Category Archives: Accounting

chit funds, crowdfunding and p2p banking (II)

April 19, 2012 By in Accounting, Asian economic development, Banks, chit funds, chit funds, Current Market Thoughts, emerging markets, Industry Analysis, P2P lending Tags: , , , , , , , , , , 1 Comment

two lessons from history

Thailand

I was just getting acquainted with Thailand when the Ms. Chamoy Thipyaso chit fund scandal broke.  “Mae” (=Mother) Chamoy, the wife of a Thai Air Force officer, appeared to be running a very large chit fund investment operation that was stringing together a sequence of startlingly high investment returns.  She had agents throughout Thailand collecting new money for her.  Money was pouring in.

The fund turned out to be a gigantic Ponzi scheme, however.

The scheme sustained itself for an unusually long time.  It continued to operate even after it had become so large (US$100 million+) it was implausible to think Mae could find enough lucrative “secret” microfinancing opportunities in Thailand.  Several reasons for this:

–people wanted to believe.

–the fund appeared to have the backing of the military, the ultimate source of political and business leadership in Thailand.  This gave an implied assurance that the investment results were real.  Prominent high-ranking Air Force officers invested with Mae, and forcefully urged their subordinates to do so as well.

–investors who thought about withdrawing some of their “profits” were pressured not to do so, with the threat that if they took money out they would be blacklisted and not allowed to invest in the fund thereafter.

Interestingly, large investors in the Chamoy fund continued to urge their friends and work subordinates to plow money into the fund even after they realized it was a Ponzi scheme.  Their rationale?   …it bought them more time.  That extra time allowed them to continue to enjoy a lifestyle they knew was going to end when the fraud was discovered.  And it allowed them to arrange their financial affairs in a way that would minimize the negative impact on them personally.  To followers of the Bernie Madoff case in the US, this must certainly sound familiar.

my thoughts

In my reading about microfinance, it seems that Ponzi schemes have been a constant problem wherever third-party chit funds–not the ones where friends and neighbors lend to one another–operate.  That means virtually everyplace in South Asia and Africa.  There seems to be an especially large amount of study done of the industry in India, which I have no practical experience with (because the stock market isn’t easily open to foreigners–and I think the political environment is particularly unfriendly toward equity investors.)

Personally, I’d worry more about Ponzi schemes in the US springing up among the firms that the JOBS Act will allow to raise equity.  These are the entities that won’t have adequate financial controls or accounting statements for shareholders.

My chief p2p banking concern is a more prosaic one–that the present very low loan loss rates will prove to be more a function of the industry’s newness rather than of the creditworthiness of borrowers.  Time will tell.  And, unlike fraud, this is a risk we can take precautions for.

Taiwan

There was a unique twist to the Taiwanese chit fund industry that I encountered in the mid-1980s.   Chit fund loans were secured by post-dated checks issued to the borrowers by the lenders.  In Taiwan at that time, “bouncing” a check–having insufficient funds in the account to cover payment–was a felony, punishable by the check writer serving time in prison.

The threat of jail time was thought to be sufficient incentive to ensure repayment.  So no one worried too much about the creditworthiness of the borrowers, which–as it turned out–included large publicly-traded companies.  American accountants I met, who’d been sent to Taiwan to break into the auditing business there, told me that they could see the fact of unaccounted-for money sloshing around in potential client companies.  They just couldn’t see how much.  Because of this, they were reluctant to take any engagements.  And they were continually undercut by local accounting firms who charged virtually nothing for “audits.”   American bank lending officers told me the same thing.

The chit fund business received a major shock, during a mild economic downturn, some large companies had made hundreds of millions of dollars in chit fund loans–all unrecorded in the financial accounts–that they couldn’t repay.  Bankruptcies resulted.

my thoughts

This is another potential problem for equity holders in firms crowdfunded under the JOBS Act.  Without audited financials, it’s impossible for an outside investor to determine what the capital structure of a company is.

I also think, à la Taiwan, a legitimate auditor will simply walk away from a suspect company rather than make a public outcry.  Non-disclosure agreements may force it to do no more.  A less fastidious auditor, one nobody ever heard of, might take the business and issue a clean opinion.  After all, Bernie Madoff got one for years, didn’t he?

higher taxes on dividends? –implications for stock markets

February 17, 2012 By in cash flow/share vs. earnings/share, Constructing a Portfolio, currency effects, Current Market Thoughts, Dividends, Industry Analysis, Investment firms, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , Leave a comment

the Obama proposal

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.

importance of the cash flow statement: it’s like mushrooms

December 29, 2011 By in Accounting, cash flow, economics Tags: , , , , , , , Leave a comment

why project a cash flow statement?

While I was in graduate school, I spent a year in Germany studying at Eberhard Karls University in Tübingen.  Before school started I lived for a while with a German family.  Every Saturday morning we would roam the local woods in search of the mushrooms that would comprise one or two of our meals during the following week.  Since I had no clue what I was doing, my hosts would scrutinize any mushrooms I found very carefully to make sure they weren’t poisonous.

One type, the death cap–which I never stumbled across–still stands vividly in my mind.  According to my family and to public service announcements on tv, not only was this mushroom deadly, but the first symptoms of its effects only developed after the poisoning was too far advanced to be treated.

There’s an analog to this situation in the investment world.  These are cases where the financial results of past management actions narrow the scope of future possible outcomes to the point where one or two become highly probable–if not unavoidable. In these cases, management is never going to spell out the constraints it it working under.  Nevertheless, the current financial condition probably makes their future actions very highly predictable.

Projecting a cash flow statement for such a company is the way to uncover and evaluate.  (An analyst should do this for every company under coverage.  In my experience, most don’t.  In “mushroom” cases, however, the cash flow statement is crucial.)

examples

a toy company

In the early Nineties I was following–and for a while owned shares in–a small publicly owned toy company.  It earned, say, $10 million annually.  One year it had a surprisingly successful spring-driven flying toy doll for girls.  The following year it decided to make a similar toy for boys, with a martial theme and a stronger spring.  As I recall, the firm decided to spend $40 million on materials and labor for this toy (a real roll of the dice at 4x total corporate earnings).  It got the money through trade financing and borrowing from its bank.  The risk was especially high, since all the manufacturing had to be done at one time, in preparation for the yearend holiday selling season.  On the other hand, the prior year’s toy had been a smash hit; the firm really understood the boy market and felt this one would be, as well.

Soon after the toy was on the shelves of toy stores, the company began to get reports that the combination of a strong spring and curious young boys was resulting in severe eye injuries to users.  The government mandated a recall.  The $20 million in profits the company had envisioned was up in smoke.  The inventory that had cost $40 million to make was now worth close to zero.

Do the math.  At most $10 million in earnings from other toys vs. $40 million in short-term financing needing to be repaid = no way out.

the Mets

The New York Times published a recent article on the Mets’ finances, titled “For Mets, Vast Debt and Not a Lot of Time.”  There isn’t enough publicly available information to draw a firm conclusion, but if the figures in the article are correct, the Mets don’t have much wiggle room.  The current club drive to lower the total player salary bill may be the only real option it has.  Specifically,

Sources of funds:

The Mets lost $70 million (I’m presuming that this is a pre-tax figure, but this isn’t clear) last season, with a player payroll of about $150 million.  Let’s say the actual pre-tax cash outflow was $30 million.

If we make the (optimistic) assumption that ticket sales and concession revenue in 2012 is constant with 2011, then lowering payroll to $100 million will result in a pre-tax loss of $20 million for 2012.  Cash flow should be positive, at about $20 million.

2013 cash inflow = $40 million ?

2014 cash inflow = $50 million ?

Uses of funds:

repayment of $25 million to Major League Baseball, now overdue

repayment of $40 million Bank of America bridge loan

repayment of $430 million team loan in 2014.

If, again, the NYT figures are correct and the cash inflow numbers I’ve made up for 2012-14 are anywhere close, the Mets won’t be able to make much of a dent in the 2014 principal repayment requirement.  It seems to me that dealing with the $430 million that comes due in three years is the major management issue.

What I’ve written above is just the bare bones.  The Mets are attempting to find outside investors who are willing to accept having no say in the running of the organization.  Suit by the Madoff trustee is pending.  And, of course, there’s the tangled relationship between the Mets and SNY, the Wilpon-controlled cable network to which the club has sold broadcast rights.

others

Eastman Kodak has been supporting its ongoing turnaround through outside financing and asset sales.   Looking at the cash flow statement for the past couple of years and projecting it forward for the next few will be highly instructive.

Current market worries about Italy’s sovereign debt also have a cash flow basis.   The issue is the current high cost of refinancing maturing debt.  Unlike the previous corporate instances, Italy’s new government has much greater scope for initiating reforms that can change market perceptions quickly.  And perceptions, rather than the amount of outstanding debt (which is typically the corporate issue), are the main concern here.  Still, projecting sources and uses of funds forward for several years will give a much clearer grasp on the issues than simply watching current yields.

 

 

 

 

 

 

Sony/Samsung LCD jv restructuring: a study in cash flow vs. earnings

December 28, 2011 By in Accounting, Basic Concepts, cash flow, cash flow/share vs. earnings/share, Stock ideas Tags: , , , , , , , , Leave a comment

the Sony/Samsung LCD-making joint venture

On Monday Sony and Samsung announced a restructuring of the joint venture they entered into during 2004 to manufacture large liquid crystal displays for televisions.

The joint venture developed out of Sony’s dire need of LCD manufacturing capacity (it had badly underestimated how quickly flat panels would replace traditional CRTs) and Samsung’s desire to achieve economies of scale and its hope for technology transfer.  But after seven years, in a world awash in LCD-making factories, and given Samsung’s technological dominance over Sony, the jv had outlived its usefulness.

I haven’t looked at Sony carefully for years.  My overall impression continues to be that the firm is a mess.  But that’s not what I want to write about.

terms of the jv restructuring

The essentials of the recasting of the LCD joint venture are:

–Samsung will buy out Sony’s interest (50% minus one share) for around $950 million in cash,

–Sony agrees to buy LCDs from Samsung (no details of the arrangement given),

–Sony will record a loss of $850 million on the sale, implying its ownership interest is being carried on the balance sheet as worth $1.8 billion, and

–Sony expects to save about $160 million a quarter–a combination of savings on LCD purchases and being freed of the need to make new investments in the jv.

earnings and cash flow implications for Sony

earnings

The writeoff of its 2004 investment will depress Sony’s March 2012 earnings by $850 million.  The $950 million payment will be treated as a return of capital and won’t show on the income statement.

If we assume that the jv is simply breaking even, which is probably much too optimistic, there will be no effect, positive or negative, on future eps for Sony from its dissolution.  To the degree that the jv is loss-making, that red ink will disappear from the income statement.

cash flow

Here’s where the significant positive impact comes.  The transaction turns a loss-making asset into significant positive cash flow.

First, of course, Sony takes in $950 million in cash early next year, an amount equal to roughly 5% of the company’s market cap.

Second, it avoids having an outflow of money that it estimates at $160 million per quarter.  In other words, Sony enhances its cash flow by that amount.

Two positives from this:

–Sony can reallocate the cash saved to more productive activities, and

–my quick perusal of Sony’s most recent form 6-K (on page 18) suggests that the $160 million a quarter the jv was using up is virtually all the cash flow Sony is currently generating.

my point

This kind of transaction is a staple of value investing, where a loss-making asset that earnings-oriented investors regard as worthless is sold–and thereby is shown to have substantially more value than the market has realized.  In the case of larger sales or smaller companies, transactions like these can be transformative.

what the big Sony writeoff means

May 26, 2011 By in Accounting, deferred taxes, earnings conference calls, Stock ideas Tags: , , , , Leave a comment

Sony’s fiscal 2010 results

Sony reported its fiscal year 2010 earnings (the company’s fiscal year ends, as is customary with Japanese companies, on March 31st) in Japan overnight.  Tokyo Stock Exchange requires that all listed firms both make an official estimate of anticipated results.  The TSE also requires companies to publish a revision–prior to releasing the actuals–as/when it realizes the actual results will differ from the official estimate by more than 30%.  In line with this requirement, Sony announced a downward revision to earnings last Monday.

the writeoff

The issue is deferred taxes in Japan.  Sony wrote off US$4.3 billion.

The company points out that:

–the writeoff is a non-cash charge,meaning no money has been lost,

–this doesn’t preclude use of  tax-loss carryforwards in the future, and

–the charge “does not reflect a change in Sony’s view of its long-term corporate strategy.”

what this means

Unlike most Japanese firms, Sony keeps its official financial reporting books according to US Generally Accepted Accounting Principles.  GAAP uses deferred taxes.

Let’s say a company loses money this year–thereby establishing a tax-loss carryforward that can be used to offset taxes on future income.  GAAP tells the company that it should record a credit for this possible future tax benefit in this year’s financials.  In other words, if you have a loss of $100 this year, but anticipate that you will have enough profit, say, five years from now to employ this loss to offset $30 in income tax that would otherwise be payable, you should take the $30 gain in the current year.  You record a loss of $100 on your income statement plus a deferred tax benefit of $30.  The net loss you report to shareholders is $70, not the full $100 amount.

One proviso, though.  You have to have a reasonable basis for thinking that you’ll have enough future profit to use the potential tax benefit that today’s loss represents.  And your auditor has to agree with you.

Sony has been in loss in Japan for three years now.  The writeoff means that Sony’s accountants no longer think the company will be able to generate enough taxable income to use $4.3 billion of future tax credits it had previously expected to enjoy.

my thoughts

Sony cites the March earthquake/tsunamis as a reason for this re-evaluation.  But at the same time it notes that the damage to its businesses in Japan haven’t been that great, are mostly covered by insurance, and that it’s confident it will collect on its policies.

The benign reading of the big writeoff would be that Sony’s overall internal profit projections haven’t changed much and the important thing to note is the “in Japan” part of the company statement.  It could be the writeoff means that Sony is going to make a major shift of production away from Japan.  It will continue to make the same profits, just not in its home country.

In my experience, though, events rarely follow the benign path.  I don’t know today’s Sony well enough to judge in this case, but typically a firm’s accountants notice business deterioration and propose a writeoff–and management reluctantly (sometimes, very reluctantly) falls in line.  It may be that the operative word in Sony’s statement of confidence in its prospects is “long term.”

SNE as a stock

I don’t know the company well enough to have an opinion.  I know what I’d look for, though.

Sony has two main businesses:  consumer electronics and video games.  The company has lost ground in the first to Samsung and Apple.  In the current generation of game consoles, Sony has regained past form after turning first-mover advantage over to X-Box, allowing MSFT to gain a market share I don’t think it could otherwise have achieved.  But rival Nintendo is already talking about a new game console.  And the game business is morphing into one favoring simple games played on a cellphone or through a social network.  What are Sony’s plans?

Ideally, one would like to see both main businesses in sync and operating profitably–not strength in one being offset by weakness in the other.

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