Financial Statement Analysis Blog #3 – in the context of a company’s strategy, execution, governance, social responsibility, and ethics
“A strategy is something like an innovative new product, globalization, taking your products around the world; be the low-cost producer. A strategy is something you can touch; you can motivate people with; be number one and number two in every business. You can energize people around the message.”
No financial statement analysis on a particular company makes sense without a broader view of the company’s strategy, execution, governance, social responsibility, and ethics. On this front, a company analysis should cover the following aspects at the minimum:
Business strategy (cost leadership vs. product differentiation vs. core competencies)
Evaluation of the business strategy
Corporate governance (board composition, board meetings frequency, executive compensation, percentage of stock ownership by executives, directors, and blockholders, the existence of independent auditor, and more)
Corporate Social Responsibility (CSR) and ethical analysis (is there a high-ranking CSR position -such as Dell’s chief ethics officer, established environmental policy, well-stipulated ethical standard – including whistleblower protection, information disclosure and ethical issues resolution policies, and more)
As with previous blog post, resources such as Hoovers, Yahoo Finance, Google Finance, Value Line Investment Survey, and Mergent Online can be used to answer these questions. In this blog post, we continue to use Caterpillar (CAT) as an example in answering these questions.
Per Mergent Online, CAT is engaged in manufacturing construction and mining equipment, diesel and natural gas engines, industrial gas turbines, and diesel-electric locomotives. The company operates in four geographical segments: North America, Europe, Asia Pacific, and Latin America and CPF. The company also has four product segments:
Construction: machinery in infrastructure and building construction applications
Resource: machinery in mine and quarry applications
Energy and Transportation: reciprocating engines, turbines, diesel-electric locomotives, and related parts across power generation and industrial industries
Financial Products: retail and wholesale financing for the company’s products
In terms of operating strategy, I believe that CAT has done well. Diversifying its geographical markets and products / service offerings hedge the company’s chances against the large demand swings in the recession/construction-dependent industry. I appreciate the company’s efforts to diversify into Energy and Transportation, as the niche is adjacent to machinery and requires a lot of engineering and assembly knowledge that is CAT’s core competitive advantage.
Per CAT’s 2016 annual meeting proxy statement (on 2015 performance), the board of directors is made of 12 individuals, 11 of which are independent directors (the equivalent of 92% of the board). The Presiding Director (Edward B. Rust, Jr) is one of these independent directors. This composition is good as it counterbalances the effect of having the CEO of CAT (Doug Oberhelman) being the same person as the Chairman of the board. The board met seven times in 2015, which is a good indicator of an active board.
There is a good amount of information of executive compensation in the proxy statement. Issues such as alignment principles, stockholder outreach on vote, compensation program structure, pay outcome, and compensation governance practices and policies were outlined. The proxy statement even admitted to the decline in supportive votes on compensation between 2012 and 2015, as well as to their outreach to nearly half of the shares outstanding stockholders in order to find out the cause for the decline. The outreach results outlined stockholders’ dissatisfaction of management’s performance and the board subsequently adjusted compensation based on the feedback. There were plenty of information on each executive’s compensation, including base pay, annual incentive, long-term incentive, equity awards, options exercises, pension benefits; as well as how these items were calculated based on the performance of each executive against the goals for the 2015 year. There is also a compensation recoupment (clawback) policy. These transparencies are positive signals for investors.
Further, the proxy statement contains information on the security ownership of executive officers and directors. Although the percentages of the stock ownership to total shares outstanding are not disclosed for these individuals, the stock ownership of the CEO can be easily calculated based on the number of shares outstanding in the company’s 10-K. Common stock percentage is 0.038% of common stock, in addition to another 0.22% of stock options exercisable within 60 days and another 0.168% of stock options upon retirement. In total, the CEO’s stock ownership of CAT is 0.428% of shares outstanding. This number is way below the 5% to 25% rule of thumb.
Per the proxy statement, there are three shareholders with stock ownership exceeding 5% of the company: State Street Corporation (at 9.9%), Vanguard (at 6.32%), and BlackRock (at 5.2%). None of these parties have representation on the board of directors. State Street Corporation serves as an investment manager for certain CAT defined contribution plans.
Per the proxy statement, CAT’s independent auditor is PriceWaterhouseCoopers (PwC). PwC is one of the big four auditors and has been CAT’s auditor since 1925. The audit fee is structured in two components:
1. Audit fees: includes audit and review of financial statements (including internal control over financial reporting, statutory, and subsidiary audits, SEC registration statements, comfort letters, and consents.
2. Audit-related fees: includes attestation services requested by management, accounting consultations, pre- and post-implementation reviews of processes or systems audits of employee benefit plan financial statement.
PwC also provides other services to CAT, such as tax compliance, tax planning, and other consulting services. The 2015 fees totaled $53.7 millions, of which $33.3 millions are audit and audit-related fees – yielding a ratio of 62% of audit fee to total fee.
Comparing CAT’s corporate governance to John Deere’s (a major US competitor) as reported in their proxy statements yielded the following findings:
*In terms of corporate governance transparency, it seems that CAT is better than John Deere (based on proxy statement). John Deere’s auditor arrangement is superior because 100% of their fees came from audit services (meaning, the auditor is not dependent on John Deere for other non-audit income, avoiding conflict of interest).
Per CAT’s proxy statement, the company was named to the Dow Jones Sustainability Index again in 2015. Although publicly available information does not reveal the existence of a high-ranking CSR position (chief ethics officer), they do seem to have a well-established environmental policy. CAT’s proxy statement listed sustainability goals such as reducing workplace injuries, byproducts, energy and water uses, greenhouse gas emissions, and increasing the use of LEED building materials in their facilities.
The company’s code of conduct, first established in 1974, is well documented in various languages on their website. CAT also produced yearly sustainability reports that contain various policies and ongoing efforts deployed in various product and geographical segments to be better in social responsibility. These reports also discussed achievements and how far along the company has been in meeting its sustainability goals. No publicly available information exists on a whistleblower protection program. The proxy statement does mention the board’s role in managing an ethics and compliance office as well as comprehensive internal audit processes.
Per Google searches on CAT’s class action lawsuits, it seems that the company has seen its fair share of both environmental and non-environmental lawsuits, ranging from the failure of exhaust emission control system on CAT trucks and busses to stealing trade secret lawsuits. Although the total amount and nature of these lawsuits would require further research, it seems that the company has settled at least some of these suits. In a number of class-action lawsuits, the stock market responded with a price drop of the stock price after the news broke.