Tuesday, 9 August 2016
Sunday, 15 March 2015
SEC- Plan Of Action On Firms "Admission of Misconduct"
For decades, the Securities and Exchange Commission
has allowed companies and individuals to make settlements without
admitting any wrongdoing. Even a company committing an egregious sin
that cost investors millions of dollars could walk away from the
proceedings without ever acknowledging its role.
But in mid-2013 the agency declared that it was doing an about-face.
“Heightened accountability or acceptance of responsibility through the
defendant’s admission of misconduct may be appropriate, even if it does
not allow us to achieve a prompt resolution,” Andrew Ceresney, the
S.E.C.’s head of enforcement, said in a June 2013 email to his
lieutenants.
The program represented a seismic shift in approach, but in practice it
is still in its early stages. After two years, the S.E.C. has generated
admissions of culpability in 18 different cases involving 19 companies
and 10 individuals. Given the hundreds of settlements struck by the
S.E.C. over this time, it is clear that most of the time defendants are
still being allowed to settle without admitting to or denying the
agency’s allegations.
S.E.C.
officials say this age-old practice saves it from having to bring — and
possibly lose — a case in court, allows the agency to return money to
victims more quickly and conserves resources for other investigations.
Nevertheless,
S.E.C. enforcement officials say they believe the policy change has
sent a crucial message. “Requiring admissions adds a powerful tool in
appropriate cases, and it has been extremely successful and positive,”
Mr. Ceresney said in a recent interview. “In cases where we have
obtained admissions, it adds accountability, and that has been very
important.”
In determining what kinds of cases are likely to be subject to such treatment, the S.E.C. has given itself wide latitude.
In her first speech on the subject in September 2013, Mary Jo White, the S.E.C. chairwoman, cited four criteria for such cases:
■ The case harmed a large number of investors.
■ It posed a significant risk to the market.
■ Admission of culpability would let investors decide if they should deal with a person or entity in the future.
■ Disclosing the case’s facts would send a message to the market.
The following year, in another speech,
Ms. White added further criteria. Admissions of culpability might be
required if misconduct was intentional or if a defendant obstructed an
investigation. “The new protocol continues to evolve and be applied,”
she said.
As
the policy evolves, it has raised concerns among securities lawyers.
They contend that the broad criteria for cases fail to provide enough
guidance on behavior that will attract scrutiny.
Lewis
D. Lowenfels, co-author of “Lowenfels and Bromberg on Securities
Fraud,” a leading treatise in the area, called for more analytical
clarity.
“The
S.E.C. should draft guidelines as to when the agency intends to demand
admissions of facts and acknowledgments of violations of law in order to
settle their enforcement actions,” he said. “Otherwise market
participants are left with attempting to interpret vague and conflicting
tea leaves from speeches by the S.E.C. chair.”
Mr. Ceresney said that the S.E.C. believed it had telegraphed the terms of its policy change clearly and consistently. But the SEC enforcement manual has not been updated to reflect it.
And
the S.E.C. acknowledges that these cases require the same judgment
calls that many of its other enforcement decisions do. For instance,
even if behavior meets some or all of its stated criteria, the agency
may not push for an admission of wrongdoing. It may decide that other
aspects of a settlement — like a steep penalty — are severe enough.
An
analysis of the cases in which the S.E.C. has secured admissions of
misconduct certainly shows a wide array of facts and types of
infractions.
Some
of the 18 cases required acknowledgments of violations of law, while
others involved lesser admissions of the S.E.C.’s findings of facts.
Most of the companies in these cases were financial firms. The other settlements involved Chinese affiliates of the big four United States accounting firms; Lions Gate, an entertainment company; and Standard & Poor’s, the ratings agency
that admitted to facts stating how it misrepresented its methodology
for assessing several commercial mortgage-backed securities in 2010 and
2011.
About one-third of the cases involved very large entities. They include a 2013 settlement with JP Morgan Chase arising from the London Whale debacle; a 2014 matter against Bank of America for a major disclosure violation; and a failure-to-register case against Credit Suisse, also in 2014. This year, the agency brought an
action against Oppenheimer & Company, which admitted a violation of
securities laws involving penny stock sales for customers. In 2014,
Scottrade, the discount brokerage firm, acknowledged that it had failed
to provide the S.E.C. with accurate information about trades.
When
the S.E.C. has demanded admissions, it says it usually gets them. If a
defendant balks, the S.E.C. can respond with litigation. Consider a 2014 case against Wedbush Securities,
a large stock trading firm. The S.E.C. contended that Wedbush had
inadequate risk controls in its business. Initially, the firm refused to
admit to the allegations. After the S.E.C. brought the case before an
administrative law judge, Wedbush settled, acknowledging the S.E.C.’s
findings and paying a $2.44 million penalty.
A
case from last summer illustrates how the new policy has continued to
evolve. That matter, involving a lawyer for two corporate directors,
indicates that the S.E.C. will also press for an admission of wrongdoing
if it thinks such a move will help it in a suit filed against another
party in the same matter.
The
case dates to 2010 when the S.E.C. filed a civil suit against Samuel E.
Wyly and Charles J. Wyly, directors who sat on the boards of Michaels
Stores, Sterling Software, Sterling Commerce and what is now Scottish
Re. The regulator accused the Wylys of evading reporting requirements
and won the matter at trial last year. Its position was aided by
admissions it had secured from Mihael French, a lawyer for the Wylys.
So
far, the S.E.C.’s moves appear to enjoy broad support among its five
commissioners, who approve its enforcement actions. Since the policy
change went into effect, the commissioners have approved every case.
For
now, because the S.E.C.’s criteria are so broad, almost any kind of
case might qualify for treatment under the policy. It will be revealing
to see how the S.E.C. uses its new power.
Sunday, 8 March 2015
Giffen Good
A good for which demand increases as the price increases, and falls when
the price decreases. A Giffen good has an upward-sloping demand curve,
which is contrary to the fundamental law of demand which states that
quantity demanded for a product falls as the price increases, resulting
in a downward slope for the demand curve. A Giffen good is typically an
inferior product that does not have easily available substitutes, as a
result of which the income effect dominates the substitution effect.
Giffen goods are quite rare, to the extent that there is some debate
about their actual existence. The term is named after the economist
Robert Giffen.
The most commonly cited example of a Giffen good is that of the Irish potato famine in the 19th century. During the famine, as the price of potatoes rose, impoverished consumers had little money left for more nutritious but expensive food items like meat (the income effect). So even though they would have preferred to buy more meat and fewer potatoes (the substitution effect), the lack of money led them to buy more potatoes and less meat. In this case, the income effect dominated the substitution effect, a characteristic of a Giffen good.
However, critics of this textbook example point to the fact that Ireland was in the grip of a severe famine at the time, and because of the shortage of potatoes – which led to higher prices – it was unlikely that people could have consumed more of them.
A more recent – and perhaps better – example of a Giffen good is offered by a 2007 study by Harvard economists Robert Jensen and Nolan Miller. Jensen and Miller conducted a field experiment in two provinces in China – Hunan, where rice is a dietary staple, and Gansu, where wheat is the staple. Randomly selected households in both provinces were given vouchers that subsidized their purchase of the staple food.
The economists found strong evidence of Giffen behavior exhibited by Hunan households with respect to rice. Lowering the price of rice through the subsidy caused reduced demand by households for rice, while increasing the price (by removing the subsidy) had the opposite effect. The evidence with regard to wheat in Gansu was weaker because two of the basic conditions for Giffen behavior were not fully observed, i.e. that the staple good should have limited substitution, and households should be so poor that they consume only staple foods.
The most commonly cited example of a Giffen good is that of the Irish potato famine in the 19th century. During the famine, as the price of potatoes rose, impoverished consumers had little money left for more nutritious but expensive food items like meat (the income effect). So even though they would have preferred to buy more meat and fewer potatoes (the substitution effect), the lack of money led them to buy more potatoes and less meat. In this case, the income effect dominated the substitution effect, a characteristic of a Giffen good.
However, critics of this textbook example point to the fact that Ireland was in the grip of a severe famine at the time, and because of the shortage of potatoes – which led to higher prices – it was unlikely that people could have consumed more of them.
A more recent – and perhaps better – example of a Giffen good is offered by a 2007 study by Harvard economists Robert Jensen and Nolan Miller. Jensen and Miller conducted a field experiment in two provinces in China – Hunan, where rice is a dietary staple, and Gansu, where wheat is the staple. Randomly selected households in both provinces were given vouchers that subsidized their purchase of the staple food.
The economists found strong evidence of Giffen behavior exhibited by Hunan households with respect to rice. Lowering the price of rice through the subsidy caused reduced demand by households for rice, while increasing the price (by removing the subsidy) had the opposite effect. The evidence with regard to wheat in Gansu was weaker because two of the basic conditions for Giffen behavior were not fully observed, i.e. that the staple good should have limited substitution, and households should be so poor that they consume only staple foods.
Saturday, 7 March 2015
Govt wants Sebi to regulate money market
The government has proposed to amend the Reserve Bank of India (RBI) Act
to take away money market regulatory powers from the central bank and
bring it under the purview of the Securities and Exchange Board of India
(Sebi).
Though the proposal wasn’t mentioned in Finance Minister Arun Jaitley’s Budget speech, the Finance Bill proposes to amend sections 45U and 45W of the RBI Act, which effectively takes away the central bank’s powers to regulate government securities and other money market instruments.
The amendment to section 45W says, “Any direction issued by the Reserve Bank of India, in respect of security, under chapter III D of the Reserve Bank of India Act, shall stand repealed.”
Usha Thorat, former deputy governor of RBI, said, “Certain powers in relation to regulating money market instruments and products and derivatives based on these instruments were given to RBI in 2005-06 by amending the RBI Act and this happened after a lot of discussion. Now, with this amendment in the Finance Bill, all these provisions are proposed to be withdrawn. RBI was given responsibility for financial stability and the power to regulate forex and money markets was given to RBI to enable it to fulfill its mandate for financial stability.
“Before such sweeping changes are brought about through the Finance Bill, there has to be an understanding of the purpose for such changes and whether these are indeed in the interest of financial stability. It has to go through a lot of discussion and dialogue.”
If the proposed amendments go through, regulations relating to the issuance and investment of commercial papers, inter-bank repo or any other repo and reverse repo used as instruments to raise liquidity by keeping these as collateral as government securities will no longer be in RBI’s hands.
To be sure, these amendments are not an extension of the Public Debt Management Act, which essentially deals with primary issuance of government securities. After the proposal is enacted, public debt management will be under the purview of Public Debt Management Agency, not RBI.
Speaking to analysts on Wednesday, RBI Governor Raghuram Rajan had said the proposed amendments weren’t part of the finance minister’s Budget speech. Answering a question on the shifting of regulatory powers over debt markets from RBI, Rajan said he expected the proposed changes wouldn’t take place. “On the shifting of regulatory powers over debt markets from RBI, there are some clauses in the Finance Bill referring to this. But the finance minister’s speech did not contain any reference to this; the speech generally flags the important actions of the government. I am not worried this will happen,” Rajan had said.
The proposal to shift the power to regulate money market operations from RBI was made by the Financial Sector Legislative Reforms Commission. Though there were exhaustive discussions on most other proposals by the council, the proposal to shift money regulations from RBI wasn’t discussed.
Though the proposal wasn’t mentioned in Finance Minister Arun Jaitley’s Budget speech, the Finance Bill proposes to amend sections 45U and 45W of the RBI Act, which effectively takes away the central bank’s powers to regulate government securities and other money market instruments.
The amendment to section 45W says, “Any direction issued by the Reserve Bank of India, in respect of security, under chapter III D of the Reserve Bank of India Act, shall stand repealed.”
Usha Thorat, former deputy governor of RBI, said, “Certain powers in relation to regulating money market instruments and products and derivatives based on these instruments were given to RBI in 2005-06 by amending the RBI Act and this happened after a lot of discussion. Now, with this amendment in the Finance Bill, all these provisions are proposed to be withdrawn. RBI was given responsibility for financial stability and the power to regulate forex and money markets was given to RBI to enable it to fulfill its mandate for financial stability.
“Before such sweeping changes are brought about through the Finance Bill, there has to be an understanding of the purpose for such changes and whether these are indeed in the interest of financial stability. It has to go through a lot of discussion and dialogue.”
If the proposed amendments go through, regulations relating to the issuance and investment of commercial papers, inter-bank repo or any other repo and reverse repo used as instruments to raise liquidity by keeping these as collateral as government securities will no longer be in RBI’s hands.
To be sure, these amendments are not an extension of the Public Debt Management Act, which essentially deals with primary issuance of government securities. After the proposal is enacted, public debt management will be under the purview of Public Debt Management Agency, not RBI.
Speaking to analysts on Wednesday, RBI Governor Raghuram Rajan had said the proposed amendments weren’t part of the finance minister’s Budget speech. Answering a question on the shifting of regulatory powers over debt markets from RBI, Rajan said he expected the proposed changes wouldn’t take place. “On the shifting of regulatory powers over debt markets from RBI, there are some clauses in the Finance Bill referring to this. But the finance minister’s speech did not contain any reference to this; the speech generally flags the important actions of the government. I am not worried this will happen,” Rajan had said.
The proposal to shift the power to regulate money market operations from RBI was made by the Financial Sector Legislative Reforms Commission. Though there were exhaustive discussions on most other proposals by the council, the proposal to shift money regulations from RBI wasn’t discussed.
Friday, 6 March 2015
India standout performer among BRIC countries: Mark Mobius, Templeton EM Group
As a foreign investor and a long-term bull on India, how do you
see the 3.9% fiscal deficit target tied with an 8-8.5% growth for FY16?
Do you see potential improvements on both fronts over the next two
years?
Mark Mobius: What was good in this budget was the fact that they are going to increase capital spending. I understand that could be very important, because India needs a lot more transport infrastructure, which should increase productivity throughout the country.The fact that they are reducing subsidies by 9% and more importantly, using direct cash transfers to make it more efficient, is also a very good move. Perhaps most important of all is the reduction in corporate income tax from 30% to 25% over a four-year period. It should increase capital spending in the private sector. So, all of those moves are quite good. They should help in pushing the economy forward.
The world over, central banks are in monetary easing mode. How much of a boost can it give to ailing global growth? Will India stand out with a strong performance due to fiscal support?
Mark Mobius: India really stands out now. We are talking about 7% growth this year, which means India is well up to the Chinese growth rate. It probably has greater potential going forward.
If you compare India to the other BRIC countries like Brazil and Russia, it comes across as really outstanding.
What investment call would you make for India post Budget 2015? Would it call for more allocation, a status quo of profit-booking after a dream 30% plus return over the last 12 months?
Mark Mobius: Usually what we see is the profitability of companies. If we look at 7% GDP increase in the economy, a good increase in profitability for companies should be achievable.
Do you think the government did enough on infra spending? Do you see India being innovative here and will it lure you to invest more into the Indian infra, railway, road, logistics space, etc.?
Mark Mobius: That is one of the things that they have opened the door to. They are also looking at non-budget financing for infrastructure. Hopefully, that would include private sector participation — either in joint projects with the government or by way of some other systems.
That would be a very good way to increase capital spending in infrastructure more rapidly. But of course, it requires much more clarity on the part of government in terms of committing to programmes. It will enable the private sector to make adequate profits on those investments. It has been done elsewhere, and there is no reason why India cannot do it.
Will the rupee hold out post the Budget? What does the fiscal policy mean for rate cuts in India, and how much more cuts do you anticipate?
Mark Mobius: With inflation coming down — and probably it will continue to come down as a result of efficiency gains — there is a good chance that we will see lower and lower rates. It is good for the economy. There is no reason to think that this cannot be achieved in India.Like all other emerging market currencies, the rupee too has weakened over the last few years. But I think that could change if the India economy continues to grow at this pace.
The rating agencies had called for an improvement in income growth and fiscal deficit to review India's investment grade. How much of that matters to an FII such as you? As of now, it does seem that it may take a while before India is upgraded to BBB status. Your take?
Mark Mobius: India can be upgraded pretty quickly if it achieves the kind of growth that we are looking at. More importantly, if the expectation of increase in tax income turns true, it will enable the government to improve its budget picture.
So, yes, I would say India can be upgraded by the rating agencies.
Mark Mobius: What was good in this budget was the fact that they are going to increase capital spending. I understand that could be very important, because India needs a lot more transport infrastructure, which should increase productivity throughout the country.The fact that they are reducing subsidies by 9% and more importantly, using direct cash transfers to make it more efficient, is also a very good move. Perhaps most important of all is the reduction in corporate income tax from 30% to 25% over a four-year period. It should increase capital spending in the private sector. So, all of those moves are quite good. They should help in pushing the economy forward.
The world over, central banks are in monetary easing mode. How much of a boost can it give to ailing global growth? Will India stand out with a strong performance due to fiscal support?
Mark Mobius: India really stands out now. We are talking about 7% growth this year, which means India is well up to the Chinese growth rate. It probably has greater potential going forward.
If you compare India to the other BRIC countries like Brazil and Russia, it comes across as really outstanding.
What investment call would you make for India post Budget 2015? Would it call for more allocation, a status quo of profit-booking after a dream 30% plus return over the last 12 months?
Mark Mobius: Usually what we see is the profitability of companies. If we look at 7% GDP increase in the economy, a good increase in profitability for companies should be achievable.
Do you think the government did enough on infra spending? Do you see India being innovative here and will it lure you to invest more into the Indian infra, railway, road, logistics space, etc.?
Mark Mobius: That is one of the things that they have opened the door to. They are also looking at non-budget financing for infrastructure. Hopefully, that would include private sector participation — either in joint projects with the government or by way of some other systems.
That would be a very good way to increase capital spending in infrastructure more rapidly. But of course, it requires much more clarity on the part of government in terms of committing to programmes. It will enable the private sector to make adequate profits on those investments. It has been done elsewhere, and there is no reason why India cannot do it.
Will the rupee hold out post the Budget? What does the fiscal policy mean for rate cuts in India, and how much more cuts do you anticipate?
Mark Mobius: With inflation coming down — and probably it will continue to come down as a result of efficiency gains — there is a good chance that we will see lower and lower rates. It is good for the economy. There is no reason to think that this cannot be achieved in India.Like all other emerging market currencies, the rupee too has weakened over the last few years. But I think that could change if the India economy continues to grow at this pace.
The rating agencies had called for an improvement in income growth and fiscal deficit to review India's investment grade. How much of that matters to an FII such as you? As of now, it does seem that it may take a while before India is upgraded to BBB status. Your take?
Mark Mobius: India can be upgraded pretty quickly if it achieves the kind of growth that we are looking at. More importantly, if the expectation of increase in tax income turns true, it will enable the government to improve its budget picture.
So, yes, I would say India can be upgraded by the rating agencies.
Tuesday, 29 July 2014
Emerging Markets Exposure
Comments about substantially stretched stock valuations from Janet Yellen on July 21, 2014 spooked the market and sent prices of the major U.S. indexes lower. When volatility in
the U.S. market increases, it is often a natural reaction to look at
pulling money out of U.S. equities. In many cases, traders reactively
put their money to work in other areas of the world that experience
better-than-average growth, like emerging markets. Vanguard Emerging Markets VIPERS. As the name suggests, this ETF
seeks to track the performance of a basket of companies that are
located in emerging market countries. Taking a look at the chart below,
you’ll find that this ETF has risen more than 7% over the past three
months and it is currently trading near its 52-week high.
Looking at Components
For traders who want to diversify their holdings outside of the U.S., it is a good idea to check out the components of VWO for interesting picks. The top holdings of the fund are shown in the table below and these choices make ideal selections for traders looking to trade the emerging markets.
Looking To Semiconductors For Growth
As the internet of things continues to take hold, semiconductors continue to play an ever increasing role in our everyday lives. The long-term growth prospects for this sector are very lucrative and there are few companies with the cost structure of TSM. For those of you who don’t know, TSM is engaged in manufacturing, selling and packaging integrated circuits and many types of semiconductor devices on a very large scale.
The stock has had an amazing run over the past five years with gains of more than 100 percent. Recent weakness is being looked at by many traders as a reversion to the mean and could be an ideal time for long-term traders to take a position. You’ll see that the price has historically been able to find support near the 200-day moving average, but it hasn’t bounced off this level as nicely as many of its large-cap U.S. counter parts. Stop-loss orders should be set below the 200-day moving average, but some room should be given due to the emerging markets' nature of inherent volatility.
The Bottom Line
---------------------------------------------------------------------------------------------------------------------------
With recent comments on stretched stock valuations by Janet Yellen, it is a natural reaction for active traders to look overseas for growth. In many cases, checking out the components of major emerging markets ETFs such as the Vanguard Emerging Markets VIPERS can provide valuable insights for those looking to develop a watch list. As discussed above, you’ll find that Taiwan Semiconductor Manufacturing Co. Ltd.TSM had a tremendous run over the past five years. Generally speaking, it is very uncommon to see companies with market caps of more than $50 billion double in value over five years. Luckily for TSM investors, there aren't major technical signals showing this trend will reverse any time soon.
For traders who want to diversify their holdings outside of the U.S., it is a good idea to check out the components of VWO for interesting picks. The top holdings of the fund are shown in the table below and these choices make ideal selections for traders looking to trade the emerging markets.
| Company (Ticker) | Weighting (%) |
| Taiwan Semiconductor Manufacturing Co. Ltd(TSM). | 2.9 |
| Tencent Holdings Ltd. (TCTZF) | 2.0 |
| Petroleo Brasileiro SA | 1.7 |
| China Construction Bank Corporation (CICHY) | 1.5 |
| China Mobile Ltd. | 1.4 |
Looking To Semiconductors For Growth
As the internet of things continues to take hold, semiconductors continue to play an ever increasing role in our everyday lives. The long-term growth prospects for this sector are very lucrative and there are few companies with the cost structure of TSM. For those of you who don’t know, TSM is engaged in manufacturing, selling and packaging integrated circuits and many types of semiconductor devices on a very large scale.
The stock has had an amazing run over the past five years with gains of more than 100 percent. Recent weakness is being looked at by many traders as a reversion to the mean and could be an ideal time for long-term traders to take a position. You’ll see that the price has historically been able to find support near the 200-day moving average, but it hasn’t bounced off this level as nicely as many of its large-cap U.S. counter parts. Stop-loss orders should be set below the 200-day moving average, but some room should be given due to the emerging markets' nature of inherent volatility.
The Bottom Line
---------------------------------------------------------------------------------------------------------------------------
With recent comments on stretched stock valuations by Janet Yellen, it is a natural reaction for active traders to look overseas for growth. In many cases, checking out the components of major emerging markets ETFs such as the Vanguard Emerging Markets VIPERS can provide valuable insights for those looking to develop a watch list. As discussed above, you’ll find that Taiwan Semiconductor Manufacturing Co. Ltd.TSM had a tremendous run over the past five years. Generally speaking, it is very uncommon to see companies with market caps of more than $50 billion double in value over five years. Luckily for TSM investors, there aren't major technical signals showing this trend will reverse any time soon.
Tuesday, 28 January 2014
Reported Earnings-True Measure Of Stock Performance
Variability Of
Earnings & Risk Assessment-
Anything that increases the variability of earnings (e.g., recession,
write-offs or poor business decisions) increases the unpredictability of
earnings and therefore increases the risk of the stock.
A focus on definitions of earnings other than reported
earnings may cause investors to underestimate the risk of a company.
If investors value a company “ Up “ the income statement and
as a result believe the company is of higher quality than it might truly be, the
company’s valuation will be higher & the cost of capital lower.
Investors should generally prefer to value companies “ Down “
the income statement in order to get a
better assessment of the risks of the company and to be compensated correctly
for those risks.
During the Technology Bubble when investors were valuing
companies on price-to-sales ratios, investors had simply handed the tug-of-war
rope to the companies without even putting up a fight.
Search For Grail-
There has been strong evidence amassed regarding the
efficacy of incorporating reported earnings into stock selection and style
rotation strategies , but investors continual search for the ‘ Holy Grail ‘
puzzles many.
It is yet to be found strategies based on any of these
supposedly superior measures that outperform reported earnings, but investors’
disbelief and their searches for “New & Improved “measures continue.
The Results-
During the last several years, valuing companies “Down “the
income statement would have clearly benefitted portfolio performance.
15-Year Annualized Return Of Selected Value Strategies
Low P/E – 15.8%
Low P/CF - 13.6% (Price To Cash Flow)
Low P/S – 11.4% (Price To Sales)
Average 12-Month Price Return Of Selected Value Strategies
Low EV/EBITDA – 12.3% (Enterprise Value To EBITDA)
Low P/E – 16.7%
Low P/CF – 14.8%
Low P/B- 13.7% (Price To Book Value)
Low P/S- 13%
DDM-12.7%
Summary-
One of the prime tenets is that reported earnings are the
ultimate drivers of stock prices.
Focusing on definitions of earnings other than reported
earnings may cause investors to underestimate the risk of a company.
A hypothetical “Tug-Of-War “exists between the investor and
company over a company’s valuation. Companies generally attempt to guide
investors to value their stocks as far up the income statement as possible in
order to better mask variability.
Why search for a new “Holy Grail “? We have yet to find
strategies based on any of these supposedly superior measures that outperform
reported earnings, but investors’ disbelief and their searches for “New &
Improved” measures continue.
Questions-
Q1. Does low P/E wok across the markets equally?
Q2. P/E may work best in the US, but may be flawed when
applied across borders. Enterprise value to EBITDA may work better. Your thoughts?
Q3. Were the ratios you used forward-looking or trailing?
Q4. If purchase of low P/E consistently works with and
across markets, what does that say about the efficiency of markets? Why does
the strategy work?
Monday, 27 January 2014
Ebitda- Can We Trust ?
Is Ebitda getting out of hand again? The same performance measure
(earnings before interest, taxes, depreciation, and amortization) that
corporate raiders cited to justify their takeovers in the 1980s is
becoming alarmingly ubiquitous in mainstream corporate America today as
an alternative to traditional bottom-line-based financial yardsticks.
Your company has lousy real earnings growth? Not enough profits to cover
interest costs? Your stock is ridiculously overvalued? No problem! Look
at Ebitda, and everything looks okay. Ebitda supposedly gives a clearer
picture of a company's operations by stripping out expenses that can
distort how the business is really doing. But it can also trick
investors into thinking a company is doing better than it really is.
Ebitda has gotten so out of hand that Martin Fridson, Merrill Lynch's
respected chief of high-yield research, recently went against the grain
with a report headlined "Ebitda is not king." While he says it can be
useful--especially in analyzing junk bonds--he believes that too many
analysts are using it as the starting- and end-points of their analysis.
Grouses Robert Olstein, who manages the Olstein Financial Alert fund:
"Ebitda is like Alice in Fantasyland. It should be outlawed from
securities analysis."
Ebitda has existed since the 1960s but only came into vogue with the leveraged buyouts of the 1980s. It became the valuation method of choice for highly leveraged companies in cable and media, where bona fide profits were hard to come by. The latest Ebitda wave appears to have no boundaries. It has become especially popular at companies with a taste for takeovers.
Coca-Cola Enterprises is one example: In its annual 10-K filing with the SEC, the giant Coke bottler goes so far as to say that "in the opinion of management, cash operating profit"--its term for Ebitda--"is one of the key standards for measuring our operating performance." A spokeswoman explains that Coke Enterprises sees itself as a cash-flow company. But to Jim Chanos, a short-seller with Kynikos Associates, looking at performance measures pretax and before major expenses such as depreciation and amortization is "just a lame excuse to get a lower multiple." Coca-Cola Enterprises trades at roughly 90 times reported earnings, or twice the price/earnings multiple of the Coca-Cola Co. However, it trades at just 14 times Ebitda.
Ebitda can also make a company look as though it has more money to make interest payments. A good example is Coinmach, a large operator of washing machines at apartment houses. In its third fiscal quarter, Coinmach had $6.8 million in operating income and nearly $12 million in interest expenses. The solution? Add back depreciation and amortization, and suddenly the company has $24 million--more than enough to cover the costs. And Coinmach encourages investors to reach that very conclusion. According to its third-quarter 10-Q, "Management believes that an increase in Ebitda is an indicator of the company's improved ability to service existing debt, to sustain potential future increases in debt."
But that assumes Ebitda is the same as cash flow, which it isn't, and Fridson says that saying so is a "scam," especially with big depreciation charges. "A capital-intensive company isn't earning a profit if its assets are wearing down from wear and tear," he says. Kathryn Staley, author of The Art of Shortselling, agrees. When a company has high interest or high depreciation, Staley prefers measures such as operating cash flow--from the cash-flow statement in the annual report, which, unlike Ebitda, is subject to generally accepted accounting principles--and return on assets. Such calculations would no doubt have pricked the Ebitda balloons floated by such notable blowups as Texas Air, Quality Dining, and Harcourt Brace Jovanovich.
Companies that prefer Ebitda, meanwhile, have plenty of caveats in their public disclosures--caveats such as "Ebitda is not intended to represent cash flows" and even (this from Coinmach's 10-K) that Ebitda is not determined in accordance with generally accepted accounting principles and, as a result, "is susceptible to varying calculations." But in the end, when it comes to Ebitda, the only caveat for investors should be caveat emptor.
Ebitda has existed since the 1960s but only came into vogue with the leveraged buyouts of the 1980s. It became the valuation method of choice for highly leveraged companies in cable and media, where bona fide profits were hard to come by. The latest Ebitda wave appears to have no boundaries. It has become especially popular at companies with a taste for takeovers.
Coca-Cola Enterprises is one example: In its annual 10-K filing with the SEC, the giant Coke bottler goes so far as to say that "in the opinion of management, cash operating profit"--its term for Ebitda--"is one of the key standards for measuring our operating performance." A spokeswoman explains that Coke Enterprises sees itself as a cash-flow company. But to Jim Chanos, a short-seller with Kynikos Associates, looking at performance measures pretax and before major expenses such as depreciation and amortization is "just a lame excuse to get a lower multiple." Coca-Cola Enterprises trades at roughly 90 times reported earnings, or twice the price/earnings multiple of the Coca-Cola Co. However, it trades at just 14 times Ebitda.
Ebitda can also make a company look as though it has more money to make interest payments. A good example is Coinmach, a large operator of washing machines at apartment houses. In its third fiscal quarter, Coinmach had $6.8 million in operating income and nearly $12 million in interest expenses. The solution? Add back depreciation and amortization, and suddenly the company has $24 million--more than enough to cover the costs. And Coinmach encourages investors to reach that very conclusion. According to its third-quarter 10-Q, "Management believes that an increase in Ebitda is an indicator of the company's improved ability to service existing debt, to sustain potential future increases in debt."
But that assumes Ebitda is the same as cash flow, which it isn't, and Fridson says that saying so is a "scam," especially with big depreciation charges. "A capital-intensive company isn't earning a profit if its assets are wearing down from wear and tear," he says. Kathryn Staley, author of The Art of Shortselling, agrees. When a company has high interest or high depreciation, Staley prefers measures such as operating cash flow--from the cash-flow statement in the annual report, which, unlike Ebitda, is subject to generally accepted accounting principles--and return on assets. Such calculations would no doubt have pricked the Ebitda balloons floated by such notable blowups as Texas Air, Quality Dining, and Harcourt Brace Jovanovich.
Companies that prefer Ebitda, meanwhile, have plenty of caveats in their public disclosures--caveats such as "Ebitda is not intended to represent cash flows" and even (this from Coinmach's 10-K) that Ebitda is not determined in accordance with generally accepted accounting principles and, as a result, "is susceptible to varying calculations." But in the end, when it comes to Ebitda, the only caveat for investors should be caveat emptor.
Wednesday, 22 January 2014
Financial Sleuth
What's going on in the world of accounting, post-Sarbanes-Oxley?
Sarbanes-Oxley [the accounting-reform act passed in 2002] is one of a number of attempts over the years by the government to make it less likely there would be financial fraud. But if you think there's no incentive to play games with accounting today, then you're in a dream world. There's complacency, and that's when bad stuff happens.
Before we start discussing specifics, keep in mind, first, that these examples I give may not be a violation of the law or even a technical violation of the accounting rules. Second, auditors are important. I recently had lunch with a veteran auditor, and to any accounting problems I described to him, he replied: "Was it disclosed? If it is disclosed, then we did our job." A company might change its revenue recognition that took a loss to a profit—but the auditors' concern is disclosure. Who is sitting there reading footnotes? People are making their decisions on a press release or a database. In general, the auditors' focus is on a legalistic interpretation. So, if you tied up your neighbor and robbed his house, but you disclosed it in footnote No. 23, it's okay.
In the fiscal year ended June 2010, Ulvac, a semiconductor-equipment company, changed from straightforward revenue recognition, under which revenue is recognized when a product is sold and delivered, to percentage-of-completion accounting. The latter is part of generally accepted accounting principles (GAAP), but isn't meant for every company. It's more used by construction firms, among others, where parts of a project are completed over time. So this company, which always used an appropriate revenue recognition method, turns on a dime in a year when business is very weak and says: 'Now would be a good time to move to percentage-of-completion. Wow, we pick up revenue as the production process is ongoing. How cool is that?'
This is a semiconductor-equipment maker. We are not talking about a five- year construction period for what it does. It helps Ulvac by allowing it to pick up revenue much earlier [then it otherwise might have]. In fiscal 2010, Ulvac reports that their sales are down 1% and profits up 38%. But the fine print in the footnotes says they changed their revenue-recognition, and that in the absence of that change, sales declined 21%, and they would have had a loss. It should say: 'We had a 21% decline in revenue from sales to customers, yet because we had a 20% increase in revenue from changing our accounting, we could still report that sales only declined 1%.'
Another example
At the beginning of 2011, Rakuten disclosed that it had changed its depreciation method from the straight-line method to the declining-balance method. Over the life of the asset, depreciation will basically be the same number. Straight-line depreciates an equal amount to each period; the other takes bigger deductions in the early years, and small ones later on. In U.S. dollars, that change added $13 million to Rakuten's operating profit, through a lower depreciation expense. Is there any place in the GAAP rule book that says: 'Thou shall never change your depreciation method?' No. But, in my interpretation, that stinks. It had nothing to do with selling additional products or having stronger margins.
Let's move to China.
China Yurun Food Group is a meat company that is taking gains on asset acquisitions, instead of on asset sales. You can't do that in the U.S. or under International Financial Reporting Standards (IFRS).
When you buy a company, if you pay more than its fair market value, you have to put goodwill on your books; conversely, if you pay less than fair market value, you put negative goodwill on your books. If you buy the asset at a big discount to fair market value, the negative goodwill is not going to be picked [as a gain] immediately under U.S. accounting rules. But in Hong Kong, they let companies pick up that negative goodwill immediately, as operating income.
Yurun drove a Mack truck through that accounting [loophole]. It appraised asset values much higher than what I believe is a reasonable fair market value. In fiscal 2010, Yurun made three acquisitions using appraised value at what I believe were inflated fair market values, and they took an immediate gain of 186 million Hong Kong dollars (about $24 million). They understood that the accounting allowed them to book a gain, which represented the difference between what they paid—in most cases, a tiny number—and what the appraiser says it's worth. [The company] got a good deal on all of these acquisitions, and accounted for it with negative goodwill. What the assets are really worth, we don't know. It's as if you bought a condo in Miami for $400,000, and it was worth $1 million before the housing crash.
So, on the day you buy it, you [report that you've made] $600,000. But you don't book income, whether it is sales revenue or investment on securities, on the day you buy the asset; you do it on the day you sell it. The most logical way to express it is that there is a connection between revenue and income when cash comes to you, not when cash is being spent. The more the appraiser says this thing is worth, the more enormous the opportunity for gains. This [type of] accounting is also used in Japan.
How about some domestic examples?
Green Mountain Coffee Roasters(GMCR). In past quarterly statements, such as the third quarter of fiscal 2010, the company made a point of things like 11 consecutive quarters of 40% net sales growth and 24 quarters of double-digit growth. If you do some compounding, the numbers start to get enormous.
There were two important changes in the footnotes describing its accounting policies over the past five years or so. In 2007, Green Mountain recorded revenue when the product was delivered to the customer. Then, it gave rebates; For example, if you buy 1,000 of those little K-Cups, they may give you a 5% rebate. They accounted for rebates as a reduction from gross sales. Fine. Then, when they started having difficulty getting to that magical 40%—this is my interpretation—the revenue-recognition wording in the footnotes became longer; in some cases, revenue was recognized upon shipment. That's not the same thing. Then, instead of treating the rebates as a reduction to sales, in some cases it was treated as an operating expense. Now, my friendly auditor will say: 'They disclosed it all.' But investors would say: 'That stinks.'
Because it flatters sales growth?
When you are telling me the business is still booming, but in order to make that assertion, you changed how you are accounting, that's just not fair play. Is it illegal? No. The auditors signed off on it. But the auditors are part of the problem.
For the fiscal year ended September 2011, Green Mountain reported net income [at] a shade over $201 million before items, up from almost $80 million [a year earlier]. Compare that to the cash flow from operations from that same year. Both measure the business's profitability. Cash flow from operating activities was $790,000 in fiscal 2011, versus a negative $2.3 million in 2010. That is a huge difference. The quality of earnings here looks suspect, because the cash flow should follow along with the net income.
Any other examples?
A recent interesting change to accounting rules was related to earn-outs [payments to the seller] in acquisitions. In the accounting, the acquirer debits intangible assets and credits something called a contingent consideration liability, which is the present value of what you expect to pay for the earn-out from the acquisition. It's a soft number, because in the case of drug companies, for example, buying research and development, you don't know if you're going to be able to get the regulatory approvals [for these products to come to market]. There are many hurdles along the way.
Mylan(MYL), a generic drug maker, in December acquired the rights to a Pfizer (PFE) inhalation technology platform for $348 million. The deal included rights of negotiation for certain Pfizer compounds in various stages of development. Acquirers on a regular basis reassess whether that number is correct. In the fourth quarter, Mylan recorded an earn-out liability of $376 million, most of which is related to the Pfizer deal. That was enormous, compared with the cash it paid in the acquisition, about $22 million. If the numbers were flipped, where they paid close to $400 million, and then there could be another 5% on the table or 10% for the earn-out, that would seem to be reasonable. But here, almost everything is non-cash.
What's the advantage of that?
Let's take a hypothetical scenario: A year from now, approvals don't come, or there are delays. Mylan knocks the contingent consideration liability down to $300 million, from $376 million. Perfectly reasonable.
What's the bookkeeping entry? You have to reduce your contingent consideration liability by $76 million, and you put that amount as a credit to income. You have created, out of thin air, a possibility of bleeding back into income some $376 million. You control the timing of it. Mylan obviously ran this through with the auditors. It is a stupid accounting-rule change.
I'm teaching people to watch for these earn-outs, and look at their accounting for the contingent liability. This could be the big abuse in the next few years, because abusive practices very often stem from accounting changes.
So, what's the lesson?
Don't let your guard down. If you are buying individual securities, you have to do some work. If you don't have the time or the interest or the expertise, buy an index.
What's your perspective now that you are back in the business? Will the next big accounting scam be outside the U.S.?
Frankly, there will be big ones in every market. It's partly human nature. It becomes more and more difficult for the auditors to stop, because the accounting rules across the world were largely written 50 years ago, in an industrial society. As the business models have changed, the accounting rules haven't really been rethought for certain type of transactions.
My goal is to find the companies where there is a disconnect between the underlying economics and how the company presents them, using whatever accounting they choose. Many times, it is completely legal, and in accordance with the rules. But the auditors interpret the rules a certain way, and don't have the imagination to just ask: "Does this reflect the underlying economics of the company?"
Here is how the auditors look at the world: They think of themselves and their legal liability issues first; if it's in the rule book and disclosed, you are covered. Second, they think of their clients. The client asked them to do something, and they want to please the client. A very distant third is they may occasionally ask: How does this look from the perspective of the investor? Investors would be astounded if they realized that this is how the party that is supposed to protect them views the world.
Sarbanes-Oxley [the accounting-reform act passed in 2002] is one of a number of attempts over the years by the government to make it less likely there would be financial fraud. But if you think there's no incentive to play games with accounting today, then you're in a dream world. There's complacency, and that's when bad stuff happens.
Before we start discussing specifics, keep in mind, first, that these examples I give may not be a violation of the law or even a technical violation of the accounting rules. Second, auditors are important. I recently had lunch with a veteran auditor, and to any accounting problems I described to him, he replied: "Was it disclosed? If it is disclosed, then we did our job." A company might change its revenue recognition that took a loss to a profit—but the auditors' concern is disclosure. Who is sitting there reading footnotes? People are making their decisions on a press release or a database. In general, the auditors' focus is on a legalistic interpretation. So, if you tied up your neighbor and robbed his house, but you disclosed it in footnote No. 23, it's okay.
In the fiscal year ended June 2010, Ulvac, a semiconductor-equipment company, changed from straightforward revenue recognition, under which revenue is recognized when a product is sold and delivered, to percentage-of-completion accounting. The latter is part of generally accepted accounting principles (GAAP), but isn't meant for every company. It's more used by construction firms, among others, where parts of a project are completed over time. So this company, which always used an appropriate revenue recognition method, turns on a dime in a year when business is very weak and says: 'Now would be a good time to move to percentage-of-completion. Wow, we pick up revenue as the production process is ongoing. How cool is that?'
This is a semiconductor-equipment maker. We are not talking about a five- year construction period for what it does. It helps Ulvac by allowing it to pick up revenue much earlier [then it otherwise might have]. In fiscal 2010, Ulvac reports that their sales are down 1% and profits up 38%. But the fine print in the footnotes says they changed their revenue-recognition, and that in the absence of that change, sales declined 21%, and they would have had a loss. It should say: 'We had a 21% decline in revenue from sales to customers, yet because we had a 20% increase in revenue from changing our accounting, we could still report that sales only declined 1%.'
Another example
At the beginning of 2011, Rakuten disclosed that it had changed its depreciation method from the straight-line method to the declining-balance method. Over the life of the asset, depreciation will basically be the same number. Straight-line depreciates an equal amount to each period; the other takes bigger deductions in the early years, and small ones later on. In U.S. dollars, that change added $13 million to Rakuten's operating profit, through a lower depreciation expense. Is there any place in the GAAP rule book that says: 'Thou shall never change your depreciation method?' No. But, in my interpretation, that stinks. It had nothing to do with selling additional products or having stronger margins.
Let's move to China.
China Yurun Food Group is a meat company that is taking gains on asset acquisitions, instead of on asset sales. You can't do that in the U.S. or under International Financial Reporting Standards (IFRS).
When you buy a company, if you pay more than its fair market value, you have to put goodwill on your books; conversely, if you pay less than fair market value, you put negative goodwill on your books. If you buy the asset at a big discount to fair market value, the negative goodwill is not going to be picked [as a gain] immediately under U.S. accounting rules. But in Hong Kong, they let companies pick up that negative goodwill immediately, as operating income.
Yurun drove a Mack truck through that accounting [loophole]. It appraised asset values much higher than what I believe is a reasonable fair market value. In fiscal 2010, Yurun made three acquisitions using appraised value at what I believe were inflated fair market values, and they took an immediate gain of 186 million Hong Kong dollars (about $24 million). They understood that the accounting allowed them to book a gain, which represented the difference between what they paid—in most cases, a tiny number—and what the appraiser says it's worth. [The company] got a good deal on all of these acquisitions, and accounted for it with negative goodwill. What the assets are really worth, we don't know. It's as if you bought a condo in Miami for $400,000, and it was worth $1 million before the housing crash.
So, on the day you buy it, you [report that you've made] $600,000. But you don't book income, whether it is sales revenue or investment on securities, on the day you buy the asset; you do it on the day you sell it. The most logical way to express it is that there is a connection between revenue and income when cash comes to you, not when cash is being spent. The more the appraiser says this thing is worth, the more enormous the opportunity for gains. This [type of] accounting is also used in Japan.
How about some domestic examples?
Green Mountain Coffee Roasters(GMCR). In past quarterly statements, such as the third quarter of fiscal 2010, the company made a point of things like 11 consecutive quarters of 40% net sales growth and 24 quarters of double-digit growth. If you do some compounding, the numbers start to get enormous.
There were two important changes in the footnotes describing its accounting policies over the past five years or so. In 2007, Green Mountain recorded revenue when the product was delivered to the customer. Then, it gave rebates; For example, if you buy 1,000 of those little K-Cups, they may give you a 5% rebate. They accounted for rebates as a reduction from gross sales. Fine. Then, when they started having difficulty getting to that magical 40%—this is my interpretation—the revenue-recognition wording in the footnotes became longer; in some cases, revenue was recognized upon shipment. That's not the same thing. Then, instead of treating the rebates as a reduction to sales, in some cases it was treated as an operating expense. Now, my friendly auditor will say: 'They disclosed it all.' But investors would say: 'That stinks.'
Because it flatters sales growth?
When you are telling me the business is still booming, but in order to make that assertion, you changed how you are accounting, that's just not fair play. Is it illegal? No. The auditors signed off on it. But the auditors are part of the problem.
For the fiscal year ended September 2011, Green Mountain reported net income [at] a shade over $201 million before items, up from almost $80 million [a year earlier]. Compare that to the cash flow from operations from that same year. Both measure the business's profitability. Cash flow from operating activities was $790,000 in fiscal 2011, versus a negative $2.3 million in 2010. That is a huge difference. The quality of earnings here looks suspect, because the cash flow should follow along with the net income.
Any other examples?
A recent interesting change to accounting rules was related to earn-outs [payments to the seller] in acquisitions. In the accounting, the acquirer debits intangible assets and credits something called a contingent consideration liability, which is the present value of what you expect to pay for the earn-out from the acquisition. It's a soft number, because in the case of drug companies, for example, buying research and development, you don't know if you're going to be able to get the regulatory approvals [for these products to come to market]. There are many hurdles along the way.
Mylan(MYL), a generic drug maker, in December acquired the rights to a Pfizer (PFE) inhalation technology platform for $348 million. The deal included rights of negotiation for certain Pfizer compounds in various stages of development. Acquirers on a regular basis reassess whether that number is correct. In the fourth quarter, Mylan recorded an earn-out liability of $376 million, most of which is related to the Pfizer deal. That was enormous, compared with the cash it paid in the acquisition, about $22 million. If the numbers were flipped, where they paid close to $400 million, and then there could be another 5% on the table or 10% for the earn-out, that would seem to be reasonable. But here, almost everything is non-cash.
What's the advantage of that?
Let's take a hypothetical scenario: A year from now, approvals don't come, or there are delays. Mylan knocks the contingent consideration liability down to $300 million, from $376 million. Perfectly reasonable.
What's the bookkeeping entry? You have to reduce your contingent consideration liability by $76 million, and you put that amount as a credit to income. You have created, out of thin air, a possibility of bleeding back into income some $376 million. You control the timing of it. Mylan obviously ran this through with the auditors. It is a stupid accounting-rule change.
I'm teaching people to watch for these earn-outs, and look at their accounting for the contingent liability. This could be the big abuse in the next few years, because abusive practices very often stem from accounting changes.
So, what's the lesson?
Don't let your guard down. If you are buying individual securities, you have to do some work. If you don't have the time or the interest or the expertise, buy an index.
What's your perspective now that you are back in the business? Will the next big accounting scam be outside the U.S.?
Frankly, there will be big ones in every market. It's partly human nature. It becomes more and more difficult for the auditors to stop, because the accounting rules across the world were largely written 50 years ago, in an industrial society. As the business models have changed, the accounting rules haven't really been rethought for certain type of transactions.
My goal is to find the companies where there is a disconnect between the underlying economics and how the company presents them, using whatever accounting they choose. Many times, it is completely legal, and in accordance with the rules. But the auditors interpret the rules a certain way, and don't have the imagination to just ask: "Does this reflect the underlying economics of the company?"
Here is how the auditors look at the world: They think of themselves and their legal liability issues first; if it's in the rule book and disclosed, you are covered. Second, they think of their clients. The client asked them to do something, and they want to please the client. A very distant third is they may occasionally ask: How does this look from the perspective of the investor? Investors would be astounded if they realized that this is how the party that is supposed to protect them views the world.
Tuesday, 21 January 2014
1999-IBM's Accounting Method Faces Scrutiny
Does an accounting strategy make the world's largest computer maker look more efficient than it really is?
On first blush, this year's results at IBM
suggest it has become a tightly run ship. With revenue growing
just 12% to $63.4 billion for the nine months to Sept. 30, operating
income rose a heady 53% to $8.9 billion. A major factor: Reported
operating expenses fell by more than $1 billion.
Louis
Gertsner, IBM's chief executive, cited "strong expense management" as
helping to fuel third-quarter gains -- and as a reason to expect better
results to come. IBM's shares, which fell $1.6875 to $106.1875 at 4 p.m.
on the New York Stock Exchange Tuesday, have nearly recovered from the
drubbing they received after the earnings announcement last month, when
revenue failed to meet analysts' expectations.
But
some accounting specialists and analysts, scrutinizing the footnotes,
now are raising questions about IBM's unusual treatment of one-time
gains. At issue: IBM booked about $4 billion in such gains from the sale
of its Global Network business to AT&T Corp.
during its second and third quarters. The gains were included in
selling, general and administrative expenses, or SG&A.
Translation: Reported costs were lowered. And reported operating income was raised.
The
issue is important on Wall Street. This is because operating income
--which excludes taxes, interest and other items that have little to do
with success in making and selling products or services -- is often more
important to investors than net income, and widely regarded as an
indicator of how well management is running the shop.
In a new report, accounting watchdog Howard Schilit says IBM should be
"roundly criticized for its policy of bundling one-time gains and other
nonoperating activities into operating income." SG&A expenses, he
says, should be "just that" -- and shouldn't include one-time charges or
gains that don't reflect operating performance. Mr. Schilit's reports
on such matters have a close following among money managers.
An IBM spokesman says it has been putting
one-time gains and charges into SG&A since about 1994 and
categorizes such items as "general" expenses.
IBM,
Armonk, N.Y., has disclosed the dollar value and impact on earnings per
share of the charges in the text accompanying its earnings releases,
the spokesman said. The gains in both the second and third quarters were
partially offset by unrelated charges, such as write-downs of other
assets also included in the SG&A line.
Instead
of the $8.9 billion IBM reported in operating income for the first nine
months, Mr. Schilit estimates it would have reported $6.5 billion
without the AT&T gains and other one-time items reflected in the
SG&A line. In the third quarter, he estimates the boost to operating
income was $758 million.
The IBM spokesman declined to comment on the analysis.
IBM's practice of defraying operating
expenses with gains makes it difficult for investors and analysts to
quickly work out the company's true performance, said Gary Helmig, an
analyst with SoundView Technology Group. But he says it doesn't matter
to the bottom line -- and thus, isn't that important.
But
that isn't necessarily the bottom line with federal regulators.
According to Securities and Exchange Commission regulations, companies
should include gains from material asset sales in a line-item called
"non-operating income" that sits below operating income, says Paul
Kepple, a senior accounting fellow at the SEC. The $4 billion gain IBM
booked "would seem to be material," and thus should "generally" be
treated as a nonoperating item, Mr. Kepple adds.
Meanwhile,
the Financial Accounting Standards Board, the body to which the SEC
delegates accounting standards, doesn't offer guidance about the proper
place to record such gains as asset sales, according to Robert J. Laux, a
FASB industry fellow. But Mr. Laux says companies generally break out
such items below the operating income line.
Mr.
Helmig says after IBM released its third-quarter results last month, he
suggested to company officials they break out the figure so it would
show operating income minus the one-time gains and charges. He says he
received no response. The IBM spokesman declined to comment.
The gains and offsetting charges are
explained in footnotes and management discussion sections of IBM filings
with the SEC. But Mr. Schilit, who runs the Center for Financial
Research and Analysis, a Rockville, Md., accounting-research
organization, says without a discrete line item for such one-time items,
investors could have a hard time evaluating IBM's financial
performance. Mr. Schilit calls IBM's practice "pretty unusual" and says
it doesn't conform to what most other companies do.
IBM's
practice "muddies the water," Mr. Schilit says, and causes investors to
"lose confidence when we look at the company's operating income in
future periods."
He predicts some
investors might be more skeptical when reading future IBM earning
releases, asking themselves: "Is that really the company's operating
income?"
1998-America Online's Fancy Accounting Methods
Not
for the first time, high flying America Online is using fancy accounting
methods, creating dollops of extra earnings that carry the stock
higher.
The provider of on-line services has assured analysts that it has its auditors' blessing for a controversial, seldom-used sale-leaseback transaction that accompanied a $430 million asset swap in January. America Online also has persuaded Wall Street to accept an unusual rationale for treating some capital gains from stock sales as regular earnings.
Says Lennert Leader, chief financial officer, "The Internet group of companies is doing business in very new ways that have not been tested in terms of business norms and accounting. We really are out there on the cutting edge having to pioneer new territory."
For some, however, the issue rings alarm bells. In 1996, America Online had to write off $385 million of deferred marketing costs, erasing many quarters of past profits. In 1997's fourth quarter, after AOL adopted what it called gold-standard accounting policies, the Securities and Exchange Commission forced it to make $32 million of accounting adjustments.
"Having fessed up, it seems to me they would be the last type of company that would want to raise red flags again. But this leaseback transaction does raise flags," says Paul Brown, chairman of the accounting department at New York University's Stern School of Business. He is co-editing a textbook that will feature America Online's earlier mishaps.
This year's leaseback transaction will contribute five cents out of 19 cents a share of estimated profit for the June quarter, calculates CIBC Oppenheimer analyst Henry Blodget. But he adds, "In our opinion, it's not an example of them cooking the books."
At issue is how America Online should account for the sale of its ANS Communications network-services unit to WorldCom in January. Essentially, America Online swapped ANS for CompuServe's on-line division, which it valued at around $280 million, plus nearly $150 million in cash. It also contracted to use ANS's services for another five years.
If ANS had been sold outright, America Online would have had to report an outsize one-time gain of roughly $380 million, which, of course, wouldn't have helped future earnings. Analysts generally disregard one-time gains in valuing stocks.
But by treating the transaction as a sale-leaseback, the company can spread the gain over five years, getting it into operating income. Profit thus will rise about $76 million a year, or 20 cents a share. It is common to sell and lease back hard assets such as buildings or railcars. But several accountants said they had never heard of anyone doing that with a whole company.
In fact, SEC rules allow the sale-leaseback of an operating company if -- as America Online is doing with ANS -- the seller continues to use the operating company's services. "The sale-leaseback transaction is somewhat unique, but our auditors advised us that this is mandatory accounting," Mr. Leader says.
Another issue is how analysts should treat America Online's stock profits. In the quarter ended Sept. 30, AOL showed four cents a share of gains on the sale of stock in Internet search firm Excite that it held in its portfolio. The gains were treated conventionally, as nonrecurring earnings that didn't add to operating profit.
But in each of the two latest quarters, America Online encouraged analysts to include in their earnings calculations two cents a share of gains on the sale of stock and warrants.
How come? In doing business and forging alliances on the Internet, AOL sometimes takes a company's stock as payment. It took stock instead of cash in a marketing agreement with Excite about a year ago. AOL quite reasonably considers such stock-sale gains "payment for services rendered," says Friedman Billings Ramsey analyst Ulric Weil, an AOL bull.
Financial officer Mr. Leader notes AOL didn't report any capital gains as part of operating income. But it did try to educate the Street that certain stock sales would be a normal event -- used, he says, "to offset investment losses and other expenses."
Unluckily for the many bears, America Online remains richly priced. At 77 3/8 Tuesday, its stock trades at 86 times estimated profit of 90 cents a share for the coming fiscal year starting in July.
Says analyst David Simons of the Internet research firm, Digital Video Investments: "Bullishness tends to have a blind eye about quality of earnings."
The provider of on-line services has assured analysts that it has its auditors' blessing for a controversial, seldom-used sale-leaseback transaction that accompanied a $430 million asset swap in January. America Online also has persuaded Wall Street to accept an unusual rationale for treating some capital gains from stock sales as regular earnings.
Says Lennert Leader, chief financial officer, "The Internet group of companies is doing business in very new ways that have not been tested in terms of business norms and accounting. We really are out there on the cutting edge having to pioneer new territory."
For some, however, the issue rings alarm bells. In 1996, America Online had to write off $385 million of deferred marketing costs, erasing many quarters of past profits. In 1997's fourth quarter, after AOL adopted what it called gold-standard accounting policies, the Securities and Exchange Commission forced it to make $32 million of accounting adjustments.
"Having fessed up, it seems to me they would be the last type of company that would want to raise red flags again. But this leaseback transaction does raise flags," says Paul Brown, chairman of the accounting department at New York University's Stern School of Business. He is co-editing a textbook that will feature America Online's earlier mishaps.
This year's leaseback transaction will contribute five cents out of 19 cents a share of estimated profit for the June quarter, calculates CIBC Oppenheimer analyst Henry Blodget. But he adds, "In our opinion, it's not an example of them cooking the books."
At issue is how America Online should account for the sale of its ANS Communications network-services unit to WorldCom in January. Essentially, America Online swapped ANS for CompuServe's on-line division, which it valued at around $280 million, plus nearly $150 million in cash. It also contracted to use ANS's services for another five years.
If ANS had been sold outright, America Online would have had to report an outsize one-time gain of roughly $380 million, which, of course, wouldn't have helped future earnings. Analysts generally disregard one-time gains in valuing stocks.
But by treating the transaction as a sale-leaseback, the company can spread the gain over five years, getting it into operating income. Profit thus will rise about $76 million a year, or 20 cents a share. It is common to sell and lease back hard assets such as buildings or railcars. But several accountants said they had never heard of anyone doing that with a whole company.
In fact, SEC rules allow the sale-leaseback of an operating company if -- as America Online is doing with ANS -- the seller continues to use the operating company's services. "The sale-leaseback transaction is somewhat unique, but our auditors advised us that this is mandatory accounting," Mr. Leader says.
Another issue is how analysts should treat America Online's stock profits. In the quarter ended Sept. 30, AOL showed four cents a share of gains on the sale of stock in Internet search firm Excite that it held in its portfolio. The gains were treated conventionally, as nonrecurring earnings that didn't add to operating profit.
But in each of the two latest quarters, America Online encouraged analysts to include in their earnings calculations two cents a share of gains on the sale of stock and warrants.
How come? In doing business and forging alliances on the Internet, AOL sometimes takes a company's stock as payment. It took stock instead of cash in a marketing agreement with Excite about a year ago. AOL quite reasonably considers such stock-sale gains "payment for services rendered," says Friedman Billings Ramsey analyst Ulric Weil, an AOL bull.
Financial officer Mr. Leader notes AOL didn't report any capital gains as part of operating income. But it did try to educate the Street that certain stock sales would be a normal event -- used, he says, "to offset investment losses and other expenses."
Unluckily for the many bears, America Online remains richly priced. At 77 3/8 Tuesday, its stock trades at 86 times estimated profit of 90 cents a share for the coming fiscal year starting in July.
Says analyst David Simons of the Internet research firm, Digital Video Investments: "Bullishness tends to have a blind eye about quality of earnings."
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