Posts filed under ‘Accounting’
EBITDA: Sniffing Out the Truth
Financial analysts are constantly seeking the Holy Grail when it comes to financial metrics, and to some financial number crunchers, EBITDA (Earnings Before Interest Taxes Depreciation and Amortization – pronounced “eebit-dah”) fits the bill. On the flip side, Warren Buffett’s right hand man Charlie Munger advises investors to replace EBITDA with the words “bullsh*t earnings” every time you encounter this earnings metric. We’ll explore the good, bad, and ugly attributes of this somewhat controversial financial metric.
The Genesis of EBITDA
The origin of the EBITDA measure can be traced back many years, and rose in popularity during the technology boom of the 1990s. “New Economy” companies were producing very little income, so investment bankers became creative in how they defined profits. Under the guise of comparability, a company with debt (Company X) that was paying high interest expenses could not be compared on an operational profit basis with a closely related company that operated with NO debt (Company Z). In other words, two identical companies could be selling the same number of widgets at the same prices and have the same cost structure and operating income, but the company with debt on their balance sheet would have a different (lower) net income. The investment banker and company X’s answer to this apparent conundrum was to simply compare the operating earnings or EBIT (Earnings Before Interest and Taxes) of each company (X and Z), rather than the disparate net incomes.
The Advantages of EBITDA
Although there is no silver bullet metric in financial statement analysis, nevertheless there are numerous benefits to using EBITDA. Here are a few:
- Operational Comparability: As implied above, EBITDA allows comparability across a wide swath of companies. Accounting standards provide leniency in the application of financial statements, therefore using EBITDA allows apples-to-apples comparisons and relieves accounting discrepancies on items such as depreciation, tax rates, and financing choice.
- Cash Flow Proxy:Since the income statement traditionally is the financial statement of choice, EBITDA can be easily derived from this statement and provides a simple proxy for cash generation in the absence of other data.
- Debt Coverage Ratios:In many lender contracts, certain debt provisions require specific levels of income cushion above the required interest expense payments. Evaluating EBITDA coverage ratios across companies assists analysts in determining which businesses are more likely to default on their debt obligations.
The Disadvantages of EBITDA
While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.
- Overstates Income: To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality by measuring income before a bunch of expenses. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTERaccounting for all expenses, including interest expense, depreciation expense, and income tax expense.
- Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
- Poor for Valuation: Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).
Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Sports & Investing: Why Strong Earnings Can Hurt Stock Prices
With the World Cup in full swing and rabid fans rooting for their home teams, one may notice the many similarities between investing in stocks and handicapping in sports betting. For example, investors (bettors) have opposing views on whether a particular stock (team) will go up or down (win or lose), and determine if the valuation (point spread) is reflective of the proper equilibrium (supply & demand). And just like the stock market, virtually anybody off the street can place a sports bet – assuming one is of legal age and in a legal betting jurisdiction.
Soon investors will be poring over data as part of the critical, quarterly earnings ritual. With some unsteady GDP data as of late, all eyes will be focused on this earnings reporting season to reassure market observers the bull advance can maintain its momentum. However, even positive reports may lead to unexpected investor reactions.
So how and why can market prices go down on good news? There are many reasons that short-term price trends can diverge from short-run fundamentals. One major reason for the price-fundamental gap is this key factor: “expectations”. With such a large run-up in the equity markets (up approx. +195% from March 2009) come loftier expectations for both the economy and individual companies. For instance, just because corporate earnings unveiled from companies like Google (GOOG/GOOGL), J.P. Morgan (JPM), and Intel (INTC) exceed Wall Street analyst forecasts does not mean stock prices automatically go up. In many cases a stock price correction occurs due to a large group of investors who expected even stronger profit results (i.e., “good results, but not good enough”). In sports betting lingo, the sports team may have won the game this week, but they did not win by enough points (“cover the spread”).
Some other reasons stock prices move lower on good news:
- Market Direction: Regardless of the underlying trends, if the market is moving lower, in many instances the market dip can overwhelm any positive, stock- specific factors.
- Profit Taking: Many times investors holding a long position will have price targets or levels, if achieved, that will trigger selling whether positive elements are in place or not.
- Interest Rates: Certain valuation techniques (e.g. Discounted Cash Flow and Dividend Discount Model) integrate interest rates into the value calculation. Therefore, a climb in interest rates has the potential of lowering stock prices – even if the dynamics surrounding a particular security are excellent.
- Quality of Earnings: Sometimes producing winning results is not enough (see also Tricks of the Trade article). On occasion, items such as one-time gains, aggressive revenue recognition, and lower than average tax rates assist a company in getting over a profit hurdle. Investors value quality in addition to quantity.
- Outlook: Even if current period results may be strong, on some occasions a company’s outlook regarding future prospects may be worse than expected. A dark or worsening outlook can pressure security prices.
- Politics & Taxes: These factors may prove especially important to the market this year, since this is a mid-term election year. Political and tax policy changes today may have negative impacts on future profits, thereby impacting stock prices.
- Other Exogenous Items: Natural disasters and security attacks are examples of negative shocks that could damage price values, irrespective of fundamentals.
Certainly these previously mentioned issues do not cover the full gamut of explanations for temporary price-fundamental gaps. Moreover, many of these factors could be used in reverse to explain market price increases in the face of weaker than anticipated results.
If you’re traveling to Las Vegas to place a wager on the World Cup, betting on winning favorites like Germany and Argentina may not be enough. If expectations are not met and the hot team wins by less than the point spread, don’t be surprised to see a decline in the value of your bet.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, GOOG, and GOOGL, but at the time of publishing had no direct positions in JPM and INTC. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Monitoring the Tricks Hidden Up Corporate Sleeves
As Warren Buffett correctly states, “If you are in a poker game and after 20 minutes, you don’t know who the patsy is, then you are the patsy.” The same principle applies to investing and financial analysis. If you are unable to determine who is cooking (or warming) the books via deceptive practices, then you will be left holding a bag of losses as tears of regret pour down your face. The name of the stock investing game (not speculation game) is to accurately gauge the financial condition of a company and then to correctly forecast the trajectory of future earnings and cash flows.
Unfortunately for investors, many companies work quite diligently to obscure, hide, and distort the accuracy of their current financial condition. Without the ability of making a proper assessment of a company’s financials, an investor by definition will be unable to value stocks.
There are scores of accounting tricks that companies hide up their sleeves to mislead investors. Many people consider GAAP (Generally Accepted Accounting Principles) as the laws or rules governing financial reporting, but GAAP parameters actually provide companies with extensive latitude in the way accounting reports are implemented. Here are a few of the ways companies exercise their wiggle room in disclosing financial results:
Depreciation Schedules: Related to GAAP accounting, adjustments to longevity estimates by a company’s management team can tremendously impact a company’s reported earnings. For example, if a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year ($10m ÷ 10 years). If for some reason the Chief Financial Officer (CFO) suddenly changes his/her mind and decides the building should last 40 years rather than 10 years, then the company’s annual expense would miraculously decrease -75% to $250,000. Voila, an instant $750,000 annual gain created out of thin air! Other depreciation tricks include the choice of accelerated or straight-line depreciation.
Capitalizing Expenses: If you were a management team member with a goal of maximizing current reported profitability, would you be excited to learn that you are not required to report expenses on your income statement? For many the answer is absolutely “yes”. A common example of this phenomenon occurs with companies in the software industry (or other companies with heavy research and development), where research expenses normally recognized on the income statement get converted instead to capitalized assets on the balance sheet. Eventually these capitalized assets get amortized (recognized as expenses) on the income statement. Proponents argue capitalizing expenses better matches future revenues to future expenses, but regardless, this scheme boosts current reported earnings, and delays expense recognition.
Stuffing the Channel: No, this is not a personal problem, but rather occurs when companies force their goods on a distributor or customer – even if the goods (or service) are not requested. This deceitful practice is performed to drive up short-term revenue, even if the reporting company receives no cash for the “stuffing”. Ballooning receivables and substandard cash flow generation can be a sign of this cunning, corporate custom.
Accounts Receivable/Loans: Ballooning receivables is a potential sign of juiced reported revenues and profits, but there are more nuanced ways of manipulating income. For instance, if management temporarily lowers warranty expenses and product return assumptions, short-term profits can be artificially boosted. In addition, when discussing financial figures for banks, loans can also be considered receivables. As we experienced in the last financial crisis, many banks under-provisioned for future bad loans (i.e. didn’t create enough cash reserves for misled/deadbeat borrowers), thereby overstating the true, underlying, fundamental earnings power of the banks.
Inventories: As it relates to inventories, GAAP accounting allows for FIFO (First-In, First-Out) or LIFO (Last-In, Last-Out) recognition of expenses. Depending on whether prices of inventories are rising or falling, the choice of accounting method could boost reported results.
Pension Assumptions: Most companies like their employees…but not the expenses they have to pay in order to keep them. Employee expenses can become excessively burdensome, especially for those companies offering their employees a defined benefit pension plan. GAAP rules mandate employers to contribute cash to the pension plan (i.e., retirement fund) if the returns earned on the assets (i.e., stocks & bonds) are below previous company assumptions. One temporary fix to an underfunded pension is for companies to assume higher plan returns in the future. For example, if companies raise their return assumptions on plan assets from 5% to a higher rate of 10%, then profits for the company are likely to rise, all else equal.
Non-GAAP (or Pro Forma): Why would companies report Non-GAAP numbers on their financial reports rather than GAAP earnings? The simple answer is that Non-GAAP numbers appear cosmetically higher than GAAP figures, and therefore preferred by companies for investor dissemination purposes.
Merger Magic: Typically when a merger or acquisition takes place, the acquiring company announces a bunch of one-time expenses that they want investors to ignore. Since there are so many moving pieces in a merger, that means there is also more opportunities to use smoke and mirrors. The recent $8.8 billion write-off of Hewlett-Packard’s (HPQ) acquisition of Autonomy is evidence of merger magic performed.
EBITDA (Earnings Before Interest Taxes Depreciation & Amortization): Skeptics, like myself, call this metric “earnings before all expenses.” Or as Charlie Munger says, Warren Buffett’s right-hand man, “Every time you see the word EBITDA, substitute it with the words ‘bulls*it earnings’!”
This is only a short-list of corporate accounting gimmicks used to distort financial results, so for the sake of your investment portfolio, please check for any potential tricks up a company’s sleeve before making an investment.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in HPQ/Autonomy, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Share Buybacks and Bathroom Violators
We all have our own unique pet peeves that drive us crazy, and I am no exception. More grating than fingernails scraping down the chalkboard or rude drivers who refuse to let you merge lanes are those citizens that unabashedly exercise poor public bathroom etiquette. The only thing worse than listening to the loud-mouth cell phone talker in the neighboring stall is watching a restroom participant move straight from zipper closure (if they remember), immediately to the bathroom exit. I mean really, would it kill you at a minimum to pay a visit to the sink and feign a phantom hand-swipe under some running water? Don’t those people understand that I have to grab the same handle they use to exit the facility after they conduct their bathroom business? OK, now that I have gotten this issue off my chest, I feel better and I can get off my soapbox (no pun intended).
Something Stinks in Share Buyback Land
Beyond potty etiquette, there is another maddening pet peeve that drives me nuts in the realm of corporate capital allocation. I like to call this particular scheme the “empty share buyback.” Those companies that announce the empty share buyback do it with the intention of either getting a quick, short-term jump in stock price, or use the ploy as a way to indirectly line their pockets with future stock and option grants.
Here are a few ways on how the ruse works:
Scheme #1 – The Empty Pump-Fake: In one form or another, here is what the CEO basically says, “We plan to buyback zillions of shares from time to time, based on market conditions, and do not have any set expiration date for the plan.” In other words, the company executives are committing to absolutely nothing, but are hoping to confuse traders into buying shares to temporarily increase the stock price, so management can unload their shares for a swift profit. In actuality the management team is not obligated to purchase one share and may keep the pseudo-share buyback plan in place for years with no benefit to shareholders.
Scheme #2 – The Pocket Swap: Another one of my favorites, I like to call the pocket swap. Management effectively exchanges money from one pocket to the other. Typically management starts off by stating, “We treasure investor feedback, so we have initiated a new program to return capital to our valued shareholders in the form of a share buyback.” What they usually don’t tell investors is that the shares are being purchased (with shareholder money), so the executives can give more shares back to themselves (and a few other fortunate employees). That’s great for them, but what about me?!
At the end of the day, if the management team is truly working for the shareholder, the game is all about reducing the outstanding share count, which thereby increases earnings per share (and better yet free cash flow per share). Despite the recent climb in interest rates, yields are still near multi-decade lows. Corporations are flush with cash after cutting expenses to the bone, delaying hiring, and riding the global recovery wave. For those real investors not trading a position for a few days, weeks, or months, it behooves you to hold management’s feet to the fire to make sure “empty pump-fakes” or “pocket swap” share buybacks are not occurring.
If you have difficulty gauging the integrity of those management teams announcing share buybacks, I have a litmus test that can be used to judge the executive’s true intentions. It’s quite simple – just follow the CEO into the bathroom (same gender required) and see whether they honorably follow bathroom etiquette by washing their hands after completing their duty. Sleuth work can be tricky, but failure in determining the genuine purpose of management’s capital allocation decisions can lead to a share buyback program that will get flushed down the toilet.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Operating Earnings: Half-Empty or Half-Full?
A continual debate goes on between bulls and bears about which earnings metric is more important: reported earnings based on GAAP (Generally Accepted Accounting Principles) or “operating earnings,” which exclude one-time charges and gains, along with non-cash charges, such as options expenses. Bulls generally prefer operating earnings (glass half-full) because they are typically higher than GAAP earnings (glass half-empty), and therefore operating earnings make valuation metrics more attractive. This disparity between earnings choice is even broader over the last few years due to the massive distortions created by the financial crisis – gigantic write-downs at the vast majority of financial institutions and enormous restructurings at non-financial companies.
Options Smoptions
The options expense issue can also become a religious argument, similar to the paradoxical question that asks if God can create a rock big enough that he himself cannot budge? Logic would dictate that operating earnings should adequately account for option issuance in the denominator of the earnings per share calculation (Net Income / Shares Outstanding). As far as I’m concerned, the GAAP method reducing the numerator of EPS (Earnings Per Share) with an expense, and increasing the denominator by increasing shares from option issuance is merely double counting the expense, thereby distorting reality. Reading through an annual report and/or proxy may not be a joyous experience, but the exercise will help you triangulate share issuance estimates to forecast the drag on future EPS.
On a trailing 12-month basis (Sep’09 – Sep’10), Standard & Poor’s calculated reported earnings with about a -9% differential from operating earnings, equating to approximately a 1.5 Price/Earnings multiple point differential (17.8x’s for reported earnings and 16.2 x’s for operating earnings). For the half-glass full bulls, the picture looks even prettier based on 2011 operating earnings forecasts – the S&P 500 index is priced at roughly 13.6x’s the 2011 index earnings value of $95.45.
Forward More Important Than Backwards
As I make the case in my P/E binoculars article, the market is like a game of chess – a good player doesn’t care nearly as much about an opponent’s last moves as he/she cares about the opponent’s future moves. Financial markets operate in the same fashion, future earnings are much more important than prior earnings. From a practical standpoint, GAAP earnings are relatively useless. Market purists can evangelize about the merits of GAAP earnings until they are blue in the face, but the fact of the matter is that investors are whipping prices all over the place based on Wall Street EPS forecasts – based on operating earnings (not GAAP). In many instances, especially throughout much of the financial crisis, operating earnings will more closely align with the cash flows of a company relative to GAAP earnings, but detailed fundamental analysis is needed.
As far as I’m concerned, much of this GAAP vs Non-GAAP earnings debate is moot because both reported earnings and operating earnings can both be manipulated and distorted. I prefer using cash flows (see Cash Flow Statement article) because cash register accounting – the analysis of money coming in and out of a company – limits the ability of bean counters to use smoke and mirror strategies traditionally saved for the income statement. In other words, you cannot compensate employees, do acquisitions, distribute dividends, or buyback stock with GAAP earnings…all these functions require cold, hard cash. The key metric, rather than EPS, should be free cash flow per share. Growth companies with high return prospects should be given some leeway, but if the projects don’t earn a return, eventually cash resources will dry up. When EPS is materially higher than free cash flow per share, yellow flags fly up and I do additional research to understand the dynamics causing the differential.
These earnings-based arguments will likely never get resolved, but if investors focus on bottom-up analysis on individual security cash flows, determining whether the glass is half-empty or half-full will become much easier.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. The trailing 12 month data was calculated by S&P as of 1/19/2011. Forward 2011 operating earnings were calculated as of 1/18/2011. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
EBITDA: Sniffing Out the Truth
Financial analysts are constantly seeking the Holy Grail when it comes to financial metrics, and to some financial number crunchers EBITDA (Earnings Before Interest Taxes Depreciation and Amortization – pronounced “eebit-dah”) fits the bill. On the flip side, Warren Buffett’s right hand man Charlie Munger advises investors to replace EBITDA with the words “bullsh*t earnings” every time you encounter this earnings metric. We’ll explore the good, bad, and ugly attributes of this somewhat controversial financial metric.
The Genesis of EBITDA
The origin of the EBITDA measure can be traced back many years, and rose in popularity during the technology boom of the 1990s. “New Economy” companies were producing very little income, so investment bankers became creative in how they defined profits. Under the guise of comparability, a company with debt (Company X) that was paying interest expense could not be compared on an operational profit basis with a closely related company that operated with NO debt (Company Z). In other words, two identical companies could be selling the same number of widgets at the same prices and have the same cost structure and operating income, but the company with debt on their balance sheet would have a different (lower) net income. The investment banker and company X’s answer to this apparent conundrum was to simply compare the operating earnings or EBIT (Earnings Before Interest and Taxes) of each company (X and Z), rather than the disparate net incomes.
The Advantages of EBITDA
Although there is no silver bullet metric in financial statement analysis, nevertheless there are numerous benefits to using EBITDA. Here are a few:
- Operational Comparability: As implied above, EBITDA allows comparability across a wide swath of companies. Accounting standards provide leniency in the application of financial statements, therefore using EBITDA allows apples-to-apples comparisons and relieves accounting discrepancies on items such as depreciation, tax rates, and financing choice.
- Cash Flow Proxy: Since the income statement traditionally is the financial statement of choice, EBITDA can be easily derived from this statement and provides a simple proxy for cash generation in the absence of other data.
- Debt Coverage Ratios: In many lender contracts certain debt provisions require specific levels of income cushion above the required interest expense payments. Evaluating EBITDA coverage ratios across companies assists analysts in determining which businesses are more likely to default on their debt obligations.
The Disadvantages of EBITDA
While EBITDA offers some benefits in comparing a broader set of companies across industries, the metric also carries some drawbacks.
- Overstates Income: To Charlie Munger’s point about the B.S. factor, EBITDA distorts reality. From an equity holder’s standpoint, in most instances, investors are most concerned about the level of income and cash flow available AFTER all expenses, including interest expense, depreciation expense, and income tax expense.
- Neglects Working Capital Requirements: EBITDA may actually be a decent proxy for cash flows for many companies, however this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated.
- Poor for Valuation: Investment bankers push for more generous EBITDA valuation multiples because it serves the bankers’ and clients’ best interests. However, the fact of the matter is that companies with debt or aggressive depreciation schedules do deserve lower valuations compared to debt-free counterparts (assuming all else equal).
Wading through the treacherous waters of accounting metrics can be a dangerous game. Despite some of EBITDA’s comparability benefits, and as much as bankers and analysts would like to use this very forgiving income metric, beware of EBITDA’s shortcomings. Although most analysts are looking for the one-size-fits-all number, the reality of the situation is a variety of methods need to be used to gain a more accurate financial picture of a company. If EBITDA is the only calculation driving your analysis, I urge you to follow Charlie Munger’s advice and plug your nose.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Fishy Fuld Finances – Repo 105
The truth may set you free, or it may just send you to jail. Right now, Anton Valukas’s high profile 2,200 page report has unearthed a reeking stench surrounding a $50 billion fund shuffling scheme. Our legal system will ultimately determine the fate of Dick Fuld, former CEO of Lehman Brothers, and any potential co-conspirators. Anton Valukas, appointed by the U.S. bankruptcy court to get to the root causes of the largest bankruptcy in history (a 158 year old investment banking institution), spearheaded the year-long investigation.
While most observers have not shed a tear over the grilling of Fuld in the media, onlookers shouldn’t feel sorry for Valukas either. His firm, Jenner & Blocker, was paid $38 million for its troubles in researching the report through January of this year.
Completing the report was a Herculean task. Finishing the report involved narrowing down 350 billion pages of documents (spread across 2,600 systems) down to about 40 million pages, which were supplemented by interviews with more than 250 individuals, according to The Financial Times.
Repo 105 Crash Course
At the heart of the Valukas’s report is a unique accounting gimmick used by Lehman Brothers to conveniently shed billions in assets off its books at opportune times. The scheme distorted the firm’s financial position so Lehman Brothers could appear financially leaner than reality. This controversial practice is called Repo 105 (“repo” is short for “repurchase”). Here’s how it works:
a) The Right Way: In a typical legitimate repurchase transaction, widely used in the banking industry, a financial institution transfers assets (collateral) to a counterparty in exchange for cash. As part of the transaction, the institution that transferred the assets for cash agrees to repurchase the collateral from the counterparty in the future for the original value plus interest. These repurchase agreements are completely valid and function as an excellent short-term liquidity tool for the financial markets. What’s more, the transactions are completely transparent with the associated assets and liabilities in clear view on the publicly distributed financial statements.
b) The Crooked 105 Way: With toxic real estate values plummeting, and Lehman Brothers’ leverage (debt) ratios rising, Lehman executives became more desperate in hunting out more creative methods of hiding unwanted assets off the balance sheet. To satisfy this need, Lehman travelled across the Atlantic Ocean to court the legal opinion of a preeminent law firm, Linklaters, in order to have them sign off on the imaginative Repo 105 practice. Under Repo 105, Lehman pledged assets equaling 105% of the cash received from a counterparty. Based on the Repo 105 design, the transaction was considered a “sale” and therefore wiped Lehman’s balance sheet clean of the assets. Cash temporarily received by Lehman could then be used to pay down debt. Lehman conveniently used this strategy to pretty up the books (“window dressing”) around critical periods when financial results were shared with the public and investors. Shortly thereafter, Lehman would take back the discarded assets for a cash and interest payment (similar to the previously described repurchase agreement).
In a way, this Repo 105 transaction is like a teenage boy selling a Playboy magazine to his friend for cash right before his mom comes home, then agrees to repurchase the magazine from his friend as soon as the boy’s mom goes back to work. Sneaky, but effective…until you get caught.
Where are the Cops?
With the fresh corporate scandal wounds from the likes of Enron, WorldCom, and Tyco (TYC) still healing, a neutral observer might expect the auditors to more responsibly monitor the behavior of questionable client behavior. The death of accounting giant Arthur Andersen (former Enron auditor) was supposed to serve as a poster-child example of what can happen if irresponsible corporate behavior goes unchecked. Apparently Lehman Brothers’ “Big Four” auditor Ernst & Young didn’t learn a lesson from the carnage left behind by its deceased competitor. Not only did Ernst & Young sign-off on these transactions, but their neglect of whistle-blower allegations also serves to land E&Y in very hot water.
Frustratingly, this outcome wouldn’t be the first time a whistle-blower was ignored – Harry Markopolos the Bernie Madoff sleuth was rebuffed multiple times by the SEC (Securities and Exchange Commission) before Madoff confessed his illegal Ponzi scheme crimes. Although the SEC may feel some more heat relating to Lehman’s Repo 105 accounting fallout, the agency may catch a little break since Lehman surreptitiously neglected to disclose any of this controversial accounting trickery.The SEC and multiple state Attorney Generals may investigate Valukas’ findings further to see if civil or criminal charges against Fuld and other Lehman executives are appropriate.
The Ignorance Defense
Will ignorance be an adequate defense for Lehman executives? So far, this tactic appears to be the leading approach of 40-year Lehman Brothers veteran, Dick Fuld. Fuld’s lawyer claims the CEO had no knowledge of Repo 105 “nor did Lehman’s senior finance officers, legal counsel or Ernst & Young raise any concerns about the use of Repo 105 with Mr. Fuld.” The Lehman chief’s supposed unawareness becomes less credible in the midst of smoking emails such as the following one from a senior trader:
“We have a desperate situation and I need another $2 bn [balance sheet reduction] from you either through Repo 105 or outright sales.”
Other executives referred to Repo 105 as a “drug” that they needed to “wean themselves off.” When Bart McDade, a senior Lehman Brothers exec was asked about Fuld’s knowledge regarding the accounting gimmick, McDade had no qualms in explaining Fuld “knew about the accounting of Repo 105.”
The sheer size of these multi-billion dollar off-balance sheet transactions won’t make Fuld’s innocence campaign any easier. I believe when courts discuss values exceeding $50 billion in size, ignorance will not qualify as an excuse you can hide under – even in the context of a company holding net assets of $328 billion in June 2008.
Valukas doesn’t mince any of his words in the report when the conversation moves to Lehman’s objectives:
“The examiner has investigated Lehman’s use of the Repo 105 transactions and has concluded that the balance sheet manipulation was intentional, for deceptive purposes.”
Time will tell how the ultimate judgment will fall upon Dick Fuld and his partnering Lehman Brothers executives, but one need not be a bloodhound to smell the stale fishy odor of Repo 105. Fuld better find some potent breath mints, to quickly fight off the horrible seafood scent, or he might end up as fish bait himself.
Read Financial Times Article on Fuld & Lehman
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position in TYC on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Cash Flow Statement: Game of Cat & Mouse
Much like a game of a cat chasing a mouse, analyzing financial statements can be an endless effort of hunting down a company’s true underlying fundamentals. Publicly traded companies have a built in incentive to outmaneuver its investors by maximizing profits (or minimizing expenses). With the help of flexible GAAP (Generally Accepted Accounting Principles) system and loose estimation capabilities, company executives have a fair amount of discretion in reporting financial results in a favorable light. Through the appropriate examination of the cash flow statement, the cat can slow down the clever mouse, or the investor can do a better job in pinning down corporate executives in securing the truth.
Going back to 15th century Italy, users of financial statements have relied upon the balance sheet and income statement*. Subsequently, the almighty cash flow statement was introduced to help investors cut through a lot of the statement shortcomings – especially the oft flimsy income statement.
Beware of the Income Statement Cheaters
Did you ever play the game of Monopoly with that sneaky friend who seemed to win every time he controlled the money as the game’s banker? Well effectively, that’s what companies can do – they can adjust the rules of the game as they play. A few simple examples of how companies can potentially overstate earnings include the following:
- Extend Depreciation: Depreciation is an expense that is influenced by management’s useful life estimates. If a Chief Financial Officer doubles the useful life of an asset, the associated annual expense is cut in half, thereby possibly inflating earnings.
- Capitalize Expenses: How convenient? Why not just make an expense disappear by shifting it to the balance sheet? Many companies employ that strategy by converting what many consider a normal expense into an asset, and then slowly recognizing a depreciation expense on the income statement.
- Stuffing the Channel: This is a technique that forces customers to accept unwanted orders, so the company selling the goods can recognize phantom sales and income. For example, I could theoretically sell a $1 million dollar rubber band to my brother and recognize $1 million in profits (less 1-2 cents for the cost of the rubber band), but no cash will ever be collected. Moreover, as the seller of the rubber band, I will eventually have to fess-up to a $1 million uncollectible expense (“write-off”) on my income statement.
There are plenty more examples of how financial managers implement liberal accounting practices, but there is an equalizer…the cash flow statement.
Cash Flow Statement to the Rescue
Most of the accounting shenanigans and gimmicks used on the income statement (including the ones mentioned above) often have no bearing on the stream of cash payments. In order to better comprehend the fundamental actions behind a business (excluding financial companies), I firmly believe the cash flow statement is the best place to go. One way to think about the cash flow statement is like a cash register (see related cash flow article). Any business evaluated will have cash collected into the register, and cash disbursed out of it. Specifically, the three main components of this statement are Cash Flow from Operations (CFO), Cash Flow from Investing (CFI), and Cash Flow from Financing (CFF). For instance, let us look at XYZ Corporation that sells widgets produced from its manufacturing plant. The cash collected from widget sales flows into CFO, the capital cost of building the plant into CFI, and the debt proceeds to build the plant into CFF. By scrutinizing these components of the cash flow statement, financial statement consumers will gain a much clearer perspective into the pressure points of a business and have an improved understanding of a company’s operations.
Financial Birth Certificate
As an analyst, hired to babysit a particular company, the importance of determining the maturity of the client company is critical. We may know the numerical age of a company in years, however establishing the maturity level is more important (i.e., start-up, emerging growth, established growth, mature phase, declining phase)*. Start-up companies generally have a voracious appetite for cash to kick-start operations, while at the other end of the spectrum, mature companies generally generate healthy amounts of free cash flow, available for disbursement to shareholders in the form of dividends and share buybacks. Of course, some industries reach a point of decline (automobiles come to mind) at which point losses pile up and capital preservation increases in priority as an objective. Clarifying the maturity level of a company can provide tremendous insight into the likely direction of price competition, capital allocation decisions, margin trends, acquisition strategies, and other important facets of a company (see Equity Life Cycle article).
The complex financial markets game can be a hairy game of cat and mouse. Through financial statement analysis – especially reviewing the cash flow statement – investors (like cats) can more slyly evaluate the financial path of target companies (mice). Rather than have a hissy fit, do yourself a favor and better acquaint yourself with the cash flow statement.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in any security mentioned in this article. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Measuring Profits & Losses (Income Statement)
So far we’ve conducted an introduction to financial statement analysis and a review of the balance sheet statement. Now we’re going to move onto the most popular and familiar financial statement and that is the income statement. One reason this particular financial statement is so popular is because it answers some of the most basic questions, such as, “How much stuff are you selling?” and “How much dough are you making?” With executive compensation incentives largely based off income statement profitability, it’s no surprise this statement is the one of choice. Unlike the balance sheet, which takes a snapshot picture of all your assets at a specific date in time, the income statement is like a scale, which measures gains or losses of a company over a specific period of time.
P&L Motivations
Like a wrestler or an overweight dieter, there can be an incentive to alter the calibration or lower the sensitivity of the financial weight scale. Fortunately for investors and other vested constituents, there are auditors (think of the Big 4 accounting firms) and regulators (such as the Securities and Exchange Commission) to verify the validity of the financial statement measurement systems in place. Sadly, due to organizational complexity, lack of resources, and lackadaisical oversight, the sanctity of the supervision process has been known to fail at times. One need not look any further than the now famous case of Enron. Not only did Enron eventually go bankrupt, but the dissolution of one of the most prestigious accounting firms in the world, Arthur Andersen, was also triggered by the accounting scandal.
Tearing Apart the Income Statement
Determining the profitability of a business through income statement analysis is generally not sufficient in coming to a decisive investment conclusion. Establishing the trend or the direction of profitability (or losses) can be even more important than the actual level of profits. The importance of profit trends requires adequate income statement history in order to ascertain a true direction. Comparability across time periods requires consistent application of rules going back in time. The “common form” income statement (or “percentage income statement”) is an excellent way to evaluate the levels of expenses and profits on an income statement across different periods. This particular format of historical income statement figures also provides a mode of comparing, contrasting, and benchmarking a company’s historical results with those of its peers (or the industry averages alone).
Shredding through the income statement, along with the other financial statements, often creates insufficient data necessary to make informed decisions. Other components of an annual report, such as the footnotes and Management Discussion and Analysis (MD&A) section, help paint a more complete picture. Interactions with company management teams and the investor relations departments can also be extremely influential forces. Regrettably, corporate viewpoints provided to investors are often skewed to an overly optimistic viewpoint. Management comments should be taken with a grain of salt, given the company’s inherent motivation to drive the stock price higher and portray the company in the most positive light.
Tricks of the Trade
One way to achieve profit goals is to improve revenues. If the traditional path to generating sales is unattainable, bending revenues in the desired direction can also be facilitated under the GAAP (Generally Accepted Accounting Principles) rules, or for those willing to risk times behind bars, criminals can attempt to bypass laws.
Due to the flexibility embedded within GAAP standards, corporate executives have a considerable amount of leeway in how the actual rules are implemented. Covering all the shenanigans surrounding income statement exploitation and distortion goes beyond the scope of this article, but nonetheless, here a few examples:
- Customer Credit: The relaxation of credit standards without increasing the associated credit loss reserves could have the effect of increasing short-term sales at the expense of future credit losses.
- Discounts: Offering discounts to accelerate sales is another accounting tactic. Offering price reductions may help sales now, but effectively this strategy merely brings future revenue into the current period at the expense of future sales..
- Adjusting Depreciation: Extending depreciation lives for the purpose of lowering expense and increasing profits may temporarily increase earnings but may distort the necessity of new capital equipment.
- Capitalization of Expenses: This practice essentially removes expenses from the income statement and buries them on the balance sheet.
- Merger Magic: Merger accounting can distort revenues and growth metrics in a manner that doesn’t accurately portray reality. Internally (or organic) growth typically earns a higher valuation relative to discretionary acquisition growth. Although mergers can optically accelerate revenue growth, acquirers usually overpay for deals and academic studies indicate the high failure rate among mergers.
Faux Earnings: Fix or Fraud?
The nature of financial reports has become more creative over time as new and innovative names for earnings have surfaced in press releases, which are not subject to GAAP guidelines. Reading terms such as “core earnings,” “non-GAAP earnings,” and “pro forma earnings” has become commonplace.
In addition, companies on occasion include GAAP approved “extraordinary” charges that are deemed rare and infrequent items. By doing so, income from continuing operations becomes inflated. More frequently, companies attempt to integrate less stringent, non-GAAP compliant, one-time so-called “nonrecurring,” “restructuring,” or “unusual” items. These “big-bath” expenses are designed to build a higher future earnings stream and divert investor attention to the earnings definition of choice. Unfortunately, for many companies, these nonrecurring items have a tendency of becoming recurring. Case in point is Procter & Gamble (PG), which in 2001 had recognized restructuring charges in seven consecutive quarters, totaling approximately $1.3 billion – recognizing these as part of ongoing earnings seems like a better choice. On the flip side, some companies want to include non-traditional gains into the main reported earnings. Take Coca-cola (KO) for example – in 1997 the Wall Street Journal highlighted Coke’s effort to include gains from the sales of bottler interests as part of normal operating earnings.
The review of the income statement plays a critical role in the overall health check of a company. From a stock analysis point, there tends to be an over-reliance on EPS (Earnings Per Share), which can be distorted by inflated revenues (“stuffing the channel”), deferral of expenses (extended depreciation), tax trickery, discretionary share buybacks, and other tactics discussed earlier. Generally speaking, the income statement is more easily manipulated than the cash flow statement, which will be discussed in a future post. Suffice it to say, it is in your best interest to make sure the income statement is properly calibrated when you perform your financial statement analysis.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing had no direct positions in PG, KO or other securities referenced. References to content in Financial Statement Analysis (Martin Fridson and Fernando Alvarez) was used also. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Balance Sheet: The Foundation for Value
Let’s talk balance sheets… how exciting! Most people would rather hear nails scratching against a chalkboard or pour lemon juice on a fresh paper-cut, rather than slice and dice a balance sheet. However, the balance sheet plays a critical role in establishing the foundational value of a business. As part of my financial statement analysis series of articles, today we will explore the balance sheet in more detail.
It’s not just legendary value investors like Warren Buffett and Benjamin Graham who vitally rely on a page filled with assets and liabilities. Modern day masters like Bill Ackman (CEO of Pershing Square Capital Management LP – read more about Bill Ackman) and Eddie Lampert (CEO of Sears Holdings – SHLD) have in recent years relied crucially on the balance sheet, and specifically on real estate values, when it came to defining investments in Target Corporation (TGT) and Sears, respectively.
Balance Sheet Description
What is the balance sheet? For starters, it is one of the three major financial statements (in addition to the “Income Statement” and “Cash Flow Statement”), which provides a snapshot summary of a company’s assets, liabilities, and shareholders’ equity on a specific date. One of the main goals of the balance sheet is to provide an equity value of the corporation (also called “book value”).
Conceptually the balance sheet concept is no different than determining the value of your home. First, a homeowner must determine the price (asset value) of the house – usually as a function of the sales price (estimated or actual). Next, the mortgage value (debt) is subtracted from the home price to arrive at the value (equity) of the homeowner’s position. The same principle applies to valuing corporations, but as you can imagine, the complexity can increase dramatically once you account for the diverse and infinite number of potential assets and liabilities a company can hold.
Metrics
Many key financial analysis metrics are derived directly from the balance sheet, or as a result of using some of its components. Here are a few key examples:
- ROE (Return on Equity): Derived by dividing the income from the income statement by the average equity value on the balance sheet. This indicator measures the profitability of a business relative to shareholders’ investments. All else equal, a higher ROE is preferred.
- P/B (Price to Book): A ratio comparing the market capitalization (total market price of all shares outstanding) of a company to its book value (equity). All else equal, a lower P/B is preferred.
- Debt/Equity or Debt/Capitalization: These ratios explain the relation of debt to the capital structure, indicating the overall amount of financial leverage a company is assuming. All else equal, lower debt ratios are preferred, however some businesses and industries can afford higher levels of debt due to a company’s cash flow dynamics.
There are many different ratios to provide insight into a company, nonetheless, these indicators provide a flavor regarding a company’s financial positioning. In addition, these ratios serve a valuable purpose in comparing the financial status of one company relative to others (inside or outside a primary industry of operation).
Balance Sheet Shortcomings
The balance sheet is primarily built upon a historical cost basis due to defined accounting rules and guidelines, meaning the stated value of an asset or liability on a balance sheet is determined precisely when a transaction occurs in time. Over time, this accounting convention can serve to significantly understate or overstate the value of balance sheet items.
Here are a few examples of how balance sheet values can become distorted:
- Hidden Assets: Not all assets are visible on the balance sheet. Certain intangible assets have value, but cannot be touched and are not recognized by accounting rules on this particular financial statement. Examples include: human capital (employees), research & development, brands, trademarks, and patents. All these items can have substantial value, yet show up nowhere on the balance sheet.
- Lack of Comparability: Comparability of balance sheet data can become fuzzy when certain accounting rules and assumptions are exercised by one company and not another. For instance, if two different companies purchased the same property, plant, and equipment at the same time and price, the values on the balance sheets may vary significantly in the future due to the application of different depreciation schedules (e.g., 10 years versus 20 years). Share repurchase is another case in point that can alter the comparison of equity values – in some cases resulting in a negative equity value.
- Goodwill & Distorted M&A Values: Companies that are active with mergers and acquisitions are forced to reprice assets and liabilities upwards and downwards (inflation, or the lack thereof, can lead to large balance sheet adjustments). Goodwill (asset) is the excess value paid over fair market value in an acquisition. Goodwill can be quite substantial in certain transactions, especially when a high premium price is paid.
- Write-offs and Write-ups: In 2001, telecom component maker JDS Uniphase (JDSU) slashed the value of its goodwill by a massive $44.8 billion. This is an extreme illustration of how the accounting-based values on the financial statement can exhibit significant differences from a company’s market capitalization. Often, the market value (the cumulative value of all outstanding market-priced shares) is a better indicator of a company’s true value – conceptually considered the present value of all future cash flows.
Some balance sheets are built on shaky foundations. A risky, debt-laden balance sheet can resemble a shoddy home foundation built on sand, along an earthquake fault-line. In other words, a small shock can lead to financial collapse. In the credit-driven global bubble we are currently working through, many companies that were built on shaky foundations (i.e., a lot of debt) are struggling to survive. Survival may be dependent on a company restructuring, selling assets, paying down debt, merging, or other tactic with the aim of shoring up the balance sheet. Using the balance sheet value of a company in conjunction with the marketplace price of the same business can be a valuable approach in establishing a more reliable valuation. Before you make an investment or valuation conclusion about a company, do yourself a favor and dig into the balance sheet to verify the condition and soundness of a company’s financial foundation.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct positions in TGT, SHLD, or JDSU. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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