How short-selling sleuths spot accounting
gimmicks on financial reports
SAN FRANCISCO (MarketWatch) -- With the economy mired in a deep slump and sales slowing, many companies found it necessary last year to reduce inventory.
Not Monsanto Co. Instead, the agricultural seed giant was building inventory. That raised questions among analysts at the Center for Financial Research and Analysis, who dig through corporate financial statements with the detail of a forensic expert.
Their goal: to tell institutional investors when stocks are worth selling or avoiding altogether. In February 2010, CFRA put Monsanto on its "biggest concerns" list.
"Most companies had been reducing inventories (in 2009), except Monsanto," said Jeremy Perler, co-director of research at CFRA. "Their inventories were building rapidly. That's a pretty powerful flag for an investor."
As the 2010 second-quarter earnings season wraps up, CFRA and other accounting sleuths are once again scouring the latest reports for disconnects between what company executives are telling investors and what the numbers are saying.
"When there is something bad going on, they'll do whatever they can to hide it," said Perler, who with Howard Schilit co-authored the most recent edition of "Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports."
While not a simple task, spending a few hours combing a company's earnings release and more-detailed quarterly and annual financial reports (10-Qs and 10-Ks) can make a difference in making money or losing your shirt.
Yet you don't have to be a forensic accountant to spot trouble on a financial statement. Here are several line items on a balance sheet you should focus on to gauge a company's strength, including inventories, free cash flow, and accounts receivable.
1. Inventories
Monsanto /quotes/comstock/13*!mon/quotes/nls/mon (MON 57.84, -0.07, -0.12%) had high hopes for two new seed products. Inventories of SmartStax and Roundup Ready Two Yield seeds were growing at a healthy clip through the fall of 2009 and into this year. The seeds were crucial to Monsanto's stated plan to double gross profit margin by 2012, which would bolster overall corporate profit.
But Monsanto was having trouble convincing customers to buy existing products that competitors sold for less. This forced the company to slash prices to clear older inventory just after it stocked up on new seeds.
As a result, Monsanto reported 17% year-over-year inventory growth for the quarter ended in November 2009. Meanwhile, analysts had forecast Monsanto to grow sales by 1% over the subsequent nine months, CFRA pointed out in a report.
Typically, inventories should rise at about the same pace as sales. If a company's inventories are growing faster than sales or expected sales growth, it's a clue that products aren't moving. In that case, gross margins could get squeezed.
The crunch soon caught up with Monsanto. The company rescinded its gross margin target, cut its profit outlook twice, and shaved sales expectations for SmartStax and Roundup. And the shares plunged 32% from April through May. By then, Monsanto had slashed its 2010 profit target to a range of $2.40 to $2.60 a share, down from $3.10 to $3.30 a share a month earlier.
2. Free cash flow
Worldcom's meteoric rise in the telecommunications world came to a crashing halt in late June of 2002. Worldcom took many by surprise when it restated five quarters of results, erasing a profit it had once presented to investors. The company's demise was swift.
Weeks later, WorldCom filed for bankruptcy in what became an $11 billion accounting fraud. While WorldCom portrayed itself as a profitable company, the company's free cash flow painted a picture of shaky enterprise, Perler and Schilit wrote in "Financial Shenanigans."
In 1999, the company reported free cash flow of $2.3 billion. A year later, free cash flow was negative $3.8 billion. Such a large swing in free cash flow is a warning sign.
A significant drop in free cash flow may occur when a company makes a big acquisition, buys new equipment, or throws money behind a new product.
Companies don't always calculate free cash flow in their financial statements. Often, you have to do it yourself by pulling "cash flow from operations" and "capital expenditures" from the cash flow statement presented each quarter. Free cash flow is cash flow from operations minus capital expenditures.
Why is free cash flow important? It's the money left over at the end of each quarter after all the bills are paid. A company can use this money to pay a dividend, trim debt, make an acquisition, or buy back stock.
"You want to see cash growing or what the companies are doing with the cash," said Eric Heyman, director of research at the Olstein Funds. "Companies with cash on their balance sheet have lots more flexibility than a company that doesn't, regardless of economic conditions."
3. Accounts receivable
Another area to check is accounts receivable, or payments due from customers. In addition to how much a company is owed, receivables also tell when it expects to be paid.
To make this calculation, divide revenue by the number of days in the reporting period. Then divide the figure given for receivables by this result.
What you don't want to see is receivables rising at a much faster pace than sales. This suggests a company is shipping too much product into the channel and possibly extending collection payment terms.
Several years ago, receivables at Harley-Davidson Inc.raised eyebrows at research firm Behind The Numbers, which issues sell recommendations to its hedge fund and mutual fund clients.
"There were years Harley-Davidson sold more inventory to the distributor" than the distributor could sell, said Jeff Middleswart, president of Behind The Numbers.
"They were financing the distributor as well," he said. "So essentially, Harley was financing its own sales."
Investors didn't show Harley the same leeway. Sales and profit slumped, along with Harley's shares. By April 2008, earnings expectations seemed enough in line with reality for Behind The Numbers to lift its warning on the stock. Link to complete article and Dell shenanigans
Grandpa: In the words of Scarlett O'hara, "I can't think about that right now. If I do, I'll go crazy. I'll think about that tomorrow". She should have listened to Rhett, "You're like the thief who isn't the least bit sorry he stole, but is terribly, terribly sorry he's going to jail".
Yes Scarlett, publically traded companies play games in an effort to keep their stock price at a hefty premium. Unfortunately, most analysts fail to peek under the covers as they do not want anything getting in the way of their buy or strong buy recommendatoins. They have stock inventory to move and listening to more than CNBC or reading comic books could present a challenge to their trading desks. IT IS FRAUD Scarlett however no one goes to jail, they simply pay the SEC out of petty cash.
If you only listened Scarlett...I told you the balance
sheet was suspect...
Should have done your homework...cry me a river...
you thought because they are publicly traded they
do not fib?
