Barron\'s - 09.09.2019

(Kiana) #1

orporate accounting practices can complicate earnings reports, but investors


ed to look out for outliers. ByAlRoot


TheNumbersGames


ThatCompaniesPlay


taking inadequate depreciation expense.


“There are so many types of aggressive (but


not fraudulent) accounting practices to choose


from,” he says.


Let’s look at five:


Excessive capitalization of “period” costs


Thismeansthatacompanyistreatinganexpense


likeacapitalasset—puttingexpensesonthebalance


sheet and spreading the recognition over many


years;inotherwords,depreciatingregularspend-


ing as if it were a building, factory, or a machine.


ThepracticeisonereasonthatshortsellerBen


Axler of Spruce Point Capital Management took


aim at precision-measurement-equipment maker


Mettler-Toledo International (MTD) in July.


Mettler disclosed in 2008 that it was capitalizing


somespendingonnewsoftwaresystems,aproject


the company calls Blue Ocean. So, instead of a


chargeagainstearnings,thecompanycreatedan


assetonitsbooks Thisisallowedbygenerallyac


atedalotoflittleexpensesformanyyears.Axler


believesthatthesoftwareprojecthasbeengoing


on too long—Mettler still talks about Blue Ocean


on earnings conference calls—and the accounting


treatmentisbeingusedtosmoothoutfluctuations


inearnings.Mettlerhasn’tmissedWallStreetana-


lyst earnings estimates as far back as 2008.


“WestronglydisagreewithSprucePoint’sself-


serving report, which is filled with inaccurate and


misleading claims,” a Mettler spokeswoman tells


Barron’s .Sheaddsthatthetotalamountofmoney


spentonsoftwarethathasbeencapitalizedonthe


balancesheetisdisclosed.Itamountsto“$471mil-


lion, which includes our Blue Ocean program.


Accounting reserves


Accountingis“accrualbased,”meaningthatcom-


paniesrecognizeexpensesandincomeevenifcash


isn’tcomingin(orgoingout)thedoor.Companies,


accordingtotherulessetters,aresupposedtodo


theirbesttomatchallexpensesintheperiodwhen


they occur. So companies take reserves—or non-


cashexpenses—forthingslikewarranties,product


returns, and even bad debts.


When a car is built, for example, the auto


maker recognizes an expense when it is shipped


to a dealer for future warranty claims. It repre-


sents the company’s best guess for required re-


pairs and recalls. The actual cash outflow for war-


ranty repairs happens far in the future and


doesn’t affect earnings when the cars are actually


in the shop.


Makingminoradjustmentstosuchreservesis


one way to save money for a rainy day—or for a


bad quarter. That’s why reserves like those de-


scribedaresometimescalled“cookiejar”reserves.


Such adjustments can sometimes send the


wrongmessageaboutearnings.Ifearningsnum-


bersaredrivenmorebyfluctuatingaccrualsthan


the health of the underlying business, that’s an


issue for investors.


Adjustments to earnings


S&P 500 companies reported $1.4 trillion in ad-


justedprofitsfor2018.Thenumberrecordedusing


GAAP was closer to $1.2 trillion. The $200 billion


differenceisn’tsmallandismadeupof“abnormal”


items, like restructuring charges and other gains


and losses that are excluded from numbers that


companiesprefertopresentbecausetheyaresup-


posed to be nonrecurring.


Someadjustmentstoearningsareprobablyin-


evitable.Thegap,however,betweenadjustedearn-


ingsandGAAPnumberisgrowing.In2016,thedif-


ference was closer to $60 billion.


Appliancemaker Whirlpool (WHR)usesearn-


ingsnetofrestructuringexpenseswhenitreports


earnings.Inthesecondquarterofthisyear,forin-


stance, the company reported $4.01 in per share


earningsonan“ongoing”basisand$1.04pershare


accordingtoGAAP.Includedinthedifferencewas


$60 million in restructuring spending.


Overthepastfiveyears Whirlpoolhasrecorded


“Thereare


somany


typesof


aggressive


(butnot


fraudulent)


accounting


practicesto


hf



RE’S A LITTLE SECRET THAT ISN’T SO SECRET ON


llStreet:Companiesliketodressuptheirearn-


s statements.


Itisn’tsomethingnefariousorillegal.Accepted


ounting practices allow companies at times to


sentnumbersthat,whileaccurate,maynotpro-


e the clearest picture to investors.


A debate over corporate accounting practices


emergedwiththeallegationsbroughtbyforen-


accountant Harry Markopolos, who says that


neralElectric (ticker:GE)hasbeenmisrepre-


ntingthehealthofitslong-termcareinsurance


iness.GEhasrejectedhisclaimsas“meritless.”


hers have said his analysis was simplistic.


What’s the lesson here?


When it comes to accounting issues, investors


ed to learn to ask the right kinds of questions


dlookintherightplacesinthefinancialstate-


nt.


AccountingexpertRobertWillenssaystolookin


ticularforcompaniesusingexcessivecapitaliza


ings reported and $2.5 billion in total


GAAP earnings reported. The differ-


encesraiseanimportantquestionforin-


vestors:Whichnumbersarebestusedto


value the company? If restructuring


doesn’t end, it makes sense to include


charges on ongoing earnings.


Whirlpooldidn’trespondtorequests


for comment.


Depreciation


Ifacompanylengthenstheusefullifeof


an asset, then the annual depreciation


charge for that asset shrinks. There


might be good reason to lengthen an


asset’susefullife,suchasbettermainte-


nance or higher quality goods, but the


consequenceisthatthedepreciationex-


pense shrinks.


Keurig Dr Pepper (KDP) increased


the maximum useful life for buildings,


machinery, and customer relationships


from 2014 to 2018. The company as-


sumed that its capital assets would last


longer today than in the past. There is


no way to calculate the precise effect


that changing useful-life assumptions


has on earnings, and, of course, auditors


sign off on changing assumptions. Still,


even subtle changes could affect re-


ported earnings by shrinking deprecia-


tion expenses and shifting the costs into


later years.


Keurigdidn’trespondtorequestsfor


comment about useful-life assumptions.


Pension accounting assumptions


Pensions are another area where a com-


pany has discretion over important as-


sumptions. And it’s complicated.


Companies make assumptions about


interestrates,andwageinflation,aswell


asexpectedstockmarketreturns.Itisn’t


easytogeneratea“pensionexpense”for


financial reports. What’s more, calcula-


tions required by pension oversight au-


thorities are different than calculations


required by accountants.


There are literally two sets of books


for pensions: one widely available to in-


vestors and one required by regulators.


Twenty-nine companies in the S&P


500 increased assumptions for pension


assetreturnsfrom2016to2018.Higher


returns on pension assets means more


moneymadeand,therefore,lessmoney


requiredtobeputintotheplantocover


retiree benefits. The pension expense


comes down—increasing reported earn-


ings per share.


These are just five examples. It


should be a flag for investors when a


co p n o g o pofco p nie h n


McKesson, AT&T, and D.R.


Horton are now relatively


cheap and showing signs of


improvement. ByJackHough


3Stocks


Forthe


Impatient


U.S. INTEREST RATES ARE HEADED FROM


low to lower, and momentum stocks are


again racing past cheap ones. An investor


who put money into the 10 best three-


month performers in the S&P 500 index


at the end of last year is up 32% so far


this year. That compares with 12% for an


investor who bought the 10 stocks with


the lowest forward price/earnings ratios.


So why not go all-in on momentum?


Too risky. When momentum stops work-


ing, investors can find themselves loaded


up on expensive shares or sector bets.


Three of the top four performers over the


past three months through August are


semiconductor companies. The fourth, the


bond trading platform MarketAxess


Holdings (ticker: MKTX), is growing


earnings per share at a midteens rate


and trades at 73 times forward earnings


estimates.


Here’s a safer approach:Search for


inexpensive stocks with a dash of recent


price momentum. Investors who do so


won’t find the absolute lowest valuations


or the top performers. But they may un-


cover some flawed companies that are


showing signs of improvement, while


avoiding perpetual turnaround candidates


that never seem to make good.


Think of this as a screen for impatient


value investors; ours recently turned up


McKesson (MCK), AT&T (T), and D.R.


Horton (DHI).


McKesson is the largest U.S. drug


distributor, delivering a third of the pre-


scription medicines in North America.


Five years ago, the stock traded at a pre-


mium to the S&P 500 relative to earnings.


Today, at less than 10 times earnings, it


trades at a 40% discount to the market.


One e on i th t polic ke e


Amazon.com (AMZN) shows signs of


interest in the drug trade. At the same


time, litigation over opioid deaths could


cost manufacturers, distributors, and re-


tailers billions of dollars.


To the first two points, McKesson


operates dozens of distribution facilities


and repackaging centers and has operat-


ing margins below 2%—not an obvious


target for a profitability crackdown or


new competition. Free cash flow of about


$3 billion a year should be enough to


cover legal settlements. Revenue growth


last quarter was strong, giving shares a


boost. An opioid settlement over the


next year could lift more worry.


AT&T combines thriving wireless and


business wireline services with weakness


in entertainment and DirecTV, which is


losing subscribers. The company has a


long-term plan to replace satellite-TV


installations with a self-installed, An-


droid-powered video box that hooks into a


standard broadband line. Later this year,


it will give more details on a planned


ThreetoGo


Stocks that look cheap and have some price


momentum.


3-Month
Recent Price Forward
Company/Ticker Price Change P/E

AT&T / T $35.87 13.5% 9.


D.R.Horton / DHI 50.27 13.7 11.


McKesson / MCK 142 79 10 2 9 8


streaming service for WarnerMedia,


which could bundle HBO service.


For now, investors should watch the


big picture. AT&T stock comes with a


5.7% dividend yield, funded by a free-


cash yield of about 10.5%. That leaves


enough for investments in the wireless


network and streaming content, along


with debt reduction in coming years. A


debt falls, investors are likely to warm


the dividend—especially when 10-year,


high-quality corporate bonds are paying


about 3.2%.


D.R. Horton beganExpress Homes,


focused on building value-priced houses


five years ago; today, the business ac-


counts for over 30% of its houses sold.


That gives Horton a first-mover advan-


tage among its peers in what could pro


to be an attractive part of the market f


years to come.


Millennials of prime house-buying ag


will peak in six years at 29 million—thre


million more than the baby boomer peak



  1. Falling mortgage rates are helping


with affordability. In an April survey by


Bank of America Merrill Lynch, 64% of


millennials said they were extremely, ver


or somewhat likely to buy a house in the


next two years, up from 53% a year earl


Near the end of July, Horton reporte


third-quarter house sales and profit ma


gins that both exceeded estimates, and


shares jumped nearly 6% in response.


The di idend ield i 12% nd the co

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