Active investment commentary & analysis

What should analysts look for in annual reports?

The company reporting season subtly changes each year. Not just new accounting standards - the style of annual reports evolves to reflect stakeholder objectives and online delivery. Analysts may miss the more subtle changes in narratives and adjustments to earnings. Corporate CEOs understand market psychology, and can game their investors. Despite the aim of consistency in auditing standards, the numbers are often fine-tuned to play to an appealing story. What should analysts look for?

A decade of easy money has moved the goalposts. The scarcity now is not growth capital, but genuine growth itself. In the past, analysts were on alert for ways of flattering profits, assets or cashflow – traditional manipulation of the numbers. The game was predictable, with just a few accounting scandals such as Patisserie Valerie, slipping through the net. Now, growth businesses have a different story, and new accounting tricks. The aim of these is to achieve the high ratings of “quality growth” stocks, much in vogue in recent years. Company results now feature the new “hot buttons” that excite today’s investors; momentum rather than value.

Growth investors favour high gross margins, and are often surprisingly willing to tolerate poor short term profitability. Gross margins may drive share valuation more strongly than growth rates. Cashflow from operations may matter less. The key is to keep investors’ faith with the growth story; not current profitability, but a journey driven by unit economics towards a rewarding future. The hope is that scale eventually pays-off, creating a moat around the business and locking-in the profit margin. Company reporting metrics aim to keep shareholders’ dreams alive.

For some earlier stage small and mid-cap growth companies, the focus may be on flattering revenue per user or some other demonstration of attractive unit economics. A range of measures that have no set standard can be used to support this; customer acquisition costs and lifetime value. But how long customers stay, and with what pricing may just be guesswork. Like-for-like comparisons and organic growth sound like simple concepts, but are hard to pin down - and management know that acquisitions complicate the calculations.

Often adjustments are not directly boosting profits or cashflow. Many growth businesses operate on a capital-lite model and they have ready access to cash from successive equity fundraisings or cheap bank finance. For those growth companies, the story is designed to boost share ratings. 

With more consumption of annual reports online, companies tend to present summaries with selected highlights. These will tell the story with numbers that may be carefully selected by management. It is hard when reading these to make a reality check. Practice now is to take a long-term view of synergies on acquisition, but how sure can anyone be of what the sector will look like that far in the future? With so much goodwill dependent on management assumptions and projections, can investors really gain much insight into the risk of impairment? Where companies have debt, management may be much more focused on meeting debt covenants than on long term shareholders. 

Some companies now have lengthy and complex explanations for the “alternative performance measures” they use. These adjustments can vary from year-to-year and may not match those of any other company in their sector. Sell-side research is more thinly spread following MiFID II, and there may not be time to examine company accounts in detail. Auditors’ reports highlight the contentious areas where judgement is being used or practice changed, but the warning is hard for shareholders to assess. Provided an auditor has flagged a concern, and total sales and assets are roughly right, flattering presentation is not seen as fraudulent or even unethical. In behavioural economics, the power of incentives is often overlooked.  Investors need to recognise that the game has changed; growth companies are playing to new rules.

A version of this article was published on Citywire on 01/04/2020.