Wednesday, April 15, 2009

Intersegment Sales Tell The Tale

A couple of weeks ago, we looked at a company which operated two segments going in very different directions. Summed together, the segments (and as a result, the company) were just breaking even, but the thinking was that if the company reduces or eliminates its exposure to the poorly performing segment, shareholders will be left with a good business (from the remaining segment) at a cheap price.

A reader brought up an interesting question, however. Since the manufacturing segment actually sells to the distributing segment, is it really possible to just cut one segment off and operate the other as if nothing has happened? The answer lies in the company's disclosure of intersegment sales, in the notes to the financial statements.

While the company had $110 million worth of sales in its distribution business in 2008, it had only $8 million worth of intersegment sales. They don't tell us whether the manufacturing segment bought from the distribution segment or vice versa, but even if we assume the distribution business did all the buying, this represents only 7% of its sales. Furthermore, this percentage dropped from 9% in the previous year, suggesting the company is able to reduce its exposure to the manufacturing segment while still growing its distribution business. Intersegment sales are reported at fair values.

As we've discussed many times for various reasons, it is essential that value investors read the notes that accompany a firm's financial statements, as it is a necessary requirement to truly fully understanding a business.

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