by Amit Kumar
LEAP and PCS were highly leveraged with a debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio of more than 5.0; their continued losses could quickly lead them to breach their covenant limit of 6–7. While liquidity issues and short-term capital needs did not seem imminent, LEAP and PCS would eventually need to access capital markets and borrow at an even higher rate than their current borrowing rates of 9–10 percent to avoid a disruption in their growth plans.
I had just started my independent research consulting firm in 2009 and published my first short thesis on these two wireless carriers. The biggest risk to my thesis was a merger between LEAP and PCS. After spending four years in bankruptcy prior to 2004, both carriers had been under constant speculation to merge. They had revenue synergies arising from complementary geographies in Las Vegas, Philadelphia, and parts of Chicago, as well as cost synergies from intercarrier agreements. PCS had offered to buy out LEAP in the past, and a merger announcement posed the biggest risk to shorting them.
How Did It Play Out?
On May 28, 2009—much earlier than I had expected—LEAP announced that it would sell 6.1 million shares to raise $240 million and refinance $1.1 billion of loans. LEAP shares declined ~6 percent to $38.74 per share. PCS did not trade down on this news; however, PCS missed its second-quarter estimates in its earnings release on August 6, 2009, and its stock dropped 30 percent to $9 per share. LEAP announced earnings on the same day, reporting higher than expected losses and subscriber churn. LEAP fell 25 percent to $17 per share on the news.
Their shares continued to decline despite repeated merger and acquisition rumors over the next three years, and their poor operating performance outweighed the value of their spectrum. Eventually, T-Mobile announced a reverse merger with PCS in 2012 and AT&T announced that it would acquire LEAP in 2013 for $15 per share in cash.
CASE STUDY:
CHICKEN AND EGG (CHEGG)
One of my clients asked me to look at an upcoming IPO, Chicken and Egg (CHEGG), in late 2013. CHEGG buys textbooks, rents them for two to three years, then depreciates the cost of these books over three years. The company turns around and rents these books at 20–30 percent of the original cost per semester. Essentially, CHEGG could break even in less than 3 years and make 10–15 percent annualized returns on average for its textbook investments.
CHEGG had a subscribed user base of 418,000 students, which is a nearly 10 percent market share of U.S. college students. CHEGG had room to grow its market share by extending its reach. The other source of growth came from bulking up the textbook inventory itself, which would in turn increase their total transaction volume. The company had increased its capital expenditure on buying books by 40 percent to $104 million, and it still had some room to increase the spending to their prior peak spending in 2011 of $134 million. In short, CHEGG seemed to have a poor business model that was capital intensive and generated low returns.
At $213 million in revenue and $23 million in EBITDA, the IPO would occur at an implied valuation of 5× sales and 25× EBITDA based on midpoint of indicative pricing. It seemed expensive at first glance, despite its growth opportunities in e-books and others. I recommended against my client participating in the IPO; however, I recognized a key risk to my thesis.
The only risk I saw with betting against CHEGG was that its business model lends well as a target acquisition to the likes of Amazon, who can extract more value out of the business model by utilizing their efficient logistics operations and technology platform. That said, it was hard to imagine a bid from Amazon on the day of CHEGG’s IPO.
CHEGG’s IPO was not very successful, falling 25 percent on IPO and continuing to fall another 30 percent over next six months.
Takeaway
Broken growth stories can clearly point out issues with growth and growth drivers, profitability, and near-term negative catalysts and events. Takeover is the leading risk with shorting stocks.
Recap
• Companies may suffer significant blows to their business model, which may be irreparable. For example, their growth story may be broken as a result of disruptive products, competition, or the value of their business being on a structural decline.
• The collapse in the subprime mortgage market permanently changed the business model of the financial services industry, and demand for related securitized products collapsed. Tightening credit cycles and tougher regulations ensued, suppressing profitability in the financial sector.
• Disruptive technologies and structural changes in industry growth, competitive landscape, and regulations can severely destroy the value of a once-successful business.
• Broken growth stories can clearly point out issues with growth and growth drivers, profitability, and near-term negative catalysts and events. Takeover is the leading risk with shorting stocks.
4
Recipes for Cooked Books
Accounting Misstatements and Shenanigans
The least initial deviation from the truth is multiplied later a thousandfold.
—ARISTOTLE
FINANCIAL ACCOUNTING IS THE LANGUAGE of both private and public companies. Companies often use poetic license to infringe on elements of accounting rules. Their intention or lack of intention behind minor misstatements or outright misrepresentations can be hard to determine ex-post for the jury and even harder to determine ex-ante for investors. However, it is possible for investors to analyze the often-misused accounting methods and assumptions to detect early warning signs.
This chapter assumes that readers are familiar with basic accounting concepts and generally accepted accounting principles (GAAP). GAAP relies on the premise that accrual accounting provides more useful information than cash accounting. Unlike cash accounting, accrual accounting is based on the concept of revenue recognition and matching revenues with expenses in an accounting period. Accrual accounting allows management to make reasonable assumptions on how and when to record these revenues and expenses.
Accounting principles allow management to make assumptions on many other transactions, such as classifying investment assets, testing goodwill impairment, choosing depreciation methods, estimating the life of depreciable assets, reporting liabilities off the balance sheet, and so on. We saw earlier how AIG chose to price its investments based on its own assumptions as opposed to the prevailing market prices of comparable assets.
More importantly, accounting guidelines allow management considerable latitude in making changes to their assumptions and frequent changes at times. Consequently, management can make ad-hoc decisions regarding changes in their accounting assumptions which may not necessarily be triggered by changes in accounting standards or changes in the way their company conducts business. In certain cases, management can switch to more favorable assumptions to improvise their financial and operating metrics and paint a better picture of their company’s financial health and future prospects. We will look at some of the common recipes for cooked books in this chapter.
Key Reasons Behind Financial Restatements
The most common reasons behind restatements include revenue recognition, expense overstatement or understatement, misclassifications, mergers and acquisitions, restructuring, and derivatives accounting. Companies can misclassify items in any or all of the three key financial statements. For example, a company may state an operating cash outflow item as financial cash outflow on the cash flow statement, misclassify a capital asset lease as an operating lease, or misclassify gain from a sale as revenue.
In its 2002 report, “Financial Statement Restatements,” the U.S. General Accounting Office (GAO) reported that more than 50 percent of accounting restatements made between 1997 and 2002 resulted from improper revenue and cost accounting. Four years after the 2002 enactment of the Sarbanes-Oxley Act, the GAO reported that 55 percent of the restatements between 2002 and 2005 resulted from revenue and cost improprieties.1
Companies are forced to restate their financial statements after these accounting i
mproprieties are discovered by internal or external parties. The restating company stands to suffer permanent damage to its stock price and reputation, and it may even cause its competitors to face loss of confidence and increased scrutiny from investors.
Changes in Assumptions Can Be the Most Critical Warning Signs
Investors can detect accounting issues by paying attention to unusual assumptions and changes in assumptions used in reporting financial statements. For example, a bank can decide to change its time period assumptions to redefine nonperforming assets, or a company can choose to report a large normal loss as a one-time extraordinary loss based on the assumption that the loss is unlikely to occur again. Accounting issues can only be uncovered by the old-fashioned way of scrutinizing financial statements, so let us take a look at some common accounting assumptions that affect the operating metrics and profitability of a company. Changes and anomalies in the assumptions can often point to early warning signs.
How Is the Revenue Booked?
Sell-in versus sell-through: When companies sell their products through indirect channels such as distributors and retailers, sell-in can allow companies to book revenues early. For example, Incyte decided in 2012 to recognize revenues when the pharmacy received its product (sell-in) versus when the pharmacy sent its product to the patient (sell-through).2
Revenues versus deferred revenue: When companies record customer advances as deferred revenues and recognize them as revenue over the estimated product life, shorter life assumptions allow companies to book revenues early. For example,3 Apple assumed a 24-month product life for its devices until 2009 when it elected to adopt changes to revenue recognition standards for multiple deliverables. Consequently, Apple could book a substantial portion of device revenues at the time of sale.
Sale-type lease versus operating lease: When companies offer customers the option to lease their products, they commonly record the leases as operating leases or sales-type leases. A sales-type lease allows companies to record a higher gain and lower assets at the time of sale because they can lower their cost of goods by the estimated residual value. For example, Tesla announced a lease financing program for electric cars in 2013, with a guaranteed resale value higher than that of any other luxury sedan.4 High resale value could allow Tesla to book higher profits.
How Are Expenses Classified?
Cost of goods (LIFO versus FIFO inventory accounting): When companies sell inventory, they can choose the last-in/first-out (LIFO) or first-in/first-out (FIFO) method to record the cost of goods sold. Companies disclose any related LIFO reserves and do not change their choice of inventory accounting without prior notification to investors. FIFO accounting allows companies to record a lower cost of goods during periods of rising inventory costs as compared to LIFO.
Capital lease versus operating lease: When companies record long-term leases on real estate, vehicles, and other major assets as operating leases, they do not record a related financial obligation on the balance sheet, unlike capital leases. Operating leases allow companies to post better returns on capital. The Financial Accounting Standards Board is considering an overhaul to lease accounting that would mandate lessees to recognize assets and liabilities for leases of more than one year.5 We saw an example of this in chapter 3 when Office Depot chose operating lease accounting for its long-term leases.
Sales and marketing costs versus deferred acquisition costs (similar to operating expense versus capital expenditures): When companies aggressively spend on sales and marketing or pay large upfront commissions to selling agents or brokers, they can choose to capitalize such expenses as deferred costs and amortize them over a longer period. This allows them to lower and smooth their expenses. For example, insurance companies amortize deferred costs based on their estimate of gross profits on an insurance contract.
Do Balance Sheet Items Adequately Provision for Losses and Write-Downs?
Inventory (raw material price): When the pricing of its product is tied to commodity prices, a company needs to perform an impairment test in the wake of falling commodity prices and may be required to increase reserves or write-down inventories. For example, gold miners and fertilizer producers have had to write down inventories amid falling prices.
Inventory (market price): Management has a lot of discretion over the timing of impairment tests and the estimation of inventory reserves. This can also allow management to write up new or used inventory. Companies tend to build up excess inventory when they anticipate the success of a new product launch; however, the value of inventory would need to be written down if sales fail to meet expectations and the company begins offering steep discounts. For example, Skechers built excess inventory of their hot-selling Shape-Ups in 2010 and did not recognize the problem of excess inventory for more than a couple of quarters.6
Accounts receivable: When a company derives significant sales from a few customers, provides financing to buy its products, or collects cash a few months after delivering a product or service, it would need to increase the allowance for bad debts when their customers face deteriorating business or credit conditions. While the company itself may have a good credit standing, it is vulnerable to tightening credit conditions for its customers as well. For example, the Circuit City bankruptcy in 2008 led Garmin to increase their allowance for bad debt expense.7
Goodwill and intangible assets: When companies complete mergers or acquisitions, they record the amount they paid in excess of fair value for their target as goodwill and other intangibles. Higher goodwill and intangibles allow companies to understate book value of equity and report higher returns on equity, and also allow management to overpay for acquisitions when organic growth is hard to come by. Goodwill and intangibles are subject to impairment tests just like inventories, and management usually writes them down when mergers prove disastrous. For example, HP blamed accounting improprieties at Autonomy prior to its acquisition of Autonomy to write down related $8.8 billion of goodwill and intangibles in 2012.8
Deferred tax assets and liabilities: Companies can make different assumptions for certain accounting items when they report to tax authorities versus investors; the resulting temporary differences may not reverse in the near future. Growth companies may assume accelerated depreciation for fixed assets and keep deferring more tax expenses. However, deferred tax liabilities begin to reverse once growth disappears and have a negative impact on the book value of equity. We saw an example of this in chapter 3, when Carpetright’s deferred tax liabilities of £28 million were at risk of becoming a liability in the absence of sales growth and increase in capital expenditures.
Do Balance Sheet Items Represent Fair Market Values?
Investment assets (historical cost versus marked-to-market): Companies can choose to record their investment assets at historical costs (held-to-maturity) or mark them to market (classified as available for sale and trading). A held-to-maturity classification allows companies to avoid reporting changes in the market value of their assets. For example, when commercial banks underwrite loans, they can record them as held-to-maturity assets (also called loan-book). They can reclassify these loans as available for sale or trading assets (also called trading-book) to lower their regulatory capital requirement.
Fair-value hierarchy of assets and liabilities (levels 1, 2, and 3 inputs): When companies report the fair value of assets and liabilities, they can use market quotes for identical assets (level 1 input), similar assets (level 2 input), or use their own assumptions, which are not observable in the market (level 3 inputs). We saw an example of this in chapter 3 when AIG (and other financial institutions) chose to report the value of certain liabilities and assets based on financial models that used their own input assumptions.
Off-balance sheet items and contingent liabilities: Companies may not report certain contractual commitments, derivative-related liabilities, and other contingent liabilities on the balance sheet but disclose them separately. For example, Disney had contractual commitments of $42.8 billion to
buy broadcast rights for sports in 2012. Banks may have an untapped line of credit as contingent liabilities.9 Manufacturing and mining companies may not have accrued liabilities for pending environmental damage complaints.
Litigation and damages: Regulators can file charges on companies for a variety of reasons, such as antitrust issues, consumer fraud, and foreign bribery. In other cases, courts may issue adverse verdicts and find companies liable for related damages. In both cases, companies may choose not to make provisions for damages in their financial statement and appeal their cases, wherein the appeals process may take months or years to complete. For example, the jury found Marvell Technology liable for $1.17 billion in a patent infringement lawsuit brought by Carnegie Mellon University; however, Marvell decided to challenge the verdict and not accrue related liabilities.10 In a different case, the U.S. Department of Justice sued Standard & Poor (S&P) for $5 billion in damages for fraud in rating Mortgage Backed Securities (MBS) while S&P decided to defend itself and not accrue any reserves for the litigation.
Are Other Financial Statements Diverging from Income Statements?
Net income versus cash flow from operations: As companies mature in their growth cycle, net income and cash flow from operations begin to converge as depreciation expenses and working capital needs stabilize. Wide variations between net income and cash flow from operations merit a closer look at the noncash items that are behind the divergence.