Short Selling

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Short Selling Page 9

by Amit Kumar


  Net income versus other comprehensive income: Net income and other comprehensive income are like left and right pockets of the company financials. Companies can choose to present components of net income and comprehensive income in a continuous statement or as separate items. Companies usually report unrealized gains and losses on hedges, available-for-sale investment assets, adjustments for pension plans, and foreign exchange translation gains and losses in comprehensive income. In particular, banks are in the business of trading securities, and any related gains and losses merit a closer look.

  Takeaway

  Revenue and expense assumptions impact profitability. Companies may not adequately provision for losses in both cash and noncash balance sheet items. Off-balance sheet commitments can hide leverage.

  Next Step: Do the Operating Metrics Pass the Smell Test?

  Operating metrics related to profit margins, returns, liquidity, turnover, and leverage are good measures to check a company’s pulse. These ratios can understate or overstate the operating performance of a company and may often need to be adjusted to show a clearer picture of the company’s performance.

  Profit Margins

  Gross margins versus operating margins: Companies can choose to classify certain expenses related to depreciation or employee wages as part of the inventory costs. When companies decide to reclassify such expenses, the resulting margins may not be comparable to prior-year margins. Margins would need to be adjusted for reclassification in such a case. In other cases, companies may shift to licensing or franchising models, which shift the cost of inventory to the licensee and allows the company to boost operating margins. Companies disclose their system-wide sales, including franchise sales and license fees, which can be used to adjust the overall sales and margins, and examine if franchising is accretive to margins.

  Returns

  Return on capital or net income/invested capital: This is an important metric to measure the economic value generated by a company. Companies may destroy economic value when their returns fall short of their cost of capital. As we saw in the case of operating leases, companies can move assets off-balance sheet or outsource production to overstate their return on capital. When it is not possible to adjust for off-balance sheet items, we can look at comparable companies to see if the returns are abnormally high or low.

  Return on equity or net income/equity: This can be analyzed using the DuPont model (Return on equity = Net income margin × Asset turnover × Leverage) to determine the contribution of profit margins, operating leverage, and financial leverage to overall returns. Companies often tend to overpay for growth and margin accretion during acquisitions and record overpayments as goodwill on the balance sheet. Goodwill allows the company to overstate equity and understate leverage. We can use tangible equity or book value adjusted for goodwill to examine if acquisitions mask poor past returns.

  Liquidity or Ability to Service Short-Term Debt

  Cash ratio (or cash/current liabilities): This is the most conservative measure of liquidity and excludes accounts receivable and inventories, which may not be readily converted into cash. When companies become unprofitable or incur heavy debt, their liquidity needs are closely tied to payables and debt maturity schedules. Companies can resolve liquidity issues by securitizing their accounts receivable, negotiating payment terms with suppliers, and tapping lines of credit or capital markets. Cash ratio and cash conversion cycle trends are prognostic indicators of impending liquidity issues.

  Turnover

  Receivables turnover and inventory turnover: These trends can help detect unusual build-up in inventory and channel-stuffing issues. Consumer and industrial companies can ship extra inventory to distribution channels and inflate revenues—a practice known as channel stuffing. As previously discussed, companies often end up marking down receivables and inventories when they are not able to move channel inventory or make cash collections.

  Leverage

  Interest coverage ratio, debt/EBITDA, and debt/equity: Companies are usually required to comply with debt covenant requirements for these three key ratios. Credit agreements can be complicated if they involve multiple loan tranches or when debt is secured by collateral such as company assets. When a company’s debt service ratio is precariously close to covenant requirements, the company can possibly enter the zone of insolvency by defaulting on loans, accruing interest payments, or filing for bankruptcy. Poor ratios can raise alarms about credit issues and merit a detailed credit analysis of the company.

  Takeaway

  Operating metrics related to profit margins, returns, liquidity, turnover, and leverage are good measures to check a company’s pulse. Trends in these metrics can provide early indications of an impending issue.

  Look for Trends in Industry-Specific Metrics

  Companies disclose industry-specific metrics to provide a better picture of operating performance to their investors. These metrics can allow investors to make better comparisons with other companies in the industry. Industry metrics are usually based on actual numbers; however, they can be based on management estimates as well. Examples include bank nonperforming assets (NPAs), such as nonaccrual loans, impaired loans, and restructured loans. Management may not place certain consumer or credit card loans in nonaccrual status prior to charging them off. We can examine if banks are reporting lower NPAs in comparison to NPAs during past recessions. NPAs provide early clues of a downturn when the credit cycle begins to tighten.

  We saw earlier that similar assumptions on revenue recognition can impact even the most basic revenue drivers, such as unit price and volume shipped. If we assume that timing issues related to management assumptions will smooth out over longer periods, we can examine cyclical trends in these industry-specific metrics. Table 4.1 summarizes the commonly watched industry metrics that can provide more information on business cycle trends.

  Which Operating Metrics Drive Executive Compensation?

  Executive compensation can be tied to GAAP metrics such as earnings per share (EPS) and operating margins, as well as non-GAAP metrics, such as the industry-specific metrics. Why is it important to pay attention to these metrics? As we saw in the case of Office Depot, the board set a low bar by tying management incentives to positive EBITDA. In addition, the board guaranteed bonuses to key executives upon approval of preferred share conversions in BC Partners’ private investment in public equity transaction that triggered change of control provisions in executive employment contracts.

  Executives will likely pursue strategies and decisions that are favorable to the operating metrics driving their performance targets and bonuses. For example, when the board ties incentives to return on invested capital, management may choose to enter sale leaseback transactions to divest assets and lighten the capital base. In other cases, executives may choose to outsource production if their incentives are tied to gross margins.

  Performance targets for these metrics can provide insight into the strategies that the management is likely to pursue. However, boards can also set vague performance targets that are tied to qualitative factors and one or more of thirty metrics. In such cases, it is harder to gauge management’s motivation to pursue one important strategy versus another.

  Table 4.1

  Key industry-specific metrics

  Industry sector

  Key metrics

  Airlines

  Available seat miles, load factor

  Banks

  NPAs, capital ratios, net interest margins (NIMs), asset quality metrics

  Energy and mining

  Cash production costs, reserves, and reserve replacement ratio

  Hotels and restaurants

  Revenues per available room (RevPAR), occupancy rates, average daily rate; restaurants disclose average ticket size, volumes other than retail metrics

  Industrials

  Order book, backlog, book-to-bill ratios, capacity utilization

  Insurance companies

  Claims and expense ratio, statutory s
urplus, investment asset quality metrics

  Media and telecom

  Net additions, ARPU, churn (subscription businesses disclose similar metrics)

  Refiners

  Crack spread, WTI-Brent crude oil spread, plant utilization

  REITS

  Occupancy, rent per square foot, cap rate, releasing spread, free funds flow

  Retailers

  Same-store sales or like for like (LFL); also comparable store sales or comps, store openings and closures

  Source: Artham Capital Partners LLC.

  Are There Any Unusual Financial Transactions?

  Companies can sometimes enter special transactions such as securitizing their accounts receivable, setting up special leasing companies to sell their products, and making transformational acquisitions. Such transactions may alter the company’s business model, and it is important to pay attention to the impacted operating metrics.

  It is even more important to pay attention to special financial transactions, such as when a company issues debt to make special dividend payments to its shareholders or when a company does a reverse stock split to attract institutional investors. Such transactions may simply turn out to be financial gimmicks and do nothing to improve operating performance in the least.

  Uncovering Accounting Problems Is Only Half the Battle

  As we have seen in this chapter, companies may make unreasonable assumptions or engage in financial shenanigans to overstate operating performance or understate financial risks. In more extreme cases, management can cover up business problems by misstating financial statements or making frequent business acquisitions. However, uncovering such accounting issues is only half the battle.

  The other half lies in finding issues with the business model; not all accounting issues end up in frauds and bankruptcies. In August 2013, I was asked by a client for my opinion on Precision Castparts (PCP), which had been recommended as a potential short by an accounting forensic company—primarily because of PCP’s accounting treatment of inventory reserves. PCP recorded 95 percent of its inventories on a LIFO basis, and some analysts believed that the carrying value may be high. The LIFO costing method matches the current costs with current sales, and it could allow PCP to boost EPS by using low prevailing metal prices.

  Average prices for key metal inputs (nickel, titanium, and cobalt) had declined 20–40 percent in the last couple of years and the raw materials portion of PCP’s inventory has grown from $437 million to $903 million during that period. PCP’s recent acquisition of TIMET had added a total $778 million of inventory at fair value, of which approximately $200 million was raw materials. Therefore, approximately $270 million of PCP’s inventory ($903 million − $437 million − $200 million) could be subject to 20–40 percent write-down, which translated to a maximum of $80 million of one-time inventory write-downs. PCP had a market capitalization of approximately $30 billion, so this write-down seemed too low to cause a significant dent to the EPS or stock price.

  While PCP’s cyclically high margins, near-term issues related to Boeing 747, and a possible macroeconomic downturn could make a case for tactical shorting, PCP did not seem to be structural short or a long-term short for several reasons. Commercial aviation market recovery and continued increase in Boeing 787 production rates were tailwinds to PCP’s organic growth. PCP sells more than $10 million of content for every 787, Boeing’s new and fast-growing airplane model, making it hard to question management’s outlook for organic growth. I recommended against short selling PCP.

  CASE STUDY:

  DIAMOND FOODS (DMND)

  When Off Wall Street noticed issues with Diamond’s accounting treatment of its prospective “momentum payment” paid to walnut growers in 2011, it suspected that Diamond was overstating profitability by trying to book the payment as a one-time integration cost. Diamond, a walnut cooperative, paid its growers 10–15 percent less than fair market price for walnuts. As purchase agreements with walnut suppliers signed at the time of the IPO expired, DMND risked losing suppliers and decided to make up for it with a one-time payment. The business problem at the root of this accounting problem prompted Off Wall Street to look for other issues with the business model.

  Diamond appeared to be losing its dominant position in the walnut industry. As a result, its business model was deteriorating and its profitability was under pressure. Management understood the problem and was trying to diversify and grow its business through acquisitions. However, their latest announcement to acquire Pringles bore integration risks. Pringles also had weak growth prospects as a small player with a mature product in a very competitive snack market dominated by Frito-Lay. Earnings estimates appeared too high as well.

  How Did It Play Out?

  Diamond stock fell more than 80 percent to $14 as the Pringles deal fell through and the company struggled to repair its reputation after restating its financials.

  Source: Off Wall Street.

  Recap

  • Start with key accounting assumptions to detect warning signs

  Revenues

  Sell-in versus sell-through

  Revenues versus deferred revenue

  Sale-type lease versus operating lease

  Expenses

  Cost of goods (LIFO vs. FIFO inventory accounting)

  Capital lease versus operating lease

  Sales and marketing costs versus deferred acquisition costs

  Balance sheet items

  Inventory (effect of market price and raw material cost)

  Accounts receivable

  Goodwill and intangibles

  Deferred tax assets and liabilities

  Investment assets classification

  Investment assets fair market value assumptions

  Off-balance sheet liabilities

  Divergence between income statement and other statements

  Key metrics, executive compensation, and unusual activities

  Gross and operating margins

  Returns on capital and equity

  Cash ratio, cash conversion cycle, and free cash flow

  Receivable and inventory turnover ratios

  Debt covenant metrics and other leverage ratios

  5

  The World Is Going to End

  It’s a recession when your neighbor loses his job; it’s a depression when you lose your own.

  —HARRY S. TRUMAN

  ON BLACK WEDNESDAY (September 16, 1992), George Soros’s Quantum fund made over $1 billion on his short bet on the British pound. Soros bet that the pound would pull out of the European Exchange Rate Mechanism (ERM). Germany was raising interest rates to combat inflationary pressures after reunification with East Germany, while the United Kingdom reeled from a recession.1

  The United Kingdom was a weak link in the ERM. Soros saw that rates would continue to diverge and force the Bank of England to abandon the ERM and devalue the pound. Nearly twenty years later, the Euro, the unified European currency, faced a similar fate as Portugal, Ireland, Greece, and Spain proved to be the weak links. These countries went out of step with target debt and deficit levels for Eurozone nations, heightening fears that the Euro could break up.

  During these economic crises, successful investors often said, “All correlations go to one during crisis.” Simply put, there is no place to hide during a crisis. You cannot avoid losses by switching from stocks to bonds, bonds to currencies, speculative stocks to defensive stocks, or junk bonds to investment-grade bonds. Even your cash in the bank may be unsafe during a systemic banking crisis.

  While you struggle to cut losses with the sky falling and bears growling on television, you cannot help but notice the schadenfreude among smart investors and some lucky ones who actually made windfall profits from the crisis. You realize that these investors had either shorted the market (stocks, bonds, currencies, derivatives, etc.) or bought some form or another of crisis insurance, such as put options, credit default swaps (CDSs), and other complex derivatives.

  While you can make profit
s many more times than the premium paid for these insurance-like products, you may not be eligible to buy CDSs and other similar instruments that are available only to institutional investors. However, you have the option to short stocks and buy puts to profit from the crisis or simply sell out to cut your losses.

  The larger goal is to predict signs of an upcoming crisis and understand the severity of an ongoing crisis. There is no easy answer, but history stores many events, which tend to rhyme.

  History Rhymes

  Let us look at some major corrections in the S&P 500 since 1929 and the reasons behind them (table 5.1). The underlying reasons behind past crises tend to reappear in different forms and provide clues to the depth of an impending crisis and corrections in the stock market.

  CASE STUDY:

  LEHMAN FILES BANKRUPTCY IN 2008, UNITED STATES LOSES AAA IN 2011, S&P 500 MOVES

  On Friday, August 5, 2011, I was not sure if the U.S. credit would be downgraded, but I was sure that a potential downgrade would likely be a tail event. I went back to take another look at the market reaction during the week of the last major tail event, the Lehman bankruptcy in 2008. The S&P 500 closed at 1251.7 on the Friday (September 12, 2008) leading up to Lehman’s bankruptcy and dropped 60 points on the Monday following their bankruptcy. While this marked the beginning of the biggest market decline in the last 75 years, the market had recouped all the losses from the Lehman event just one week later on September 19, closing at 1255.08—helped by two strong rallies.

 

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