I just couldn’t help myself. When the WSJ’s Rolfe Winkler mentioned cash-flow in the first sentence of his article titled Questioning Receivable Wisdom at H-P, I just had to take a look. And I was not disappointed. Yes, there is the “quality of operating cash flow” issue, of course, but there also is a problem with H-P’s income tax note. Yes, it is quite a stretch from cash flow to taxes, but that’s why I’m grumpy.
As for cash flows, Rolfe Winker is right on point to question the “quality” of the cash flows reported by H-P in its most recent 10K (page 81). It appears that the sale of trade receivables is a relatively recent phenomenon having begun in 2011 (see note 4 on 10K page 101). The billion dollar question is whether such receivable sales reflect “business as usual” going into the future (will they persist), or are they are temporary liquidity enhancing measures. One clue is provided by the statement of cash flows itself, where we see a cash inflow from accounts and financing receivables of $1.269 billion. This represents an actual liquidation (or shrinkage) of receivables which generally is not a positive thing in healthy, growing companies.
It is also interesting to note that H-P’s discussion of liquidity and cash flows for 2012 (pages 66 and 67 of the 10K) do not discuss receivable sales at all, instead explaining cash generation as coming from simply “collections of accounts and financing receivables.” Don’t collections imply cash receipts from customers? Should proceeds from receivable sales really be labeled “collections” in the traditional sense?
And while I’m being picky, let me tell you why I don’t consider these receivable sales to be “persistent,” and why I would exclude them from operating cash flows altogether. H-P describes the receivable sales as being part of a third-party financing arrangement which “qualifies as true sales” (note 4 on page 101). Call me old fashioned, but any time something has to “qualify” as a sale, I become suspicious! Despite all of the FASB’s rules and criteria in ASC 860-10, what you really have is an H-P borrowing, collateralized by receivables (remember substance over form)…and after all, if the collateral is insufficient, H-P recognizes a current liability. So, from an analyst, creditor, or investor perspective, I think the proceeds would have been more appropriately reflected as cash proceeds from financing activities.
Oh, and the fact that the amount of receivables “sold” “approximates the amount of cash received,” provides another clue that this is indeed really a short-term borrowing arrangement. A traditional sale or factoring arrangement would generally include some type of discount or “haircut.”
So, what do I think H-P’s operating cash flows really are? Take a look at the following schedule. Simply reduce reported operating cash flows by the proceeds received from the securitized borrowings (“sales”) each year.
As you can see, my adjusted operating cash flow number is significantly lower than that reported. I also have included a comparative ratio analysis (OCF to current liabilities) to illustrate the impact of the potential overstatement on at least one liquidity ratio, not to mention H-P’s cash conversion cycle.
But enough on cash flows! What really troubles me is what I found buried in H-P’s tax note (note 14, page 132). The Company’s statutory to effective tax rate (ETR) reconciliation, while mathematically correct, is totally misleading. Why you ask? Take a look at the reconciliation reported by H-P below:
The reconciling amounts reported for 2010 and 2011 are not a problem, but do provide a hint that something is amiss in 2012. First of all, H-P reported earnings from operations in 2010 and 2011, but losses in 2012. So how can the Company start its reconciliation with a positive percentage in 2012? The answer is that it can’t! Second, H-P incurred and reported provisions for taxes (income tax expense) in all three years. So, why is the ETR negative for 2012? Shouldn’t it be positive? Absolutely! And you no doubt noticed that an increase in the deferred tax asset valuation allowance for 2012 decreased the ETR, as did non-deductible goodwill…both of these should increase the ETR.
So what’s the impact? Basicly, all of the signs on the 2012 reconciliation column must be reversed for comparability purposes. They just make no sense when compared to 2010 and 2011! H-P’s 2012 reconciliation should have looked like that provided by Kenexa for 2009 and 2010 (note 14, 2011 10K). The statutory federal tax rate should have been reported as negative and the income tax expense as positive!
It is just unbelievable that with all of H-P’s accounting expertise, as well as that of its auditor E&Y, this sloppy reporting error was not picked up. Back when this grumpy old accountant was a Big Eight auditor, allowing such an erroneous disclosure to go undetected would have ended one’s career. My how times have changed…
What’s next? Well, the SEC needs to add this tax note to its list of restatement issues (accounting errors) for H-P (remember the Autonomy write-offs?). And of course, there remains E&Y’s obligation to question the adequacy of the Company’s internal controls over financial reporting.
This essay reflects the opinion solely of the author.