How to CLOSELY Read the "Competition" Section of a 10-K — Gannon on Investing 21/2/18, 7(19 pm

How to CLOSELY Read the

"Competition" Section of a 10-K
February 19, 2018

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.”

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How to CLOSELY Read the "Competition" Section of a 10-K — Gannon on Investing 21/2/18, 7(19 pm

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

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How to CLOSELY Read the "Competition" Section of a 10-K — Gannon on Investing 21/2/18, 7(19 pm

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

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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

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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

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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
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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

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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
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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

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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
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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

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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

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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

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