I thought bunnies were supposed to be cute and cuddly little creatures?  Well after looking at Annie’s, Inc….maybe not.  This Company has recently “hit the trifecta:” a restatement of its financials (2014 10K, p. 54), a material weakness report on its controls over financial reporting (2014 10K, pp. 45 and 74), and an auditor resignation (2014 8K dated June 1)…all in the space of a week.  And if this weren’t bad enough, along comes a class action suit alleging false and/or misleading financial statements and disclosures.

But should we really be surprised.  No, not really since until this year the Company avoided scrutiny of its accounting and controls via its JOBS Act status as an “emerging growth company”(2014 10K, p. 32).  It has been less than a year since I reminded you in Garbage In, Garbage Out – Are Accountants Really to Blame? that:

Proponents of “emerging-growth” company (EGC) internal control reporting exemptions claim cost savings that promote business development. The reality is that most ECGs simply have no internal controls.

So, did PricewaterhouseCoopers (PwC) really dump Bernie, Annie’s mascot, just over a restatement and some internal control weaknesses?  After all, there’s many a PwC client that has committed far greater sins and still remained a client of the firm (hint: Financial Crisis of 2007 and 2008).  Just how could PwC disapprove of Bernie, Annie’s “Rabbit of Approval?”  This is just the kind of question this grumpy old accountant likes to tackle.

Management Under Fire

Given recent allegations made in the class action suit filed in United States District Court, Northern District of California, and docketed under 3:14-cv-03001, it seems reasonable to first investigate whether Annie’s management had any incentives to engage in inappropriate financial reporting behaviors.

Clearly, management experienced significant pressures to report positive performance results.  The following factors individually and collectively may have created demands to engage in aggressive financial reporting:

The Company’s history of operating losses as evidenced by its retained earnings deficit (2014 10K, p. 47)

  • The recent rapid growth in profitability despite declining gross profit percentages (2014 10K, p. 34)

  • Restrictions imposed by credit agreements (2014 10K, p. 22)

  • The steady decline in the Company’s stock price per share from a high of $51.36 on November 15, 2013 to its current price of 33.14 (a decline of over 35 percent)

  • The role of stock based rewards in management compensation (2014 10K, pp. 63-65)

And all of these hurdles had to be addressed in a highly competitive market (2014 10K, pp. 9 and 12). 

Could the Company’s operating environment contribute to or facilitate inappropriate financial reporting by management?  The recent negative report on internal controls over financial reporting would seem to suggest so.  Acknowledging “an insufficient complement of finance and accounting resources” (2014 10K, p. 74) is a fairly damning admission for any organization, much less a publicly-traded company.  The statement suggests an environment devoid of controls and oversight…one just perfect for aggressive financial reporting.  And contrary to managements’ assertions, there is no quick fix to this problem.

Then, there is the issue of key officer turnover at Annie’s.  Amanda K. Martinez joined the Company as Executive Vice President in January 2013 (2013 8K dated January 5), was promoted in December 2013 (2013 8K dated December 9), and resigned without a stated reason in March 2014 just prior to the end of the fiscal year (2014 8K dated March 26).  Also, the Company’s previous chief financial officer, Kelly J. Kennedy, resigned effective November 12, 2013 and was succeeded by Zahir Ibrahim on the following day (2013 8K dated October 16).  Such changes in the C-suite can wreak havoc on internal controls, and potentially negatively affect financial reporting.

So, is there any quantitative support for my qualitative concerns about the quality of Annie’s financial reporting? Absolutely!  Let’s first see what the Beneish Model reveals about the likelihood of earnings manipulation by the Company’s management. 

Using inputs from Annie’s 2014 10K, the Beneish Model reveals only a slight probability of earnings manipulation driven primarily by the rapid increase in sales and disparity between operating income and operating cash flows (OCF) (i.e., accruals).  More on OCF shortly.

The Conservatism Ratio also provides some evidence of aggressive revenue recognition.  This metric compares reported GAAP income before taxes with an estimate of an entity’s taxable income (current taxes payable divided by the effective tax rate). Generally, a ratio approximating one suggests relatively conservative income recognition practices, while those larger than one may signal increasingly aggressive revenue recognition practices.

Coupled with the Company’s rapid growth in sales and profitability, and the aforementioned apparent disconnect between operating income and OCF, the Conservatism Ratio seems to confirm concerns about aggressive revenue and expense recognition practices.

But there’s more…the Company’s financial reports raise additional questions for investors about accounting quality and transparency and provide more clues to PwC’s recent departure.

Transparency Failures

Non-GAAP Metrics

By now you all know how I feel about non-GAAP metrics.  So, why does the Company feel compelled to rely on flaky pro-forma disclosures when its GAAP numbers look so good?  Selected financial data (2014 10K, p. 28) reports a history of increasing net sales, gross profits, income from operations, and improving Earnings Per Share (for the last three years), and the statement of cash flows (SCF) reports dramatic annual increases in OCF (2014 10K, p. 49).  And the Company uses pro-forma reporting not just for EBITDA but for net sales and gross profit as well.  Particularly troubling are the nature if its non-GAAP adjustments which go well beyond those witnessed even in the case of Black Box, and include product recall adjustments, plant (not business) acquisition costs, secondary offering costs, management fees, and fair value changes (2014 10K, p. 29 note 3).

And note how the Company justifies these metrics (10K, 34):

We believe these non-GAAP figures provide additional metrics to evaluate our operations and, when considered with both our GAAP results and the related reconciliation to the most directly comparable GAAP measure, provide a more complete understanding of our business than could be obtained absent this disclosure.
— 2014 10K, p. 34

Yet, only four sentences later, Annie’s warns us that their non-GAAP metrics are of limited usefulness due to non-comparability:

Our computation of these non-GAAP figures is likely to differ from methods used by other companies in computing similarly titled or defined terms, limiting the usefulness of these measures.
— 2014 10K, p. 34

Who’s writing and reviewing this stuff?  I think we know the answer…no one…that’s what a material weakness in internal controls is all about.

Revisions, Restatements, and Errors

Where would you expect to find a detailed discussion of material accounting errors requiring a restatement of a Company’s set of financial statements?  This Grumpy Old Accountant can tell you that creditable, transparent companies report such things in a separate note with an appropriate title to highlight the event.  Not Annie’s…their error corrections are “buried” at the very end of note 2 (2014 10K p. 54) and labeled with the responsibility-avoiding caption of “revision.”  This behavior speaks volumes.

Adequacy of Allowances and Reserve

We know that the Company has booked some allowances by looking at the tax note for deferred tax assets (2014 10K, p. 69).  The Company reports total reserves and allowances related to temporary differences of approximately $1.2 million (tax effected), suggesting recorded GAAP allowances of approximately $3.5 million if adjusted using the federal statutory tax rate.  Annie’s reports no allowance for uncollectable accounts (2014 10K, p. 52), and discloses no inventory obsolescence reserves despite recent inventory write-offs (2014 10K, pp. 35 and 36). So, to which assets do the “reserves” listed in the tax note relate?  Once again, transparency and disclosure adequacy is an issue.

Sustainability of Reported Operating Cash Flows

The Company’s limited discussion of cash flows from operating activities (2014 10K, p. 39), makes no mention of the fact that the current year increase in OCF over the prior year resulted primarily from account receivable declines (i.e., an $8.012 million swing from $7.580 million of increases receivables to a $432 thousand decrease).  Does this make sense for a growing company?  And let’s not ignore the fact that 2013 OCF were driven significantly by increasing liabilities.  This weak disclosure’s lack of transparency makes one wonder what the Company’s real OCF look like.  So, let’s take a peek.

I “normalized” Annie’s reported OCF by adjusting for unusual or exceptional changes reported in the Company’s statement of cash flows (operating section only) during the past three years.  When one restores the operating section of Annie’s statement of cash flows to more “normal” activity levels, we find that OCF range between $8.6 million and $10.8 million over the past three years, are far cry from the soaring GAAP OCF reported in the 2014 filings.

Given Annie’s infatuation with non-GAAP reporting, let’s explore the changes and related differences in a schedule that actually provides some insight!  As shown above, in 2012, the Company’s OCF were abnormally low due to payment of unusually high amounts of accounts payable ($9,499). These “excess” payments were added back to OCF.  In 2013, reported OCF were impacted in opposite directions by stock option tax benefits ($8,113), as well as unusually high liability accruals ($8194). So, both of these were reversed even though the amounts almost offset each other. And in 2014, the Company liquidated its accounts receivable ($432), an interesting strategy for what is presumably a “growth” company. In this latter case, I assumed that the 2013 receivable increase was more appropriate for 2014 rather than the reported decrease.  Not surprisingly, my adjustments reveal a much different picture of the Company’s OCF. The soaring increases reported in OCF are gone, replaced by more modest, stable amounts that reflect a declining trend when compared to asset increases over the past three years.

The Goodwill Mystery

Also very troubling is that Annie’s provides little discussion as to the source of its reported goodwill other than it came from “prior acquisitions”.  Why were excess purchase prices paid and for what acquired assets?  Goodwill represents almost 30 percent of the Company’s balance sheet at FYE 2014 yet we have no idea of what it represents.  And given the Company’s admitted material weaknesses in controls over financial reporting, how can we have any confidence that goodwill impairment tests are even believable?  Given the impact of goodwill on the balance sheet and my declining ratio of normalized OCF as a percent of assets, one can’t help but wonder if an impairment charge is looming.

And that’s not all on the goodwill front.  How can goodwill be allocated to the purchase of a plant facility (2014 10K, p. 70)?  The Company provides no indication in note 18 of its financial statements that the Joplin snack manufacturing plant purchase was a business acquisition. 

Hopefully, by now you have a better idea why PwC abandoned this not-so-cute BNNY…a myriad of accounting issues, internal control problems, performance pressures, and non-transparent financial statements.  And let’s not forget that the NEW CFO blessed these financial reports (2014 10K, p. 78).  Toss in the threat of a little litigation and Bernie looks a lot less harmless. Good call PwC!


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.



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AuthorAnthony Catanach

With all of the bad weather here in the East, this aging number cruncher has had his hands full with scraping and shoveling. But I just had to take a break and comment on Twitter’s recent Form 8-K (February 5, 2014), particularly given the Company CEO’s comments last Fall on the importance of transparency to being a good leader.

According to Kurt Wagner of Mashable, CEO Dick Costolo said the following about transparency at a TechCrunch Disrupt event last September:

The way you build trust with your people is by being forthright and clear with them from day one. You may think people are fooled when you tell them what they want to hear. They are not fooled. As a leader, people are always looking at you. Don't lose their trust by failing to provide transparency in your decisions and critiques.

Well, when you go “on the record” about one of my favorite themes, I just had to give Twitter’s 8-K a look. And what did I find? Apparently, Twitter’s CFO does not share the same transparency philosophy as his boss.

But before I begin, I thought it useful to report on the accuracy of some predictions that I made about Twitter’s financial performance before the Company’s IPO. In “What Will Twitter’s Financials Really Tell Us?”, I took a shot at forecasting the Company’s post-IPO balance sheet using a comp group consisting of Facebook, Sina Corp, Yelp Inc., and Meetme Inc. And while the average revenue to assets percentage for this comp group (46.84%) yielded total assets of only $1.3 billion instead of $3.4 billion, the forecasted balance sheet category percentages were quite close as illustrated in the following table:

 

 

My comp analysis forecasted the high levels of cash and short-term investments and stockholders’ equity reported by Twitter, and was almost spot on in predicting other current assets, net PPE, and other intangibles. However, my predictions for goodwill were a bit off the mark.

As for the income statement, I expected operating losses (no surprise there), but nothing close to the $645 million reported by Twitter for the 12 months ended December 31, 2013. And of course, I predicted the Company’s use of non-GAAP metrics to transform poor performance into “a great year” as noted by CEO Costolo (Exhibit 99.1, page 1). Sure enough, Twitter converted its over half a billion dollar net loss into an Adjusted EBITDA of $75.4 million by deducting over $600 million in stock-based compensation from EBITDA.

When it came to operating cash flows (OCF), I expected either negative or transitory numbers, and the Company delivered exactly that: an anemic $1.4 million in OCF driven largely by the non-payment of accounts payable and increases in accrued and other liabilities. So, basic market multiple analysis did a decent job painting us a picture of Twitter’s post-IPO primary financial statements.

Then, there was my rant about the Company’s cost structure in “Twitter’s S-1: More Social Media Company IPO Drama.  As you may recall, I used the High-Low Method of Cost Estimation to calculate a breakeven sales point of $639.5 million for Twitter.  Well, guess what?  Had the Company not expensed $600 million for stock-based compensation (an increase of $575 million over the prior year), this prediction would have come close to being reality.  Actual revenues which approximated $665 million yielded an adjusted net loss of $45.3 million (actual net loss of $645.3 million less stock-based compensation of $600 million).  So again, fundamental cost estimation tools can provide insights even for social media companies.

But back to the transparency of Twitter’s recent 8-K. What really stirs me up this time is the Company’s blatantly positive spin to the exclusion (or minimization) of anything negative.  For example, quarterly and annual revenue increases are reported, but little or nothing on costs.  And when losses are reported, they are accompanied naturally by non-GAAP numbers that paint a much rosier performance picture.  What about some real operating data?  After all, Twitter devoted a whole page to non-GAAP metrics (Exhibit 99.1, page 8)! Could it be that real operating data highlights some "chinks in the armor?" The following table raises some questions about the Company, its business model, and its management:

Operating Data Chart.jpg

Of particular concern is the slowdown in growth in the Company’s revenues over the prior year (almost 200% growth in 2012 and only 110% for 2013). Also of interest are the declines in several key percentages: operating assets to total assets and revenues to operating assets.  And if we buy into the validity of adjusted EBITDA, note that the ratio of adjusted EBITDA to operating assets increased only about 1.5% during the past year, despite a 178.4% increase in operating assets during the same period.  What are those operating assets contributing?  Well, it’s definitely not OCF, as OCF to revenues totaled only .21% for 2013.  I am not sure that I buy into the “great year” description of CEO Costolo.

And why doesn’t the Company tell us about its cost problems? I’d gladly swap the non-GAAP metrics page for some insights into why costs increased over 230% from the prior year. Yes, earnings were adversely affected by over $600 million in stock-based compensation, but that raises another question? Given this type of performance, were these “rewards” really earned and warranted? And this wasn’t just a one-time pop…the 8-K indicates that next year’s stock-based compensation will be just as large (Exhibit 99.1, page 3).

If we adjust the Company’s operating expenses for stock-based compensation and amortization of intangibles, some interesting insights about Twitter’s business model (or lack thereof) surface.

Operating Expense Adjusted Data.jpg

Without stock-based compensation and intangible amortization, total costs and expenses still increased at a whopping 95.6% rate.  Although this represents a slight decline from the prior year (12.2%), the decline is much less than the revenue decrease for the same period (88.3%).  And as the above table shows, this year’s increase was driven primarily by continued triple digit R&D spending, and sales and marketing, suggesting that the Company’s business model is still ill defined and in flux.

And as I pointed out in “Twitter’s S-1: More Social Media Company IPO Drama,” goodwill and intangible asset valuations are more questionable than ever given the Company’s operating losses and anemic OCF.  Then, there’s the issue of potentially unrecorded liabilities for contingent consideration associated with the Company’s recent acquisitions.

So will Twitter address these financial reporting and operating concerns in its next quarterly or annual report? Probably not…why should management tackle these tough questions, when the answers just might jeopardize the Company’s share price? On the other hand, didn’t CEO Costolo preach transparency just a couple of months ago? Or is this just another case of “do as I say, not as I do?”

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AuthorAnthony Catanach
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For those of you that may have thought that my grumpiness may have been tempered a bit by the advent of the holiday season…Bah Humbug!  There is just so much accounting and financial reporting nonsense out there this quarter, that I have been simply overwhelmed by stuffing stockings with lumps of coal for my favorite global accounting firm (GAF) partners, and the humbug large bank clients they serve.

Let’s begin with Jonathan Weil’s recent discussion of Morgan Stanley’s “immaterial” $9.2 billion correction of an operating cash flow (OCF) classification error.  The problem?  Morgan Stanley (MS) accountants didn’t formally restate the Company’s financial reports for the error as required, instead opting for the sleazier “stealth restatement” route on the basis of immateriality.  Where were the auditors?  Well, the auditors actually appear to have discovered this error…my heart be still.  But MS has been “audited” by Deloitte (of recent PCAOB fame) since 1997 according to Audit Analytics.  Why should I be surprised that a GAF auditor actually found something, then looked the other way?  

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AuthorAnthony Catanach

I love Twitter!  Why you ask?  It allows me to easily discover and distribute content…that’s why!  But as Twitter continues its march to a November 15th offering date, there’s a storm brewing that just might end this love affair.  The Company’s recent filing raises a whole new series of questions about its strategy, business model, AND accounting that probably won’t get answered before its initial public offering (IPO).  There just isn’t enough time left for capital market regulators to force answers (thanks to the JOBS Act), nor is management likely motivated toward transparency given the nature of the issues. 

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AuthorAnthony Catanach

Recently, the popular press has been filled with a number of articles that question whether social media sites like Facebook and Twitter are appropriate channels for releasing material operating information.  Many of these have appeared in the wake of the Security and Exchange Commission’s release of an investigative report on Netflix.  But how can we forget the numerous cases almost two decades ago of companies disclosing significant non-public information to analysts and/or “selected” investors before making full disclosure of the same information to the general investing public?  How could we have become so desensitized to insider trading threats?  

Well, this Grumpy Old Accountant is still bitter about past management reporting abuses, and sees today’s social media as creating new risks for financial reporting transparency.  Most of today’s social media pundits have failed to address the advantages and disadvantages of using specific social media tools for distributing financial and operating data to the markets.  Is one tool better than another for insuring transparency?  Could social media be the latest mutation of the “selective disclosure”  virus?

To address such concerns, I penned the following article for Corporate Finance Insider, a publication of the American Institute of CPA’s.

Is social media worth the risk for reporting earnings?

Three guiding principles for companies to consider as they weigh using a blog, Facebook status update or tweet to send out material information.

June 6, 2013

It is now the norm for public companies to distribute financial, regulatory, and stock-pricing data to the markets via investor relations sections on their corporate websites. In fact, many analysts and investors actually prefer such websites to the SEC’s EDGAR tool because investor relations sites often present downloadable data in a variety of formats, from PDFs, to Excel to HTML. So common is this medium that many consider it a “red flag” when a public company does not provide such information access.

The recent Netflix experience sparked debate on a different form of digital delivery of material information—the role of social media. Netflix CEO Reed Hastings last July posted, on his personal Facebook page, company operating data that had not previously been reported in a press release, Form 8-K, or on the company’s website. The SEC initiated an investigation and recently issued a final report (Release No. 69279), in which it decided not to pursue an enforcement action. Yet, the securities regulator did emphasize that social media communications require “careful Regulation FD analysis,” and that investors should be alerted to how companies plan to use social media channels to distribute information.

The Regulation FD issue has its roots in the SEC’s attempts to curb insider information at the turn of the 21st century. So, the real question today is not whether social media is “good or bad,” but whether these channels might actually contribute to “selective disclosure” that might promote trading abuses. This article suggests three guiding principles for companies considering social media for releasing material information: simplicity, caution, and control.

Where are we today?

While Twitter, and even Facebook status updates, may convey more timely data, it is at a potentially high cost. Message length limitations combined with the speed with which tweets and updates are generated may detract from decision usefulness, relevance, and representation faithfulness. 

Additionally, a recent study questions whether corporate managers are really ready to use social media to distribute operating data. A report issued by Stanford University’s Rock Center for Corporate Governance in conjunction with the Conference Board found that most companies appear to be relatively unsophisticated when it comes to formally gathering data from social media and incorporating them into corporate strategy, operational plans, and risk management. Why then would anyone expect them to be sophisticated in terms of how they use social media to disseminate data? The study also acknowledged the potential for misinformation in the market when information shared among social media users is not verified.

Despite its global following of more than 1 billion users, Facebook has not been used much to distribute corporate performance updates despite a high character limit (more than 63,000) for “status updates.” However, a number of companies have taken to blogging to distribute information. Dell, for example, uses its DellShares blog site to provide “new insights and perspectives into Dell and the world of investor relations.” As shown below, Dell also uses this blog to report quarterly earnings information and related commentary.

Corporate blogs generally appear to be valid means of distributing operating data as long as the disclosures are complete representations of what a company has reported through press releases and Forms 8-K. In short, blogs appear to be useful “supplements” and possibly even “substitutes” to a company’s traditional financial reporting channels, as long as they meet the SEC’s most recent social media guidance issued in August 2008 (Release No. 34-58288).

However, a handful of companies recently have begun using Twitter as an information distribution channel for operating data. For the month ended April 2013, Dell, eBay, and PepsiCo reported a significant number of followers and posting volume:

  • Dell has two Twitter accounts: @Dell for official news and tweets and @DellShares for information and insight for the investor community. @Dell had more than 68,000 followers and more than 2,600 tweets, while @DellShares had far fewer followers (almost 5,500) and tweets (fewer than 800). 
  • eBay’s official Twitter news feed, @ebayinc, had more than 14,000 followers and 10,000 tweets.
  • PepsiCo’s official home on Twitter, @PepsiCo, had almost 83,000 followers and more than 17,000 tweets.

But as last year’s Netflix case suggests, the emerging use of social media channels such as Twitter and Facebook are not without their own unique set of challenges. A strength of these communication channels is undoubtedly the speed with which data can be transmitted to “followers.” However, the SEC’s concern is whether the number of Twitter “followers” is sufficiently large as to ensure “non-exclusionary” distribution of information. In the cases of Dell, eBay, and PepsiCo, it is unlikely today that Twitter could replace the companies’ traditional information distribution channels.

The quality of information posted on Twitter also raises questions, given its maximum message length of 140 characters, which necessitates the use of numerous postings to communicate a message. Look at the numerous tweets posted by Dell in a recent earnings release:

 

These tweets prompt one to wonder if the intended message was communicated completely and accurately. Also, remember that Dell has two Twitter accounts. Did investors know which one to follow for the earnings release? One is left wondering why it was so important to “rush” this limited information disclosure to the market. The author prefers eBay’s approach, which used Twitter to warn investors of an upcoming earnings release and provided a link: 

Later, when the company did report selected information, it also warned followers that its tweets were not complete:

The above tweets suggest that eBay explicitly considered not only Regulation FD, but also Regulation G, which deals with the reporting of non-GAAP financial metrics. This suggests regulatory compliance might actually be complicated by the use of social media. 

Simplicity

The old adage says, “If it ain’t broke, don’t fix it.” If the corporate investor relations page is getting the job done, there’s probably no reason to change it. For unsophisticated and/or resource-constrained companies, it is probably best to stick with the investor relations page as the primary information distribution tool. The more adventurous corporate social media users might consider blogging, but only after linking content to corporate investor pages. If a company needs to quickly alert the market to a fresh piece of operating data, it might consider using an occasional tweet or status update that directs followers to a link to the appropriate corporate webpage. 

Caution

When it comes to today’s developing social media, two sayings seem particularly appropriate: “speed kills” and “haste makes waste.” SEC disclosure guidance in this area is developing, and corporate tweets and Facebook status updates are likely to attract regulatory scrutiny. Corporate executives need to do a cost/benefit analysis and ask themselves whether a brief corporate announcement is worth the potential legal and regulatory headaches that it might create. Again, if Twitter, Facebook, or the like must be used to alert markets, simply announce that new data is available at the corporate website, and include a link to it. 

Control 

Companies need to control their social media technologies. At a minimum, they need formal governance and control procedures to ensure accuracy, completeness, and regulatory compliance. This does not need to be that complex. A simple start would be to have any corporate-related social media “burst” reviewed and approved by an appropriate authority who could ensure compliance with applicable company and regulatory guidelines. This might slow down the marketing department a bit, but, as noted above, “speed kills.” 

The potential regulatory compliance and information accuracy risks associated with social media information distribution are simply too great and clearly outweigh any benefits that a quick tweet or status update might provide. Focus on simplicity, caution, and control when using social media for distributing company operating information.


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


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AuthorAnthony Catanach

With recent market rallies in U.S. stocks taking many indexes to all time highs, the popular press has witnessed an increasing number of articles questioning whether this “bull run” just might be nearing its end.  One such article by Tomi Kilgore titled “Analysts Chart Stocks’ Voyage to the Unknown” reviews the use of technical analysis in predicting future stock prices and trends.  Another piece by Larry Swedro titled “Is a Stock Market Bubble Brewing?” discusses the Shiller P/E 10 ratio which is based on inflation-adjusted earnings.  What really got my attention in this article was that the reported Shiller P/E 10 ratio is now more than 40 percent higher than its historical average.  And according to the Wall Street Journal’s Market Data Center, regular unadjusted Price/Earnings (P/E) ratios for most indexes are soaring as well. 

And while I am thrilled with the market’s gains, as you might expect, this Grumpy Old Accountant couldn’t “let a sleeping dog lie.”  I just had to share with you a concern about today’s market multiples, and the data upon which they are based.  So what’s my beef this time?  I believe that these commonly-used valuation metrics may actually be misstated, because of the poor quality accounting information on which they are founded.  For example, I actually think that the P/E ratios for many companies may be higher than what is being reported today. This means that P/E ratios being cited in the press may be providing a false sense of security to investors on the future price appreciation potential of the markets.  

What’s causing the potential measurement error in these metrics?  The increasingly judgmental and subjective amounts being reported in today’s financial statements coupled with poor audit quality.  If you think I am overreacting, just look at the continuing number of accounting errors (i.e., restatements) being reported in U.S. securities filings.  According to an Audit Analytics research report titled “2012 Financial Restatements A Twelve Year Comparison,” there were 768 restatements in 2012 alone. And if that’s not bad enough, what about the repeated unfavorable critiques levied by the Public Company Accounting Oversight Board (PCAOB) against our large accounting firms for poor audit quality.  Yes, it’s happened once again…this time Ernst & Young thumbed its nose at the PCAOB who responded by releasing the nonpublic portions of its July 2, 2010 report.

But before I discuss how accounting may be distorting market multiples, let’s review why these metrics are so important.  Although many consider discounted cash flow modeling and analysis (DCF) the most theoretically sound approach to valuing equity securities and assets, market multiples analysis is widely used in practice.  What makes these multiples so attractive?  Three things: their usefulness, their simplicity, and their relevance. Valuation is about judgment, and multiples provide a framework for making value judgments (i.e., usefulness).  Their ease of calculation makes them an appealing and user-friendly method of assessing value vis-à-vis DCF (i.e., simplicity).  Finally, they focus on commonly used, key statistics that are considered to have the most impact in the markets (i.e., relevance).  Unfortunately, however, multiples are only as good as their input (just like DCF), and the quality of their inputs is getting “more questionable” each day.  

Market multiples analysis is founded on the idea that similar assets should sell at similar prices. So, if you can find a company that has a similar risk and growth profile as the one being valued, then you should be able use it as a “comparable” or “comp.” To date, many have held that the most difficult part of using multiples is in selecting comparable companies given firm-specific differences caused by such factors as industry, technology, customers, size, capital structure, and growth. But several structural developments have dramatically transformed the quality, comparability, and reliability of the inputs to market multiples, and threaten their usefulness in valuation.

First, global financial accounting standard-setters have moved from rules to principles-based accounting standards which has introduced significant judgment into “rule” application. A problem with our increasingly principles-based standards is that their lack of specific guidance can often produce unreliable and inconsistent information that makes it difficult to compare one organization with another.  Are you beginning to see why my concern about market multiples is growing? You may remember that I first raised my concern about all the judgments standard-setters have forced on accountants in “Is FASB Killing the Auditing Profession?” 

Complicating the matter is the fact that every major accounting firm now has its own interpretation of our new principles-based “standards.”  As Francine McKenna detailed in “ Social Media’s Phony Accounting,” Ernst &Young now creates its own revenue guidelines in certain industries.  I thought this was the responsibility of the standard-setters…Securities and Exchange Commission (SEC) are you okay with this? 

More troubling is that we cannot rely on the independent auditor to ensure the numbers are correct. The Grumpies have weighed in on this issue numerous times (see “Arrogance or Ignorance: Why the Big Four Don’t Do Better Audits” for a summary of prior rants).  Independent audits for public companies are so bad, that the auditors have auditors now (i.e., the PCAOB). So, how are we going to satisfy ourselves that even the most subjective, judgmental numbers in today’s financial statements are reliable?

So what does all this mean for market multiples like P/E ratios?  First off, two companies that may appear to be keeping their books the same way, may not really be.  They may actually differ in a number of ways including revenue recognition (e.g., multiple deliverables, gross vs. net, etc.), expense and loss accruals (e.g., contingencies, impairments, etc.), and fair value estimates (e.g., Level 2 and Level 3 assets). Even if you manage to find what you believe to be  “comparables,” the changing landscape of accounting will complicate your life when it comes to computing your multiples. After all, much of the data in the multiples comes from the financial statements. So ask yourself…are the two companies really comparable?

Just look at the some common market multiples and their links to financial statement numbers.  Any overstatement of revenue, understatement of expense, or overstatement of operating cash flows will clearly affect these well-known market metrics.

  • Price/Earnings Ratio – The denominator is earnings per share (EPS), which is a function of the income statement.
  • Price to Book Ratio – The denominator is book value (BV) which is a function of the balance sheet (i.e., assets less liabilities) .
  • Price to Free Cash Flow – The denominator is free cash flow (FCF), which is a function of the statement of cash flows (operating cash flows less capital expenditures).
  • Enterprise Value to EBITDA – The numerator is a function of the balance sheet  and the denominator comes from the income statement.

Are Today’s P/E Ratios Understated?

Let’s begin by looking at some possible income statement and EPS issues that might impact the P/E ratio.  My concerns here fall into three categories: revenue recognition methods, unusual revenue transactions, and expense reporting.  The Grumpies have opined on all three of these individually in the past.  Who can forget our work on multiple deliverables and gross vs. net reporting in “The ‘Beauty’ of Internet Company Accounting” where we lambasted the unsupported assertions and assumptions that drive such revenue recognition methods.  And who uses such methods?  Linked In, Demand Media, Facebook, Groupon, Amazon, Google, etc….that’s who.

Then there are unusual revenue transactions.  Remember when we discussed how recent business combination accounting opened the door to creating revenue on acquisition transactions (see “Need Profit? Buy Something!”)  While we focused our attention on Miller Energy, Under Armour, and Cenveo, we noted that the banking industry had become particularly adept at structuring such deals.  And let’s not forget Groupon’s interesting gain on an E-commerce transaction (see “Groupon: Still Accounting Challenged”).

As for expenses, one major concern is the underreporting of impairment charges (i.e., asset overstatement) for goodwill and other intangible assets.  You might recall the Grumpies piece titled “Deloitte’s Intangible Asset Clients Revisited,” in which we suggested that:

In today’s world of fair value reporting, maybe we should require companies to prove that an intangible has value (above and beyond what managers tell us)!  No consulting reports based on “pie in the sky” estimates and discounted cash flow analysis allowed.  Show us the actual, asset specific cash flows coming from these so called assets.  Prove that they are generating above average returns.  Show us the money!  If you can’t, then don’t book it!

Then, there are the rosy valuation estimates made by management for their deferred tax assets.  Increasingly, companies are recording tax benefits (negative tax expenses) for the reversal of valuation allowances set up to cover tax assets previously considered impaired.  The effect?  You guessed it…more bottom line.  To show you just how common this is, we need only look to Ford Motor Company who increased its bottom line by 57 percent in fiscal year 2011 via a $11.5 billion reversal of its deferred tax asset valuation allowance (see 2011 10-K, Schedule II, FSS-1).

So, how do all of these revenue and expense examples affect the P/E ratio?  Well, in each case earnings per share (EPS) was positively impacted, thus deflating the P/E ratio.  Yes, I am suggesting that the “real” P/E ratios may actually be higher than reported, since revenues are routinely being overstated, and expenses understated.  Two questions immediately come to mind.  By how much are current P/E ratios understated, and what does this mean for our proximity to a market “top.”  

What Are Today’s “Real” Price to Book Ratios?

A myriad of today’s accounting judgments also can potentially affect how “book value” is computed.  Here are a few more examples of how book value computations can be damaged:

  • Inflated fair value “guesstimates” for Level II and III financial assets will overstate book value.
  • Unjustified cost capitalization for questionable assets like capitalized interest, software development costs, etc. overstate book value.
  • Reporting of hybrid securities as equity potentially overstates book value, as does the excessive use of off-balance sheet financing.
  • Current reporting guidelines for variable interest entities and equity method investments also may affect book value, but the effect direction depends on transaction specifics.

As with the P/E ratio, the move from rule to principles-based accounting has significantly increased the assumptions and judgments required for financial reporting.  And the result is similar…today’s price to book ratios may be deflated for those companies engaged in aggressive financial reporting practices.

Are Today’s Price to Free Cash Flow Ratios Understated?

To answer this, you have to first answer another question. Is reported cash flow really what you think it is?  Do you realize that many companies now define cash to include short-term receivables, as well as checks written and mailed but which have yet to clear the bank?  If not, then check out “What’s Up With Cash Balances?”  Managers are becoming increasingly aggressive at what they report as operating cash flows.  When this happens, both operating and free cash flows are overstated, and the price to free cash flow is understated.

What Does the Enterprise Value to EBITDA Ratio Really Tell Us?

Great question!  As you may recall, enterprise value (EV) is defined as the total value of a firm’s equity and debt (market value of common and preferred equity, minority interest and debt) plus unfunded pension liabilities and other debt-deemed provisions, less the market value of equity method investments and cash and cash equivalents.  Given all of the judgment-driven accounting dilemmas raised earlier in this commentary, I am skeptical of EV’s value (pun clearly intended).  And then there’s EBITDA, which also is plagued by the previously mentioned income statement issues.  So, what does EV to EBITDA really tell us given its inherent subjectivity?  I have no clue.

So, where does all of this leave us?  Are the equity markets approaching a market top?  All I can say is that our market multiples may no longer be the useful metrics we thought they were, and that the P/E and Price to Book ratios may very possibly be higher than currently stated.  We are likely closer to a market top than these multiples suggest.  

What is one to do about all of this?  Auditors aren’t auditing and accounting standards are becoming increasingly flexible and “non-standard like.” Does this mean that market multiples should be abandoned in favor of DCF? Of course not, because DCF’s problems are twice as bad…you have DCF’s model assumptions themselves, as well as the problems with the accounting numbers!

But this grumpy old accountant has a few recommendations that might lead you through this valuation nightmare:

  • Never take reported accounting numbers at “face value.” Apply analytical review procedures to determine if the amounts reported in the financial statements make sense.
  • Use simple “fraud” detection models to identify comparables where the numbers may be questionable.  Useful models include the Altman and Beneish models and detective ratios include the conservatism ratio, quality of earnings ratio, quality of revenues ratio, and the Sloan accrual measure.
  • Compare the numbers with the company’s “story.”  Do they make sense given the expectations you developed from listening to management’s “story.”
  • Keep current with accounting rule changes and their impact on the financial statements.

And here are a few accounting-related final thoughts when preparing and evaluating comparables for use in market multiple analysis:

  • Review the consistency of revenue recognition methods among the “comp” companies.
  • Adjust for any unusual income and/or expense sources (i.e., non-recurring or not persistent).
  • Reclassify reported income and expense items accordingly (i.e., impairment and restructuring charges sprinkled throughout the income statement).
  • Review the balance sheet for completeness and potential valuation issues.
  • Look for unusual definitions of cash and cash equivalents.
  • Analyze the “quality” of reported cash flows and evaluate their persistence.
  • Evaluate the company’s capital structure (debt and equity) for completeness and valuation pitfalls.

Global accounting standard-setters have diluted the usefulness of market multiples by introducing so much subjectivity into the reporting process during the past decade, that the value of these metrics themselves is questionable, and their use in comparing companies quite problematic.  The shift from rule to principles-based accounting also has rendered comparison of today’s market multiples with historical metrics meaningless: it is akin to comparing apples and oranges. Or should I say rules and principles?


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


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AuthorAnthony Catanach

As many of you might suspect, this grumpy old accountant is not a big fan of last year’s JOBS Act.  As so eloquently communicated by Andrew Ross Sorkin in “JOBS Act Jeopardizes Safety Net for Investors,” my primary concern is the decreased amount of time that investors now have to analyze critical corporate information.  Three weeks is simply not enough to evaluate the financial viability of a company before it goes public.  As Mr. Sorkin suggests, the Act:

dismantles some of the most basic protections for the most susceptible investors apt to be drawn into get-rich-quick scams and too-good-to-be-true investment ‘opportunities’.

So, when Model N founder and CEO Zack Rinat told Maxwell Murphy at the CFO Journal recently that the Company believes in “complete transparency,” and won’t use the JOBS Act to hide material information from investors, I just had to take a look.  Now I can’t promise the Company that it would have avoided my scrutiny had it gone through the normal IPO filing process, but it sure would have gotten some good comments that would truly have helped the CEO honor his transparency pledge to investors.  My review of Model N’s Amendment  No. 4 to Form S-1 Registration Statement filed on March 15, 2013 (S-1), did not disappoint.

Two things immediately tipped me off that this was going to be an interesting read.  First, there was the unlabeled circular graphic presumably depicting the life cycle of revenue management using the Company’s solutions that preceded the table of contents.  Not until page 86 of the S-1 does the Company actually attempt to explain this illustration.  Then, there was the Company’s motto, “More Revenue, Made Simple.”  I found this marketing hype particularly annoying since it challenges the intelligence of experienced business professionals who recognize there is nothing easy about creating customer value.  So, right out of the gate we have transparency issues.

Next, there is the issue of what the Company actually does.  The reader must wade through page after page of MBA speak (85 pages in fact) to learn what the Company’s strategy and business model is.  Why mystify us with such terms as “revenue management solutions, strategic end-to-end process, application suites, and domain expertise” when the Company is nothing more than another software provider attempting to remedy the age old problems of transaction processing, reporting, and system integration.  Why all the marketing spin, legalese, and accounting verbosity?  All of this detracts from transparency. 

Then, there are the numerous questions raised by the Company’ s historical operations.  We learn early on that an investment in Model N is quite risky (S-1, page 4).  Recent operating losses, dependence on a few key customers (75 percent of revenues come from 15 customers), reliance on a single product, and a single industry focus all make this grumpy old accountant wonder what makes this Company “worthy” of an IPO.  

And then you have the declining margin issue masked in the Summary Consolidated Financial Data (S-1, page 8).  Margins on license and implementation products have decreased from almost 62 percent in 2010 to 54.81 percent at the end of the most recent fiscal year end. Why is this? Wouldn’t it be more transparent to explicitly report this very troubling trend in the introductory summary table?  

Instead, we don’t even see these negative margin trends until page 59 of the S-1.  Sure, Model N provides exhaustive detail of revenue and cost of goods sold changes, but it does so without answering the million dollar question: why the margin erosion?  Excuse me, but this is a pretty significant transparency deficiency.

And of course, as with so many IPO’s today, the Company feels compelled to spin its losses into profits via non-GAAP performance metrics (i.e., adjusted EBITDA).  When we get to the EBITDA reconciliation (S-1, page 10), we learn that the biggest reconciling item is for something called “LeapFrogRx compensation charges,” but the LeapFrogRx transaction has not been detailed up to this point in the S-1.  Again, is this what transparency is all about? And this is significant.  If not for the LeapFrogRx compensation charges and stock-based compensation, there would have been no need for “adjusted EBITDA” at all!  By the way, the LeapFrogRx transaction is not even mentioned until page 49 of the S-1, and we don’t get any of the specifics until much later in the actual financial statements (S-1, F-21 and F-22).  

As an aside, I particularly got a kick out of the Company’s justification for paying an excess purchase premium for LeapFrogRx: synergies in skill-sets, operations, customer base and organizational cultures.  Goodwill impairment can’t be far behind, can it?  And, oh by the way, why is stock-based compensation going up as the Company begins to lose money (S-1, page 9)?  Another transparency issue?

As I navigated the Company’s risk factor section (S-1, page 15), I was stunned to see accounting policies listed as a risk factor!  Essentially, Model N is “warning” potential investors that its reported revenues may be lower than they “really” are because of accounting.  Specifically: 

Our revenue recognition model for our cloud-based solutions and maintenance and support agreements also makes it difficult for us to rapidly increase our revenues through additional sales in any period, as a significant amount of our revenues are recognized over the applicable agreement term.

Does the Company require a specific type of accounting to report profitability? Unbelievable! Such disclosure does little to enhance transparency.

And the Company continues to imply that accounting will somehow “hurt” the business (S-1, page 31) in the following risk disclosures:

Our financial results may be adversely affected by changes in accounting principles generally accepted in the United States...If our estimates or judgments relating to our critical accounting policies are based on assumptions that change or prove to be incorrect, our operating results could fall below expectations of securities analysts and investors, resulting in a decline in our stock price.

Why is the Company warning us so much about the accounting?  Is there a problem?  Should we even be relying on the S-1?  Again, transparency sure seems to be an issue.

And if Model N is so transparent, why did it take advantage of certain exemptions from reporting requirements that public companies make, including not complying with auditor attestation requirements of Section 404 of Sarbanes-Oxley, reduced disclosure of executive compensation, etc. (S-1, page 32).  And then there is the issue of how Model N management intends to use the funds received in the IPO.  Surely, a Company wouldn’t do an IPO if it didn’t have some idea of how the proceeds would be used.  Yet, once again, Model N fails the transparency test by not telling us its plans for the monies raised (S-1, pages 36 and 41).

And then there are the bookkeeping errors (S-1, page F-18).  Is it really transparent to label accounting mistakes as “out-of-period adjustments?”  You make the call.

Finally, it is noteworthy that Model N reported income tax expense in 2012 even though it reported a pre-tax loss for the period.  The reason: a significant increase in its valuation allowance for deferred tax assets suggesting poor future operating performance prospects even with an IPO (S-1, F-32).  Then there is the issue of whether the IPO will trigger Section 382 limitations on the Company’s net operating loss carryovers.  While the Company does identify this as a risk (S-1, page 34), it seems to suggest that this “might” occur when in reality the likelihood is significantly greater than might.  This disclosure clearly plays down the loss of this asset, and again causes one to question the Company’s transparency.

Sujan Jain, Model N’s CFO, in the aforementioned CFO Journal indicated that filing offering plans confidentially with the SEC allowed the Company to avoid distractions of early IPO publicity.  You tell me…are the issues I raised “distractions?”  I think not…and to take a page from the beloved radio announcer Paul Harvey, “and now you know the rest of the story.”
But there’s more.  Earlier this week, Model N issued a press release to report its second quarter fiscal year 2013 results.  And once again, the Company disappointed us with its lack of transparency by introducing new non-GAAP metrics: non-GAAP gross profit, non-GAAP research and development expenses, non-GAAP sales and marketing expenses, and non-GAAP general and administrative expenses. Clearly, Model N is learning the new IPO game. But is this accounting-conflicted, non-GAAP focused, JOBS Act loving Company transparent?

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


Posted
AuthorAnthony Catanach

It’s been over six months since the Grumpies’ last Groupon commentary.  Remember the financial restatements, revenue corrections , SEC criticism of the Company’s non-GAAP performance metrics, the internal control weaknesses over financial reporting, and public critiques of reported operating cash flows? Well, quite honestly, many of us had just tired of the Company’s story, until recently that is.  But two events during the past month, Andrew Mason’s “resignation” and the Company’s 2012 10-K securities filing, made it impossible for me to remain silent any longer.  As the marketing slogan suggests, Groupon is simply “the gift that keeps on giving.”

First, there’s Mr. Mason’s so-called “resignation” letter.  Let’s be clear here…according to Groupon’s Form 8-K filed on February 28th, “Andrew D. Mason was terminated as Chief Executive Officer.”  Unbelievable are those that actually praised Mr. Mason’s letter.  But what really troubles me is that at least one person found his memo to employees “geeky, hilarious, and touching,” and another titled it a “charming goodbye letter.” I think more appropriate descriptors might be immature and irresponsible.  Why am I being so grumpy about this?  Let’s not forget that the Company incurred a $9 billion loss in value (a decline from a $12.7 billion IPO valuation to an estimated $3 billion value on February 28th) during his tenure as CEO.  Phrases like “ I’m OK with having failed at this part of the journey,” or “maybe I’ll figure out how to channel this experience into something productive” are simply not acceptable. And for those that applaud his wisdom about having the “courage to start with the customer,” what about the investors?  How could Mr. Mason have forgotten about them in his letter? Those who invested $9 billion in his business education should be outraged!  His company’s loss in market capitalization makes today’s college tuition look amazingly affordable, if not downright cheap.  Okay, enough of Mr. Mason…let’s turn to Groupon’s most recently filed 10-K.

The first thing the 10-K does is confirm what Matthew Lynley reported in “Groupon Is No Longer a Daily Deals Business.”  It appears that the Company has a new mission.  According to last year’s 10-K:

Groupon is a local commerce marketplace that connects merchants to consumers by offering goods and services at a discount…By bringing the brick and mortar world of local commerce onto the Internet, Groupon is creating a new way for local merchant partners to attract customers and sell goods and services.
— 2011 10-K, page 3

But the recently filed 2012 10-K reveals a major change that has profound implications for Groupon’s business model and processes:

Our mission is to become the operating system for local commerce. Groupon seeks to reinvent the traditional small business world by providing merchants with a suite of products and services, including customizable deal campaigns, credit card payments processing capabilities and point-of-sale solutions to help them attract more customers and run their operations more effectively.
— 2012 10-K, page 3

Apparently, management finally realized that its original “daily deals” strategy just wasn’t creating much value or delivering on the differentiation dimension. So, now Groupon has decided to pursue a more Amazon-like approach.  While a dubious strategic shift, it does makes sense given Jason Child’s (Chief Financial Officer) tenure with Amazon from 1999 to 2010 (2012 10-K, page 11).  Also, don’t forget that Jeffrey Holden, Sr. Vice President of Product Management, also spent time at Amazon between 1997 and 2006 (2012 10-K, page 11).  When a plan is not working, it is not uncommon for some managers to fall back on what they know best.

But before we get to the financials, let’s reflect on what the Company’s redirection means for performance measurement (i.e., the numbers).  A new strategy means new processes, which in turn affect metrics and reported results. This means that traditional financial statement analysis (FSA) cannot be relied upon to provide its usual meaningful results.  FSA’s ratio and trend analyses are founded on the assumption of stable relationships, so when a company is transforming itself, the usefulness of these tools is somewhat limited.  Further complicating FSA is the Company’s decision to reclassify financial statement items from prior years (2012 10-K, page 69).  Does Groupon bother to tell us where the changes are?  Of course not.  Nevertheless, here are a few grumpy observations.

My biggest concern is the Company’s continuing struggle with estimates (and judgment).  Remember how the grumpies complained last August about Groupon’s “unusual” gain on an e-commerce transaction that created second quarter profitability (see Groupon: Still Accounting Challenged)?  This was a gain driven solely by the Company’s own estimates of fair value, the reasonableness of which we questioned at the time.  Well, guess what?  We were right again!  In the fourth quarter (literally at the eleventh hour), the Company revised its value estimate of its F-tuan investment downward by almost 40 percent resulting in a write-down of $50.6 million (2012 10-K, page 84). This turnabout almost completely reverses the pre-tax $56 million gain that Groupon reported in the second quarter of 2012. 

And while I’m on the topic of estimates and valuation, let’s not forget intangibles. Goodwill just keeps on growing from 9.4 percent of assets in 2011 to 10.17 percent in 2012.  With the Company’s new mission and related business models, one can’t help but wonder what the implications are for previously recorded goodwill, particularly since the Company couldn’t get F-tuan’s number right.  And a change in strategic direction clearly must impact intangibles.  In fact, cracks are beginning to appear in the goodwill numbers.  International segment revenue actually declined 15.9 percent in the final quarter of 2012 (2012 10-K, page 38) raising questions about reported international goodwill amounts.  More troubling is that liabilities exceed assets for the EMEA and LATAM reporting units, and that Groupon actually looked at possible impairment for these units this year (2012 10-K, page 53).  Ultimately, the Company decided that no write-down was necessary, but you have been warned again.  In fact, I suspect this year’s 10-K language may be signaling an impairment charge in the very near future.

And then there is the Company’s deferred tax asset (DTA) intangible.  As you may recall, the Grumpies first sounded the alarm on this intangible almost one year ago exactly in “Groupon’s First 10-K: Looking Under the Hood.” Well, guess what?  The Company is still reporting a loss because it FINALLY recorded an allowance for the DTAs which it likely will never (ever) be able to use.  It’s the increase in the DTA allowance (and several other tax factors) that drove the Groupon’s effective tax rate to an astronomical 153.7 percent in 2012 (see 2012 10-K, pages 46, 54, 104, and 114).  This is what we warned you would happen in our previous blog postings, and it has come to pass.  This is just more evidence of the Company’s struggle to make reliable estimates.  If I were the regulators, I would consider the Company’s F-tuan write-down, it’s delay in reserving for its DTAs, and its forthcoming goodwill impairment as evidence of a potential material weakness in controls over financial reporting as it relates to fair value estimation.  Heads up SEC…you too E&Y!

No review of Groupon would be complete without a discussion of non-GAAP performance metrics, and the Company does not disappoint us again.  Yes, Groupon still relies on non-GAAP metrics (2012 10-K, page 47), but there are changes. The Company has shed its infamous CSOI metric in favor of “operating income (loss) excluding stock-based compensation and acquisition-related expense (benefit), net.”  What would the acronym for this mouthful be?  OIESBCAEN?  I think I liked CSOI better…nevertheless, it’s still a curious metric that inflates operating performance.  And there’s more…last year, the gross billings metric was considered by the Company to be an “operating metric” (2011 10-K, page 41), while now it is reported as a financial metric (2012 10-K, page 31).  

What’s the big deal?  Gross billings is a total sales number that does not deduct the merchant’s share of transaction revenue.  Thus, gross billings is not a valid financial performance indicator…for goodness sakes, it doesn’t even appear in the financial statements. Moreover, to report gross billings as a financial performance metric actually decreases financial reporting transparency!  Why?  Well, Groupon reports growth rates in gross billings of 35 percent and 434.7 percent for 2012 and 2011, respectively (2012 10-K, page 35).  Yet gross profit (a “real” financial indicator) decreased from 83.9 percent in 2011 to 69.2 percent in 2012 (2012 10-K, page 41).  Now, you tell me…which sounds better, huge growth rates in gross billings or declines in gross profit?

While I’m on the topic of performance, despite the declines in gross profit percentage, income from operations has turned positive for the first time primarily due to reduced marketing expenses. The dramatic reversals in marketing and selling, general, and administrative (SG&A) expenses may reflect the Company’s changing business model, but given Groupon’s past reporting issues, one wonders if some of this expense volatility is due to the aforementioned decision to reclassify financial statement items.  Just a thought. And did you notice that the percentage of stock based compensation as a percent of operating expenses is increasing (2012 10-K, page 35)?  Why are managers continuing to reward themselves so highly despite continued losses, diminishing growth, and stock price declines?

Could there possibly be anything else you ask?  Well yes, there are a couple of lesser financial reporting issues that continue to irritate this grumpy old accountant.  Operating cash flows (OCF) have declined in 2012 despite accounts receivable liquidations, and the decrease is largely due to diminishing contributions of merchant payable flows to reported OCF.  We warned you about this in “Groupon’s First 10-K: Looking Under the Hood.”  

And why isn’t inventory reported separately as a current asset on the balance sheet?  Given the Company’s new retail strategy, the $40 million inventory amount reported in the notes (2012 10-K, page 89), and the existence of separate accounting policy note (2012 10-K, page 70), inventory has earned its own line item disclosure on the face of the balance sheet.

Then there is the Company’s segment disclosure. Groupon acknowledges having four reporting units: North America, Europe, Middle East and Africa (EMEA), Asia Pacific (APAC), and Latin America (LATAM) (2012 10-K, page 70). Yet, the Company only discloses two business segments, North America and International.  Oh, Groupon is probably GAAP compliant here basing their reporting on the size of the individual reporting units.  But why can’t the Company just report all four units, and why the need to deduct certain expenses in calculating segment operating income (see note (2) in 2012 10-K on page 106)?  Is this the 2012 version of last year’s CSOI?

So, where does all of this leave us? 

  • The Company is operating without a permanent CEO. 
  • The Company has abandoned its old mission in favor of a new one.
  • The Company is transitioning to an untested business model which raises serious balance sheet valuation questions, particularly given management’s recent estimation difficulties.
  • The Company continues to struggle with providing consistent and reliable financial reports, its efforts now further complicated by its current state of flux.
You tell me.  At my advancing age, I just can’t take any more April Fool’s Day surprises!

This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


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AuthorAnthony Catanach
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The last I heard, the purpose of financial reporting was to provide information that investors, creditors, and others can use to make decisions.  Well, when a publicly traded company fails to file its required financial statements, and market regulators let it get away with it, that’s a real problem.  How are investors and creditors supposed to evaluate their investments?  And that’s the $3 billion question being asked of Chimera (CIM) by Aaron Elstein in “A mythical name and profits, too?

Here is a company that has neither filed a quarterly report since November 18, 2011 (for the quarter ended September 30, 2011), nor an annual report since February 28, 2011 (for the year ended December 31, 2010).  Yet, securities regulators permit Chimera to operate, and allow its stock to be listed and traded.  John Maxwell at the Motley Fool has described this situation as “inexcusable,” and that’s an understatement, for all the questions this situation raises.

Okay, why no financial statements? According to its Form 8-K filing with the Securities and Exchange Commission (SEC) on March 1, 2012, the Company needed additional time to “review the application of GAAP guidance to certain of its non-Agency assets.”  But then the story gets interesting when Chimera “fires” Deloitte as its auditor on March 11, 2012, replacing them with Ernst & Young.  What’s particularly curious is that the Company kept Deloitte to audit its 2011 10-K which has yet to filed. Then, in an August 1, 2012 Form 8-K filing, we learned of Chimera’s erroneous accounting for its non-agency residential mortgage-backed securities portfolio.  Basically, the Company accounted for this portfolio as if it were high credit quality, rather than reflecting its actual poor quality, necessitating a correction to reduce net income by almost $700 million during the affected reporting period (fiscal years ended 2008 through 2010).  And just recently, on March 1, 2013, Chimera notified the SEC in a Form NT 10-K filing that its annual financial statements for the fiscal year ended December 31, 2012 are not yet ready either.  However, there is a bit of good news…according to the filing, Chimera has finally completed its review of the accounting policies for its non-agency residential mortgage-backed securities portfolio, and that its 2011 annual report is forthcoming.  Better late than never, right?  Well, that’s just the first of my many questions.

Let’s start with the accounting error, or as today’s politically correct accountants call it, the restatement.  Given all of the expertise that Deloitte’s New York office presumably gained accounting for, auditing, and valuing financial instruments during the financial crisis of 2007 and 2008, it is unbelievable that it didn’t discover the “erroneous” accounting earlier.  My review of Chimera’s 2010 10-K uncovered plenty of clues that the Company’s non-agency residential mortgage-backed securities (RMBS) portfolio was “poor quality.”  Here are just a few:

  • Page F-14 reveals that non-agency RMBS with an estimated fair value of $2.5 billion had over $412 million in unrealized losses.  That’s unrealized losses of over 14 percent of their cost.
  • Page F-15 reports that 48.1 percent of all RMBS’s are rated below B or are not rated at all.
  • Page F-17 indicates that non-agency RMBS are collateralized by Alt-A mortgages of subprime fame, 56.1 percent of which were originated during the 2007 pre-bust mortgage boom, and 57.8 percent financed properties in the overheated California market.
So you tell me…does that sound like a high quality mortgage securities portfolio?  How could such an “error” have occurred?  Surely it wasn’t due to accounting ineptitude, after all, according to Aaron Elstein, Chimera's CEO received $35 million in compensation in 2011. That kind of money should buy some expertise, right?  And according to the Company’s proxy statement (Schedule 14A) Deloitte received a whopping $827,625 in audit and audit related fees for 2010 for its work on what should be a fairly straight-forward engagement.  The balance sheet is nothing more than securities funded by repurchase agreements and collateralized debt.  How could Deloitte not see the accounting problem for three years?  
Given the magnitude of this accounting “bust,” it’s pretty clear that Chimera’s internal controls over financial reporting don’t work, and Deloitte will no doubt confirm that in the near future (and after the fact).  However, given that the Company has only been operating since November 21, 2007, I would have thought that Deloitte would have carefully scrutinized accounting policies and procedures for this young entity, particularly with such rapid growth in the high risk RMBS portfolios.  Chimera’s total assets increased over 400 percent between fiscal year ends 2007 and 2010 (2010 10-K, 50).  And again, this is Deloitte New York…a Big Four firm center stage on Wall Street.  Is it any wonder they were fired?
But that raises yet another question?  You can’t fault Chimera for canning Deloitte, but why rely on the firm that couldn’t find the accounting problem to “fix” it? That’s right…E&Y doesn’t take over as auditor until the 2012 fiscal year engagement.  It just gets “curiouser and curiouser!”  Oh, you might argue that the Company will save money by having Deloitte clean up its (Chimera’s) mess, but let’s be realistic…E&Y is going to bill Chimera heavily anyway when it takes over given the material weaknesses, accounting errors, risky investments, and valuation issues.  E&Y is going to re-audit a lot of what Deloitte does anyway, so why not just have E&Y audit the delinquent years and restatements?
And then there’s the delay in fixing the accounting.  With all of Deloitte New York’s 2007 financial crisis expertise, as well as the Company’s own management experience, why is it taking so long to fix the books and issue an audit report?  Could the tardiness be signaling something else?  Is the situation worse than represented?  Are the books and records in shambles?  Or is it the RMBS portfolios that are causing the problems…after all these are Alt-A loans?  And then there’s always the possibility of an auditor-client conflict despite what is documented in the auditor termination letters.  It would not be surprising if the two parties disagreed over the magnitude of the RMBS valuation adjustments.  Or has the audit been completed, and Deloitte is “sitting” on the report at the client’s request for some reason?  See what kinds of questions surface when a company is not transparent?
And if you think these concerns are too farfetched, what about the creditors?  According to Chimera’s 2010 10-K (F-22 and F-23), the Company’s RMBS portfolios were funded significantly by short-term repurchase agreements (repos) and securitized debt.  How are these creditors functioning without some type of valuation information?  Normally, short-term repo borrowings are re-priced and renewed based on underlying collateral values.  Since the Company has not been forced into bankruptcy by these lenders, it seems reasonable to assume that these creditors have renewed Chimera’s short-term borrowings.  But what collateral valuation data did these creditors use to make their refinancing decisions?  Did they receive some “private” RMBS information that was not made available to investors and regulators?  If so, that might suggest that the delays in correcting the accounting error and issuing financial statements may be unjustified, right?  

And then there are the regulators…why do they “rubber stamp” extension request after extension request by the Company?  According to Chimera’s February 14, 2013 Form 8-K, the New York Stock Exchange has given the Company one final extension until March 15th to file its 2011 10-K.  So some very stale data may be forthcoming shortly.  But can’t the NYSE see the potential problems associated with the issues raised above?  And given the tardiness of the 2011 10-K, why is the NYSE cutting Chimera so much slack with the delinquent 2012 10-K?

See what chaos a lack of transparency in financial reporting can create?  Chimera is definitely living up to its name when it comes to its financial reports…for the past months, the Company’s reports have been nothing more than a “fanciful mental illusion” that create so many questions, and provide too few answers.  In a post 2007 financial crisis environment, one would not have expected that such a situation would be tolerated.


This essay reflects the opinion of the author and not necessarily that of The American College, or Villanova University.


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AuthorAnthony Catanach