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Related Party Transactions Explained With Simple Examples (and in 10-k’s)

Corporate structures for public corporations can get confusing, between the various affiliates and subsidiaries that a company might hold. Then through ownership stakes into the mix– and potentials for conflict of interest can create questions on legitimacy of some revenues. The disclosure of related party transactions in the 10-k can help an investor understand whether this can be the case.

Related party transactions can include any regular transaction between 2 businesses, but those businesses are affiliated, or “related”, in any way. This can often occur between businesses where ownerships are shared, or when one company is 100% owned by another.

An example of a related party transaction could be several companies involved in the same logistics or distribution chain.

A wholly owned subsidiary could be responsible for packaging, for example, and then sell the packaging to another wholly owned subsidiary who combines raw materials with packaging to create a product, who then sells this product to a parent company, who will sell that product to distributors and/or direct to consumer.

Let’s summarize that example to review it. Here’s an example corporate structure:

  • Parent company “Yummy Soda Inc.”
    • Wholly owned subsidiary “Can Packaging, LLC”
    • Wholly owned subsidiary “Yummy Soda Brands, LLC”
    • Wholly owned subsidiary “Yummy Soda Sales, LLC”

The transaction flow, then, could look something like this:

Can Packaging, LLC (sells to) –> Yummy Soda Brands, LLC (sells to) –> Yummy Soda, Inc. (sells to) –> Yummy Soda Sales, LLC and Direct to Consumer

You should be able to observe parts of this supply chain by examining the packaging of everyday products such as soaps, food, and drinks.

Complex Related Party Transactions and Revenue Legitimacy

To further complicate things, any of the subsidiaries in the example above could be partially owned rather than completely owned, with or without majority ownership (and thus, voting control).

So if a business has a complicated structure between its holding company, various subsidiaries and/or affiliates, and other related parties, it’s very worth it to investigate and understand any related party transactions that may occur (and should be disclosed in a company’s 10-k).

Making matters worse, managements can sometimes use related party transactions to mask revenue problems, or make current revenues sound better than reality.

John Del Vecchio, CFA highlighted an example of this in his book What’s Behind the Numbers with a company called UTStarcom (USTI) in 2004.

This was a company with 80% of revenues in China. Looking to diversify, the company announced a goal to reduce that to 50% by 2006. But an investor keen on understanding the related party transactions outlined in the footnotes to the 10-k would see that even the small part of revenues outside China in 2004 was questionable. As John explained:

“At the time, 15 out of that 20 percent foreign revenues—that is, three quarters of it—was generated in Japan. The majority of that came from BB Technologies, a subsidiary of the Masayoshi Son-controlled investment bank SoftBank. Masayoshi Son was chairman of the board of UTSI beginning in 1995.”

Turned out, there was not enough disclosure about this potential conflict of interest to inform investors on the legitimacy of that revenue. This can concoct doubt to the character of management and its ability to meet shareholder goals.

For UTSI, the company failed to reach their goal in 2006 and the stock dropped catastrophically, from about $26 in 2004 all the way down to $1.43 by 2011.

John goes on to recommend that high proportions of related party revenue compared to total revenues can be a huge red flag, and one that that requires a deep reading into the 10-k footnotes to conclude whether that is the case or not.

An Example of Related Party Transactions Disclosed in a 10-k

Let’s take a chemical company involved in producing plastics, Westlake Chemical Corp ($WLK). Companies in industries where vertical integration becomes a key source of competitive advantage, such as chemical companies or oil companies, can often have complex ownership structures which require an investor to carefully examine those and the transactions underneath them.

A simple search (“ctrl+f”) for “related party” or “parties” can highlight any disclosures. Doing this for $WLK brings up Note 20. Related Party and Affiliate Transactions:

To fully understand some of the terminology embedded in the related party transaction disclosures, it helps to carefully read the Business description on the top of the 10-k, where a company will often describe any complex ownership structures.

From Item 1. Business, $WLK describes (bolded emphasis mine):

“On November 12, 2019, we, through one of our subsidiaries, Eagle US 2 LLC (“Eagle”), completed the acquisition of an additional 34.8% of the membership interests in LACC, LLC (“LACC”) from Lotte Chemical USA Corporation, a subsidiary of Lotte Chemical Corporation (“Lotte”), for approximately $817 million (the “Transaction”). Prior to the Transaction, Eagle owned approximately 12% of the membership interests in LACC. As of December 31, 2019, we owned an aggregate 46.8% membership interest in LACC. The LACC ethylene plant has 2.2 billion pounds per year of ethylene production capacity and is adjacent to our chlor-alkali facility in Lake Charles. During the third quarter of 2019, the LACC ethylene plant began commercial operations. As a result of the Transaction, we will receive our proportionate share of LACC’s ethylene production on a cash-cost basis, which is expected to benefit our integrated downstream operations.”

Ok, now we understand what the company is referring to when they mention LACC, which they also explain in this Note 20 that there’s more information on LACC in Note 9. Parsing through this, you find this gem (bolded emphasis mine):

“The Company accounts for its investment in LACC under the equity method of accounting. The LACC joint venture is a cost-sharing arrangement between the members of LACC. The members of LACC receive their proportionate shares of ethylene offtake each month and fund cash operating costs, excluding depreciation and amortization. As a result, LACC recognizes net losses equal to depreciation and amortization each period. The Company’s equity in losses from LACC, which is equal to its share of depreciation and amortization expenses, is recognized in cost of sales in the consolidated statements of operations. The Company’s investment in LACC is recorded as a component of equity method investments in the consolidated balance sheets. The Company’s capital contributions to fund its share of capital expenditures are classified within investing activities in the consolidated statements of cash flows.”

Included also in this Note 9 is the following table, providing full disclosure on the LACC, LLC venture as it relates to $WLK:

Understanding this particular related party transaction helps the investor understand where a large portion of the company’s Net Cash used for investing activities (-$1,954 million in 2019) was used for, which helps an investor analyze the $WLK’s allocation of capital.

Now that we know that this $817 million (also described in the “Additional interest purchased” line item) added ethylene offtake rights to 2.2 billion pounds of production, we can compare this number with the company’s total ethylene production and estimate a historical ROIC from this production, to determine whether the LACC, LLC transaction was a good use of investor capital or not.

Going back to the Related Party Note (Note 20), we can see that their partially owned subsidiaries/ joint ventures are described, outlining the various impacts to financials.

You can see by skimming the Note that most of these are immaterial, but the note about YNCORIS GmbH & Co KG could be something to watch—as the company discloses that charges of $155 million and $145 million were recorded in 2019 and 2018 as a result of this related party transaction.

Noting this relationship to the company’s total COGS (Cost of Goods Sold), which has been over $6B over the past 3 years, we can determine that the impact of this transaction is probably much less significant than the LACC, LLC transaction—and evaluate its impact to the complete analysis of the company accordingly.

Example of No Related Party Transactions in a 10-k

This next example is a packaging foods company, Hormel ($HRL). I like this example because they manufacture and distribute a wide range of everyday foods that you’ll see in most every grocery store in the United States.

One example of a popular product of Hormel’s is Skippy peanut butter. Another product the company manufactures is Hormel Chili, and I happen to have both in my pantry. Looking at the labels for both products, I can see that both provide the disclosure “Distributed by Hormel Foods Sales, LLC”.

Now let’s go to the company’s 10-k.

From the company’s Business section (Item 1), the parent company is called Hormel Foods Corporation. There’s no mention of “Hormel Foods Sales” in this 10-k, so it’s probably safe to assume that their distribution company is a wholly owned subsidiary, and thus their profits and losses included in the Consolidated financial statements.

Management describes their business in the following way:

The Company is primarily engaged in the production of a variety of meat and food products and the marketing of those products throughout the United States and internationally.

They describe their manufacturing process (also in Item 1) like this:

The Company manufactures its products through various harvest and processing facilities along with custom manufacturers.

And under the Products and Distribution section of Item 1, they mention multiple distribution channels within the U.S. and internationally, as well as a sales force to serve major customers (think the BIG retailers), and independent brokers and distributors.

Obviously the two products I’m using as an example from my home, Hormel Chili and Skippy Peanut Butter, are distributed in-house and those sales are generated from the direct sales force to retailers rather than through an independent distributor (again for the case of these two products). A screenshot of their Products and Distribution explanation:

They also mention “HFIC” which is explained at the very top of Item 1 as Hormel Foods International Corporation, which is their wholly owned subsidiary with joint ventures throughout many various countries and also a part ownership stake in The Purefoods-Hormel Company, Inc in the Philippines.

Through this analysis of the general structure of this large, vertically integrated business—we now have some pretty good insight into the company’s revenue drivers, risks, and other factors that impact profitability and the company’s financial results.

Now to find Related Party Transactions, to see if there’s a piece of this picture that we’ve missed. Doing a search again for “related party”, we get this disclosure in Item 13: Certain Relationships and Related Transactions, and Director Independence:

Information under “Related Party Transactions” and “Board Independence” in the definitive proxy statement for the Annual Meeting of Stockholders to be held January 28, 2020, is incorporated herein by reference.

This means we have to do one more step to find this information, since the company didn’t make it easy for us in this instance. The proxy statement is called DEF 14A and can be found on sec.gov. For Hormel, their proxy statement was released a couple weeks after their 10-k. Clicking on the DEF 14A filed December 18, 2019, we can search for “related party” again to get this explanation:

Well that’s good news, at least in the sense that no further investigation is needed. Though the company has both wholly owned subsidiaries and part ownership stakes (through The Purefoods-Hormel Company), there doesn’t seem to be anything in that ownership structure that could cause questioning on the legitimacy of any revenues from complex related party transactions.

Investor Takeaway

You can see that companies with complex operations in vertically integrated strategies can sometimes have transactions which are murky in the interleaved nature of their businesses.

If these comprise significant aspects of a business, it’s a very worthwhile use of an investor’s time to closely scrutinize any related party transactions and their impacts to financial results.

If something looks extremely complex, it could be for a reason, like famed investor Warren Buffett has said:

“If we read a bunch of public relations gobbledygook, and we see lots of pictures and no facts, it has some effect on our attitude toward the business. We want to understand the business better when we get through the annual report than when we picked it up.”.

But many times companies aren’t trying to fool investors or hide problems, but the inherent nature of how these transactions are recorded could mask true operating results.

It’s just another example of the importance of reading 10-k footnotes carefully, and when something jumps out, to go into a deeper investigation. You don’t necessarily need to read every word when dissecting a 10-k, but know what to look for and how to investigate things further, which is what we try to teach with many of the blog posts on this website.