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The Earnings Season: "House Of Cards"

Tyler Durden's picture




 

Submitted by Lance Roberts of STA Wealth Management,

Just like the hit series "House Of Cards," Wall Street earnings season has become rife with manipulation, deceit and obfuscation that could rival the dark corners of Washington, D.C. From time to time I do an analysis of the previous quarters earnings for the S&P 500 in order to reveal the "quality" of earnings rather than the "quantity" as focused on by Wall Street.  One of the most interesting data points continues to the be the extremely low level of "top line" revenue growth as compared to an explosion of the bottom line earnings per share.  This is something that I have dubbed "accounting magic" and is represented by the following chart which shows that since 2009 total revenue growth has grown by just 31% while profits have skyrocketed by 253%.

As I have discussed previously:

"Since 2000, each dollar of gross sales has been increased into more than $1 in operating and reported profits through financial engineering and cost suppression.  The next chart shows that the surge in corporate profitability in recent years is a result of a consistent reduction of both employment and wage growth.  This has been achieved by increases in productivity, technology and offshoring of labor.  However, it is important to note that benefits from such actions are finite."

As we enter into the tsunami of earning's reports for the first quarter of 2014, it will be important to look past the media driven headlines and do your homework.  The accounting mechanizations that have been implemented over the last five years, particularly due to the repeal of FASB Rule 157 which eliminated "mark-to-market" accounting, have allowed an ever increasing number of firms to "game" earnings season for their own benefit.  

This was confirmed in a recent WSJ article which stated:

"If you believe a recent academic study, one out of five [20%] U.S. finance chiefs have been scrambling to fiddle with their companies' earnings.

 

Not Enron-style, fraudulent fiddles, mind you. More like clever—and legal—exploitations of accounting standards that 'manage earnings to misrepresent [the company's] economic performance,' according to the study's authors, Ilia Dichev and Shiva Rajgopal of Emory University and John Graham of Duke University. Lightly searing the books rather than cooking them, if you like."

This should not come as a major surprise as it is a rather "open secret." Companies manipulate bottom line earnings by utilizing "cookie-jar" reserves, heavy use of accruals, and other accounting instruments to either flatter, or depress, earnings.

"The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big "restructuring charge" that would otherwise stand out like a sore thumb.

 

What is more surprising though is CFOs' belief that these practices leave a significant mark on companies' reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study's respondents said it was around 10% of earnings per share."

 

Of course, the reason that companies do this is simple: stock based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. A "miss" of Wall Street expectations can lead to a large penalty in the companies stock price. 

As shown in the table, it is not surprising to see that 93% of the respondents pointed to "influence on stock price" and "outside pressure" as the reason for manipulating earnings figures.

Note: For fundamental investors this manipulation of earnings skews valuation analysis particularly with respect to P/E's, EV/EBITDA, PEG, etc. Revenues, which are harder to adjust, may provide truer measures of valuation such as P/SALES and EV/SALES.

So, as we head into earnings season, it is important to be aware of what is real, and what isn't. Wade Slome brought this into focus recently via the Investing Caffeine blog: where he pointed out four things to look for:

"Distorted Expenses: If a $10 million manufacturing plant is expected to last 10 years, then the depreciation expense should be $1 million per year. If for some reason the Chief Financial Officer (CFO) suddenly decided the building would last 40 years rather than 10 years, then the expense would only be $250,000 per year. Voila, an instant $750,000 annual gain was created out of thin air due to management’s change in estimates.

 

Magical Revenues: Some companies have been known to do what’s called 'stuffing the channel.' Or in other words, companies sometimes will ship product to a distributor or customer even if there is no immediate demand for that product. This practice can potentially increase the revenue of the reporting company, while providing the customer with more inventory on-hand. The major problem with the strategy is cash collection, which can be pushed way off in the future or become uncollectible.

 

Accounting Shifts: Under certain circumstances, specific expenses can be converted to an asset on the balance sheet, leading to inflated EPS numbers. A common example of this phenomenon occurs in the software industry, where software engineering expenses on the income statement get converted to capitalized software assets on the balance sheet. Again, like other schemes, this practice delays the negative expense effects on reported earnings.

 

Artificial Income: Not only did many of the trouble banks make imprudent loans to borrowers that were unlikely to repay, but the loans were made based on assumptions that asset prices would go up indefinitely and credit costs would remain freakishly low. Based on the overly optimistic repayment and loss assumptions, banks recognized massive amounts of gains which propelled even more imprudent loans. Needless to say, investors are now more tightly questioning these assumptions. That said, recent relaxation of mark-to-market accounting makes it even more difficult to estimate the true values of assets on the bank’s balance sheets."

For really short term focused traders none of this really matters as price momentum trumps fundamentals. However, for longer term investors who are depending on their "hard earned" savings to generate a "living income" through retirement, understanding the "real" value will mean a great deal. Unfortunately, there are no easy solutions, online tips or media advice that will supplant rolling up your sleeves and doing your homework. 

As the WSJ article concludes:

"The CFOs in the study named and ranked several red flags.

 

First and foremost, investors should keep an eye on cash flow: Strong earnings when cash flow deteriorates may be a sign of trouble. The advantage of this approach is that, unlike some of the other warning signs, it is easily measurable, arming the investors and analysts who do their homework with strong ammunition against management.

 

Secondly, stark deviations from the earnings recorded by the company's peers should also set off alarm bells, as should weird jumps or falls in reserves.

 

The other potential problem areas are more subjective and more difficult to detect. When, for example, the chief financial officers urge stakeholders to be wary of 'too smooth or too consistent' profits or 'frequent changes in accounting policies,' they are asking them to look at variables that don't necessarily point at earnings (mis)management.

 

As the quarterly ritual of the earnings season approaches, executives and investors would do well to remember the words of the then-chairman of the Securities and Exchange Commission Arthur Levitt in a 1998 speech entitled "The Numbers Game."

 

'While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.'"

Couldn't have said it better myself.

 

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Mon, 04/21/2014 - 19:34 | 4681146 Slave
Slave's picture

Fuck this, just print moar. Numbers getting bigger = wealth getting bigger.

Mon, 04/21/2014 - 19:37 | 4681156 knukles
knukles's picture

Its all thanks to the miracle of lower health premiums, greater, broader health insurance coverage, falling hospital and doctor costs and happier, healthier plebes courtesy of ObieCare, Bitchez

Greenshoot!
Blowjobs all around, boys! 

Mon, 04/21/2014 - 19:53 | 4681198 Pure Evil
Pure Evil's picture

I'd buy that (blowjob) for a dollar.

Mon, 04/21/2014 - 20:50 | 4681306 max2205
max2205's picture

Just face it....this market is going a lot higher before they tank it....

Mon, 04/21/2014 - 21:11 | 4681338 Soul Glow
Soul Glow's picture

Yeah, sure.  Use triple leverage at the top and see what happens.

Mon, 04/21/2014 - 20:50 | 4681308 OpenThePodBayDoorHAL
OpenThePodBayDoorHAL's picture

If you like your BJ you can keep your BJ

Mon, 04/21/2014 - 22:11 | 4681489 Ban KKiller
Ban KKiller's picture

And...shity cocaine cut with baby lax! The article is the banksters playbook.

Mon, 04/21/2014 - 19:40 | 4681162 stocktivity
stocktivity's picture

It's all Bullshit!!!

Mon, 04/21/2014 - 19:54 | 4681202 knukles
knukles's picture

Dissident

Mon, 04/21/2014 - 22:54 | 4681578 Slave
Slave's picture

It's all Bullish!!!

 

FTFY

Mon, 04/21/2014 - 19:35 | 4681153 TeamDepends
TeamDepends's picture

GAMAP:  Generally Accepted Magic Accounting Principles

Mon, 04/21/2014 - 19:44 | 4681171 dirtyfiles
dirtyfiles's picture

what's earnings?

Mon, 04/21/2014 - 19:48 | 4681185 Winston Churchill
Winston Churchill's picture

Seems fraud is the best growth industry, does it have a ticker symb.?
Hard to imagine where those earnings came from, only so
much overhead you can cut.
COGS may have remained flat at the expense of wages, whilst materials rose.
Oh wait we don't make anything anymore except weapons,financial or military.
Stawks overvalued by 250% at least.
Different this time no doubt.

Mon, 04/21/2014 - 19:51 | 4681196 buzzsaw99
buzzsaw99's picture

it is the cfo's job to maximize the ceo's bonus. duh.

Mon, 04/21/2014 - 20:06 | 4681216 Caveman93
Caveman93's picture

Now, I may not be the smartest man in the room, but do my eyes deceive me? Looking at the Largest Historical Gap of Profits to Employees Chart...was the last time there was NO gap REALLY in 2008 when we had a "correction"? Must we why they call those events "corrections". I guess they decided to fix the correction so all is well now? OMG! My head is going to pop off in 3...2....

Mon, 04/21/2014 - 20:17 | 4681239 SmilinJoeFizzion
SmilinJoeFizzion's picture

I'm "profitable"too, Ex-Items

Mon, 04/21/2014 - 21:02 | 4681331 Seasmoke
Seasmoke's picture

Mark to Fantasy. 

Mon, 04/21/2014 - 21:07 | 4681341 Ignorance is bliss
Ignorance is bliss's picture

Layoffs = increased bottom line

Mon, 04/21/2014 - 21:32 | 4681402 Soul Glow
Soul Glow's picture

Corporations are bastards.  I hope they all die painful deaths.

Mon, 04/21/2014 - 23:01 | 4681592 El Hosel
El Hosel's picture

Cook the books, rig "the Market" Reaction, disregard the dead Banksters... Pass the apple pie.

Tue, 04/22/2014 - 03:03 | 4681872 caustixoid
caustixoid's picture

Such a great example of the psychopathic elites.  "House of Cards" that is, not your graphs.

Tue, 04/22/2014 - 03:47 | 4681896 mumbo_jumbo
mumbo_jumbo's picture

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