Download How to Predict the Next Fiasco

How to Predict the Next Fiasco
In Accounting and Bail Early
By CASSELL BRYAN-LOW and JEFF D. OPDYKE
Staff Reporters of THE WALL STREET JOURNAL
So you're not a Wall Street analyst or professional short seller. Still, you do have some
tools at hand for avoiding being caught in a stock that suffers an accounting blowup.
While the highly publicized accounting problems at collapsed energy-trading firm Enron
are just the latest in a series of corporate accounting scandals, there are numerous
warning signs that skeptical investors use to protect their money, and some are
straightforward enough for individual investors to follow.
"After Enron, investors realize they have to question every financial statement they get,"
says Murray Stahl, director of research at Horizon Research, a New York investmentresearch firm. If nothing else, the Enron debacle "will make the issue of accounting very
important in the future."
Short sellers -- bearish investors who try to profit from a stock's decline by selling
borrowed shares in hopes of replacing them with shares bought later at a lower price -see no shortage of occasions where their hard-nosed approach to financial analysis will
come in handy. Thanks to factors such as stock incentives for executives and auditors
collecting fees for consulting, "accounting now is worse that it ever has been," says Marc
Cohodes, a partner at Rocker Partners, a New York hedge fund.
Here are some red flags that such professional investors watch out for to guard against
potential trouble down the road:
Invoices Increasing, Sales Slipping: If a company's accounts receivables are growing
faster than sales, that signals some concerns about the quality of the sales. Among other
things, swelling accounts receivable could indicate "channel stuffing," or overselling to
distributors to pad short-term financial results.
Similarly, if inventories are growing faster than sales, that could signal a company isn't
able to sell inventory as quickly as originally believed. Depending on the type of
inventory, there might be the added risk of the inventory becoming obsolete, resulting in
write-downs.
In 1998, Sunbeam, a maker of household
Sunbeam Reports Total Net Losses of
$533 Million for Two Quarters (Dec.
consumer products, restated earnings downward
17, 1998)
for six previous quarters. The company, which
had seen a surge in accounts receivable,
acknowledged that the original revenue had been
prematurely booked, and it cited a variety of other accounting moves that were necessary
to restate. Sunbeam had inflated sales of such things as barbecue grills by offering
retailers low prices and easy cancellation terms, promising, say, to hold the grills in
Sunbeam's warehouses for later delivery.
Dubbed a "massive financial fraud" by the Securities and Exchange Commission, the
company filed for bankruptcy reorganization in February 2001.
Concentrate on Cash: The cash-flow statement tracks all the changes that affect a
company's cash position, be it cash flowing in from debt and stock offerings, or cash
flowing out in the form of dividends. It can also serve as an indicator of potential
chicanery inside a company's accounting.
A telltale sign of trouble is negative cash flow from operations while the company's socalled Ebitda (earnings before interest, taxes, depreciation and amortization) is positive.
Short sellers note that in such a case, a company could be using accounting gimmickry to
make its business look healthier than it really is. If operating cash flow is negative, in
reality the company is consuming cash rather than generating it, as its Ebitda figure
would suggest.
Risky Returns: At the end of the day, what makes a stock move is its return on capital -how much profit a company generates off the assets it employs, such as its cash,
inventories and property, plants and equipment.
Most financial statements break apart a company's operations to show investors which
segments generated which portion of sales and profits. By isolating individual segment
returns, says one short-selling analyst, investors can determine where earnings are
coming from and whether they seem fishy. A few simple calculations can reveal a lot.
Consider Mirant, an energy peer of Enron. As part of its balance sheet, the Atlanta
company shows assets and liabilities "from risk management activities," both current and
noncurrent. Subtract the liabilities from the assets, the analyst notes, and Mirant has $80
million of equity in that business. As part of the footnote attached to those balance-sheet
items, Mirant noted that it generated essentially $221 million off those assets during the
third quarter.
That kind of stunning return, about 275%, is hard for any company to sustain, raising
questions about the likelihood that such strong performance can be maintained
indefinitely. The same analysis shows the other segments had far more humble returns. A
Mirant financial expert wasn't available to comment.
It's All Relative: Often, a company's financial statements will include a "related-party
transactions" section, pointing to dealings with its own officers or related companies.
Maybe the company has loaned money to its officers to buy company stock, or cash to an
affiliate to buy products from the company.
Either way, investors should be aware of the potential pitfalls. Some short sellers say
these dealings can signal that a company thinks of corporate cash as belonging to
management and not the shareholders, and thus is more freewheeling with it than a more
conservative company is. Enron may be a case in point; its downward spiral into
bankruptcy-court protection started as investors focused on nettlesome related-party
transactions involving the then-chief financial officer.
Recurring Nonrecurring Charges: Another red flag, according to Nathaniel Guild, a
partner at Short Alert, a research firm in Charlotte, N.C., is the practice of repeatedly
labeling restructuring and other charges as "nonrecurring," "one-time" or "unusual," when
they aren't truly one-off expenses. Because most analysts ignore such charges in their
earnings models, this can create a cloud of smoke that obscures the company's true
earnings power. "You can write off anything, in any fashion," Mr. Guild maintains.
"There is very little regulation in that area."
Consult the Consulting Fees: The case of Enron also has focused the spotlight on the
issue of auditor independence. Thanks to new rules introduced by the Securities and
Exchange Commission, companies now are required to disclose how much they pay their
auditors not just for auditing, but for nonauditing work as well. The question investors
should ask themselves, says Rocker Partners' Mr. Cohodes, is how independent an
auditing firm can be that is getting paid as much or more for consulting services as it is
for auditing. "It is a huge conflict," he contends. In the Enron example, the company in
2000 paid Arthur Andersen $25 million in audit fees and $27 million for nonaudit work,
including consulting.
***
COHEN CUTS: Wall Street once wrote off write-offs. Companies said they were onetime events, so investors shouldn't lose any sleep.
No longer. Wednesday, Abby Joseph Cohen, Goldman Sachs Group's investment
strategist, slashed her earnings estimates for the Standard & Poor's 500-stock index,
blaming "aggressive" write-offs that should continue for the next several quarters, as well
as "the impact of the official announcement of recession."
"Simply stated, many companies are writing off not only the kitchen sink, but the bathtub
as well," Ms. Cohen wrote in a note to investors. She did not return calls seeking
comment.
Ms. Cohen now expects S&P 500 companies to record $34 a share in operating earnings,
down from $47. Despite the move, Ms. Cohen, a longtime bull on stocks, retained an
estimated level of 1300 to 1425 by the year's end for the S&P 500. Wednesday, the S&P
500 closed at 1128.18, down 1.73% so far this year.
-- Gregory Zuckerman