Latest / How Canadian Markets Work / Episode 78: Trend and Comparative Analysis (The Five-Year Story)

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Episode 78: Trend and Comparative Analysis (The Five-Year Story) · How Canadian Markets Work

0:00
Remember how we learned in our last deep dive
0:02
that a cyclical company's lowest price to earnings
0:04
ratio usually arrives like right at the top of
0:07
a cycle? Oh, yeah, the absolute peak. Right.
0:10
And it makes the stock look incredibly cheap
0:12
exactly when it's most dangerous to buy. It's
0:15
the classic cyclical value trap. And I think
0:19
it perfectly illustrates why relying on a single
0:22
year snapshot of corporate performance is never
0:24
enough. I mean, you can look at one exceptional
0:27
year, see a low P .E. multiple, and completely
0:30
convince yourself you've found the bargain of
0:32
the decade. And you're completely unaware that
0:35
the cycle is about to turn and just crush you.
0:38
Exactly. It is arguably the most common illusion
0:40
in finance, you know. We are wired to look at
0:43
the most recent data point because it just feels
0:45
like the most relevant one. Yeah, that makes
0:46
sense. Right. You look at a company's trailing
0:48
12 months, you see top line growth, you see solid
0:51
net income, and your brain immediately extrapolates
0:54
that into a permit. reality. But analyzing a
0:56
business based on a one -year snapshot is, well,
0:59
it's like trying to understand the plot of a
1:01
two -hour movie by looking at a single still
1:03
frame. That's such a good way to put it. You
1:05
have to actually watch the film. You need to
1:07
watch the film. And so that is our mission for
1:09
today's Deep Dive. We are figuring out how to
1:12
properly read a company's financial story over
1:16
time. We're moving past the snapshot and into
1:19
the actual machinery of the business. Getting
1:22
under the hood. Exactly. To do this, we're going
1:25
to use trend analysis. common size analysis,
1:28
and comparative analysis to dissect a fictional
1:31
Canadian manufacturer from our sources. We'll
1:34
call them Meridian Tool Works. A textbook case
1:37
study for this exact type of illusion, by the
1:39
way, because when you isolate their most recent
1:42
year, the financials paint a well, a rather comforting
1:45
picture. They really do. If you're just glancing
1:47
at their latest annual report, Meridian looks
1:50
like a highly functional growing business. I
1:52
mean, revenue for the year is up 8%, hitting
1:55
$200 million. Not bad at all. Right. And net
1:58
income is sitting at 18 million dollars, which
2:01
is an increase from 17 million the year prior.
2:04
So on the surface, you see respectable margins
2:07
and a healthy operation. If you stop your research
2:09
there, you know, you're probably feeling pretty
2:11
good about the company. But that false sense
2:13
of security is exactly where the trap is set.
2:16
A single year tells you where a company happens
2:19
to be standing at one specific moment in time.
2:22
but it tells you absolutely nothing about the
2:25
momentum carrying them there. Wait, what do you
2:27
mean by momentum in this context? Like, are they
2:30
accelerating into that $200 million revenue figure,
2:33
or are they limping across the finish line? To
2:35
answer that, we have to stretch the timeline.
2:37
Five years is generally the gold standard for
2:41
this. Why five years specifically? Well... It's
2:43
long enough to filter out the noise of a single
2:45
bad quarter or, you know, a temporary macroeconomic
2:48
hiccup, but it's short enough that the core identity
2:51
of the business remains recognizable. And when
2:54
we apply a five -year lens to ready -and -tool
2:57
works, every single metric that looked acceptable
2:59
in the current year just, it starts to fracture.
3:02
Okay, so we need to pan the camera out. Let's
3:04
start with the first tool you mentioned, which
3:06
is horizontal analysis, also known as trend analysis.
3:09
This basically means tracking the exact same
3:12
line item on the income statement or the balance
3:14
sheet across those five years. Exactly. We are
3:17
looking beyond just the absolute dollar amounts
3:19
to find direction, acceleration and divergence.
3:23
Right. OK. Let's unpack this because I picture
3:25
this like a tightly cropped photo on a real estate
3:28
listing. You see a pristine, beautiful hotel
3:31
pool. It looks like the perfect vacation spot.
3:34
The one year snapshot. Right. That's the one
3:36
year snapshot. But horizontal analysis is when
3:40
you take the camera and pan it wide. You zoom
3:43
out over a five -year landscape and you realize
3:45
the hotel directly behind that beautiful pool
3:48
is structurally collapsing. That is a great analogy.
3:51
Thanks. So let's apply that horizontal pan to
3:54
Meridian's top line. We just look at the absolute
3:56
revenue over five years. It goes from $130 million
3:59
to $150 million to $168 million to $185 million
4:03
and finally to that current $200 million. To
4:07
a casual observer, that sounds fantastic, right?
4:11
The dollars are going up every single year. They
4:13
are, definitely. But let's calculate the acceleration.
4:17
Yes, the raw dollars are increasing, but let's
4:20
look at the actual growth rate year over year.
4:22
From year one to year two, Meridian grew its
4:25
revenue by a very healthy 15%. Okay, solid. But
4:29
the next year, that growth rate dropped to 12%.
4:32
The following year, it fell to 10%. And in this
4:35
most recent quote -unquote decent year, the growth
4:38
rate compressed to just 8%. Oh, wow. So the momentum
4:42
is dying. The absolute number is still rising,
4:45
sure, but the engine is clearly losing power.
4:48
Every single year, the growth decelerates. Which
4:50
is your very first structural warning sign. I
4:53
mean, a company can still post record -breaking
4:55
total revenue while the underlying demand for
4:57
their product is steadily eroding. Because if
5:00
you only look at the most recent year's 8 % growth,
5:03
you might just assume they've always grown at
5:04
8%. Right. You completely miss the fact that
5:08
they've lost nearly half their growth velocity
5:10
in just 48 months. And if top line growth is
5:13
steadily decelerating like that, the management
5:15
team definitely knows it. I mean, they feel it
5:17
in every board meeting. And human nature dictates
5:20
that when growth starts slowing, management will
5:23
usually do whatever it takes to fix it or at
5:25
least mask it to keep investors happy. Which
5:28
leads us to the next metric. Right. My immediate
5:31
suspicion here is that they might be running
5:33
a constant clearance sale because if the product
5:36
isn't moving naturally, you start bribing customers
5:39
to buy. So let's look at what it costs them to
5:41
make those sales by pulling their gross margin
5:44
into the horizontal analysis. That is the logical
5:47
next step. Gross margin is essentially the purest
5:49
measure of a company's pricing power. It represents
5:52
what's left over from revenue after you subtract
5:55
the direct physical costs of manufacturing the
5:58
goods. Okay. So over the same five -year period,
6:01
Meridian's gross margin went from 42 % down to
6:04
40%. Okay, a little dip. Then 38%, 36 .5%, and
6:08
finally 35 % this year. It dropped seven full
6:13
percentage points over five years, and it dropped
6:16
consecutively, like every single year, without
6:19
a single bounce back. When you fuse those two
6:21
horizontal trends together, the narrative pretty
6:24
much writes itself. I mean, a one -year dip in
6:27
gross margin could be easily explained away.
6:29
Maybe there was a temporary supply chain shock
6:31
or a sudden spike in the cost of raw steel or
6:35
aluminum. That happens all the time. But five
6:37
consecutive years of margin compression alongside
6:40
five consecutive years of decelerating revenue
6:43
growth, that points to a severe loss of pricing
6:45
power. Meridian is basically buying its revenue
6:49
growth by slashing prices and it's working less
6:51
effectively every single year. Man, the sales
6:54
reps are probably out there offering massive
6:56
discounts just to hit their revenue quotas because
6:59
that keeps the top line dollar amount moving
7:00
up. They're fighting to maintain the illusion
7:03
of the snapshot. Yeah, they are masking the problem.
7:06
But this has to be cannibalizing the bottom line.
7:09
If we check their net income over this five year
7:11
stretch, it went from 13 million to 18 million.
7:14
That represents a 38 % increase in total profit.
7:18
But their revenue went up 54 % in that same window.
7:22
So profit is growing significantly slower than
7:25
sales. That's the divergence we were looking
7:28
for earlier. Ideally, revenue and net income
7:30
should move somewhat in lockstep. If sales jump
7:33
54 % but profit only manages a 38 % crawl, the
7:38
friction of that margin compression is bleeding
7:40
the company dry at the bottom line. They're working
7:42
vastly harder. Exactly. Producing and shipping
7:45
significantly more physical product just to squeeze
7:48
out a disproportionately smaller amount of profit.
7:51
So the income statement clearly shows a company
7:53
discounting its products to survive. But if a
7:55
manufacturer is working that hard just to push
7:57
volume out the door to mask a declining business,
8:00
the operational pain has to be building up somewhere,
8:03
right? No, it is. To find the real carnage, we
8:05
have to move over to the balance sheet. And we're
8:08
going to use the second tool from our sources,
8:10
vertical analysis, also known as common size
8:13
analysis. So if. Horizontal analysis is how we
8:16
track a specific metric across time. Vertical
8:20
analysis is how we examine the structural integrity
8:23
of a company within a single period. Okay, so
8:26
instead of tracking the absolute dollars across
8:28
five years, we're sort of freezing time and turning
8:31
every line item into a percentage of total revenue,
8:34
basically building a structural blueprint of
8:36
the business for that specific year. That is
8:39
the perfect way to visualize it. It entirely
8:41
removes the distortion of absolute size. It's
8:44
like looking at architectural blueprints. If
8:46
you decide to scale a one -story suburban house
8:48
into a 50 -story skyscraper, you can't just multiply
8:52
the amount of wood and nails by 50. Right, it
8:54
would just fall over. Exactly. The structural
8:56
proportions have to fundamentally change. You
8:58
need a steel skeleton. deep concrete foundations,
9:01
and complex elevator shafts, or the building
9:04
collapses under its own weight. So vertical analysis
9:06
shows us if Meridian's financial skeleton can
9:08
actually support its new $200 million size, or
9:12
if it's structurally compromised. Let's test
9:15
that structural integrity by applying vertical
9:17
analysis to their accounts receivable. And just
9:19
to clarify, this is the money that customers
9:22
formally owe Meridian for goods that have already
9:24
been delivered. Correct. Unpaid invoices. In
9:27
year one, they had $9 million in receivables.
9:30
By year five, that figure ballooned to $22 million.
9:34
Which is 144 % increase in accounts receivable.
9:38
Compare that directly to the revenue, which we
9:40
know only grew 54%. The money owed to them is
9:43
growing almost three times faster than the actual
9:45
sales. Now let's view that vertically to see
9:48
the structural shift. In year one, 9 million
9:51
in receivables on 130 million in revenue meant
9:54
that receivables made up roughly 7 % of their
9:57
total sales. But by year five, 22 million in
10:00
receivables on 200 million in revenue means it
10:03
had expanded to 11%. How does that actually happen
10:06
in a business -to -business environment? It sounds
10:09
like channel stuffing. That's exactly what it
10:11
looks like. The sales team, desperate to keep
10:14
that decelerating revenue growth from stalling
10:16
out completely, starts calling up their distributors
10:19
and saying, listen, take a million dollars of
10:22
our tools right now, and we won't even invoice
10:25
you for 90 or 120 days. Yeah. They are pulling
10:28
forward future demand to make the current quarter
10:31
look good. And they're essentially acting as
10:32
a free bank for their own customers. Wow. They
10:35
are entirely financing their own customers purchases
10:38
to keep the top line moving. And the operational
10:41
chaos of this strategy becomes even more apparent
10:44
when we look at the other major asset on their
10:46
balance sheet, which is inventory. Oh, boy. Over
10:49
the same five year window, Meridian's unsold
10:51
inventory grew from 11 million dollars to 30
10:55
million dollars. That is a massive 173 % increase.
11:00
Vertically, as a proportion of total revenue,
11:03
it nearly doubled, expanding from 8 .5 % to 15%.
11:07
Wait, let me push back on this for a second.
11:09
Couldn't a massive inventory build just mean
11:11
they have incredible foresight? What if they're
11:14
anticipating a massive surge in demand next quarter,
11:17
or maybe they're hoarding raw materials before
11:20
a forecasted tariff hits? Why is a huge warehouse
11:24
of inventory automatically a bad thing? Well,
11:27
in an absolute vacuum, building inventory can
11:29
sometimes signal anticipated growth. But we are
11:32
not analyzing this in a vacuum. We have already
11:35
established through horizontal analysis that
11:37
their revenue growth has steadily decelerated.
11:40
for five consecutive years. So if growth is slowing
11:43
down, building massive stockpiles of inventory
11:46
is a massive red flag. It proves the product
11:49
simply isn't moving. And the physical reality
11:51
of bloated inventory in the manufacturing business
11:53
is brutal. I mean, that $30 million in product
11:56
isn't just sitting there peacefully. No, it costs
11:58
money just to exist. Right. It incurs massive
12:01
holding costs. You have to lease overflow warehouse
12:03
space. You have to pay for climate control, security,
12:07
and forklift maintenance. And worse, industrial
12:09
manufacturing, older inventory risks obsolescence.
12:13
If a competitor releases a better tool, that
12:16
30 million dollars of stockpiled inventory suddenly
12:19
has to be written down and sold for scrap. It
12:23
is quite literally a cash incinerator. And it
12:25
creates a catastrophic cash flow gap. Think about
12:29
the cash conversion cycle here. Meridian has
12:31
to pay its suppliers and its factory workers
12:33
in 30 days to build those tools. But the tools
12:37
are now sitting in a warehouse for months, and
12:39
when they finally do sell them, they're giving
12:41
the customers up to 120 days to pay. So the cash
12:44
is bleeding out immediately, but it's taking
12:47
quarters or even years to flow back in, which
12:50
leads to the most critical question of this entire
12:52
deep dive. If Meridian is bleeding cash to fund
12:56
bloated inventory and uncollected receivables,
12:58
how are they keeping the lights on? They can't
13:00
pay their factory workers in unsold drill bits.
13:03
They have to borrow. To fund this cash -draining
13:05
charade, Meridian had to rely on debt. Let me
13:08
guess. It spiked. Oh, it did. Over the five -year
13:10
period, their total debt went from $35 million
13:13
to $45 million to $58 million to $70 million
13:16
and finally to $82 million. Their debt increased
13:20
by 134 % in five years. But let me play devil's
13:25
advocate again here. Go for it. Over the last
13:27
five years, macro economic interest rates have
13:30
been historically low. Isn't taking on cheap
13:33
debt to fund expansion exactly what a smart management
13:36
team should be doing to optimize their capital
13:39
structure? Like, why is leverage here so toxic?
13:42
Because borrowing cheap capital to build a highly
13:46
productive new factory that yields a high return
13:48
on investment. That is smart leverage. Borrowing
13:51
money simply to float unsold inventory and uncollected
13:54
invoices, that is toxic leverage. Ah, I see.
13:58
The revenue growth wasn't just bought with price
14:00
cuts. The underlying operations were heavily
14:02
subsidized by debt. They are masking an operational
14:05
failure with a financial band -aid. And that
14:07
creates an incredibly fragile business structure,
14:09
especially when we consider the mechanics of
14:11
debt maturity. Eventually that $82 million comes
14:14
due. Let's examine their interest coverage ratio,
14:17
which measures how easily their operating income
14:19
can pay their annual interest expense. Today
14:22
on paper, it sits at a seemingly comfortable
14:24
five times coverage. Seems fine. But corporate
14:28
debt isn't permanent. What happens when that
14:30
ballooning $82 million reaches the maturity wall
14:33
and has to be refinanced? Oh man. they get hit
14:36
with a massive rate shock. Exactly. If they secured
14:39
that debt years ago at 3 % and they had to refinance
14:42
the entire chunk today at 7 % or 8%, their annual
14:46
interest expense is going to double or triple
14:48
overnight. And because we already proved their
14:51
gross margins are compressing, they have zero
14:53
internal cushion to absorb that higher interest
14:56
cost. The coverage ratio just plummets. The company
14:59
is highly leveraged, operationally inefficient,
15:03
and wholly dependent on continuous borrowing
15:05
just to sustain the illusion of growth. It is
15:08
a house of cards. Yet if you go back to the single
15:10
-year snapshot, their current net income is technically
15:14
the highest it has ever been. It is genuinely
15:16
terrifying how easily that can be hidden. But
15:19
before we completely write off Meridian, we have
15:21
to run the final check from our sources. We need
15:24
to determine if this is just Meridian making
15:26
terrible strategic decisions or if this is an
15:29
industry -wide contagion. Right, and this is
15:32
where we bring in comparative analysis. We need
15:34
to benchmark Meridian against its peer group.
15:37
So we're asking, are these falling margins and
15:40
ballooning inventory specific to this one company?
15:43
Or is the entire industrial manufacturing sector
15:46
suffering from some tectonic shift, like a sudden
15:50
influx of heavily subsidized overseas competitors,
15:54
or a permanent spike in global supply chain costs.
15:57
Because the remedy for those two scenarios is
15:59
completely different. If competitors are holding
16:02
their margins steady and collecting cash efficiently
16:04
while Meridian is failing, then it's a company
16:07
-specific problem. You fire the CEO, bring in
16:09
new management, and overhaul the sales strategy.
16:12
Right. But if everyone's margins are collapsing
16:14
simultaneously, it's a structural industry decline.
16:18
You can't outmanage a fundamental deterioration
16:20
in the underlying economics of the sector. So
16:22
we just pull up an industry index or a list of
16:25
comparable peers and see how Meridian stacks
16:27
up. Right. You can, but... And I really want
16:29
listeners to mull this over. There is a massive
16:33
analytical trap there that you must account for.
16:36
When you compare a company to its peers using
16:38
an index, you have to adjust for survivorship
16:41
bias. Survivorship bias. Meaning we're only looking
16:45
at the companies that haven't already gone bankrupt.
16:47
Yes. Think back to the dot -com bubble or the
16:50
2008 financial crisis. If you look at the industry
16:53
averages for those sectors immediately following
16:56
the crashes, The metrics often look surprisingly
16:59
robust. Really? Why? Because the indices had
17:02
been cleansed of all the failures. When you pull
17:04
up a list of Meridian's peer competitors today,
17:07
you are exclusively comparing them to the survivors.
17:10
You are completely omitting all the other manufacturers
17:12
who tried to play this exact same game of debt
17:15
-fueled inventory expansion, ran out of cash,
17:17
and went bankrupt two years ago. Oh, wow. So
17:19
the bankrupt companies get delisted, they fall
17:21
off the spreadsheet, and their terrible financial
17:24
ratios just vanish from the industry average.
17:26
Both are gone. By ignoring the casualties, survivorship
17:29
bias artificially inflates the health of the
17:32
entire sector. You might look at the peer group
17:34
and think, oh, Meridian's martens are slightly
17:36
below average, but the industry looks stable.
17:40
But the industry only looks stable because the
17:42
weakest links were quietly erased from the data
17:45
set. It creates a comparison that is fundamentally
17:48
flattering by its very construction. Survivorship
17:51
bias happens constantly in comparative financial
17:54
analysis, yet it's rarely adjusted for. That
17:56
is wild. So if an industry seems unusually resilient
18:00
despite severe microeconomic headwinds, you always
18:03
have to ask how many companies quietly disappear
18:06
to make the average look that good. That is a
18:09
deeply unsettling reality to keep in mind when
18:11
looking at sector benchmarks. But it brings us
18:13
to a powerful synthesis of everything we've covered
18:16
today. We've thrown a lot of percentages, mechanical
18:18
processes, and millions of dollars around. I
18:20
have. But if you are listening and want to take
18:22
exactly one actionable rule of thumb away from
18:25
this entire deep dive, it should be this. Any
18:28
line item growing fundamentally faster than revenue
18:31
demands an immediate explanation. It is the single
18:34
most powerful filter you can apply to a financial
18:36
statement. Growth should be organic and structurally
18:40
proportional. When the components that are supposed
18:42
to support growth start vastly outrunning the
18:45
growth itself, the system is breaking down. Accounts
18:49
receivable grew 144%. Inventory grew 173 percent,
18:54
debt grew 134 percent, and revenue only managed
18:58
a decelerating 54 percent. Every single one of
19:02
those metrics dramatically outpaced sales, and
19:05
together they exposed a terrifying reality that
19:08
the one -year snapshot completely buried. You
19:10
always have to look for the story, not just the
19:12
snapshot. We want to encourage all of you listening
19:15
to apply this five -year framework to the companies
19:18
you research or work for. Don't let a decent
19:20
trailing 12 months lure you into a false sense
19:23
of security. Run the horizontal analysis to check
19:26
the momentum. Run the vertical analysis to test
19:28
the structural integrity. And pan that camera
19:31
all the way out until you know for sure there
19:33
isn't a fire burning just out of frame. Thank
19:36
you for joining us for this deep dive into trending
19:38
comparative analysis. We'll see you next time.