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Course 310
Segment Analysis

Introduction

Many companies aren't in just one business. Companies often have two or more businesses, each contributing to the bottom line and each influencing the overall character of the company. That's why it is a good idea to pick apart a company's business segments when valuing the entire corporation. It may be helpful to think about these companies as mutual funds, but instead of holding portfolios of stocks or bonds, they hold businesses. Stocks and bonds drive the performance of a fund, and individual businesses drive the operating performance--and therefore the stock price--of a company. U.S. companies with more than one business generally list a breakdown of sales, operating earnings, and assets by business segment and geographical region in their annual reports. Segment information is usually at the back of the report, toward the end of the footnotes. You can find segment information for some companies in their Morningstar Stock Report.

Research Revenues

The first thing to look for is how the company's various businesses contribute to its total revenues. The company may have a big sideline business that reduces the influence of mainline operations. Take Philip Morris MO. You may consider it a tobacco company, but food and beer operations accounted for 43% of overall sales in 1998. In analyzing Philip Morris, we can't just concentrate on the tobacco piece of the puzzle. We have to consider issues related to its food and beer businesses, as well. For some companies in cyclical industries, a variety of businesses can lessen the impact of cyclicality on the bottom line. A chemical company, for example, may sell both industrial chemicals, which are very cyclical, and chemicals used in consumer products, which aren't cyclical at all. The latter division's steady sales would help offset the cyclical segment's ups and downs. Alternatively, a cyclical company may have divisions that have different cyclical peaks, so that while some segments are in a cyclical trough, others are enjoying strong demand. As the economic cycle moves along, the segments in the trough will strengthen as the strong segments weaken. International sales can help, too, because foreign countries often have a different economic cycle than the U.S. market. Overall, a diversified company's results should be more stable than a nondiversified company's results.

Profitability Is Key

While it is important to know how a company's business is divided, it is also good to consider those businesses' profits. For example, Johnson & Johnson JNJ garners a roughly equal portion of sales from its pharmaceutical and consumer divisions, each accounting for about one third of revenues. But because pharmaceutical products tend to be more profitable than mundane products such as Band-Aids, the pharmaceutical division accounted for 69% of total operating profits in 1998. Consumer products, meanwhile, contributed less than 10% of operating profits. As long as a company's maturer business segments are reasonably profitable, there should be no problem. But if a major segment is lagging or showing signs of slowing growth, that could mean trouble. Take Tommy Hilfiger TOM, the popular clothing manufacturer. Investors sent the company's stock down in 1999 after Tommy showed signs that growth from its men's wear line was slowing. The company tried to make up for that slowing growth by turning to other segments, mainly women's wear and children's wear. Regional growth can also be important for companies. Some firms expect to become more profitable as they expand into new areas of the country. Many older companies expand internationally once they're firmly established in the United States. At McDonald's MCD, for example, international operations are growing at a fast clip while domestic operations are growing only slightly. Adding sales in new geographic areas can not only make a company more profitable, it can sometimes protect a company from economic downturns. If one region or country is in an economic slump, another area may be booming and could offset disappointing results elsewhere. Differing economic conditions is one reason why you should consider a company's expansion plan carefully before investing. If a company is hitching its growth plan to a region that is economically depressed, that may be reason enough not to buy a company's stock. At the same time, an expansion into a booming area can drive up earnings and company's share price.

Quiz 310
There is only one correct answer to each question.

1 Investors can find a breakdown of revenues and profits from a company's segments in:
a. The footnotes of the company's annual report.
b. Each press release a company issues.
c. The CEO's letter to shareholders.
2 A cyclical company may diversify so new business segments make the company's earnings:
a. More consistent during all economic conditions.
b. More likely to stay in a trough.
c. Easier to report to shareholders.
3 If Johnson & Johnson's pharmaceutical division posted a loss, it would:
a. Have less of an impact on earnings than if its consumer division reported a loss.
b. Have a greater impact on earnings than if its consumer division reported a loss.
c. Have no meaningful impact on earnings.
4 If a company's mature segments are showing signs of slowing growth, the company may:
a. Issue a higher dividend.
b. Report earnings more frequently.
c. Look to other business segments to provide future growth.
5 If McDonald's were <em>not</em> expanding overseas:
a. Americans would have more dining options abroad.
b. The company's growth rate would be slower.
c. Russia would be importing more potatoes.
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