Ian Striplin  by Ian Striplin
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

Here at Gradient Analytics, where we specialize in forensic accounting research and consulting, it may seem to the outsider that we are just a bunch of pessimistic short researchers, sniffing out aggressive accounting practices that might soon cause a given company to miss earnings expectations and reduce forward guidance, for the benefit of our clientele of long/short hedge funds. To be honest, we are jaded in our belief that most companies will, from time to time, take liberties with their accrual accounting in order to achieve short-term reporting objectives. But most only do it sparingly and temporarily, and only those that become overly extended in employing aggressive practices – while facing fundamental headwinds that make it likely certain metrics will persist or worsen – make good short candidates. But that doesn’t automatically make all the others good long candidates.

Thus, our expertise is also useful for identifying solid earnings equality for the vetting of long candidates. Earnings quality analysis can reveal accounting benefits to future earnings potential and help ensure that a quant model or fundamental analysis that created a positive equity profile for a given company is indeed based on the underlying economics of the business rather than an aberration of accrual accounting. In other words, it can serve to add conviction or a confirmation signal to a long thesis.

In this article, we will describe several positive earnings quality factors that can act as a tailwind to sustainable future earnings growth, with four real-life examples. In forming a stock universe for this article, we screened the output file of our proprietary Earnings Quality Rank (EQR), which assigns a quintile score of 1-5 (with 5 being the “best” earnings quality relative to peers), and limited the population to companies in the top quintile and a market capitalization greater than $500 million, to avoid liquidity constraints. (Note: On the other hand, when seeking short candidates, we look to the bottom quintile of the EQR model.)  Read on….

gradient / Tag: forensic accounting, earnings quality, CFOA, GAAP, non-GAAP, accruals, AFDA, COGS, TTEK, ASML, PRO, FELE / 0 Comments

Dominic Finney  by Dominic Finney
  Senior Analyst & Chief Technical Editor, Gradient Analytics LLC (a Sabrient Systems company)

Perhaps the most reliable shortcut to identifying a company at elevated risk of a downturn in its share price is looking at how executives and directors use their equity instruments. This might sound too simple to be predictive – something that would be quickly understood by the market and integrated into investors’ thinking on a scale that would cause the “edge” to disappear. But there are complications that have prevented that from happening, on which I will elaborate shortly. But first, let’s look at some recent examples.

Over the past two years, Gradient Analytics has published five brief “snapshot” reports based on our Equity Incentive Analytics examining signs of unusual and concerning equity use by executives and directors. The subject companies were Amarin (AMRN), United States Cellular (USM), WW International (WW, or WTW when we wrote on it), Supernus Pharma (SUPN), and Magellan Health (MGLN). All five of the reports preceded significant declines in company share price, with four of the five stocks showing double-digit declines over the ensuing three months and all of them hitting double-digit declines over six months. Read on....

Rachel Bradley  by Rachel Bradley
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

While the accrual method of accounting has its usefulness, it also opens the door for companies to “manage” and even overstate earnings through various tactics – some merely aggressive, others more nefarious. There are a variety of levers that management can pull to either book expected revenue sooner than normal or push current expenses farther out into the future. However, earnings growth sourced this way is unsustainable. Unless the firm expects a massive boost in sales in the near future (such as from the rollout of a highly anticipated new product), sustaining the growth story would require not only continuing to pull revenue forward but to do so at an accelerating rate.

Pulling sales forward or pushing expenses farther down the road both overstate the firm’s sustainable earnings power and result in a presentation of financials that obfuscate reality. There is also a myriad of other tools available to dress up financial statements to present a firm that appears financially healthier than it truly is. A common way to pad the balance sheet is through so-called “soft assets,” i.e., goodwill and other intangibles like brands, logos, trademarks, corporate reputation, client lists, and contracts.

At Gradient Analytics we have a saying, “With soft assets, come soft profits.” Put another way, when a firm has material intangible assets and most of its valuation is tied to the terminal value dependent on a set of unrealistic assumptions, then earnings have a higher risk of write-downs. As an example, we take a deeper look at the financials of The Kraft Heinz Company (KHC), specifically examining some overly optimistic assumptions management used in valuing its soft assets. Read on….

Ryan Frederick  by Ryan Frederick
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

In 2003, the SEC first officially adopted rules (following Sarbanes-Oxley in 2002) related to the reporting of non-GAAP financial metrics. The new regulations called for a reconciliation of GAAP versus non-GAAP results to be included in various investor resources and to refrain from excluding non-recurring items from non-GAAP metrics if they are reasonably likely to reoccur, which is subject to wide interpretation. Since then, it seems the perceived importance among investors of non-GAAP financial performance has been elevated above traditional GAAP measures. Between 2015 and 2017, less than 10.0% of companies in the S&P 500 did not report a non-GAAP income calculation. However, the ability for management to subjectively decide what is or is not relevant to a company’s core business leaves plenty of room for earnings manipulation.

On the one hand, companies tend to justify their exclusion of various transactions as necessary for “comparability” to historical results, given that GAAP rules have changed over time. Fair enough. However, when an investor chooses to rely upon non-GAAP results when comparing a given company’s results to another’s, the comparisons can be deeply misleading as management has great leeway for subjective (and sometimes ad-hoc) adjustments in their exclusions – i.e., what one company concludes should be excluded in a non-GAAP calculation may not be consistent with what another company may exclude.

In fact, in 2010 former SEC chief accountant Howard Scheck identified non-GAAP performance metrics as a “fraud risk factor.” The SEC even created a taskforce to analyze non-GAAP earnings metrics that could be misleading. Then, in an effort to provide more clarity, the commission provided Compliance and Disclosure Interpretations (C&DIs) which detailed ways in which the SEC may find non-GAAP disclosures to be misleading, but more on that later.

Here at Gradient Analytics, our focus on earnings quality analysis (for both short idea generation and vetting of long candidates) regularly includes an examination of non-GAAP adjustments to determine whether they are appropriate in helping represent the true performance of the firm, or whether they are misleading. There is a plethora of unique adjustments a company could make to a non-GAAP income calculation; however, some are more common than others. One of the more frequent adjustments to GAAP income is the exclusion of restructuring costs. Read on….

Ryan Frederickby Ryan Frederick
Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

Stock buybacks (or share repurchases – we will use the terms interchangeably) have garnered significant attention as publicly-traded companies have repurchased shares at record levels (in terms of dollars spent). In 2018, companies in the S&P 500 spent $806 billion on buybacks (about 3.8% of public float), shattering the previous record of $590 billion spent in 2007 (about 5.3% of public float) by 36.6%. Few topics provoke as intense of a response from those in the world of finance as to what role buybacks should play – whether in a given company’s cash management strategy or for the broader market as a whole. There are various viewpoints on the subject, but there’s a good chance you’ve primarily heard buybacks described in pejorative terms. The negative framing ranges from management using buybacks to manipulate EPS growth and share prices (with no underlying change in the company’s financial condition), to shortchanging long-term investments and employees, to cannibalization, to mis-spending tax cuts, to outright calls for the practice to be outlawed.

Indeed, it is easy to frame buyback programs in a negative light, and some of the connotations may be deserved. To be sure, corporate executives often focus so much on EPS performance that they might choose to engage in short-sighted and/or self-centered activities. (Whether they can get away with it is another matter.) However, the truth about buybacks is much more complicated than typically presented as there is a confluence of many factors and questions that must be considered, such as: What timeframe was used to analyze the effects? Was it the right timeframe? What are a company’s alternative investment opportunities before, during, and after a buyback program? Can an outsider refute with certainty what is/isn’t a good use of cash? What is the cost of capital and opportunity cost? What are the macroeconomic conditions, e.g., interest rates, fiscal policy, trade wars?

Moreover, do buybacks actually lift a given company’s share price and the value of an index that holds it? Is this practice such an epidemic and scourge on society that the federal government should step in to regulate what a private company (or by extension, its shareholders) can or cannot do with its cash? Should a buyback intended to reduce public float be made illegal once again (as it was until 1982)? We believe the answers to these questions are more nuanced than the media presents, so we will attempt to offer some additional insight. Read on….

Bradley Cipriano by Bradley Cipriano, CPA
Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

At Gradient Analytics, our forensic accounting analysis includes assessing the quality of a company’s reported earnings and the strength of its balance sheet. A key element of this process is understanding whether recently reported growth is sustainable and whether forward expectations are reasonable. New GAAP (Generally Accepted Accounting Principles) standards – such as Contracts with Customers (ASC 606), which went into effect at the beginning of this year – have distorted year-over-year growth figures, such that it has become routinely necessary for an investor/analyst to adjust income statement and balance sheet accounts to get a clearer like-for-like comparison. For example, ARRIS International plc (ARRS) has grown 2018 YTD GAAP EPS by $0.17, which includes an $0.18 benefit from ASC 606. So, while ARRS is showing earnings growth on the surface, its comparable YOY earnings have actually declined. Understanding how new accounting standards can be manipulated to positively impact earnings can help investors better assess reported results.

While such new standards are often viewed as “a wash” since there is no change to the underlying economics of a business, the changes under the new leasing standard Leases (ASC 842), which is coming into effect in 2019, may prove quite material for certain corporate filers. The new leasing standard follows a convergence in accounting principles between International Financial Reporting Standards (IFRS) and U.S. GAAP to improve comparability among different filers. Currently, operating leases (which are similar to debt) are disclosed off-balance sheet in the footnotes with limited qualitative or quantitative disclosures. But following the adoption of the leasing standard, this debt must be brought back onto the financial statements along with increased disclosure requirements. It is important to question why a company has relied on off-balance sheet debt in the past to better understand the risks that may surface once this debt is brought back onto the statements.

In this article, I explain ASC 842, summarize the major changes it introduces and its expected impact on corporate financial statements, and discuss how this new leasing standard allows for management subjectivity that might be used to distort earnings growth and disguise a firm’s sustainable operating performance. Read on….

gradient / Tag: asc 842, forensic accounting, earnings quality, lease, GAAP, IFRS, leasing standard / 0 Comments

By Rachel Bradley
Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

In mid-June, the Federal Reserve raised interest rates by 25 bps and signaled it was on track to raise rates twice more in 2018. With interest rates near zero for almost ten years, we believe that this gradual normalization to higher rates signals a long-term positive for the sustainable growth of the economy. The Fed is signaling its satisfaction with current inflation and unemployment trends and its confidence in the health of the broad economy. Fed chair Jerome Powell has stated that the economy has become sufficiently healthy such that the Fed can be more hands-off in stimulating economic activity.

During a normal expansion phase characterized by robust economic growth and rising equity prices, the Fed typically will push up interest rates (causing bond prices to fall). But in its most recent comments, the FOMC signaled it would likely allow inflation to hover above its official 2.0% target. Such a lenient (or dovish) stance on inflation is generally more favorable for continued growth as the Fed is in no hurry to increase the speed of its rate hikes. Even after the latest rate hike, the target nominal fed funds rate is 1.75%-2.00%, which is still a negative real rate once inflation is subtracted. The last time the fed funds rate was over 2.00% was in 2008.

One of the basic tenants of finance is the inverse relationship between interest rates and bond values. However, as the Federal Reserve continues on its path to normalize rates, we believe it’s worth exploring how interest rate changes can also affect equity valuations. The questions that seem to be on the collective investment community’s mind is, “What does this mean for me and my holdings? Are valuations peaking? Should I sell?” While it normally takes a year or more for changes in interest rates to be felt across the entire economy, the market often has a more immediate response.

To explore this in greater detail, we analyzed SeaWorld Entertainment, Inc. (SEAS) as an illustrative example of the potential impact of a future rate hike, given that it is heavily levered with a material proportion of variable-rate debt. We believe that the consensus forward EPS estimates for SeaWorld are likely overstated (and out of management’s control) as interest rates – and the firm’s interest expense – continue to rise, putting downward pressure on its valuation. Other companies with similar balance sheet exposure may be similarly at risk. Read on....

Nicholas YeeBy Nicholas Yee
Director of Research, Gradient Analytics LLC (a Sabrient Systems company)

Over the past five years, Gradient Analytics has observed a shift from companies making acquisitions for strategic purposes to companies acquiring mainly for short-term financial gains. This stems at least in part from investors and a sell-side community that have become complacent in accepting managements’ accounting statements at face value without looking “under the hood.” To be sure, the complexity of acquisition accounting and the opaqueness of financial performance analytics is daunting. Therefore, it is incumbent upon earnings quality analysts to try to understand whether a company’s senior management may have other motives fueling an acquisition platform (aka “roll-up”) strategy.

Where previously we might have screened for deteriorating free cash flow and accruals to identify poor earnings quality trends, we now find that some managers have been circumventing cash from operating activities (CFOA) and moving working capital into investing activities on the cash flow statement through acquisitions. Why is this important, you ask? Should analysts always lump the cash paid for an acquisition into free-cash-flow calculations? Not necessarily; there is no hard and fast rule here to put into an automated screener in this situation. Rather, our analysts must perform a deep dive to determine whether the company is a “serial acquirer.” Is this a one-time acquisition that integrates seamlessly into the parent company, or is this just one of a series of mediocre acquisitions used to aesthetically grow the top-line and obfuscate traditional performance metrics?  Read on....

gradient / Tag: forensic accounting, earnings quality, acquisition, 10-K, 10-Q, GAAP, non-GAAP, roll-up, cash flow / 0 Comments

Byron MacleodBy Byron Macleod, CFA
Associate Director of Research, Gradient Analytics LLC (a Sabrient Systems company)

Given that Gradient Analytics’ research is primarily focused on forensic accounting, this common client question falls into our sweet spot. However, the link between earnings quality concerns and share price underperformance can be difficult to assess for two reasons:

   1.  Investors and sell-side analysts tend to focus their attention on the income statement, but there is not always a predictable correlation between the highlighted balance sheet trends and the income statement impact.
   2.  Because management has a huge amount of discretion over how accounting entries are handled (including when to recognize built-up expenses, impairments, non-cash gains, etc.), earnings quality concerns often have ambiguous timing.

Thus, investors often are left wondering just how and when eroding earnings quality in their portfolio holdings – whether long or short – will ultimately impact their fund’s performance.

Nevertheless, to illustrate how such red flags may indeed lead to notable share price decline, I will describe three real-life examples. For compliance reasons, I won’t disclose their names, but will simply refer to them as Company A, B, and C. Read on....

Brent MillerBy Brent Miller, CFA
President & COO, Gradient Analytics (a Sabrient Systems company)

“Change is the law of life. And those who look only to the past or present are certain to miss the future.” – JFK

When evaluating the earnings quality of a given company, a forensic accounting firm like Gradient Analytics focuses on key indicators that may indicate that a company has taken liberties to cosmetically enhance its financial performance via aggressive revenue recognition and/or the understatement of expenses. Signals that a firm may be engaging in financial gamesmanship include:

  1. Divergence between reported earnings and free cash flow (i.e., an increase in accruals)
  2. Overstatement of assets
  3. Understatement of liabilities
  4. Negative or decelerating organic revenue growth
  5. Persistently widening gap between GAAP and non-GAAP EPS

In this article, I discuss a new amendment to the accounting standards that seeks to reduce inconsistencies and improve standardization of revenue recognition practices.  Read more...