Adjustment Error On the previous post, I introduced a capital structure trade on Town Sports International, recommending to sell short the equity and to buy the 11% Senior Note. However, it was brought to my attention by an alert follower that the adjustment for off-balance sheet liabilities was a little off. The correct adjustment for operating leases is to capitalize them, adding the PV of minimum lease payments to assets and liabilities and adding rent expense or calculating EBITDAR. For Town Sports Intl, the adjustment creates an EV/EBIDTAR multiple of 7.1 and EBITDAR/Interest Expense of 1.93, a slight improvement from my previous calculations but the fundamental idea remains intact. Now I want to take some time to go over few key aspects of investing: warning signs of earning s manipulation and balance sheet adjustments.
Skeptical When you are valuing a company, as an investor, it is important to look at financial statements and management projections with skepticism. Sometimes management has an incentive to increase earnings or increase sales rather than maximize shareholders value. Sometimes financial statements need to be adjusted for valuation purposes, changing the picture of the overall company.
Manipulation When financial information is reported to capital markets, security prices move. This creates a clear incentive for management to report financial performance that meets or exceeds current expectations. The target that a Company is trying to achieve is a moving benchmark: the consensus sell –side analyst forecast. Investors need to be particularly skeptical about reporting earnings when: top management has a significant portion of vested options in the money, the company is trying to maintain a track record of successively meeting analyst forecasts and is looking to raise additional financing. The presence of these risk factors can provide an incentive to accelerate recognition of earnings or report aggressive earnings, which are transitory and non-persistent. A good example is Microstrategy. Between the end of 1999 and early 2000, the stock price of Microstrategy rose from $25 to above $300. But in March 2000, they announced a restatement of earnings because they accelerated the recognition of revenue by booking legitimate future sales orders in the current fiscal period. At a first glance, this doesn’t seem particularly egregious: after all, these would have been legitimate sales. But placed in the context of significant capital market pressures, where analysts and investors were looking for exponential sales growth to support very lofty stock prices, the front loading of revenues allowed Microstrategy to report very large revenue increases over the 1998-1999 period. When investors learned that this run up in sales was the result of front loading future sales, there was a quick correction in price. Did management knowingly accelerated earnings recognition? We will probably never know that but it’s beyond our point. A skeptical view on earnings report will help you identify potential manipulations.
Adjustments I will now introduce a brief discussion on two balance sheet issues, off-balance sheet debt and goodwill. Off-balance sheet debt includes items not reported in the body of the balance sheet but that might be associated with an obligation for future payments. The classic example is leases. US GAAP recognizes two types of leases (operating and capital) and provides different accounting rules for each. The treatment of operating leases relative to capital leases is dramatically different. An operating lease treats the cash outflow associated with the lease as a rental expense, which will be recorded on the income statement. With a capital lease, the PV of minimum lease payments is recognized on both assets and liabilities at the inception of the lease, and amortized over the life of the lease. Companies have a strong preference for operating leases, as this keeps the lease obligation off the balance sheet. The use of operating leases is pervasive in the retail sector with companies such as Walgreen, Wal-Mart, CVS and others having very large off-balance sheet operating leases obligations. The consequence of bringing these leases onto the balance sheet will be to increase leverage ratios; and depending on how these companies amortize the value of their assets, there could also be significant impact on reported earnings.
When a company acquires another company and records part of the acquisition price as goodwill, the goodwill is capitalized as an asset and no periodic amortization charges are taken against it. Instead, companies evaluate goodwill and other acquired intangible assets for impairment annually or whenever circumstances indicate that the value of such an asset is impaired. Disclosures for goodwill can be found in the supplemental information to the financial statements. Investors should look carefully at changes (or the absence of an impairment given overall economic conditions) in reported goodwill. Companies that continue to report goodwill on their balance sheet, but they have a market capitalization less than book value of equity, are certainly worth an examination to understand why an impairment charge was not taken.