Tag Archives: Accounting

2013–year of the “Great Rotation”?

January 16, 2013 By in "Great Rotation", Constructing a Portfolio, Current Market Thoughts, Portfolio management, Recent Market Action Tags: , , , , , , , , , Leave a comment

The “Great Rotation” is what journalists have begun the call the idea that investors of all stripes–but particularly retail–are starting to reverse the sharp shift in asset allocation away from stocks and into fixed income that they made as the Great Recession unfolded in 2008.

There’s some evidence that a shift of this kind is beginning.  Recent weeks have shown sharp increases in flows into equity mutual funds, although the main winners have been global/international funds and emerging markets funds–not US-only ones.  At the same time, there have been sharp outflows from developed market bonds funds.  At least some of this money has gone into stocks, although most may have been reallocated into emerging markets bond funds.

I have some reservations, though:

–Yes, the flows have been unusually large.  But until we see more data it’s hard to know whether these are beginning-of-the-year adjustments that will disappear come February, or whether they’re a more enduring trend.

–More important for us as equity investors, it’s not clear that shifts like this are good for stock market performance.  Intuitively, you’d think they should be, but historically they’re not.

Fidelity, for example, released a study more than a decade ago about investor experience in one of its flagship funds.  The results were that the fund itself had made, say, a 100% gain over a ten-year period.  The average investor in the fund, in contrast, had a gain of only, say, 30%.  Why the difference?  People were always selling at low points for fund net asset value (when they were afraid) and buying at high points (when they were feeling good and when the fund had already been showing strong returns for  while).

I’d been working for about a year for a load fund organization trying, unsuccessfully to that point, to improve the performance of a chronically underperforming portfolio (it subsequently did really well, and for a long time).  A very successful broker came up to me at a sales meeting and told me he’d just put a large amount of his clients’ money into my fund.  When I thanked him, he asked me if I wanted to know why he’d done this.  With some trepidation, I said yes.  He told me he looked for competent managers whose portfolios were underperforming and who were generally unloved.  His exit signals?   …a sustained period of outperformance, followed by strong inflows of cash.  The clincher for him was if the organization began a sales campaign touting the fund.

Colleagues at other organizations have told me basically the same thing–they found it’s always time to become defensive if they start seeing large cash inflows.

Look at the past four years.  Despite continual cash outflows from the US market, the S&P has more than doubled from the early 2009 lows.

–a rotation out of bonds, in my view, will only start when interest rates begin to rise–and bond investors begin to experience losses. My guess is that this is a least a year off.  During periods like this in the past, stocks have been flat to up.  Rising interest rates are a negative for stocks, too.  But rates can rise only if the economy is healthy enough to be producing increasing corporate profits, which act as a stabilizing influence on equities.

the fiscal cliff: why not just raise income tax rates?

December 13, 2012 By in capital flight/brain drain, economics Tags: , , , , , Leave a comment

There are several arguments–some theoretical, some the fruit of bitter experience–against raising income tax rates beyond a certain level.

To be clear, personally I don’t think they apply in the present argument about how to close the current US annual $1 trillion+ Federal deficit.  After all, the country seemed to run perfectly fine in the 1990s, when rates were higher.   So I don’t see how turning the clock back to the status quo ante can be so bad.  (Following that logic would also imply rolling back the extra healthcare benefits enacted at the same time.)

I suspect that the biggest stumbling block is that patronage politicians know very well how to divide up shares in an ever-expanding economic pie (who wouldn’t?) but are incapable of agreeing on how to apportion mutual sacrifice.  It doesn’t help matters that, in my view, Republicans have an antediluvian economic philosophy and Democrats have none.

Nevertheless, there’s a limit to how high rates can be pushed.

how can higher tax rates be bad?

When rates reach a certain point:

1.  people start to work less.  I had an eccentric uncle (one of my favorites) who quit his brokerage house back-office job (the only position Irish Catholics would be hired for) and supported himself for the rest of his life investing his own portfolio–turning $400 into $1 million+.  Why leave?  …he was so incensed at the income tax he was paying on overtime.  Uncle Harry wasn’t your typical worker.  But if you’re losing, say, 70% of your incremental income to the tax man, what’s the point of doing extra work?

2.  people spend increasing amounts of time on gaming the tax code, diverting economic energy from more productive uses. Behavior can get crazy.  In the UK in the early 1980s, companies were buying suits and renting them to their executives rather than giving pay raises, because the tax on incremental individual income was so high.  If history runs true, the loophole-ridden US tax system would spawn huge amounts of new tax shelters–very profitable for promoters, disastrous for the purchasers.

3.  tax avoidance accelerates.  I was sitting next to the Spanish finance minister at a lunch early in my career.  I naively suggested that his country would have to raise income taxes in order to close a troublesome budget deficit.  The minister looked at me like I had dropped from the moon.  He explained that income tax rates in Spain were already as high as they could go.  Experience showed that pushing them higher resulted in lower tax receipts.  Very many people would begin to hide substantial amounts of their income from official eyes through off-the-books transactions.

4.  people leave the country.  In the US, we can see this behavior on the state level, in the steady migration from high-tax areas like New York, New Jersey or California.  France, which has recently raised the top income tax rate on high earners to 75%, is now seeing the wealthy starting to renounce their French citizenship and move elsewhere in the EU, like the UK or Belgium.

thoughts on Hewlett-Packard (HPQ) and Autonomy

November 26, 2012 By in earnings conference calls, Stock ideas, Technology Tags: , , , , , , Leave a comment

background

In mid-August 2011 HPQ announced an all-cash, $11 billion+ bid for the British software company, Autonomy.  The offer came at more than a 60% premium to the latter stock’s close the prior day.  The deal, masterminded by HPQ’s then CEO Leo Apotheker, closed in early October last year.

By mid-May 2012 both HPQ executives who championed the deal, Mr. Apotheker and HPQ’s head of strategy, Shane Robison, had been shown the door, as had Autonomy founder Michael Lynch, as well.

Last week, when reporting its 4Q results for fiscal 2012, HPQ announced a whopping $8.8 billion writeoff “relating to the Autonomy business”!  In an 8-K filing with the SEC, HPW explained:

“The majority of this impairment charge relates to accounting improprieties and disclosure failures at Autonomy Corporation plc (“Autonomy”) that occurred prior to HP’s acquisition of Autonomy, misrepresentations made to HP in connection with its acquisition of Autonomy, and the impact of those improprieties, failures and misrepresentations on the expected future financial performance of the Autonomy business over the long-term.  The balance of the impairment charge relates to the recent trading value of HP stock (emphasis mine).”

What’s going on?

two aspects to the mammoth charge

–first, according to the statement above, HPQ now realizes it paid twice as much as it should have ($5 billion+ extra) for Autonomy.  It feels this happened because it received false, misleading or incomplete information about Autonomy’s business while considering the acquisition.

HPQ has asked both the FBI and the UK’s Serious Fraud Office to determine whether any laws were broken.

–second, HPQ says something like $3.5 billion of the charge comes from “the recent trading value” of HPQ stock.   Huh!?!

let’s start with the second item

Oddly, the company gave no further explanation on its conference call, even though, assuming it’s $3.5 billion–we’re talking about a writeoff equal to 15% of HPQ’s market cap.  No analyst asked about what the charge was about, either.  Nor have I seen any financial media comment explaining what the charge is.

What really gets my attention is that in thirty years of looking at stocks, I’ve never before seen a statement/explanation like this one.   What can it mean?

–To begin with, the charge is big enough that it had to be disclosed.

–HPQ isn’t making an off the cuff remark.  The 8-K statement above was repeated, word for word, at least twice during the earnings conference call.  So the wording has been carefully crafted and presumably approved by batteries of lawyers.  It also can’t be an accident, in my view, that there’s no further elaboration (isn’t this a “disclosure failure”?).

We have a few other clues.  The $3.5 billion or so is a non-cash charge (meaning no actual money is being paid out by HPQ).  It relates to the Autonomy acquisition.  It appears to have been triggered by the recent declines in HPQ stock.

On the other hand, the charge appears to have nothing to do with the wildly optimistic estimate of the present state and future profit potential of Autonomy that HPQ made in 2011.

My guess:  to me, it looks as if the recent decline in HPQ stock below some level, say, $20 a share, has triggered a contingent liability of HPQ’s–one by which it either forfeits a payment of $3.5 billion or which requires it to issue new stock with that market value.

If so, this could be “related” to the Autonomy acquisition in the sense that HPQ interprets the fall in its stock to be a direct result of Autonomy’s shortcomings (how you can make that argument is beyond me, though).

Or it could be “related” in the sense that the bank agreement HPQ struck to finance the Autonomy purchase called for stock issuance in the event the riskiness of the loan increased–as measured by a fall in the HPQ stock price.  I’ve looked at the Autonomy acquisition-related documents, including the bank financing arrangement pretty carefully (okay, sort of carefully)–and have found nothing.  A good bit of the loan agreement has been redacted, however, so it’s still possible that the banks have demanded collateral.

All in all, this part of the writeoff seems to me to have more to do with HPQ decisions on how to shape its capital structure than about Autonomy per se.  The worst part is the lack of explanation.

HPQ’s information shortfall about Autonomy

As I understand it, there are several questions of accounting technique that HPQ is now calling improper:

–when Autonomy delivered software to OEMs or other distributors, it booked the revenue immediately, rather than waiting for the distributor to resell it to an end user.  This isn’t the most conservative approach, but it’s what sellers of video game software customarily do.

–when Autonomy sold multi-year software licenses, it recognized all the profit immediately, rather than over the term of the license.  Again, not the most conservative  …but the way Apple accounts for its iPhone sales.

–when Autonomy sold directly to end users, it recognized revenue when the sale was agreed to, unless there was an acceptance period, in which case it would wait until the user signed off as satisfied on the installation.

None of these practices are in themselves deceptive, in my view.  Autonomy maintains they’re fully disclosed in the annual report (which, in general terms, they are).

HPQ has made more than fifty IT-related acquisitions over the past decade.  So it should know that the way a company chooses to recognize revenues and costs is perhaps the question in understanding an acquisition target’s financials–and that the devil is in the details, not in the annual report generalities.  Nevertheless, it sounds like neither the top management at HPQ nor the directors of the company asked for any elaboration.  The firms HPQ hired to do due diligence also found nothing wrong.

I’ve seen intimations in the press that during the time Autonomy was shopping itself to other software firms it may have “stuffed” its indirect distribution channel with more software than distributors could reasonably be expected to sell, or persuaded direct customers to start the software purchase process early–measures calculated to make recent growth rates look better than they actually were.   Anyone with a skeptical bone in his body would check for this.  And either tactic should be relatively easy to detect–for anyone who had some knowledge of accounting, the experience to be aware of typical “tricks” used in the industry, and a willingness to do due diligence.    Apparently in this case no one did until mid-2012.

In short, it’s hard to understand how a group of seasoned technology veterans in an M&A-intensive firm could have allowed itself to be as thoroughly deceived as HPQ is now claiming.

And then there’s Oracle, which asserts Autonomy pitched itself to it on April Fool’s Day 2011.  Oracle says it knew simply on the basis of a short presentation that Autonomy was substantially overvalued, even at the then market price of $6 billion (Oracle has posted the slides presented by investment banker Frank Quattrone.  The fine print Disclaimer at the end of the first set says it’s sent “in connection with an actual or potential mandate,” meaning an M&A transaction.  Ugly slides;  not much pertinent info.)

call for criminal/civil investigations 

I suppose it takes a certain amount of courage for a highly compensated group of supposed battle-scarred businesspeople to admit to having been bamboozled out of $8.8 billion of shareholder cash.  On the other hand, coming clean is probably the best option the HPQ management and board had.  Certainly, trying to disguise the facts would be worse–and would weigh on reported results for years.

The call for criminal and civil probes of the Autonomy transaction may well boomerang on some present or former HPQ executives.  But alerting the regulatory authorities eliminates a lot of possible skepticism that HPQ might be downplaying the affair.  Of course, so far as I’m aware, none of the HPQ directors who rubber-stamped the Autonomy acquisition feel bad enough to have offered to resign.

a stock market buy?

Deep value investors might be tempted.  Why?  …precisely because the company has a recent history of inept management and because the stock has lost 3/4 of its market value since ex-CEO Mark Hurd departed in a personal conduct scandal.  The S&P is up by about 1/3 over the same span.    The argument would have two aspects:

–the same assets in more competent hands could be worth a lot more than the current $12.44 a share.  Mr. Hurd demonstrated during his tenure how that can happen.

–you can’t fall off the floor.  i.e., the worst is already in the HPQ share price.

The big imponderables are:  whether all the company’s dirty laundry is in display, and how different from current management the new hands might be.

As a growth investor I don’t have the background/skills or inclination to reach a conclusion and place a bet.

why does Wall Street care about sales gains and not just earnings gains?

October 22, 2012 By in margins, Portfolio management, reasons analysts mis-estimate company earnings, sales/share vs. earnings/share Tags: , , , , , Leave a comment

…after all, what ultimately matters is how much profit a company’s management is making for its shareholders, isn’t it?

Yes, and no.

two special cases

Let’s deal with two special cases before getting to the main topic.

–Investors who focus a lot of their attention on startups that are not yet making money will typically use sales growth as their major metric.  There are no profits yet.

–Value investors will be drawn to mature companies with lots of sales and little or no earnings because of their turnaround potential.  This is especially true if they can see other firms in the same industry who are comfortably profitable with similar levels of sales.

Neither is an example of the phenomenon we are now seeing as some companies report 3Q12 results.

strong earnings, weak sales

When earnings meet/beat the consensus estimates of brokerage house analysts–and sales don’t, the stock in question often goes down, sometimes by a lot.

Why?

it’s all about recurring earnings

1.  Investors typically look for recurring gains when they buy stocks, not one-off profits.

Consider this oversimplified example:

A company reports earnings per share of $1 for the current quarter.  If you know that this is all the profit the firm will ever make, then–assets (if any) aside–you won’t pay more than $1 for a share of stock.  (In fact, you’d probably pay less, since the $1 of profits is in the hands of management, not in yours.)

On the other hand, if you thought the company would earn $1/share every three months for the next ten years, you could be willing to pay up to $40 for a share of stock.

So there’s a huge difference between the value to investors of recurring and non-recurring profits.

2.  If a company reports higher earnings without what analysts consider an appropriate increase in sales, investors assume that the firm has achieved its profit target through cost-cutting of some type.  They argue, correctly in most cases, that the profit increase isn’t sustainable.

More than that, they view the slower sales increase as a leading indicator of slowing profit growth that will emerge in subsequent quarters.  They can see the train coming at them, as it were, so they don’t wait to get off the track.  They sell now.

Their picture is this:

Suppose the company has been spending $1 million a quarter on marketing up until now, but cuts the budget to $500,000 for the just-reported quarter.  That produces just enough extra margin that the company reports $1/share in earnings instead of $.90, thus meeting consensus eps expectations.

The worst case is that the reduced marketing is a mistake that will negatively affect sales and profits in coming quarters.  But even in the best case–that this is a true savings–the company can only cut marketing expense once.  

Yes, the company will also report an extra $.10 in eps for the next three quarters.  But that’s it.  This is really no longer a company earning $1 a share per quarter for as far as the eye can see.  It’s a company that’s earning $.90 a quarter + a non-recurring $.10 now and for the next three reports.

If you were previously willing to pay $40 for $1 a share in quarterly earnings, you should (at most) pay $36 for $.90 a quarter profits.  Add (at most) $.40 for the non-recurring earnings.

The main point is that cost-cutting has to end relatively quickly–and should not be mistaken for a permanent element of a company’s profitability.

3.  Some managements won’t be inclined to call attention to this information and will just show it somewhere in the financials (in the hope analysts won’t bother to read the fine print).  The cost-cutting could also be a bunch of little things, significant in the aggregate but not big enough individually to require disclosure.   If so, the slowdown in sales is the only clue to what’s really going on.

4.  For multi-line companies, the situation isn’t so simple. Sometimes, a firm may be phasing out a line of business where it earnings little or no profit, so it’s sales growth sags while profits advance smartly.  Here, “Shoot first, ask questions later,” may be the wrong strategy.  But it’s what short-term traders always do.  And, in my experience, “Shoot first…” is right more often than not.

the Intel (INTC) 3Q12 preannouncement: studying operating leverage

September 12, 2012 By in Constructing a Portfolio, margins, operating leverage, Portfolio management Tags: , , , , , , , , , Leave a comment

the preannouncement

As I wrote about yesterday, INTC preannounced weaker than expected 3Q12 earnings.  The main culprit?  …worldwide general economic slowdown.

The company said it now expects revenues of $13.2 billion for the quarter, down by 7.7% from the $14.3 billion it guided to when it announced 2Q12 earnings two months ago.  The gross margin will come in at 62% instead of 63%.  Virtually all other cost items will remain the same.

looking at leverage

This isn’t much data.  But it’s enough for us to see two things about the company, manufacturing leverage and leverage on SG&A (Selling, General and Administrative) expenses.

manufacturing leverage

two kinds of costs

In the simplest terms, in every accounting period employees get paid and the accountants apportion costs for the use of the factory and the machinery in it, whether or not anything gets build.  So, in a sense these are indirect costs of manufacturing.  In the short run, they’re relatively fixed.

In addition, there’s the cost of the materials–electricity, gas, silicon, who knows what else–that get used up in making INTC chips.  These are direct costs.   Their total in any period is variable, depending on how many chips get made.

Accountants assign each chip a total cost that depends on two factors:  the out-of-pocket cash (variable cost) spent making it plus its share of indirect costs, a figure that depends on how busy the factories are.

gross margin

Total cost ÷ sales price = gross margin.

separating the two

Is there a way to find out how much of the total cost is variable and how much depends on how well sales are going in a given quarter?  In INTC’s case, yes.

Management has just told us that sales will be $1.1 billion less than anticipated and that this fact will lower the gross margin by a percentage point.  That’s not because the variable cost of making a chip has changed; it’s because the indirect (or fixed, or overhead) costs of running the factories are being distributed over a smaller number of chips.  (It’s a little more complicated than that, but not a worry in this case.)

Another way of saying this is that in order to get to the new, lower, sales and operating profit estimates, INTC has subtracted the sales price of the extra chips it won’t sell and only the variable cost of making those chips.  If we calculate the change in estimated gross profit and divide by the change in sales, we’ll get a variable cost margin for those “extra” chips.

Here we go:

$13.2 billion x .62  =  $8.18 billion in gross profit

$14.3 billion x .63  =  $9.01 billion in gross profit

The difference is $.83 billion, the gross profit lost from lower sales.   This gross profit   ÷ $1.1 billion in lost sales   =  75.5%.

Therefore, 75.5% is the profit margin from producing/selling an extra chip during the quarter.  That’s the manufacturing leverage INTC gets at current production levels for getting/losing additional sales.

Note, too, that the new operating profit is 9.1% less than the original estimate.  That compares with a 7.7% drop in sales.  So, while there is operating leverage in the manufacturing operation, but at current production levels it’s not huge.

SG&A leverage

INTC has two types of SG&A.  One is R&D.  The other is the typical SG&A that any industrial company has. The two items are roughly equal in size.  This quarter they’ll amount to $4.6 billion.

Let’s subtract that from both the original gross profit estimate and the new guidance.

$8.18 billion  -  $4.6 billion  =  $3.58 billion in operating income

$9.01 billion  -  $4.6 billion  =  $4.41 billion in operating income

Now calculate the percentage drop in operating income that our 7.7% decline in sales produces.

It’s 18.8%!

To recap, the 7.7% fall in sales produces a 9.1% drop in gross profits and an 18.8% contraction in operating profits.  Of the 11.1 percentage point differential, 1.4 comes from the manufacturing process, 9.7 from SG&A leverage.

In other words, the operating leverage at INTC is coming from SG&A, not manufacturing.  If INTC wanted to reduce costs in a way that would affect current reported profits the most, it would attack either R&D or “normal” SG&A.

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