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?  

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. 

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. 


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. 


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. 


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.

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.

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.

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.

AuthorAnthony Catanach
2 CommentsPost a comment

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.

AuthorAnthony Catanach

According to Merriam Webster, a black box is broadly defined as “anything that has mysterious or unknown internal functions or mechanisms.”  How appropriate that Jonathan Weil called our attention to an “unconventional profitability metric” used by Black Box (the Company) to report third quarter performance in its January 29th press release (Form 8-K, Exhibit 99.1).   As usual, Jon got right to the point, and suggested that using the term “adjusted Ebitda (as adjusted)” was just another ploy to make “earnings look better.”  While I generally agree with Jon’s conclusion, I am particularly stunned by the lack of creativity exhibited by the Company’s accountants in naming their performance metrics.  After all, even a bean counter should be able to come up with something better.  As a grumpy old accountant, I'd recommend using Lynn Turner’s “everything but bad stuff” EBS title (coined over a decade ago)…now that might have been more appropriate!  But why did Black Box’s accountants just give up?  Well, after a bit of digging, I think I know why.  I also discovered that this was just one of five non-GAAP measures used by the Company in its press release, but not in its current 10-Q or 10-K.  And finally, Black Box omitted a very important income statement disclosure in its press release that was included in its 10-Q and prior year 10-K.  All of this raises questions about the transparency of the Company’s most recent financial disclosures, and what is prompting the recent move to non-GAAP metrics.

But first, even though I have little or no respect for most performance based non-GAAP metrics, I must confess that Black Box’s “unconventional profitability metric” appears to comply with the policies of the U.S. Securities and Exchange Commission (SEC). The SEC outlines its rules for such measures in its Final Rule on Non-GAAP Financial Measures, as well as its Compliance and Disclosure Interpretations on Non-GAAP Financial Measures.  In fact, the Company’s cumbersome EBITDA moniker is likely due to SEC guidance to use the word “adjusted” when reconciling net income to a non-standard definition of EBITDA.  However, Black Box adopted two separate non-GAAP EBITDA metrics: EBITDA as adjusted and the hilarious “adjusted EBITDA (as adjusted)” term, the two of which differed only by stock compensation expense.  The table below shows how these two non-GAAP measures relate to each other, as well as to the more traditional notion of EBITDA.  The first column reflects income statement data for the Company’s nine months of operations for the current fiscal year (3QYTD13) as reported in the January 29th press release (8-K, Exhibit 99.1, page 10), while the other three columns reflect related P&L data from prior Company 10-K’s.

As Jon Weil noted, Adjusted EBITDA (as adjusted) provides an improved perception of operating performance (over traditional EBITDA and net income) for the four periods presented.  But why is this performance metric needed?  Black Box argues that varying stock compensation expense levels could lead to misleading period comparisons (8-K, Exhibit 99.1, page 10).  However, I suspect the Company might be feeling a bit sheepish about its high stock compensation expenses given its recent performance declines.  In fact, the ratio of stock compensation expense to traditional EBITDA has steadily increased from 7.87 percent in 2010, to 9.43 percent in 2011, to 11.8 percent for the nine months ending December 29, 2012 (traditional EBITDA was a loss for FYE 2012).  So, this “excessive” stock compensation does not look quite so bad if you use the non-GAAP performance measures upon which the share awards actually were based (current 10-Q, page 15)…just a thought.

But now this is where it gets really interesting.  In addition to these two “new” non-GAAP financial performance measures, Black Box also reported in its recent press release THREE other creative metrics: operating EBIT, operating net income, and free cash flow (adjusted, but not labeled as such).  Now we know why the accountants allowed the use of the “adjusted EBITDA (as adjusted)” term…they simply couldn’t think of any more possible names given all of the non-GAAP measures used by the Company!

As with the non-GAAP EBITDA metrics, the below schedule again shows how Black Box’s net income “fails” to capture the Company’s “true” performance.  In this case, the non-GAAP metrics titled operating EBIT (as adjusted) and operating net income (as adjusted) both exceeded GAAP net income by significant margins for the nine months ending December 29, 2012 (3QYTD13).  

Operating net income (as adjusted) could not be computed for fiscal years 2010 through 2012 as the Company’s operational effective tax rate (yet another non-GAAP metric) was not provided in prior filings.

Black Box also adopted a non-GAAP free cash flow measure that “adjusted” for foreign currency exchange impacts and proceeds received from the exercise of stock options (8-K, Exhibit 99.1, page 8).  The below table shows that the Company’s new cash flow metric once again “improves” performance over traditional definitions of free cash flow.

Next, it is quite interesting to note that Black Box does not report ANY of the above listed five non-GAAP metrics in its current 10-Q (quarter ended December 29, 2012), nor were any of them discussed in the prior year 10-K.  This is particularly troubling given that the Company asserts that:

The Company has historically reported these non-GAAP financial measures as means of providing consistent and comparable information with past reports of financial results.
— Press Release, Exhibit 99.1, page 7

Why would the Company feel the need to use these measures to explain performance in its recent press release, but not in the required securities filings for the same period?  Very interesting indeed…I wonder what the SEC thinks about this inconsistency in financial reporting?  Could Black Box’s sudden interest in non-GAAP reporting be signaling a sustained decline in the Company’s future operating performance?  After all, only companies with poor earnings or cash flow prospects generally rely on such metrics, right? 

Moreover, could Black Box’s future dividends and share repurchases be at risk?  Perhaps so, given that the Company reported actually reported an increase in cash overdrafts for the first time in its current 10-Q statement of cash flows (page 6).  And while I’m discussing cash flows, it’s worthwhile to mention that the Company’s operating cash flows for the nine months ended December 29, 2012 as reported in its recent 10-Q were positively affected by asset liquidations for receivables, inventories, and other assets, all of which are not sustainable long-term.

Finally, the Company neglected to include in its income statement press release an asterisk next to cost of sales (Exhibit 99.1, page 5) to clarify that “cost of sales excludes depreciation and intangibles amortization.”  Why is this omission such a big deal?  Well, the third quarter 10Q (page 4) DOES include this disclosure next to cost of sales, and generally mirrors the press release except for the omitted asterisk.  The omitted disclosure also appeared in the prior year 2012 10K on page 29.  The result is reduced transparency and comparability of the Company’s press release income statement with those of other companies.  Sounds like an accounting and reporting “error” to me, prompting the need for a restatement of the press release exhibit.

In summary, the Company’s “adjusted Ebitda (as adjusted)” metric appears to be the tip of a financial reporting iceberg.  Instead of improving financial reporting transparency, Black Box may really be a Pandora’s Box of non-GAAP metrics that obfuscate “true” performance.

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

AuthorAnthony Catanach
2 CommentsPost a comment

Sunshine is the best disinfectant.

                                      - Justice Louis Brandeis

And it’s on that note that Pershing Square Capital Management ended its presentation on why Herbalife is a pyramid scheme titled “Who Wants to Be a Millionaire?”  Given this forum’s devotion to financial reporting transparency and ethical reporting, how could you expect me NOT to weigh in on Herbalife’s disclosures, particularly given the recent televised fight between Bill Ackman and Carl Icahn.  So, exactly what do the Company’s financial statements tell us?  

Incentives and Reporting

My review of Herbalife’s most recently audited 10-K (fiscal year ended December 31, 2011) yielded some interesting points both positive and negative in terms of openness and transparency. As usual, I began by evaluating the Company’s possible incentives to misreport (e.g., overstate operating performance).  Yes, Herbalife suffers from the usual performance pressures to meet operating targets imposed by debt contracts (see covenants in 2011 10-K, page 40). And the fact that the Company’s five year total return has greatly exceeded that of its peer group and the S&P 500 index the past several years no doubt creates market expectations and performance pressures.  Yet, Herbalife didn’t play any of the traditional pro-forma reporting games (i.e., adjusted EBITDA) in its 2011 10-K. It didn’t need to given its steadily improving gross profits, contribution margins, operating and net income (10-K, page 57).  However, the Company does report extensively using a non-GAAP “retail sales” metric which it touts as playing a “fundamental role in our compensations systems, internal controls and operations (10-K, page 55).” In short, there do not appear to be significant performance pressures which might prompt aggressive financial reporting behaviors.

Next, I read the 10-K looking for any management and control red flags that might suggest an environment ripe for aggressive reporting.  Yes, management wealth is tied to company performance via stock-based compensation, but the amounts are not deemed excessive.  Also, according to Audit Analytics, an independent research provider, Herbalife’s internal controls over financial reporting were considered effective each year from 2004 through 2011. Moreover, the Company did not restate its financial statements to correct any reporting errors during the same time period.  On a totally unrelated note, it was quite refreshing to see Herbalife actually admit that debt is being used to fund share repurchases and dividends (10-K, page 71).  While often true, most companies do not put this in print.  So, there is little to suggest that management and internal control factors might promote aggressive reporting.

Finally, I searched the 2011 10-K for any industry or market structure factors that might affect the quality of Herbalife’s financial reporting.  But frankly, there just weren’t any of the usual suspects (e.g., rapid or declining industry changes, new technologies or accounting, etc.).  The only industry factor of any consequence noted was not a surprise.  Herbalife disclosed its regulatory risks associated with running a network marketing program, specifically mentioning “pyramid” or “chain sale” schemes (10-K, page 32).  It just doesn’t get any clearer than this:

The failure of our network marketing program to comply with current or newly adopted regulations could negatively impact our business in a particular market or in general.  

In summary, I just didn’t find that many performance, management control, or industry pressures that might prompt the Company to misreport.  That being said, I actually started to crunch a few numbers to validate my observations.

Risk Model Analysis

I began with an old grumpy favorite, the Beneish Model, to detect any signs of possible earnings manipulation.  Despite the Company’s asset and sales growth, the model did not signal earnings manipulation, yielding probabilities of less than two percent for financial statement years 2008 through 2011.

Next, I ran a panel of five other tests (the quality of earnings and revenues ratios, the Sloan accrual measure, the excess cash margin metric, and the conservatism ratio) in a search for possible red flags.  Again, the tests proved negative.  Simply put, the financial statements do not signal accounting problems related to revenue recognition (e.g., accruals, etc.), nor do they suggest any cash reporting issues.  And while I’m on the topic of cash, I was pleasantly surprised by Herbalife’s cash disclosures (10-K, page 101).  Herbalife gets a star in my book for reporting credit card receivables as actual receivables, and NOT as cash, like so many other companies are doing today (see What’s Up With Cash Balances).  Also, the Company should be commended for reporting any cash overdrafts as financing activities, rather than operating activities.  But enough with the complements, nobody is perfect!

Financial Statement Issues

With almost three weeks left until Herbalife reports its full-year, audited results for FYE 2012 (see press release dated January 17, 2013), here are a few things the Company and its auditors might want to consider.

First, the percentage of the allowance for bad debts to gross receivables has declined from almost 5 percent in 2009 to 2.45 percent in 2011.  Although I am not particularly happy about this, it could be due to the percentage of credit card receivables increasing from 53.62 to 70.83 percent during the same period.  Then, there is inventory which grew significantly in 2011 by 35.7 percent.  Unfortunately, inventory turnover slowed from 9.173 in 2008 to 8.117 in 2011.  Complicating the analysis is that Herbalife for some reason stopped reporting data on reserves for inventory obsolescence in 2011, as it did in prior years (see 10-K’s for FYE 2007 and FYE 2010).

The assets causing me most concern are Herbalife’s intangibles: goodwill and marketing related intangibles.  These assets in total comprise almost 29 percent of the Company’s balance sheet at FYE 2011.  It is noteworthy that the reported asset values have remained relatively unchanged since they were first reported in FYE 2004.  FYE 2011 disclosures provide absolutely no insight as to what these assets represent, or when these intangibles originated.  Only a review of the FYE 2004 10-K tells us that the bulk of the intangibles originated with the 2002 merger of WH Acquisition into Herbalife International.  But still, there is no information on exactly what the sizable marketing intangible represents.  Also, in its FYE 2011 10-0K, the Company doesn’t even bother with a specific intangible asset note, preferring instead to discuss intangibles within its accounting policy notes…interesting.  Why do I care about this?  Intangible impairment may be lurking.

Some of you will no doubt argue that net earnings and operating cash flows are strong and increasing, as are market capitalization, and the related market to book ratios.  Nothing there signals impairment, right?  Well, here are a few things to consider.  First, Herbalife freely acknowledges a relatively high turnover in its distributor customers (e.g., sale leader retention rates of approximately 50 percent, FYE 2011 10-K, page 54).  Additionally, and more problematic, is what the Company’s “pop and drop” business model might tell us about the value of reported intangibles.  Slides 251 through 256, as well as slide 260 of the “Who Wants to Be a Millionaire?” presentation appear to confirm a lack of customer loyalty and/or marketing effectiveness in mature markets.  So, given the documented “pop and drop” cycles of Herbalife’s business model, isn’t it likely that the intangible assets recorded in 2004 should have been written off in the subsequent three to five year period? Recent earnings and cash flows might simply reflect the “pop” provided by new markets, rather than revenue and cash streams related to the 2004 intangibles. This grumpy old accountant sees a problem here, and the paucity of intangible asset disclosures raises some red flags in my book.

And then there are the leases…the off-balance sheet financing!  Herbalife reports that it leases ALL physical properties on page 45 of the FYE 2011 10-K.  Of course you remember how the grumpies feel about lease accounting.  See CVS Caremark:  Why Operating Leases Must Be Capitalized.  So, using the data in note 5 of the FYE 2011 10K, I made the following assumptions to estimate Herbalife’s off-balance sheet lease liability: 

  • Discount rate of 5 percent based on an approximation of Herbalife’s borrowing cost.
  • Thereafter lease obligations occur equally over the remaining 5 years.  
  • Tax effects are ignored.

Even with these “crude” assumptions, the Company’s estimated unrecorded lease liability approximates $140 million, which represents 9.7 percent of total assets at FYE 2011.  And the liability to assets ratio jumps from 61.3 to 70.9 percent when the unrecorded lease obligations are considered.  But GAAP is what it is…and, if anything,  Herbalife is GAAP compliant when it comes to leases.  

Finally, I do have a couple of complaints about Herbalife’s income statement presentations.  Yes, I have the usual issues about “cash flow hedge” accounting and other comprehensive income reporting.  But what troubles me more is the Company’s highly aggregated income statement.  Financial reporting transparency would be improved if revenues were disaggregated to highlight product returns, distributor allowances, shipping and handling revenues, and product returns and allowances.  Additionally, there is little or no detail on Selling, General, and Administrative expenses in the income statement or notes.  And as pointed out by Pershing Square Capital Management on slide 301 of its presentation, the Company no longer reports shipping and handling costs (in FYE 2011), despite reporting them for 2008 through 2010.

So, is Herbalife a pyramid scheme?   Well, if it is, the GAAP financials don’t really appear to signal it, nor does the auditor.  This suggests to me that the recent uproar in the markets may be less about the Company’s financial condition, and more about Herbalife’s business model, not to mention the ego.  If I were the Company’s financial physician, I would tell it:

You look healthy, but I don’t necessarily agree with your life style.

And by the way, In Herbalife’s case, the financial statements may be masking some longer-term health risks, particularly if regulatory authorities make the Company re-engineer its way of doing business.

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

AuthorAnthony Catanach
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