Finding La Cucarachas
Bull markets have a way of obscuring irregular activities. Bending accounting conventions and related-party transactions are the most typical ways for managers to benefit from the lack of substantive analysis that usually accompanies bull markets. Amazingly, once the bull market ends everything comes to light. It is akin to turning on the light in a cellar and seeing one or two roaches scurrying under the wall. You only see a couple at first, but there are dozens if not more in the hiding. Now investors are looking for the roaches, and they are finding them. When the Enron fiasco first surfaced, analysts were quick to say it was an isolated incident. That is highly doubtful. Just this week we learn that Cisco executives participated in partnerships which would often make private investments in start-up companies. Then, low-and-behold, Cisco would acquire the company resulting in a handsome profit for the partnership. Global Crossing gave a contract to a company owned by a senior executive's son. While not illegal, it certainly calls into question the extent Global Crossing was being run for the benefit of shareholders. Today the New York Times reported that federal prosecutors started a "preliminary inquiry into whether Computer Associates deliberately overstated its profits to inflate its stock price and enrich its senior executives." According to the article, CA changed the wording of its contracts when it started issuing pro-forma financial results. While CA continues to report GAAP results, due to the changes made in the contracts "the standard results are essentially meaningless for investors." PNC Financial this week restated 2001 results for the second time; will the third time be a charm? It was not too long ago that these were the issues short sellers looked for in small $250 million companies, not $250 billion companies.
A lot of pundits and analysts are calling this a witch hunt. I'm not sure it can be called a witch hunt if you actually find real witches. Just today, Lou Thompson, president and CEO of the National Investor Relations Institute, said "I think as more and more companies are put under the microscope, they'll be 'outed'." Thompson believes there will be more Enron's that will surface and it will be sooner rather than later because of the increased investor scrutiny.
It is looking grimmer for the unemployed. Challenger, Gray & Christmas, reported that the average time to find a new job in the fourth quarter increased by over a month compared to the first half of the year. It is now taking an average of 3.4 months for workers to find new jobs. "Rising job search times are unlikely to reverse course any time soon," according to John Challenger. "Some major employers are saying that they do not see a turnaround in hiring until 2003." One would think this would put some pressure on personal consumption, but nope. Housing continues to surge ahead. Housing starts increased 6.3% in January over December. Some are starting to view housing choices as investments. ``Given Ryan Brecht, a market analyst at Standard & Poor's MMS, thinks that compared to "the troubles in the stock market, housing looks like an even more attractive investment.'' Combined "with low mortgage rates, that makes housing affordable and a good investment.'' Unfortunately, this is quickly becoming quite popular and I think it is very dangerous when individuals start to look at their primary residence as an investment. This allows people to justify buying more home than they can really afford. If housing values decline, mortgage payments do not.
For those looking for some background or like to hear someone else raise the same concerns, Yesterdays Scott Burns article, A Somber View To a Longer Recession, included an interview with Lacy Hunt and Van Hoisington of Hoisington Investment Management. Yesterday, Rob Peebles included a link to Hoisington's latest economic review.
Now that accounting has moved front and center, I thought I could go through some of the "red flags" that we look for. Perhaps the easiest to spot and understand is increasing accounts receivable and inventories. When receivables and inventories are growing faster than sales it may indicate business conditions are faltering. When business is slow companies often give better terms to its customers as a way to entice them to buy. It can also be an indication of "channel stuffing," which is when companies give very good terms to customers at the end of a quarter for the purpose of meeting estimates. Since these purchases have not been paid for, accounts receivables increase. A/R will grow as business grows. But when A/R grows much faster than sales, it should be investigated. For ease in analysis, analysts usually calculate the days of sales. This is simply the number of days that sales are tied up in accounts receivable. There are several ways to calculate the days of sales. I prefer using a more sensitive calculation that divides accounts receivables for the most recent quarter by sales for the trailing 12 months, and then multiply by 365 to get the number of days. Because of seasonality this can only be compared to the same period historically.
A quick example:
AMD had receivables of $660 million at 12/31/01 and had revenue of $3,892 million in 2001.
$660 million divided by $3,892 = .17 times 365 = 62 days.
Last year, AMD had receivables of $547 million with $4,644 million in revenue. Just by glancing at the number we know days of sales increased since A/R increased and sales decreased. $547 / $4,644 * 365 = 43 days.
The increase in receivables while sales declined is definitely not something you like to see if you are long a stock.
The same calculation can be done for inventory days of sales, except trailing sales is replaced with the 12-month trailing cost of goods sold. Cost of goods sold is used instead of sales because inventory is valued on the books at cost, and the numerator and denominator both need to reflect the same cost. Increasing inventory is not necessarily a negative. Management could be forecasting a rapid increase in sales and is stockpiling inventory. A new product being launched would be one example. But too often it means management simply has too much inventory on hand and will have to start discounting to sell the product. This obviously would lower gross margins and reduce earnings.
On the extreme side, increasing accounts receivables can be a clue to fraudulent activity. In 1995, I published a research report on HBO & Company (a medial software company, not Home Box Office) for our institutional research publication Behind the Numbers. One of the primary concerns was it increasing accounts receivables days of sales. Here is part of the report from 1995:
The last two quarters have shown 30% sales growth and 100% A/R growth, bringing days-of-sales to 113 at year-end from 66 a year ago. In fact, 1994 growth in sales was $40 million, while dollar growth in A/R was more than $55 million. After the 9/30/94 quarter, management attributed one-third of the A/R increase to the acquisition of Serving Software (accounted for by a pooling of interest). However, in looking at the quarter preceding the acquisition Serving Software reported A/R of $5 million compared to the $74 million reported by HBOC. Plus, during the first six months of 1994 HBOC had already increased days-of-sales to 101, while Serving was reducing theirs from 230 to 127.
The growing accounts receivable continued beyond anything I could have imagined. The updates to the reports followed about every four months. Accounts receivable was usually mentioned, before the warning was canceled after the company was acquired by McKesson in 1999. Here are brief excerpts from the updates:
Account receivable growth continues to outpace sales growth, bringing days of sales to 115 days. (4/96)
Account receivable days of sales continues to hover at more than 110 days. (8/96)
We still express concern over HBOC levitating A/R days of sales as it now has climbed over 130 days. Even more disturbing is how allowance for doubtful accounts actually declined while accounts receivable increased by 60%. (3/97)
Warning retained. HBOC continues to grow by acquisition, and the price is starting to increase. HBOC paid almost 10x revenue for HPR, Inc. Accounts receivable days of sale remain high at 134 days for the 12/97 quarter. (3/98)
Right after the acquisition closed and the auditors starting looking at the books they found that HBO & Company had booked sales before the contracts were completed and had to restate its earnings. The stock immediately lost about half its value. The New York Times reported that:
McKesson appears to have detected the sales discrepancies during its routine year-end audit. According to analysts, McKesson's accounting firm, Deloitte & Touche, mailed a survey to several clients asking for the amount they had actually purchased from the company. Several of the amounts returned by clients did not match what HBO had recorded.
It took more than a year to sort everything out, including the SEC filing charges against two HBO & Company executives for securities fraud. Here is another quote from a New York Times article in November 2000:
The Deloitte auditors concluded that in 1996 and 1997, HBO had improperly recorded sales before customers had approved the transactions. The Bear, Stearns memorandum says that "did not accord with G.A.A.P.," as generally accepted accounting principles are known. Deloitte was said to have concluded that Andersen knew of the incorrect accounting but "apparently did not challenge" it on the basis that the amounts involved, $5 million or more a year, were not material to the company.
The Deloitte accountants are also said to have concluded that HBO was recognizing too much revenue when it sold software that it was required to maintain and that it abused merger reserves to hide costs that should have been treated as ordinary expenses. The lead Deloitte accountant on the review, Theresa Briggs, is quoted as saying the likelihood of a required restatement of profits, if the S.E.C. learned of the details, was "high."
According to the Securities Litigation & Regulation Reporter, the SEC suit was based on:
In part, the fraud consisted of concealing contingencies related to software sales contracts in "side letters," which were hidden from HBO & Co.'s accounting staff, says the SEC. The side letters included contingencies regarding the contracts, which affected when the revenue could be recognized under generally accepted accounting principles.
In addition, the agency says the perpetrators of the fraud backdated contracts so they fell within the previous quarter and made false journal entries that understated expenses and inflated the company's net income.
While not all instances of rising days of sales turn are indications of fraud, know what "red flags" to watch out for can help find torpedo stocks before they do the damage. It should also be noted that companies can hide items it does not want investors to see for years. Whether it was HBO & Company in the late 1990s or more recently Enron, there is usually something that does not pass the smell test. Let me know if this was helpful and I will try to do it more often.