US Steel – a case study on getting insights from annual reports.
Value Investing Case Study 32-1. This post focus on how I establish my investment ideas for US steel through reading the annual reports/Forms 10k.
Over the past few months, I had published the following two articles on US Steel Corporation (X or the Group) in Seeking Alpha.
- U.S. Steel: A Different Group Than 9 Years Ago. This was based on the information up to Q1 2022.
- US Steel Corporation – value is there even without any contribution from Europe. This was based on the information after the release of the Q2 2022 results.
For each article, I presented my Investment Thesis together with the appropriate fundamental analysis and valuation. The insights to formulate the theses were based on information gleaned from the past 10 Annual Reports/Forms 10k.
Although both articles had the same conclusion, the Investment Thesis in each of the articles were based on different ideas.
I will share with you what I did to get the insights for the articles. I hope that it can be another guide for you when analysing companies. The focus is on how I got the investment ideas and how I pulled together the supporting evidence.
Consider this as a continuation of my post “The ultimate look at how to analyse companies for investments”
Contents
- Annual Report/Form 10k
- Background of X
- First investment idea
- Quantitative analysis
- Second investment idea
- Divisional analysis
- Pulling it all together
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Annual Report/Form 10k
An Annual Report is a document that public companies provide annually to shareholders that describes their operations and financial conditions.
The typical contents are:
- General corporate information.
- Profile of the Board of Directors and senior management.
- Operating and financial highlights.
- Chairman/CEO statement.
- Management's discussion and analysis (MDA).
- Statement on Corporate Governance, Risk Management and Internal Controls.
- Financial statements and notes to the financial statements.
- Auditor's report.
- Accounting policies.
In the U.S., a more detailed version of the annual report referred to as Form 10k is filed with the SEC. In Malaysia, the Annual Report would also include the company’s Sustainability Report.
Uses
The goal is to provide public disclosure of a company's operating and financial activities over the past year. The Annual Report is issued to shareholders and other stakeholders.
- Shareholders and potential investors use them to get a better understanding of the current position of the company. This helps them make better investing decisions.
- Banks and creditors use them to determine a borrower's capability to repay a loan.
- Employees often use them to understand some of a company’s different focus areas. Many employees are also shareholders of a company due to stock option benefits.
- Customers use them to help them decide on which one to build a relationship with.
The Annual Reports are standardized practices for companies to report their business performance. Such standardization helps authorities in taxation and audit purposes.
The Annual Report is also used as a promotional tool to highlight some of the company’s key initiatives or goals that were recently achieved. It is sometimes released to attract investors and suppliers. The prospective expenditures and income are thus projected in a way that makes the business appealing.
My approach
The main point is that an Annual Report contains a lot of information as it is meant to serve multiple parties. You are a retail investor looking for an investment idea. It would be madness to read the whole report in details. This is especially if you are covering 10 to 12 years.
My approach in using the Annual Reports is:
- Start with the business profile and look at the current performance, prospects and risks.
- Formulate one or two investment ideas and look for the supporting evidence within the Annual Reports. These would cover both quantitative and qualitative information.
- Crystalize the investment thesis based on the data available from the Annual Reports. I am a retail investor and while scuttlebutt is logical, I focus on desk research. Staying within my circle of competence replaces the scuttlebutt.
- Look for data to support the valuation assumptions. Having a standard template with standard formula can help in this.
Background of X
The Group is an integrated steel company that was established in 1901. An integrated producer uses iron ore and coke as primary raw materials for steel production.
The Group produces flat-rolled and tubular products. It has major production operations in North America and Europe. The Group also undertakes a wide range of applied R&D and technical support in Pennsylvania, Michigan, Texas, and Slovakia.
By 2021 the Group had an annual raw steel production capability of 26.2 million tons. 21.2 million tons of these were in North America and 5.0 million tons in Europe. Refer to Table 1. You can see that the Group reported its performance under 4 segments.
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| Table 1: Segment Capacity |
First investment idea
I am a long-term value investor holding my stocks for an average of 8 years. When I analyse and value companies, I look at their performance over the past 10 to 12 years. This is because in the Malaysian context, the period will cover one business cycle. In the US, this will cover about 2 business cycles.
In the context of X, the Group is in the steel sector. While this is a cyclical sector, the cycle may be different from the business cycle. As such, I first check the duration of the cycle. In the case of X, I check against the historical hot roll prices as illustrated below. You can see that from 2010 to 2020, there is at least one price cycle.
To ensure that I cover the performance over at least one price cycle, I started from X’s 2010 Annual Report/Form 10k.
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| Chart 1: Hot roll steel sheet and strip prices |
Business profile
I started by reading the business description. This covers what the Group does, who its customers are, and the primary industry in which it operates. I also read the descriptions from its corporate website. In the context of X.
- I first read the Business Section in X’s 2021 Form 10k.
- Then I looked at the description in 2010 followed by that for 2015.
This gave the picture that the Group today is different from what it was a decade ago. To trace the changes, I then went through the description year by year.
Based on this approach, I found that X has transformed itself over the past 10 years. It has reduced its capacity to match its demand and diversified to making steel via EAF mini-mills. I summarized the position as follows:
- In 2013, X adopted “The Carnegie Way,” to transform the Group.
- Over the past 9 years, the Group had instituted several programmes to improve its operations. These included the reliability centred maintenance and the realignment of reporting segments with new team leaders. Other initiatives were the shutting down of certain facilities and/or the sale of certain subsidiaries.
- The Group also reduced its steel-making capacity in the US and diversified into Electric-Arc-Furnace (EAF) steel-making. Thus, the Group flat-rolled steel-making capacity in the US was reduced from 27 m tons in 2013 to 17 m tons in 2022.
Seed of the Investment Thesis
Given the above, I then got the idea that my article should focus on how the Group had changed since 2013. Qualitatively, I want to understand what was done. Quantitatively, I wanted to see the financial and operating impact of these changes.
Quantitative analysis
Over the years, I have established a standard worksheet to collect the information for the company analysis and valuation. If you want to see this worksheet, refer to the following link “Standard worksheet”.
The standard worksheet serves the following purposes:
- To ensure that I do not miss out on the types of analysis to be performed.
- To ensure that I do not make computational errors. Over the years, I have occasionally found a few such errors in my worksheet and have corrected them. I am very confident that the current worksheet does not have any computational errors.
- It provides a template to add new analysis.
When I first started value investing 2 decades ago, I entered the inputs manually from the data obtained from the Annual Reports/Forms 10k. The bulk of the data were taken from the Financial Statements and the Notes to the Accounts. Some times the data were extracted from the MDA or Chairman’s Statements.
Today I use the TIKR.com platform to extract the financial data. TIKR.com* provided 15 years of financial data – Income Statement, Balance Sheet, Cash Flow Statements, Ratios and Segments. Refer to Chart 2.
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| Chart 2: Financial Page of TIKR.com |
In the case of X, my focus was for 2013 to 2021. I carried out the analysis as follows:
- I first copied the financial data for X into an EXCEL worksheet.
- I then linked the standard worksheet to the copied data. It took me less than 10 minutes to populate the standard worksheet as illustrated in Chart 3.
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| Chart 3: Extract of Worksheet |
I have standard charts to show the trends of the various performance metrics as illustrated below.
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| Chart 4: Balance Sheet Indices |
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| Chart 5: Performance Index |
The benefit of a standard template is that you can focus on how the company has performed over a period. In the case of X, the idea was to see how the Group had changed over the past 9 years. Examples of some of the questions going through my mind were:
- Has the balance sheet has become stronger or weaker over time?
- Did the transformation result in better top-line and bottom-line performances?
Non-standard information
Each company is different and the standard worksheet only provides the first cut analysis. More detailed analysis will depend on the company and investment idea.
In the case of X, there were 2 non-standard issues that affected any trend analysis:
- The 2021 performance was skewed by the high steel prices.
- The 2020 performance was affected by the Covid-19 situation.
To account for these, I “normalized” the metrics by working on either a per ton basis or per constant price basis. You can see that I required that tonnages and product prices for this. I thus had to go through the various Forms 10k to extract the information as illustrated in Chart 6.
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| Chart 6: Steel tonnage |
With the information, I could then chart the relevant metrics at 2013 constant prices or shipment tonnage as illustrated in Chart 7.
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| Chart 7: Operating Indices |
Second investment idea
The goal of a company analysis is not only to understand the company’s performance and prospects. You also want to understand the risks.
This is where the US companies differ from the Bursa Malaysia companies. As part of the SEC requirements, US companies provide a comprehensive risk report in the Form 10k. In the case of X, it covers strategic, operational, financial, and regulatory risks.
In contrast, most Bursa Malaysia companies do not provide such a risk report. They usually provide the Corporate Governance Statement, Audit Committee Report and Statement on Risk Management and Internal Control. These tend to be motherhood statements and there is nothing that helps the fundamental analysis.
In the case of X, the risk report highlighted the issues with the USSE/Europe segment given the Ukraine invasion. In the Q2 2022 SEC filings, the Group stated the following:
“In the third quarter, the Company expects flat-rolled steel demand to be adversely impacted by the declining steel price environment. In Europe, the conflict in Ukraine…reducing manufacturing and industrial demand…the Company is seeing significant margin compression as steel prices have softened while input costs remain elevated.”
Focus of risk analysis
My perspective when analysing companies is that I am an external investor. I am not running the company so I rely on management to address the various risks.
Secondly, I am a long-term value investor with about 8 years holding period. I am interested in where the company will be in 8 years’ time. As such, I pay little attention to quarterly performance. This is unless there are issues that will impact the long-term performance of the company.
I also looked at risk from a permanent loss of capital perspective. I classify the various ways I can suffer a permanent loss of capital into 4 main ones as illustrated by the boxed items in Chart 8. For details refer to the following
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| Chart 8: Ways to incur permanent loss of capital |
Given the above views, when reading the Annual Reports/Forms 10k, the focus is on risks than can cause a reduction in the for the intrinsic value. For this to happen, X must face some business or financial problems.
Management had highlighted the problems with Europe. While there should not be any impact for the third quarter, there are risks thereafter.
- “The Company has built up sufficient inventory on site or in-transit to meet current customer demand. (For Q3 2022). Efforts to secure alternate sources of supply are underway to continue meeting demand.”
- “Additionally, in response to sanctions, Russia has limited supply of natural gas to certain countries…While not expected, if a natural gas crisis is declared in Slovakia, operations at our USSE business could be materially adversely impacted.”
The European segment employed about 1/3 of the Group’s Total Assets and accounted for about 1/5 of the Group’s Revenue. Any disruption to this segment will have a significant impact.
Seed of the Investment Thesis
Given the above, I had the idea to look at the performance of the Group from a segment perspective. I wanted to find out the impact on the intrinsic value if the European business was disrupted.
This led me to think about analysing and valuing X from an individual segment's perspective. The different business segments serve different customers with different risk profiles. As such, a sum-of-parts valuation may make more sense.
In my first Seeking Alpha article, I focused on X as a Group. For the second article, I focused on the individual business segments. This is because the challenges and risks in the US are different from those in Europe. At the same time, the customers for the tubular segment are affected by different economic forces than those for the flat products.
- The tubular products serve mainly the oil & gas and petrochemical sectors.
- The flat products are shipped to steel service centres, transportation & automotive, construction, containers & packaging, and appliances & electrical equipment customers.
In its 2021 Form 10k, the Group reported 4 business segments. Looking at the customers and products, it made more sense to analyse the business from the customer-end product perspective. As such I classified X into the following 3 Divisions:
- US – this comprises the reported US flat roll and mini mill segments.
- Tubular – this is the reported tubular segment.
- Europe – this is the reported USSE business.
Divisional analysis
It is obvious that I had to compile a different set of figures to carry out my divisional analysis. At the same time, the TIKR.com platform did not provide the breakdown of the data I needed. I had to extract the data manually from the various Forms 10k.
Based on this, I built up a picture of the business that would not be there if looking at just one year of Form 10k.
One example is shown in Chart 9. From 2013 to 2021, the shipment tonnage had reduced from 20.4 million tons to 16.0 million tons. The decline was due to lower shipments for further conversion and to the oil & gas, and petrochemical sectors.
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| Chart 9: Customer Profile |
I could also chart how the contribution from each of the divisions had changed over the years as shown in Charts 10 and 11.
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| Chart 10: Revenue by Divisions |
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| Chart 11: Steel Shipment by Divisions |
Division Returns
To get a sense of the returns for each of the Divisions, I needed the earnings and assets employed by Division. Again, I had to extract the data manually from the relevant parts of Form 10k as illustrated in Charts 12 and 13.
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| Chart 12: Extract from Form 10k - Earnings |
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| Chart 14: Extract from Form 10k - Total Assets |
With the information, I could then produce the return analysis as shown in Table 2.
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| Table 2: Returns by Divisions |
To give you a sense of the return, Table 3 shows the average returns for some of the key steel players. The Group has underperformed its peers.
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| Table 3: Peer Returns: Source: TIKR.com |
Pulling it all together
For the retail investor, the stock market is a zero-sum game. Every time you buy thinking that prices will go up, there is someone on the other side selling thinking that prices will come down. Only one of you can be right.
To be on the right sight, you then need to think differently and/or have different insights. This does not come from thin air. It has to be based on facts. As a retail investor, one way to get such facts is to read the company’s Annual Reports/Forms 10k.
I am a long-term value investor and as such I am more interested to where the company is going to be in 8 to 10 years’ time. My starting point is the past 10 to 12 years of historical performance obtained from the Annual Reports/Form 10k.
My approach is to first get an overview of the business and looked at what had changed over the decade. I then formulate a draft investment idea and look for supporting data to validate the idea.
If I am lucky, the quantitative data for the analysis is readily available from platforms such as TIRK.com. Otherwise, I have to extract them manually from the Annual Reports/Forms 10k.
When it comes to qualitative data, I compared the reports in the MDA and Risk sections over the past 10 years. This is the most challenging part. Historical qualitative information is seldom provided by the commercial platforms.
I think I have an advantage because of my corporate background. As part of my work, I have done a lot of business strategies and plans many of which requires detailed analysis. My edge comes from combining this experience with the quantitative and qualitative analysis.
But the starting point is extracting the information from the various Annual Reports/Forms 10k.
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Disclaimer & Disclosure
I am not an investment adviser, security analyst, or stockbroker. The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies. Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them.
The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such.
I may have equity interests in some of the companies featured.
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