Hello. I'm Professor Brian Bushee. Welcome to week ten of the course. What we're going to do this week is go through a detailed systematic financial statement analysis of a company's financial statement. Now at the end of each week through out the course we've been looking at the 3M company example to try to see where to find the information that we've been talking about during the week in a company's footnotes in their financial statements. What we're going to do this week is talk about all the other information that you can pull out of a financial statement in order to do a higher level or bigger picture financial statement analysis. And so we've got a lot to get to this week, so let's get started. Before we dive in, and start analyzing the financial statement, it's good to first talk about what our objectives are in looking through the financial statements. So, first thing we're trying to do is evaluate a company's past performance. So, how has the company fared in recent industry and market conditions? Is it doing well? Is it doing poorly? More importantly, where's it doing well, where's it doing poorly, and then how effective is the management and their strategy? So we'll figure out what's the company's strategy and then we'll use the financial statements to figure out which parts of those strategy is working and which parts are not working. And another, objective of financial statement analysis is to try to predict the future, try to predict future performance. So, answer the question, what is the quote-unquote true value of the company? Maybe you see something in here that allows you to predict future performance better than the average investor, and so maybe the stock prices are over or undervalued. Also, can the company meet it's future debt obligations. So looking forward, do we think there's any bankruptcy risk where the company won't be able to meet its debt obligation. Now, these two items under, Predict Future, Future Performance, we are not going to do. The tools and techniques are beyond the scope of this course. What instead we're going to do is focus on the first part which is what you'd have to do anyway before you could do the second part, which is using the financial statements to try to evaluate how well the company's done historically. I'm going to follow a road map sort of a systematic set of questions that we're going to try to answer from the financial statements. So the first one is what's the companies business, their strategy and their competitive environment? So the numbers won't make any sense unless we know first what the company's doing, what the company is trying to do, what its strategy, and what competitive environment it faces in terms of challenges from competitors in different parts of his business. We're going to look at whether the company is growing. Almost every interpretation that you do in a financial statement really depends on whether the company's growing or whether it's a mature company, or in decline. So, a certain ratio, or a certain performance number might be good news if you're growing, and bad news if you're in decline, or vice versa. So before we dive in too far, we have to get a sense for the company's growth. Then the heart of this is what was the company's performance this year. We'll look at a bunch of different metrics to see where the company performed well, where it performed poorly and try to get a sense of all of the different parts of the business that are doing well or not doing well. Then we'll talk about whether the company is investing for the future, and of course this is related to whether its growing, but this is a more forward looking question. So, does the company seem to be investing enough now to continue to do well into the future? What are its debt obligations? And this helps us to get to this question of future bankruptcy risk. Do we think the company is going to be able to generate enough cash to cover its future obligations? And then finally, are there any significant off balance sheet items? So, believe it or not, in the financial statements there's some information about things that are not in the financial statements. And so we're going to take a look at those parts of financial statements to see what we're missing that's not in there. So the company that we're going to look at for this financial statement analysis is Vulcan Materials Company with their 2010 Annual Report. >> Come on Professor Bushee, give me a break! You only chose Vulcan Materials so you could spend the week making Star Trek jokes! >> [LAUGH] In case you didn't get Dave's reference, Star Trek is this old TV show and there are a bunch of movies that have been made after it. Where it's set in the future. They're in space. And there's this character named Spock who comes from this race of aliens called Vulcans. I did not choose Vulcan Materials for that reason. Rather, it's a company that I've used in the past in financial statement analysis classes that I've taught. And I like it because it's a fairly simple business. So it doesn't take a lot to get up to speed on what they're doing. So that was the reason I chose it. Not so I could make Star Trek jokes. I promise. I mean, I promise. So let me first give you an overview of what's going to be in the annual report. I highly encourage you to download the annual report from the site. And take a look at it at your leisure. You know, in all your free time ah,ah, to get a sense for everything that is in there. And of course I'll pull up relevant segments of the annual report as we go along. So as I'll show you in a little bit the first of the section is pure marketing. With, there's no rules that cover what's in this part of the annual report. You can spin things however you want. And so it's going to be a little bit less reliable than the second session, which is the copy of the 10-K filing. That's going to be where all the SEC and GAAP rules apply, and that's going to have the reliable information, which follows the rules that we were talking about throughout the course. Then items one through six of the 10-K will give you basic information about the business. So here's where we'll learn a lot about the business, its strategy, the competition, and so forth. Item seven is the management discussion and analysis. This is where management tries to explain what happened to their performance, try to explain the state of the business so this will help us a lot with the questions about the company's performance, it's investment, it's debt obligations. Then of course there are the financial statements which should need no introduction at this point. There are the four financial statements plus 120 pages of footnotes. And then beyond that, there's even more information in a series of exhibits almost 50 pages of exhibits of additional information. So let me bring up the Vulcan annual report and we'll start taking a look at what's there. Okay here's the front page of the Vulcan Materials Company 2010 annual report. Says what we know for certain. So they're going to tell us I guess what they know for certain. You can see in the background that this is probably a construction related company, I see a big pile of gravel and a, and a loader. So then, here we go. So, let's find out what they know for certain. These have been difficult times for our country, our customers, and our business. So, my guess is they haven't been doing well. And there's this one interesting finding that, in academic research, that when companies are doing well, managers tend to take the credit, so they'll say, we had a great year, we are implementing our strategy well. But when companies are doing poorly, it's all external blame. So, as you can see here, it's been tough times for our country, our customers and our business. There's no we've done this or we've done that anywhere to be seen. So then what else do they know for certain. Acquisitions in our business are for the long term. Uh-oh. This must mean we've made an acquisition that's not doing well in the short term, and as we'll see. They acquired this company called Florida Rock, which made things more challenging for us in the present, but again acquisitions are for the long term. So that's something we're going to look at is this acquisition. What else do they know for certain? In time the private sector will recover. Public investment in infrastructure remains critical, now and for the future. So, what this means is basically, as we'll see, we need the government to start building highways again so that we can get more business. Our business has great natural advantages. Now as far as I can tell this is a pun, so what the company's [LAUGH] product is as we'll see are basically rocks. Rocks and gravel. They are called aggregates, which, of course, are natural resources that you dig out of the ground and then sell, so we'll learn more about that as we go on, but a little pun that they slip in here. Fundamentals of our business remain strong. Again, if we could just get the government to start building these highways again. Our business would take off. So after we find out what we know they know for certain there's a shareholder letter. Now there's been more economic research that says the bigger the picture of the, the CEO is the more narcissistic the CEO is. And you want to stay away from narcissist CEO. So this is a nice reasonably sized picture. He's wearing a hard-hat, seems like a down to earth guy. I think I would trust him. So anyway, the shareholder letter talks about their spin, I mean, their explanation about what happened during the year, trends that have gone on. Now remember, this is not subject to SEC scrutiny. So, you know, there's a lot of spin in this. And keep going through. We see some of their footprints which we'll talk about more later. Graphs total share holder return over 40 years. So if you bought in 1970 you're doing pretty well. If you bought in the last five years not so much. [LAUGH] And then finally we get to the form 10-K. >> Are you going to spend the whole video making fun of this poor company's annual report? Or are we going to actually look at some numbers? >> Sorry. I, I didn't mean to pick on this poor company. We will eventually look at some numbers. But not much in this video. Really what we're going to try to do in this video is get a good hand on the company's business and its strategies so that we have a context for understanding the numbers that we're going to see in subsequent videos. So I. going to take your comment as, let's move on. Okay, so, yeah. Getting back to the road map, the first thing we're going to look at is the company's business strategy and competitive environment. So we want to find out about their business segment, and in a second, I'll show you in the report that it's pretty much all construction materials. It's the only segment that they're selling to and their product lines are aggregates, concrete, asphalt and cement. So let me flip over to the report and we can take a look at where this comes from. Okay, so this is item one of the 10k. Which always tells you about the company's business, so they're the nation's largest producer of construction aggregates. What an aggregate is, it's a mixture of crushed stone, sand, and gravel. So basically you take this mixture of stone, stone, sand, and gravel. You mix it with cement to make concrete, to build concrete buildings. You mix it with petroleum products to make asphalt which is what we use to pave highways, roads, airplane tarmacs and so forth. We go ahead a few pages, again we'll come back to this stuff. Their business strategy here's where they talk about their business segments and it's basically all infrastructure based. So used some types of construction so asphalt, concrete as I talked about, built roads, tunnels, bridges, railroads, airports. Hospitals, churches. I guess also synagogues and mosques, shopping centers and factories that are essential to our lives and the economy. Then, below we see the, the four operating segments, which are basically their product lines. So 67% of their business are these aggregates which are these mixture of stone, sand and gravel. About 15% is asphalt mixture, so that's the stuff that's used to pave roads. 16% is concrete which is used to build buildings and the other 2% is cement, cement is mixed with aggregates to get concrete. And then, they actually have their, you know, their sales. And basically, what they're doing is they're selling aggregates and asphalt or concrete or cement to go along with it. So basically, 96% of their sales are driven by aggregates. There's only about 4% where they're selling stuff other than aggregates. >> Dude, what is like Vulcan's favorite rock band? >> I don't know, what is it? >> The rolling stones, duh! >> [LAUGH] That may be, but their favorite song is life is a highway. Next on our road map is what are the geographic locations in which the company operates so that we can have a sense for the macro economic effects that the company faces in their different markets. So it turns out Vulcan is primarily located in the southern half of the United States. So let me show you where that is in the report. So here is a map of the US. And as you can see, if we draw a line that's basically the southern part of the US, they're big in California, Texas and Florida which are three of the most highly populated states in the US. >> While I love your beautiful country, professor, I can't tell the difference between Alabama and Alaska. Are these locations high-growth areas or is this the so-called Rust Belt? >> Okay so Alabama is the state with the good college football team. Alaska has polar bears, that's how you want to keep them apart. So the southern part of the US is the high growth part of the country. So Vulcan is well positioned to take advantage of future growth. The rust belt. As you say, is up here in the north where Vulcan doesn't have many operations, which is a good thing because the construction industry road building is much less active here than it is in the southern states where they operate. Next thing you want to look for are who are the company's customers. And we're going to see it's both public and private construction. And I'll show you the report where they talk about that again, or talk about that on page seven and ten. And we're also going to look for competition, and we're going to see that there's basically 5,000 plus companies that are competitive, so it's a highly fragmented industry. So let's flip to the report and see where we can find this information. Okay, if we go to page seven there's a handy chart US Aggregates Demand by End-Market. Highways are the big demander, they use a lot of these aggregates depend on federal state and local funding. Airports, sewers, water and utilities are next. Then non residential buildings, so these are things like hospitals or municipal buildings. And then finally residential buildings which use a low amount of these aggregates. And then if we keep going, to the next page, they have a section called Our Markets. 55% of their business comes from public sector spending. Big thing here, of course, they're the highways. And one of the problems they're having is, in the US, the most recent transportation bill expired and Congress has yet to pass a, a replacement bill as of the time of this report, which is 2010. And I know that's unusual that the US Congress has trouble passing something in an expeditious fashion. But that's what Vulcan is dealing with here is that there's no new highway bill, and until there's a new highway bill there's no new highways being built. Then the other part of their business is private sector construction, which is the other 45%, so there's non-residential construction and then single family homes or multi family homes, and how those businesses have been doing are summarized in a little chart here. Here are single family homes and here are non-residential buildings and as you can see it's been a tough couple years after the financial crisis with the recession in the US. So, their customers are struggling which means that their business is going to be struggling as well. Now, we're going to jump back to the competition. So this is back on page three. We see a list of the competitors. The industry's very fragmented. And I guess if you're making crushed stone it would make sense that it's fragmented [LAUGH] Vulcan is the largest producer. They have the largest market share. But their market share is less than 10% so there's a bunch of other public companies that compete but, but really it's about 5,000 companies that compete with them and they say there's many opportunities for consolidation to exist. >> Why is the industry so fragmented? What don't these companies aggregate into larger companies to cement their market shares? >> [LAUGH] Why don't they aggregate into larger companies to cement their market shares? Good use of the product lines. Aggregate and cement. So this is a peculiar industry. Because the synergies from acquisitions are not that clear cut. Yes, the acquisition gives you this benefit of geographic diversity. But, other than that, it doesn't seem to have a lot of benefits from my point of view. It's not like you can establish a global brand so that when consumers go to the store they ask for bulk and brand stones. And it's not like you can set up central warehousing facilities to improve service to customers because basically the business is, get a plot of land, dig out the stones and ship them as close as possible to the people who need them, which makes it a very local operation without much benefit for global or national synergies, and that's why the acquisition of Florida Rock is so controversial. Because it's not clear cut that there is going to be benefits from it, as there often are in other companies doing acquisitions in other industries. The next thing we want to look at for Vulcan's business are what are the drivers of their success? And to summarize it's going to be the reserve of these stones. Managing transportation costs, geographic diversity and acquisitions. That's on page four and five. And this big Florida Rock Industries acquisition in 2007 having that work out is a big driver to their success. So let me go to the report and show you where those are. So on page four and five they talk about these drivers of success so a big thing is building and holding substantial reserves. Basically I don't, any of you have carried a bag of rocks before but they're pretty darn heavy and so you need to have both reserves of the rocks, I mean, rocks don't grow on trees, you have to have places where you can dig them out of the ground, and have them where they're close to the construction project, because of the cost of transporting them. So big thing for Vulcan is to basically get these pieces of land all over their footprint, where there's bunches of stones they can dig up and then transport not that far to the construction project. They're trying to take advantage of being the largest producer, get the economies of scale. Obviously try to generate cash, good cash flow even in a recession, which I think is a general thing that companies try to do, but in terms of their strategy, getting back to this coast to coast footprint, it gives them this geographic diversity. So if you have a Governor in California who decides they're going to stop building highways, whereas the Governor in Texas is like, let's build more freeways, tollways, whatever we can. What'll happen is you're insulated because your business will go up in Texas even if it's struggling in California. Also there's issues about weather. Bad weather can stop construction projects. So the geographic diversity allows them to weather a problem in one area and still get growth in another area to preserve their business. To try to do this, geographic diversity, they've done a lot of acquisitions. Because basically, you have all these small companies that are located where the stones are, so if you want to get stones in that area, the best way to do it is to just buy one of the companies. Now one of their biggest acquisitions was Florida Rock Industries, the largest acquisition in their history, which basically got them into Florida, Maryland, Virginia, and Washington D.C. expanded them a lot into the east coast. So the question is whether that acquisition will finally payoff and do well in terms of those markets. The final thing we're going to want to look at to get a handle on Vulcan's business are risk factors. And as I'll show you, they are leveraged in their acquisitions, high fixed costs. Local composition, competition and the struggle to get reserves. Commodity prices and legal issues. So, let's flip to the section of the report so I can show you where all these come from. So, item 1A is risk factors, this is a required disclosure. A lot of this is boilerplate, it's stuff that sort of every company throws in. But, you can actually learn a lot about the company's risks and competitive pressures by looking through this section. So, first they have financial and accounting risks. Of course, accounting should be the number one risk. First risk is they incurred additional debt for the Florida Rock merger. So that's affecting their interest expense, leverage, and debt service. So, the big thing we're concerned about, is their cash flow isn't going to be enough to meet the additional debt from this merger. Then there's volatile conditions in the credit markets. So, this is two years after the financial crisis. Are they going to continue to be able to borrow when they need it. Their industry's capital intensive, which means the earnings are highly sensitive to changes in volume. They need high volume to cover fixed costs and semi-fixed costs, so volume is a, an important thing that drives their business,. There's risks in measuring the accounting. And this is sort of boiler point, but all of these items that we do in the financial statements have, we have to make estimates, as you've seen as we've gone through. And so there's a risk that you're looking at the statements and they made bad estimates. Then there's economic and political risks. So, obviously, commercial and residential construction is a big driver of their business which depends on the overall U.S. economy which has been recovering at a slow pace. There's been a lot of foreclosures and low housing starts in the, in the residential housing industry. Particularly in Florida and California which is a little bit of a problem because those are two of our big states in terms of our business. Then we need this highway bill to pass so the lack of a multi-year highway bill is affecting the construction of roads which is affecting over half of their business in aggregates. There's risks to changes and requirements for government policies related to zoning, land use, environmental and other issues. So there could be environmental laws that stopped construction, which hurt their business. >> Dude, they have listed everything but global warming here. >> So here it is, climate change and climate change like, legislation could affect their business, so here's the global war, warming warning. There are growth and competitive risks, it's a highly competitive industry. They've got to get reserve to strategic locate areas. Future growth is going to depend on acquiring other businesses, and acquiring businesses some times don't go well if you can't integrate them into your existing operations. This is sort of boiler plate that we have to attract and retain qualified personnel. Cost of providing pensions and healthcare benefits is high. Weather is a risk. Our products are transported by truck, rail, barge, or ship, and they're really heavy, so any kind of increase in the cost of this transportation could effect them. They have to use a lot of electricity, diesel fuel, and other things to get the, the stones out of the ground and ship them. So basically, they're really sensitive to oil prices. And they're involved in a number of legal proceedings because basically if you're making stones there's going to be a lot of potential product li, well no actually this is related to previous ownership of a chemical business and there's still some big lawsuits pending from when they had the chemical business that could hurt them down the road. So to summarize, the key things that we're going to look at in Vulcan's numbers based on this analysis is, what's their growth in market share as that's a big driver of their success and a big risk if they don't keep up their market share. How are they doing on their cost control? So we'll take a look at their margins to see how they're managing all these potential costs that could increase on them. And we're going to look at their ability to service their debt. Especially since they've had this big acquisition. Taking on a big debt load. Is this going to be a problem going forward? Wow, so that was a lot of discussion of the company's business and its strategy and so forth. But it's important because you really can't understand the numbers and figure out what those numbers are telling you unless you know the company's business and what it's trying to do through its strategy. So we'll come back next video and start looking at the company's growth and it's performance during the prior year. I'll see you then. >> See you next video.
