funds to provide loans to real estate developers, leasing companies and SMEs. The difference between the cost of taking in clients’ deposits and the interest rate MBK demands from its borrowers is MBK’s most important revenue stream. The second revenue stream are commissions earned by providing various consulting services to clients and borrowers.

MBK is not engaged in any sort of proprietary trading or investment banking. This allowed MBK to survive the financial crisis of ’08-’09 and the “Euro crisis” unscathed because it did not have to record any write-downs. In fact, MBK has been profitable during these times of financial turmoil. MBK also refrains from performing maturity transformation as far as possible.

MBK’s business model, i.e. focusing on the “traditional” banking business, makes the bank quite insensitive to the prevailing low interest rate environment. From 2009 to 2016 the bank’s interest rate spread fluctuated between 3.24% (2010) and 2.78% (2016) and the average (= median) interest rate spread being 2.92%. The main factor affecting MBK’s profitability are competitive pressures, i.e. when its competitors demand lower interest rates on new loans to gain market share. These pressures have intensified in the last three years, as the interest rate spread declined from 2.94% to 2.78% (2016).

Focus on Munich’s housing market should provide potential for further growth.

MBK’s most important business segment is real estate financing and, here, the bank is particularly focused on Munich.

Munich is an attractive city for real estate developers because of a chronic scarcity in housing. This situation will probably not change as Munich’s population is likely to grow in the future, as it has done in the past. This is due to the high quality of living the city offers (it constantly ranks among the top ten cities in the world) and its …

Geoff Gannon July 3, 2017

What My Portfolio Looks Like Right Now – July 3rd, 2017

Frost (CFR): 42%

BWX Technologies (BWXT): 23%

Natoco: 6%

Cash: 29%…

Jayden Preston July 2, 2017

Kroger (NYSE:KR): A Little Too Hard

On 16 June 2017, Amazon announced a $13.7 billion acquisition of Whole Foods. The announcement then engendered meaningful declines in stock prices of major grocers/supermarkets, not just in the US but also in Europe. Kroger, in particular, dropped as much as 17% that day. This brings its YTD performance to -31% as of 29^th June 2017.

Below, we take a brief look at Kroger to see if it is now the right time to consider an investment in it.

Introduction

Founded in 1883, Kroger is now one of the largest retailers in the world, with more than $115 billion in revenue in 2016, serving more than 8.5 million customers every day. As of January 28, 2017, Kroger operated, either directly or through its subsidiaries, 2,796 supermarkets under a variety of local banner names. 2,255 of them have pharmacies and 1,445 have fuel centers. They also offer ClickList™ and Harris Teeter ExpressLane— their personalized, order online, pick up at the store services — at 637 of the supermarkets. Approximately 48% of these supermarkets were operated in Company-owned facilities, including some Company-owned buildings on leased land.

Kroger also operates 784 convenience stores, either directly or through franchisees, 319 fine jewelry stores and an online retailer.

Several things stood out in the above description of Kroger:

With sales of $ 115 billion, Kroger is the third biggest retail chains in the world. It is also the largest traditional supermarket chain in the US.
Kroger’s 2,796 supermarkets are operated under a variety of local banner names.
Fuel is a significant contributor to Kroger’s revenue, generating almost $14 billion in 2016. More than 50% of Kroger’s stores have fuel centers.
48% of Kroger’s supermarkets are operated in their own facilities.

We will come back to the above points below.

Durability and Moat

The durability of demand for food and groceries is very good. Most grocers do not experience significant fluctuations in real sales per square foot over time. This is especially true for a general food and grocery retailer like Kroger, whose store size is big enough for them to have room beyond providing traditional grocery to also sell items that are popular. In other words, they have more room to experiment and adapt according to the latest trends.

For example, 10 years ago natural and organic was not a central focus in their stores because it was not a central focus for customers. 5 years ago Kroger made a concerted effort to make natural and organic the “plus a little” part of their product strategy (Kroger wants their most loyal customers to say “At

Kroger, I get the products I want, plus a little”). Today, natural and organic foods are integral to their business, reaching $16 billion in annual sales in

In fact, this makes Kroger a bigger organic food retailer than Whole Foods.

In terms of moat, supermarkets’ competitive advantage mostly stems from local economies of scale. Kroger uses a 2 to 2.5 mile radius to define its local market for each …