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A. B. Wilson Communications
How (and Why) to Read an Annual Report

This article appeared in the spring/summer 1998 issue of General American Solutions   for the life insurance policyholders of St. Louis-based General American Life Insurance Company, and it is reprinted here with the permssion of General American.

Good, bad or indifferent, annual reports have one thing in common. They
are not news. Typically, the annual report appears about three months after publication of a company’s year-end results. By that time, anything unexpected or startling in the final numbers will be picked clean of any significance as far as the stock market is concerned.

Why, then, should one pay attention to an annual report?

There is one very powerful answer to that question. If you approach the task of reading annual reports in the right spirit, it will help you select great investments and avoid poor ones.

Consider the nature of an annual report. Most companies go to considerable lengths to cooperate with reporters and financial analysts who want to prepare in-depth reports on their progress. The annual report is the only in-depth report over which the company, for better or worse, has total control. It is the unfiltered truth, if not always the unvarnished truth, from the company perspective. As Cecile Sorra, editor of Corporate Annual Report Newsletter, notes, “The annual report is the one chance a company has to tell its own story without interruption.”

An annual report bears the signature of the chairman and CEO and goes to everyone whose opinion the company cares about: to every shareholder and to every stock analyst covering the company, to employees, to news reporters, and to customers. In reading an annual report, you therefore get an immediate sense of how well top management communicates, both internally and externally. But that is only the beginning of what you learn, if you exercise your critical faculties in the act of reading.

Given a chance to speak freely about themselves, companies, like people, will often reveal more than they intend, disclosing certain flaws in their character... and they will sometimes surprise you in a wholly positive way, demonstrating insight and strength that you might never have suspected from the second-hand accounts rendered by newspapers, magazines, stock market analysts, and brokers.

You can usually tell from reading an annual report whether the company in question is daring to do great things, or whether it is already out to pasture. You also gain a personal sense of the quality of the company’s leadership and the clarity of its vision and strategy. Ms. Sorra notes acutely, “When annual report editors complain to me about the difficulty of pulling together the information they need, I think it has a lot to do with a lack of focus on the part of the people in top management.”

The best annual reports take you inside the belly of the whale in a way that no outside account of the company can duplicate. For example, I cannot remember a turnaround story in Fortune, Forbes, or Business Week that is as compelling as the one told in the 1995 Continental Airlines annual report. Continental’s Gordon Bethune began his 1995 letter to “co-workers, customers, and shareholders” with these words:

“In January, 1995, our company faced tremendous challenges. For more than a decade we had neglected the two vital requirements for any company to achieve long-term success -- you must have a product you are proud of, and you must have employees who enjoy coming to work every day. As a result, we were widely known as a last-place airline... As we told you last year, our company couldn’t be fixed with another deal or a visit to the Bankruptcy Court judge. We simply needed to act like a real airline.”

This dramatic opening was followed with a detailed account of the  radical, yet practical, actions that the airline was taking to boost morale, regain the faith of the traveling public, and restore profitability. By the way, if you had purchased the company’s stock on the basis of reading the annual, you would have doubled your money at today’s stock price.

McDonnell Douglas Corporation (now merged with Boeing) is another company that used its annual report both to recount and to reinforce a dramatic turnaround. In an article in the June, 1995, issue, the Corporate Annual Report Newsletter was moved to comment: “When this defense contractor was almost flat on its back after the end of the Cold War, producing little or no earnings, all we could see when we read its ARs was determination, a direct and unflinching facing of facts, and a truly infectious optimism. If you read our stories and acted on them by buying the stock, lucky you: the stock has tripled in two years, during which McDonnell Douglas Corporation has provided higher combined annual returns than any other aerospace company.”

It is not just the companies in turnaround situations that invite and reward readership. If you read the annual reports of Coca-Cola, General Electric, Berkshire Hathaway, and Southwest Airlines, you get a powerful, first-hand impression of the factors that have made them great companies... and why they have been able to achieve outstanding results and great returns to their shareholders, year after year.

You might think that reliance on a single product -- even if it is the world’s best-known brand -- would severely limit Coca-Cola’s horizons.
Plenty of analysts have thought so -- and have therefore missed out on a stock that has created more value for shareholders over the past decade than any other. Perhaps they weren’t paying enough attention to passages  like this at the opening of the late Roberto Goizueta’s 1993 letter to shareholders: “When people ask me about the growth prospects of The Coca-Cola Company, I always respond with three simple facts. First, every day, every single one of the world’s 5.6 billion people will get thirsty. Second, only in the last few years have world events allowed us true access to more than half of those people. And third, as the world’s foremost beverage company, we are in the best position to satisfy their need for refreshment. We do not plan to squander even a tiny portion of that remarkable potential.”

A close reading of annual reports can also help in picking winners among emerging growth companies. By definition, these are companies that do not have much of a track record. If the combination of a great concept and great motivation is there, you should be able to tell from the annual report.

Every annual report is a self-portrait. Look at them as such, and they will reward your scrutiny.

You will find some in which the subject appears uncertain, evasive, bombastic, or simply dull. You will find others in which the subject appears deep seeing, knowing, confident, filled with energy and purpose.

It all comes down to character. And character, as the saying goes, is

“Varnished or unvarnished?”

Truth is easy to impart when a company’s business is surging with record growth and financial gain for its stakeholders. The same applies to an annual report from a non-profit enterprise if revenue during the year in question has met or exceeded goals.

But what if an organization’s financial results that year weren’t so great? Some companies in such circumstances will try to cast a ray of sunshine, or fog, if necessary, on the awful truth.

How can the typical reader and prospective shareholder  spot subterfuge?

By looking for clues:
• Read the CEO’s letter. Compare what he or she says or doesn’t say about earnings for the year with the published income statements. The audited numbers won’t lie.
• Look at the selected financial data, consolidated balance sheets, and consolidated statements of income. If the organization’s revenues, operating income, net income, and earnings per share for that year were up compared with the previous year, the numbers will reveal that. If not, the numbers should reveal that, too.
• If negative earnings are not addressed in the CEO’s letter but a look at the report’s five-year income statement reveals an earnings decline be wary.
• A section called management’s discussion and analysis typically discusses financial activities and conditions that contributed to the company’s performance. It may discuss how such activities are expected to affect the company’s future. Look here for insights about why, for example, sales in a division increased or decreased or how the company dealt with interest expense.
• Look for discussion of the company’s historic record of dividends, assuming it has one. A positive record of dividend distribution and growth is a good sign.
• Does management offer a frank discussion of problems? The more candor, the better.

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Andrew B. Wilson

26 Taylor Place Drive
St. Louis, MO 63108
Phone: (314) 361-1195

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