Phil Oakley 

Back to basics

Phil Oakley

Back to basics

I have always believed that a company’s annual report is the single best piece of information that an investor in a business can get their hands on. It has always surprised me how underused they are. Yet they are packed full of useful information and with some simple bits of number crunching a diligent investor can learn a great deal about a company and improve their investing decisions. Over the next few weeks, I am going to show you how you can do this and will start by looking at income statements.

When you start looking at a company, I always think it’s a good idea to look at the numbers in the financial statements first and build up your own picture of it. This encourages independent and critical thinking, which is so important to investing and stops you from being influenced by what the management has to say. You should read that later, and see whether the view you have built up by looking at the numbers matches with theirs. Sometimes it will not.

To keep things as simple as possible, I am going to use the annual report of one company for most of the examples. In this case, I have chosen Marston’s (MARS), which makes its money from brewing beer, owning and managing pubs and hotels and renting out pubs to tenanted landlords.

The income statement

Sometimes called a profit-and-loss account, the income statement shows a company’s revenues and expenses over a period of time. Here is Marston’s for the year to September 2018.

Before we get into turning this income statement into useful information, it is important to understand how the numbers you see in them are arrived at.

Income statements are prepared under what is known as the accruals or matching concept. What this means in practice is that revenues and costs are recorded when a transaction has taken place not when cash is received or spent. The revenues that are generated are then matched with the costs incurred to generate them.

For example, a sale of goods can be booked as revenue when they are shipped to the customer even though a company might have to wait days or weeks before getting paid for them. The costs incurred – such as raw materials, stock, wages and general overheads – are matched against them whether they have been paid for or not.

You will notice that next to the separate line items in the income statement are numbers relating to notes. These notes tell you how the numbers are made up and are a great source of information, as we shall see.

You will also see that there is a column relating to underlying and non-underlying income. Underlying is supposed to give the reader a picture of the trading performance of the business and excludes gains and costs that are considered to be exceptional or one-off, which are included in the non-underlying figure. The concept of non-underlying or adjusted income is subject to much abuse, with companies often being very aggressive with their definitions as to which costs should be excluded and which ones should not. Investors need to be wary of companies that have large non-underlying items in their income statements on a regular basis.

Revenue

Revenue refers to the income generated from selling the goods and services that a business specialises in. It is sometimes referred to as turnover.  If we go to note 2 of Marston's accounts we can see where its revenue came from and how it changed compared with the year before.

The company gives a short, helpful explanation of what each of its businesses segments does to earn its revenues. When you have these numbers I find putting them into a spreadsheet is the best way to learn more from them.

 

Segment (£m)

2018

2017

Change £m

% change

Destination & premium

450.7

438

12.7

2.9%

Taverns

312

301.3

10.7

3.6%

Brewing

377.7

252.9

124.8

49.3%

Underlying revenue

1140.4

992.2

148.2

14.9%

     

Segment revenues (%)

2018

2017

  

Destination & premium

40%

44%

  

Taverns

27%

30%

  

Brewing

33%

25%

  

Underlying revenue

100%

100%

  

Source: Annual report/Investors Chronicle

 

We can see that revenue increased by £148.2m or 14.9 per cent in 2019 and that most of that growth came from brewing where revenue increased by £124.8m or 49.3 per cent. The other segments saw very modest growth.

The growth rate from brewing represents a big increase, which is quite unusual and would be a very encouraging sign if it had come from an existing business. The rate of growth seen here is often the sign of an acquisition, which the company should refer to in its discussion of its businesses (it bought the brewing business of Charles Wells).

It’s also useful to calculate the proportion of revenue that each segment contributes to the company as a whole. We can see that brewing was a quarter of total revenues in 2017 and increased to a third in 2018. Destination and premium pubs remains the biggest source of revenue at 40 per cent of the total.

 

Operating expenses

Marston’s incurs many different costs in generating its revenues. These are shown in a detailed note to the income statement.

First of all, we can see that some items actually reduce expenses – they are netted off. Increases in stock, costs capitalised (put on the balance sheet rather than expensed through the income statement) and other income reduced expenses, but are not big in terms of overall costs and did not increase materially from year to year.

The biggest cost items are:

  • Raw materials and consumables (mainly food and drink) and taxes paid on alcoholic drinks.
  • Employee costs.
  • Other net operating charges.

 

Marston’s operating expenses

Costs £m

2018

2017

% change

% of revenues 2018

% of revenues 2017

Change in stocks of goods & WIP

-3.4

-1.8

89%

-0.3%

-0.2%

Own work capitalised

-7.3

-5.8

26%

-0.6%

-0.6%

Other operating income

-10.6

-8.7

22%

-0.9%

-0.9%

Raw materials, consumables and excise duties

456.4

370.9

23%

40.0%

37.4%

Depreciation of property, plant & equipment

39

38.1

2%

3.4%

3.8%

Amortisation of intangible assets

1.1

1.1

0%

0.1%

0.1%

Employee costs

234.3

219.1

7%

20.5%

22.1%

Hire of plant and machinery

0.9

0.8

13%

0.1%

0.1%

Other operating lease rentals

17.6

20.6

-15%

1.5%

2.1%

Income from other non-current assets

-0.4

-0.2

100%

0.0%

0.0%

Impairment of properties

39.4

3.9

910%

3.5%

0.4%

Other net operating charges

240.9

202.9

19%

21.1%

20.4%

Total operating expenses

1007.9

840.9

20%

88.4%

84.8%

Source: Annual report/Investors Chronicle

 

Again the spreadsheet comes in handy here. I like to see what percentage of revenues are eaten up by particular costs. The lower this number is, the more profitable the business. We can see that 88.4 per cent of revenues were in 2018 compared with 84.8 per cent in 2017. Significant increases came from raw materials and impairments, while employee costs as a percentage of revenues came down.

The note says that £50m of costs were non-underlying. The biggest of which was £39.4m of impairment on freehold and leasehold properties (pubs). An impairment occurs when an asset’s value is written down or reduced. This is usually done to reflect a decline in its profitability. If there are regular impairments this is often a sign of a business that is struggling.

Impairments are often ignored as they are treated as one-offs and are not an outflow of cash. However, they have the potential to boost future years’ profits by reducing depreciation – the annual cost of using an asset over its useful life. This is done by reducing the cost of the asset.

Big impairments have the potential to significantly reduce a company’s profit reserves (the sum of all the past profits of a business that have not been paid out to shareholders) which can limit the ability of a company to pay dividends.

We can see with Marston’s that the £39.8m includes a £70m impairment and a £31.4m reversal of past impairments. The latter can be seen as positive as it indicates that assets that were performing badly in the past might be improving their profits.

 

Operating profit and profit margins

For me, this is the most important number on the income statement. It shows the profit made from trading activities. This profit number is my preferred measure of profit as it is not influenced by how a business is financed (like pre-tax profit) or the tax paid (post-tax profit or net income).

The accompanying note also has some extra numbers relating to depreciation and investment spending (capex) in each business, which allows us to get some valuable information on the cash-generating ability of each segment.

 

Marston’s segmental profits

Underlying profits (£m)

2018

2017

Change (£m)

% change

Destination & premium

89.4

88.9

0.5

0.6%

Taverns

86.1

84.1

2

2.4%

Brewing

32

25.5

6.5

25.5%

Total segment profits

207.5

198.5

9

4.5%

Group services

-25

-24

-1

4.2%

Total profit

182.5

174.5

8

4.6%

     

Profit (%)

2018

2017

  

Destination & premium

43.1%

44.8%

  

Taverns

41.5%

42.4%

  

Brewing

15.4%

12.8%

  
     

Profit margins

2018

2017

  

Destination & premium

19.8%

20.3%

  

Taverns

19.1%

19.2%

  

Brewing

7.1%

5.8%

  

Total

16.0%

17.6%

  

Source: Annual report/Investors Chronicle

 

We can see that underlying operating profits have grown by £8m and that virtually all that growth has come from the brewing business. Growth elsewhere has been very modest.

Destination and premium pubs are the biggest source of profit for the company, closely followed by taverns. Brewing is making a bigger contribution to profit in 2018 than it was in 2017.

We can take the segmental profit figures and divide them by the segmental revenue figures to calculate their profit margins. Destination and premium and taverns are fairly high-margin businesses, which is a positive sign, but margins are slightly lower than in 2017. Brewing margins are much lower than pubs but are higher than a year ago. The total operating margin fell from 17.6 per cent in 2017 to 16 per cent in 2018.

These simple calculations provide you with questions to seek answers to. For example, you should read the annual report to see if the management makes any comments about profit margins and the reasons for any change.

By adding depreciation and amortisation to profit we can calculate Ebitda (earnings before interest, tax, depreciation and amortisation) per segment – a rough estimate of steady-state trading cash flow. We can then take away capex (additions to non-current assets) and calculate an estimate of pre-tax, pre-interest free cash flow. The numbers for Marston’s here are not very pretty, especially when you compare them with the profit figures.

 

Ebitda less capex

2018

% op profit

2017

% Op profit

Destination & premium

3.2

3.6%

-48.4

-54.4%

Taverns

66.2

76.9%

64.1

76.2%

Brewing

15.4

48.1%

17.8

69.8%

Group

-27.9

111.6%

-27.9

116.3%

Total

56.9

31.2%

5.6

3.2%

Source:Annual report/Investors Chronicle

 

The poor cash generation of the destination and premium pubs would be a big source of concern for me. Lots of money is being invested in the business, but the profits don’t seem to be growing very much. Maybe the investments need time to pay off or perhaps they are not earning acceptable returns. Again, here, we have identified an important issue for further research.

 

Finance costs

One of the most important things to understand as a shareholder in any business is that you get paid last. Lenders such as banks, bondholders and the government all have to be paid before you are entitled to anything that is left over.

This is why it is often wise to avoid businesses with lots of debt and big interest expenses or finance costs. Marston’s is one such business.

We can see that finance income is negligible but finance costs are big and have increased over the year, which suggests that debts may have increased and/or the interest rate paid on them has.

Interest cover is a very important calculation of safety for shareholders. It measures how many times the company’s operating profits can pay the interest costs on its borrowings. You work this out by dividing operating profit by the finance costs. Marston’s interest cover was just 2.3 times in 2018, the same as 2017. 

This is a very low number and a sign of high risk to shareholders. This is the kind of interest cover you might see on very stable businesses such as network utilities, but pubs are not in the same category despite some arguing that the rents from taverns are very stable. The last recession proved this to be far from true.

 

Taxation

Taxation is a complicated subject and cannot be covered in depth here. Companies pay corporation tax on their pre-tax profits at a standard rate. In 2018, this rate was 19 per cent for Marston’s in the UK, where all its profits are made. Individual tax rates can differ from standard rates due to the differences between accounting profits and taxable profits – sometimes the differences between the two can be substantial.

I look at the tax rate on underlying profits. Marston's paid £16.1m on pre-tax profits of £104m – a rate of 15.5 per cent, which is broadly the same as the year before. 

You should always try to understand why a company has a lower tax rate than the standard rate as it might be temporary and increase in the future, which could reduce profits for shareholders. The financial review of the annual report will often comment on this.

Higher tax rates might be telling you that the company’s taxable profits are higher than its accounting profits. Time spent researching the causes of this  can often be very enlightening and are worthy of a separate article.

 

Profits for shareholders and earnings per share (EPS)

Sometimes referred to as net profit or earnings, this number tells you how much profit there is left over for shareholders after all other expenses have been paid. EPS expresses this as a profit for each share.

Marston’s underlying earnings have increased by just over £3m to £87.9m, but its diluted EPS has fallen from 14.0p to 13.7p due to an increase in the weighted average diluted number of shares in issue throughout the year.

The business is less profitable from a shareholder's point of view. Net profit as a percentage of turnover has decreased from 8.5 per cent to 7.7 per cent.

You can see that the income statement has four different EPS figures. You should always use diluted EPS figures, which take into account shares that will be issued in the future that will dilute existing shareholders’ stake in the business.

Pay close attention to big differences between underlying and basic EPS (which includes one-off gains and losses) over time. This can be a sign of aggressive accounting. Marston’s gap is explained largely by one-off impairments, which are not overly suspicious in my view.

You should also find out the reason why the number of shares has increased. In this case it was to help finance the acquisition of the Charles Wells business in June 2017. At the same time, you should look at the year-end number of shares as this may affect future EPS calculations.

Marston’s actually has just over 660m shares in issue. The difference is explained by just over 26m held in treasury for share award schemes (options) to employees in the future. Only 6.7m of these are included in the diluted EPS calculation as they have an option price below the weighted average share price and have been assumed to be exercisable.

Some companies – such as rival JD Wetherspoon – include all the shares held in treasury when calculating diluted EPS.

 

Key takeaways

A lot of what I have gone through here is very simple and basic stuff, but I hope you’ll agree that it can be very informative and valuable.

Just by looking at Marston’s income statement and its accompanying notes we have learned that:

  • Revenues and profits have grown but virtually all of this appears to have come from a full-year contribution by the Charles Wells business. This contributed for four months in 2017 but a full year in 2018.
  • Profit growth in the pubs and taverns business is very modest, with profit margins down slightly.
  • The underlying cash generation of the premium and destination pubs was poor in 2018 and 2017 while profits haven’t grown much.
  • Interest payments are large and have been getting larger. Interest cover remains very thin and leaves shareholders very exposed to any fall in profits.
  • Many of its pub assets have been struggling and have been written down in value (impaired).
  • The tax rate is slightly below the standard rate of UK corporation tax, but not by much.
  • The business is less profitable for shareholders than the year before.
  • Profit for shareholders has increased slightly, but is being shared out across a larger number of shares and so EPS has fallen. The company does not include all shares held in treasury when calculating diluted EPS.

Next week I will move on to Marston's balance sheet.

Related topics

Subscribe today

Full access for just £3.37 a week:

• Tips and recommendations - to beat the market 
• Portfolio clinic & Mr Bearbull - build a well-planned portfolio 
• Expert tools - track and manage investments effortlessly
• Plus free delivery to your home or office

Subscribe Now