Tag Archives: Accounting

using days sales to measure inventory: a dangerous method

July 24, 2012 By in Accounting, Inventory Cycle, inventory days Tags: , , , , , , , , Leave a comment

an example

I started out on Wall Street as a securities analyst covering the oil industry during the oil and gas boom caused by the second OPEC “oil shock” of 1978-80.  The sharp rise in prices (which today looks a bit ludicrous) from $7 a barrel to $14–implying a spike in gasoline prices above $.50 a gallon!!!–caused a huge increase in drilling for new deposits.

One key shortage element was the steel pipe used to line the well hole already dug, to prevent the hole from collapsing in on itself.  Without steel pipe to line the well you couldn’t drill.  So one of my standard questions during the interviews I did with company managements as I was preparing to write evaluations of their stock prospects was how much steel pipe they had on hand.  It was usually only two or three months’ worth.  It was never enough.  And the makers of the pipe were never able to ramp up capacity fast enough to meet demand, no matter how fast they put up new plants.

Anyway, one day I was talking to the CFO of a small exploration company in Texas.  When I had last talked with him, a couple of months before, he had said his company had about two months’ worth of pipe on hand.  I asked the question again.  He said, “We have a year’s worth of pipe on hand.”

I said, “You must have finally gotten a big shipment in.  How did you do it?”  He replied. “No.  Our drilling plans have changed.”

This was my first concrete indication that the commodity bust, which often follows a big boom, had arrived in the oilpatch.  What the CFO in my story meant to say was that prices had already fallen to a level where the wells his firm had been planning to drill were no longer economical and he could no longer get financing to carry out the projects.

the cash conversion cycle

This is a measurement of how much cash a company needs under current conditions to turn a dollar invested in working capital to make a new product back into cash.  It’s the sum of three parts:  the time it takes from purchasing raw materials until the sale of a final product is made + days credit extended to purchasers – days credit extended by suppliers.

In most cases, the key time element is the first element, the time in inventory.  Hence, the focus on inventory days.

supply and demand is much more important

…as my oil company example shows.

housing

Just as the situation of extremely constrained inventories can prompt one to draw the misleading conclusion that conditions will always be tight, the situation where inventories are massive can also be deceptive.  Housing in the US may well be a current case in point.

Despite the evidence that the housing market has been picking up in the Us for the past year, until just the past two or three weeks media reports have been strongly biased to the negative side.  One of the key figures being cited is the large inventory of unsold homes available for sale.

Two elements are wrong with this analysis, in my view:

–after many years of languishing on the market, and presumably not being maintained, I think it’s questionable whether all the dwellings counted in that inventory number are actually salable.  Maybe a quarter aren’t.

–even small changes in demand can make large differences in the days- sales measure.  For example, the latest Department of Commerce figures show that the inventory of new homes available for sale in the US has shrunk by 29% in the past year to 4.7 months.  Half of that decline is from builders creating fewer new homes.  The other half is from an increase in demand.  It wouldn’t take much more demand to push that figure into shortage territory.

I’m not saying that demand will increase (although I suspect it will).  I just want o point out that relying on days-sales figures for conclusions is potentially dangerous.

 

 

 

book value in an intellectual property world: Facebook and others

May 8, 2012 By in internet, Stock ideas, Technology Tags: , , , , , Leave a comment

the Facebook IPO

I’ve had a couple of requests to write about the upcoming Facebook IPO.  So I’m slogging through the preliminary prospectus.  I’m not sure I’m going to come out with a final conclusion, but I think I will be able to highlight important points. Today, book value.

In the prospectus, Facebook (NASDAQ ticker:  FB) makes what I regard as an unusually strong effort to point out that the company has very little tangible book value.  As of March 3, 2012, the figure is $2.85 per share.  The expected inflow of cash to the company from the IPO, calculated at a purchase price of $31.50 a share (the midpoint of the expected pricing range of $28-$35) will raise that to $5.15 a share.  So FB really wants buyers to be aware they are paying a little over 6x book for the stock.

What does this mean?

book value

Every investor looks for bargain stocks.  Techniques differ, though.  One of the main tools used by early 20th century securities analysts was looking for stocks that traded at steep discounts to the net asset value shown in the company’s official accounting records.

The measure is “net” in the sense that it is arrived at by subtracting the carrying value of everything the company owes to others (its liabilities) from the carrying value of all its assets.  The resulting number is also called book value, because it’s derived from the official accounting ledgers.

an example

The idea is simple:  say a firm starts with a single asset, $1 million in cash, and has 100,000 shares of stock outstanding.  Book value is $1,000,000/100,000 shares, or $10/share.  If the company spends all the money to buy land and build a cement plant, it still has book value of $10, but now it’s all in land and plant and equipment.

Suppose shortly after this, the stock market turns down–for whatever reason–and the company’s stock falls to $5 a share, or 50% of book value.

The plant is still there, however, and would still cost $1 million, or $10 a share, to duplicate.  So you can now buy $10 worth of assets for $5!!  How can you go wrong?  (You can, but that’s a story for another day.)  At the very least, the idea that the company holds valuable assets that can–at worst–be sold should act as a cushion against further declines.

One other thing about book value:  it also includes, as plusses, profits made and retained in the business, as well as losses, as minuses.  So for a successful company, book value gradually rises; for a consistent money-loser, it gradually falls.

Warren Buffett and intangibles

Fifty years or so ago, Warren Buffett had the idea that made his investing reputation.  He noticed, far ahead of his contemporaries, that some companies–Coca Cola, for example–had substantial advantages, like famous brand names, efficient distribution networks, a reputation for high quality, that were “intangible” in the sense that they weren’t reflected directly on the company’s accounting records at all.

Nevertheless, these intangible assets have a value.  They are predictors of longevity of a business and of higher than average profit margins.  Companies that possess them fetch high prices in mergers and acquisitions.  Buffett was the first one willing to pay a little bit extra for companies that had strong intangibles. Nowadays everyone does.

most IT is all about intangibles

In the early years of the computer industry, tech companies were allowed to “capitalize,” or list as assets on the balance sheet, the salaries and expenses of their research and development efforts, instead of subtracting them from current revenue in the income statement.  But by the time I arrived on the scene in the late 1970s, the practice had led to such horrible abuses (it made profits a lot higher than they should have been) that it was banned.

Like advertising expenditures, R&D is treated as an expense, and reduces income, even though, if successful, it creates an important competitive advantage for a firm.  The more R&D, the lower profits are–which means that book value doesn’t rise very quickly.  But the intellectual property is at the heart of what makes tech companies valuable.

the Facebook case

As the prospectus indicates, pre-offering, FB has book value of $2.85.  The largest chunk of that is cash, generated both by operations and prior sales of stock.  The book value of other assets is slightly over $1 a share.

In addition, the inflow of cash from the IPO will almost double that number, creating a tremendous benefit for pre-IPO shareholders.  An IPO participant’s $31.50 becomes a claim on company assets worth $5.15.  Prior owners will have their claim on book value of $2.85 boosted a lot.

significance?

1.  Unlike the cement company, in the FB case there’s no safety net of salable assets to fall back on if the company is unable to make money. In that sense, FB carries with it a large amount of risk.

2.  For FB, it’s all about intangibles–the brand name, the goodwill imbedded in the huge number (900 million) of users of the service, whatever patents the company may have.  Traditional accounting statements aren’t built to showcase these attributes.  So analysis of the statements may not get you very far in understanding the company or its potential.

What about other tech companies.  How do they trade versus their book values?

Here’s a sample:

Priceline.com      12x book value

LinkedIn     12x book

Amazon.com     11x

Netflix          7x

Microsoft      5x

Google     3x

eBay     2.5x

Yahoo     1.5x.

It’s hard to generalize from these instances.  For fast-growing firms, trading at huge premiums to book value doesn’t appear to be a problem.  On the other hand, Yahoo traded at 8x book in 2004, when its future appeared to be more promising–and 6x book when it turned down Microsoft’s takeover bid.  So the fact of a large premium to book doesn’t guarantee anything.

 

All in all, this implies to me that evaluation of FB will be a much more subjective, and difficult, process than for a typical IPO.\

More tomorrow.

 

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?

collective action clauses: Greece’s deus ex machina

March 8, 2012 By in Banks, Derivative instruments, Industry Analysis, Trading Tags: , , , , , , , , , 1 Comment

Greek sovereign debt restructuring under way

Greece is in the final stages of restructuring €270 billion in government debt.  Its deadline for holders to “voluntarily” exchange their bonds for new debt that’s worth only a little more, on a present value basis, than a quarter of what creditors were originally promised, is today at 8pm London time.

For the past few months, EU governments have been engaged in high stakes behind the scenes duel with their major commercial banks, which hold a majority of the Greek securities, over whether the financial institutions would agree to the Greek offer.  During the past couple of days, the banks have all been falling in line and saying they’ll take the Greek deal.  I don’t think the banks ever seriously considered doing anything else.  The discussion has all been, I think, about what quid pro quo they would receive in return.

That leaves private holders  …who don’t stay up at nights worrying that the bank examiners will be unusually thorough this year or that their applications to open new branches might be denied.  So both the threat of future bureaucratic ill will and the call to make a patriotic sacrifice of their (own and their clients’) capital fall on deaf ears. That’s where collective action clauses come in.

collective action clauses

A collective action clause is a stipulation in a bond indenture saying that if holders of a certain majority percentage of the issue agree to a given proposal by the issuer, then the rest can be forced to go along with the decision of the majority.

About one outstanding Greek government bond in seven was issued under English law and have had collective action clauses in the indentures from the outset.

The rest were issued under Greek law.  Being subject only to local law isn’t the norm for emerging markets debt, but I guess buyers weren’t concerned because Greece is part of the Eurozone.  Until a few days ago, those bonds had no collective action clauses.  Then the Greek parliament passed a new law to retroactively include them in its government bond indentures.

Not only that, but the lawmakers conveniently set a low threshold of around 60% acceptance (usually, it’s 75%) as the point at which the clauses can be invoked.  EU banks who have been arm-twisted into agreeing to the restructuring will doubtless lift Greece past that mark.  So, like it or not, private holders will be forced to accept the huge haircut Greece is proposing.  The maneuver is all perfectly legal.  The move isn’t a surprise to the bond market, no matter what you hear in the news.  It has been anticipated by bond pundits for at least a couple of years.

the English-law bonds

The case of the English-law bonds is more interesting.  From what I’ve read, their collective action clauses are set at 75% acceptance.  Early betting is that Greece won’t come close to that amount.

But Greece has already announced that if holders don’t tender in lat least large enough amounts to allow it to exercise the collective action clauses, it simply won’t pay anything.  The holders can see Greece in court.  Tomorrow we’ll see how much of this is bluff–and how successful the tactic has been.

rating agencies have already declared a Greek default

Major credit rating agencies have already declared that Greece has defaulted on its bonds.  So far, the body that decides whether credit default swaps (effectively, insurance policies against default) must be paid off is saying that no default has yet occurred.  That’s because the language of the swap agreements that describes what a default is contains an accidental loophole.  The government-inspired “voluntary” restructuring doesn’t qualify, even though holders are losing almost three-quarters of their money.   If Greece invokes collective action clauses and forces bondholders to take the new securities, however, that may change.

not many Greek CDSs?

Reports I’ve read say that Greek CDSs amount to a relatively small €3+ billion.  If that figure is correct, it’s hard to see why the EU has put so much effort into arranging a “voluntary” restructuring that avoids triggering them.  Maybe bank issuance of CDSs on Spanish and Italian debt is immense and contagion is the worry  …or the official figures may substantially understate bank exposure.

This time tomorrow we’ ll have more answers.

dealing with hedge funds: …industry analysts

March 6, 2012 By in Industry Analysis, Investment firms Tags: , , , , , , , , 1 Comment

calling on customers

Two brokerage areas routinely call on corporations.  They are:

–investment bankers.  They’re somewhat like bank lending officers, in that they visits company to try to sell services.  In the investment banking case, that’s typically the possibility of stock or bond offerings, mergers and acquisitions advice or general consulting.

–securities analysts specializing in the company’s industry.  Analysts are members of the firm’s research department.  For smaller and privately held firms, the analyst will want to gather information that may be useful in his reports on publicly traded companies.  He’ll also want to set the stage for possible investment banking business with his firm as/when the company goes public.  For already publicly traded companies in the analyst’s coverage universe, the visit will be for updates–usually right before the analysts issues one of his periodic reports to clients.

Prior to 2000, securities analysts usually reported to the head of investment banking.  After the Internet Bubble-related scandals, where analysts were seen to have written inaccurate reports solely to stimulate demand for the stocks of companies their firms had brought public, that supervisory relationship has been broken.  I’m not sure there is a general rule about who supervises the research department today.

securities analysts

calling on clients

Securities analysts also spend a lot of time interacting with the firm’s brokerage clients, in the expectation that the client will trade with the firm–thus generating commission/spread profits–in return for the information provided.  This interaction may either be with the client’s own securities analysts, their buy-side counterparts, or with the client’s portfolio managers.  Communication may be by phone or e-mail or in person.

Like any other brokerage service, the appropriate institutional salesman will control/advise the analyst about the quality (phone or in person) and quantity of time he spends with a given client.  This will depend on the importance of the client to the firm, measured by the profitability of the relationship.

spreadsheets

Analysts or their assistants create spreadsheets to forecast company earnings.  They also write research reports that either analyze the company’s operations in detail, or highlight recent developments and their significance.  As well, they make buy, hold and sell recommendations for the company’s stock.

technical background?

In many cases, analysts will have worked in the industry they cover before moving to Wall Street.  They may also have relevant advanced technical degrees, such as in petroleum engineering for oil and gas analysts, or in electrical engineering for analysts covering technology hardware firms. (In my experience, such technical training can be a mild positive.  But it can also be a major hindrance, if the analyst mistakenly thinks this exempts him from having to do actual financial analysis of a company’s profit prospects.)

reliant on companies for information

No matter what their background, however, analysts remain very reliant on the companies they cover for industry and firm-specific information.  They’re also dependent on the continuing attractiveness of their industries to investors, whose commission business with the broker influences the analyst’s compensation.

In my experience, therefore, analysts tend to be a bit like home town sports announcers.  They’re highly reluctant to make negative assessments about their industries.  After all, that puts them out of work.  They also can be subject to considerable pressure from holders of large positions in a stock not to write anything negative about it.  Also, some companies may demand that analysts not only make positive statements but also adhere closely to company-issued earnings guidance.  Non-compliance can mean that the offending analyst is denied access to company management that’s routinely given to others.

Sounds crazy, doesn’t it?  But stuff like this happens.  The case of bank analyst Mike Mayo is perhaps the most famous recent case of this type.

A possible response to this pressure is for an analyst to give a “base case” in print, but to supplement this with a “whisper” number that’s noticeably different.  This will be disseminated to clients orally, with or without attribution to the analyst, but never put down on paper.

To be successful, analysts have to be good either at marketing themselves and their research to clients or at analyzing the companies they follow.  Of course, it would be better to excel at both, but in my experience that’s not necessary.  At one end of the spectrum there are (only a few) analysts who have completely pedestrian information, but are witty and know where a client likes to be taken to lunch.  For the majority who provide analytical insights, they come in several varieties:

–able to forecast earnings very accurately

–able to give a good qualitative appraisal of the industry and where all the companies stand within it

–able to say whether the stocks will go up or down.

These are all separate skills, and each worth paying for, I think.