An honest look at profitability

July 13, 2021

As I near the end of my studies in energy and management at ESCP Business School, I wanted to share some feedback on some of the most interesting set of lectures I had during the course last week.

What initially drew me to ESCP was the fact that it is both international and European - with campuses in six major European cities - and that it offers programs that are designed for people who work and have significant family commitments. I was only able to complete a business degree as a mother of two working full-time because of the way the course is structured and the collaborative approach of professors and administration.

Because of the module format, we have discovered several subjects from the perspective of different professors working in different countries. This is critical when trying to understand a topic as complex as energy, which although globally relevant to every citizen in every country, certainly looks different depending on where you sit.

One of the most interesting exercises from last week was the analysis of P&L statements. One of the things our professor told us was that we should not satisfy ourselves with explanations that are obvious.

What does that mean? If you want to understand a company and its impact, it's not enough to simply read the headlines of the company's earnings release or the latest report published by research analysts following the company.

It's very important to take an honest look at the P&L to not only understand WHETHER a company is profitable but WHY it is profitable.

Beginning at the top of the P&L, you must begin by understanding the company's fundamental revenue model. Is the biggest driver of value derived from their product, scale, geographic scope or reputation? How would a change in consumer preferences affect this model? Are revenue streams based on subscriptions, contract award or distribution? Understanding these first questions will help you understand the biggest risks for the company.

You must also understand the reasons for trends in sales. Why are they up or down? Is it due to the success of the company's model or due to external factors such as seasonality or other trends that do not necessarily show good management and cost control? Have there been regulatory developments or changes in consumer behavior that are really driving the increase?

Next, cost of goods sold. Assuming the gross margins are high, you must understand why they are high. Is it because the company has natural synergies or historic relationships that lend themselves to favorable purchasing and sourcing arrangements? Are these relationships certain going forward? This is particularly true of companies with complex supply chains. It is important to understand whether the value is truly being generated at the Tier 1 level or whether the Tier 1 company is maintaining its margins due to the pressure it is putting on suppliers further down the chain.

Next, operating expenses. This provides a window into how the company treats its employees through salaries and benefits as well as how the company interacts with its customers through sales and marketing. How does the company maintain control over these aspects? Is consistent profit a reflection of inherent value or successful arbitrage?

How have these aspects changed since the pandemic? Have they maintained profitability due to state aid or voluntary departure plans or has the inherent model successfully weathered the crisis?

These are all complex questions, to be carried through the analysis of the balance sheet and cash flow statement. Perhaps the most interesting question to me was about shareholders' equity. How is the company distributing or reinvesting its equity? Is its value distribution strategy sustainable and consistent with a new stakeholder-driven vision of capitalism that is emerging?

In our ESCP class, we spent several hours dissecting a few energy companies' P&Ls. And we all had different views and some of our assumptions were proved wrong. Unfortunately, markets move quickly and can't ask and answer these questions in real time. We rely on the headlines to make short-term buy and sell decisions and the opinions
of analysts to help us making longer term corrections. But it is risky to rely too much on either of these.

We need to make our own decisions, ask our own difficult questions, take an honest look at the P&L not only of the companies we invest in but also our own businesses in order to ensure that we are really supporting true value generation and not just successful resource arbitrage.

CPM