Summarise how a company makes money and which risks it says could hurt it most.
Many investors can name a company's industry but can't say how it makes money. Annual reports don't make this easier. The sections on the business and its risks are long, and lawyers write part of the risk text to protect the company. You need a quick way to reduce the business to a few claims you can test, and then a way to find the risks that matter.
A category such as "makes parts for chip companies" is not a business model. A business model says four things: who pays, what they pay for, why they keep paying, and what would make them stop. With any annual report, an analyst's first job is to answer those four questions in two sentences. The next job is to find what management says could go wrong.
The operating review and the business section describe what the company does, usually at length. Read both and compress them into two sentences: who pays, what they pay for, and why they come back. The reason customers come back is the most important part because it names something you can test, so check that yours is testable.
Marcus holds two chip companies. One is Larkspur, a fictional company with a made-up annual report. The other is an unnamed US chip designer. Before this module he would have described Larkspur as "makes parts for chip companies". From its business section he wrote: "Larkspur machines precision parts and assembles modules to order for a handful of global chip equipment makers, who pay per part under multi-year supply agreements. They come back because qualifying a new supplier for a part inside a chipmaking machine takes many months, so once Larkspur is approved, switching is slow and costly." If that reason holds, Larkspur should keep its customers through a downturn even when orders fall.
Next he wrote two sentences for the chip designer. It designs processors, sells them to companies that make devices and data centres, and outsources manufacturing. Customers come back because their own products are built around its chip architecture and software tools. With the two models side by side, he could see that his holdings earn money in completely different ways, even though both rise and fall with the same industry cycle. If you hold more than one company, write their models side by side in the same way.
In a US 10-K, Item 1A lists the risks management considers material. SGX (Singapore Exchange) reports usually cover risks in one of three places: the operating review, the risk management section of the corporate governance report, or a separate risk section. Part of this text is written by lawyers so that the company can show investors were warned. A 10-K can list dozens of risks over twenty pages, and many of them are generic: competition, cyber attacks, key staff, economic conditions. Reading them in order from start to finish is mostly wasted effort, and two habits get you further.
First, look for what is specific. A specific risk names a number, a customer, a country, a product or a contract. "We face competition" tells you nothing. "Two customers accounted for 62% of revenue, and losing either would materially reduce revenue" shows where the business is exposed. That 62% is the figure for Larkspur's top two customers, an invented figure first given in module 4.
Second, look at the order of the risks and how it changes. Companies tend to put the risks they worry about most near the top. When a risk moves up the list, or a new risk appears, management or its lawyers have decided it matters more than it did before.
The most useful single exercise is to put this year's risk section beside last year's and mark the differences. Use a text comparison tool, or copy both sections into a word processor and use its compare function. In a 10-K the item numbers make this quick. For an SGX report, first find the risk section in each year's report. Mark new paragraphs, deleted paragraphs, risks that moved, and sentences that got longer.
Marcus compared the chip designer's last two 10-Ks and found three changes, all invented for this example. The export controls paragraph had moved from the middle of the section into the top three and doubled in length. That matched the 18% of revenue billed to China and Hong Kong that he found in lesson 4.3, Semiconductor supply chains and export controls. A new paragraph described reliance on a single foundry for its most advanced chips. A paragraph about a lawsuit from a former competitor had been deleted because the case had settled.
Larkspur's risk sections change less from year to year. This year he found one new sentence, saying that a major customer has begun qualifying a second supplier for some parts, and he marked it in red.
The risk text shows what management chose to say. The notes to the accounts often say more, and say it more plainly. The two disclosures that matter most are segment information and customer concentration. Segment information shows revenue and profit by business line and by geography. Customer concentration is the share of revenue that comes from the largest customers. Accounting standards require companies to disclose it when a single customer accounts for a large share of revenue, and many companies also give the percentage for each of their largest customers. A business with high customer concentration can look stable for years and then lose a third of its revenue in one announcement. Lesson 6.4, Notes to the accounts: revenue, segments, leases and debt, covers the notes in detail.
Read the segment information first and the customer concentration disclosure second. Then go back over the risk changes with those numbers beside them. Larkspur's segment note puts semiconductor equipment parts at 85% of revenue and coatings at 15%, with coatings earning a thin margin. That showed Marcus where the business really is more clearly than any paragraph did. Its customer concentration note puts the top two customers at 62% of revenue, and with that number beside it, the new sentence about a major customer qualifying a second supplier read very differently to him.
For the activity, write a two-sentence business model for the company you chose in lesson 6.1. Then put its last two risk sections side by side and pick out the three risks that changed most.
Write your chosen company's business model in two sentences. Then list the three risk factors that changed since last year.
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