modeling income statements

Alexander Motola, 2013 1

Modeling Income StatementsAlexander Motola, CFA


Modeling Growth BusinessesHow the markets works;

expectations based investingWhat is “Net Revenue”Overview of Modeling

ApproachesHow does the CEO get paid?

(Proxy)What does a revenue model look

like?Modeling TipsSpecific Examples


How the market worksEfficient Market HypothesisThe weak form (prices on traded

assets (e.g., stocks and bonds) already reflect all past publicly available information) is true for most of the market, and is most true for the “best known” stocks

The strong form of EMH (all info is instantly priced in) is definitely NOT true; if you thought so, you wouldn’t be in this class


How the market works The market is expectations based “If we buy the stock today, then each

day we move forward, the headlights of the market move forward one day (let's call it). The return that I earn over the next twelve months is the difference between the market's expectations for the first twelve months relative to the expectations it will have twelve months hence. You are looking at an expectation set change one year forward.” – Bill Miller

Past data is priced in; how the market thinks about future data is not


How the market worksWhat does this mean for modeling

growth rates of individual companies?

If a company grow revenues 20% a year for the next 5 years, and you correctly predicted that, will you outperform the market?

Why is modeling growth rates (revenue) important?◦Revenue is the lifeblood of growth

stocks; it is also the “headliner” for the financial statements


What is “Net Revenue”According to InvestingAnswers.com,

“Net revenue typically refers to a company's revenue net of discounts and returns”

Therefore, what you see at the top of the income statement is a number already adjusted by management

Every other statement flows from the income statement

Only via astute analysis can you determine “discounts and returns”; sometimes it is not even possible to derive this number


Overview of Modeling ApproachesWhat is “the

fade”?Top DownCompany

GuidanceLinear

ExtrapolationPast

PerformanceUnit

Level/Product Level

Sequential (QoQ)

CyclicalityDeferred

Revenue, Waterfalls, etc.

The impact of Acquisitions

One Special Case: Retailers


Modeling: Fade (Growth Rates)In theory, all growth rates will

become asymptotic to GDP◦Rate of fade◦Time Matters – is the fade gradual, or

is there something which causes a step function (patent expiry, etc.)?

◦What does the market think, and why?Re-Acceleration is a “holy grail” for

investors, because even if the market has the direction correct, it usually is overly conservative on the magnitude


Modeling: Top Down Relevant GDP growth rates

◦ How fast is the company growing relative to national or global GDP?

◦ Can you use GDP growth rates by country along with revenue mix by geography?

Industry Growth Rates◦ How many players in the industry?◦ Can you look at all of them?◦ Read multiple companies’ 10-Ks, etc or

industry reports to get industry growth rates

Taking or Losing Share?


Modeling: Company Guidance Companies often provide short or long term

forecasts◦ Earnings Calls, Analyst Days (often webcast);

never in their SEC filings Forecasts can be meant for many different

constituencies◦ Competitors◦ Investors◦ Other Stakeholders (suppliers, employees, etc.)

No Accountability, poor accuracy Can be useful as a basis for a high end of

range boundary (companies will almost never exceed, but will often fail to achieve their forecasts)


Modeling: Linear Extrapolation Newton’s First Law of Motion – “An object

that is in motion will not change its velocity unless an external force acts upon it”

Analysts often do this◦ It’s easy◦ It’s “intellectually dishonest”

Continues past growth into the future, blindly◦ Ignores “the fade”◦ Some projects succeed, some fail

Sometimes, in the absence of other data, this can (but not usually) be the “best” approach; however, this can easily lead to an overestimation of future revenues.


Modeling: Past PerformanceA close cousin to “linear

extrapolation”Uses history as the sole guideCan be useful for understanding

the revenue cycles of deeply cyclical industries, but even those usually have some secular growth rate (higher highs, higher lows)

If this is used, 15+ years of history should be used, and the margin impact (gross margins) should also be studied (Who covers INTC?)


Modeling: Unit LevelDifferent business units

(“segments”) have differing growth rates

Understanding the impact of the growth rates of the various segments can provide a huge advantage in determining the future direction of the total revenue growth rate

Companies usually provide a lot of disclosure around segments (and geographies)


Modeling: Product LevelRevenue = Price * Volume

(mostly true, there are reserves)Register data, company reported

data, Nielsen data, government data – all sources of units sold

Sell in ≠Sell through Best opportunity to reach an “out

of consensus” perspective on a stock


Modeling: QoQ Growth RatesQoQ is only useful if you are

modeling time periods less than a year (Quarters, Halves)

Linearity refers to how the company collects revenue within a given period (front or rear end loaded)

QoQ is very misleading for “seasonal” companies, such as retailers

QoQ is very appropriate for highly predictable, recurring style models


Modeling: CyclicalityCyclical business experience

dramatic changes in price and demand, with huge margin impacts

A long history of revenue (20+ years) is useful, along with an understanding of where you might be in the cycle (you must be WELL AHEAD of the cycle to make money)

You typically want to buy these when they look the worst

“This time” is NOT different 99% of the time


Modeling: D/R, Waterfalls, etc.Certain business have future

revenue on or off balance sheet which can increase the accuracy of any forecasts (keep in mind the delta to expectations drives the stock price)

This works best for quarterly forecasting

Focus on key drivers to predict business success


Modeling: AcquisitionsBusinesses can give a lot of

information about acquisitions; you can usually get enough to impute the “organic” growth rate

PEP recent 10-K, page 53 has a section called “Organic Revenue Growth” which provides a nice table showing what aspects of their growth are more repeatable than others.

Most smaller companies make you do the math or hide acquisitions


Modeling: Acquisitions (PEP)Will Exchange Rates be the same

in the future or move as much as they did in 2012? ForEx helped in 2011.

How integral to PEP’s strategy are ongoing acquisitions?


Modeling: RetailersCertain business/industry models

are unique enough to require another method of analysis (retailers, banks, smaller E&P companies)

WAG (2Q13 Results Press Release) gives us the following data: Front-end comparable sales, traffic, basket size, total sales.

“Pure” Retailers often disclose SSS, comps, new stores, square footage, etc. which will allow a fairly robust model


What’s in a Revenue Model?Very simple model of AMG;

includes 3 revenue segments


What’s in a Revenue Model?AMG’s model is pretty basic –

AUM * fee for all 3 segments, plus small adjustments for performance fees, so you need to forecast AUM (a function of market performance, marketing, and product performance) and the fee.

The last slide had the AUM; here’s the fee history


Modeling: TipsDifferentiate between Fact and

AssumptionReduce your key assumptions;

simpler is better and often more accurate

Forecasting is a flawed “science”; your goal is more to understand what can happen, how it can happen, and “What the market is missing”; you will not forecast an EPS number in the future

Track your performance to understand your forecasting errors


Price * Unit Model: HANSHansen’s (HANS) is now Monster

Beverage (MNST) – one of the biggest misses of my career

Relatively unique in that they disclose gross revenues and detailed product level information

Typically a company discloses less and less specific information as they get bigger or face slowing growth; they also change definitions, which impacts comparability


Price * Unit Model: HANSI chose to model HANS based on

Case Units and Gross Price per case◦Instead of picking numbers, I used

growth rates in units and $ (my estimates shown in green, blue italic represents forecasts)

◦Forecasts supported by other data (see Excel model)


Organic Growth: MFE (INTC) A lot of investors owned MFE because mgmt

claimed the organic growth was fairly high; I didn’t agree at high prices because I thought the organic (non-acquisition) growth was much lower. In fact, my best guess is it was 0%

Revenue Model (R166- 357) R193-243 focuses on acquisition analysis; it

shows revenue contribution from various acquired companies or combinations of acquired companies

For example, MFE bought SCUR+Reconnex+Solidcore (R208-209); look at 3Q09, if they had those companies in 2Q09, revenue growth would have been 3.6% yoy, instead of the reported +18% (R325)


Mix Shift: ZOLL Exciting new product is growing much faster than corporate average, becoming a bigger and

bigger part of revenue each quarter, and moving the corporate total growth rate higher (notice

how fast LifeVest grew each Q)

Zoll reported 1Q09 on 1/22/09; stock was $16.54; by 7/28/11 (3Q11 report) stock was at $69.66; if

you caught this mix shift, you made a lot of money; stock was finally acquired by Asahi Kasei on

4/23/12 for $93 as LifeVest continued to grow rapidly


Retail Model: CAKE


Waterfall Model: RNOWExcel Model R8-23; 2Q11 beat and guidanceR206-222; key metricsR280+ Revenue model

◦Segment & geography (R281-318)◦OBS backlog tracking (R320-328)◦Waterfall (R347-413)◦Deal Metrics, Beat History, D/R◦Start of tracking forex impact (R494-

520)


SummaryWhat’s priced in? (expectations)Modeling helps you understand

what makes the business workDifferent Techniques for Different

Business ModelsKeep things simple, estimate the

fewest variables in your forecastFit your projections to the data,

not the other way aroundFocus on what’s material

modeling income statements

Documents

market worksthe market

modeling growth businesseshow

market think

market workswhat

growth rates revenue

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