Thursday, September 13, 2007

Systematic Analysis: In-Depth Accounting Analysis

This is the fifth part of my series looking at the steps of a systematic financial analysis. This is probably the most thought intensive step. What I'm talking about is the In-Depth Accounting Analysis step.

Think of the previous step, Quantitative Analysis, like you were looking at a Lego house. The house is made up of many individually shaped pieces that make up a whole structure. When we were examining the Balance Sheet, Income Statement, and the Statement of Cashflows, we were looking at the big picture. Using various ratios and forecasts, an analyst is able to eliminate bad investment choices.

However, in this In-Depth Accounting Analysis step, we want to take that Lego house apart. We want to see what makes up each of those blocks in the house and make sure that the structure is well built. We want to find out not only what's wrong with potential investments, but what's right with them as well.

To start with, an analyst should dive into the financial statements on a line by line basis. Think about whether the numbers make sense and if something has changed, try to figure out why. Look at the footnotes to find out how the numbers were calculated, how things such as depreciation were reported, and whether any of the reporting procedures in the company have changed.

When you were a kid, did you ever read the instruction booklet that came with the Legos on how to put the house together. If not, it's time to learn. Read the rest of the annual report to discover any hints to progress and growth from the President. Has everything been disclosed in the document that will affect the company? Often times good news will be reported but bad news may be minimized. Has the workforce changed in size? Has the options reporting changed? Etcetera, Etcetera, Etcetera.

Now what are some can we learn from a company that sells grown-up Lego bricks? Quite a bit as well take a look at the 2006 Annual Report for Home Depot, stock symbol HD. In full disclosure, I do not own any Home Depot stock but I do like to shop there occasionally.

Now, the first thing I noticed on the Annual Report's first page (after the table of contents) is that they've opened 247 additional stores over the last two years. That works out to a 13.6% store growth. This could be a concern because of the current housing crisis. Someone wanting to investigate this further would want to look at the individual housing markets that these new store opened in. I'm not going to look at that at the moment. Let's move on to the shareholder letter from CEO Francis Blake. We should look to see if he mentions anything that might increase or decrease the risk of investing in Home Depot. Okay, I see that Mr. Blake is talking about the soft housing market. That's good because it means that they are aware of the problem and are looking to address it. Of course, an analyst should be on the look out in case the company is using a problem in the economy as an excuse. However, since home building materials and a soft housing market are obviously interconnected, let's assume that Home Depot isn't making excuses. We can also see in the letter to shareholders that some acquisitions have been made, including acquisitions in China. Could this be added risk? It's certainly something to consider.

The next several pages have a lot of pretty pictures of people at Home Depot doing things, with a few nice paragraphs about how great the company is. There's nothing wrong with a little bit of self-congratulations. On Page 9, we move into the 10-K. This is where things start to get more interesting. Look at this phrase:
"In February 2007, the Company announced its decision to evaluate strategic alternatives for HD Supply, including a possible sale or initial public offering of the business. There can be no assurance that any transaction will occur or, if one is undertaken, its terms or timing."
An analyst will probably want to check out more recent news events to see if anything has happened with HD Supply since February. Why does the company want to spin off this decision? Has HD Supply been particularly profitable? What would the strategy be? These are some questions I have, and perhaps you have some questions too. Here's another part of the 10-K that raises an eyebrow:
Professional Customers: These customers are professional remodelers, general contractors, repairmen and tradesmen. In many stores, we offer a variety of programs to these customers,
including additional delivery and will-call services, dedicated staff, extensive merchandise selections and expanded credit programs, all of which we believe increase sales to these customers.
EXPANDED CREDIT? I'm not sure that offering expanded credit to any customers is a wonderful idea in the current economic environment. However, this is something that could be explored deeper once we know about the issue. Perhaps Home Depot has a plan that works and perhaps not. An analyst would continue on reading each section of the 10-K. Item 1A covering risk factors is particularly interesting, discussing areas such as the housing market, rising interest rates, and potential supplier issues. There are other things that could add to risk. Item 3 mentions some class action lawsuits that may be a future concern.

Pages 45, 46, and 47 have the Financial Statements. Diligent examination of each line would take time, but this step of the Systematic Analysis is where you would do that. Look at the jump in the Goodwill line in assets. It nearly doubled. It went from to $3,286 million to $6,314 million. That may be a result of the acquisions. However, further analysis may be warranted before any investment takes place. Continuing on are all of the notes. Look through all of those to see if anything stands out as added risk. So on and so forth. It's a big 84 page Annual Report that I don't have time to go through here. However, you get the idea that an analyst will want to do a full examination of the entire Annual Report during this part of the analysis.

An analyst may want even want to re-calculate his or her ratios at this point using any new risks that have been discovered or calculated for. Now with all of this information in hand, it's time for the next step. Put those lego blocks back together, we need to put together a Comprehensive Analysis report. Click HERE to go to the next blog entry.

Previous posts in the series:
  • Systematic and Consistent Financial Analysis Decisions
  • Systematic Analysis: The Purpose Of The Financial Analysis
  • Systematic Analysis: The Corporate Overview
  • Systematic Analysis: Quantitative Analysis

  • I would like to remind you to visit the website of Gary Giroux, a very knowledgeable author in financial analysis:
    Much of the material in this series of blog entries contains wisdom borrowed from his book "Financial Analysis: A User Approach"

    Also, I found that neat picture of the Lego Home Depot over at the Brickshelf, a fan club for builders. Check them out here.

    View Trevor Stasik's profile on LinkedIn

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