How to CLOSELY Read the "Competition" Section of a 10-K

by Geoff Gannon


In the most recent podcast, Andrew said: “There are some people I’ve spoken to who have said you’re not really going to find a lot of gems out of 10-Ks.”

I disagree. Reading a company’s 10-K is the most important thing I do. And once I’ve finished reading a 10-K, I’m usually more than 50% of the way to making an investment decision.

 

At the Risk of Sounding Heartless…

To understand what I get out of a 10-K we need to talk a little bit about my single-minded view of what makes a good business and what makes a bad business.

To me, a good business is a business with market power and a bad business is a business without market power. In what I think is the most important article I ever wrote I defined market power as:

“Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.”

This is similar to the Warren Buffett quote I started that article with:

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

So, when I sit down to read a 10-K I’m focused on one thing above all else: does this business have market power?

 

The Competition Section

The most important section of a 10-K is the part entitled “Competition”. It is a sub-heading under “Item I. Business”. So, it is always close to the beginning of the 10-K.

If you’re only going to read one section of the 10-K it should be “Item I. Business”. And, if you are only going to read one sub-heading it should be “Competition”. The “Competition” section of the 10-K is really short. So, I thought the best way to talk about it is simply to quote from actual 10-Ks and show you how I’d interpret the language these companies use.

 

The Standard Passage – High Competition Industries

Here is an example from the Zoe’s Kitchen (ZOES) 10-K. Zoe’s Kitchen is a fast casual (higher priced fast food) restaurant operator in the U.S. I am quoting the “Competition” section in its entirety:

“We compete in the restaurant industry, primarily in the fast-casual segment but also with restaurants in other segments. We face significant competition from a wide variety of restaurants, grocery stores and other outlets on a national, regional and local level. We believe that we compete primarily based on product quality, restaurant concept, ambiance, service, location, convenience, value perception and price. Our competition continues to intensify as competitors increase the breadth and depth of their product offerings and open new restaurants. Additionally, we compete with local and national fast-casual restaurant concepts, specialty restaurants and other retail concepts for prime restaurant locations.”

Zoe’s Kitchen is missing a line of boilerplate that is common in 10-K’s and looks something like this:

“…many of our competitors have significantly more financial and other resources than we possess”.

That exact line appears in the iRobot (IRBT) 10-K. However, a line very much like it appears in probably most 10-Ks out there.

 

The Altered Passage – Lower Competition Industries

We’ll now look at how far the competition section of some 10-Ks departs from the standard passage (of which Zoe’s Kitchen is a good example).

 

BWX Technologies (BWXT)

“Nuclear Operations. We have specialized technical capabilities that have allowed us to be a valued supplier of nuclear components and fuel for the U.S. Government’s naval nuclear fleet since the 1950s. Because of the technical and regulatory standards required to meet U.S. Government contracting requirements for nuclear components and the barriers to entry present in this type of environment, competition in this segment is limited. The primary bases of limited competition for this segment are price, high capital investment, technical capabilities, high regulatory licensing costs and quality of products and services.”

This company is not subtle about their market leadership (they are the monopoly provider). They come right out and say “competition in this segment is limited”. In fact, that term is repeated. Repetition of the term “limited competition” is incredibly rare in 10-Ks. You almost never see that.

 

U.S. Lime (USLM)

“The lime industry is highly regionalized and competitive, with price, quality, ability to meet customer demands and specifications, proximity to customers, personal relationships and timeliness of deliveries being the prime competitive factors…The lime industry is characterized by high barriers to entry, including: the scarcity of high‑quality limestone deposits on which the required zoning and permitting for extraction can be obtained; the need for lime plants and facilities to be located close to markets, paved roads and railroad networks to enable cost‑effective production and distribution; clean air and anti‑pollution regulations, including those related to greenhouse gas emissions, which make it more difficult to obtain permitting for new sources of emissions, such as lime kilns; and the high capital cost of the plants and facilities. These considerations reinforce the premium value of operations having permitted, long‑term, high‑quality limestone reserves and good locations and transportation relative to markets.”

U.S. Lime is more subtle about the low levels of competition in this industry. However, it does – like BWX Technologies – use the term “barriers to entry” which is often the way a U.S. public company will suggest it operates in a less competitive industry. Note also that BWXT and USLM include items like “high regulatory licensing costs” and “clean air and anti-pollution regulations” along with the word “permitted” to stress the ways that government regulations make it harder for new competitors to catch up to the established players.

It’s also common for a company to present information suggesting competition is limited in a way that sounds unfavorable to the company rather than favorable. For example, later in this competition section, USLM says:

“Consolidation in the lime industry has left the three largest companies accounting for more than two‑thirds of North American production capacity. In addition to the consolidations, and often in conjunction with them, many lime producers have undergone modernization and expansion and development projects to upgrade their processing equipment in an effort to improve operating efficiency.”

You have to read between the lines (micro-economically) to understand just what this means. If, over time, fewer and fewer companies operating fewer and fewer sites are supplying the nation with the same amount of lime – we can guess that two things are happening. One, the economics of each site in terms of cost is getting better (they are producing at greater scale). Two, the rivalry each site faces is decreasing. Obviously, if you decrease the number of points of distribution without increasing the deliverable distance – some customers end up with fewer potential suppliers being within a deliverable distance.

Here, it’s helpful to know that lime doesn’t get shipped very far. All you have to do is read the 10-K to know that. It’s mentioned directly here:

“Lime and limestone products are transported by truck and rail to customers generally within a radius of 400 miles of each of the Company’s plants.”

And then, if you go back and closely read the part of U.S. Lime’s 10-K I already showed you paying special attention to any mention of location, you’ll notice indirect references to a small delivery zone:

“The lime industry is highly regionalized and competitive, with price, quality, ability to meet customer demands and specifications, proximity to customers, personal relationships and timeliness of deliveries being the prime competitive factors…high barriers to entry, including…the need for lime plants and facilities to be located close to markets, paved roads and railroad networks to enable cost‑effective production and distribution…”

 

Fair Isaac (FICO)

“In this segment, we compete with both outside suppliers and in-house analytics departments for scoring business. Primary competitors among outside suppliers of scoring models are the three major credit reporting agencies in the U.S. and Canada, which are also our partners in offering our scoring solutions, Experian, TransUnion and TransUnion International, Equifax, and VantageScore (a joint venture entity established by the major U.S. credit reporting agencies). Additional competitors include CRIF and other credit reporting agencies outside the U.S., and other data providers like LexisNexis and ChoicePoint, some of which also represent FICO partners.”

This is a tough one. FICO scores are the industry standard for credit decisions in the U.S. If Windows was a monopoly in the desktop era, FICO is a monopoly. However, the company is very indirect about this in its 10-K. You can still find some really, really strong hints in the 10-K that FICO doesn’t face much competition. But, you’ll have to read closely to find these.

I’ll break down some of the tricks for doing that now.

 

Trick #1 – FICO is side-stepping a discussion of direct competition with rivals and instead discussing the potential for clients to be rivals in some situations. This is a huge tip-off that the industry is not competitive. When a company tells you competition is generally due to “in-housing”, it’s probably not a competitive industry. Read the passage again, paying special attention to my bolding:

“In this segment, we compete with both outside suppliers and in-house analytics departments for scoring business. Primary competitors among outside suppliers of scoring models are the three major credit reporting agencies in the U.S. and Canada, which are also our partners in offering our scoring solutions, Experian, TransUnion and TransUnion International, Equifax, and VantageScore (a joint venture entity established by the major U.S. credit reporting agencies). Additional competitors include CRIF and other credit reporting agencies outside the U.S., and other data providers like LexisNexis and ChoicePoint, some of which also represent FICO partners.”

Here, we see that FICO dodges the normal question of competition. They are offering an answer that basically consists of: some of the end users of credit scores use in-house analytics instead of paying for outside scores like ours (this is the equivalent of Campbell’s Soup saying they compete with people making soup from scratch) and some of the sellers of our product also compete with us by trying to cut-out the need for our product.

Both of these are legitimate concerns. They reduce FICO’s addressable market. And VantageScore can be considered a real competitor. However, the fact that a competing credit score system was created as a joint-venture by FICO’s biggest customers is a strong hint that FICO doesn’t face direct rivals. What I’m saying is: VantageScore was created because FICO’s customers thought FICO had too much market power.

Trick #2 – FICO does give you little snippets elsewhere in the 10-K – just not in the competition section – that strongly hints it’s a monopoly or something very close to a monopoly:

“Our FICO Scores are used in the majority of U.S. credit decisions, by nearly all of the major banks, credit card organizations, mortgage lenders and auto loan originators.”

So, almost everyone who could be a customer is a customer – and customers use FICO more often than they use something else. While this doesn’t directly tell you much about competition, it does tell you that any competitor has to have less market share than FICO and has to be competing by trying to get organizations that already use FICO scores to shift some of their business to the competitor.

“End users of our products include 98 of the 100 largest financial institutions in the U.S., and two-thirds of the largest 100 banks in the world. Our clients also include more than 700 insurers, including nine of the top ten U.S. property and casualty insurers; more than 400 retailers and general merchandisers, including more than one-third of the top 100 U.S. retailers; more than 150 government or public agencies; and more than 150 healthcare and pharmaceuticals companies, including seven of the world’s top ten pharmaceuticals companies. All of the top ten companies on the 2017 Fortune 500 list use FICO’s solutions. In addition, our consumer services are marketed to an estimated 200 million U.S. consumers whose credit relationships are reported to the three major U.S. credit reporting agencies.”

Again, FICO doesn’t come out and say we are the dominant provider of credit scores in the United States. However, a reader of the 10-K would certainly come to that conclusion.

 

Landauer (LDR) – Recently Acquired

Here’s another example of a company that quickly moves from discussing direct competition from rivals to talking about “in-housing”:

“In the U.S., the Company competes against a number of dosimetry service providers. One of these providers is a division of Mirion Technologies, Inc., a significant competitor with substantial resources. Other competitors in the U.S. that provide dosimetry services tend to be smaller companies, some of which operate on a regional basis. Most government agencies in the U.S., such as the Department of Energy and Department of Defense, have their own in-house radiation measurement services, as do many large private nuclear power plants. Outside of the U.S., radiation measurement activities are conducted by a combination of private entities and government agencies. The Company competes on the basis of advanced technologies, competent execution of these technologies, the quality, reliability and price of its services, and its prompt and responsive performance. The Company’s InLight dosimetry system competes with other dosimetry systems based on the technical advantages of OSL methods combined with an integrated systems approach featuring comprehensive software, automation and value. Changing market demand for combining active and passive dosimetry will be redefining the competition and the opportunities going forward.”

Nothing here suggest Landauer enjoys as much market power as FICO. However, take this passage and put it side-by-side with the Zoe’s Kitchen passage. If you had to guess which company had more market power, you’d guess Landauer.

Now, we move on to a really tough topic. Sometimes, there are good businesses where the 10-K will tell you the industry is highly competitive. Let’s look at advertising.

 

Omnicom (OMC)

“We operate in a highly competitive industry. Key competitive considerations for retaining existing clients and winning new clients include our ability to develop solutions that meet client needs in a rapidly changing environment, the quality and effectiveness of our services and our ability to serve clients efficiently, particularly large multinational clients, on a broad geographic basis. While many of our client relationships are long-standing, from time to time clients put their advertising, marketing and corporate communications business up for competitive review. We have won and lost accounts as a result of these reviews. To the extent that we are not able to remain competitive or retain key clients, our revenue may be adversely affected, which could have a material adverse effect on our business, results of operations and financial position.”

I admit you have to read this one really closely to notice the ways in which an ad agency might actually have market power. You’ve seen a lot of these 10-K quotes on competition by now. So, take a second. Can you guess the three hints I’m going to say suggest advertising might not be as intensely competitive as something like the restaurant industry?

One, Omnicom says: “while many of our client relationships are long-standing”. Two, Omnicom says “…from time to time clients put their advertising, marketing, and corporate communications business up for competitive review.” Note, this means business in this industry is only up for periodic review. And three: when Omnicom lists “key competitive considerations for retaining existing clients” it doesn’t mention the price of its services.

This is a huge hint. When reading the competition section of a 10-K, you want to give special attention to the use of the word “price”. How often is the word “price” used? Where in the order of competitive considerations does it appear? How much emphasis does the company give to the importance of being price competitive?

 

Interpublic (IPG)

“The advertising and marketing communications business is highly competitive. Our agencies and media services compete with other agencies and other providers of creative, marketing or media services, to maintain existing client relationships and to win new business. Our competitors include not only other large multinational advertising and marketing communications companies, but also smaller entities that operate in local or regional markets as well as new forms of market participants. The client’s perception of the quality of our agencies’ creative work and its relationships with key personnel at the Company or our agencies are important factors that affect our competitive position. An agency’s ability to serve clients, particularly large international clients, on a broad geographic basis and across a range of services may also be an important competitive consideration. On the other hand, because an agency’s principal asset is its people, freedom of entry into the industry is almost unlimited, and a small agency is, on occasion, able to take all or some portion of a client’s account from a much larger competitor.”

Note that neither Interpublic nor Omnicom lists price as an important competitive factor. Whenever you find an industry where price is not listed as a competitive factor, you want to explore it further.

 

Tandy Leather Factory (TLF)

Here is a company that mentions price. So, price is important. But, it also makes it clear their relative market share is high:

Most of our competition comes in the form of small, independently-owned retailers who in most cases are also our customers. We estimate that there are a few hundred of these small independent stores in the United States and Canada. We compete on price, availability of merchandise, and delivery time. While there is competition in connection with a number of our products, to our knowledge there is no direct competition affecting our entire product line. Our large size relative to most competitors gives us the advantage of being able to purchase large volumes and stock a full range of products in our stores.”

That’s just a few lines in the 10-K of a micro-cap company. I’d consider it a gem of a research discovery. And it takes 30 seconds of your time to read the competition section of TLF’s 10-K. What I just quoted to you is the entire competition section for the company.

 

Breeze-Eastern (BZC) – Recently Acquired

Interestingly, simple micro-cap companies are often more blunt about their competitive position than big companies. Here is the competition section of Breeze-Eastern in its entirety:

“We compete in some markets with the hoist and winch business unit of the Goodrich Corporation, which was acquired by United Technologies in calendar 2012, and is part of a larger corporation that has substantially greater financial and technical resources than us. United Technologies is also our second-largest customer. We also compete in some markets for cargo hooks with Onboard Systems. Generally, competitive factors include design capabilities, product performance, delivery, and price. Our ability to compete successfully in these markets depends on our ability to develop and apply technological innovations and to expand our customer base and product lines. Technological innovation, development, and application requires significant investment and capital expenditures. While we make each investment with the intent of getting a good financial return, in some cases we may not fully recover the full investment through future sales of products or services.”

By now, you know what parts of that passage I’m going to bold:

“We compete in some markets with the hoist and winch business unit of the Goodrich Corporation, which was acquired by United Technologies in calendar 2012, and is part of a larger corporation that has substantially greater financial and technical resources than us. United Technologies is also our second-largest customer. We also compete in some markets for cargo hooks with Onboard Systems. Generally, competitive factors include design capabilities, product performance, delivery, and price. Our ability to compete successfully in these markets depends on our ability to develop and apply technological innovations and to expand our customer base and product lines. Technological innovation, development, and application requires significant investment and capital expenditures. While we make each investment with the intent of getting a good financial return, in some cases we may not fully recover the full investment through future sales of products or services.”

Also, notice the company did not say the industry was “fragmented”, “highly competitive”, etc. In fact, it names only one competitor in each of the markets it talks about (rescue hoists and cargo hooks). So, it may be telling you it competes in duopoly markets. Note: there is zero mention of “smaller competitors” or anything like that. The only competitors mentioned are mentioned by name. That sometimes suggests a duopoly or oligopoly.

There is one point here that you’d have to read really, really closely to catch. As recently as 2015, United Technologies (UTX) owned a helicopter company (Sikorsky). Those helicopters had traditionally been outfitted with Breeze-Eastern rescue hoists. After United Technologies acquired a competing supplier of rescue hoists (Goodrich), it didn’t stop using Breeze-Eastern hoists. This could mean United Technologies has a policy of having each of its subsidiaries managed separately without any prodding from headquarters to make use of synergies from purchasing inside the same corporate umbrella. Or, it could mean there’s some reason why helicopter models that were already using a particular rescue hoist supplier wouldn’t want to switch suppliers – even if the alternate supplier was an internal corporate source.

That’s the kind of thing you’d want to follow-up on.

But, the 10-K is the starting point. And to get off to the right start you have to read it very closely.

I read a print out of the 10-K. I take notes by writing directly on my printed copy of the 10-K. This helps me read the important section closely. You might want to consider doing the same.

You can learn more about Geoff Gannon by emailing him: gannononinvesting@gmail.com, following him on Twitter: @GeoffGannon, or listening to his podcast. His stock specific write-ups appear on a subscriber supported website: Focused Compounding