Why Should You Worry About The Sorry State Of Segment Disclosures?

The FASB’s proposed new rule trying to tighten segment disclosures does not go far enough although segment disclosures are hugely important to investors and citizens.

Segment disclosure is a nerdy topic that will not get me many clicks on this story beyond the die-hard followers of the twists and turns of financial reporting developments in the US. But it’s a hugely important area that overlaps with many policy issues of the day including antitrust action, capital allocation and how to value a conglomerate. The key question that I want an answer to, as a reader of financial statements: what are the unit economics of a product or a segment? Unit economics is jargon for revenue and cost per unit of a product or service sold. This question becomes even more complicated when bundling of products or services is involved. Consider a few examples.

Apple’s services segment

Information technology is tailor made to sell bundled products. Apple’s services business is a $56 billion business today because they have an installed base of millions of iPhones on which apps can be sold and service revenue can be earned. Customer acquisition costs spent on selling the iPhones and retention costs, incurred on providing updates of the operating systems, effectively made the massive revenues on services possible. Should we not capitalize some of these iPhone customer acquisition and development costs and then amortize those against the services revenue earned later? How profitable is the app store, for instance, a question that came up, in Apple’s lawsuit against Epic Games.

CEO Tim Cook is reported to have testified in that case that no one at Apple really knows how profitable the app store really is! Apple’s 10-K for year ended October 31, 2022, reports sales by geography but not margins (Americas, Europe, Greater China, Japan and Rest of Pacific area). They do disclose gross margin, broken by products and services, as shown below, but not for the app store:

Does this answer any of the questions about unit economics for Apple’s major products or services? I am not sure. What is worse, I don’t even know how much of the $114 billion of gross margin associated with products is due to iPhones as opposed to iPads, Macs and watches? Moreover, what does Apple define as “gross margin” in general and especially for its services business? What might cost of services sold meaningfully be, especially when we do not amortize capitalized development and customer acquisition costs for services? How many app downloads went into such services?

“Free” products and platforms related to Alphabet

Moreover, what is seen as free by the customer is rarely free in the world of information products. Google search and YouTube are free in theory but are obviously subsidized by the data collected and the advertising sold. What are the economics of Google search and YouTube? How much money does Google Maps make? What are the economics of the Android platform, given that all Google phones run on Android?

Alphabet does disclose revenues and profitability for three segments: Services, Cloud and Other Bets, as shown below in their latest 10-K:

Operating income, subject to the definition of operating income used by Google, is still better than gross margin than Apple discloses. Note, however, Google Services is a very big tent that includes advertising, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube. Google Services generates revenues primarily from advertising; sales of apps and in-app purchases, and hardware; and fees received for subscription-based products such as YouTube Premium and YouTube TV. Of course, none of these product lines is disclosed separately.

Again, were any of my questions related to the economics of the products such as YouTube or “free search” fully addressed. I am not sure. There are reports that the SEC pushed Alphabet to report YouTube as a separate segment back in 2018. Indeed, Alphabet reveals revenue that YouTube (and Google search) makes ($29.2 billion in 2022), as shown below in their “disaggregated revenues” note, but profitability at YouTube is not disclosed.

The ultimate superstore, Amazon

Let us now turn to Amazon. Amazon’s business model relies uniquely on running segments at a loss perhaps even forever (e.g., Amazon Prime) deliberately to cross-subsidize online sales. How much does Prime lose and are such losses effective at generating online sales and if yes, by how much? How much money does Amazon’s “free shipping” lose and how much does such loss mitigate customer defection? Did Amazon make any money on their Kindle product? How many users does Prime have? How many Kindles have been sold?

What does Amazon actually disclose in their latest 10K? Amazon discloses sales and operating income for three broad segments: North America, International and AWS, as seen below:

It is interesting to note that a line item such as AWS will get called out only after if it has become a viable business. Hence, cross-subsidized businesses that are being incubated will fly under the disclosure radar for a long while before investors are aware of the clout that such businesses wield in terms of users or market share.

What about individual product lines? Well, we see sales numbers for some product lines as follows. Expenses and income are not disclosed:

This is helpful but did I get an answer to any of the questions I had posed. I don’t think so. I also wonder about the narrative that AWS is very profitable. What exactly are the “operating expenses” under AWS segment? How are common expenses allocated across segments?

The segment problem is not unique to Tech. Consider Home Depot

The segment problem remains a concern even in other areas. Consider Home Depot’s 10-K for the year ended December 31, 2022. Home Depot reports revenues for 14 segments such as appliances, building materials, décor and kitchen and bath and so on, as shown below. There is nothing mentioned in relation of expenses and profits.

What are the reporting rules today?

The current rules involve four steps to decide what to report:

· Step 1: a publicly listed firm needs to identify a chief operating decision maker (CODM), defined as someone who receives financial information about the operating segment and uses that information to assess each operating segment’s performance and allocates resources to each operating segment.

· Step 2: the firm needs to identify an operating segment, defined as a component of a business where:

o the component engages in business activities from which it may recognize revenue and incur expenses

o discrete financial information is available for the component; and

o the component’s operating results regularly reviewed by the CODM.

· Step 3: the firm then runs quantitative tests to identify a reportable segment. A component is considered a segment if they pass the

o the revenue test where operating segment’s revenue ≥ 10% of combined revenues of all operating segments or;

o the P&L test where the operating segment’s profit or loss ≥ 10% of the combined reported profit of all operating segments (losses have a special treatment not discussed here) or;

o the assets test where the operating segment’s assets constitute ≥ 10% of combined assets of all operating segments.

· Step 4: once we decide that we have an operating segment, the firm is required to report

o Factors used to identify reportable segments

o Types of products and services that produce revenue for each reportable segment

o Profit or loss and asset measures for each reportable segment

o Additional quantitative and qualitative information about profit or loss and assets

o Reconciliations of corresponding consolidated amount to total reportable segment revenues, total reportable segment profit or loss, total reportable segment assets, and total reportable segment amounts for other significant items disclosed.

Three points are worth noting. First, Google got out of reporting YouTube as a separate segment back in 2018 arguing that Larry Page, the CODM, does not explicitly allocate resources to the YouTube unit. The YouTube incident highlights the huge potential for gaming in the CODM rule. Second, on the surface, Amazon and Home Depot do not really seem to comply with these rules as they don’t disclose profits by segment. Third, what is profit? Gross margin, operating income, with or without allocated overhead, or with or without operating expenses such as R&D and SG&A or something else?

What does the FASB want to change?

The FASB is now proposing adding the following requirements:

o Disclose segment expenses that are regularly provided to the chief operating decision maker (CODM); and

o Disclose difference between segment revenue less significant expenses.

Adding “segment expenses” is an improvement as it might make an Amazon and a Home Depot report profit or loss on each segment although what is an expense, especially allocation of common overhead across segments, is always going to be debatable. Having said that, the CODM criterion is prone to be managed by firms to get the reporting answer they want.

What, instead, would I want to see?

Here is what I would like to see as a consumer of financial statements:

o Impose a dollar metric to assess materiality, as opposed to the CODM measure. That is, if a component’s revenues exceed say $X billions, that’s a segment. I hear that the FASB hesitates to write bright line rule-based standards after they were abused by Enron back at the turn of the century. But a dollar-based standard is somewhat easier to verify and less gameable than a squishy CODM filter.

o Apply that materiality filter for a product as well. This idea would require disclosure of the economics of a say a Kindle or an iPhone.

o Do we need to also consider materiality in terms of number of users? Even if ioS or Android per se makes no revenues or assets, if they have X million users, disclose that product’s zero revenues and expenses so that the investor can understand cross-subsidization of these platforms that make it difficult for me to migrate from say the Apple walled garden to the Google ecosystem.

o Disclose unit economics, especially for tech, at the segment level. I have written extensively about such unit economics earlier.

o Last, but not least, what is an “expense”? Give us clear information about how common overhead is actually allocated across segments.

Jack Ciesielski, publisher of The Analyst’s Accounting Observer, points out that investors are usually interested in understanding the effectiveness of capital allocation to segments. He recommends the following additional disclosures to enable calculation of the return on assets in a segment or to learn about the allocation of financial, intellectual, and human resources, across segments:

· Gross intangible assets and their accumulated amortization balance, per segment.

· Gross property, plant & equipment and other tangible assets, and the associated accumulated depreciation balances, per segment.

· The ending and average employee count, per segment.

· The research & development expense, per segment.

· The selling, general & administrative expense per segment.

What about proprietary costs?

The standard pushback to these proposals is that firms do not want to reveal proprietary information about segments, especially the nascent ones, to everyone, in a 10-K. Fair enough. Except that the regulator and the average investor is usually the last to know such information. Competitors can easily hire a senior employee from their peer firm and pay them 50% more to ask about the peer’s strategic plans, if not, about the financials of a specific product. NDAs (non-disclosure agreements) are not enforced in California and are hard to enforce elsewhere. Well-resourced hedge funds will probably mine Linked In or a related database to assess patterns of staff joining specific divisions of companies and even look at early patent filings.

The other pushback I often offer is that barriers to information are less important in today’s world than barriers to imitation. Even if we perfectly unraveled Amazon’s strategy, how many of us have the scale and resources to imitate their strategy?

And, if one were to stretch this proprietary cost argument to an extreme, why ask for even aggregate sales of a company? Couldn’t that disclosure cause proprietary harm to a firm? In essence, completely acceding to the “proprietary” defense will ensure provision of no public disclosure that is meaningful to an investor.

In sum, every investor and concerned citizen might want to worry about the sorry state of segment disclosures in corporate America.