Acquisition accounting gimmickry

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....

One key metric that provides some insight into this question is the company’s organic revenue growth rate (i.e. revenue growth ex acquisitions). If the company’s organic revenue growth rate is stagnant or declining, it is more likely a serial acquirer that is making use of an aggressive M&A strategy to obscure deterioration in its core operating performance. Consequently, we are more likely to classify such firms as operating under an aggressive roll-up or platform strategy.

Our classification of a company as operating under a platform strategy has several important implications. First, we are more likely to closely scrutinize their non-GAAP earnings adjustments. In particular, we may determine that restructuring, acquisition, and amortization expenses are part of a company’s core operating strategy and should not be excluded from non-GAAP earnings. Such adjustments have material earnings power and valuation implications.

Second, if we classify a company as a roll-up, we must analyze it on an adjusted free-cash-flow basis that considers cash paid for acquisitions. The reason is that through acquisitions, managers can essentially buy the firm’s working capital through this investing line-item. So, whereas an acquisitive firm’s working capital trends may look favorable on the cash flow statement, it may be a misleading metric as the cash paid for acquisitions progressively balloons.

As an example, let’s review an actual company where using an automated screener would not have been able to identify the accounting issues. Back in 2012, we looked at the filings for a company I will call “XYZ Corp.” In examining its 3Q 2012 10-Q, we found that the company had just recently acquired a private firm for $182 million. In the Business Combination/Acquisition footnote, we saw that that XYZ disclosed a warranty reserve of $9.9 million and long-term liabilities of $11.4 million. Curiously, it also disclosed (probably auditor-related) an excerpt about the acquired firm’s warranty guidelines – something rarely seen in this particular section. On its own, it might not have appeared to be out of place, but having read through hundreds of similar footnotes, our analysts recognized how rare and out of place such an excerpt really is.

Moving on to the firm’s 10-K release in the next period (year-end), we saw these two entries (warranty reserve and long-term liabilities) had been inflated in the same exact table to $10.6 million and $26.5 million, respectively (with the long-term liabilities entry changed to “long-term portion of warranty reserve”). The offsetting debit would be to goodwill. Furthermore, we found that the warranty excerpt noted earlier had tripled in size, detailing its warranty recognition process step by step.

So, what exactly was going on here and what could we deduce? The acquired firm was a private company, not subject to the same disclosures required of a publicly-traded company; however, it did publish some insights into its financials on its website. Specifically, the company disclosed that it had just recently passed the $100 million revenue mark as of 2012. So, we wondered, why would a company that does approximately $100 million in sales need a warranty reserve of about $37 million, or 37% of TTM sales?  

Remember that long excerpt detailed in the 10-K? Well, here we read, “[The firm] has experienced a significant number of warranty claims in one of its product lines.” A point that was not disclosed anywhere else by XYZ Corp. We could make two observations here that were both unfavorable outcomes for XYZ:  1) The acquired firm had a glut of future warranty claims that it will need to pay out, and/or 2) The acquired firm spring-loaded its warranty accrual before the acquisition so later on it could reverse it to create an aesthetic benefit to XYZ’s earnings subsequent to the acquisition. And while that would make earnings figures look good initially, what happens when this aesthetic benefit ends? The unsustainability of a one-time reserve reversal could eventually leave unsuspecting investors with an unwelcome surprise.

So, an examination of XYZ’s stock chart in mid-2013 and beyond (after this benefit annualized) showed that the firm had a dramatic drop in its share price. And while it may not be solely attributable to this warranty reserve accounting gimmick, experience tells us that management typically does not play games with its accounting when things are going great, but rather it is when there are significant headwinds that such gimmicks are employed.

To summarize, an accounting irregularity was uncovered in the footnotes of a financial statement, the discovery of which provided real value to investors. Gradient’s skilled analysts exhaustively read through filings to discern what was relevant and what was not. And as more sell-side analysts wise-up to these techniques to “manage” earnings, we expect senior management will continue to evolve new gimmicks for acquisition accounting and non-GAAP exclusions. And when they do, we too will evolve – and remain skeptical and vigilant.  While no analyst can provide complete assurance that all irregularities will be uncovered, an experienced team can help mitigate the risk.

Our nine-person analyst team spends most of its time reading through corporate filings in a search for accounting anomalies (something that cannot be easily automated), both to identify short candidates for its institutional clients and to vet long candidates for parent company Sabrient Systems. The reason the job of an accounting-focused analyst is not easy is because no one likes to do the dirty work of endlessly reading through 10-Ks, 10-Qs, and proxies. It reminds me of a quote I once heard, “Opportunities are usually missed by most people because they are dressed in overalls and look like hard work!”

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any opinions, commentary, rankings, or stock selections provided by Sabrient Systems or its wholly-owned subsidiary, Gradient Analytics. Neither Sabrient nor Gradient makes any representations that the techniques used in its rankings or analysis will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.