When it comes to evaluating a large cap company, in many cases, analyzing key financial data may only be a starting point. As a general rule, the size and scope of business of many large caps means that in order to really understand them, we need to analyze them as a set of companies within a company. A company's segment data can be a great place to start this analysis. In this article, we'll detail the importance of segment data and what it can tell you about a large cap company.
Large Caps are Conglomerates
One way to start a company analysis is with the footnote that discloses a company's segment performance. The larger the company, the more you'll need to break it down. Large-cap companies are thought to be safer than less-capitalized companies because they are more diversified and liquid (i.e. active market for buyers and sellers - volume of trades is one measure but not the only) than smaller companies. As an investor, illiquidity can really hurt. You may be absolutely right about the fundamentals of your small company but illiquidity can overwhelm matters and keep the price depressed. As a general rule, the smaller the investment, the more you should prioritize liquidity as a consideration. (For related reading, see Footnotes: Start Reading The Fine Print and How To Read Footnotes - Part 1, Part 2 and Part 3.)
However, there is also a neglected cost of buying large companies, a cost that could be referred to as the complexity premium. This refers to the inherent, relative complexity of any large publicly-traded company. Some small caps are indeed "pure plays," but this is rarely the case with large caps.
Although we sometimes read that conglomerates are historical artifacts that have given way to more focused companies in recent years, and that spinoffs generally are held in better esteem than acquisitions. But in reality, every company is a conglomerate, and your average large-cap company is a multi-dimensional amalgamation of dizzying complexity and breadth. In fact, it's probably an investment that you can never fully comprehend. But that's OK - just as self-doubt strengthens faith, skepticism encourages onion peeling.
Warren Buffet, one of the world's leading value investors, has succeeded, in part, by projecting relatively stable economic profits forward in time, as a function of a company's economic moat. However, this analytical game is becoming harder, as fewer companies are able to build solid moats around a stable income stream, much less project them forward with high confidence. (For related reading, see Competitive Advantage Counts and What Is Warren Buffett's Investing Style?)
Key Financials Are Not Enough
If you are evaluating a large-cap company, in most cases the key financials (e.g., revenues, margins, returns) at the corporate level are just a starting point. For most large caps, corporate-level metrics are aggregates that combine the performance of several different units. Regardless of the size of a company, it is a good idea to analyze each company as a set of several companies within a company. The market, being a voting/weighing machine, needs headlines; it will reduce most companies to a story that can be summarized in a banner. However, in many cases, the best companies are the ones that are incubating high-growth units within the overall organization. And you won't find those high-growth units in the corporate metrics. Take Ceradyne, for example. It is commonly labeled as a defense contractor, but if you look closely, it's not really a defense contractor but an advanced materials firm. If you analyze the company based on that premise, then you'll be more concerned about their materials business than their body armor sales.
A great place to start learning about what division of a company really earns money is the segment data. Per SFAS 131, companies are required to disclose reportable segments. A reportable segment is defined by SFAS 131 as a part of the company that accounts for at least 10% of any one of the following:
Take for example, Intel's Q2 2006 filing. Many analysts tend to concerned with a company's gross margin, but given the breadth of Intel's product line and the strategic importance of truly new markets, it is not obvious what you can really do with this overall gross margin number. It is an average. It may commingle high-performing units with mature units and sub-performing units. Therefore, it is more important to identify Intel's different markets, to evaluate the respective importance of each of these markets and then, finally, to evaluate Intel's respective prospects vis-a-vis each market. For example, what is the relative importance of the desktop segment compared to mobile and other platform opportunities? If it is important, what are Intel's prospects here? Looking at the company from this perspective can give you a better overall picture of what it will be able to accomplish for shareholders.
Figure 1 is a chart of the Q2 2006 reported segment data. Intel reports three segments, digital enterprise, mobility and flash memory.
Figure 1 shows the big differences that exist between Intel's segments. Digital enterprise is 70% larger than mobility, but contributed fewer operating margin dollars ($931 million versus $946). Flash memory deepened its loss, which is natural for a high growth unit (except it didn't grow). If we look further, we can find vivid illustration of the competitive chip market.
Consider this note from Intel's Q2 10Q about the mobility group:
Net revenue for the Mobility Group operating segment increased slightly by $67 million, or 3%, in Q2 2006 compared to Q2 2005. We experienced significantly higher microprocessor unit sales, and to a lesser extent, higher revenue from sales of chipsets in Q2 2006. These increases were largely offset by lower microprocessor average selling prices. These increases were largely offset by lower microprocessor average selling prices. Higher operating expenses, and higher unit costs each contributed to the decline in operating income in substantially equivalent amounts.
To paraphrase, the mobility group sold "significantly" more product, but that volume increase was met by an (almost) equivalent price deflation. To make matters worse, both operating and product costs increased. You might expect this segment to get more credit for growing sales, but this is a fiercely competitive business, and price deflation in technology is always rampant.
To render a final opinion on a company would require much more analysis than we've done here for Intel. What is clear is that looking into the segment data provides a much more complete picture of the company, allowing you to gauge its ability to succeed.
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