How do you analyse a new company?
Standard interview question. But I left feeling like my answer didn't do the process justice.
Why?
It’s like smashing in badminton. When the shuttlecock is in the perfect spot, I just whip. I don’t consciously think about my grip or my stance.
Beautiful analogy. But it’ll be a terrible answer during an interview.
Today, let me try to put into words how I analyse a new company.
I am going to skip the idea-generation process. Let’s assume I have already found a potential long idea - a company that could generate more cash than expected.
Summary
Understand the business. How much cash can the business generate? How is management using the cash? Use the 10-year financial statements as a starting point.
Get a sense of consensus. Look at the media, sell-side estimates and reports. Compare stocks’ total return vs benchmark. Who are the major shareholders?
Compare. If there’s a significant variance between consensus and my understanding, shortlist for further investigation.
We will use B&M European Value Retail plc (BME LN) for this walkthrough.
Liquidity
If the average daily trading value is too small, I can’t touch it. Skip immediately.
If liquid enough, read a brief description of the business. BME “operates as a European variety discount retailer in the United Kingdom and France.”
Understand The Business
Income Statement
BME grew revenue 2.4x over the past 10 years.
Revenue grew strongly during FY2020 and FY2021. That’s expected. BME was classified as an essential business during COVID-19 lockdowns.
But why did revenue shrink in FY2022? Why has revenue growth decelerated from double digits to single digit now? Throw these questions into Gemini Notebook, Alphasense or Quartr.
Cost of sales is the biggest expense. That’s expected for a retailer. Why did gross profit margins improve nearly 2 percentage points?
Selling, general and administrative expenses increased 2.7x, faster than revenue. Why? This caused operating profit margins to decline nearly 2 percentage points.
Effective interest expense is ~ 6.3%. This is ~ 1 percentage point premium over the UK 10 year gilt. Looks reasonable.
If the premium is very high, I want to know why. Are there any hidden risks? Could they be understating debt?
A high premium doesn’t automatically mean a red flag.
Companies that face seasonality usually use short-term loans to buy inventory and fund receivables. Because these loans are repaid within the year, the interest expense shows up on the income statement but the loan does not get recorded on the balance sheet.
Numbers have to be interpreted in the context of the business. I try to understand the business instead of blindly following hard and fast rules.
BME’s effective tax rate (ETR) ranges between 26% to 28%, close to the UK’s 25% corporate tax rate (CIT). Looks reasonable.
There will always be some minor differences because of deferred tax items.
If the ETR is persistently lower than the CIT, the company is likely enjoying tax incentives. Find out when the tax incentives expire and account for this in the valuation model.
Not applicable for BME.