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

Special Purpose Acquisition Companies (SPACs) are publicly traded companies formed with the sole purpose of raising capital to acquire one or more unspecified businesses – which is why they are often called “blank-check” companies. They will often (but not always) have an espoused target market or desired exposure for which they are pursuing target companies, but little else in the way of visibility to indicate what an investor ultimately will own. The management team that forms the SPAC (the “sponsor”) funds the offering expenses in exchange for founders shares in the entity.

SPAC preference has been increasing in recent years as a way to get a private firm into public markets more expeditiously. We believe the change in preference likely tracks well to abundant liquidity, ultra-low interest rates, and lofty valuations in many equity markets. Therefore, we view the rash of SPAC deals announced this year as a cautionary signal that markets may have become overly speculative. The SPAC process can be instrumental in unlocking private “unicorn-style” valuations, and its rise in popularity is contemporaneous to growth in private equity demand. Furthermore, many of the headline-generating deals are principally based on a long growth runway into questionable TAM (total addressable market) estimations. However, the growing reliance on non-GAAP earnings and consistently unprofitable public companies illustrates that investors’ willingness to wait for a return appears greater than ever.

In this article, I highlight several considerations for evaluating SPAC investments both in the pre-target phase and following the release of audited financials. I discuss several recent adaptations of the SPAC model, branding and potential outcomes from the blank-check boom, and use South Mountain Merger Corp (SMMC) and its reverse merger with Billtrust as an example of how investors might recognize “creative accounting” tactics with limited financial disclosures. As Elon Musk recently tweeted, “Caution strongly advised with SPACs.”  Read on...

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

 “Only time can heal what reason cannot.” – Lucius Annaeus Seneca

In response to the pandemic-driven economic downturn, both Congress and the Federal Reserve have intervened with fiscal and monetary support in the form of direct subsidies, loans, bailouts, tax rebates, supplemental unemployment benefits, ultra-low interest rates, support of capital markets, reduced regulatory constraints, and quantitative easing (QE). The Fed expanded its purchase program beyond Treasury bonds to also include municipal bonds, corporate bonds of both investment and speculative grade, as well as ETFs for the first time. While these policies can raise aggregate demand, employment, and investment in the short run, excess liquidity also supports inefficient firms that otherwise might not survive. The increased prevalence of these firms, as well as the valuation metrics at which their stocks trade can muddy the waters for analysts and thus contribute to a misallocation of capital. These firms also weigh on productivity growth going forward.

Because the downturn was spurred by the pandemic rather than the typical overheated economy and inflation, it has yielded several surprises for investors. For instance, despite unemployment reaching record levels, consumers spent more than expected on home repairs and remodeling which boosted sales at stores like Home Depot (HD) and Lowe’s Companies (LOW). Likewise, residential home sales have surged despite escalating unemployment. An intuitive expectation of an inverse relationship between the two would be incorrect, at least thus far. Outperformance of online retailers, like Amazon.com (AMZN), over some traditional recessionary picks, like Procter & Gamble (PG), has also been unexpected. Moreover, this was the first recession that drove people to spend more time outdoors, giving a boost to firms like sports vehicle maker Polaris (PII). However, the question to ask is:  Is this burst of COVID-driven growth anomalous and short-lived, or is it sustainable?

Another aspect to highlight is the conjectural nature of forward estimates and current valuations. The wild swings in near-term consensus estimates between earnings cycles seem to be highly speculative and largely based on the latest news headlines rather than analysis of underlying firms’ fundamental metrics. Similarly, it appears that some previously struggling firms are getting an unsustainable boost by pivoting to create products that help customers deal with COVID-19 impacts. In this article, I explore examples of two firms for which analysts anticipate rising near-term growth rates specifically driven by COVID-19 related tailwinds that we do not believe are sustainable longer-term. Read on....

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

At times, there are conflicts of interest between a company’s management and its investors, specifically shareholders, which creates a structural agency problem. So, it is common for companies to try to align the monetary interests of management with shareholders by awarding a large part of executive compensation in equity. As a result, management performance metrics often create an incentive to present the current period financials in the best light possible, even if it is unsustainable in the longer-term. This dynamic creates opportunities for a forensic accounting firm like Gradient Analytics, which specializes in assessing the quality of reported earnings of publicly traded companies to both vet long candidates and to identify short candidates.

An astute investor might ask the perfectly reasonable question, “If publicly traded companies are regulated and audited, then aren’t all reported earnings of passable quality?” However, consider that it is possible for a company to engage in “earnings management” by publishing financial statements that may mislead investors as to the firm’s true financial health without violating accounting standards. Moreover, we would argue that even though two given companies both followed GAAP accounting standards and received clean opinions from their auditor, earnings growth at Company A may be dramatically more sustainable than at Company B. Of course, it can be quite valuable for an investor to know when a firm is showing signs of unsustainability in its reported earnings growth.

In this article, I use three real-life examples to provide a high-level overview of our analysis process, which includes assessing earnings quality, anomalous insider trading activity, audit control risk, and corporate governance. Although Gradient does not employ a team of investigative journalists to knock on doors, interview company employees, or rummage through the trash for evidence, our comprehensive analysis of the published financial statements (and, importantly, the footnotes) can help stack the odds a little bit more in investors’ favor.  Read on....

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

As interest rates remain at historic lows, mergers and acquisitions (M&A) have soared in recent years. With the rise in M&A activity comes a rise in accounting complexity, introducing a plethora of ways that management can cosmetically improve their as-presented results – and mislead investors. Gradient Analytics specializes in forensic accounting analysis that helps to uncover these types of financial shenanigans, including overstated assets and revenues, understated liabilities and expenses, and weakening earnings quality. This type of analysis is useful for both vetting long positions and generating short ideas.

In this article, I describe four acquisitions that we believe were used to obscure underlying financial weakness at the parent company by temporarily shoring up growth and earnings. Key takeaways are how management can utilize acquisitions, purchase price accounting, and non-GAAP adjustments to optically improve their as-presented results. In each case, the theme will remain consistent: the acquiring company was under fundamental business stress.

The subject transactions include:

• SodaStream (SODA) acquisition of its distributors in 2012 and 2013
• SNC-Lavalin (SNC) acquisition of WS Atkins in 2017
• Belden Inc. (BDC) acquisitions in 2017 and 2018
• The Walt Disney Corporation (DIS) acquisition of 21^st Century Fox in 2019

Read on....

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

In any given quarter for almost every company, there is often a swirling vortex of different signals as to the long-term health and future opportunities for each particular firm. Within this conflux of signals, there are two that often cause investor stress and confusion when they contradict each other: the firm’s GAAP versus non-GAAP earnings.

The simple rubric that often comes to mind is that GAAP earnings are the more conservative figure for the firm [as these accounting standards are closely monitored and controlled by a governing board, the Financial Accounting Standards Board (FASB)], while its non-GAAP earnings are the more optimistic view (after being heavily tweaked and adjusted by management). However, this assumption does not always hold true. Often, a firm’s non-GAAP results will be the more accurate representation of its historical earnings power.

Although Gradient Analytics specializes in forensic accounting research and consulting to identify weak earnings quality for short idea generation, our expertise is also valuable for identifying solid earnings quality for the vetting of long candidates, as we discussed in a previous article. And with the impacts of the coronavirus still working their way through both the US and global economies, it is a certainty that the next twelve months of corporate financial reports will be littered with a variety of non-GAAP adjustments that will need to be deciphered.

With this flood of adjusted earnings about to hit the market, we felt it would be a good time for some examples to illustrate that not all non-GAAP adjustments are created equal, and although investors need to carefully consider when and how they use non-GAAP results, often they may be better served by focusing on non-GAAP earnings.  Read on....

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

“Every man hears only what he understands.” – Goethe

Often, details in the financial statements hold the key to understanding a company. Here at Gradient Analytics, we specialize in forensic accounting research and consulting, and our analysts stay up-to-date on changes in the regulatory landscape, including crucial updates to disclosure requirements. Normally, we focus research on areas that might tempt companies to “manage” or overstate earnings, either by pulling forward future revenues or pushing out current expenses. Layer on more complexity from changing reporting requirements and it becomes clearer how a vital piece to the puzzle might slip through the cracks.

Below, I cover three broad topics. First, effective January 1, 2020, the governing accounting boards updated the very definition of a business. This new definition has multiple implications for reporting, but my focus in this article is the impact on M&A transactions. Moreover, this year both the Financial Accounting Standards board (FASB) and the International Accounting Standards Board (IASB) changed required disclosures for U.S. and international companies. Among other things, there is a new method for determining appropriate loan loss reserves, and there will soon be a requirement for companies to stop using Inter-Bank Offered Rates (IBOR) as reference rates, instead switching to Alternative Reference Rates (ARR). I describe these updates with four real-life examples of how they shape financial statements, with the potential to mislead investors. Read on….

  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 quality 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….

  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….

By 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....