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

The very nature of borrowing shares, securities lending, and short selling is opaque. During recent equity events, existing reporting procedures exacerbated the misperception of short interest levels and influenced the intentional short squeeze mechanics. Without rehashing what has been discussed at length, written about, and even chronicled in film, the SEC has been put in a difficult – but not unmanageable – position to “do something” about nefarious practices among some powerful short sellers. As a result, the SEC is proposing Rule 10c-1 under the Exchange Act, which would require any person who loans a security on behalf of itself or another person (Lender) to provide the specified material terms of their securities lending transactions to a registered national securities association (RNSA).

While the proposal impacts many asset classes, the securities lending market is dominated by US equities, and we focus on those impacts here at Gradient Analytics. Our clients look to us for differentiated short ideas built on a foundation of earnings quality concerns. Along with other liquidity measures, Gradient has always been mindful of short interest, not only to avoid crowded short trades but also to provide fresh ideas to our institutional clientele. If anything, we believe our research will stand to benefit from increased transparency, which demands greater effort to find actionable short ideas.

There are many items on SEC chairman Gary Gensler's agenda, and this may simply be the “topic of the day.” Indeed, we believe the short-seller bogeyman fits well with other recent demands – including a congressional stock trading ban, forced ESG investment, and T+0 (i.e., same-day) settlement of security transactions. In the interim, we looked at the proposal and came away with several thoughts, many of which one also might find in the comment section of the SEC website.  Read on…

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

A common misconception is that accounting figures are always black and white, i.e., well known and precise. But in practice, there are many ways that the estimates and subjective judgement of management can color financial statements. Recent amendments to accounting standards address specific examples when companies have applied prior accounting guidelines differently from their peers. When this occurs, analysts are unable to compare accounting figures across companies without additional analysis. Further, differing accounting methodologies coupled with opaque disclosures may prevent analysts from ascertaining an accurate apples-to-apples comparison.

Here at Gradient Analytics, we specialize in forensic accounting research and consulting, and our analysts stay current on changes in the regulatory landscape, including crucial updates to disclosure requirements. Normally, we focus research on areas in which companies might be tempted 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.

In this article, I provide details on updates to four accounting standards – and how they may shape financial statements with the potential to mislead investors. First, several Interbank Offered Rates (IBORs) ceased to exist at the end of 2021, and countries are transitioning to alternative reference rates. Second, the International Accounting Standards Board (IASB) revised guidance such that companies no longer may deduct certain items from the cost of property, plant, and equipment (PPE). Third, the IASB now requires that a proportion of production overhead must be included when reporting so-called “onerous contracts.” And fourth, the Financial Accounting Standards Board (FASB) issued a proposal to eliminate accounting for loans in modification through troubled debt restructurings.  Read on....

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

 At Gradient Analytics, we spend a significant amount of our time analyzing financial statements and looking for accounting irregularities (or shenanigans) and signs of misleading “financial engineering.” When we find a firm employing aggressive accounting tactics, we often notice that they operate in industries that are undergoing significant change or are in secular decline. This makes sense, considering that companies in such industries tend to exhibit declining top- and bottom-line growth rates. By applying aggressive accounting assumptions, management can temporarily juice both sales and earnings growth.

However, just because a company operates within an industry in secular decline does not necessarily mean it will struggle to grow. The stronger players often can accumulate greater market share and prosper, while the weaker players lose market share and fade away.

In this article, I provide a cursory overview of ten industries that we believe are in secular decline and opine on some of their constituents – highlighting a few that we think may thrive and a few that we think will struggle.  Read on…

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

The software industry is rapidly adopting a Software-as-a-Service (SaaS) subscription model, which tends to drive higher lifetime customer values, and lower volatility in revenue and earnings growth compared to the traditional software licensing model. SaaS companies, which provide their software on a subscription basis via the cloud, have grown at a rapid pace in recent years. Moreover, they are poised to continue their strong growth trajectory as more enterprises adopt cloud-based services. And yet according to Synergy Research Group, SaaS revenue accounted for only about 23% of the total software market in 2019 despite growing 39% YOY and eclipsing $100 billion in annual sales, as shown below in Chart 1.

Chart 1. Enterprise SaaS Market Growth

The relatively low penetration rate of SaaS models implies that there is plenty of runway left for increased adoption. Unfortunately, when companies migrate toward a subscription billing model, financial transparency diminishes as the financial statements are impacted by the change. For example, sales growth tends to decelerate and cashflows tend to decline. These trends can be misconstrued as a sign of a financial distress when instead the company is rapidly growing while transitioning its billing model. However, sometimes the distress is real.

Given the benefits and the relatively low penetration rate of SaaS models, we believe that software providers will increasingly migrate towards a subscription model going forward. Therefore, we likely will continue to observe software companies reporting decelerating growth and deteriorating cashflows during the migration. However, we also must be on the lookout for companies that are under fundamental pressure and are using the SaaS migration explanation to disguise growth and cashflow headwinds.

In this article, I attempt to discern between these two possibilities. First, I describe how transitioning from a licensing sales model to a subscription billing model can impact a software company’s financial statements. Then, I examine two different companies that have undergone a SaaS billing model transition – Adobe Inc. (ADBE) and MicroStrategy Inc. (MSTR) – and point out key differences between them that can help investors differentiate between an apparent slowdown in sales caused by a successful SaaS transition and an actual slowdown caused by fundamental headwinds. In my view, ADBE is an example of a successful SaaS transition, while MSTR is an example of a company that was struggling to grow sales all along but temporarily disguised these issues as a “normal” transition. I conclude by applying the same analysis to Splunk (SPLK), which is in the midst of its own transition to a SaaS billing model.  Read on...

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

Here at Gradient Analytics, our focus extends far beyond domestic equity research. We are known to cover an extensive group of publicly traded companies whose shares trade on a wide variety of stock exchanges around the globe. Our team of analysts must be vigilant in keeping up to date on new accounting standards issued by both the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). More importantly, our team must be able to understand and reconcile the key differences between United States Generally Accepted Accounting Principles (US GAAP) and International Financial Accounting Standards (IFRS) in order to accurately assess a firm's financial health.

The ability to distinguish between these accounting standards has become a crucial skill for investors as IFRS has become increasingly prevalent in recent years. Today, more than 140 countries worldwide (including the United States in some cases) either permit or require the use of IFRS for publicly listed companies. In fact, there are only three major capital markets that don't currently mandate the use of IFRS for publicly traded firms: Japan, China, and the United States. Since 2010, when Japan added IFRS to its list of approved standards for domestic issuers, more than a third of companies traded on the Tokyo Stock Exchange have either adopted or instituted a plan to adopt IFRS in the near future. China continues to amend its accounting standards to broadly align with IFRS. Furthermore, domestic investors must also be mindful of the variations between accounting standards as the SEC allows foreign issuers to report under IFRS despite trading on US exchanges.

In 2002, the FASB and IASB entered into the "Norwalk Agreement," which aimed to eliminate the many variations between US GAAP and IFRS. Since then, the boards have worked together to issue several accounting standard updates in an attempt to enhance the consistency and comparability of global accounting standards. Despite these ongoing efforts, many key dissimilarities remain between the two standards that present a number of obstacles to investors. This article uses earnings quality and fundamental perspectives to discuss key challenges while providing tips on evaluating a firm’s true earnings power.  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….