Tag Archives: Accounting

Apple (AAPL) is splitting its stock, 7 for 1

April 24, 2014 By in earnings conference calls, Recent Market Action, Stock ideas Tags: , , , , , , , 2 Comments

AAPL’s 2Q14 earnings report last night was full of mostly positive surprises:

–earnings per share came in at $11.62.  That’s about 15% more than the Wall Street analyst consensus had expected, and higher, by about the same amount, than results in the same quarter a year ago.  It’s the largest margin AAPL has beaten the consensus by in years.

–the company is raising its dividend and increased its proposed share buyback amount by $30 billion

–AAPL is going to split its stock by 7 to 1.

Of these developments, I think the most important is the stock split.

stock splits

Academics will tell you two things about stock splits:

1.  Stock splits have no direct economic significance.  Its’ simply paper shuffling.  Instead of having one share that trades at, say, $560 you’ll soon have seven shares, each trading at $80.

2.  The stocks of companies that have stock splits tend to underperform for a period after the split occurs.

 

The second comment, while true, is, well, silly.  All the outperformance comes between the period when the stock split is anticipated by the stock market or actually announced and the date when the split takes place.

The first is also true–particularly in the United States (but not in many foreign markets).  But this doesn’t mean that the AAPL split has no relevance.

(See my post on stock splits for more details.)

Two reasons:

–stocks with very high per share prices tend to underperform.  Why?  I don’t know.  I think it’s because retail investors prefer to buy stock in round” lots (usually 100 shares).  This may be an echo from the days a half-century ago when trading costs were very high and when the commission for an “odd” lot (anything that isn’t a round lot) was particularly expensive.  For AAPL, this would be a commitment of over $50,000–too rich for a single position for most people.

Yes, it makes no sense.  But, whatever the reason, retail investors like stock splits and respond positively to them.

–more important, studied management contempt for shareholders, who after all are the owners of the company, has long been a key feature of the AAPL persona.  It’s part of the Steve Jobs legacy.  But it’s not a good one.  To me the stock split is a sign that the current management finally realizes how poisonous the Just-Like-Steve mentality has been and is beginning to shake off its shackles.

I don’t think this means AAPL returns to the super growth of its past.  On the other hand, I do think that, if I’m right about the attitude change, that the JLS discount multiple Wall Street now applies to AAPL stock will gradually disappear.  Just achieving a market multiple would imply a 30% gain in the stock.

 

natural resource production companies: accounting quirks to watch for

January 15, 2014 By in Energy, Gold, Industry Analysis, Mining Tags: , , , , , , 1 Comment

mining

Mining is mostly about how a company develops resources that have already been discovered, sometimes very long ago.

1.  Metals orebodies can vary considerably from one part ot the next in the proportion of valuable minerals they hold.  Standard practice is to mine the highest-grade ore when prices are low, and the lowest-grade when prices are high.

Not a lot of operating leverage this way.  But the idea is to enable the mine to stay open even during the inevitable cyclical downturns.  Doing the opposite, which will likely boost the stock price in good times, can lead to disaster during the bad.  There’s no easy way for an outsider to tell, except by the reputation of company management.  In the case of gold, we may find out who’s been prudent and who’s been reckless when the 2013 financials are published.

2.  Same thing with site preparation.  Standard, and prudent, practice is to routinely spend money on things like removing overburden (layers of dirt covering the ore) in places where the company is not mining today, but plans to in the near future.  This activity can be quite expensive.  But it’s necessary.  On the other hand, a firm can make short-term profits look considerably better by not doing so.

oil and gas

Oil and gas is much more involved with finding new deposits, and how to account for those costs, than metals mining.

1.  Companies have two ways to account for the costs of buying mineral rights and doing exploratory drilling.  They are:

–successful efforts, where, as the name suggests, only successful fields are put on the balance sheet and gradually written of as oil and gas is produced.  The costs of unproductive areas are written off as expense as soon as they’re incurred.

–full cost, where all exploration costs, both for productive and non-productive projects, are capitalized and written off against production.

Successful efforts is more conservative, but normally results in lower earnings.

2.  Accumulated costs are written off pro rata as each unit of oil or gas is produced.  The amount expensed against the revenue from each unit is its proportionate share of the total cost of finding and developing all oil and gas (it’s a little more complicated than this, but this is basically what you need to know).  That proportion, in turn, is calculated based on periodic estimates by petroleum geologists’ of the total size of reserves.

Big oil companies use their own geologists; smaller ones hire outside consultants.  The important point is that this estimate–and therefore the amount of cost written off per unit produced–can vary a lot, depending on the particular consultant hired.  It may also depend on the tone, conservative or aggressive, company management sets.

Just as important, as I mentioned yesterday, oil and gas price changes can alter the size of total reserves.  The cost of recovery doesn’t change, but the amounts of hydrocarbons that can be brought to the surface at a profit can be.  Lower selling prices can raise the per unit amount expensed;  higher selling prices can lower the unit amount.  Potentially, lots of operating leverage–that’s completely out of management’s control.

3.  A minor clarification of #2:  subject to some limits, the company decides how to group reserves and associated costs into different “cost pools” for figuring out depreciation and depletion.  Artful grouping of these pools can help disguise an extended run of bad drilling luck.  Not usually a worry, except with small firms with limited history.

4.  As with any other capital construction project, when oil and gas companies explore and develop with borrowed money, they can capitalize (that is, put on the balance sheet rather than expense immediately) the interest expense on that borrowing.  The interest expanse becomes part of the general costs that are written off against oil and gas production.  For smaller companies with an ambitious drilling program, this can sometimes create the peculiar (and potentially disastrous) result that it shows positive earnings while it is suffering cash outflows.  This is because interest is being paid to creditors but these payments basically don’t show up on the income statement.  Check the cash flow statement!!

 

 

 

goodwill: a quirky concept

November 14, 2013 By in Accounting, goodwill Tags: , , , , , Leave a comment

goodwill

My daughter, who’s in an MBA program, called up the other night to register her thoughts (read: complaints) on how bogus the concept of goodwill is.

She’s right…the concept of goodwill is a patchwork fix of a problem that arises with an accounting system like GAAP (Generally Accepted Accounting Principles, used for financial accounting)  whose ground-level assumption is that value resides in the net worth (after depreciation) of tangible assets.

On the other hand, past attempts to alter GAAP to account for intangibles have ended in disaster.  So, GAAP may be the least of the possible evils.

where GAAP goes wrong

1.  For tangible assets like buildings or equipment, GAAP assumes that they decline in value through use.  Depreciation/depletion reduces their balance sheet carrying value according to a regular schedule to account for this.

But the parking lot that was on the outskirts of town fifty years ago may be in the center of downtown today–and worth a fortune, even though its current balance sheet value is close to zero.  This kind of thing has been the idea behind the recent wave of takeovers of retail companies like JCP–that their properties are worth way more (sometimes in alternate use) than the balance sheet shows.

2.  For intangible assets, like patents, software, brand names, the ability to make extra-good, extra-dependable products that consumers love, distribution networks…, they usually don’t appear on the balance sheet anywhere.  In fact, the money spent creating these company attributes–like advertising, R&D, and training–appear only as expenses on the income statement.  These expenditures reduce income, and, therefore, shareholders’ equity.  GAAP treats them as a net minus!

how goodwill arises

Suppose Company A buys Company B.  Company B has book value of $1,000,000, but Company A pays $2,000,000 to obtain it.

Overbidding?   …maybe not.  Maybe Company B has a lot of undervalued property.  In that case, Company A is allowed to revalue Company B’s tangible assets upward to reflect current market values.  Say that adds $200,000 to asset value.

What about the other $800,000?

Maybe Company A has indeed overpaid.  If so, it has to immediately write the $800,000 off as a loss.  But maybe Company A wants Company B because it has valuable patents or a great brand name or a powerful sales force–all intangibles.  In Company A’s view, these factors alone justify the entire purchase price.  If it can make its case convincingly to its auditors, Company A can add the value of the patents, etc. to the balance sheet at a value of $800,000 as goodwill.  That way it avoids a gigantic writedown on the acquisition–something that wouldn’t thrill Wall Street, and might ding its credit rating.

What’s bogus about the concept is that Company B can’t do this for intangibles it developed itself while independent.

Why not?

a history of abuse

1.  At one time, GAAP allowed tech companies to put their R&D expenditures on the balance sheet as an asset.  But after widespread abuse–companies claimed tons of loss-making activity was “R&D”–led to the bankruptcy of a bunch of companies with apparently pristine income statements, the practice was prohibited.

2.  In the early 1980s, the SEC required companies to calculate and disclose their own shareholders equity using “current cost” accounting, a method of dealing with the effects of then-rampant inflation.  The idea was that companies would know the true value of their assets better than anyone else.  They could, in effect, write up their assets for increases in value of their tangibles, as well as give a value to intangibles.

Firms did know their true value, all right.  But the way I read the resulting numbers, company managements fell in to two categories.  Those afraid that disclosing their true value would make them takeover targets lied by making their book value figure extraordinarily low.  Those that wanted to be taken over made their book values laughably high.  Despite the fact that the SEC was asking, few companies told the truth, in my view.  The project was abandoned.

 

But I think the lesson was learned.  Management political agendas are too powerful to allow companies to do their own asset valuations.  GAAP is as good as we’re going to get.

calculating operating leverage

September 17, 2013 By in operating leverage Tags: , , , , , , Leave a comment

I’ve written a number of posts on operating leverage.  You can use the search function on the blog to get them.

The basic idea is that a company has both fixed costs, which it must pay whether it sells anything or not, and variable costs, which are a function of the number of things a company sells.  Once a company covers its fixed costs through sales, the operating profit on additional sales can be very high.  This is a key source of positive–and negative–earnings surprise.

As a practical matter, though, how can we calculate how operating leverage works in a given company?

For some firms, it’s impossible.   Take 3M (MMM).  It makes a gazillion different items, many of them sold in massive quantities. For an investor, there’s no way to see very deeply inside the company.

We also have to realize that the data we get from any company’s financials is going to be imperfect, at the very least during our initial look.  If we take the time and energy to compare our projections to the actuals the company publishes, listen very carefully during management conference calls for clues, and call the company every once in a while, we may be able to refine the numbers we come up with in a surprisingly significant way.

Nevertheless, for smaller companies that sell only one or two main products, there’s a very simple way to get an idea of whether a firm has significant operating leverage or not:

–take two most recent consecutive quarters

–subtract the revenue reported for Q1 from the revenue reported from Q2

–subtract the operating income of Q1 from that of Q2

–calculate an incremental operating margin by dividing the operating income change by the sales change

–compare that with the operating margin achieved during either quarter.

An example:

Harley-Davidson (HOG–I own shares, despite the fact the ticker symbol spells a word) sells motorcycles, spare parts and branded merchandise.

During 2Q13, the company posted motorcycle-related revenues of $1.631 billion and operating profit of $362.9 million.  The operating margin was 22.2%.

During 1Q13, HOG had motorcycle revenues of $1.414 billion and operating profit of $279.0 million.  The operating margin was 19.8%.

The quarter-on-quarter revenue difference was $217.9 million, and the q-on-q operating profit difference was $83.1 million.  The operating margin on the extra production was 38.1%.

In HOG’s case, we can go on to make a number of refinements.  We can try to separate out the profits from sales of merchandise and spare parts, which are relatively small in revenue in comparison with motorcycles but which carry higher margins.  And we can examine whether the much higher margin on incremental sales comes from manufacturing efficiency or from leveraging SG&A (it’s the latter).

But the main point is clear.  HOG makes almost twice as much on incremental sales as it does on average sales.  And we found this out just by making some simple subtractions.

 

the SEC investigates store chains’ internet sales claims

August 30, 2013 By in Amazon, Industry Analysis, internet, Retail Tags: , , , , , Leave a comment

the SEC questions internet sales hype

According to the Wall Street Journal, the SEC recently sent inquiry letters to a bunch of retailers asking them to quantify claims managements were making in quarterly earnings conference calls about internet sales and internet sales growth.  Fifth & Pacific (Kate Spade, Juicy Couture…), for example, told investors it had a “ravenously growing” web business.  Others tossed around numbers like up 30%.

On the other hand, while online sales in the US may be growing faster than revenues from bricks-and-mortar operations, they’re still only in posting increases in (low) double digits, and make up less than 6% of total retail.  So the SEC was concerned that the company talk might be more hype than reality.  Why no disclosure of internet sales as a percentage of total sales?

The SEC got two types of reply:

—equivocation.  Some retailers said they don’t disclose the size of online sales because they’re “omnichannel” firms.  An individual customer may sometimes visit a store, sometimes order from a desktop at work, sometimes buy from a smartphone on the train going home in the evening.  It’s the total customer relationship that counts, they said, not the way someone may buy any particular item.  Translation:  online sales are almost non-existent, but we know shareholders will react badly if we say so.

—confession, sort of.  Others said that online sales were “immaterial,” meaning no more than a couple of percentage points of total sales.

there’s information here

Why not just say so?

…because it sounds bad.

Why bring up internet sales in the first place?

…because we have no other good things to say.

look at the income statement

I could have told you that, just from taking a quick look at company income statements.

Here’s my reasoning:

–if a company’s internet sales are growing at, say, 20% and comprise 10% of total sales, then they’ll contribute 2% to overall sales growth.  Because online sales are free of many of the costs of bricks-and-mortar stores, like salespeoples’ salaries and rent, they should carry (much) higher margins than sales in physical stores.  Therefore, if internet sales are big, we should see accelerating sales growth and rising margins.

Take Target (TGT) as an example.  Aggregate sales are growing at about a 3% annual rate with no signs of acceleration.  Operating margins are flat to down.  If online sales contributed 2/3 of total growth, TGT would have to disclose that  …and margins would be heading up noticeably. Therefore, internet sales can’t be anything close to 10%–or even 5%–of TGT’s business.

By the way,  TGT’s response to the SEC was that its internet sales are immaterial.

why the SEC investigation?

Every company is going to try to spin the facts of its performance in a favorable way.  Just take a look at the 10-K, where management can go to jail if disclosure is incomplete or counterfactual.  It’s chock full of dire warnings of what might go wrong.  It’s also in dense print with no pictures.  Compare that with the annual report, where every page is glossy, every face is smiling and the skies are always blue.

Also, retailers are marketers, after all, so we should expect an unusually rosy portrayal of results and prospects from them.

Still, there are limits.  Even if the border line is a bit fuzzy, there comes a point where  positive spin becomes deception, where touting the fantastic prospects of a currently minuscule business becomes fraud–especially if it’s in an area like online where Wall Street is intensely interested.

I interpret the SEC letters a warnings to the companies involved that they have been treading dangerously close to that line, and may even have stepped over it.  Expect a much more 10-K-ish assessment from now on.