Earnings Chicanery Part Two

Last week in part one of Atlas’ surprisingly popular series on financial statement trickery – Earnings Chicanery, we looked at the three financial statements and some measures a company can take to “dress up” their financial results. In part two we are going to build on this and take a look at some warning signs that there may be problems with a company’s financial statements.

Red Flag 1: The statements don’t match

On results day most attention is focused upon a company’s profit and loss statement. In particular, analysts and commentators scrutinise whether the company has achieved the expected profit or earnings per share guidance, which was usually given at the last result. Whilst the profit and loss statement usually provides good guidance as to how the company has traded over the past six months, as discussed last week it is also the statement most open to manipulation and should be read in conjunction with the cash flow statement. It is a good idea to compare a company’s operating cash flow with its reported profits. If there is a big divergence, then the accounts should be examined carefully.

The red flag that we are looking for here is when a company’s cash flow statement and profit and loss statements are moving in different directions over an 18 month period, and where a company is showing growing profitability, but declining cash flows. In the below table from the 2015 accounts, Dick Smith Holdings reported income growing from $19 million to $38 million, yet operating cash flow fell from $52 million to -$4 million.  This suggests that the sales generating profits reported on the profit and loss statement were actually pushing the company towards administration.

Another recent example of this can be seen in Slater+Gordon. In the below table from their 2015 accounts, the company reported that 2015 financial year profits were up +6% to $84 million, yet their operating cash flow had deteriorated by -25% to $41 million. Here it appears that the company was overstating its profits through the accounting of its “legal work in progress”, and was overly aggressive in anticipating the expected cash generated through won cases. Whilst the company was able to deliver the earnings growth the market was expecting, in reality the declining incoming cash flows showed signs that it was actually a business in trouble.

However there are exceptions to the rule
The earnings on the profit and loss statement for some businesses can diverge from the cash flow statement. For example, a construction company such as Cimic (nee Leightons) or Downer might not physically be paid until July in the next financial year for work done on a railway project. Here the profits at a point in time may be greater than the cashflows, though the lumpiness of the cash flows received from large individual contracts will even out over time.

Red Flag 2: A company has consistent extraordinary
Extraordinary items are gains or losses included on a company’s income statement from unusual or infrequent events. Importantly, they are excluded from a company’s operating earnings. These items are excluded from earnings to give investors a more “normalised” view of how the company has performed over the period. For example, if an industrial company such as Amcor books a $50 million gain from selling excess industrial land, including this profit would obscure information about how the company’s packaging businesses have performed over the past six months.

While reporting extraordinary items can be valid and useful, investors should be wary or make their own adjustments to company earnings where a company has frequent (and almost always negative) extraordinary items that they are seeking to exclude from their reported profits.

As a long-term observer of the Australian banks, almost every year they put through a write-off of software below the profit line. In my view, investing in banking software is a core part of their business model and it seems curious that the institution is willing to take the productivity benefits in their normalised earnings whilst ignoring a portion of the costs needed to achieve these gains.

Red Flag 3: Divergence from comparable companies
The warning sign we are looking for here is when a company consistently has higher average profitability, revenue growth or better working capital management than their industry peers. Invariably when management is asked they will give an answer that relates to management brilliance or superior controls, but realistically mature companies operating in the same industry tend to exhibit very similar characteristics. As such, their financial statements should to some extent correspond to the statements of companies operating in the same industry. For example, supermarkets such as Woolworths should have a similar cash conversion profile to Coles (operating cash flow divided by operating profits) and not dissimilar profit margins as they are selling identical products to largely the same set of customers.

Hollow Logs?
Occasionally management teams may be incentivised to under-report profits in any current period. This generally occurs when a company is under heightened union scrutiny due to wage negotiations with their employees, excessive government attention from perceived excessive profits, or expects a problem in the next year and wants to smooth their profits. For example, in the current environment of extremely low bad debts a bank could be incentivised to boost their bad debt provisions aggressively. This action would reduce current period profits, potentially a politically astute move when politicians are calling for a Royal Commission into Australia’s banking sector. These excess provisions, if not required, could then be written back at a later date to boost future profits.

Our Take

Earnings misrepresentation is difficult for investors to detect from the publicly available accounts, but when revealed can sometimes have extreme results for a company’s share prices. In my experience this is more an art than a science, as the investor gets a sense that something is not right with the accounts, rather than definitive proof of earnings manipulation. Normally actual manipulation generally only becomes obvious ex post facto, after management has been removed or a company goes into administration.

Earnings Chicanery Part One

Last week it was announced that Slater and Gordon’s former accountant was included in a shareholder class action over its auditing work. This demonstrates the recognition of legal costs as revenue, before the ASX-listed law firm actually won the case. Obviously, this becomes an issue for a company with a business model that is based on “no win no fee”, as their revenue is predominately based on a percentage of the damages awarded when the case is won. In previous years this assumption contributed to the troubled legal firm reporting healthy revenue and profits to investors, although at the same time financial stresses were significantly increasing.

In part one of a two-piece series on financial statement trickery, we are going to look at some measures a company can take to “dress up” their financial results.


Why engage in earnings chicanery?

Company management teams are always under pressure to deliver results in line with or above market expectations, or face the negative share price reactions. By my observations, negative reactions to earnings disappointments have only increased in recent years with the increasing influence that short sellers have in setting market prices. Their strategy is to sell stock that the manager does not own prior to a catalyst event such as an earnings result. They anticipate being able to buy stock back at a lower price if company profits are below market expectations.

This gives management – in particular the chief financial officer as the executive with central involvement in preparing the accounts – strong incentives to present the most positive picture possible of the company’s financial health. This is especially true if management believes that the negative factors influencing profits could be temporary and likely to reverse in the near future.  Additionally, most senior management teams have short-term incentives tied to earnings growth or total shareholder returns, which can motivate them to present favourable accounts.

The three sisters

When a company releases its financial accounts, these consist of three separate statements. These are designed to provide investors with a picture as to the company’s profitability (profit and loss statement), assets and company solvency (balance sheet), and the cash flows in and out of the business (cash flow statement). All three are interconnected and should not be read in isolation as each statement can explain elements of another. For example the net debt on the balance sheet drives the interest payments on the profit and loss and cash flow statements. Below we take a closer look at each of these statements.

Profit and loss

Most of the attention in the financial media focuses on the company’s profit and loss statement (P&L). The P&L provides a six-monthly summary of the company’s revenues, expenses, depreciation charges, interest costs and taxes. The investment community tends to be most concerned about the net profit figure. Whilst this statement provides the headline result, it is also the easiest to manipulate.

A typical way to do so is when companies recognise sales as revenue before payment is actually collected from customers. A more extreme version of this is referred to a “channel stuffing.” Then is where a company makes a large shipment to a customer at the end of an accounting period (recorded as revenue), however the customer may end up returning those goods. In 2005 donut maker Krispy Kreme got itself into hot oil and was forced to restate prior year’s earnings. Here it was proven that the company systematically increased shipments of its sugary glazed treats in the final month of numerous quarters so the company could meet the guidance that it had provided investors.

The balance sheet

The balance sheet provides a snapshot of a company’s assets, liabilities and shareholders’ equity at the end of the period. This offer investors an understanding of both how the company is financed (debt or equity), and also what it may be worth if it is liquidated at that point in time. Typical ways of manipulating the balance sheet are by adjusting the value of assets and moving debt off the balance sheet. Enron famously used special purpose vehicles to hold debt outside the company’s balance sheet and misrepresent the company’s gearing. In 2001 Enron’s financial accounts reported total debt of US$10.2 billion, however it was later determined that the real figure was US$22.1 billion.

Closer to home, Harvey Norman in 2017 moved A$610 million of franchisee liabilities off the company’s balance sheet, based on the new position that Harvey Norman is no longer liable for the inventory costs taken on by its franchisees. This sparked a range of commentary in the financial press and prompted ASIC to look at the retailer’s accounts; see the interview Torpedo Tuesday Harvey Norman.

Profit is an opinion, cashflow is a fact

The cash flow statement shows a picture of the actual cash flowing in and out of the company over the past six months and is generally harder to manipulate than the profit and loss statement. Conceptually it is akin to blood pumping through the veins of the corporate entity, with the balance sheet comparable to the skeleton.

The P&L is more often associated with chicanery as a company may record sales as revenue on the P&L, and hence profit, before that cash is actually collected from their customers. However company cash flow statements are also open to manipulation. One practice that I have seen over the years has been capitalising operating expenses as an asset. This converts a cost or outflow of cash on the cash flow statement into an asset on the balance sheet: accounting magic! Whilst this is legal under the accounting rules, as an analyst I was uncomfortable with instances of this conversion, for example Santos capitalising the interest costs for the construction of the Gladstone LNG export terminal. Through the construction process the company’s cash flow statement showed a healthier picture than was actually the case. Ultimately, Santos wrote down the value of this asset by A$2.9 billion and was forced to raise $2.5 billion in 2015 and $1 billion in 2016 to pay down debt.

Aside from converting expenses into assets, a company can boost their cash flow statement by selling accounts receivables (at a discount to face value) or delaying payment of accounts payables. These two actions can temporarily improve the cash flow statement, though they can be detected by abnormal changes to working capital on the balance sheet.

One of the tactics that can be used by owners prior to floating a company is to boost cash flow by economising on capital expenditure, especially the capital expenditure required to maintain a company’s assets. The rationale behind this is to present the healthiest set of accounts possible prior to the initial public offering (IPO), with the aim of generating a high sale price. However, in the year or so after the company is floated on the share market, the new investors end up with cash flows lower than they expected due to higher maintenance capital expenditure.

In the short term companies can economise by delaying capital expenditure, but in the medium term assets have to be maintained otherwise they deteriorate. A tragic example of this was alleged to have occurred with the transport company McAleese Group, where the previous owners were believed to have reduced capital expenditure on trucks in their fleet prior to the IPO. It is alleged that this scrimping on capital expenditure contributed to a range of accidents which resulted in fatalities.

Our Take
Earnings misrepresentation is difficult to for investors to detect from the publicly available accounts, but when revealed can have fairly extreme results for a company’s share prices. Printing these three statements and reading them side by side can often reveal signs of problems a company could have that can be minimised or ignored when management present their results to the market. As the result of bitter experience, I look at the cash flow statement first, as profits can be manipulated and companies with great – albeit illiquid – assets can still become insolvent without the cash flow to service debt.

Banks Reporting Season Scorecard 2017

Over the last ten days the major Australian banks have reported their financial results for 2017, reporting collective annual profits of $31.5 billion. In comparison to the May reporting season (which saw the surprise introduction of a 0.06% levy on the liabilities and $50 billion being wiped off the bank’s collective market capitalisation), the results were mostly in line with expectations. A key feature that we noticed was how efficiently the financial impact of this “game changing” levy or tax was passed onto borrowers, something that we expected when we looked at the bank results earlier this year in the May Reporting Season Score Card.

In this piece, we are going to look at the common themes emerging from the November reporting season, differentiate between the different banks and hand out our reporting season awards to the financial intermediaries that grease the wheels of Australian capitalism.

Across the sector profit growth was generally in-line with the credit growth in the overall Australian economy. ANZ reported headline profit growth of 7.6% when backing out the impact of the sale of the bank’s Asian retail businesses, Esanda and property gains from 2016. The solid profit growth displayed across the sector was achieved by improving economic conditions and lower bad debts. All of the banks reported lower trading income due to decreased volatility over the year.  During periods of higher market volatility, the banks can boost their income by both selling more foreign exchange and interest rate derivative contracts to their clients. However, they can also generate trading income by using their large balance sheet reserves to trade securities on the global markets.

Gold Star

Angry on costs: Reducing costs featured prominently in the plans of bank CEOs for the upcoming year, with much discussion about branch closures and headcount reductions. The removal of ATM bank charges and the migration of transactional banking from the physical bank branch to the internet is likely to deliver an efficiency dividend to the banks. NAB took the most aggressive stance, announcing that the bank will reduce its workforce by 6,000 employees due to business simplification and increasing automation. However, this will come at a cost with NAB expecting to book a restructuring charge of between $500-$800 million in 2018 and increases in investment spend by $1.5 billion.

Gold Star 

Bad debt charges still very low: One of the key themes across the four major banks and indeed the biggest driver of earnings growth over the last few years has been the ongoing decline in bad debts. Falling bad debts boost bank profitability, as loans are priced assuming that a certain percentage of borrowers will be unable to repay and that the outstanding loan amount is greater than the collateral eventually recovered. Bad debts fell further in 2017, as some previously stressed or non-performing loans were paid off or returned to making interest payments, primarily due to a buoyant East Coast property market and higher commodity prices. CBA gets the gold star with a very small impairment charge in 1st quarter 2018 courtesy of their higher weight to housing loans in their loan book. Historically home loans attract the lowest level of defaults.

Gold Star  

Dividend growth stalled but may return: Across the sector dividend growth has essentially stopped, with CBA providing the only increase of 9 cents over 2016. With relatively benign profit growth a bank can either increase dividends to shareholders or retain profits to build capital (thereby protecting banks against financial shocks); but not both. In the recent set of results the banks have held dividends steady to boost their Tier 1 capital ratios. Additionally, dividend growth has been limited as the banks have had to absorb the impact of the additional shares issued in late 2015 to boost capital.

Looking ahead, there may be some capacity to increase dividends (especially from ANZ and CBA after asset sales), as the rebuild of bank capital to APRA’s standards is largely complete. The major Australian banks in aggregate are currently sitting on a grossed-up yield (including franking credits) of 8.2%.

Gold Star

Net interest margins in aggregate increased in 2017, despite the imposition of the major bank levy. This was attributed to lower funding costs and repricing of existing loans to higher rates. In response to regulator concerns about an over-heated residential property market and in particular the growth in interest-only loans to property investors; in 2017 the banks have repriced these loans higher than those repaying both principal and interest. For example, Westpac’s currently charges 6.3% on an interest only loan to an investor, which contrasts to the 4.4% being charged to owner occupiers paying both principal and interest. This has had the impact of boosting bank net interest margins.

One of the key things we looked at closely during this results season was signs of expanding net interest margin (Interest Received – Interest Paid) divided by Average Invested Assets), and this was apparent even after allowing for May’s Major Bank Levy

Gold Star Australian banking oligopoly

Total Returns: In 2017 only NAB has been the top performing bank, benefiting  from delivering cleaner results, after it jettisoned its UK issues with spin-off of the Clydesdale Bank and Yorkshire Bank. CBA has been the worst performing bank as it faces both the imminent retirement of its CEO and the uncertainty around possible fines from foreign regulators for not complying with anti-money laundering laws. This has resulted in CBA losing the market premium rating that it has enjoyed for a number of years over the other banks.

Gold Star

Our Take

What to do with the Australian banks is one of the major questions facing both institutional and retail investors alike. The Australian banks have been very successful over the past few years in generating record profits, benefiting from lower competition from non-bank lenders and record low bad debts.  Looking ahead it is not easy to see how the banks can deliver earnings growth above the low single digits in an environment of low credit growth, increased regulatory scrutiny and the sale of some of their insurance and wealth management divisions.

Competition amongst the big four banks is likely to increase, as for the first time since 1987 (NAB’s purchase of Clydesdale Bank) we have no Australian banks distracted by foreign adventures, with all four focused on the Australian market.  However, looking around the Australian market the banks look relatively cheap, are well capitalized and unlike other income stocks such as Telstra should have little difficulty in maintaining their high fully franked dividends.

Monthly Newsletter October 2017

  • The Fund posted a small gain of +0.8% over the month of October, trailing the S&P/ASX 200 A-REIT Accumulation index that was dragged upwards by the strong performance of the trusts with property development earnings. Following the McGrath profit warning in the first week of November (attributed to slowing off the plan apartment sales), we are happy with the Fund’s focus on rent collectors rather than property developers.
  • In the first week of October the Fund paid out a distribution to investors of 4.85 cents per unit.
  • In October the Fund bought put protection out till March 2018 that will offset some of the impact of a significant fall over the next five months. In our opinion the market appears to be mispricing downside risk and we will look at add to this protection.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in October and the fund’s strategy

High Priced Shares

Earlier this week Macquarie Bank’s share price almost touched $100 after releasing a solid set of profit results and there was speculation in the press that Macquarie Bank would join Cochlear, Blackmores and CSL in having a three-figure share price. What was missing in these articles was the subsequent performance of other market darlings that have scaled these lofty price heights. Indeed, in a six-month period in late 2015 to early 2016 we saw Blackmores go from $100 a share to $220 per share, before sliding below $90 per share in in August 2017.

In this week’s piece we are going to look at over-valuation and reverse engineering the share price of two high flying stocks on the ASX; Macquarie Bank and A2M milk.

Price versus Value
Historically Australian investors have greatly preferred to invest in companies that have share prices below $10-20. My impression is that this is based on the logic that a 20c move in the share price has a bigger proportional impact, and that investors get more shares in the company when they invest. Fundamentally the actual dollar price per share means very little when deciding whether to buy or sell a stock. The decision is most often made by comparing a stock’s price with the expected profits and, ultimately, the dividends that you can expect as an owner of a fraction of the company. These expected cash flows are then discounted for both their timing and the risk of the company. This analysis derives a valuation that guides an investment decision. A $120 per share company could be much better value than one priced at $12 per share, if the expected dividends discounted for risk and inflation are higher than the price being quoted on the ASX.

Share price momentum
Often when a share price is rising in response to unexpected good news, underlying valuations tend to be ignored and risks glossed over. Analysts at both fund managers and the investment banks (including the author in his younger days) will tweak their valuations to justify why a strong performing stock is still worth buying, thus pushing the price higher.

Additionally, a range of quantitatively managed funds use momentum as a key factor in their investment strategy. Momentum investing is based on the principle that stocks that have been rising (or falling) in the past will continue to do so in the future. This strategy has nothing to do with the fundamentals of a company, but rather with the human propensity to extrapolate trends into the future. Active fund managers can also fall into the momentum trap, as good performance from owning these high flyers attracts inflows from investors that tend to be re-invested in these same stocks, creating a circular  loop.

Momentum tends to work well as an investment strategy until it abruptly  stops working. Like Icarus flying towards the sun, when these high-flying share prices melt there is often little valuation support.

What does the current share price imply?

One of the best methods I have used over the years to analyse expensive companies like Macquarie is to back-solve the earnings growth that the current $99-dollar share price implies. In other words, we reverse engineer the share price .

This model uses consensus earnings drawn from sell side analysts’ estimations of company earnings for the next three years. Whilst we recognise that broker earnings are inevitably too optimistic, they provide something of a base estimation of a company’s earnings power. Similarly, we use a terminal growth value of 2.5% in line with the estimated long-term growth rate of the economy.

Logically Macquarie Bank cannot grow towards infinity at 4% if the economy grows at 2.5%, otherwise as a matter of mathematical necessity it will become 99.9% of the Australian economy. Perhaps this would involve consumers buying Silver Doughnut branded cars, breakfast spreads, bread and beer, all funded by a Macquarie Bank mortgage. A chilling thought to most outside of Macquarie Bank’s Beaux-Arts revivalist-style Headquarters in 50 Martin Palace.

The above model suggests that Macquarie Bank’s profit growth needs to maintain a growth rate of just under 2% from 2021 to 2027 to justify the current share price. This is not unfeasible for Macquarie Bank. However, even if it executes well and expands its current A$482 billion assets under management, earnings are likely to be buffeted by external shocks over the next decade.

Milk and yogurt company A2M is a favourite holding of many fund managers and its share price is up a staggering 1,542% since listing in 2015. Currently the market sees such upside in the demand for A2M’s milk products that the company is trading on 41 times next year’s earnings per share. A2M is a company with a very solid growth prospects, however using the same model as we used for Macquarie Bank, A2M’s current share price requires a profit growth rate of over 20% for the next three years followed by 14% for the rest of the decade. Whilst it is far easier for a smaller company to achieve these compound growth rates, the current share price does not appear to allow for issues such as Chinese import restrictions or future manufacturing problems.

The growth implied by the current share price is a good sanity measure for investors. While even the best companies can deliver high earnings growth for a short amount of time, inevitably this growth falters either due to new competitors, management hubris or even the mathematics of compounding growth. Even for the m

ost wonderful company it is becomes progressively harder to grow those earnings at a high compounded rate, as the addressable market for a company’s products is always finite.
The last company to achieve a compounded growth rate of 10% over a 10-year period was Microsoft in the period ending 2004. Here the company benefited from the launch of Windows, Microsoft Office, Windows 95 and the global demand for computers spurred by a desire to access the Internet. Whilst A2M’s milk is gaining market share, it is hard to make the case that it will have as big an impact as Microsoft Excel.