Reading between the lines – scrutinising a company's annual report

Before we get into this, let’s just recap what a study of Marston’s (MARS) 2018 financial statements told us:

• Revenue and profits growth was weak in 2018.
• Most of the growth came from the acquisition of the Charles Wells brewing business in 2017.
• Profit margins were lower.
• The company has lots of property assets.
• Some of its pubs have been struggling to make acceptable profits and have been written down in value.
• Despite this, return on capital employed (ROCE) for the whole business is very modest at just over 6 per cent.
• The company has a lot of debt and pays substantially more interest to lenders than it does in dividends to shareholders.
• It is not very good at converting its post-tax profits into free cash flow for shareholders. 
• The company is a consumer rather than a net generator of cash flow.
• It is reliant somewhat on selling pubs to generate enough cash to pay dividends.
• Depreciation looks too low – and profits therefore too high – based on what the company is spending to maintain its assets.

Now let’s see what Marston’s annual report says about these issues and its business in general.

First of all, I think Marston’s annual report is a good one. It tells its readers a great deal about its business, how it has performed and the future prospects for it.

Many years ago, annual reports were very dry reads. Today, many companies use them as a marketing tool to promote their businesses, as well as providing essential information to investors.

Studying an annual report can take many hours of careful reading, but it is possible to learn a great deal by focusing on some key parts of it. This is what I will be focusing on.

Unsurprisingly, the report starts by accentuating the positives about revenues and profits without saying much about how they came about. This is not an issue, as you already know a lot about the numbers after going through the financial statements.

One of the things I like about some annual reports is that they can give the reader some interesting and useful background information about their businesses. This is simple stuff, but is not picked upon by the vast majority of investors who don’t read them.

A great example of this is found on page 5 where Marston’s gives a map showing where its pubs and breweries are located in the UK and how many it has.

We can see that Marston’s has:

• 406 destination & premium pubs
• 1,139 taverns
• 1,551 rooms
• 6 breweries

The Taverns business is heavily concentrated in the north and Midlands, whereas the destination and premium pubs are more skewed towards the Midlands and the south of England. If history is anything to go by, it has generally been more advantageous to have more pubs located in the more prosperous south than in the north of the country.

Page 6 has the chairman’s statement. Sometimes these can be quite revealing – particularly if the chairman has a hands-on executive role in the business – but this one is rather routine. The only real thing of note is the comment on the outlook for the business that refers to “good opportunities for growth.”

One of the main criticisms I have of some annual reports is that they often don’t make it easy for the reader to understand how the company makes its money – surely a key requirement before anyone invests in its shares. Marston’s addresses this with a very useful table on page 7 which explains clearly how it does so.

We learn here how important food sales are to the destination pubs but less so for the taverns business. In brewing, the business is dominated by premium beers, with most of its brewing output sold to other companies. More than half of its beers are bought by supermarkets. This is positive, given the growth of drinking at home, but supermarkets are well known for flexing their buying power and driving a hard bargain on the price they will pay.

The report contains lots of useful case studies on different parts of the business. Sometimes these can be very useful in helping you understand a company. That said, the real value has for years come from reading the chief executive's report and the operating and financial review. On page 14, the chief executive simply sets out the strategy for the business:

He then goes on to comment on our observations on revenue growth and profit margins and explain their development over the year:

“Total underlying revenue increased by 14.9 per cent reflecting the rollover benefits of the acquisition of the Charles Wells Beer Business (‘CWBB’) from last year, new distribution contracts in brewing, the positive impact of new openings and pub acquisitions, together with positive like-for-like sales in our pub business.”

“As anticipated, Group operating margins were 1.6% behind last year reflecting the dilution impact from the CWBB acquisition which operates at a lower margin than our existing beer business, the impact of distribution contracts in Brewing and the anticipated cost increases in our pub business.”

On page 15, he goes on to talk about the valuation of the company’s property portfolio of £2.2bn. He says this is broadly in line with the balance sheet value and underpins a net asset value (NAV) per share of £1.51 compared with £1.47 at the end of 2017: “During the year, the external valuation of our property portfolio was completed confirming a value of £2.2bn broadly in line with book value. At the period end NAV per share was £1.51 (2017: £1.47).”

What he doesn’t talk about is that the value of some of the property has been reduced due to poor performance. Nor does he comment that the business as a whole is making a very modest ROCE as we have calculated, which might suggest that the balance sheet value of the property assets are overstated. Instead, he refers to another measure called cash return on cash capital employed (CROCCE), which has improved from 9.8 per cent to 10.3 per cent – in other words not by much – since 2009.

The reader is also told that the company has been very acquisitive in buying companies and assets, as well as building its own since then, but that profits growth has lagged revenue growth. Pre-tax profits have grown by 44 per cent (an average of 4 per cent a year) compared with revenue growing by 77 per cent (7 per cent a year). This confirms a view from the numbers that spending lots of money is not generating lots of money in return.

As with the chairman, he reiterates the view that the company expects to make progress in the year ahead. This is assumed to mean that profits in 2019 are expected to be higher.

Pages 16-21 provide some very interesting background on the three main businesses and their markets. For example, on page 18 the company mentions the current challenges facing the restaurant industry in the UK and what it is trying to do to face up to them. 

“In the last five years, there has been a net increase of c.4,000 in the number of restaurants across the UK, mainly in high-street locations in towns and cities. In our view, this has led to extensive discounting which, in a backdrop of tighter operating margins and increasing costs, is unsustainable.”

Basic economics tells us that when the supply of a product or service exceeds the demand for it, prices tend to fall. This is what Marston’s is up against and so you have to ask whether the company can make good returns by ploughing lots of money into this sector.

The company tells us that it targets a CROCCE of 12-15 per cent on new bar investments and 12 per cent on new room investment. But we already know that the overall CROCCE is just over 10 per cent – a lot less. So if the new investments are meeting these target returns it must mean that a lot of the existing ones are not. If this is true then perhaps the value of the assets on the balance sheet are overstated. This may explain why Marston’s shares have traded at a significant discount t its NAV per share in recent times.

On page 19, the company tells us a lot about its brewing business. We learn that it has a 14 per cent market share of the total UK ale market and 20 per cent of the premium ale market. It has four national beer brands in Pedigree, Hobgoblin, Wainwright and Bombardier, of which Hobgoblin is the biggest.

It also has a portfolio of local brands, such as Marston’s, Jennings and Banks, as well as licensed brands – which is brews and sells in the UK – including Shipyard, Estrella and Kirin.

Marston’s is clearly a significant brewer. It sells its beers to one in four pubs in the UK via a national distribution network and six breweries and sold over 1m of its own barrels and 2.2m barrels in total in 2018. Exports account for 9 per cent of total sales and have grown significantly in recent years.

On page 24 we come to the operating and financial review, which is always a must-read. Here you will often find some answers to the questions that your previous study of the numbers have raised.

We learn that the destination and premium business has not done too well. Like-for-like (LFL) sales fell by 1.2 per cent and is blamed on hot and wet weather, as well as the World Cup (which is usually good for pubs). Profit per pub fell by 3 per cent. Margins fell due to higher wages, business rates and energy costs.

Taverns have performed fairly well due to the performance of its franchised and managed pubs. LFL sales increased by 3.8 per cent and profit per pub increased by 4 per cent. Higher costs and the costs of franchise conversions explains the slight fall in operating margins.

In brewing, the company says that most of the growth has come from the full year of profits from the Charles Wells acquisition and new distribution contracts. Margins are lower because the Charles Wells business has lower margins than the existing brewing business.

The finance director addresses the issues of debt and cash generation that an analysis of the numbers have identified. The company is targeting a one point reduction in its net debt to Ebitda ratio over the next three to five years. This will be done by reducing investment in new pubs and lower payments into its pension fund as the deficit is eliminated.

However, the view that depreciation is too low and profits may be overstated is given some weight when the company says that its maintenance capital expenditure will be quite a bit higher than its £40m depreciation expense in 2019.

“Other capital investment in 2019 will be around £80m, including £50m maintenance capital and £30m growth capital.”

Page 29 contains details of the risks that the company faces and what it is doing to mitigate them. This is an extremely useful part of the annual report where you can often learn a great deal about a business. An example is given of the market risks facing its business.

Page 42 gives some information about the board of directors. What you are looking for here is that the main executive directors have plenty of industry experience and that the non-executives can bring some expertise to the company rather than just being administrators. Marston’s board looks pretty good. The chief executive has been with the business for more than 20 years. The finance director also has extensive experience of the drinks industry, having previously worked for Guinness and Bass Brewers. The non-executives bring experience of property, retail, restaurants and pubs.

The audit report on page 52 is where the auditors give their view on the financial statements. More often than not they will say that they give a true and fair review of the financial performance. It will also discuss significant accounting issues such as non-underlying items and the value of property assets.

The auditors think that the approach to valuing property assets is fine. My view is that the low ROCE of the business suggests that they might not be and that further impairments in the future are very possible.

The directors’ remuneration report beginning on page 53 is essential reading. You want to check out whether the executive directors are getting paid too much, have a decent shareholding in the business and have bonuses that are based on targets that make shareholders better off.

Marston’s chief executive and finance director are paid quite well and have a modest pay increase in 2018. They have received bonuses, as the 3.9 per cent increase in pre-tax profit was deemed to be good enough to warrant one even though this largely came from having bought a business in 2017. They will get pay rises of 2 per cent in 2019, which is the same as other employees.

The chief executive has to – and does – own more than 200 per cent of his annual salary in shares, which is a meaningful amount. The finance director also owns more than his 100 per cent requirement.

No money has been paid out on long-term incentive plans (LTIPs) as the criteria has not been met. LTIPs can have very soft targets and are often based on earnings per share (EPS) growth which can be met by buying companies or buying back shares rather than improving the underlying business.

Few LTIPs are perfect but Marston’s is based on decent performance criteria of CROCCE, free cash flow and total shareholder returns which is a much better way of aligning the directors’ interests with shareholders than EPS.

The non-executives have a reasonable stake in the company based on their shareholdings. New chairman William Rucker was only recently appointed, but you would hope that he would have built up a meaningful shareholding by the time the 2019 annual report has been published.

Over the past few weeks, I have given a general overview of what you should look out for in company annual reports and the great value that is contained in them. This value is enhanced when you build up a picture of a business by reading several years’ of annual reports.

For me, annual reports remain the single best piece of information an investor can get their hands on and should be used more widely than they currently are. Those that take the opportunity to study them can gain an information advantage over those that do not. All it takes is a little bit of time and some simple number crunching.