Die Fruehstueckslektuere/Guten Morgen allerseits

verfasst von XERXES, 26.03.2002, 08:03

What Evil Lurks in the Heart of Corporate America

If anyone knows, it's the short sellers. They were on to Enron before anyone else, and they made a bundle off the tech wreck. What do they know that you don't? We found out. Here are 10 red flags you need to look for in a potential investment's financial statements.

By Gerri Willis
March 12, 2002

IN THE BEGINNING there were Internet analysts.You learned to ignore their slick research reports, understanding they were designed to deliver investment banking clients, not objective advice. Then there were telecom analysts, ignorant of the developing glut of bandwidth. But you took a pass on their recommendations too. After all, you were a sophisticated investor. You couldn't be fooled that easily.

But Enron was a betrayal of a different magnitude. Not only were the sell-side analysts looking the other way while executives of the Houston energy-trading company set up elaborate schemes to line their own pockets, but so were the company's accountants, its auditing committee and its board of directors. Even the fund analysts and regulators — traditional allies of the small investor — failed to do their homework. Some $60.7 billion of Enron wealth has been wiped out, and the chain reaction has taken with it such former giants as Global Crossing and threatened others, such as Tyco and Qualcomm. While it's abundantly clear that Enron is far from alone in pushing accounting to its limits, it's also true that some of the stocks that were creamed by the Enron selloff didn't deserve it.

Welcome to the new era of investor skepticism, a time when you have to question every pronouncement, every last statement, no matter the source. For ideas on how better to navigate this new world, we turned to the people who are skeptical for a living, the ones who make their money betting that stocks will go down rather than up — the short sellers.

While we're not advocating that you sell stocks short yourself, there are plenty of good lessons to be learned from the people who do, lessons you should apply to any stock you're considering adding to your portfolio."There's no cookbook approach," says David Tice, manager of the Prudent Bear fund and one of those who shorted Enron early on. His credo:"Don't believe Wall Street." He and the other short sellers we spoke to say their best tips still come from corporate financial statements filed with the Securities and Exchange Commission and available free at www.sec.gov. In this story, we'll show you the red flags in those reports that make short sellers look twice. The payoff? You won't have to rely on the pundits, the analysts or your broker to tell you what to think.

Pro Forma Earnings
would you drive on roads where the traffic laws didn't apply? That's exactly what happens when you invest in companies on the basis of pro forma earnings (aka"normalized,""recurring,""core" or even"cash" earnings). Typically released before final audited figures are available, pro forma results suspend the rules of the road — what are called Generally Accepted Accounting Principles — in order to downplay special items or costs. Think of it as Earnings Before the Bad Stuff.

Yet because these numbers are available as much as two months before audited figures, most Wall Street analysts and mutual fund managers dump them into their spreadsheets."The risk is that investors are hoodwinked into thinking income is a lot higher than it is," says Mark Bradshaw, an assistant professor at Harvard Business School who's studied pro forma earnings extensively."They are ignoring expenses that are real for the company."

A pro forma filing tells you the company issuing it can't meet Wall Street expectations without some equivocating. Check out the items excluded from earnings — the big restructuring charges and everything-but-the-kitchen-sink writeoffs — and do your own smell test: Are the excluded items really continuing costs of doing business? (This can be more obvious than you think. One company recently excluded its costs for painting its fleet of garbage trucks.) Does this company typically issue pro forma earnings? When you subtract the charge from net income, are earnings wiped out? If the answer to all these questions is yes, you should hold off investing.

Fake Revenue
It's not just earnings that are difficult to decipher. Even revenue is subject to interpretation. Take Priceline.com, the online travel agent. Unlike its nonvirtual rivals, Priceline books as revenue the entire price of an airline ticket rather than simply its fee. Yet the savvy investor can easily figure out the company's revenue policy by checking the description of its travel revenue in its quarterly reports and comparing that with the typical description of revenue in its rivals' quarterly filings.

Louis Corrigan, a hedge fund manager at Aesop Capital Partners in Atlanta who uses short-selling as one of his strategies, picked up on a more subtle revenue problem in a cash flow statement. Curious about an outpatient-surgery company called Dynacq International that had been getting favorable press coverage, he compared its cash flow from operations with net income, looking for a divergence between the two. That's when he spotted a red flag: negative cash flow. Corrigan suspected that the company was recording sales well before getting paid by customers. Dynacq CFO Philip Chan counters that cash flow has since rebounded strongly and that the company's booking of sales is handled conservatively. But in the meantime, the stock plummeted from a high of $29.25 to less than $7. Corrigan, who had shorted the stock, was well rewarded.

Channel Stuffing
Imagine the kind of pressure companies face to put up quarter after quarter of solid earnings gains. Now imagine that you're the CFO and it's near the end of a punk quarter. Do you encourage the customer who's thinking about placing an order for your company's wares a month from now to do it today instead? Sure you do. Trouble is, those last-minute orders steal business from your next quarter.

It's what short sellers call"stuffing the channel." To find out whether it's a big factor at a company whose stock you're thinking of buying, check out the accounts receivable line on the balance sheet. Compare the quarterly trends with revenue. If receivables grow dramatically and revenue lags, watch out. Ultimately, the difference will show up in the earnings.

Hidden Conflicts
cfos who have something to hide generally leave a trail of clues. To find them, pick up the annual report and thumb through to the back, where you'll find a section entitled something like"Notes to Consolidated Statements." This is typically where the bad stuff gets hidden.

Look for red-flag phrases such as"related party transaction," which, roughly translated, means that insiders are getting paid for providing some service to the company beyond their usual duties. Think Enron CFO Andrew Fastow, who made millions setting up partnerships that did business with Enron. Aesop Capital's Louis Corrigan says it was this phrase that led him to short EquiMed, a Pennsylvania health care company that bought physician practices. By reading the fine print, Corrigan discovered that EquiMed's founder was being paid 3 percent of revenue by the company to handle its accounting and billing; he also owned the company that leased EquiMed its offices. The stock is no longer trading.

Another red flag:"sales leasebacks." Robert Mullin, also a hedge fund manager at Aesop Capital, says he shorted natural-gas-equipment company Hanover Compressor last year after discovering it used this technique. How did it work? It set up an affiliated partnership to take over expensive equipment built by Hanover, then Hanover leased the equipment back. Such a move rids the parent of debt associated with the equipment. Sweet deal for Hanover, and an even better deal for Mullin once the rest of Wall Street caught on.

Mountains of Debt
Too much debt can sink a corporation in a matter of months, as Enron so aptly demonstrated, but for many companies, especially those in capital-intensive industries or those experiencing rapid growth, access to cold, hard cash is vital.

Most investors look at debt/equity ratios to figure out which companies are overextended. But Paul McEntire, manager of the Marketocracy Technology Plus fund, says that metric can be misleading when equity values are out of whack, as they were at the height of the bull market. Instead, he advocates comparing a company's long-term debt with its annual revenue (you'll find the first on the balance sheet and the second in the income statement). If there's a one-to-one relationship, it could mean trouble, McEntire warns. It's that kind of back-of-the-envelope analysis that led McEntire to successfully short Exodus in the first quarter of 1999, when the shares were trading just under $10. It has since been delisted.

Extreme Spending
One of the big lies of the Internet age was the argument that whatever a company had to spend to grow — its capital expenditures — was okay. Prudent Bear manager David Tice knows better. Several years ago he became intrigued by a red-hot pager company called Paging Network. Analysts touted its rapid-fire subscriber growth and strong cash flow. As it rolled up paging businesses from the Baby Bells, bulls licked their chops over the possibility of holding a company that dominated a vast and lucrative market.

But by digging into its financial statements, Tice discovered that the company was awash in debt. If Paging Network was getting money from new subscribers, why was debt so high? He finally got the answer in a footnote to the financial statements, where he found that while it was true the company was constantly signing up new customers, it was just as rapidly losing the old ones."They had to outfit each of these new customers with pagers," he says."It didn't take a rocket scientist to see why their debt level kept rising." Paging Network filed for bankruptcy protection in 2000.

It's not just spending for equipment that went through the roof over the past few years. Bloated share prices during the bull market allowed companies to binge on acquisitions, too. One of the biggest was America Online's $103 billion buyout of Time Warner last year. Like most companies, AOL booked the amount of the transaction over and above its market value as"goodwill," and planned to amortize the costs over time. But now accounting regulators say that companies can write off"impaired goodwill" and make it all go away in one quick charge. For AOL, that charge will be $40 billion to $60 billion this year.

AOL shares have tanked since the announcement, and you can expect other big acquirers to go through the same thing in coming months. Possible candidates with big goodwill expenses on their books include AT&T, WorldCom and Aetna.

Venture Capital Gains
Another internet era boon to earnings that's causing problems for companies: Gains from venture capital investments. Big tech companies invested in small upstarts throughout the 1990s, hoping to reap some of the gains enjoyed by Silicon Valley venture capitalists. Intel added the investment gains from its venture unit directly to its bottom line. In fact, in 2000 these gains accounted for a third of Intel's earnings. Critics said that since venture capital investing wasn't the core business for these tech companies, they shouldn't be accounted for that way. Now the strategy is coming back to bite the corporate VC: Intel, for one, recently announced losses of $632 million from its venture capital arm in 2001.

Overreliance on Pensions
during the bull market companies found their pension funds growing fat along with the rise in the major market indexes. According to one study, as much as 3 percent of the operating income of S&P 500 companies came from pension plan surpluses. At some companies, the amount was far higher. But now some short sellers believe that layer of fat will disappear because of a weakened stock market, which could hurt earnings. Already, chemical company PPG Industries has announced it will recalculate the annual return on its pension fund, and other companies are expected to follow suit.

To find out if one of the stocks in your portfolio faces this kind of squeeze, check out the note on pension or postretirement benefits at the back of the last couple of annual reports. Look for a line item called"Net Pension Income." That's the contribution the pension fund made to that year's earnings — and the amount of money that might not show up in next year's net income.

Hidden Obligations
The trouble with running a company that develops cutting-edge products is that it costs a lot of money. (Notice the raft of earnings-challenged biotech companies.) But clever CFOs have found ways around this by moving some obligations off their balance sheet. Enron was hardly the only offender: Consider PeopleSoft. Back in 1999 the otherwise healthy software company spun out a unit called Momentum Business Applications, funding it with $250 million. Momentum's one employee soon was joined by multiple PeopleSoft code writers, and Momentum paid PeopleSoft"development costs" to conduct research on the software maker's behalf. In return, Momentum got a small stream of royalties.

But the big beneficiary was PeopleSoft itself, which transformed its hefty R&D costs from an earnings-eating liability into a stream of revenue that could bolster earnings. After questions about this accounting method surfaced earlier this year, PeopleSoft's share price fell 26 percent. The company has since said it will acquire Momentum. How did short sellers sniff out the relationship? All the information they needed was clearly laid out in Momentum's SEC filings.

Bad Parenting
Perhaps some of the most creative bits of financial sleight of hand happen when companies spin out a unit as a public company. Consider the story of GameStop, a spinoff of Barnes & Noble. Originally called Babbage's, the retail operation was purchased by B&N CEO Leonard Riggio and others in 1996. B&N later bought them out, paying $215 million for the money loser in 1999. Now, two and a half years later, investment bankers have taken GameStop public.

One scan of the prospectus, though, would convince you to stay away from this IPO. Why? GameStop is far from being the master of its own fate. Most of the proceeds from the IPO won't be used to expand the new company's business, but will go right back to B&N to pay off the unit's considerable debt. What's more, B&N will retain voting control, as well as a board seat in the new company, which could set the stage for conflicts of interest in the future."The main issue is that B&N is effectively using public money to pay Riggio for acquiring Babbage's," points out Renaissance Capital's Linda Killian, a specialist in IPOs. A Barnes & Noble spokeswoman declined to comment.



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• Die Fruehstueckslektuere/Guten Morgen allerseits - XERXES, 26.03.2002, 08:03