warts becoming visible (i)

receivables vs. payables

I’ve always been a fan of analyzing working capital, which shows the flow of cash in the inventory cycle, from the bank account to raw materials to finished goods to sales and getting paid.

There are lots of standard ratios, but my favorite has always been receivables vs. payables.  Taken in its simplest form this shows how eager people are to obtain the company’s goods (small receivables, which means little financing provided by the company) vs. how eager suppliers are to have the company as a customer (large receivables, which means easy payment terms).

Whenever markets go south, some limitation or other–or some abuse–of financial reporting rules invariably comes to the fore.   This time, for me at least, the culprit is payables.

factoring

I’ve known for a long time about factoring receivables, meaning the company sells them to a third party, getting them off the balance sheet.  Whatever the motivations of management, factoring makes the demand from customers and the company’s need for cash look better.

Until the financial crisis of 2008, financial accounting standards did not require that this activity be disclosed to shareholders.  Since then, as I read the FASB rules, big changes in the level of factoring, up or down, must be disclosed   …but nothing else.

reverse factoring

Something I’m just learning about during the current downturn is reverse factoring aka supply chain finance.  It’s the cousin of factoring, but on the liabilities side of the balance sheet.

This one’s a little more complicated, but there’s a bad case where a company arranges for a bank credit line.  A supplier essentially takes his payable to the bank for payment, creating a loan balance for the arranging company.  But this debt either doesn’t appear, or doesn’t appear in an easily understandable way, in the company financial statements.

This esoteric financing ploy only came to the market’s attention in the bankruptcy of Carillon in the UK in early 2018.   But the recent call by the big four accounting firms for the SEC to clarify what disclosure of reverse factoring must be made suggests that
Carillon is not an isolated case.

My sense is that this is not an issue for most companies but that highly financially leveraged firms may be in considerably worse shape than the reported financials show.  This presents a problem for anyone wanting to speculate on a turnaround in world economies or world stock markets.  The most aggressive strategy would be to bet on the companies that have been pummeled on fears they won’t survive the pandemic-related downturn.  To my mind, however, these are precisely the firms where risk of large “hidden” debt is the greatest.

 

 

 

when is a sale a sale?: the EFII case

On Thursday, Electronics for Imaging (EFII), a copier company I knew well twenty years ago, issued a press release which it filed as an 8-K with the SEC.  The release reads in part:

“Electronics For Imaging, Inc. (Nasdaq:EFII), a world leader in customer-focused digital printing innovation, is postponing the conference call at which it anticipated discussing second quarter 2017 preliminary results in order to enable the Company to complete an assessment of the timing of recognition of revenue. The assessment is related to certain transactions where a customer signed a sales contract for one or more large format printers and was invoiced, and the printer(s) were stored at a third party in-transit warehouse prior to delivery to the end user.

In addition, EFI is in the process of completing an assessment of the effectiveness of EFI’s current and historical disclosure controls and internal control over financial reporting. EFI expects to report a material weakness in internal control over financial reporting related to this matter. EFI also expects to report that EFI’s disclosure controls were not effective in prior periods.

The Company currently expects that the total aggregate revenue for the periods under review will not be materially different from the aggregate revenue that was previously reported for those periods, taking into account any revenue from the prior periods that may be moved into the current or upcoming periods.”

The stock lost 45% of its market value in Friday trading.

What’s this about?

While the situation is still pretty muddy, the basic issue is what counts as a sale–how an order for a company’s products ends up being counted as revenue in the company’s income statement.

In the case of large, expensive precision equipment (think: multi-million dollar semiconductor production machines), an order doesn’t become a sale until the unit is delivered to the plant and is installed and working to the satisfaction of the receiving company’s engineers.  This process can take weeks from the time the equipment leaves the factory.

For just about everything else, an item is considered sold the second it leaves the factory–whether in the mail or a UPS van, or in a truck owned by either party to the transaction–and a bill is sent.  Initiating delivery allows the sender to book the associated revenue on the income statement.  (Returns?  Companies typically reduce reported revenue by an estimate–based on their past experience–of likely returns.  The estimate is usually not disclosed.  Returns only become an issue if they’re much larger than the return provision.)

 

In the EFII case, in contrast, it sounds like items were shipped, a bill was sent and revenue was recorded on the income statement, even though no one had actually ordered the shipped merchandise.  The merchandise was then held in a third-party warehouse until an actual customer order came in–at which point the items were shipped.

 

Why do this?   …to make current earnings look better than they actually were.

What’s still unclear:

–who knew about this

–how long the practice was going on

–how large the phantom sales had grown

–how it was discovered.

 

The press release, which I’m regarding as having been carefully crafted by EFII’s lawyers, suggests to me that the revenue overstatements:

–have been going on for a long time (“controls were not effective in prior periods”), and

–the amounts involved may be large (“revenue from the prior periods…may be moved into…upcoming periods(emphasis mine)).

Yes, the warehoused merchandise may eventually be sold (that’s my reading of the third press release paragraph above).  The biggest issue for investors is that the company may have been overstating its growth rate for some time through phantom “sales.”

 

 

buying an individual tech stock

This is just a brief overview:

–Buying any stock involves both a qualitative and a quantitative element.  That is:  What does the company do that makes this a good stock to own? and How do the numbers–the PE ratio, asset value, dividend yield and earnings growth–stack up?

–For value stocks, the numbers are more important; for growth stocks, the story is the key.  That’s because the primary element in success for value investors is how carefully they buy (because the ceiling for a given stock is relatively clearly defined).  For growth investors, it’s selling before/as the drivers of extra-fast earnings expansion run out of steam.

–Most tech stocks fall in the growth category.  My advocacy for Intel a few years ago was one of the rare occasions where a tech story is about under valued assets.

–In most cases, tech companies own key intellectual property–software, patents, industrial knowhow–that is in great demand, and which competitors don’t have and can’t seem to create substitutes for.  As long as that remains true, the company’s stock typically does well.  As I just mentioned, a crucial element in success with tech (or any other growth sector) is to exit before/as the growth story begins to unwind.  One yardstick is that this typically happens five years or so after the super-growth starts.  Yes, the best growth companies, like Apple or Microsoft or Amazon, have an ability reinvent themselves and thereby extend their period of strong earnings success.  But this isn’t the norm.

–Learning to be a stock investor is sort of like learning to play baseball.  There’s no substitute for actually playing the game.  The best way I know to learn about a stock is to buy a very small position and see what happens.  Don’t just sit idle, though.  Read everything on the company website, and the websites of competitors.  Read the last annual report and 10k.  Listen to (or read the transcripts of) the firm’s earnings conference calls.  Find and monitor (at least the headlines) financial newspapers and relevant blogs.  Try to form expectations about what future earnings might be and check this against what actually happens.  Then figure out where/how you went wrong and adjust.  Watch how the market reacts to news.  At first you may be terrible.  I certainly was.  But if you’re honest with yourself in your postmortems, you’ll probably make considerable progress quickly.

–Sooner or later–preferably sooner, learn to interpret a balance sheet and income statement.  A local community college course would probably be good, but you can get the basics of financial accounting (definitely don’t worry about double entry bookkeeping) from a book over a weekend.  Remember, here too there’s no substitute for the experience of trying to work out from a given company’s actuals what future income statements, balance sheets and flow-of-funds statements will look like.

 

three ways to account for associated companies

This post is to lay the groundwork for understanding what Nintendo actually said about Pokemon Go last Friday.

There are three basic ways to account for companies that a firm owns an interest of less than 100% in another firm.

–the cost method.  This is used when the firm whose financial reports we’re talking about has neither influence nor control over the operations of the enterprise held.  A good rule of thumb is that this means a holding of less than 20% of the outstanding shares.

In this situation, the holding is listed on the balance sheet as a long-term investment at acquisition cost.

Under normal circumstances, the income statement contains no accounting of the holding’s financial results.

Two exceptions:  dividends paid are recorded as income; if the asset is impaired, the loss is shown on the income statement.

On the other hand, if the value of the holding increases, there’s no reflection of this in the owner’s financials.  Yes, accounting theory says the holding value should be adjusted periodically for changes in the investment’s fortunes, but as a practical matter this is rarely done.

equity interests.  This is where the holding firm is judged to have influence but not control over the entity held.  Typically, this applies to holdings that fall between 20% and 50% ownership of the investment.

If so, the owner records his share of the financial results of the holding on a single line toward the bottom of the income statement.  This line is called “Equity Interests” or something like that and is an after-tax aggregate of all such equity interests.

The holder also adjusts the balance sheet value for profits (up), losses (down) and dividends received (down).

consolidation.  This is the case where the holding firm exercises influence and control.  The rule of thumb here is that ownership of 50% or higher implies having both.

If the ownership is less than 100%, the consolidating company still reports results–revenues, costs etc.–from operations as if it owned 100%.  But it add correcting, after-tax entries, both in the income statement and on the balance sheet, typically labelled “Minority interests” that subtract out the portion of earnings and assets held by others.  Again, these are aggregate figures and not broken out holding-by-holding.  Minority interests are usually recorded toward the bottom of the income statement, somewhere near the consolidated net income line.

Tomorrow, how this applies to the Nintendo announcement

 

transfer pricing

transfer pricing

Consider the case of a Japanese company that makes cars in Brazil, which it then sells in the US.  Its internal control books will allocate a portion of the revenues and costs of a given car to operations in Japan for use of the brand name and the firm’s intellectual property, another portion to the manufacturing operations in Brazil and a third to the sales operations in the US.

This allocation process is called transfer pricing.  This in itself is a benign process.  After all, the firm has to understand whether Brazil is a profitable place to make cars and whether the Brazilian output should be allocated to the US or to other, potentially more profitable, markets.

What makes transfer pricing controversial, however, is that the firm also has tax books.  And the logic that dictates the management control profit decisions may not be the same as the one that minimizes taxes.

An example:

When I began working as a global portfolio manager in the mid-1980s, Tokyo was a very important stock market.  Multinational brokers all had lavish offices in swanky downtown districts and very large staffs–all of which seemed to be growing by the day.  Yet, I kept reading, at my then glacial, now non-existent, kanji speed–in the Nihon Keizai Shimbun that these same brokers were losing tens of millions of dollars a year.  This state of affairs had been going on for years, with no relief in sight.

I began asking around.  What I learned , after a long time of digging, was that all of the Japanese securities trades that customers placed with these brokers were funneled through their Hong Kong offices.  In an operational sense, this was crazy.  I knew most of the Hong Kong operations of these firms.  They knew nothing about Japan, in my opinion.  And, of course, this was an extra, possible mistake-inducing, step.  Why?

The answer is simple.  Japan had, along with the US, the highest corporate tax rates in the world.  In Hong Kong, the tax on foreign corporations’ profits was zero.  So every foreigner in any line of business established a Hong Kong office and recognized on its tax books as much international profit there as it thought it could get away with.

What’s in this for Hong Kong ?  Again, simple.  The move created employment, commerce and taxable salary income that the now-SAR would not have had otherwise.  The price was only forgoing tax income it would never have had anyway.

The general transfer pricing tax strategy:  recognize as much profit as possible in low-tax jurisdictions, the minimum amount in high-tax locations.

turning to the EU today…

Margrethe Vestager, the new EU competition commissioner, is starting a crackdown on what the union considers abusive tax practices.  Her first targets are Starbucks and Fiat.

In the Starbucks case, Vestager has two gripes.  Both relate to a low-tax corporate subsidiary set up by Starbucks in the Netherlands, using an aggressive tax strategy endorsed as legal by that government thorough an informal tax letter.   (The situation is outlined best, I think, in a New York Times article).  The subsidiary allegedly:

–bought coffee beans for Starbucks worldwide from Switzerland and marked them up by 20% before selling them to other parts of the company, thus shifting profits away from higher-tax jurisdictions around the globe, and

–levied charges for the use in the EU of the Starbucks name and its secret coffee roasting recipe (which the EU competition commission claims was basically a temperature setting).  In the case of the large UK subsidiary of Starbucks these fees for intellectual property apparently amounted to most of its pre-tax income.

 

Vestager is not saying that Starbucks, Fiat and others did anything wrong.  She’s saying the Netherlands, and other countries that offered sweetheart tax deals did.  And she wants those countries to collect back taxes.

It will be interesting to see what develops, since presumably every multinational doing business in the EU is employing similar devices.