As well as writing books, we also love reading them. We always make it a point to step into bookstores as often as possible, whether they’re part of a mega chain like Barnes & Noble or the literary jewel of Portland, Oregon—Powell’s Books. Once we’re inside one of these places, it’s hard not to notice the scores of self-help and diet books. They are everywhere. No doubt, we all yearn to look, feel, and be better at work, play, and all the other stuff. It’s certainly a big business teaching people to feel better about their lives and to look fabulous.
Who knows if any of these plans really make us healthier or make us look any better? We do know, however, that upper management spends a great deal of time trying to make its Balance Sheets look great, even if they are loaded up with junk. This chapter highlights four techniques that struggling companies might use to convince investors that the company not only looks great but is in excellent health. Our hope is that these folks won’t be as effective in fooling investors as the diet book authors are in persuading readers to trust their advice.
Corporate executives understand that many investors review working capital trends carefully for signs of poor earnings quality or operational deterioration. They realize that a surge in receivables that is out of line with sales will lead investors to question the sustainability of recent revenue growth. To keep these kinds of questions at bay, companies may seek to distort the receivables numbers by (1) selling receivables or (2) converting them into notes receivable (both of which are discussed in this section) or (3) moving them somewhere else on the Balance Sheet (we address this later in the chapter).
In Chapter 10, “Cash Flow Shenanigan No. 1: Shifting Financing Cash Inflows to the Operating Section,” we discussed how selling accounts receivable may be considered a useful cash management strategy, but an unsustainable longer-term driver of cash flow growth. Selling accounts receivable also serves another useful purpose: it lowers the days’ sales outstanding (DSO) reported to investors (making it appear that customers have been paying more quickly). Dishonest management can conceal a jump in DSO simply by selling more accounts receivable.
Let’s refer to our discussion in Chapter 10 of Sanmina-SCI’s stealth sales of receivables. After selling these receivables, the company highlighted a decline in DSO and an increase in cash flow from operations in its September 2005 quarterly results. Astute investors would have understood that it was the sale of receivables, not operational improvements, that drove DSO lower and CFFO higher. Such investors understand that the sale of receivables, in substance, represents a financing decision (that is, collecting cash due on customer accounts earlier). Therefore, the now lower accounts receivable balance naturally also results in a smaller DSO figure.
TIP
Whenever you spot a CFFO boost from the sale of receivables, also realize that by definition, the company’s DSO will have been lowered as well.
Also recall how Peregrine recorded bogus revenue and then shamelessly faked the sale of the related bogus accounts receivable in order not to raise any alarms. Those receivables, obviously, went uncollected, and management became concerned that the bulging account balance would drive up DSO indefinitely—a clear warning for investors. By faking the sale of these receivables, Peregrine inflated its CFFO and removed the potential DSO red flag from investors’ sights in one fell swoop.
The first examples of lowering receivables to improve DSO involved either selling them outright or faking the sale. Another way to hide accounts receivables is simply to reclassify them elsewhere on the Balance Sheet.
TIP
To calculate DSO on an apples-to-apples basis, simply add back sold receivables that remain outstanding at quarter-end for all periods.
Symbol Technologies’ receivables had been growing rapidly because of aggressive revenue recognition and channel stuffing, surging to 119 days in June 2001 (up from 94 in March 2001 and 80 in June 2000). To avoid investor concerns, management engineered a cosmetic reduction in accounts receivable.
It was a pretty dirty trick, in our view. Symbol simply asked some of its closest customers to sign paperwork that would convert these trade accounts receivable into promissory notes or loans. Apparently, the customers acquiesced, since it made no difference to them; they owed the money either way. However, the new paperwork gave Symbol a convenient cover to move these accounts receivable to the notes receivable section of the Balance Sheet. In effect, Symbol waved a magic wand and, with the help of some compliant customers, “reclassified” these trade receivables to an account that was not as closely monitored by investors. It seems that Symbol’s primary purpose for this reclassification was to lower its DSO and fool investors into believing that sales had been kosher and that customers had paid on time. And according to plan, DSO fell from the 119 days in June 2001 to 90 days the following period.
TIP
Investors should be as concerned when they see a large decrease in DSO (particularly following a period of rapidly rising DSO) as they are when they see a substantial increase in DSO.
Watch for Increases in Receivables Other Than Accounts Receivable UTStarcom pulled a similar switcheroo in 2004 by taking more payment in the form of “bank notes” and “commercial notes.” Since UTStarcom chose not to classify these notes receivable as accounts receivable on the Balance Sheet (in fact, the bank notes were considered to be a subset of cash!), the company presented a more palatable DSO to investors, despite a severe deterioration in the business. Diligent investors could have spotted this improper account classification by reading UTStarcom’s footnotes. As shown in the box, the company disclosed clearly that it had accepted a substantial amount of bank and commercial notes in place of accounts receivable.
Investors received another warning on UTStarcom’s Balance Sheet: notes receivable surged, from $11 million in December 2003 to $43 million the following quarter. By now, it should be abundantly clear that identifying the reason for such a change is extremely important. If management cannot provide you with a plausible reason, assume that the company may be playing a game with accounts receivable and trying to hide otherwise bulging DSO.
Watch Out for Varying Company DSO Calculations For the purposes of identifying aggressive revenue recognition practices, we suggest that investors use the ending (not the average) receivables balance when calculating DSO. Using average receivables works well for assessing cash management trends, but it works less well for trying to detect financial shenanigans. End-of-period balances are more representative of the revenue transactions that took place later in the period, which are more relevant in assessing revenue quality.
Watch for Changes in a Company’s DSO Calculation Be especially wary if a company changes its own DSO calculation in a way that conceals deterioration, as Tellabs Inc. apparently tried to do in December 2006. Tellabs had been calculating DSO based on the ending receivables balance, but it then changed to using its quarterly average receivables balance. Since receivables surged in the quarter in which the change was made, the average receivables balance was naturally much lower than the ending one, allowing for a more favorable presentation of DSO on an earnings conference call with investors. As a result, Tellabs disclosed that DSO in December 2006 had increased by only 5 days sequentially (to 59 days from 54 days in the previous quarter). Had management made no changes in its calculation, Tellabs would have reported an increase in DSO of 16 days (to 82 days from 66 days the previous quarter). The change in the DSO calculation was mentioned in the same conference call. In this case, being aware of the change in calculation was the easy part; knowing it was a big deal was key for alert investors to realize that management was playing games and trying to hide its bulging receivables.
TIP
Astute investors should note a change in the calculation of DSO; when management changes how it computes operational metrics it is often attempting to hide some deterioration from investors.
Investors typically view an unexpected rise in inventory as a sign of upcoming margin pressure (through markdowns or write-offs) or falling product demand. Some companies with inventory problems seek to avoid this negative perception by toying with inventory metrics.
You may recall from Chapter 4 that Symbol Technologies had overstated sales by offering customers very generous return rights. Moreover, some sales turned out to be completely bogus because customers had sent back products they never wanted, and based on a side agreement with Symbol, they could return them at any time and pay nothing. These returns became more than a minor nuisance, as they increased Symbol’s inventory levels, a potential warning sign for investors. So as one cover-up often leads to another, Symbol created an “inventory reduction plan” designed to reduce inventory levels. The plan (as described by the Securities and Exchange Commission) included recording fictitious accounting entries to reduce inventory, leaving product deliveries on the receiving docks without recording them as inventory, and selling inventory to a third party but agreeing to repurchase it.
Watch for Inventory That Moves to Another Part of the Balance Sheet Companies will sometimes reclassify inventory to a different account on the Balance Sheet. Pharmaceutical giant Merck & Co., for example, in 2003 began reporting part of its inventory as a long-term asset, included in the “other assets” line on the Balance Sheet. A footnote revealed that these oddly classified inventories related to products that were not expected to be sold within one year. In December 2003, the long-term portion of Merck’s inventory represented 13 percent of the total, and the next year, it jumped to 25 percent. Investors should certainly have included these long-term inventory totals when analyzing Merck’s inventory trends. A sudden spike in long-term inventory warrants concern by investors.
Be Cautious About New Company-Created Metrics Inventory balances at mall retailer Tween Brands Inc. had been bloated in late 2006 and early 2007, and management correctly assumed that investors would be less than overjoyed. Specifically, days’ sales of inventory jumped to 60 days in the May 2007 quarter from 52 days the preceding year, marking the third consecutive quarter of increase. Moreover, inventory per square foot (a non-GAAP metric often cited by Tween) increased by 18 percent.
To divert potential investor concerns about inventory, management began highlighting a new metric: “in-store” inventory per square foot. In May 2007, Tween management claimed that the surge in inventory should not be a source of worry because “in-store” inventory had increased only a modest 8 percent ($27 per square foot versus $25 last year). Despite the absurdity of this new metric, Wall Street bulls were pleased; all they needed was an explanation, no matter how weak.
Tween’s explanation should have given astute investors pause on two grounds. First, it would be completely inappropriate for Tween to simply ignore inventory that it owned and included on its Balance Sheet but that was not on store shelves. “Out-of-store” inventory qualifies as inventory and has no less markdown risk than “in-store” inventory. Second, and even more troubling, Tween tricked investors by providing an “apples-to-oranges” comparison of its inventory growth. Specifically, the $25 cited by management as the prior year’s in-store inventory per square foot reflected total inventory per square foot. By definition, comparing the current year’s in-store number with the prior year’s total number would understate inventory growth; of course, it was up only 8 percent! Since the in-store metric was new, the prior year’s number was not previously disclosed, which made it difficult for investors to notice the inconsistency. However, diligent investors would have been skeptical enough about the creation of a new inventory metric at a time when inventory was increasing, and they would have questioned its usefulness as a measure of the company’s health.
Financial assets (such as loans, investments, and securities) are significant sources of income for banks and other financial institutions. Therefore, assessing the “quality” or strength of these assets should be a key part of understanding the future operating performance of such companies. For example, it is crucial for investors to understand whether a bank’s investment portfolio consists of risky, illiquid securities and to know if its loan portfolio is weighted toward dicey subprime borrowers.
Consider two banks that are identical in every way, except for the composition of their loan portfolios. One bank’s loan portfolio consists entirely of loans to subprime borrowers, 20 percent of which have failed to pay their bills on time. The other bank’s loan portfolio consists mainly of loans to prime borrowers, only 2 percent of which have failed to pay on time. It does not take a banking expert to realize that the second bank’s operating performance will be steadier and that the first one will be more volatile.
Financial institutions will often present extremely helpful metrics that allow investors to understand the strength and performance of their assets. For example, a bank might report delinquency rates, nonperforming loans, and loan loss reserve levels. However, sometimes management dresses up or conceals important metrics that would show a deterioration in order to present itself in a more favorable light.
Consider the case of New Century Financial Corp., once the largest U.S. independent nonprime lender, whose risky mortgage lending culminated in its April 2007 bankruptcy. New Century kept its earnings afloat in September 2006 by reducing its loan loss reserve, instead of increasing it, despite facing higher delinquencies and bad loans. However, when it released its September 2006 earnings, the company was less than completely honest with investors about its reserve level. Most investors reading the Earnings Release came away thinking that New Century had raised its loan loss reserve.
Here’s why. New Century realized that investors would be seriously spooked if they knew that the company had reduced its reserves while its subprime loan portfolio was souring and that this reduction was the primary driver of earnings. Indeed, analysts who followed New Century were monitoring the company’s allowance for loan losses closely as the subprime market started to crack. So when the company released its September 2006 results, management quietly changed its reserve presentation.
Previously, New Century’s Earnings Release had presented the loan loss reserve on a stand-alone basis. However, in September 2006, the company grouped the loan loss reserve with another reserve (allowance for real estate owned) and presented the two together as one unit (see the accompanying disclosure in the box). By combining the two reserves, New Century could say in its release that reserves increased from $236.5 million in June to $239.4 million in September. However, the number on which investors had previously been focused—the loan loss reserve—declined from $209.9 million to $191.6 million. The loan loss reserve fell because bad loans that had been written off (called charge-offs) had accelerated and New Century had failed to record a sufficient expense to refill the reserve; if it had done so, EPS in September 2006 would have been sliced to $0.47 from the $1.12 as reported.
By simply changing the presentation of a key metric, New Century was able to avoid signaling that asset quality had deteriorated, while also reporting higher earnings. This charade probably bought the company some time before its bankruptcy several months later. Astute investors who were monitoring not only the level of the loan loss reserve, but also the presentation, would have had a warning of the company’s demise. Investors who missed the presentation change in New Century’s Earnings Release, but read the 10-Q released several days later, would have seen the disaggregated loan loss reserve and had fair warning as well.
Executives at New Century eventually got into trouble for their tactics. In 2009, the SEC charged New Century’s former CEO, CFO, and Controller with securities fraud for misleading investors, alleging the company sought to assure investors that its business was not at risk and was performing better than its peers.
A company’s cash obligations, such as debt payments, may have an impact on future operating performance as well. Large near-term debt obligations may prevent a company from funding its desired growth initiatives or, at worst, send it spiraling toward bankruptcy.
Parmalat Finanziaria SpA, the Italian-based dairy producer and one of the world’s largest packaged-food companies, grew its business rapidly in the 1990s by aggressively acquiring food service companies around the world. Parmalat relied heavily on the debt markets to fund its shopping spree, borrowing at least $7 billion in various offerings between 1998 and 2003. As its business ran into serious problems, Parmalat began having trouble generating sufficient cash to pay down this debt. Moreover, top executives of this family-owned and family-dominated company began funneling hundreds of millions of dollars to other family businesses. Therefore, when bonds came due, Parmalat had a desperate need to issue new bonds and float equity offerings to raise enough cash to pay off the older debt.
Normally, investors would be reluctant to purchase new bonds and equity from a poorly performing company that was strapped with heavy debt obligations and had no cash. So to attract investors, Parmalat concocted a widespread scheme to fraudulently hide its debt and conceal bad assets. By dressing up its Balance Sheet, Parmalat fraudulently portrayed itself to investors as a company that was in robust economic health. In September 2003 (the quarter before the fraud was revealed), Parmalat’s unreported debt amounted to an astonishing €7.9 billion. The company’s net worth, reported to be €2.1 billion, was negative €11.2 billion—an inconceivable €13.3 billion overstatement!
The centerpiece of Parmalat’s fraud seems to have been the company’s use of offshore entities to hide fictitious or impaired assets, fabricate the reduction of debt, and create fake income. The scope of the fraudulent activities that Parmalat is alleged to have engaged in is quite amazing. SEC litigation against the company names a few, including forging the repurchase of its debt, faking the sale of bogus or uncollectible receivables, falsifying the payment of payables, recording fictional revenue, mischaracterizing debt as equity, disguising intercompany loans as income, and diverting company cash to various businesses owned by members of the CEO’s family.
As usual, there were warning signs for perceptive investors to find. One key warning occurred in late October 2003 when Parmalat’s auditors (Deloitte & Touche) wrote in an audit report that they were unable to certify certain transactions involving an investment fund called Epicurum, which later turned out to be one of these fraudulent offshore entities. These transactions were quite significant. Parmalat had recorded gains on a derivative contract just signed with Epicurum that accounted for more than all Parmalat’s €119.9 million in pretax earnings in the first half of 2003. Moreover, these gains were revealed because of Parmalat’s commenting on Deloitte’s review report, but they had not previously been disclosed by Parmalat in its June 2003 Earnings Release.
Less than two weeks later, in early November 2003, Parmalat decided to formally respond to Deloitte’s report in a very public manner. It issued four press releases over a span of three days seeking to clarify Deloitte’s reasons for not signing off on its financial statements and also to explain its Epicurum investment in further detail. To be clear, Parmalat decided to refute its auditor in a public forum over a transaction with an obscure offshore entity that had accounted for all its recent earnings.
The late 2003 series of events at Parmalat is perhaps the reddest of red flags. As an investor, you should cringe when you see a company having a public disagreement with its auditor, particularly on a shady transaction of significant magnitude. Surprisingly, many investors in Parmalat did not feel that way. It was not until several weeks later that Parmalat’s stock price plunged as the company defaulted on its debt.
This chapter completes the section on Key Metric Shenanigans. The next section of the book, Part Five, “Acquisition Accounting Shenanigans,” introduces readers to the most complex companies to analyze—acquisitive ones—and how to navigate the many accounting tricks used by companies favoring an acquisition-driven strategy.