IPG Photonics – charts up to Q1 2015

Disclosure – I’m long IPG Photonics Corporation (IPGP).

There are a few remarks about particular issues, but I mostly let the charts speak for themselves. My sources are the SEC filings and the press release “IPG Photonics Reports First Quarter 2015 Revenue Growth of 17%” on IPG’s site.

Charts of quarterly data

In the first chart, for Q2 2015 “Net sales”, I used the figures for “revenue” in the guidance ($215 million to $225 million). “Revenue” is likely to mean the same as “net sales” because the earnings release gives similar figures for Q1 2014 “Revenue” and “Net sales” ($170.6 million and $170,575 thousand).

IPG results to Q1 2015 bars and line

In the short period charted, I’d say Q2 and Q3 look strong, but the 10-K for 2014 has –

    “Historically, our net sales have been higher in the second half of the year than in the first half of the year.”

IPG results to Q1 2015 stacked

IPG EPS to Q1 2015

IPG EPS growth to Q1 2015

I have not charted quarterly Other Comprehensive Income, but annual charts further down show a big OCI loss for 2014 due to “translation adjustments”, i.e. the effect of changing exchange rates on the U.S. dollar value of assets and liabilities. For Q1 2015, the OCI loss was $38,276 thousand, leaving comprehensive income of only $19,070 thousand.

Cash flow charts

In the cash flow charts below, cash from operations includes variation in current assets and liabilities, particularly inventories, accounts receivable and accounts payable. If I’d also shown cash from operations without those movements (still with depreciation, stock-based compensation, etc. added back to net income), the resulting chart might look smoother, but it’s a lot of work.

For some companies, it would be essential to use capex rather than cash invested, because cash put into short term investments is more like parking cash for a while than an investment in the company’s operations. Some long term investments can also have little to do with investing in operations.

In IPG’s case, there were “Purchases of short-term investments” of $25,451 thousand in 2011, and exactly the same amount was “Proceeds from short-term investments” in 2012, due to the investments maturing. (Financial activity in 2012 included a stock offering, a special dividend, and buying out a minority interest.) As a result of the short-term investment, the investment flow I’ve used overstates the cash invested in IPG’s operations in 2011, and understates by the same amount in 2012. I only use the charts to get a general impression and I’m not concerned by shifting a portion of old investment by a year.

The short-term investment accounted for 32.2% of the investment flow in 2011, and 46.1% in 2012. There were no purchases or proceeds from short-term investments in other years from 2009 to 2014. In 2013 there were “Proceeds from sale of investment”, but only worth $495 thousand.

For comparison, Net cash used in investing activities rose from $10,639 thousand in 2009 to $90,080 thousand in 2014.

The cash invested is dominated by investment in the company’s operations. “Purchases of property, plant and equipment” accounts for most of the investment flow ($88,601 thousand, or 98.4% in 2014). There’s also “Acquisition of businesses, net of cash acquired”, which hit $11.6 million in 2012, the highest amount in the past six years, and the “Purchase of intangible assets” of $2 million in 2014 also counts as an investment in the company’s operations.

IPG cash from ops against cash into investment

IPG cash from ops against cash invested per share

A more conventional chart of cash flow per share –

IPG cash from ops and cash invested per share

This chart is logarithmic, so the slope of a line corresponds to the compound growth rate –

IPG logarithmic cash flow - to 2014

The charts for growth in OCF between any two years are probably understood best if I show the spreadsheet first. Although there’s no “2014”, the table is up to date, for example the bottom row is for 2013, the only entry is “49.6%” in the column for 1 year ahead, and the increase from 2013 to 2014 was 49.6%. The figure in the top right shows growth of 30.2% (CAGR) between 2004 and 2014.

IPG CAGR CFO per share - spread

IPG CAGR CFO per share by year

Sometimes growth over five years is used as a metric. In the chart below, find the columns grouped above “5”, and you can see that growth measured over the previous five years has been over 20% for each of the past five years, i.e. for 2004 to 2009, 2005 to 2010 … up to 2009 to 2014.

IPG CAGR CFO per share by number of years

Sales, costs and profit charts

In some cases I’ve used a stacked and a non-stacked chart of the same data. If any subjective bias results from the way a chart represents data, a different type of chart might not produce the same bias.

In order to get the stacked charts, I needed to change the sign of expenses, which are negative in the 10-Ks (as indicated by brackets). For some years in some stacked charts there will be minor distortion due to the inclusion of a negative quantity, for example “Interest expense (income)” has mostly negative figures, but the absolute amounts have declined from about 5% of net sales in the early years, to 0.01% in 2014.

I changed some item-names, e.g. “OTHER INCOME (EXPENSE), Net:” in the 2014 10-K is “Other expense (income), net” in my charts, to make the name consistent with the sign change which was needed to get a stacked chart.

Interest expense is the only expense I found to be capitalized as investment, instead of charging it as an expense on the income statement. From the 10-K –

    “Expenditures for maintenance and repairs are charged to operations. Interest expense associated with significant capital projects is capitalized as a cost of the project. The Company capitalized $383 , $524 and $142 of interest expense in 2014 , 2013 and 2012 , respectively.” (thousands)

That compares to an expense of $77 and $1 for 2014 and 2013 on the income statements (i.e. not capitalized), and interest income of $319 in 2012 (all in thousands). The capitalization is small and probably conservative. The capitalization of expenses is too complicated a subject to explain in detail here, I’ll just mention that a few companies have taken it to fraudulent levels.

The items reported changed between 2006 and 2014, which presented problems. A few expenses were only significant or relevant in 2005 or in early years, for example the Series B warrants have not been relevant since 2007. 2006 is the earliest 10-K I used.

IPG sales breakdown by cost and income

IPG sales breakdown by cost and income as percent

In the next chart I’ve zoomed in and the detail is clearer, but some percentages for 2002 and 2003 are off the scale. The percentages are represented in the chart above, and they’re in the spreadsheet titled “Data as percentage of sales” near the end.

IPG income and cost as percent of sales

IPG sales costs and income

IPG operating expenses

IPG sales and profit

The following chart is unorthodox. It’s often supposed that a drop in margins warns of problems. When a company has pricing power, falling margins can warn of the erosion of pricing power through increased competition. Analysts are aware of other causes, such as variation in product mix, but it still occasionally happens that an officer at a company with high margins will remind analysts of just how high the margins are, when the analysts are probing a drop of 1% or 2%. The chart is intended to let you judge if margins predict results, as in sales, operating income, net income or cash from operations. By showing the quantities as a percentage of 2014 net sales, I got everything to fit the percentage scale on the left.

IPG margins and main results

I do not see evidence that a fall in margins predicts disappointing results, but this is a subjective exercise and you may interpret the chart differently. 2013 was a relatively poor year for margins, cash from operations, net income and operating income, but 2014 was a good year all round.

IPG earnings per share

IPG annual EPS growth

IPG Logarithmic chart of sales and profit

Comprehensive income charts

Other comprehensive income (OCI) in 2014 consisted mostly of an unusually large loss on Translation adjustments, of -$110,734 (thousand). The loss on translation adjustments was more than twice as big as the rise in net income in 2014, with a sharp fall in comprehensive income as a result.

“Translation” refers to the currency exchange rates at which assets valued in foreign currency are converted to U.S. dollar values. For the Russian operations, a low Ruble keeps costs low, and is good for net income, but a fall in the Ruble’s value against the dollar reduces the dollar value of Russian assets, which affects OCI. If the Ruble stays at a constant low level, there would be no further effect on asset values and OCI, while costs in Russia could continue to stay low, depending on inflation. I have not seen the impact of the Ruble broken out.

The impact of a low Yuan would be different. China is not a production center and does not have large long-lived assets (find “long-lived assets” below). It follows that local costs are likely to be small relative to sales in China, so there would be little benefit to costs from a lower Yuan, while the exchange rate would be bad for sales, although the size of the hit would depend on various factors including the price elasticity of demand and competitors’ costs. I don’t mean to imply that the Yuan is still falling – the Yuan’s big fall ended in January 2014.

Recently, the high U.S. dollar and low Ruble have dominated the currency effects, although the Ruble has partly recovered this year and the U.S. dollar index (DXY) has weakened since March.

25.45% of the $110,734 (thousand) translation loss is explained by the currency hit on Cash and Cash Equivalents. From the 10-K for 2014, in thousands –


The 10-Q for Q1 2015 has a “Total other comprehensive loss” of $38,276, due to Translation adjustments of -$38,319.

This is from the 10-K, about valuing foreign assets, and where they put the cash –

    “Foreign Currency — The financial information for entities outside the United States is measured using local currencies as the functional currency. Assets and liabilities are translated into U.S. dollars at the exchange rate in effect on the respective balance sheet dates. Income and expenses are translated into U.S. dollars based on the average rate of exchange for the corresponding period. Exchange rate differences resulting from translation adjustments are accounted for directly as a component of accumulated other comprehensive loss.

    Cash and Cash Equivalents — Cash and cash equivalents consist primarily of highly liquid investments, such as bank deposits, marketable securities with original maturities of three months or less with insignificant interest rate risk and marketable securities with remaining maturities of three months or less at the date of acquisition.”

Don’t worry about bars you can’t see in the next chart. Charting an insignificant quantity is my way of demonstrating the insignificance visually.

IPG comprehensive income

IPG comprehensive income per share

Geography and sales breakdown charts

Russia is included in CIS, which is in IPG’s region “Other including Eastern Europe/CIS”. CIS is the Commonwealth of Independent States, which includes Azerbaijan, Armenia, Belarus, Georgia, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Uzbekistan and Ukraine.

IPG geography stacked

IPG geography stacked percent

IPG physical assets by location

    “Our major manufacturing facilities are located in the United States, Germany and Russia.” (10-K for 2014)

The three countries account for nearly all the long-lived assets. China accounted for 32% of net sales in 2014, but only 2.30% of the long-lived assets. (IPG have two application centers in China, in Shenzhen and Beijing.)

The evidence suggests that long-lived assets are dominated by manufacturing, and the relative size of long-lived assets by physical location is likely to be a reasonable proxy for relative production, although it is affected by foreign exchange rates and changes in them. There could also be differences in asset turnover, for example diode production is centered in the U.S., and the turnover is not necessarily the same as for other production.

IPG physical assets by location percent

IPG’s materials processing sales have grown, but other applications have not. Three small categories were consolidated into “Other applications” in 2012.

IPG materials processing and other

IPG materials processing and other - percent

Days Sales Outstanding and days of inventory charts

I fitted trend lines to DSO and days of inventory in the next chart. The DSO trend line formula shows that every year on average, DSO increases by 0.3771 of a day. However, the R-squared of 0.0707 shows the line only explains 7.07% of the variation. Taking the square root gives R, the correlation coefficient, of about 0.2659 which is low, with a 45.78% chance that there was no underlying linear trend, with random variation probably the most likely alternative. It’s conventional to reject a hypothesis with 5% or more chance of being false, as here.

The trend line formula for days of inventory shows that every year on average, days of inventory falls by 2.8046 days. The R-squared of 0.5212 shows the line explains 52.12% of the variation. Taking the square root gives R, the correlation coefficient, of 0.7219418, with only a 1.84% chance that there was no underlying linear trend. I’m wary of projecting the trend, for example a step change between the first five years and the last five years would also fit the data.

If you want to check the figures, there’s a calculator on The Chinese University of Hong Kong‘s site. Navigate – Stats toolbox Home / Correlation / Stat Sig of r. For the days of inventory, enter 10 for the sample size, and 0.7219418 for R. The results include “p=0.0184”, which translates to a 1.84% chance of the hypothesis being false.

IPG DSO and days inventory

Analysts and markets generally don’t like rising DSO or rising days of inventory. Some less sophisticated investors might even look at accounts receivable and inventory without adjusting for sales. There is some statistical evidence for the predictive power of the metrics, for example in Beneish’s work on his M-Score for earnings manipulation. If rises in DSO or days of inventory are a strong indication of trouble for IPG, the effect ought to be discernible in the next chart. I suggest looking at the chart and seeing if DSO or days of inventory predict anything for sales, income or cash from operations.

IPG DSO days inventory - sales income and CFO

So far as I can tell, rises in DSO or days of inventory have not foreshadowed problems, and neither have above average DSO or days of inventory. The only serious blip was in 2009, when IPG were affected by the recession which followed the financial crisis. I would not blame the results on the lengthening of IPG’s cash conversion cycle, especially as cash from operations was hardly affected. I would also not try to predict the next recession by looking for a rise in IPG’s DSO or days of inventory. The chart shows that the metrics fell along with sales and income in 2009.

Analysts will continue to probe any increase in DSO or days of inventory, some authors will take a gloomy view of any such rises, and so might the markets, but so long as the metrics don’t rise by or to unprecedented levels, I don’t see evidence that they predict trouble for IPG. I have not completed a full investigation, and in particular I have not looked at quarterly figures.

IPG hold high levels of inventory, keeping stocks of parts that can be assembled quickly when orders are received. This helps sales by giving customers low lead times, but the low lead times reduce the visibility of future sales. Given the high net cash and the good free cash flow, IPG might as well operate with high levels of working capital so long as it benefits sales. Growth adds to the need for inventory, and occasional preparation for higher growth and the launch of new models adds more. From the 10-Q for Q1 2015 –

    “Given our vertical integration, rigorous and time-consuming testing procedures for both internally manufactured and externally purchased components and the lead time required to manufacture components used in our finished products, the rate at which we turn inventory has historically been comparatively low when compared to our cost of sales. Also, our historic growth rates required investment in inventories to support future sales and enable us to quote short delivery times to our customers, providing what we believe is a competitive advantage. Furthermore, if there was a disruption to the manufacturing capacity of any of our key technologies, our inventories of components should enable us to continue to build finished products for a reasonable period of time. We believe that we will continue to maintain a relatively high level of inventory compared to our cost of sales. As a result, we expect to have a significant amount of working capital invested in inventory. A reduction in our level of net sales or the rate of growth of our net sales from their current levels would mean that the rate at which we are able to convert our inventory into cash would decrease.”

Balance sheet charts

The value of overseas assets and liabilities is affected by exchange rate movements, and for 2014 both will be lower than otherwise due to the higher dollar. The lower Ruble will have had an effect on asset values, particularly on Property, plant, and equipment, net. From an accounting perspective, the translation adjustments which dominated the negative Other Comprehensive Income in 2014 would have the effect of pushing asset values down (but that was more than offset by income pulling the value up). The translation adjustments imply that overseas assets are bigger than overseas liabilities. That’s to be expected as the overall assets are bigger than liabilities, and it’s common for an international company with head office costs in the U.S. to have its liabilities concentrated there.

The unrealized gain on derivatives in 2014 was only $172 thousand, and I found no indication of a realized gain on currency hedges in 2014. IPG report Cash Flow Hedges but they were for fixing interest rates, not hedging currencies. From the 10-K for 2014 –

    “We have no foreign currency derivative instrument hedges as of December 31, 2014 . We will continue to analyze our exposure to currency exchange rate fluctuations and may engage in financial hedging techniques in the future to attempt to minimize the effect of these potential fluctuations.”

The 10-Q for Q1 2015 has a similar statement with “We have no foreign currency derivative instrument hedges as of March 31, 2015 .”

IPG assets

IPG assets per share

IPG assets per cent of total

IPG liabilities and equity

Regarding the note in the graphic above, in the balance sheet spreadsheet at the end, the equity is called “Total IPG Photonics Corporation stockholders’ equity”. The name is used in 10-Ks for 2009 to 2014. My calculation agrees with Total liabilities for 2012 to 2014, but is greater than stated total liabilities for 2011 as my calculation includes minority interests. In 2010 the term “Total liabilities” was used but not on the balance sheet, and in 2006 the term was only used in connection with a covenant ratio.

There were many claims on assets in 2005, including series A, B and D, warrants, Notes receivable from stockholders, and Deferred compensation. Most of those items were gone by 2006, but I still preferred to use my simplification so I could take the charts back to 2005. The term “non-stockholder claims on assets” would have been more accurate, as my “calculated liabilities” includes liabilities, minority interests, and the variety of claims on the 2005 balance sheet.

IPG liabilities and equity per share

IPG liabilities cash and current assets

IPG liabilities as percent of cash


I don’t repeat the spreadsheet for cash flow growth which I’ve shown above. The only omission I know about is for the “Logarithmic chart, base 2, of sales and profit” (before the title “Comprehensive income charts”, above), where I don’t show the results or formulas of the logarithmic functions. The logarithmic formulas all have this format, with only the cell address varying –


IPG results to Q1 2015 spread

IPG cash from ops and into investment - spread2

IPG Photonics sales costs and profit - spread

IPG Photonics sales costs and profit - sign adj - spread

IPG Photonics sales costs and profit - sign adj - formulas

IPG Photonics sales costs and profit sign adj percent - spread

IPG Photonics sales costs and profit sign adj percent - formulas

IPG comprehensive income - spread

IPG comprehensive income - formulas

IPG sales breakdowns spread

IPG DSO days inventory - sales income and CFO - spread

IPG balance sheet spread

That’s all.

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IPG Photonics – the hard-to-gauge reliance on their Russian operations

Disclosure – I’m long IPG Photonics Corporation (IPGP).

About this piece

This is about possible disruption to IPG’s vertically integrated supply chain, if political action restricts supply from the Russian operations to the rest of the company. If you are sure that sanctions against Russia won’t get worse, or that escalated sanctions would not hit IPG’s Russian operations, there isn’t much point in reading any more.

Company profile

    “As a pioneer and technology leader in fiber lasers, we have built leading positions in our various end markets with a large and diverse customer base.” (10-K for 2014)

IPG claim “significant competitive advantages” (2013 Annual Report) from having vertically integrated operations, which are likely to be a big part of why the company has industry-leading margins.

Main sources

I’ll be quoting from the 10-K for 2014, which you can find on IPG’s SEC page, where there’s also a link for the Annual Reports. For SEC filings in .htm format you could try these EDGAR Search Results (if that doesn’t work, try the EDGAR Company Search and put IPGP in the ‘Fast Search’ box).

Find “Conference Call” and “Q3 2014 Results” (below) for the transcripts on Seeking Alpha I’ve quoted from.

The risk

The bold highlighting is mine. From the 10-K for 2014 –

    “Recent events in Ukraine have resulted in the United States and the European Union imposing and escalating sanctions on Russia and certain businesses, sectors and individuals in Russia. The United States and the European Union also suspended the granting of certain types of export licenses to Russia. Russia has imposed its own sanctions on certain individuals in the U.S. and may be considering other sanctions on the U.S. and the European Union or certain businesses or individuals from them. We have a large manufacturing facility and research and development operations in Russia which supplies components to our U.S. and German manufacturing facilities and finished lasers to our subsidiary in China. In addition, we supply components from our U.S. and German manufacturing facilities to our Russian facility. To date, we have not experienced any material disruptions or impact from current sanctions. Should there be disruption of our supplies from or to our Russian operations, or should the United States, the European Union or Russia implement different sanctions, our production and/or deliveries as well as results of operations would be affected.”


An important question is, if the Russian operations were severely restricted and the company faced a shortage of components as a result, just how badly would IPG have to be affected before the statement above becomes too mild to protect management from regulatory consequences? The phrase “would be affected” does not imply an upper limit to the damage, so I expect that management are well covered by the statement, though I have no expertise in the area and I’d appreciate a comment if you know better.

IPG’s production sites

It would be nice to have some idea of how dependent the non-Russian manufacturing facilities are on components from Russia. I found nothing that settles the matter, but there’s some information in the 10-K for 2014. If you find –

    “Our main facilities at December 31, 2014 include the following:”

there’s a list of 13 locations. Five locations include “Components” under “Primary Activity”, and the other eight do not. I’ve extracted info for the five locations with component production, and included the two locations with other manufacturing. The locations I’ve omitted only have administration and service listed.

    Owned or Leased (with expiration date if leased)
    Approximate Size (sq. ft.)
    Primary Activity

    Oxford, Massachusetts
    Diodes, components, complete device manufacturing, administration

    Marlborough, Massachusetts
    Manufacturing, administration

    Mountain View, California
    Leased February 2015
    Components, complete device manufacturing, administration

    Burbach, Germany
    Optical fiber, components, final assembly, complete device manufacturing, administration

    Fryazino, Russia
    Leased July 2016
    Components, complete device
    Manufacturing, administration
    (I explain further down why I believe the activities are not split as shown between the Leased and Owned floorspace.)

    Manchester, New Hampshire
    Leased December 2016
    Components, complete device manufacturing, administration

    Cerro Maggiore, Italy
    Complete device manufacturing, administration

    Total (Owned plus leased)

    Total Russia (Owned plus leased)

    Total Russia / Total (Owned plus leased)

    (Total sq.ft. occupied, including locations with no manufacturing: 1,647,900.)

There’s no reason to suppose that the proportion of the total floorspace in locations with manufacturing is a good guide to the dependence of the company on component production from a country. It’s a massive leap from the result for “Total Russia / Total” to say that about 40% of IPG’s component-production is in Russia, but I can’t see any better way to estimate it. The problem is not just that 39.33% is a lot, but that the true figure could be much more (although it could also be much less).

There may be some ambiguity about the “Primary Activity” in Russia. Either the activities are split between the leased and the owned floorspace as I’ve indicated, or all the activities listed for Russia are spread over both kinds of floorspace.

    Leased – “Components, complete device”
    Owned – “Manufacturing, administration”

The five other instances of “complete device” are all part of “complete device manufacturing” with a lower-case “m” in “manufacturing”. My guess is that “Components, complete device manufacturing, administration” applies to both classes of floorspace (for Russia), with no allocation of an activity to only one class of floorspace. I believe that’s supported by the long quote near the top, which includes “We have a large manufacturing facility and research and development operations in Russia which supplies components to our U.S. and German manufacturing facilities and finished lasers to our subsidiary in China.”. It does not necessarily matter if I’m wrong about that, as I explain in the next paragraph.

Most of the floorspace in Russia is owned, and here I’ll assume the activity is “Manufacturing, administration” (the activities on the same line as “owned”). If Manufacturing does not include components, then only 79,000 sq ft or 13.35% of the floorspace in Russia is for “Components, complete device”. That only works out to 5.25% of the “Total” (for all locations with some kind of manufacturing). However, I regard that 5.25% as even more tenuous than the 39.33% figure (as a guide to IPG’s dependence on Russian-made components), because there is no information for the overall percentage of floorspace used for making components (relative to the manufacturing floorspace, or in fact any class of floorspace).

I did not find much hard information about IPG’s reliance on components made in Russia. Without more information, points about the reliance are likely to be speculative and arguable. Unfortunately, that’s likely to be true for claims that the reliance is low, as well as for claims that the reliance is high, although I don’t want to pre-judge arguments which I have not seen or thought of.

Diodes all made in Oxford, Massachusetts

These are laser diodes, which are more like Light Emitting Diodes (LEDs) than the kind which only function as a ‘one-way-street for current’.

If supplies from Russia are disrupted, it’s good that diodes were not in Russia’s “Primary Activity” list. (There’s some risk in only making diodes in Oxford, Massachusetts, which suggests that economies of scale apply at IPG’s diode capacity, and they are big enough to outweigh the risk of concentrating production, or managements’ perception of the risk.)

More square feet

    “We plan to continue our expansion of our operations in Russia, Germany and the United States to meet the demand for our products and our sales and support needs. We believe that we will be able to obtain additional land or commercial space as needed. The additional expansion for Russia, Germany and the United States will provide an approximately additional 212,200 square feet, 114,500 square feet, and 191,200 square feet (excluding building and land purchases in 2014 for our California and Alabama locations), respectively once these additions are completed and occupied. With the amount occupied as of December 31, 2014, once all expansions are completed in 2015, we will have approximately 2.1 million square feet of occupied space to continue to execute on our planned strategies.” (10-K for 2014)

The “additional expansion”s listed sum to 517,900 sq ft, and Russia’s 212,200 additional expansion is 40.97% of the sum. Adding Russia’s additional expansion of 212,200 to my “Total Russia” figure of 591,700 (based on data “at December 31, 2014”), gives 803,900 sq ft, or 39.75% of the total floorspace in locations with some kind of manufacturing, after the additions referred to in the quote. That’s only slightly above the 39.33% I calculated using data “at December 31, 2014”. However, my calculations based on the “additional expansion”s are fairly rough, because locations are not broken out of countries, and the U.S. includes Novi, Michigan where IPG only list “Administration, service”.

Subsidiaries and the scope of sanctions

When sanctions against Iran were extended to cover overseas subsidiaries of U.S. corporations, a wind-down period was granted (see “U.S. Tightens Sanctions on Iran: Foreign Subsidiaries Wind-Down Period Ends March 8” (foley.com).). See also “Clarity for foreign subsidiaries of U.S. companies winding down Iran ops” (worldecr.com).

It looks like U.S. companies with Iranian subsidiaries would have been forced to divest, but I have not found an explicit statement of that. It would be a big blow if IPG is forced to sell its Russian subsidiary. It would also make many of my ‘if’s and ‘but’s irrelevant.

Finished lasers from Russia

    “We are subject to risks of doing business in Russia through our subsidiary, NTO IRE-Polus, which provides components and test equipment to us and sells finished fiber devices to customers in Russia and neighboring countries as well as finished pulsed lasers to China. Further, over 30% of our sales are to customers in China. The results of our operations, business prospects and facilities in these two countries are subject to the economic and political environment in Russia and China.” (10-K for 2014)

If IPG’s supplies of finished lasers from Russia dried up, I expect that to some extent the subsidiary in China could be supplied from other locations (although any shortage caused by not being able to export components from Russia to the U.S. and the E.U. would affect IPG’s global production of finished lasers). IPG are likely to have spare capacity after substantial investment (find “near finishing a round of investment” under “Nothing about Russian components in the Conference Call”, below).

The supply of finished lasers from Russia would be affected if IPG were unable to export their diodes from Massachusetts to Russia. So long as suitable diodes and other parts are available in Russia, components produced there could (possibly) be used in finished lasers for sale in China, the Russian home market, and many other countries even if the U.S. and the European Union tighten sanctions to include lasers (unless IPG would be punished for exporting from Russia, to China, for example). If sanctions caused a shortage of Russian-made components in the U.S. and the E.U., that could be offset by increasing Russian exports of finished lasers to countries where the trade is allowed (given the conditions: suitable diodes and other parts remain available in Russia, and IPG would not be punished in the U.S. for exports such as Russia to China).

The CEO has claimed that an auto product (presumably a laser or laser-system) has been made in Russia with Russian parts except for some metal parts which could be made in Russia if needed. From “IPG Photonics’ (IPGP) CEO Valentin Gapontsev on Q3 2014 Results – Earnings Call Transcript” Oct. 28, 2014 (seekingalpha.com) –

    “… our Russian company, really sales efficient Russian entity, which produced of auto product without any impact of the devices from outside of Russia. It’s all made in Russia from Russian components. Is only a few metal parts (indiscernible) we still import outside, but it is not — this is a part we can replace if need …”

The transcript also has management stating that Russian revenue was less than a twentieth of the total revenue (“Russian revenue” must be only for the Russian home market), although seasonal factors and expectations of strong growth in Russia are mentioned (find “It is less than 5%” in the transcript).

The ‘worst-case’ and the business model

I’ll assume here that sanctions stop the export of components from Russia, and the possible offset I just described is not enough to stop a shortage of IPG-made components. The only countries that I know have imposed sanctions against Russia are in North America and Europe, which is where IPG have their manufacturing. (In addition to the U.S. and the E.U., there’s Canada, where the sanctions seem to be mostly against named individuals and some entities, and Norway.)

If IPG don’t have enough components coming out of Russia, and that continues until stocks run out, they face a difficult choice – 1) Sell fewer lasers, or 2) Use the same sources as their competitors. The consequences of selling fewer lasers are likely to include lower revenue, customers not regarding the supply as assured, and lost customers who might be reluctant to return. About the downside of using the same sources as their competitors, from the 10-K for 2014 –

    “Our vertically integrated operations allow us to reduce manufacturing costs, control quality, rapidly develop and integrate advanced products and protect our proprietary technology.”

About the second item, “control quality”, would IPG say “Some of our lasers are not as good as they were.”? If they say “All our lasers are as good as ever.” it will be hard to claim a quality advantage from vertical integration when it’s restored. If they say nothing, there could be speculation about IPG’s sourcing of components which could force a statement, and customers who believed that IPG’s vertical integration resulted in higher quality would feel cheated. Obviously I can’t accuse IPG of a crime that’s in the future, I’m just showing how none of the choices available would be attractive. A reduction in quality would be bad, and if there’s no reduction in quality, the statement about vertical integration would look rather tenuous. A claim that standards were being maintained by thorough quality control could be met by competitors claiming that’s just what they’ve always done. On top of the hard choice, some quick redesigns may be needed if components from other suppliers can’t always be simply ‘slotted in’ to replace IPG components.

IPG say –

    “we design and manufacture most of our key components used in our finished products, from semiconductor diodes to optical fiber preforms, finished fiber lasers and amplifiers.” (10-K for 2014, the bold italic highlighting is mine)

That may leave some leeway for substitution if components can’t be shipped from Russia.

Competitors are unlikely to follow Grantland Rice‘s advice –

Instead, they’re likely to take maximum advantage of any weakness at IPG that results from sanctions. Any market areas where IPG have become weak, could be examined by competitors to see if they could dominate or address the areas profitably. IPG shareholders would be hoping that competitors settle for higher margins, rather than think strategically (see “What is strategy?” June 4, 2013 (build2think.wordpress.com).)

IPG reported Cash and cash equivalents of $522 million, compared to only $164 million of Total liabilities. It’s good to have a cash cushion if a crisis hits.

Is the ‘worst-case’ too crazy to happen?

You could argue that sanctions by either side which would affect IPG, would hurt both sides, without any measurable gain. However, in conflict a simple cost-benefit analysis is not necessarily relevant, any more than it applies to a game of ‘chicken’. The relevant branch of math is game theory, not the more direct methods of optimization.

For comment on geopolitics, you could try ‘Stratfor‘ (Strategic Forecasting, Inc.) who give free weekly Intelligence Reports. Their point of view tends to be based on the long term effect of geography, such as the lack of natural barriers which made Russia hard to defend.

Before World War I, many people thought that war in Europe was unlikely due to the interdependence of the European economies (possibly due in part to not understanding a book called “The Great Illusion“). It’s not the only war which demonstrated that mutually-advantageous trade links could be broken.

In less violent conflict, trade can be disrupted when it favors one side more than the other, and also when it’s believed that something needs to be done, and the alternatives are less attractive.


Maybe IPG could quickly replace lost Russian component production by stepping up production in the U.S. or Germany, but there isn’t much information to base that on. IPG’s soon-to-be-completed round of investment suggests that there should be spare capacity, but not necessarily of the right kind to replace Russian component production.

Inventories for the latest quarter fell year-on-year (from $172,700 to $171,009, in thousands), so there’s no evidence there of increased production of components in Russia for stockpiling outside the country. While the effect on reported inventories might not be great if vital components are produced at low cost, the simplest explanation is that IPG were not stockpiling components made in Russia.

About resilience more generally, IPG were hit by the financial crisis/recession in 2009, and bounced back very quickly (see the Morningstar link at the top, and find the nine-year history on the ‘Ratio’ tab). The problem then was probably the recession causing low demand across the industry, which is different to a single company having a problem with supply.

Costs in Russia

Employment costs are probably lower in Russia. You could try finding “What is the Russian Middle Class?” on forbes.com. Doctors earn less in Russia than in other European countries, see “Russian Doctors Protest as Reforms Threaten Jobs” Agence France-Presse, November 18, 2014 (ndtv.com). That isn’t directly relevant, but google keeps thinking I want to know about sanctions when I’m trying to research staff costs. If employment costs are much lower in Russia, that could explain some of IPG’s superior margins. In any case, so long as a low Ruble translates to lower costs in Russia, news which is bad for the Ruble is good for IPG’s costs. Potentially, increased tension could increase IPG’s margins via a lower Ruble, at the same time as increasing the risk in various areas (to the Russian operations, the company’s revenue, the share price etc.).

Nothing about Russian components in the Conference Call

See “IPG Photonics’ (IPGP) CEO Dr. Valentin Gapontsev on Q4 2014 Results – Earnings Call Transcript” Feb. 20, 2015 (seekingalpha.com).

These are the Russia-related topics covered –

In Q4 2014, revenue from the “other products” category “decreased 47% year-over-year to $9.6 million”, the result of “a decline in system sales in Russia due to economic conditions and foreign currency devaluation there as well as having had a comparatively large system order” (in Russia) “in Q4 of last year”. The “other” category is volatile, and small compared to the quarter’s total revenue of $207 million.

Sales in Europe grew to $69 million, “partially offset by weakness in Russia related to the economic environment there” (and the year-ago system order mentioned previously).

There’s a paragraph about the effect of the strong dollar and weak Ruble on the value of inventory, which was about $9 million lower as a result.

The quarter’s revenue from Russia is described as “good” given the headwinds.

The company is near finishing a round of investment in Russia, the U.S., and Germany, which should provide enough capacity to double revenue (find “finishing the round” in the CC).

I saw no questions from analysts about the effect on the rest of the company if components can’t be shipped from Russia. Maybe they are wrong to ignore the risk, or maybe they have better information and regard the risk statement about Russia as legal boilerplate.

Corruption in Russia

Yukos (wikipedia.org). Oil giant Yukos was seized by the Russian government, over 2003 to 2007, under Putin’s leadership.

U.S. Investor’s Lawyer Dies in Moscow Jail by Gregory L. White, updated Nov 18, 2009 (wsj.com). Hermitage Capital were accused of not paying taxes. Hermitage claim they paid, but the taxes were pocketed by fraudsters. The company’s lawyer was jailed and denied medical treatment.

See Russia, Corruption Timeline (mapreport.com) and Corruption in Russia (wikipedia.org). I’ve read that IPG were developing their own distribution network in Russia, due to the corruption there, but I can’t find any evidence. Many of IPG’s management team were educated in Russia and some of them may be able to advise on how to avoid trouble.

All IPG say about corruption in the 10-K is that anti-corruption laws are complex and often difficult to interpret and apply, with penalties if they get it wrong. They comment on the risk associated with Russia and China –

    “The results of our operations, business prospects and facilities in these two countries are subject to the economic and political environment in Russia and China. In recent years, both countries have undergone substantial political, economic and social change. As is typical of an emerging economy, neither China nor Russia possesses a well-developed business, financial, legal and regulatory infrastructure that would generally exist in a more mature free market economy. In addition, tax, currency and customs legislation is subject to varying interpretations and changes, which can occur frequently.”

Miscellaneous links

IPG’s Management and Board of Directors (investor.ipgphotonics.com).

This article briefly mentions the proportion of IPG’s employees based in Russia – “IPG Photonics – Growth And Technological Leadership Offer Appeal” by The Value Investor, Feb. 23, 2015 (seekingalpha.com). (Some comments by myself repeat points I’ve made in this piece.)

I wrote positively (mostly) about IPG in my blog post “Three cash3 companies“, January 17, 2014 (on wordpress.com).


I’ve focused on the adverse possibilities, and it’s worth bearing in mind that maybe sanctions will not be escalated, or an escalation will not have much effect on the Russian operations, or the effect will mostly be limited to Russia, or a shortage will be dealt with by quickly by ramping up production of components outside of Russia. If the risk is material, management ought to have considered it, and plans could already be in place.

Thanks, SA

With thanks to Seeking Alpha for their policy about quoting from transcripts, which can be found at the end of the transcript.

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

Ubiquiti Networks – charting volatile revenue

Disclosure – I’m long Ubiquiti Networks, Inc. (UBNT).

Closing price February 17, 2015: $29.44

Short profile

From the company’s 10-K – “Ubiquiti Networks develops high performance networking technology for service providers and enterprises.” The service providers are typically Wireless Internet Service Providers (WISPs). “Our technology platforms deliver highly-advanced and easily deployable solutions that appeal to a global customer base, particularly in under-networked markets.” They are able to price disruptively due to their business model, which I describe later.

About this piece

This is mostly about illustrating the volatility of the company’s revenue, a peripheral issue which is not as important as the long term prospects, or even the prospects for launches and upgrades when they can have a significant effect on results. However you aren’t likely to find the product types and geographies charted anywhere else.

While anyone who has studied the company will know about the volatility, IMO it’s still worth charting the quarterly revenue from the geographic and product segments. The charts are more important than the writing, and the trendlines and R-squared values in the charts are secondary. In fact the R-squared values are low, indicating volatility and showing the trendlines can’t be projected reliably. There may be some irony in using quarterly charts to show you shouldn’t read too much into the latest quarterly change.

Before the quarterly revenue charts I look at mostly annual data for cash flow, revenue and earnings, for a longer and more comprehensive view.

Cash flow

The first chart is based on annual data from the cash flow statements. It tunes out most of the quarterly noise, but it has its own noise. The chart shows a recent dip in the operating cash flow (OCF) per share, which is still very high compared to the capital invested per share.

Ubiquiti cash walks per share to 2014

The OCF dip is the result of big swings under “Changes in operating assets and liabilities:” –

($ thousands)
2014 ~ 2013 ~ 2012

Accounts receivable
(18,329) ~ 38,664 ~ (36,648)
(33,764) ~ (8,996) ~ (2,266)

Those are the contribution to cash from the change over the previous year, and (33,764) is negative meaning Inventories increased by 33,764 ($ thousand). Big increases in Inventories and Accounts receivable can be warning signs of problems, but there are good explanations for the rises in Ubiquiti’s case. One factor is that with the CEO having a majority holding, and with the company having good net cash and cash flows, there’s no pressure on the CEO to manipulate earnings (some forms of earnings manipulation can lead to increased receivables).

Inventory is built up before product launches. There was also a decision to increase inventory to avoid stock-outs, which I wrote about in “Ubiquiti Networks – long term sense meets a short-sighted market” May 13, 2014.

My conclusion about the ‘changes’ part of cash flow is that receivables and inventories will not increase relentlessly, and for various reasons cash flow was effectively pulled into 2013. The drop in OCF in 2014 does not negate the underlying trend. The trend in cash flows is important and a one year blip is not, so long as the blip has a good enough explanation.

Ubiquiti’s fiscal year ends on June 30 and there have been two quarters reported since 2014 (the last point on the chart).

(thousands, except per-share quantities)
Q1 2015 ~ Q2 2015

Shares (diluted)
89,913 ~ 89,737
$46,942 ~ $32,676 (calculated for Q2)
Cash invested
$3,461 ~ $4,930 (calculated for Q2)
OCF per share
$0.5221 ~ $0.3641
Cash invested per share
$0.0385 ~ $0.0549
Annualized OCF per share (x4)
$2.0883 ~ $1.4564
Annualized Cash invested per share (x4)
$0.1540 ~ $0.2198

Cash flow has been affected by greater Days Sales Outstanding, as distributors who have built up a good credit history have been allowed to take longer to pay and bigger distributors have been signed up (who expect more time before they have to pay).


Because I mentioned distributors taking longer to pay, I need to explain why Ubiquiti do not depend on distributors creating sales. About an internet forum refered to as the Ubiquiti Community –

    “Word of mouth referrals from the Ubiquiti Community generate high quality leads for our distributors at relatively little cost.” (10Q for Q2 2015)

That makes distributors keen to sign up, and with the pull from customers there’s no need to push the products through the channels, and no pressure to offer discounts to distributors.

Using the cash

With plenty of cash and low investment needs, it makes sense to use the cash to fund inventory and receivables, within reasonable limits, when it helps to increase sales. (See the earnings call transcripts on Seeking Alpha for more information.) One alternative – to use the cash for acquisitions – is limited by the low headcount which results from the lean business model. An acquisition candidate with half of Ubiquiti’s revenue is likely to employ far more staff than Ubiquiti, demanding more management attention and diluting the benefit from the business model.

Annual revenue 2010 to 2014

I’m about to investigate five years of annual revenue data using statistical methods. Given the short data set and the variation, I’m not surprised that the results were inconclusive. If you don’t mind negative results, or if you want to repeat the online test yourself, read on, otherwise skip to the three charts below.

In this short series of revenue data, 1 corresponds to 2010, 2 to 2011, etc. –

    ($ thousands)

    1 136,952
    2 197,874
    3 353,517
    4 320,823
    5 572,464

I fed the data into the Linear Regression Analysis page on The Chinese University of Hong Kong. You can repeat the exercise if you like, but you need to navigate via “Data modelling” and “Linear Regression”. Then put “5” into the “Number of rows” box, and copy and paste the data into the “Data …” box, and then click on the “Calculate” button. You should see the results –

    Model y = 99,397.3200x + 18,134.0800
    Pearsons product moment correlation Coefficient(r) = 0.9342
    Standard Error of Slope SE(b) = 21,922.3815
    t-test for the significance of the slope = 4.5341 Two-tailed probability = 0.0201
    95% confidence interval for slope 52,044.9763 to 146,749.6643

That means the low, mid, and high cases for revenue growth are approximately $52 million, $99 million, and $147 million (increase in revenue per year). The results imply only a 5% chance that the trend is for revenue to increase by less than $52 million or by more than $147 million, with a probability of 2.5% for each of the tails (the ‘out of range’ cases). The numbers can only reflect factors that have already had an effect on revenue, for example because Ubiquiti have not been affected by key personnel risk, the risk is not factored into the range of slopes (the slope of the graph is the increase in revenue per year). On the other hand, the period includes infringement of Ubiquiti’s IP, and Ubiquiti are now better protected against the risk.

The stats site reports using “Pearsons product moment correlation Coefficient” which is the standard method. It assumes a normal distribution which in finance is a standard but not necessarily correct assumption (it’s assumed in the Black Scholes equation for pricing options, and fractals-genius Benoit Mandelbrot didn’t approve). While the calculations take the low number of data points into account, for a sample size as low as five, the results are less reliable.

Even at the high-limit of $147 million, linear growth would eventually become a miserably low percentage growth, so I put the same data into the Exponential Regression page. I’m not confident about the results because they were a bit different when I replaced 1, 2, 3 … with 2010, 2011, 2012 …, and the rate of exponential growth should not depend on the period labelling (if you decide year zero was when Elvis Presley was born, it wouldn’t affect the growth rate of trees, corporations, or anything not Presley related). The relevant lines from China were –

    Linear Regression Model of the log10 transformed value is y = 0.1452x + 5.0134
    95% confidence interval for slope 0.0916 to 0.1989

I calculated the low, mid and high annual growth rates were 23.5%, 39.7% and 58.1%. I’m not confident about those, but the mid-range growth rate of 39.7% applied to the 2010 revenue of 136,952 would turn it into 521,620 by 2014, which is less than the actual figure of 572,464, but isn’t too far off and I wouldn’t expect a close match (all in $ thousands).

Even 23.5% annual revenue growth, at the bottom of the confidence interval, is a good growth rate, and given Ubiquiti’s margins it suggests good prospects.

The mid-case of $99 million linear growth only predicts annual growth of 17.3% in 2015 (from 99 / 572.464 = 0.173, not assuming any reversion-to-trend). But, the same $99 million growth would have been 72.3% growth over the 2010 figure of $136.952 million.

The Chinese University site does not show charts and only regresses linear and exponential functions. The problem is that the exponential function is concave-up, while other functions that could fit the data such as logarithmic are concave down.

In the chart on the right, below, the ‘concave down’ trendline implies growth that deteriorates faster than the linear trend, and the R-squared value is not far off the value for the ‘concave up’ exponential trend. If I’ve made statistics look indecisive, it’s better than being too sure about a trend. Five data points is not enough for very reliable results, meaning that even though a wider range of slope will be reported, the range is still less reliable. It would help if the points were all very close to the trend line, but that isn’t the case, and the three charts below confirm that it’s hard to fit a trend line with much confidence.

Ubiquiti - revenue - three trends

The fact that two very different trends fit about as well as each other, confirms my impression that while growth has been high, the data does not reliably indicate a likely rate of deceleration (growth companies usually slow down as they get bigger).

My long term expectation is that growth will hold up better than for most companies, due to the advantage of the business model, which can be applied to new products so long as ‘high-touch’ is not required and the forum can provide a useful function. The ability to stay lean and avoid bureaucratization is also a factor in delaying the onset of aging.

Revenue, earnings and margins

Ubiquiti revenue and earnings to Q2 2015

Ubiquiti margins to Q2 2015

Quarterly revenue, total and by geography

Quarterly revenue has been variable. The sharp dip in Q1 2013 was the result of widespread IP infringement. The situation was serious but effective action was taken and UBNT recovered.

Ubiquiti quarterly revenue total and by geography

The trendline has an R-squared value of 0.742, which means it only explains 74.2% of the variation. IMO few such trendlines can be extrapolated with confidence, and this one is no exception. If you believe the trendline, then fluctuations around it account for 25.8% of the variation. The results from the Linear Regression Analysis page at The Chinese University of Hong Kong (linked to above) were –

    Model y = 6,946.1300x + 58,165.7300
    Pearsons product moment correlation Coefficient(r) = 0.8616
    Standard Error of Slope SE(b) = 1,181.4866
    t-test for the significance of the slope = 5.8791 Two-tailed probability = 0.0001
    95% confidence interval for slope 4,394.1188 to 9,498.1409

My method was to test the correlation between the sequence 1, 2, 3, … and the quarterly revenue figures 79167, 87817, 91665 … (If you want to check the result, you’ll need the data, which you can get via a link at the end under “Tables and formulas” with instructions to ‘Paste special’ into a spreadsheet.)

The last line in the results implies that you can be 95% confident that the underlying trend in revenue is between an increase per quarter of $4.4 million and $9.5 million, with a ‘model’ mid point of $6.9 million. That’s slower trend-growth than the annual data gave, which could be because the quarterly data starts at Q1 2012, while 2012 was a good year with a big rise from 2011. The “t-test” line means you can be extremely confident that the growth in the period was not just the result of random fluctuations.

By not showing the total revenue, the next chart shows the revenue from the four regions more clearly.

Ubiquiti quarterly revenue by geography

Every region has experienced volatile revenue. While the two largest regions have demonstrated obvious and signigicant growth, that’s not quite as clear for APAC, and it’s quite arguable for South America (with only incremental growth between the first and last points). Any two regions you pick are capable of moving in opposite directions for a quarter or two (I quantify the low correlation using R-squared values in charts further on). Here I’ve added trendlines and shown their R-squared values:

Ubiquiti quarterly rev by geog with trends

The R-squareds show the percentage of variation explained by the trendlines – 64%, 65%, 21% and 54%. Taking the square root of the R-squared numbers gives R, the correlation coefficient (for a trend, the correlation is between the variable with the trend, and time, for example the end date of a quarter). The values are 0.800, 0.806, 0.458, and 0.7345. Putting the R values into a page on the University of Hong Kong site (linked to above) gave “p” values of 0.0006, 0.0005, 0.0996 and 0.0028 (navigate with “correlation” / “stat sig of r”). Taking the highest p-value of 0.0996 which is for South America, it means that there’s nearly a one-in-ten chance of no linear correlation (meaning revenue is not linearly correlated with time, and may just fluctuate randomly, possibly about a mean), whereas the p of 0.0005 for North America implies only one chance in 2000 that there’s no underlying growth. The p values do not give much idea of the variability, but I believe you can get some idea just by looking at the chart, and R-squared gives the proportion of variation which is ‘on trend’. (If you want the variability of the slope and don’t mind some work, find “You can get all the data” (above), follow the instructions, and find “I fed the data into the Linear Regression Analysis page” (above).).

All the R-squareds in the chart above are lower than the 74% for the total revenue. It’s expected that a total such as total revenue will have less variation than the parts it’s the sum of, provided the parts can fluctuate independently, because sometimes the parts will move in opposite directions, and they’ll tend to move at different rates. That’s why a big conglomerate will have more stable results than most other companies, although as well as the number of subsidiares, its results are smoother the more diversified its markets are, the more stable its markets are, and it helps if the subsidiares are about equal in size. Ubiquiti will become more diversified if it becomes more established in new areas. Machine-to-machine would be such an area, but there doesn’t seem to be much focus on it at the moment, and video is more promising in the near term.

Here’s a 3D view of the same data (no special glasses required).

Ubiquiti quarterly revenue by geography 3D

Quarterly revenue by product type

The product type charts are complicated by the change in disclosure which you can see by comparing either side of the gap. (New platforms, Antenna’s/other etc. can split between the later categories “Service provider technology” and “Enterprise technology”.)

Ubiquiti quarterly revenue by product type

The next chart is for “Service provider” and “Enterprise” only, with trendlines fitted, but six points is a small number to use in a statistical test, especially when the R-squared values are low. I saw no point in putting the data into any further statistical test. There are reasons to believe that ‘Service provider technology’ will grow, but there’s a big lack of evidence for it in the chart and the R-squared value of only 0.01.

Ubiquiti quarterly revenue by type with trends


The stacked view of the same data lets you compare the revenue of a product type to the total revenue.

Ubiquiti quarterly revenue by product type stacked

And in glorious 3D:

Ubiquiti quarterly revenue by product type 3D

While Service provider technology rose and fell, Enterprise technology fell then rose. It’s highly unlikely that there’s an underlying inverse relationship which would reliably predict movement in opposite directions in the future.

It’s not worth extrapolating a few quarters

While the overall growth of revenue is evident, the conclusion I draw from the quarterly ‘geography’ and ‘product type’ charts is that it’s hard-to-impossible to make a meaningful short-term prediction based on any of them. Analysts can put too much emphasis on the latest quarter’s results (maybe it’s in their job description), and some commentary can be knee-jerk over items like an increase in inventory in a quarter.

Currency and emerging markets headwind

While a dip in total revenue could easily be the result of the two product types happening to have a random dip at the same time, or the consequence of geographies happening to move down at the same time, there is currently a headwind. Much of Ubiquiti’s revenue is from emerging markets, especially where the telecoms infrastructure is not very developed. Those markets in particular could be affected by the strong dollar. Countries with an especially weak currency will be more affected, and countries that depend on oil exports or other depressed commodities are likely to have weak currencies and weak economies.

Ubiquiti are far from unique in being affected by dollar strength (Proctor & Gamble had a fair amount of publicity when their results suffered from it). I started warning on November 3, 2014 (before most of the Ruble’s fall) of the risk that a strong dollar and massive dollar-denominated debt could put some countires into crisis, with some similarity to the 1990s when Mexico, Asia and Russia were hit. That could still happen and is under-appreciated, but at least now there is general awareness that the strong dollar is a problem for exporters, and of weakness in emerging markets and primary producers, especially where the geopolitics has been in the news. Guidance seemed to build in a lot of downside for the effect of weak foreign currencies and weak emerging markets (my impression from the CC transcript), IMO leaving upside if Ubiquiti’s overseas markets are not hit as hard as feared, or if the company outpaces those factors. While the market is aware of the adverse factors (currency risk, low oil price, depressed commodities, weak emerging markets), the share price seems to indicate it is either not aware of the advantage of Ubiquiti’s business model, doesn’t believe it, or doesn’t care due to a short-term focus.

The business model

Ubiquiti concentrates on R&D, and outsources manufacturing. A vibrant forum gives feedback about products (especially new products), provides support, and evangelizes the product. By not needing a large staff for sales and support, the company can keep prices at levels that are disruptive for the competition, while still keeping a good net margin. Ubiquiti have a prototyping facility in China which CEO Pera described as a factory in an answer during the Q1 2015 CC, but he explained it was purely so they can introduce new products faster.

The business model is intact. So long as the model stays intact, the best time to buy is when a real or imagined problem sends the share price down. The net cash, cash from operations, low investment needs and disruptive pricing mean that Ubiquiti can ride out problems and emerge stronger, as they did after their IP was widely infringed.

Keeping it brief

I’m trying to stick to the subject and not say too much about related issues. There are good authors writing about Ubiquiti on Seeking Alpha and for a wider treatment I’ll refer you to “Ubiquiti Networks: A Rare Opportunity In An Overvalued Market” by Mingran Wang, Feb. 11, 2015 (seekingalpha.com). It’s reasonable to ask “How can the business model be intact when there’s no evidence of growth in the revenue of the largest product type?”. I suggest reading Mingran’s piece and then see what you think.

Abitrary categorization

The geographies could have been organized differently, e.g. Africa could have been included with South America instead of Europe and the Middle East, or there could have been three regions or five instead of four. A different categorization would have made the geography charts look different, but the volatility can’t be magicked away by regrouping, and the regions would always be more volatile individually than their sum.

The geographies move fairly independently

I could be criticized here for applying linear regression (with a trendline) to sets of points that don’t look linear. My excuse is that the points don’t suggest any better curve, and I’m quantifyng the lack of much relationship, rather than saying “This is the formula that relates the variables.”. The lines indicate the order of the points, which start at Q1 2012 in the bottom left and end at Q2 2015 on the right. The order of the points is not relevant to the trend lines or the R-squared values.

Ubiquiti quarterly revenue scatter chart EMEA

The R-squared values in the chart above correspond to 37%, 32% and 68%. The first two of those percentages are low, and they imply that revenue in the second and third biggest regions (North and South America) fluctuates fairly independently of the revenue from the biggest region (EMEA). Putting the data for EMEA and North America into the Hong Kong site’s Linear Regression page got the result

    “95% confidence interval for slope 0.0911 to 0.9055”

In other words, on average, for every $100 million per quarter that EMEA grows by, North America would grow by at least $9.11 million and at most $90.55 million, with a 5% chance of being outside that range. (That’s about the uncertainty of the trend, not the noise around it.) The wide range reflects the 63% independent variation (from 1 minus R-squared), although the number of data points is also a factor. Common sense might suggest you can make the range narrower, but that brings in more information than the 2 x 14 array of numbers which went into the test.

Ubiquiti quarterly revenue scatter chart N America

The main point from the chart above is that the R-squared of 0.29 (or 29%) implies that revenue in the third biggest region (South America) fluctuates fairly independently of the revenue in the second biggest region (North America). With the previous result, all the regions except for the smallest (APAC) move fairly independently of each other. Although APAC has some dependence (statistically) on EMEA and North America, it’s still fairly low, and evidently not big enough to make EMEA and North America move in step.

Any time two quantities grow, there’s a statistical correlation between them, even when it’s obviously meaningless. For example, a baby walrus could happen to be growing at the same time as the economy of Japan, and statistically there would be a positive value of R-squared, very likely a higher value than some of the R-squareds above. The long term growth in Ubiquiti’s regions is clearly related, because it depends on factors like new product launches, the quality of the products, the business model that allows a low price point, and evangelizing on the forum (because the understanding of languages crosses over the regions). Without underlying growth, it’s likely that the R-squared values in the scatter charts would be even lower. In any case they are low enough to say that a short term upswing in one region can easily be accompanied by a move in the other direction for whichever other region you care to pick (though less so for APAC, the smallest region by revenue).

Regions can also move in the same direction purely through chance. As a hypothetical example, if there’s a 40% chance of any region having lower revenue in a quarter, and if the regions moved completely independently, then there’s a 16% probability of the two biggest regions both falling purely through chance, and a 6.4% probability of the three biggest regions falling purely through chance. Adjusting for the level of dependence would increase those probabilities.

If there was a 60% chance of any region having higher revenue in a quarter, and if the regions moved completely independently, then there’s a 36% probability of the two biggest regions both rising purely through chance, and a 21.6% probability of the three biggest regions rising purely through chance.

The subject raises the fairly tricky question, can the fluctuations really occur through chance when most people would agree that they have rational causes? My attitude is that, to the extent that you can’t predict the movements, they might as well be random (on top of a long term growth trend).

Ubiquiti would be more volatile if they only had one of the four regions, and the relative independence actually helps stability, just not enough to make revenue stable.

Limited evidence suggests the product types move fairly independently

Ubiquiti Enterprise tech on Service provider tech - scatter

The short data series for the current two product categories shows an inverse relationship (the slope of the trendline down to the right means that the more revenue it reads on one axis, the less revenue it reads on the other axis). The R-squared of 0.35 shows that 35% of the variation in Enterprise technology revenue is accounted for by the variation in Service provider technology. Apart from the fact that 35% is quite low and there aren’t many data points to base it on, it might not be a feasible relationship. Two explanations don’t seem likely – 1) customers with limited budgets who spend more on one product type have less to spend on the other (that probably fails because different product lines address different markets). 2) When Ubiquiti develop one product they have less resources for the other. Because Ubiquiti are not short of cash, the second explanation would have to mean a shortage of R&D staff or of management time for managing them, but it seems unlikely that either product type has been short of development effort. If there’s no underlying inverse relationship, the product type revenues are likely to be more independent of each other than the R-squared of 0.35 suggests.

While I don’t believe the product types have an underlying inverse relationship, it’s still true that they have tended to move in opposite directions, but that has not been enough to make the overall revenue very stable or stop it from falling since Q4 2014.

Why Ubiquiti’s revenue is volatile

Ubiquiti supply high-tech capital equipment, with significant sales to emerging markets. Revenue from new models is hard to predict. Upgrades are a relatively more reliable source of revenue, but there’s no recurring revenue. Given those factors, it’s remarkable how steady the growth in OCF has been, and it would have been steadier if the swings in inventory and receivables had been smaller.

Stock price volatility

The share price is also volatile, and probably over-reacts to results and headwinds. That may be understandable for a few reasons. The CEO holds most of the stock and is hanging on to it. The staff hold stock, and some customers who were impressed by the technology available for the price may also hold stock. Shareholders with experience of the company may be less likely to trade.

While the articles and comments on Seeking Alpha might not represent the attitude of small investors, there is general agreement in the articles and comments that Ubiquiti are a good long term investment. The investors there may add when the price is low, and a few might take some profit when prices are high, but the attitude seems weighted towards holding long term rather than trading.

With many of the shares effectively not for sale, the share price can move up fairly sharply. Lately the movement has been down (since September, with a small uptick after the Q2 results). The size of the slide may be greater because small shareholders are unable or unwilling to add much at lower prices, for whatever reason.

Another factor is that the company uses its cash to buy back shares, but only when the price is fairly obviously low. I don’t follow the short selling much, but the short % of float seems to be around 30% quite often. There’s info from NASDAQ, and the Morningstar link at the top gives the short % of float.

Also, while a results surprise or disappointment is likely to be temporary, there isn’t a clear trend for results to revert to, which could discourage traders who aim to ‘buy low, sell high’ rather than follow momentum. There will also be investors who add when the price is low, with the general expectation that the long term prospects are good (which is usually my approach).

Seeing patterns in randomness

It’s often said that people see patterns where no pattern exists. There’s a recent case concerning random playlists, with users believing they are not random and there’s some kind of conspiracy. The solution has been to tweak the results of the standard and well-founded algorithms to conform to common misconceptions of what a random sequence should be like. (I heard that on BBC radio but I can’t find it on the internet. The subject area is covered in the book “Fooled by Randomness” by Nassim Taleb. Also see “Patternicity” and “Apophenia“.) It seems at least possible that when analysts try to abstract something meaningful from quarterly results, sometimes they find it when it doesn’t exist. I could fall into the same trap myself, and it’s hard to ignore quarterly results.


Ubiquiti’s parts move fairly independently, but they are volatile enough that the sum of them is still volatile, though less volatile than any individual geography or product type. While volatility in the results and the share price creates opportunities for trading, it would be a waste of a good business model to only trade and avoid long term investment, especially when volatility has contributed to a good share price for entry or adding.

Tables and formulas

See “Spreadsheets for Ubiquiti Networks – charts and volatile revenue“.

Data in semicolon-seperated format with instructions to ‘Paste special’ into a spreadsheet, formulas not included – “Data for Spreadsheets for Ubiquiti Networks – charts and volatile revenue

This is fairly advanced. For each trend line, it would be nice to have a line above and a line below representing “regression channels” (aka “confidence channels”), which you might have seen in technical analysis. IMO the trend lines here have too much uncertainty about the slope for that to be more useful than potentially misleading. If you want to know more, try How do I calculate confidence channels above and below a trend line. Find “richdiesal2009-03-15 at 20:13:39” for the comment I think is most relevant.

A simple guide – “Using Linear Regression to Predict an Outcome” by Deborah J. Rumsey, PhD from Statistics For Dummies, 2nd Edition (dummies.com).

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

The M-Score and The Female Health Company

Disclosure – I own shares in The Female Health Company (FHCO), and also in EMN, GE, GIS, IPGP, ITW, LSCC, MKL, SNCR, SUNE, TIBX, UBNT (links are to Seeking Alpha).

FHCO Share price $7.76, Market cap $224 million, Price/Earnings per share (ttm) 18.2, Yield (ttm) 3.61%, Price/Cash from operations per share (ttm) 18.71. As at March 31, 2014.
(ttm figures based on ttm EPS $0.4257, ttm dividend $0.28, ttm Cash from operations per share $0.4148)

Seeking Alpha FHCO, Morningstar FHCO, Yahoo FHCO
Female Health SEC filings (femalehealth.investorroom.com)


This blog piece is about the Beneish M-Score for earnings manipulation, using The Female Health Company as an example. You might expect me to pick a company guilty of grossly overstating their earnings, but that’s not true of Female Health. Showing how a company can be innocent is more complicated than explaining why a ratio can point to guilt, and the explanations benefit from an example. Articles about forensic analysis always seem to be about nailing the bad guys, with little about the case for the defense.

Material that’s purely about the company is in “A quick intro to The Female Health Company”, “Female Health – ethics and incentive to manipulate earnings”, and from “The Female Health Company – 1Q 2014 results release” onwards, with charts at the end.

There’s a reason to believe that the M-Score is less effective now than it was when statistical tests were made. Readers who want to know about that first can skip to ‘What are accruals and do they matter?’ below.

The articles and papers I’ve found about the M-Score are either meant for investors but lack depth, or are highly technical and aimed at academics and regulators. I hope this piece provides depth, while avoiding phrases like “t-statistics based on the Huber/White sandwich estimator”.


I claim that the Beneish M-Score has two minus signs which are either wrongly reported or are not what was intended, indicating that a company is more honest if its leverage increases or its SG&A expense rises as a proportion of sales.

I claim there are serious problems with the ratios used in the M-Score, and improvements are possible.

I claim that The Female Health Company have booked nearly all the future benefit from their tax assets into Net income already, and a major contribution to their reported income will soon run out.

Many clever and/or well paid people must have checked the signs on the M-Score’s indexes, so I’m likely to be wrong. The M-Score has statistical support, and if I’m right, it ought to work even better when it’s fixed.

I’ve tried telling investors in Female Health about the tax situation. The few who have responded were not convinced. If I’m proved right, I’ve demonstrated the usefulness of looking into components of a company’s M-Score, because that’s how I was alerted to the unsustainable tax-related component of net income. Earnings that depend on tax benefits derived from previous operating losses are regarded as low quality. While tax assets are an easy target for manipulation, the evidence is against that, and in favor of Female Health’s tax assets having been estimated conservatively.

What’s an M-Score?

Here’s the formula:

M-Score = -4.84 + 0.92 * DSRI + 0.528 * GMI + 0.404 * AQI + 0.892 * SGI + 0.115 * DEPI – 0.172 * SGAI – 0.327 * LVGI + 4.679 * TATA

An M-Score above -2.22 is commonly supposed on various websites to indicate a serious risk that a company’s earnings have been manipulated. For anyone who can’t remember that lower is better, remember “Score high, more lie.”, and -2 is higher than -2.22.

Of the eight indexes in the M-Score, the simplest is SGI, the Sales Growth Index, which is this year’s sales divided by the previous year’s sales. Each index is multiplied by a number called a coefficient, for example 0.892 is the coefficient of the index SGI, and “+ 0.892 * SGI” is part of the M-Score formula. LVGI has the negative coefficient -0.327, and “- 0.327 * LVGI” is part of the M-Score formula. I explain later why I believe the two negative coefficients should be positive.

The constant of -4.84 at the front is an inconvenience for investors. Removing it would require adding 4.84 to any threshold the score is compared to, and would cause confusion about which version of the score was being used.

These M-Score indexes indicate distortions in the balance sheet which result from earnings manipulation:

    DSRI – Days Sales in Receivables Index
    AQI – Asset Quality Index
    TATA – Total Accruals to Total Assets

The indexes don’t prove or disprove balance sheet distortion, but provide some measure of how likely it is.

This index indicates earnings manipulation that will distort the value of Property, plant and equipment (net) in the balance sheet:

    DEPI – Depreciation Index

These indexes measure the pressure to manipulate:

    GMI – Gross Margin Index
    SGI – Sales Growth Index
    SGAI – Sales General and Administrative Expenses Index
    LVGI – Leverage Index

Even when the pressure to manipulate is high, in some cases management will stay honest.

The score was invented by Messod D. Beneish, with work published in 1997, but it’s the 1999 version which is most widely used, and used here. The coefficients in the M-Score were optimized to indicate the risk that regulators or auditors would require the accounts to be restated. That comes under the heading “earnings manipulation”, which is not usually as serious as fraud, as the restatement of accounts is not usually accompanied by prosecution. The term “earnings management” is sometimes used to mean arranging the accounts in a way which gives a truer picture than otherwise, or massaging the accounts when it isn’t serious enough to require a restatement.

The M-Score calculation needs numbers for the latest year and the previous year. The numbers will all be in a single 10-K form filed with the SEC. The score has statistical support, but I haven’t heard of the coefficients being retested or recalibrated to make sure they are up-to-date and still valid. Even when the TATA index was replaced by an index called ACCRUALS (which had been used before TATA), all the coefficients stayed the same.

Six of the indexes in the M-Score consist of one ratio divided by another, such as LVGI which is this year’s leverage divided by the previous year’s leverage, where leverage is the ratio of total debt to total assets. Ratios with that form can be misleading in the same way that a big percentage rise is often not as important as it sounds if the rise is from a small base.

Technically, a ratio should be written like this: 2 : 5, meaning two of something for every five of something else. In practice it’s easier to treat the ratios as decimals, and 2 : 5 translates to 2/5 or 0.4.

Calculating a list of financial ratios for a company leaves the problem of how to weight them to draw an overall conclusion. The M-Score and other financial scores solve that problem by using statistical procedures to weight the ratios. I do the opposite, by looking into each index in the M-Score, not just to explain the reasoning behind the index, but because the context matters. Here’s an analogy – a BMI (Body mass index, Wikipedia) of 27 generally indicates a person is overweight, with too much fat, but an athlete with a BMI of 27 is unlikely to be overweight or have too much fat. The interpretation is also different for children, and there are international variations. The additional information helps to put the number in the correct context.

I’ve written a lot about each index, and there’s a short list near the end under “M-Score definitions” for reference.

Why I show a spreadsheet that could have mistakes

My spreadsheet gives The Female Health Company a Beneish M-Score of -3.31. Gurufocus reported -2.5 on January 25, 2014, when they must have used the same source as I used (the 10-K for 2013). I expect from Gurufocus’s wide coverage of companies that they don’t copy and paste from SEC filings (a possible source of error), and they should have noticed by now if their calculation was wrong, so I could be showing a spreadsheet with serious mistakes. Different versions of the M-Score formula are possible, and Ycharts use a narrower definition of low quality assets. You have to subscribe to Ycharts before they let you see their M-Scores, and I haven’t subscribed.

    [ADDED APRIL 18, 2014 – Gurufocus have improved their M-Score calculator and now show the intermediate results. This means some of my writing about online M-Scores and Gurufocus’s in particular is now out of date. It’s a very useful feature, but there’s currently a glitch. As well as the sign-up windows that have to be clicked away, the first attempt to get an M-Score is likely to get an error message instead. If you click on “Beneish M-Score” in the alphabetical list on the left, you should then get the M-Score. Recently I’ve only used the calculator for SUNE (SunEdison) which needed the workaround, and SCTY for Solar City (I read in a comment they’re being investigated regarding their accounts). SCTY only gave a history of zeros, meaning the calculator didn’t work. I won’t know the success rate until I’ve tried more companies.

    The difference between the Gurufocus score and my own might be explained. The index they call TATA has a formula which looks more like the ACCRUALS index. I explain both indexes and why I use TATA, later. There were also two program errors warning of division by zero. While that causes some doubt about the result, the intermediate results show the working is alright. If the calculator was a ‘black box’ without the intermediate results, there would be no way of knowing if the end result was reliable.

    Find ‘M-Scores’ in my “SunEdison still set for growth and profit” piece, for a quick and rough analysis of SunEdison’s high M-Score in a comment, based on info from the gurufocus calculator.]

Gurufocus only give you the final score, and the M-Score is a measure with statistical support rather than a perfect indicator. If you like a company enough and find the M-Score indicating a serious risk of earnings manipulation, you might prefer to investigate rather than simply trust or not trust what the score is saying. It’s reasonable to target the investigation by seeing which component terms of the M-Score are mostly accounting for the signal. Until a free service turns up that shows the workings, some investors will need an M-Score spreadsheet. (For a free spreadsheet if you register (I haven’t) find “Beneish M Score to Detect Earnings Manipulation” below or under the “Links to free resources” tab.)

As an example, for Female Health Co the only two areas of possible concern about earnings manipulation are the gross margin and asset quality, highlighted by the GMI and AQI indexes. The signal from GMI is small. The AQI index measures the change in asset quality, and looking into it meant thinking about tax assets, and learning how the benefit to Net income had already been booked as tax assets were recognized. That kind of analysis is not possible if you only see the number spat out by an online M-Score calculator.

The intermediate results can be informative even when they aren’t signaling a problem. For example, Female Health’s sales and the SG&A expense have both fallen, which is obvious just by looking at the figures, but the change in the ratio between them isn’t obvious. The spreadsheet shows that as a proportion of sales, the SG&A expense has fallen from 0.2763 to 0.2452 (or from 27.6% of sales to 24.5% of sales). Further research shows that a fall in incentive payments was a large factor in this.

In other words, just as financial ratios can be looked at individually or composed into a score, the indexes in the M-Score can be looked into individually, as well as getting the overall picture from the M-Score.

The spreadsheet also gives readers something definite to refer to. Although it involves some work, you could look up the AQI calculation in the formula-view version, and trace the cell references I29, I30 and I33 back to Total assets, Total current assets and Property, plant and equipment, net, in the normal view of the spreadsheet. This provides an alternative if I don’t explain a calculation properly.

The file sizes of the graphics are only 362 KB and 162 KB, but the images are wide and you’ll need to view them separately. In Firefox, right click, select “Open link in new tab”, and use the magnifying glass. I don’t mind if you save the spreadsheet images.

Female Health M-Score 2013

Female Health M-Score 2013 formulas

A quick intro to The Female Health Company

Female Health’s only product is the female condom known as FC2, with the trademark “FC2 Female Condom” registered in the United States, and with registration or applications around the world for 14 trademarks including femidom, femy, and Reality. The company mostly sells to agencies in the public health sector, who supply the condoms to women who need them, mostly in less developed countries, and usually at no cost or low cost. Female Health’s customer concentration is high, the ordering process can be bureaucratic, and orders are lumpy. The three biggest customers are the United Nations Population Fund, USAID, and Sekunjalo, the Company’s distributor in the Republic of South Africa (RSA). The Bill and Melinda Gates Foundation supports programs with funding, some of which is likely to find it’s way to Female Health’s revenue.

Female Health have a history of growing cash from operations, with low investment costs, and have accumulated cash which exceeds their total liabilities, although they need some cash to see them through lean times. The growth has been ‘per share’ as well as in aggregate.

The M-Score spreadsheet is based on the 10-K for Female Health’s 2013, which ended on September 30, 2013. I ignore more recent results until I finish with the M-Score and only write about the company, from “The Female Health Company – 1Q 2014 results release” onwards. I’ll be referring to the spreadsheet and Female Health’s 10-K to illustrate some points, with more referencing when I get to the indexes in the M-Score.

Why the M-Score matters

1) Because when earnings manipulation results in the SEC or auditors requiring a restatement of earnings, the share price typically drops by about 40%.

2) Because an academic paper shows that the M-Score predicts future share price performance.

Both of the reasons could be undermined by recent investor awareness of the ‘accruals anomaly’, see ‘What are accruals and do they matter?’ below.

About 1), the 40% drop is under “The Model as a Classification Tool” in “The Detection of Earnings Manipulation” by Messod D. Beneish, June 1999. (PDF)

From the same PDF, it’s supposed to take about 20 to 40 similar non-manipulators in a portfolio to compensate for the discovery of earnings manipulation in a quarter, based on assuming that share prices will go up 1% to 2% on average per quarter. If the 40% drop has changed since 1999, it’s still likely to be big.

The PDF “The Predictable Cost of Earnings Manipulation” by M. D. Beneish and D. Craig Nichols, 2005 – 2007, starts by describing the ‘considerable losses’ caused by financial fraud.

The PDFs I link to are aimed at academics and regulators, but they’re worth referring to, and tend to have relatively plain English at the start and sometimes at the end.

About 2), the M-Score predicting future share price performance. I expect the prediction is with both real-world and statistical significance, to be worth publishing, which still leaves room for plenty of exceptions. The summary in this academic paper …

Earnings Manipulation and Expected Returns” by Messod D. Beneish, Charles M.C. Lee, and D. Craig Nichols, March/April 2013. Financial Analysts Journal

… suggests that the lower the M-Score, the better the share price performance, over a wide range of scores. As usual for statistical effects, it’s likely there will be plenty of exceptions.

In “The Predictable Cost of Earnings Manipulation” (above), it’s suggested that even sophisticated investors haven’t caught on to fraud detection, so mispricing occurred, or did in 2007.

Forensic accounting usually involves looking into the detailed accounts which companies don’t make public, but some of the leads are derived from information in the SEC filings (SEC – Securities and Exchange Commission), as in this case where the M-Score was used – “Using analytical tests to zero in on possible fraud” There’s enough to back up the claim, but you have to be a member to read the full story. (Some readers might have seen it already, from my “Links to free resources” tab.)

Some of the information about likely manipulators will be priced in, but I expect that for small companies the pricing-in is not a smooth process, with under-informed investors driving the price up until the overvaluation attracts short selling.

Limitations of the M-Score

The sample used to build Beneish’s model excluded financial services companies, and companies with sales under $100,000 or market capitalization under $50 million. That was in 1999 and there’ll have been some inflation since.

The M-Score is about earnings manipulation, and is less likely to pick up cash-based tricks. Sometimes cash takes a ’round-trip’, like A buying from B, B buying from C, and C buying from A. A round-trip of cash might have economic substance in a village with a butcher, a baker and a candlestick maker, but between companies it’s likely to be a ruse to create fake revenue. Any of the companies involved can class the purchase as investment, with the result that earnings, cash from operations, and cash into investment are all inflated. Detection depends on finding clues outside of the accounts, such as in the ‘Liquidity and Capital Resources’ section of a 10-K (which Female Health Co call “Liquidity and Sources of Capital”). If you spot that a company has bought from a customer, you may have spotted a short round trip of cash. Longer round trips are more complicated to arrange but are harder to detect. When a company has a history of substantial free cash flow, meaning there’s generally an excess of cash from operations over cash into investment, the excess can’t be faked by round trips and there’s less point in faking the rest of it.

The classic inflation of revenue by stuffing the sales and distribution channels can be detected through a build-up of Accounts receivable, and the M-Score covers this with DSRI, the Days Sales in Receivables Index. This tell-tale sign can be covered up by selling some of the receivables. If the receivables are sold ‘with recourse’ to a bank, it means the bank has a claim on the company if the customers don’t pay up, and the supposed sale of receivables is in fact a loan dressed as a sale. Finding that receivables are sold ‘with recourse’ is a clear indication that receivables are understated, but sales of receivables are not in the main accounts and not in the M-Score calculation. An alternative for manipulators is to sell the good part of the receivables without recourse, and receivables should usually be adjusted for any sales of them when calculating days sales outstanding.

Fraud evolves, and while big fraud gets the attention, it’s likely that lesser forms of manipulation also evolve. The practices used will reflect what is convenient for individual companies, what will influence share analysts and investors, what is less likely to cause suspicion among analysts, investors and regulators, and what is easier to defend in court and avoids the most serious personal punishment.

The phrase “the bottom line” became popular and along with revenue, earnings were an obvious target for manipulation. Savvy investors learned to distrust earnings and focused on cash. There are still investors who believe that cash can’t lie, although manipulators have long since focused much of their effort on cash. This is likely to make pure earnings manipulation and therefore the M-Score less relevant.

Another possibility is that when manipulation of earnings reaches a point where further manipulation becomes too obvious, companies switch to ‘pro forma’ (or non-GAAP) accounting in the earnings press release. That’s my understanding of this abstract: “The Relation between Earnings Management and Pro Forma Reporting” (five authors, two universities, May 1, 2013)

The paper also looks specifically into switching to non-GAAP measures where recurring items are excluded. It’s common for non-GAAP measures to exclude recurring items, and while EBITDA excludes four of them, anything starting ‘EB’ (Earnings before) is likely to exclude some recurring items. Tech companies in particular like to exclude high stock based compensation, although I can’t back that up with research. The paper implies that when companies use aggressive non-GAAP reporting, their GAAP earnings are accurate, with no further balance sheet distortion. The abstract is worth reading and I haven’t covered everything in it.

Researching a company would be easier if all the manipulation was diverted into non-GAAP measures, because it’s easy to check the ‘GAAP gap’ between GAAP and non-GAAP results. I believe that non-GAAP measures have their uses, but they are easy for management to abuse. A common method of stage magicians is to frame the area where they want the audience’s attention, which is away from where the real action is. Some believers in management’s preferred metrics and non-GAAP figures can be distracted from the GAAP figures, which are usually worse, not as smooth, and more risky to manipulate. Acacia Research are an example where anyone writing or commenting about them on Seeking Alpha would be told if they had strayed from management’s preferred metrics, and I saw no-one argue that you shouldn’t place so much trust in management. The issue died when those metrics deteriorated.

Scale-sensitive ratios

The ratio income / dividend is known as the ‘dividend cover’. The ratio is scale-insensitive, for example if a company’s Net income covers the dividend payment 3.4 times, the meaning is the same if the calculation is $3.4 million / $1 million, or $34 billion / $10 billion.

If staff turnover doubles, it sounds very bad, but if the doubling was from 0.1% a year to 0.2%, it’s not a problem at all. The doubling is a ratio of change and also a ratio of ratios, because the percentage turnover is the ratio of staff departures to staff. Six of the indexes in the M-Score have the same structure. For most of the six, this is not a big problem. For example, the ratio of SG&A expense to Sales is unlikely to be vanishingly small, although a small company is more likely to have a big increase in the ratio than a big company, quite possibly for a good reason such as employing more sales staff before launching a new product. GMI, the Gross Margin Index, can be quirky, but only when the gross margin is abnormally low or negative. The biggest problem is with leverage.

Beneish recognized the problem of division by small numbers, and used a standard fix called “winsorizing” which turns very small denominators into acceptably small denominators (so you might divide by 0.05 instead of by 0.001, which is like multiplying by 20 instead of by 1,000).

The winsorizing is at the 1% threshold. These are my simple but idiosyncratic instructions for how to winsorize a list of numbers (making the small numbers bigger), and limit outliers (making the big numbers smaller):

    1) Find the lowest 1% of numbers
    2) Call the biggest of those numbers WTD (for world’s tallest dwarf)
    3) Replace any numbers smaller than WTD with WTD
    4) Find the biggest 1% of numbers
    5) Call the smallest of those numbers WSG (for world’s shortest giant)
    6) Replace any numbers bigger than WSG with WSG

That might not be how Beneish would describe it. Winsorizing at 1% still leaves about 98% of the variation of scale, which matters, and is ignored by the M-Score calculation. I regard winsorizing as a rather brutal procedure which loses information.

The fixes were applied to the data Beneish used to build the model and get useful coefficients. That leaves two problems that could occur when calculating an M-Score –

1) Finding the cut-offs. You might have to buy the right academic paper, and understand it, or get access to a suitable financial database and know what to do with it.

2) If you know Beneish would have upped a 0.001 to 0.05, and you do the same, you don’t know how that affects the reliability of the result, without the right expertise or data.

If you need to know how gurufocus deal with the problem for their online M-Scores, you could try asking them.

Flaws in the M-Score – LVGI, a scale-sensitive ratio

LVGI, the Leverage Index

this year’s ratio Total debt / Total assets
divided by the previous year’s ratio

where Total debt = long term debt + current liabilities

Coefficient -0.327

To take an extreme example, imagine a software company with plenty of cash and no long term debt, the main expense is compensation, and the only current liability is a small Accounts payable. Near the end of a successful year, the company buys some new kit, increasing the Accounts payable. In such a situation, leverage defined as (Current liabilities + long term debt) / Total assets could have a huge percentage increase, as a result of change from a low base rather than high liabilities at the end. The definition of leverage is the ratio Beneish uses, and with that definition, LVGI can be shortened to –

    LVGI = This year’s leverage / the previous year’s leverage

To illustrate the “increase from a low base” case, suppose that leverage increases from 1% to 4%.

    LVGI = 0.04 / 0.01 = 4

That’s a big index. and after multiplying by the coefficient -0.327,

    the term for leverage = 4 * -0.327 = -1.308

When there’s no change in leverage, LVGI = 1, and after multiplying by the coefficient -0.327, the “neutral” term in the M-Score = 1 * -0.327 = -0.327.

The difference made when LVGI = 4 is therefore -1.308 – -0.327 = -0.981. That’s far enough below zero to have a substantial effect on the M-Score. (WordPress turns some minus signs into dashes, and 1 – -2 means 1 minus the number minus 2.)

If you can stretch your imagination to an increase in leverage from 0.001 to 0.004 (or 0.1% to 0.4%), LVGI gets the same result as before, because:

    LVGI = 0.004 / 0.001 = 4

with an effect on the M-Score which is completely disproportionate to the change in LVGI (in common sense terms. It’s exactly proportionate in terms of the arithmetic.)

At the other end of the scale, if leverage jumped massively from 20% to 80%:

    LVGI = 0.8 / 0.2 = 4

with exactly the same effect of adding -0.981 to the M-Score.

Find “Winsorizing” above, for Beneish’s fix and the problems with it.

Flaws in the M-Score – LVGI and the minus sign

LVGI, the Leverage Index

this year’s ratio Total debt / Total assets
divided by the previous year’s ratio

where Total debt = long term debt + current liabilities

Coefficient -0.327

Beneish defined leverage as (long term debt + current liabilities) / Total assets. By that definition, Female Health’s leverage fell from 5.83% to 2.57%, giving LVGI = 0.0257 / 0.0583 = 0.440.

Multiplying by the coefficient, the term added to the M-Score is:

    -0.327 * 0.440 = -0.144

Now suppose instead that Female Health Co’s leverage had shot up to ten times the previous level. That would make LVGI = 10, and the term added to the M-Score would be:

    -0.327 * 10 = -3.27

making the M-Score much smaller, and giving a much weaker indication of earnings manipulation.

The authors of “The Predictable Cost of Earnings Manipulation” (already linked to) change “LVGI” to “LEVI”, but it’s still the same formula. They state, as you’d expect, that LEVI is a measure of financial risk, and more of it increases the chance of earnings manipulation to meet the debt covenants set by lenders (but find “relatively low cost of breaking covenants” below). So, why does the coefficient have a negative sign, meaning that more LEVI and more financial risk indicates less chance of earnings manipulation, as I’ve shown above?

It looks to me as if the minus sign must be wrong, or is at least surprising enough to need an explanation. Either I’ve made a stupid mistake and have a complete blind-spot to it, or Beneish made a simple mistake which has not been picked up by peer review (I suppose they have that in the subject) or by at least several website publishers, or by the regulators, auditors, forensic accountants and short-sellers that use the M-Score. Or, academics spotted a mistake but it hasn’t filtered through to anywhere I’ve looked. Take your pick.

A different possibility is that while Beneish expected a high LVGI to correlate with earnings manipulation, the data said otherwise, so the software spat out a negative coefficient. Such a counter-intuitive result would need an explanation, and I haven’t seen any.

Using the positive coefficient 3.27 gives Female Health an ‘M-Score 3’ of -2.97.

No positive leverage for all practical purposes

LVGI, the Leverage Index

this year’s ratio Total debt / Total assets
divided by the previous year’s ratio

where Total debt = long term debt + current liabilities

Coefficient -0.327

The reasons given for including LVGI in the M-Score are financial risk, and not wanting to break debt covenants. (The “financial risk” reason is from “The Predictable Cost of Earnings Manipulation” (already linked to), where the term LEVI is used instead of LVGI.) This poses a problem, because a company with zero debt has no covenants, but could be short of cash to see it through shocks and lean periods. The company could reduce its liquidity risk by long term borrowing. But, should “financial risk” include liquidity risk, or did the term mean only the risk of breaking debt covenants?

Liquidity risk is a kind of financial risk, and borrowing to reduce it will increase leverage. One complication is that a company can increase its liquidity with a credit facility, which could have covenants attached, but won’t affect the leverage number until funds are drawn down from the facility.

A factor here is the relatively low cost of breaking covenants (1% or 2% of market cap, according to Beneish and Press 1993). Beneish states that the coefficients for LVGI (leverage), DEPI (depreciation) and SGAI (sales, general & admin) are not significant, and suggests they might only indicate “earnings management” which he considers to be less serious than earnings manipulation. For LVGI, that’s consistent with a relatively low cost of breaking covenants.

There’s a five index M-Score which excludes LVGI, DEPI and SGAI. That’s confirmed in this short description, where you can also download nine free spreadsheets including an M-Score spreadsheet which gets the numbers it needs from the internet, if you register (I haven’t registered).

Using Beneish M Score to Detect Earnings Manipulation” by Jae Jun, June 24th, 2010 (oldschoolvalue.com)

As well as some doubt about the reasoning behind using long term debt + current liabilities on the top of the leverage calculation, I’ve questioned the sign of the LVGI coefficient (and the SGAI coefficient, later). Also, the indexes where I’ve questioned the sign are two of the three indexes which Beneish says have insignificant coefficients, and may only indicate earnings management.

I’m going to give an opinion which is not based on Beneish’s writing. Leverage matters, but not necessarily as Beneish defined it. A company with insufficient cash and no debt might need to borrow in a hurry, and have an incentive to manipulate earnings when they need to borrow. If they borrowed before a crisis, they have more liquidity and some debt, but have the same net cash as before borrowing. The situation changes if they invest the cash they borrowed, which cancels the gain in liquidity and leaves the company with debt, and with financial risk unambiguously increased.

What I think matters are these ratios:

    All liabilities net of cash / Total assets
    Available cash / Total assets

The first ratio is instead of other definitions of leverage, and the second ratio is the liquidity of the assets.

The first ratio will be more like the usual definition of leverage when a company has high debt and little cash, which could result if a company borrows heavily to invest, and gets by with a credit facility instead of keeping much cash to cover the fluctuations that happen with normal operations. When a company has more cash than total liabilities, the ratio shows ‘negative leverage’. Some liabilities don’t ever have to be paid, such as Female Health’s Deferred grant income (explained below). Other liabilities are unlikely to be paid, such as deferred revenue (usually). In Nanometrics’ case, deferred revenue occurs when tools have been delivered and paid for, but none of the tools in an order have been tested and signed off by the customer, so revenue has not been officially recognized. In contrast, when deferred taxes are listed as a liability, the tax bill has been been deducted from taxable income but not paid yet, and it’s unlikely that the payment can be avoided. When there’s enough time to look into the liabilities, some could be excluded from the leverage calculation, some could be scaled back, but in my opinion some should remain, even if they aren’t current or classed as long term debt. I could have written “All liabilities scaled in proportion to how payable they are, net of cash” instead of “All liabilities net of cash”, but I preferred to use a number that can be found easily, with the option to refine the number. It’s more conservative to include liabilities that don’t have to be paid, than to exclude liabilities that do have to be paid.

‘Available cash’ means you can include the unused part of credit arrangements if you believe they won’t be taken away when they are needed, and you can include marketable securities if they’re included in current assets and you believe they can be sold at the value reported. That isn’t always a safe assumption. From Lattice Semiconductor (LSCC)’s 10-K for 2013:

    “Due to continued multiple failed auctions and the resultant illiquidity of these investments, we have classified our investment in auction rate securities as long-term.”

With hindsight, those securities should not have been classed as short term, showing that judgment can be involved in the accounting as well as the investing, and can be wrong.

Check a company’s securities for ‘investment grade’ (the alternative is ‘junk’), if they’re from the U.S. government or a very reliable government, and duration. Long durations are particularly risky when interest rates are low and could rise, or inflation could erode the value. Denomination in a foreign currency could be appropriate if the company has obligations in the same currency. That’s very brief. You could write a whole book about security analysis.

There are three levels of financial instruments and other assets. In my words:

    Level 1 – The instrument is reliably priced by the market. Little or no judgment is required to get the price.
    Level 2 – Either a market exists but it’s thin or infrequent, or the value of the instrument is gauged by the value of similar but not identical instruments.
    Level 3 – It’s anybody’s guess. Lattice had a long paragraph which included:

    “third party valuation results, investment broker provided market information and available information on
    the credit quality of the underlying collateral.”

and it went wrong. Currently:

    “Our Level 3 instruments are classified as Long-term marketable securities”

and that’s about the problem investments (auction rate securities) which were reclassified as long-term and they don’t sound very marketable to me.

Level 1 means the price ought to be reliable, but does not necessarily mean it’s a safe investment. Junk bonds are particularly liquid when they are generally overpriced.

A different variation is that non-recourse debt does not pose the same financial risk as ordinary debt. SunEdison (SUNE) use non-recourse debt to finance some of their solar projects. If a solar project does not generate enough income to pay the interest and repay its debt, the lender can take ownership of the project, but has no other claim on the company. It’s a bit like dividing a ship into watertight compartments – one or two big holes won’t sink the whole ship. The non-recourse debt is not included in leverage calculations included in SunEdison’s debt covenants, which means that lenders making ordinary loans regard the existing non-recourse debt as having much less risk than existing (senior) normal debt (that’s less risk to the ability to repay new debt). SunEdison’s non-recourse debt is also not amortized, meaning it stays on the books at full value until the last payment is made, which is usually about 20 years after the money was borrowed. Anyone or anything that simply takes the debt figures from SunEdison’s accounts and drops them into a leverage calculation will over-estimate the financial risk posed by the debt.

If there’s plenty of cash, you might as well just stick with cash. The ratio Available cash / Total assets says nothing about the particular liquidity needs of a company, which is a more complex matter.

Female Health Co have $8,922,430 of cash and only $3,766,996 Total liabilities. My spreadsheet uses Total liabilities instead of debt (for the main calculation), but otherwise sticks to Beneish’s definition of leverage and the LVGI index, because it doesn’t net-out the cash as I proposed. The result is 10.7% leverage (for 2013).

Going purely by Beneish’s definition, the leverage is a tiny 2.6%. The difference is because the company has long term liabilities but none of them are classed as long term debt, so by Beneish’s definition, the top of the ratio for 2013 only consists of the $904,049 current liabilities.

I don’t see Female Health as having financial leverage in any real economic sense. Even if they somehow had to pay all the liabilities immediately, and needed to repatriate the cash from overseas and pay 35% tax as a result, the total cash cost would be $5,795,378, leaving $3,127,052 cash and with zero liabilities on the balance sheet. Far from being juiced-up by debt, Female Health are ‘unjuiced’ by having more cash than Total liabilities. (For more about the tax rate, see “Links for the U.S. corporate tax rate”, below.)

Because I mentioned repatriation of cash, I’ll quote this from the 10-K,

    “Cash concentration: The Company’s cash is maintained primarily in three financial institutions, one located in Clayton, Missouri, one located in London, England and the other in Kuala Lumpur, Malaysia.”

but it doesn’t say how much of the cash is held overseas or how much tax would be payable if cash was repatriated to the U.S. It’s likely that the information isn’t disclosed because there’s little chance of needing to repatriate much of the cash.

Using my alternative to leverage, (Total liabilities – cash) / Total assets, the measure is negative for Female Health, at -$5,155,434 / $35,169,953 = -14.67%, which could be roughly interpreted as ‘negative leverage’.

The ratio Cash / Total assets is $8,922,430 / $35,169,953 = 25.4%. The ratio is high, but it’s simpler to say that the $8,922,430 provides a substantial cushion against lean times, than to draw conclusions from the liquidity of the assets, which is best seen next to my version of leverage (-14.67%). I haven’t included the revolving line of credit with Heartland Bank for up to $2 million, which was unused at the year end (and at the end of 1Q 2014).

I have not attempted a full round-up of Female Health’s obligations, commitments and contingencies (as in my “Three cash3 companies”), but the total for Contractual Obligations is $2,147,677, all for lease obligations, which stretch to 2018 apart from $102,222 beyond 2018. So:

    Cash = $8,922,430
    Total liabilities = $3,766,996
    Cash net of Total liabilities = $5,155,434
    Total Contractual Obligations = $2,147,677
    Cash net of Total liabilities and Total Contractual Obligations = $3,007,757

    “The Company has no off-balance sheet arrangements as defined in Item 303(a) (4) of Regulation S-K.”

I haven’t checked Item 303(a) (4) of Regulation S-K to see what kind of off-balance sheet arrangements they could in principle have without disclosing it.

The point of this is that Female Health have not racked up their cash through off-balance sheet arrangements or by incurring excessive contractual obligations, although I haven’t made a thorough check of commitments and contingencies. The company has risks such as customer concentration and emerging competition, but for practical purposes they have no financial risk, are not ‘juiced up’ by debt, contractual obligations or off-balance sheet arrangements, and their leverage is above zero in a formal sense but not in an economic sense. That could change if the cash flow drops and they don’t cut the dividend, but currently I see no financial risk.

When I think about a company’s cash I like to check their definition, and Female Health’s definition of cash and cash equivalents is clear. From the 10-K, under the sub-heading “Financial instruments:”

    “The Company currently does not have any assets or liabilities measured at fair value on a recurring or non-recurring basis. Substantially all of the Company’s cash and cash equivalents, as well as restricted cash, are held in demand deposits with three financial institutions. The Company has no financial instruments for which the carrying value is materially different than fair value.”

I’m happy with “Substantially all” which is much better than “include” and the general woolliness of the companies in my “Three cash3 companies” blog piece.

There’s no sign of any marketable securities or investments in Female Health’s 10-K, as you’d expect from “not have any assets or liabilities measured at fair value” in the quote above.

More on Female Health’s leverage

Forgetting my version of leverage which gives Female Health negative leverage, I prefer Total liabilities / Total assets to leverage defined as (Long term debt + current liabilities) / Total assets, because liabilities usually have to be paid or offset whether they are called debt or not (but find “Deferred grant income” below). Beneish considered three alternative definitions, but not the one I prefer. Liabilities which aren’t counted as debt aren’t subject to covenants as long term debt is, but current liabilities don’t always have covenants either.

Female Health have a revolving credit facility with Heartland Bank, limited to 70% to 80% of eligible accounts receivable plus 50% of eligible inventory. Covenants restrict corporate activity such as mergers and selling substantial portions of the assets, and restrict dividends and share buybacks, but “The Loan Agreement does not contain any financial covenants that require compliance with ratios or amounts.” Dividends are likely to be limited by income and cash flow rather than the terms of the Loan Agreement, see “FHCO – Female Health’s dividend cover and covenant restrictions” below.

Using Total liabilities instead of Total debt, my spreadsheet calculated the leverage for Female Health Co for 2013 and 2012 –

    2013 leverage = 0.1071
    2012 leverage = 0.2046

    LVGI = 2013 leverage / 2012 leverage
    = 0.1071 / 0.2046
    = 0.5235

My spreadsheet also includes Beneish’s definition, where these long term liabilities of Female Health Co are excluded:

    Deferred rent $66,799
    Deferred grant income $57,819
    Deferred income taxes $235,179

The exclusions add up to $359,797. It’s reasonable to exclude Deferred grant income, which means that someone else paid for at least $57,819 of capital expenditure. U.S. GAAP rules mean the benefit has to be recognized over the life of the capital assets bought. The mechanics of this are that the grant received is initially offset by the same amount of Deferred grant income, under Long-term liabilities. The grant is released into income by a process which cancels the effect of the depreciation charge. Therefore the Deferred grant income is not a bill which ever has to be paid in cash, and could reasonably be excluded from the top of the leverage calculation (if you prefer ‘liabilities that have to be paid’ to only ‘long term debt + current liabilities’).

Deferred rent arises when an operating lease agreement includes rising payments. The increases will have to be paid, but for more detail see “Straight-line Expense Recognition of Leases” by hhadmin, May 22 2012 (hhcpa.com/blogs). The accounting rules could change, see “Operating lease obligations – billions or trillions to land on balance sheets” below.

Deferred income taxes are 65.4% of the Long-term liabilities, and they have to be paid.

Companies sometimes report liabilities which are false, so they can conjure-up income when they like by reducing the liability (find “The way ‘cookie jars’ work” below). Cookie-jar liabilities are relevant here because they’re in the ‘never have to be paid’ category, but usually you would want to avoid a company with a cookie jar, although detecting them isn’t easy.

In the spreadsheet, the version of LVGI which sticks to the conventional ‘long term debt + current liabilities’ definition is called ‘Current LVGI’ because FHCO has no long term debt, and only current liabilities remain in the top of the leverage ratio. The Current LVGI = 0.4408, and using Current LVGI gives ‘M-Score 2’ = -3.28.

Either way, leverage has come down, by 48% (using Total liabilities / Total assets) or by 56% using Beneish’s definition. I see that as an excellent reduction in leverage, and the reduction gives no cause for concern about earnings manipulation. Taking the view as in “No positive leverage for all practical purposes” above, the situation still gives no cause for concern about earnings manipulation.

Female Health – ethics and incentive to manipulate earnings

Having made the first judgment about Female Health Co, that their leverage is nothing to worry about and does not indicate earnings manipulation, I’ll explain why I believe the company is probably less likely to manipulate earnings than most. They sell to organizations with ethical aims, including the reduction of infection and both maternal and infant mortality, partly by providing barrier-contraceptives. Any lack of ethics might not go down well with the customers. Funding sources include the Bill and Melinda Gates Foundation, who I think would rather not be associated with companies noted for dubious accounting, even though the quality of the suppliers’ financial reporting won’t be their highest priority. To a lesser extent that could be true of governments, but they’ve probably dealt with companies that have behaved improperly quite often.

In business-to-business or business-to-consumer relationships, I believe there’s less reason to care about the other party’s financial reporting. Some big retailers don’t pay their suppliers until after cash has been received from customers, so they have no financial incentive to care about the honesty of their suppliers’ financial reports. Some retail customers care about fair-trade or environmental issues, but they won’t blame a retailer if a supplier was guilty of inflating earnings, or care much, if they even know about it. The issue doesn’t matter if the business relationship isn’t close, and no-one cares about the reporting standards of the company they buy paperclips from.

Some manipulation depends on cooperation from the manipulator’s customers. The transformation of receivables to financial instruments is possible because the mechanics of payment don’t make a financial difference to business customers, and the customers are prepared to cooperate. The Penn Traffic Company are a retailer that recognized promotional allowances (like payments for advertising) before they were earned, in the early 2000s. Vendors were willing to send emails that backed up the false invoices, when they were reassured that they would not be billed twice.

The honesty of the funding sources and international agencies isn’t relevant, what matters is they could have more to lose and nothing to gain if they are associated with a company which manipulates earnings. I don’t want to overstate the case. Counterexamples are possible, and programs wouldn’t be canceled due to a company restating its accounts, but there’s still some incentive to avoid the possibility of embarrassing partners.

That’s all in my own opinion.

I’ve seen claims that Female Health Co are highly ethical, and my guess is they’re probably above average. From the Motley Fool: “The 25 Best Companies in America” (fool.com)

Fool’s list seems to have been published early in 2013, with the ranking based on how companies served their stakeholders, not just investors. Female Health Co scored highly in the ‘Investor’ category, with a low score for ‘Employee’. IMO using recruitment-related websites is a particularly unreliable method for judging a company in relation to its employees, when the company is small. Female Health made number 21, and were much smaller than any of the other companies in the Fool’s top 25.

There’s more on Fool’s page by clicking ‘Expand’ on the right, then a link to see more. Then there’s ‘click here’ to keep reading, but they ask for an email address.

If you think ethics extends to management not being over-rewarded if the company is acquired, find “FHCO – Anti-takeover provisions” below, and find “FHCO – Indemnification of directors and officers” (below) if you think they ought to at least leave some clues so shareholders don’t have to open many 8-K forms to find the wide indemnification.

Flaws in the M-Score – SGAI and the minus sign

SGAI, the Sales, General and Administrative Expenses Index

this year’s ratio SGA expense / Sales
divided by the previous year’s ratio

Coefficient -0.172

Other sources usually describe SGAI as the ratio of SGA expense to sales, for year t relative to year t-1.

The simplest way to illustrate the problem is with an unfeasibly extreme example. Imagine:

    2013 SGA expense $100 million
    2013 Sales $1,000 million
    2012 SGA expense $1 million
    2012 Sales $1,000 million

    so SGAI = (100 / 1,000) / (1 / 1,000)
    = 100 / 1
    = 100

The SGAI of 100 represents a massive increase in the SGA expense as a proportion of sales.

The term added to the M-Score equals the index times its coefficient:

    term added to M-Score = coefficient * SGAI
    = -0.172 * 100
    = -17.2

Because that’s massively negative, it pulls the M-Score down, indicating an honest company with virtually no risk of manipulating earnings. That’s the opposite of what Beneish intended, because he explained that increasing SG&A expense (as a proportion of sales) indicates more risk of earnings manipulation.

I’ve seen a claim that SG&A is usually a fairly constant proportion of sales, and since fake sales have little SG&A cost, less SG&A / sales indicates that sales have been faked. That’s an obscure belief and I can’t find it again. There is a case where a falling ratio of SG&A to sales was the result of misleading accounting, but it was for fiddled SG&A rather than sales.

In 1999, IBM sold their Global Network business, and somehow the proceeds ended up as a reduction in their SG&A cost. (Find “IBM sold their Global Network business in 1999” in my “Three cash3 companies” January 17, 2014.)

As a result, SG&A fell nearly 12%, while revenue was up 7% and Cost of goods and services was up over 9%. Investors who didn’t find the right footnote in the 10-K could have applauded IBM’s efficiency, at least if they didn’t stop to think that the figures were implausible for the bureaucratic behemoth. The M-Score doesn’t check the footnotes, and the calculation is (in $ billions):

    SGAI = (14.7 / 87.5) / (16.7 / 81.7)
    = 0.168 / 0.2044
    = 0.8219

In my opinion the result means “looks good, but investigate”. A low SGAI is more feasible when sales and the SG&A expense both grow but the sales growth is faster. That’s because the SG&A expense usually includes some fixed costs. That’s especially true for automated processes, for instance the cost of a paperless billing system doesn’t change much with volume. Publishing is an industry where revenue can increase without much change in SG&A. If a book sells a hundred times as many copies as expected, the SG&A expense doesn’t have to increase by much, although it might be worth spending more on promotion and investing to cash-in with merchandise. Similar economics apply to software and anything virtual or ‘in the cloud’, if little support from staff is required.

It’s also possible for some of the fixed SG&A costs to be cut if a reduction in sales looks like a permanent condition the company has to adapt to. Inefficient companies can streamline, but there should be evidence such as a reduction in headcount, a claim to have cut out layers of management, or the disposal of inefficient parts of the company. It’s also possible to cut too much and provide a poor service in order to hit a short term target. (See also “More with less”, below.)

When a company’s management want to hide a rising SG&A-to-sales ratio, they could be tempted to find some one-time proceeds to dump into SG&A, IBM fashion. Management can tune this by splitting the proceeds into different areas, like between SG&A and investment, and keep the SG&A-to-sales ratio constant if they want to. This can only be found if there are clues in the 10-K or 10-Q, which is reasonably likely as a lack of clues makes rather odd financial reporting more like fraud. The M-Score obviously can’t go looking for such clues, but if one index in the M-Score fails because management have covered their tracks, earnings manipulation might show up sufficiently in another index.

In “The Predictable Cost of Earnings Manipulation” (already linked to), Beneish and the other authors said that a high SGAI predisposes a company towards earnings manipulation. Administration costs that increased without creating sales signaled declining prospects, and they wrote about the GMI and the SGAI indexes, “both signals of declining prospects”. There is a strong implication that declining prospects predispose management to manipulate earnings. Gurufocus echo this interpretation, and relate a high SGAI to inefficiency in generating sales, which I believe is in keeping with what Beneish says. They also use basically the same formula for SGAI, and the same coefficient, as Beneish, and myself. Again, I’m wondering what simple mistake I’ve made that I can’t see. (Find “picked up by peer review” above for why a simple sign error is likely to have been spotted by now.)

SGAI for Female Health Co

SGAI, the Sales, General and Administrative Expenses Index

this year’s ratio SGA expense / Sales
divided by the previous year’s ratio

Coefficient -0.172

By ignoring the coefficient and whether it should be positive or negative, the situation regarding Female Health Co’s SG&A expense and Sales becomes clear enough, but first there’s a little complication about including the Advertising expense.

Female Health report Advertising separately from Selling, general and administrative. The SG&A figures I use are the sum of both expenses (Advertising + Selling, general and administrative). That’s done in a section of the spreadsheet headed “SPECIFIC TO FHCO”, which should make it easier to adapt the spreadsheet. If you made a spreadsheet for Ubiquity Networks, you’d use the section for calculations that belong under “SPECIFIC TO UBNT” rather than under “STANDARD”.

Including advertising, Female Health’s SG&A fell from $9,681,083 to $7,714,761 (in 2013).

The Sales figures are in the spreadsheet under “NUMBERS FROM THE ACCOUNTS” / “STANDARD”, which is where most of the numbers copied from the 10-K are. There you can see that Sales fell from $35.0 million to $31.5 million (in 2013).

If you find the “M-SCORE CALCULATION” area (to the right of the “NUMBERS FROM THE ACCOUNTS” area), and find the “SGAI” row in the list under the heading, you’ll see these two numbers:

    0.2452 (under “top”) and 0.2763 (under “bottom”)

Those cell values show how SGAI was calculated:

    SGAI = 0.2452 / 0.2763

The proper terms would be “numerator” for “top”, and “denominator” for “bottom”.

The text on the right of the row explains the calculation:

    “SGAI – Sales General and Administrative Expenses Index (-0.172) = this year’s SGA expense / Sales, divided by the previous year’s ratio”

That text explains how the numbers were derived:

0.2452 (under “top”) is from

    this year’s SGA expense / Sales

0.2763 (under “bottom”) is from

    the previous year’s SGA expense / Sales

That can be expressed as:

    The ratio SG&A / Sales fell from 27.6% in 2012 to 24.5% in 2013.

Summing up the change in SG&A, Sales, and the ratio between them:

    SG&A fell from $9,681,083 to $7,714,761
    Sales fell from $35.0 million to $31.5 million
    SG&A / Sales fell from 27.6% in 2012 to 24.5% in 2013
    SGAI = 0.2452 / 0.2763 = 0.8875

Very often, the ratio SG&A / Sales rises when Sales falls, as some of the SG&A expense is relatively fixed and can’t be scaled back as quickly as sales fall. Because a rise is expected, the fall needs an explanation. It’s in the 10-K for 2013:

    “The decrease was primarily due to a reduction in incentive payments partially offset by increased spending in education and training and consulting expenses.”

The reduction in incentive payments could be seen as partly reverting to 2011 levels:

    “Selling, general and administrative expenses increased $3,091,144 to $9,628,134 in fiscal 2012 from $6,536,990 in fiscal 2011. The increase was primarily due to increased spending in education and training and incentive payments based on the achievement of performance goals relating to the Company’s unit sales and operating income.”

In case there’s any doubt that the payments were cash, it’s confirmed by:

    “The increase of $1.4 million in cash generated from operating activities … was primarily due to the decrease in … accounts receivable … and the reduction in incentive payments.” (10-K for 2013, about 2013)

but the incentive payments aren’t broken out of the Selling, general and administrative expenses (or I didn’t find them).

The “share-based compensation expense” didn’t vary much, with the expense recognized for 2013, 2012 and 2011 being a fairly steady $728,000, $782,000 and $706,000, and the fair value of stock awards granted was $471,000, $218,000 and $1,677,000.

Overall, the Selling, general and administrative expense has been volatile over the past three years, with the latest year’s expense in between the two previous years. The SG&A expense has fallen as a proportion of sales (which is good), and the fall is probably accounted for by lower incentive payments. The size of the incentive payments wasn’t found, but something must have lowered SG&A, and I saw no sign of any one-off benefits that could have somehow been used to reduce the SG&A cost, IBM-style. There’s no sign here of earnings manipulation.

The value of SGAI in the spreadsheet is 0.8875, under “ratio” (I could have used the heading “index” instead). The number is the result of dividing the “top” by the “bottom” in the SGAI row. The value 0.8875 is less than one, indicating that the ratio SG&A / Sales fell (because ‘this year’ is on top, for SGAI).

In the SGAI row, in the column headed “top”, the blue mark on the left indicates that the quantity on the top of the ratio relates to “this year” (2013, the latest with a 10-K), and the pink mark on the left under “bottom” indicates that the quantity on the bottom of the ratio relates to the previous year, 2012. The marks were added to the graphic, but you could use background or border colors to show which year is on top in a spreadsheet.

DSRI, the Days Sales in Receivables Index

this year’s Days Sales in Receivables / previous year’s Days Sales in Receivables

Coefficient +0.92

A bill is said to have been outstanding for 31 days if 31 days have elapsed since the date of the bill, without the bill being paid. It’s useful to know how long the average bill has been outstanding. Using a year’s sales, the common formula for DSO or Days Sales Outstanding is:

    DSO = 365 * Accounts receivable / Sales (annual)

although this is easier to understand:

    DSO = Accounts receivable / Sales per day

You can check the definitions in “Days’ Sales Outstanding (DSO) Ratio” (accountingexplained.com)

DSO as calculated above gives an accurate result for the number of Days Sales In Receivables, which is the terminology Beneish uses. It does not always give an accurate picture of how long bills have been outstanding for, when sales or collection are lumpy, but it might be the best possible estimate given the information available.

It’s logically possible for all the bills in Accounts receivable to date from the first month of the year, or from the last week of the year, if business is sufficiently lumpy to allow the cases. Even if Accounts receivable are 90% of Sales, the sales could have been made in the last week of the year. Those are extreme cases, but they illustrate the need to check the DSO figure if you want to be sure about it. The checks include looking at the quarterly Sales and Accounts receivable figures, reading the ‘Liquidity and Capital Resources’ section of the 10-K, and knowing how lumpy sales and collection can be for the business. Searching the 10-K for ‘receivable’ could find relevant information.

Replacing ‘Days Sales in Receivables’ in the definition, with the formula for DSO …

    DSRI = (365 * this year’s Accounts receivable / this year’s Sales) / (365 * previous year’s Accounts receivable / previous year’s Sales)

… the ‘365’s cancel, to give

    DSRI = (this year’s Accounts receivable / this year’s Sales) / (previous year’s Accounts receivable / previous year’s Sales)

which is the formula I used in the spreadsheet, but with cell references, and split into ‘top’ and ‘bottom’ before dividing.

Female Health Co’s DSRI is 0.3250, which represents a dramatic fall in DSO from 76 days to 25 days. (I got the DSOs by multiplying the ‘top’ and ‘bottom’ numbers in the spreadsheet by 365.) Big changes in DSO can be expected due to the lumpiness of Female Health’s sales and the high customer concentration. It’s likely that in future DSRI could be high, possibly even pushing the M-Score over the commonly used threshold of -2.22. The reaction to a high DSRI should be “don’t panic”, and the big customers will probably pay their bills. However, it would be worth checking the 10-K (or 10-Q) for anything that allows customers to delay payment or return goods, or any change in the policy for revenue recognition. The current policy for product sales starts:

    “Revenue recognition: The Company recognizes revenue from product sales when each of the following conditions has been met: an arrangement exists, delivery has occurred, there is a fixed price, and collectability is reasonably assured.”

There’s also a small amount of revenue from royalties. If this grew, it might be necessary to adjust the DSRI calculation to exclude the effect of royalties.

The full policy is four times as long as the quote, but that still leaves the policy clear and short. Ubiquiti Networks sell through resellers and distributors, and their “Recognition of Revenues” policy covers a page, with details like “Revenues allocated to the PCS are deferred and recognized on a straight-line basis over the estimated life of each of these devices …”. I expect Ubiquiti’s revenue recognition is honest and conservative, but it’s hard to tell by reading the policy.

It’s not impossible for a big customer or funding source to become short of cash. For the funding sources and international agencies, any reduction in funding that would hit Female Health is likely to show up in the news rather than the DSO number, and if it’s in both, the news will be first. See “FHCO – Some thoughts about program-funding” below.

While Sekunjalo and possibly other customers are more like regular businesses, receivables are not broken down by customer or type of customer in the 10-K.

Female Health Co’s DSRI of 0.3250 is well below 1 and points in the opposite direction to earnings manipulation.

To illustrate the customer concentration (a hyphen indicates less than 10%):

    Customer, 2013, 2012, 2011
    UNFPA, 62%, 40%, 25%
    USAID, -, 25%, 26%
    Sekunjalo, -, 20%, –

UNFPA -United Nations Population Fund
USAID – United States Agency for International Development
Sekunjalo – Sekunjalo Investments Corporation (PTY) Ltd, the Company’s distributor in the Republic of South Africa

GMI, the Gross Margin Index

previous year’s Gross Margin / this year’s Gross Margin

Coefficient +0.528

A declining gross margin is one of the indications of poor prospects that predispose management towards earnings manipulation.

GMI has a particular quirk, because it’s possible for a company to have a negative gross margin. That’s unlikely for an established company, rather than a startup, but SunEdison (SUNE) managed it in their 4Q 2013 quarter, so a whole year of negative gross margin shouldn’t be impossible. (SunEdison are more ‘fresh start’ than startup, and are probably doing quite well, see my recent comment under my piece “SunEdison still set for growth and profit”.) Suppose in a bad year gross margin fell from 20% to -20%. Then, GMI = 0.2 / -0.2 = -1. Because the coefficient is positive, a GMI of minus one pulls the M-Score down, saying “everything’s fine here”. If the gross margin recovers to 20% in the next year, then GMI = -20% / 20% = -1, and the recovery produces the same index value as the drop to negative gross margin. More generally, if the sign on gross margin flips, GMI is negative, whether the sign flipped from plus to minus or from minus to plus. The minus sign is more accurate for the recovery. In positive territory, GMI doesn’t shout if this year’s gross margin is low, so long as it’s not worse than in the previous year. In other words, like the other indexes, it’s only sensitive to change.

GMI is also scale-sensitive, as a company which essentially breaks even at the gross profit level will not have exactly zero gross profit, but a fairly random amount of gross profit or loss, so meaningless changes like 0.3% to 0.1% are possible.

Female Health Co’s gross margin fell from 58.86% to 55.65%, giving GMI = 0.5886 / 0.5565 = 1.0578. Here’s a simpler way to calculate the effect on the M-Score compared to the ‘no change’ state. It works for seven of the eight indexes, for which the ‘no change’ state = 1, but not for TATA which is closer to zero when there’s no change:

    Effect on M-Score = (index – 1) * coefficient = (1.0578 – 1) * 0.528 = 0.0578 * 0.528 = 0.0305

So, a fall in gross margin resulted in a GMI over 1, increasing the M-Score by 0.0305 compared to the neutral “no change” situation where GMI = 1.

The term in the M-Score for an index is the value of the index multiplied by its coefficient, so except for TATA the term for the neutral ‘no change’ case always equals 1 * the coefficient, which is just the coefficient. In the case of GMI, the coefficient = 0.528, and so the neutral term = 0.528.

For Female Health’s GMI, the effect on the M-Score is small (only adding 0.0305). At 55.7% the gross margin is still high, and volatility is expected, with lumpy sales translating to lower sales in 2013 and less sales to spread fixed costs over, which reduced the margin. I don’t regard the fall in gross margin represented by GMI as indicating poorer prospects or a significant risk of earnings manipulation.

I haven’t seen fixed costs mentioned for 2013, but for 2012: “The increase in gross profit was the result of higher unit sales which improved the absorption of fixed overhead costs.”.

To illustrate the lumpiness of the business, regarding 2011 and 2012:

    “During fiscal 2011, the Company’s unit shipments, revenues and net income were adversely affected by bureaucratic delays and other timing issues involving the receipt and shipment of large orders from Brazil and the RSA. Significant orders for both countries were received in the first quarter of fiscal 2012.” (RSA – Republic of South Africa)

    “Gross profit increased $10,755,823, or 109 percent, to $20,621,013 in fiscal 2012 from $9,865,190 in fiscal 2011. Gross profit as a percentage of net revenues increased to 59 percent in fiscal 2012 from 53 percent in fiscal 2011.”

Those delayed orders made 2012 a tougher year to compare 2013 against. The quotes are from the 10-K for 2013.

AQI, the Asset Quality Index

this year’s ratio (Non-current assets – Property plant and equipment) / Total assets
divided by the previous year’s ratio

Coefficient +0.404

An AQI greater than 1 indicates a deterioration in the quality of the company’s assets, and the positive coefficient means that a deterioration in asset quality pushes the M-Score up, indicating more chance of earnings manipulation.

If I define:

    Suspect assets = Non-current assets – Property plant and equipment


    Suspect assets ratio = Suspect assets / Total assets

then AQI = this year’s Suspect assets ratio / the previous year’s Suspect assets ratio

and AQI goes up as the Suspect assets ratio goes up, which translates to:

AQI goes up as the quality of assets goes down.

I can re-write Suspect assets as:

    Suspect assets = Total assets – Current assets – Property plant and equipment

which makes it more clear that Current assets and PPE (Property plant and equipment) are excluded from the top of both the Suspect assets ratios in AQI.

The exclusions are because the distortion of some assets is picked up by other indexes, and the M-Score doesn’t cover cash.

While cash flows can be inflated, and the cash held can be increased as a result, the M-Score was not intended to specifically identify the manipulation of cash flows, although it can pick up deferred costs (explained soon) which affect the cash flow figures as well as earnings. Cash is excluded from AQI as a result of excluding Current assets. The rest of Current assets are taken care of by the TATA index, which checks the change in non-cash working capital. The value of Property plant and equipment could be distorted upwards by under-depreciation, which is tested by the DEPI index. The M-Score doesn’t cover everything, see “Flaws in the M-Score – no check on non-current liabilities” and “Beyond the scope of the M-Score” below. The “Beyond the scope” section covers ways to manipulate earnings which affect the balance sheet, but it’s hard to say they distort the balance sheet.

The equation above can be rearranged to:

    Total assets = Suspect assets + Current assets + Property plant and equipment

which is true by definition (the definition of Suspect assets).

Any distortion of assets ought to show up as a change in “Total assets” on the left, which must be balanced by a change in at least one of the three categories on the right. Asset distortion can now be broken down into three areas:

    Potential asset distortion in a year =
    Increase in Suspect assets + Increase in non-cash working capital + Probable under-depreciation

I’ve morphed “Increase in current assets” to “Increase in non-cash working capital” because that’s the main focus of the TATA index. “working capital” means current assets minus current liabilities, and “non-cash” means that cash, marketable securities and debt are excluded. I explained above that the M-Score doesn’t look specifically at cash, and it’s reasonable to extend that to exclude marketable securities and debt from the top of the TATA ratios, though in my opinion it could depend on the company having a reasonable and safe definition of marketable securities.

Total assets is used as a scaling factor on the bottom of ratios in AQI and TATA, and there’s no point in excluding either ‘good’ or ‘bad’ assets from Total assets when it’s on the bottom.

There’s a case for scaling by revenue instead of by total assets, which I don’t look into, but I think it’s not a good idea as revenue usually varies more than total assets. When total assets change more than revenue, I think it’s worth scaling by revenue to see what’s happening with the assets.

The Probable under-depreciation is different to the two increases. That’s because it’s calculated using depreciation, which is a charge that reduces net asset values. The two increases would have to be calculated by subtracting the size at the start of the period, from the size at the end of the period. That’s actually done for non-cash working capital in the TATA index, although depreciation also makes an appearance there. AQI does not use subtraction to calculate the increase in Suspect assets, instead it calculates the change in the proportion of assets which are Suspect assets, as a ratio.

The Suspect assets (my term) are what’s left from Total assets after the exclusions, and the theory is that the leftovers could represent improperly deferred costs. An example would be improper capitalization of R&D (research and development) which should be an operating expense, unless there’s a good enough reason to value the intellectual property produced by R&D as an asset. By capitalizing R&D, the expense can be transformed into investment, and without deduction of the expense, the operating income, net income, cash from operations and cash into investment are all inflated. See “IMPROPER CAPITALIZATION AND THE MANAGEMENT OF EARNINGS” by Ryerson, Frank E. III, Macon State College, 2009 (8 page PDF) (asbbs.org). Find “Fine Host” to get to the actual cases, which are easier to follow.

It’s been argued that securities or long term investments should be excluded, to give:

    Total assets – Current assets – PPE – Securities – Long term investments

on the top of the ratios. I’m not completely convinced. Any securities in current assets will be excluded from AQI anyway, as current assets are excluded. When securities are not in current assets, they should only be excluded from the AQI calculation when it’s clear that they have been given a genuine salable value, just in case they could be overvalued, because no other index would pick that up. Find “multiple failed auctions” above, about Lattice Semiconductor’s problem investments. They are honest about it and I’m not suggesting earnings manipulation, but their problem investments used to be classed as short term. That shows you can’t even rely on the value of marketable securities in current assets, without digging into and assessing the details. I might be pitching anecdote against statistics, but this isn’t science and the statistics can change.

The PDF “Popular Earnings Management Techniques” (linked to below) has a section titled “Flushing the investment portfolio” which explains how investments can be sold selectively to smooth earnings, choosing when to realize a gain or a loss. While that’s earnings manipulation, the sale of investments does not leave inflated values on the books, so keeping investments included in the top of the AQI ratios won’t help in such situations. Unless management have been very inventive, investments aren’t like the deferred costs which AQI was aimed at.

Ycharts deduct securities and long term investments in their AQI calculation, and cite some academic support, see “Beneish M Score” (ycharts.com). (They also use Depreciation and Amortization where only Depreciation is wanted.)

It would not make sense to calculate a company’s M-Score and at the same time trust management’s valuations. The famously fraudulent Enron Corp. provide an extreme case of mis-valuation. They valued contracts as if they were a securities trader, not a utility company, but the markets for the contracts were largely hypothetical. With no true market price, the valuation was a management decision, and the result of that was wildly inflated values. That supports not excluding any quantity from AQI (in the top of the ratios) where management judgment has been exercised, except for the quantities tested by other indexes (which are Current assets and PPE). The test ‘where management judgment has been exercised’ is wider than only looking for deferred costs.

Suppose a company arranges a sale-and-leaseback transaction for a large amount of PPE. First, there will probably be a gain or a loss on the transaction, but that’s dealt with under “Beyond the scope of the M-Score” below. If the company uses the cash to retire debt, the leverage ratio is affected, but there’s also a reduction in Total assets. That affects ratios which have Total assets on the bottom to scale the quantities on top. AQI and TATA will both be increased, even though the low quality assets and accruals they are testing are not affected by the sale-and-leaseback transaction. (If TATA was negative, it would get more negative.) It would take a big transaction to make much difference, but when that’s the case it’s an effect to bear in mind. The effect will depend on the nature of the lease and on proposals to put all lease obligations on the balance sheet, see “Operating lease obligations – billions or trillions to land on balance sheets” below.

One possible result of a sale-and-leaseback transaction followed by debt reduction is:

    1. A reduction in leverage (and the LVGI index)
    2. New off-balance sheet lease obligations, and
    3. False increases in AQI and TATA, due to less Total assets.

I say ‘false increases’ because in my opinion, AQI and TATA are ratios with an ambiguous meaning. While it’s reasonable to scale the low quality assets and the accruals by dividing by Total assets, changing the size of Total assets doesn’t really change the size of the effect of the low quality assets and accruals, and they stay in the same ratio to income if income is adjusted for the gain or loss on the sale-and-leaseback transaction. It’s a fairly subtle point, and if a growing company kept the same AQI and TATA ratios as it grew, I wouldn’t ignore growth in Total assets and focus only on the absolute increase in low quality assets and accruals.

It’s easier to illustrate an ‘ambiguous ratio’ with a different example. Suppose management learned that after checking the stock, 1% of the stock of finished goods was damaged. Obviously, it would be much worse if 10% of the stock was damaged. Now suppose a large order was filled using 91% of the undamaged stock. That would leave 10% of the stock damaged, but the company is better off, not worse off. Management would have to be idiots to say, “We can’t accept the order because that would leave us with 10% of stock damaged.”. So, is 10% of the stock damaged a worse ratio than 1% or not? There is no unambiguous answer. If damage occurs, you want as small a percentage as possible, but when the percentage rises through concentration rather than new damage, a high percentage becomes good because it means more sales.

This is an ambiguous ratio without any concentration effect: it’s usually a bad sign if a store has a high proportion of empty shelves, but if the shelves had just been cleared out by enthusiastic customers, it’s great.

A sale-and-leaseback transaction followed by debt reduction concentrates the more doubtful assets, but with no generally harmful effect that I can see other than increasing the AQI and TATA indexes.

Similar concentration of low quality assets and accruals occurs if cash is used to pay debt, but sale-and-leaseback puts big debt repayment within the reach of more companies.

I’ll rename my Suspect assets ratio to “proportion of uncertain assets” to avoid being too provocative, and using that still-prejudicial label, Female Health Co’s proportion of uncertain assets rose from 0.3702 in 2012 to 0.4602 in 2013, giving an AQI of 1.2433, and an M-Score term of 0.5023, which is 0.0983 above the contribution from the neutral case when asset quality doesn’t change. (The term for the neutral case equals the coefficient which is 0.404, and 0.5023 – 0.404 = 0.0983.)

The extra 0.0983 on the M-Score from AQI is not very big, but it’s a higher addition to the M-Score (above the ‘no-change’ case) than for any other index. It’s accounted for by the $4,900,000 rise in Deferred income taxes from $11,148,000 to $16,048,000, and a fall of $255,046 in PPE (net) from $2,349,876 to $2,094,830.

It’s what’s left after deducting PPE (net) that matters, rather than any change in PPE (net), so I don’t have to look into the small change in PPE (net), as I do next. The fall in PPE (net) is due to a $514,580 increase in accumulated depreciation and amortization (the two aren’t separated) with more Equipment, furniture and fixtures (before depreciation) offset partly by less Construction in progress that account for the $259,534 difference. None of that looks at all suspicious. I checked the ‘Useful life’s that assets are depreciated over and they’re normal and fairly conservative (Manufacturing equipment 5-10 years, Office equipment 3 years, Furniture and fixtures 7-10 years).

That leaves the $4,900,000 rise in the Deferred income taxes. The rise opens a Pandora’s box of complication, so I list my conclusions for anyone who can’t spare the time for the full treatment.

Conclusions about Female Health’s tax assets

1) The benefit from offsetting previous losses against taxable income has been real enough in the past. This is supported by tax payments which were lower than would be the case otherwise. The signal from AQI that dubious assets have increased, is probably false. There is no evidence of earnings manipulation here, even though the index is the biggest indicator of manipulation, numerically. Tax losses provide an opportunity for earnings management, but the evidence is against any inflation of earnings.

2) There’ll be little further benefit to Net income from previous losses, as most of that cake has already been eaten. When management aren’t confident that all the potential benefit from NOLs can be realized in the foreseeable future, the Deferred income tax valuation allowance holds the amount of potential tax benefit that’s not likely to be used, and the Net deferred tax assets hold the amount of potential tax benefit that is likely to be used. Net income has been increased as Gross deferred tax assets have been transferred from the valuation allowance to the Net deferred tax assets. There’s only $2,703,000 left in the valuation allowance. In future, when Net Operating Loss (NOL) carryforwards are offset against taxable income, the tax asset will be reduced, canceling the effect on Net income. The valuation allowance has generally fallen as growth meant more NOLs were likely to be utilized before expiry. The “little further benefit to Net income” is what really matters to investors, rather than trying to guess the intention behind the transfers to the deferred tax assets, although that hasn’t stopped me from noting the temptation to manipulate, and arguing that the deferred tax assets have been valued conservatively, with an effect opposite to inflating earnings.

3) The 2013 Net income of $14,342,598 includes $2,070,947 Utilization of NOL carryforwards, and $5,845,000 Decrease in valuation allowance, which sum to $7,915,947, or 55.2% of the Net income. If the valuation allowance had run out at the end of 2012, Net income would have been only $6,426,651. The $2,070,947 Utilization of NOL carryforwards would have been offset by a $2,070,947 reduction in the value of Net deferred tax assets, with zero net contribution to the tax expense. The $7,915,947 lifted the company’s tax expense to an Income tax benefit of $4,408,744. Doubters ought to ask how the company has been able to report substantial Income tax benefits for the past five years, while the direction of actual payments has been from the company to the IRS (Internal Revenue Service).

4) The deferred tax assets will still be good for cash flow, as they reduce the tax payments, which are in cash. The benefit will continue until the Gross deferred tax assets of $21,326,018 have either been used or the associated NOLs have expired. The $2,703,000 in the valuation allowance is more likely to expire before use, than the deferred tax assets. Growth is not strictly required by the aggregate figures to avoid NOLs expiring, but that leaves the possibility that growth of taxable income in the U.S. is required in the next few years to completely avoid NOL expiration.

5) There’s uncertainty, because the deferred tax assets depend on difficult projections which involve judgment. I believe the estimates have been conservative, but there’s room for error as there are factors which do not involve growth, such as tax planning strategies.

6) If future earnings are not high enough to avoid transfers from Net deferred tax assets back into the valuation allowance, then with hindsight the asset quality won’t look good, but that’s unlikely to be through earnings manipulation. While the tax assets are probably high quality, the Net income is low quality because it contains a source which will run out soon. Management don’t seem to have alerted investors to the issue, but they could argue that the information is there and it was up to investors and analysts to process it. The new CEO might prefer clarity.

7) In general, the GAAP requirement for management to base their valuation of tax assets on long term projections offers an opportunity for earnings management. Departing management also have an incentive to make the figures look good. However, no-one can be blamed for having unavoidable incentives, and my argument that management’s projections have been conservative is evidence against earnings manipulation (see “FHCO – Female Health’s deferred tax assets imply management’s forecasts have been conservative”, below). In addition, the M-Score of -3.31 is not indicating a risk of earnings manipulation, AQI is the only index pushing the M-Score up by much, and investigation around the other indexes mostly found reasons why the index could give a false indication of earnings manipulation in the future, due to the lumpiness of orders and cash collection.

8) The figures for ‘Decrease in valuation allowance’ for 2013 and 2012, are not exceptional given the history. While the valuation allowance has dropped dramatically in the past two years, the chart below shows that the “Decrease in valuation allowance” which contributes to Net income (through the tax benefit) has been roughly in line with the income before tax. Because the big decreases were not abnormal given the income before tax, they do not indicate earnings manipulation. All the dollar figures are in thousands.
Female Health - decrease in allowance vs pre-tax income - spread n chart

All the numbers in the charts above are from either the 10-K for 2013 or the 10-K for 2011. The original 2011 figure of $2,279 became $2,145 in the 10-K for 2013. I haven’t checked the other figures for revisions.

If that’s all you want to know about the company’s tax, skip to “How management use ‘cookie jars’ to smooth earnings”. You might want to check the other charts on the way.

More about Female Health’s tax assets

The background regarding Deferred income tax is complicated and for a full explanation you’ll need to read ‘Note 6. Income Taxes’ in the 10-K. The company made losses until 2005, and has made taxable profits since, but still has losses that can be offset against income to reduce tax. These “net operating loss carryforwards” are big, but the extent to which they can be utilized depends on the taxable income the company will make in the future, and where they make it (or where they are able to shift it to).

    Sizes of net operating loss carryforwards –

    U.S. federal – $19,165,000
    U.S. state – $17,220,000
    (both expiring 2018 to 2027)

    U.K. – $63,264,000 (Can be carried forward indefinitely and offset against future U.K. taxable income.)

NOLs (Net Operating Losses) are described in “The Net Operating Loss Carryback and Carryforward” (accountingtools.com). The NOLs are offset against taxable income, not tax, and their value depends on the tax rates. For Female Health Co, that’s the U.S. federal, U.S. state, and U.K. tax rates.

The taxable income which NOL carryforwards offset is income before tax but after other adjustments, such as deducting an allowance for R&D (when it’s available). The Utilization of NOL carryforwards is the amount of tax that’s canceled when NOL carryforwards are offset against taxable income. For example the U.K. NOL carryforwards could offset $63,264,000 of taxable income, but the corresponding total of Utilization of NOL carryforwards would be much less, and is smaller the lower the statutory tax rate.

There’s an amount called the “Gross deferred tax assets”, which is an estimate of the total tax benefit if all Female Health’s NOLs were utilized. This is split into two amounts –

1) Net deferred tax assets – the amount of Gross deferred tax assets which the company expects to be utilized in the foreseeable future. “In management’s analysis to determine the amount of the deferred tax asset to recognize, management projected future taxable income for the subsequent ten years for each tax jurisdiction.” (10-K for 2013)

2) Deferred income tax valuation allowance – the Gross deferred tax assets that haven’t gone into 1) because there’s a 50% or more chance of them not being utilized in the foreseeable future (including expiry before use).

For 2013:

    Gross deferred tax assets $21,326,018
    – Deferred income tax valuation allowance $2,703,000
    = Net deferred tax assets $18,623,018

The Net deferred tax assets are split into two items on the balance sheet:

    Deferred income taxes (under Current assets) $2,552,000
    Deferred income taxes (under Other assets) $16,048,000

except for a small difference, because the balance sheet amounts add to $18,600,000, which is $23,018 less than the Net deferred tax assets. That might be accounted for by the tax asset “Other, net – Malaysia $23,018” if it didn’t get onto the balance sheet for some reason. Another complication is that the company re-used the term “Net deferred tax assets” for the amount left after subtracting $258,197 of Deferred Tax Liabilities, which also relate to Malaysia.

When the company offsets NOLs against income, they ought to use the NOLs closest to expiry in the relevant jurisdictions, rather than caring if they were classified in 1) or 2) as above.

Management acknowledge that the income projections and the estimates of usable tax losses based on the projections are not straightforward or particularly reliable, and I’d expect the projections to be difficult, complicated and require judgment. It’s the kind of situation where even capable and honest management can be wrong. Generally, when a company is in a situation where judgment needs to be exercised to arrive at figures that affect the accounts, that’s when investors need to be wary.

There’s also some uncertainty because tax authorities can audit recent tax returns and possibly want more tax.

    Tax audits –

    U.K. (the Inland Revenue) – audit within 1 year – includes 2012 (expires in 2014)
    U.S. – audit within 3 years – includes 2010, 2011, 2012. (which expire in 2015 through to 2019)
    Malaysia – audit within 6 years – includes 2007 through 2012 (which expire in 2015 through to 2019)

It’s only Malaysia that gives the company more risk of a tax audit due to the six year period before the books are closed, and this is balanced to some extent by the U.K.’s period of a single year compared to three in the U.S.. It’s hard to aggregate the risk for the three jurisdictions, as the breakdown by country (in Note 10.) lists both United Kingdom and Malaysia as having less than 5% of Net Revenues to External Customers. The United States accounted for 8.3% of the revenue. There are ways to transfer income from where the revenue occurred to where a company wants it, often involving one subsidiary charging another for a service, but the only clue that Female Health might be doing anything along those lines is that the low percentages of revenue in the three jurisdictions have not prevented the significant utilization of NOLs and the large transfers from the valuation allowance into Net deferred tax assets.

An Income tax benefit of $4,408,744 is added to the 2013 pre-tax income (instead of having to deduct tax). The benefit is calculated by starting with a tax expense of $3,378,000, which is adjusted for several factors, listed under “A reconciliation of income tax benefit”. The adjustments include items such as “Effect of lower foreign income tax rates” and “Effect of stock option exercise”.

The Income tax benefit is increased by two adjustments related to NOLs, at the bottom of the reconciliation. The first is $2,070,947 from Utilization of NOL carryforwards, and the second is $5,845,000 from the reduction in the “deferred income tax valuation allowance”. In recent years, when the company has reassessed it’s Gross deferred tax assets, the result has been to transfer an amount from the valuation allowance to the Net deferred tax assets by decreasing the valuation allowance and increasing the Net deferred tax assets by the same amount. The same amount is reported as “Decrease in valuation allowance” and added to the tax benefit (or subtracted from the tax expense, resulting in a positive benefit). The valuation allowance can also change due to expiry or changes in the statutory tax rates.

When $5,845,000 was added to the Income tax benefit, due to the decrease of the tax valuation allowance, it’s like saying “$5,845,000 was added to the Income tax benefit, due to the increase in the Net deferred tax assets.”. Then it’s apparent that the Net income is increased on the same basis as from the increase in value other assets (except that some other changes in value will go into “Income before income taxes”, and some go into “Other Comprehensive Income”). Depreciation provides a familiar analog, but in the other direction: if a machine is depreciated by $10,000, there’s a $10,000 depreciation expense which reduces income before tax, and a $10,000 reduction in the value of the machine net of accumulated depreciation. A $10,000 reduction of the Net deferred tax assets should have a fairly similar effect on net income as a $10,000 depreciation of an asset, although the accounting is different (the depreciation expense affects income before income taxes). A reduction in liabilities increases income in a similar way (this is sometimes abused by companies that set up liabilities to use as a ‘cookie jar’. See “How management use ‘cookie jars’ to smooth earnings” below). Also see “The Importance Of Other Comprehensive Income” by Ryan C. Fuhrmann, October 10, 2012 (investopedia.com).

Technically, in U.S. GAAP, the expense or benefit is recorded as if it’s the cause of the change in the value of an asset, but here it’s easier to think of it the other way round, and either way a change in the value of the deferred tax assets will need a corresponding expense or benefit.

While I believe that management’s projections have been conservative, if growth in taxable income is consistently below the growth projected, disappointing results will have misery heaped on top from lower NOLs utilization and a valuation allowance that eats the tax asset instead of the other way around, creating an expense instead of a benefit. It should take more than the poor results often produced by lumpy orders to require a reversal of the deferred tax assets, as the company has experienced considerable volatility and lumpiness without having to make such reversals. Find the table under “Although the boost to the tax benefit is fizzling out” for the deferred tax assets from 2001 to 2013, showing the figure has never fallen (although it was zero up to 2006).

$5,259,065 of Deferred income taxes is subtracted in the cash flow statement, as one of the adjustments to Net income to arrive at cash from operations. This implies that one way or another, $5,259,065 of Gross deferred tax assets contributed to Net income for 2013 without any cash flow.

There’s a detail which I can’t explain. The Valuation allowance for deferred tax assets fell from $12,600,000 (2012) to $2,703,000 (2013), a reduction of $9,897,000, which is more than the $5,845,000 Decrease in valuation allowance given in the tax reconciliation. The difference is $4,052,000.

The immediate cause of the difference is the fall in Gross deferred tax assets, from $25,900,000 to $21,326,018, a fall of $4,573,982.

The Gross deferred tax assets are reduced when NOL carryforwards are utilized or expire, or the benefit from them is revalued down because lower statutory tax rates are expected. Subtracting the Utilization of NOL carryforwards, the remaining difference = $4,573,982 – $2,279,000
= $2,294,982

The $2,294,982 can’t be accounted for by NOL carryforwards expiring, because the 10-Ks for 2013 and 2012 both describe the carryforwards as “expiring in years 2018 to 2027”. That leaves a downwards revaluation due to expectations of paying less tax anyway per $1,000 of taxable income (before utilizing NOLs), but I’m not confident that “whatever remains must be true” due to the complexity.

The fall in the valuation allowance is split into $5,300,000 Charged to Costs and Expenses, and $4,597,000 Deductions/Other, but the split isn’t explained, and neither figure is repeated anywhere else in the 10-K.

With only $2,703,000 in the rapidly decreasing valuation allowance, and no expiry until 2018, if the company keeps growing it’s fairly likely that no more NOLs will expire unused. After concluding that management’s estimates have been conservative, it looks like growth is not strictly necessary to ensure that all the NOLs can be used. It could still require growth up to 2018 in the U.S. federal jurisdiction and the right U.S. state jurisdictions, depending on exactly how much expires when and where.

What’s more important for the Net income figure in future, is that with the valuation allowance down to $2,703,000, there isn’t much left to transfer to the Net deferred tax assets, or to utilize without decreasing the Net deferred tax assets. This means there can’t be a repeat of the $5,845,000 Decrease in valuation allowance, which was added to the Income tax benefit, which was added to Income before incomes taxes to get the Net income for 2013. There will still be contributions from “Utilization of NOL carryforwards”, but these should be offset by a reduction in the Net deferred tax assets, until they’re all gone. Otherwise, the same amount of tax offset would add to Net income twice, first when it’s transferred from the valuation allowance to the deferred tax asset, and again as Utilization of NOL carryforwards.

The cash benefit will continue until the $18,623,018 of Net deferred tax assets plus the $2,703,000 valuation allowance are all gone.

What I conclude from the details is that the Deferred income tax asset is not like the improperly capitalized expenses which AQI is meant to signal, and I go on to show that the NOLs have had a real effect on cash. While the decreases in the valuation allowance have accelerated the effect of the company’s NOLs on Net income, the method is a GAAP requirement, so management can’t be blamed for it (find “Tax and the liability method” below). The value of the Net deferred tax assets is the result of projections by management, but the tax assets have genuine value provided the company earns enough, and the assets couldn’t be compared to improperly capitalized R&D, or the assets Enron could inflate due to the false markets in them.

It ought to be good news when most of the Gross deferred tax assets are judged to be in the “Net deferred tax assets” category, because the tax benefit is more assured and because management’s projections were favorable enough to allow it, but investors might not be aware of the unsustainable nature of the contribution to Net income from the Decrease in valuation allowance.

Although the boost to the tax benefit is fizzling out, it shouldn’t matter to anyone who looks at cash rather than Net income, or who has been unusually diligent. Such investors could still consider how other investors are likely to react when they become aware of the tax situation, or its effect on future Net income.

Female Health income cash and tax assets to 2013 spread

Female Health tax assets income and cash to 2013

Female Health tax assets and cumulative income and cash to 2013

Normally I’d say management would feel pressure to avoid reversing the tax assets back into the valuation allowance, due to the effect on Net income, and it would look like an admission that long term prospects are not so good. However, for the new CEO, there’s an incentive to reverse the tax asset sooner rather than later if a reversal starts to look unavoidable. That’s a huge ‘if’ which is only likely if earnings do not meet the expectations that the decreases in the valuation allowance were based on. Reversing the tax asset would create a reserve for later use, as parts of the valuation allowance could once more be transferred to the Net deferred tax assets.

Low tax payments show the benefit of NOLs

It’s obvious that tax assets mean lower tax payments for a profitable company, but in a piece about earnings manipulation I don’t want to take much for granted. The reliability of the value of the tax asset in general is supported by the relatively low tax payments:

    (in thousands)
    Total, 2013, 2012, 2011, 2010, 2009

    Income before income taxes
    $33,232, $9,934, $10,792, $3,232, $4,224, $5,050

    Utilization of NOL carryforwards
    $7,099, $2,071, $1,637, $973, $1,087, $1,331

    Tax paid (from the cash flow statements)
    $1,575, $346, $926, $57, $112, $134

    Utilization of NOL carryforwards / Income before income taxes
    21.36%, 20.85%, 15.17%, 30.11%, 25.73%, 26.36%

    Tax paid / Income before income taxes
    4.74%, 3.48%, 8.58%, 1.76%, 2.65%, 2.65%

    Tax paid / Utilization of NOL carryforwards
    22.19%, 16.70%, 56.57%, 5.86%, 10.30%, 10.07%

Figures for 2013, 2012 and 2011 are from the 10-K for 2013 where the term “Cash payments for income taxes” is used in the cash flow statement, but for 2010 and 2009 the term “Income tax paid” is used instead, under the heading “Schedule of noncash financing and investing activities:” at the bottom of the cash flow statement in the 2010 10-K. I rounded the figures to get them in thousands.

The tax paid has been only a small proportion of Income before income taxes, at 4.74%.

Because the tax paid has only been 22.19% of the Utilization of NOL carryforwards, the NOL Utilization has canceled 81.84% of the tax that would have been payable otherwise. That’s only a rough estimate, due to variation in the tax rates between jurisdictions. There’ll also be some error due to the timing differences between the income statement and the cash flows, but not much, as deferred tax liabilities only increased by $235,179 – $152,227 = $82,952, or 5.27% of the $1,575,000 total tax paid. Even with the unquantifiable total error, it’s still clear that the Utilization of NOL carryforwards has drastically reduced the tax payments.

I also show that the tax paid is low compared to ‘Normal tax’, by which I mean tax before utilizing NOLs and before transfers from the valuation allowance to the tax asset. The variation over the three years used shows that this is not an exact calculation.

    Normal tax = Tax before any adjustments + Normal adjustments

where Normal adjustments don’t include anything to do with NOLs or the valuation allowance.


    Income tax benefit = NOLs + Decrease in valuation allowance – Normal tax

That should be correct, because everything in the tax reconciliation is included somewhere in the formula. The reconciliation starts with “Income tax expense at statutory rates” and has various adjustments down to “Income tax benefit” at the bottom.

It’s possible to calculate Normal tax because the other quantities in the equation are in the reconciliation:

    Normal tax = – (Income tax benefit – Utilization of NOL carryforwards – Decrease in valuation allowance)

I could simplify the equation by changing the signs and getting rid of the brackets, but the way I’ve written it, it’s more obvious that if you start with a positive tax benefit, and deduct the positive sources of the benefit, you are left with the tax before adding the good stuff (with a bit of sign magic). Then,

    % of normal tax paid = Cash payments for income taxes / Normal tax

and aggregating the three years, only 24% of Normal tax was actually paid. This should be reasonably accurate because although there can be a delay between tax hitting the income statement and all the cash being handed over, the deferred tax liabilities only increased by $235,179 – $188,177 = $47,002 from 2011 to 2013. This lends further support to the proposition that use of NOLs has reduced the tax paid in cash, without a build up of deferred tax liabilities, although it’s obvious anyway from the figures above showing the low tax payments compared to Income before income taxes.
Female Health - Normal tax etc - spread

The NOLs used produced a cash benefit, and the Deferred tax assets are likely to be as useful. I argue later that the Deferred tax assets have been conservatively estimated, under “FHCO – Female Health’s deferred tax assets imply management’s forecasts have been conservative”, and conclude that the Deferred tax assets are fairly high quality. I can’t say they are top quality, because by their nature they are not the kind of asset which is useful in tough times, see “When tax accounting blinds” below.

I don’t believe the indication from AQI that the proportion of low quality assets has increased, and there’s no evidence here of earnings manipulation.

The quality of the company’s earnings is another matter. The 2013 Net income of $14,342,598 included the Utilization of NOL carryforwards and the Decrease in valuation allowance, which add to $2,070,947 + $5,845,000 = $7,915,947, or 55.2% of Net income that would not have been there if the valuation allowance had run out at the end of 2012. There’s only $2,703,000 in the valuation allowance as at September 30, 2013 (and now only $2,410,068 or less, due to the $292,932 Decrease in valuation allowance in 1Q 2014).

If the NOLs are utilized at the 2013 rate of about $2 million per year, the $18,623,018 of Net Deferred tax assets will last about nine years, with the $2 million per year benefiting Cash from operations (but not Net income).

There’s some evidence under “Do deferred tax assets benefit income when they are used?” below.

This is an extract from an email Female Health’s CFO sent me.

    Mar 19 (2 days ago)

    to me

    We do not anticipate any further reduction in the valuation allowance, therefore there will not be any more tax benefit as a result of the reduction.

    Utilizing the NOL will have a favorable impact on our cash flow.

    Hope this answers your question.


    Michele Greco

    Vice President and C.F.O.

    The Female Health Company

    515 North State Street, Suite 2225

The sentence “Utilizing the NOL will have a favorable impact on our cash flow.” suggests that Net income will not benefit from utilizing NOLs.

How management use ‘cookie jars’ to smooth earnings

The way ‘cookie jars’ work is that in a good year, instead of reporting a high net income, a false expense is created that inflates a liability. The expense offsets some of the net income. In a bad year, it’s easy to reduce the liability because it was overstated or false, and the reduction in the liability creates an increase in net income.

Krispy Kreme Doughnuts used to save any earnings above their target Earnings Per Share (EPS) into the liability for their incentive plan, with an incentive compensation accrual. In years when the target would have been missed, enough of the liability was reversed to reach the target EPS. There’s more about Krispy later.

Cookie jar reserves aren’t always disclosed individually, and could be lumped under a heading like these:

    Accrued Liabilities
    Accounts payable and accrued liabilities
    Accrued Expenses And Other Liabilities
    Accrued Liabilities And Other Operating Liabilities

The categories are legitimate, but they are open to abuse. Accrued liabilities are usually under Current liabilities where the TATA index will pick them up, but can be in Other liabilities where the M-Score doesn’t look. That’s where General Mills put their accrued liabilities, according to this, which is only for confirmation as it’s not a good read: “Accrued Liabilities” (mcgraw-hill.com).

I’ve no reason to suspect General Mills of using cookie jar reserves, I was just showing that accrued liabilities don’t have to be in Current assets. The M-Score is blind to non-current liabilities, and if that’s where management put the cookie jar, the M-Score wouldn’t see the cookies going in or coming out the jar to prop up income. If investors expect cookie jars to be in current liabilities, that’s a reason for management to put the jar somewhere else, if they can.

This is one of the few articles that actually say where the cookie jar is, but the situation is unclear and contentious due to the company being complicated: “Gulfport energy’s accounts payable and accrued liabilities” Tuesday, February 26, 2013

This is about cookie jars with restructuring charges and the allowance for doubtful accounts as examples: “Aggressive Accounting: Reserves, Allowances, Contingent Liabilities” May 3rd, 2011 (oldschoolvalue.com)

The PDF “Popular Earnings Management Techniques” (linked to below) lists seven jar areas from sales returns to pension plans.

I wrote about Deferred grant income above. It’s a liability which is created and then periodically reduced to release a grant into income over the lifetime of an asset instead of all at once. That’s quite similar to how a cookie jar works, except it’s a GAAP requirement, and it would be obvious if management adjusted the timing to suit themselves.

Flaws in the M-Score – no check on non-current liabilities

Non-current liabilities follow Current liabilities on the balance sheet where they’re usually called “Other liabilities”, but they’re sometimes referred to as Long term liabilities. They’re probably less likely to be affected by earnings manipulation, or the M-Score would have an index to check them, but possibilities exist, such as ‘cookie jar’ accounting with the cookie jar in Other liabilities (see the section immediately above).

Non-current liabilities were covered by Beneish’s index ‘ACCRUALS’ which he used in 1997, but the index was replaced with TATA in 1999. The theory behind ACCRUALS is that income not backed by cash is low quality and less likely to be repeated. I write ACCRUALS as:

    ACCRUALS = (Income – Non-recurring items – Cash from operations) / Total assets

Every dollar on the top of ACCRUALS would accrue somewhere on the balance sheet, and while non-current liabilities aren’t specifically targeted, an abnormal reduction of non-current liabilities would have an equivalent contribution on the top of ACCRUALS. See also “The M-Score’s coverage of the balance sheet” below.

SGI, the Sales Growth Index

this year’s Sales / previous year’s Sales

Coefficient +0.892

Most investors want to see sales growing quickly, but fast sales growth isn’t all good news, and the SGI index is the M-Score’s speed cop. Beneish gave reasons why the growth creates incentives for earnings manipulation, which you can find in his 1999 PDF. I’ve paraphrased Beneish’s points and added to them. I also say why I believe they aren’t very relevant to Female Health, although that’s for consideration in the future, as sales fell and SGI pulls the M-Score down, relative to the neutral constant-sales case.

Sales growth promotes earnings manipulation through two incentives and a problem, in short: 1) The need for capital to fund the growth. 2) A later slowdown in growth can signal poorer prospects. 3) High growth companies often lack proper financial controls.

1) Growth companies need capital to fund the growth, and are often in debt due to the funding of previous growth. If sales or earnings fall short of targets, then raising capital is harder and more expensive.

This won’t affect Female Health Co, as they generate cash, and their investment requires little capital relative to the growth in sales and cash from operations that results, assuming that reasonable utilization of capacity can be maintained. While the timing of sales, income and cash from operations can verge on erratic, the company has plenty of cash to see them through thin years, such as 2011 when bureaucratic delays pushed orders into 2012.

2) A later slowdown in growth can signal poorer prospects. Beneish actually says more about the pressure to manipulate earnings when a company’s share price is over-sensitive to early signs of a slowdown, but the two are related. Slower growth would not make a share price dive so much if investors expected growth to get back on track.

When a growth company has a slowdown, it could signal a permanent loss of momentum. Warren Buffett has written about the problems of retail, including the “shooting-star phenomenon” where high growth ends with a sudden drop. Find “shooting” in the 1995 Berkshire Hathaway letter to shareholders (berkshirehathaway.com/letters/1995).

Krispy Kreme Doughnuts, Inc (Wikipedia) went from high-flier to a disappointment for investors, although they’re still around. In August 2003, the shares were up 235% from the April 2000 IPO price, and with a price/earnings ratio usually above 50. This was followed by missing quarterly estimates in May 2004, and then a loss.

The SEC became interested on two counts, using an incentive plan for ‘cookie-jar’ accounting (see “How management use ‘cookie jars’ to smooth earnings”, above), and round-trip transactions: “In the Matter of KRISPY KREME DOUGHNUTS, INC., Respondent.” March 4th 2009 (sec.gov) (PDF). In 2003, $528,323 was reversed from the ‘cookie jar’ incentive plan, allowing EPS to beat the target by $0.01. Round-trip transactions sent cash to franchisees and back again, inflating sales and income. The M-Score is not good at detecting cash-based fraud.

Sales growth over the previous year, for the three years to 2003 was 36.5%, 31.1% and 24.6%,
and the growth in earnings per share (EPS) was 80%, 67%, and 47%.

The highest signal from SGI would be from the 36.5% growth reported in 2001, which translates to SGI = 1.365 because:

    SGI = this year’s Sales / previous year’s Sales
    = 1.365 * previous year’s Sales / previous year’s Sales
    = 1.365

and multiplying by SGI’s coefficient of 0.892 gives 1.2179 added to the M-Score, or 1.2179 – 0.892 = 0.3256 more than if sales had stayed constant.

Then for 2002 and 2003, using
extra on M-Score = coefficient * growth as a proportion

    extra on M-Score = 0.892 * 0.311 = 0.277
    extra on M-Score = 0.892 * 0.246 = 0.219

The author of “Stop Using the Altman-Z Score.” (linked to below) suggests short-selling distressed companies with extreme growth.

Beneish cites Fridson (1993) who is emphatic about the effort by management to avoid the appearance of decelerating growth. I don’t agree with the claim if it’s meant too literally, because deceleration is normal, and Krispy’s reported sales deceleration from 36.5% to 31.1% to 24.6% growth in 2003 was not a sign of trouble by itself, and did not stop the share price rise. Taken literally, growth of 500% followed by 490% is deceleration. I can understand that there’s a degree of deceleration that would concern investors and a similar degree of deceleration that management are tempted to hide by manipulation, which seems to have happened for Krispy’s figures as they would have been without manipulation.

Beneish’s writing and the high coefficient of 0.892 make SGI one of the more important indexes in the score, but I’m not completely comfortable with suspecting earnings manipulation when management achieve sales growth which is good news provided management are honest. I would need to find other evidence of manipulation, but I also prefer to invest in companies where cash and high free cash flow removes the problem of funding growth.

Manipulation is more likely when management commit to high targets for more than a year. Anything like “We’re going to grow 35% CAGR for the next three years.” is ‘above and beyond’. Management will be tempted to manipulate earnings if that’s the only way they can keep the promise, they might even have manipulation in mind as a backstop when they make the promise, and they might have filled up the cookie jar before promising earnings growth. They could also achieve unsustainable growth in other ways, by cutting R&D or providing the minimum service that fulfills contracts.

Below I calculate that a company with no change (as far as possible) has an M-Score between -2.845 and -2.48. No change means that many indexes equal 1, for instance GMI would be the previous year’s gross margin divided by the same margin this year. It might be impossible or unlikely for a company to have no change in its results except for sales growth, but if you can imagine it, 30% to 70% sales growth is enough to lift the M-Score from the ‘no change’ values of -2.845 to -2.48 up to -2.21, which is above the threshold of -2.22 commonly supposed to indicate earnings manipulation. (Half the calculation is: M-Score = -2.48 + 0.30 * 0.892 = -2.2124.) With no contribution needed from other indexes, it’s possible for a company with 30% to 70% sales growth and honest management to be flagged as having a serious risk of earnings manipulation. That seems like a high sensitivity to sales growth. (See “M-Score thresholds, probabilities, and sensitivity to sales growth”, below.)

It’s claimed that the 1999 version of the M-Score (the version I’m using) would have flagged Enron Corp.’s fraud in 1998, three years before Enron collapsed in 2001. That’s from “The Predictable Cost of Earnings Manipulation” (already linked to), but they don’t give the M-Score. The threshold was very probably -1.89. Enron’s revenue growth in 1998 was 54.2%, giving an SGI = 1.542.

I’ve calculated that sales growth somewhere between 66.2% and 107.1% is enough to put an M-Score over the -1.89 threshold, provided the indexes other than SGI don’t collectively pull the M-Score down, relative to their ‘no change’ contributions. The revenue growth of 54.2% does at least half the work of giving Enron its hypothetical early warning. Enron’s revenue growth was unprecedented and suspicious for a company with the massive revenue they reported, but SGI only measures the growth rate, and no part of the M-Score depends on absolute size. It’s likely that Enron would have failed the M-Score test due to low quality assets (AQI) and accruals (TATA) as well as SGI.

For more about the sales growth range of 66.2% to 107.1%, see “M-Score thresholds, probabilities, and sensitivity to sales growth” below.

The reliability of growth depends on the economic moat. While that’s true by definition, the difference between growth and moat isn’t always obvious, until the growth ends.

There’s a difference between areas where demand can decelerate with a big chance of never recovering, and cyclical or lumpy demand. When lumpy demand is a well known characteristic of the market or a company’s sales, attempts at smoothing won’t usually be worth the risk.

See also “Growth, bloat, decline and recovery” below.

Female Health Co’s growth looks reasonably safe until emerging competition makes serious inroads, although there are various risks such as reliance on a single site for manufacturing (Selangor D.E., Malaysia). The company’s share price is volatile and in my opinion, the market over-reacts to results. The lumpiness of orders is well known, but the reaction isn’t surprising given the small capitalization, the customer concentration, single product and now the emerging competition. My charts near the end show how the company has achieved long term growth with high volatility, but here’s some recent data showing a slide to 2011 and a sharp recovery:

    2013, 2012, 2011, 2010, 2009
    Net revenues $31,457, $35,034, $18,565, $22,222, $27,543
    Net income $14,343, $15,299, $5,399, $6,737, $6,535

The evident volatility means there’s little or no incentive to manage the share price or reassure investors and analysts by smoothing results. In contrast, the state-sponsored mortgage giant popularly known as “Freddie Mac” had a “steady Freddie” image to keep up, they manipulated earnings to smooth out a windfall (from a change in accounting rules), and ended up hiding losses until it became untenable (the details are in my ‘cash3’ post).

In Female Health’s case, there’s no incentive to keep the share price high to enable capital to be raised (see point 1), above).

Female Health only give general guidance and don’t guide with a range of revenue and income. This won’t completely stop share analysts from having expectations, but they shouldn’t expect with much confidence, given the lack of guidance from the company and the lumpiness of orders. The pressure to meet ‘street’ expectations is probably low.

Early in this piece, the only motivation mentioned for fraud is meeting ‘street’ expectations: “The SEC’s New Financial Fraud Task Force: Part III, Cases Following the Speech – Revenue Enhancement” by Thomas O. Gorman, 08-19-2013 (lexisnexis.com)

3) Financial controls are not as developed in very small companies, and companies that grow fast from a small start often don’t implement effective controls as soon as they ought to. This can be because the limited resources available are devoted to expansion of production, sales to new customers, and development and launching of new products, with more change to manage generally, from leases to hiring. Some companies are exempt from external audits of financial controls under the JOBS Act (Jump Start Our Business Act), and they tend to be the newer growth companies.

Female Health’s internal financial controls were OK’d by their auditors: “The Female Health Company and Subsidiaries maintained, in all material respects, effective internal control over financial reporting …”. The accounts were also OK’d. The auditors didn’t actually use the term “unqualified opinion”, but the opinion wasn’t qualified. The auditors McGladrey LLP are not one of the big four, but that’s usually more of a problem when a big company uses a small auditor, especially if it’s for many years.

The Audit Fees were $374,051, and Tax Fees of $45,600 were paid to the same company. I believe it’s better to avoid using the firm that does the audit for any other work, otherwise the firm might consider the business it could lose if their opinion about the accounts isn’t well received, although the fee for tax work is only 12% the size of the audit fee.

My impression is that Female Health Co don’t have the kind of frenetic growth activity that leaves little time for arranging proper financial controls. They should be generally used to doing things properly, having complied with FDA “Good Manufacturing Practices” and been “monitored through periodic inspections by the FDA and foreign regulatory agencies.”. Their cash and cash flow means there’s little pressure to cut corners, regarding financial control or anything critical (not counting failure to develop another product).

Female Health Co’s sales fell from $35,033,897 in 2012 to $31,456,778 in 2013. Dividing the 2013 sales by the 2012 sales, SGI was 0.8979, with an M-Score term of 0.8009, which is 0.0911 below the 0.892 contribution from the neutral case when sales stay constant (0.892 is the coefficient).

I’ve explained why a high SGI is unlikely to indicate earnings manipulation in Female Health’s case, and as the SGI is low due to reduced sales, there is absolutely no indication from SGI of earnings manipulation.

The M-Score terminology uses ‘Sales’, while Female Health report Net revenue. I don’t see any point in using gross revenue, even if it was reported, and I usually write ‘Sales’ instead of ‘Net revenue’ unless I’m quoting.

DEPI, the Depreciation Index

previous year’s ratio Depreciation / (Depreciation + net Property plant and equipment)
divided by this year’s ratio

Coefficient +0.115

The reason for adding Depreciation to net PPE (Property plant and equipment) is to rewind the net PPE back by a year, to the value before the latest round of depreciation. The ratio:

    Depreciation / (Depreciation + net Property plant and equipment)

is called the rate of depreciation, and a fall in the rate can signal that management are depreciating assets by less in order to understate the depreciation expense and inflate earnings. The depreciation expense is the result of an accounting construct, and a deliberate reduction is more likely to be about earnings manipulation than about reducing real wear and tear.

Because the previous year is on top, DEPI is the inverse of the change in the depreciation rate, so the more the rate falls, the higher DEPI is. Because the coefficient (0.115) is positive, more DEPI means more M-Score, pushing it towards signaling earnings manipulation. Cutting out most of the steps:

    A lower depreciation rate


    DEPI higher, M-Score higher, earnings manipulation more likely

DEPI is more accurate as an indicator when a company’s investment is smooth every year, or more accurately, when the investment in assets which are given the same number of years of ‘Useful life’ is nearly the same each year, otherwise DEPI will be particularly high or low in some years, in the normal course of business without any manipulation.

Suppose a company only has a single asset, bought for $4 million in year zero. The asset is given a Useful life of four years, starts with zero accumulated depreciation, and using the common straight-line method of depreciation, each year $1 million is added to the accumulated depreciation until the $4 million historic cost is accumulated. This table shows how the rate of depreciation increases automatically as the fixed annual depreciation is divided by a net asset value that gets smaller.

hypothetical depreciation

The highly simplified table has blank cells in the Rate of depreciation and the DEPI columns. If the company also had some smaller assets which were depreciated every year, that’s what the blanks would show, while the other cells would still be dominated by the large asset. In year 5, when the large asset was fully depreciated, the rate of depreciation would drop sharply from nearly 100% to a more normal level, and DEPI would go through the roof. For example, if the rate of depreciation fell from 95% to 10% in year 5, DEPI would equal 0.95 / 0.1 = 9.5. That’s an extreme example, but it shows how a high DEPI can have an innocent explanation when investment is very lumpy.

Some assets are depreciated down to a salvage value rather than zero. See “What is salvage value?” (accountingtools.com). There’s the potential for the salvage value to be fraudulently high, to reduce the depreciation expense. Fraudulently high salvage values can be picked up by DEPI when large investments in PPE are made with percentage salvage values higher than previously used. DEPI will also identify any big upwards revisions to the salvage value. A company which always has high salvage values will have less volatile depreciation rates as described previously for large assets, because the rate never reaches 100% for an asset with a salvage value. Permanently high salvage values won’t be picked up by DEPI, but the auditors should notice it.

It’s also worth searching a 10-K for ‘Useful life’, to find the assumed lifetimes that categories of assets are depreciated over. I interpret high numbers as indicating aggressive accounting, while low numbers indicate conservative accounting. Wide bands such as 5 to 10 years give management leeway to pick a shorter or longer useful life for any particular asset, although bands as wide as 5 to 10 years are common. Any change for assets that are already being depreciated ought to be disclosed (but it can’t be guaranteed), even if a new useful life still fits in the band. For the Useful life assumptions of four companies, which could be used for comparison, see my previous post, “Three cash3 companies”. The cash-rich cash-generating companies might not be representative, and if you find the Useful life assumptions of Masonite International (who were at the other end of the cash scale) you’ll see they have the highest assumed lifetimes.

Female Health’s rate of depreciation rose from 16.4% to 21.0%, making DEPI = 0.7822. Because DEPI is below 1 and has a positive coefficient (of 0.115), the index is pointing in the other direction to earnings manipulation, and pulls the M-Score down by 0.025 compared to the ‘no change’ situation, because:

    Effect on M-Score = coefficient * (index – 1)
    = 0.115 * (0.7822 – 1)
    = 0.115 * -0.2178 = -0.025

The annual depreciation rose from $461,447 in 2012 to $556,304 in 2013, while net PPE after the annual depreciation fell from $2,349,876 in 2012 to $2,094,830 in 2013.

The ‘Useful life’ assumptions are –

    Manufacturing equipment 5-10 years, Office equipment 3 years, Furniture and fixtures 7-10 years

which is reasonable IMO, and the wide 5-10 year band for Manufacturing equipment is not unusual.

TATA – Total Accruals to Total Assets

(this year’s working capital other than cash – the previous year’s working capital other than cash – Depreciation)
divided by Total Assets

and everything is ‘this year’ unless labeled ‘previous year’.

Coefficient +4.679

Accruals are what you are left with after subtracting cash-from-operations from net income. There’s broad agreement that such earnings are lower quality than earnings which are supported by cash, but not everyone agrees with the definition of accruals, see “What are accruals and do they matter?” below. The section includes a link where it’s claimed that investors are now wise to accruals, and low quality earnings get a lower share price. I expect that’s true or mostly true, but not everyone agrees. In the same section I explain why I stick to TATA, and not “ACCRUALS”, an earlier measure which Beneish later reverted to.

The TATA ratio or the amount on the top of it don’t seem to be a very popular measure of accruals, but after writing about accruals, Beneish describes TATA as a proxy for how well cash underlies earnings. While TATA will catch accruals that relate to current assets and current liabilities, and catch withdrawals from the ‘cookie jar’ when the jar is in current liabilities, I prefer to ignore Beneish’s use of the word “accruals” and say instead that TATA catches distortions in Non-cash working capital, just as AQI catches distortions in Non-current assets excluding Property plant and equipment, although TATA also looks at depreciation as a proportion of assets. The difference between TATA’s check on depreciation and DEPI’s, is that DEPI looks at the change in the rate of depreciation, whereas TATA looks at the rate of depreciation (scaled by Total assets instead of PPE).

It’s the difference between ‘this year’ and ‘the previous year’ that is calculated (for non-cash working capital) on the top of TATA, whereas the other indexes are ratios between ‘this year’ and ‘the previous year’ for a quantity (with variation about which year goes on top). This makes TATA’s neutral value more like zero (when there’s no-change), although that’s complicated by subtracting depreciation from the rise in non-cash working capital.

Non-cash working capital isn’t usually disclosed. This is how I derive a formula:

Starting with these:

    1) Non-cash working capital = Non-cash current assets – Non-debt current liabilities

    2) Non-cash current assets = Current assets – Cash & cash equivalents – Marketable securities under current assets

    3) Non-debt current liabilities = Current liabilities – Short term debt

Plugging 2 and 3 into 1:

    4) Non-cash working capital =
    Current assets – Cash & cash equivalents – Marketable securities under current assets – Current liabilities + Short term debt

The principle behind that is to remove cash, and anything that can be very easily turned into cash without affecting business operations, from the Current assets, to leave the Non-cash current assets. Similarly, Short term debt is removed from Current liabilities to leave the Non-debt current liabilities. It isn’t completely obvious that marketable securities should be excluded, because while they aren’t as relevant to operations as inventories and receivables, the reliability of their reported value is variable (find “multiple failed auctions” above) and their value could be inflated. Another problem is that companies can vary the split between cash and non-cash working capital. A toy retailer will have more cash and less inventory after Christmas, and then build up inventories ready for the next Christmas. At least that case has regular variation, whereas some companies such as Female Health have lumpy orders and cash collection.

My version of the theory behind TATA is:

1) Some inflated earnings aren’t backed up by manipulating cash.

2) Some earnings that aren’t backed up by cash end up in Non-cash working capital.

3) The two ‘Some’s intersect, so some inflated earnings end up in Non-cash working capital.

If part of the Accounts receivable are sold, then inflated revenue might have no effect on the Non-cash working capital that can be derived from the balance sheet. That shows how inflated earnings might not be detected by TATA or the M-Score if cash is manipulated to support them.

If revenue is inflated and Accounts receivable are not sold, the inflated earnings that result are not backed up by manipulating cash, and end up in Non-cash working capital (as in point 2) because Non-cash working capital includes Accounts receivable.

Point 2) has ‘Some’ rather than ‘All’ because, for example, an increase in Net deferred tax assets will increase earnings without any cash flow, and does not add to Non-cash working capital. It’s picked up by AQI instead. The under-depreciation of assets will also inflate earnings, not be backed up by cash, be picked up by DEPI, and not affect Non-cash working capital.

If revenue is inflated and Accounts receivable are turned into financial instruments, so long as they are payable within a year and not classed as marketable, they will be in Non-cash working capital and TATA should pick it up. There’s a bit of a loophole here, as the term ‘marketable’ is fairly elastic, find “Level 3 – It’s anybody’s guess” above.

Beneish uses the TATA ratio as a proxy for the extent to which earnings are not supported by cash, and it’s reasonable to ask: Why not just look at cash?

Beneish’s former measure “ACCRUALS”, does look at cash.

I’m in favor of looking at cash but I prefer to look at several years history of cash flows, with less chance of noise hiding the trend (if there is one). The picture can be partial and skewed if you only look at one or two years of cash flow. Female Health Co show that you can’t just look at Net income, and you can’t just look at the latest figure for Cash from operations. In 2013, most of Net income was from tax effects which won’t repeat, and from the 10-K,

    “The increase of $1.4 million in cash generated from operating activities in fiscal 2013 as compared to fiscal 2012 was primarily due to the decrease in the amount of outstanding accounts receivable at year end and the reduction in incentive payments.”

The 68% decrease in accounts receivable can’t be repeated, and the reduction in incentive payments was due to less good performance. Therefore, the increase in Cash from operations from $10.4 million to $11.8 million isn’t anything to get excited about. Beneish’s ACCRUALS would have signaled an increase in the quality of earnings, when with hindsight, the cash collection shows the company’s receivables were always high quality. I’m not denying cases where looking at cash over shorter periods can help to spot earnings manipulation, or show that a company will probably run out of cash even if the income looks healthy. If you read about the “deferred income tax valuation allowance” above, you might agree that Female Health’s historic cash flows are more realistic overall than their historic Net income, and are a better guide to future performance.

I don’t trust the ACCRUALS index based on two cash flow figures and a few other variables to give a reliable indication, although it might flag that something needs investigating. That might be too much opinion, as the index has been in, out, and back in the M-Score, and it must have tested alright the first time.

In my previous blog piece, “Three cash3 companies”, if you find “Sun Microsystems”, you’ll see how a windfall from a legal settlement was disclosed in the income statement, but if you only looked at the cash flow statement you wouldn’t know about it.

Here’s a hypothetical case.

    Net income = $20 million
    Cash from operations = $16 million
    Windfall = $18 million

If you don’t know about the windfall, you might calculate 16 / 20 = 80%, and say, “80% of income has turned into cash flow, I don’t expect them to match exactly, and 80% isn’t too bad.”

If you know about the windfall, you subtract it, to get adjusted Net income = $2 million, and adjusted Cash from operations = -$2 million. Then it’s obvious that net of the windfall, the cash flow is in the opposite direction to the income.

Windfalls are often from legal settlements and sometimes from having to do the accounts differently (mandated changes in accounting practices). Neither of those causes sound like they belong in cash from operations, but that’s where the cash ends up so long as the windfall is included in Net income, because there’s no non-cash adjustment for it when Net income is adjusted to arrive at cash from operations (by the usual ‘Indirect’ method), when the cash is received in the same reporting period.

This shows that if you want to check that earnings are backed up by the cash flow, you need to understand the cash flow in order to make adjustments if necessary, and the cash flow statement might not have the necessary information. An M-Score index looking at cash would know nothing about windfalls.

The paragraphs about Sun Microsystems in my ‘cash3’ blog are in a long section under the heading “The trouble with cash”. The section includes much about the manipulation of cash flows. It might not be a good idea to rely too much on a quantity that could be a target for manipulation, and ignore the change in non-cash working capital, although it’s likely that a company which fiddled its cash flow would avoid a big rise in non-cash working capital, either intentionally or as a side effect.

One problem I have with TATA is that a company could be punished for asset growth, even if non-cash working capital is a constant or decreasing proportion of assets, so long as the absolute increase outweighs the depreciation. This definition would remove the problem …

    this year’s (Non-cash working capital – Depreciation) / Total Assets


    the previous year’s Non-cash working capital / the previous year’s Total Assets

… and changing the ‘minus’ to ‘divided by’ would make TATA more like the other indexes, but there’s room for argument about whether either of those would be a better definition. It could be argued that the growth of non-cash working capital matters independently of growth in other assets, but I would argue that you wouldn’t expect a big company to have only as much Non-cash working capital as it had when it was much smaller.

I’d say it’s safer to look into the company’s situation, rather than assume there’s no problem when a high TATA is the result of Non-cash working capital growing at the same rate as other assets.

Female Health Co’s TATA is -0.0824. Because the TATA is negative and TATA’s coefficient (4.679) is positive, the company’s TATA is pulling the M-Score down, and not signaling earnings manipulation.

The low TATA is the result of high collection of cash from customers, reducing the Accounts receivable, which is a non-cash current asset and part of the Non-cash working capital.

Female Health could easily and innocently have a high TATA in the future due to the lumpiness of orders, as inventories could build up, and Accounts receivable can be high. The current liabilities are also quite variable. The company manufactures their condoms “… in a single leased facility located in Malaysia.” Any disruptions could affect the inventory level, and therefore accruals, but I can’t say how big or likely any disruption would be. If inventories fall to abnormal levels, that would pull TATA down, and if inventories recover from abnormally low levels, that would push TATA up.

If Female Health gets a high TATA in future, investors will need to look into the details and decide if it’s explained well enough by the usual lumpiness. It could be hard to tell if an inventory build up without firm orders is the result of the usual lumpiness, or major customers becoming less keen on the product. Clues could be from the company, or from customers and providers of funding if they state their priorities in public. It’s not likely that major customers and fund providers will reduce the priority they give the product for a while yet:

    “On July 11, 2012, World Population Day, the U.K. Government and the Bill and Melinda Gates Foundation held the London Summit. It was an invitation only meeting attended by public health officials, government officials, and private sector companies that supply contraceptives and related products. The primary goal of the London Summit was to increase access to contraceptives to an additional 120 million poor women in 69 developing countries by 2020. Achievement of this goal will reduce maternal and infant immortality, HIV/AIDS babies and orphans and health care costs.”

I have to say, I didn’t realize “maternal and infant immortality” was a problem.

    “At the close of the London Summit it was announced that commitments of $4.6 billion had been made to fund the 2012-2020 program.”

    “On September 24, 2013, the U.K. Government announced it was donating $1.5 billion over a 3 year period to the Global Fund for HIV/AIDS, TB and Malaria treatment and prevention.”

    “FHC was one of only fourteen companies invited to attend the London Summit.”

    Also at the summit, “… the Company has pledged to significantly increase its global education and training investment over the period from 2013 through 2018.”

    “U.S. Secretary of State Hillary Clinton, as part of the President’s Emergency Plan For AIDS Relief (“PEPFAR”), issued a blueprint for an AIDS Free Generation. In the blueprint it states that female condoms are unique in providing a female controlled HIV prevention option and that PEPFAR will work with partner governments and other donors to promote female condoms wherever effective programs can build a sustained demand.”

    (all from the 10-K for 2013)

If inventories are higher than planned or expected, it’s less of a problem when future demand is relatively assured and the product doesn’t deteriorate quickly. If existing competitors develop and grow, or a big company enters the market, inventory build-ups will be more of a concern, although the usual lumpiness won’t be any less.

The M-Score’s coverage of the balance sheet

I’m using the 1999 version of the M-Score, which has small areas of overlap. Accounts receivable are in DSRI, the Days Sales in Receivables Index, and are also in the broader TATA or Total Accruals to Total Assets index. TATA also includes depreciation, which is the focus of DEPI, the Depreciation Index. The overlap does not imply inefficiency, as Beneish measured the effectiveness of the indexes, and would have thrown out any that were redundant.

Beneish had previously used the ACCRUALS index, which I write as:

    ACCRUALS = (Income – Non-recurring items – Cash from operations) / Total assets

The quantities in the top of the ratio are annual flows, and the Total assets on the bottom are only for scaling. However, the accruals have to accrue somewhere, and have an effect somewhere on the balance sheet. The ACCRUALS index covers a wide range which overlaps with DSRI, DEPI and AQI, and also with TATA if both were in the M-Score at the same time.

Beneish uses “income before extraordinary items” where I prefer to subtract Non-recurring items, but there’s a problem whichever description is used. Some Non-recurring (or extraordinary) items also affect Cash from operations, such as a jury award. If a company receives the cash from a $10 million jury award in the same period as the award is included in the income statement, the top of ACCRUALS will be $10 million lower for no good reason. If the cash is received in a later period, the same problem occurs in that period. If Beneish wanted non-recurring or extraordinary items to be excluded from both Net income and Cash from operations, IMO he didn’t make it clear, but please feel free to check rather than trust my interpretation (see “The Predictable Cost of Earnings Manipulation“, already linked to.)

I wrote about a gap in “Flaws in the M-Score – no check on non-current liabilities”, above. It’s highly unlikely that a new index for non-current liabilities will be added, but if it happened, it might be worth seeing if the old ACCRUALS index should be included, without removing TATA (previously, the two indexes have been swapped around). It’s possible that ACCRUALS would not increase the score’s predictive power, as it would cover areas already covered by DSRI, DEPI, AQI, TATA, and the new index for non-current liabilities, but it could be worth testing, and if indexes overlap, it seems more balanced to have ACCRUALS overlapping all the relevant indexes rather than only some of them. One problem is that higher Accounts receivable would show up in three indexes: DSRI, TATA and ACCRUALS.

The advantage of having more indexes covering the balance sheet is greater when a spreadsheet is used, as the problem areas show up in the index values. Once the data is in, it’s easy to check if TATA (or ACCRUALS) is much above zero, and which of the other indexes are significantly above one.

Beyond the scope of the M-Score

This link has a window where you can view “Popular Earnings Management Techniques”, which is chapter 2 of “Earnings Management” by Thomas E. McKee. There’s also a button for downloading a free PDF of the chapter. I can’t vouch for the site, but I expect it’s safer than the average free download site. The chapter covers most of the topics in this section.

“Flushing the investment portfolio” is a section which explains how investments can be sold selectively to smooth earnings. Investments which can only be sold at a loss are sold in a good year, and investments where a gain can be booked are sold in a bad year.

The value of investments is included in the AQI calculation:

this year’s ratio (Non-current assets – Property plant and equipment) / Total assets
divided by the previous year’s ratio

but selling investments will usually reduce AQI, although it depends on how the cash is used. Very little of the effect on AQI depends on whether a gain or a loss was booked, and AQI can’t tell if the sale was timed to smooth earnings. I don’t mean to be too critical by listing such details, because the M-Score is statistical in nature. It’s a little like an insurance calculation, where no-one can predict if a particular building will be damaged by a hurricane, but the risk can be estimated. An important difference is that with earnings manipulation, management will adapt by finding the tricks that are the most difficult to detect.

Subsidiaries and assets can also be sold to book a gain or a loss when it suits management.

A sale-and-leaseback transaction allows the company to keep using an asset. If a loss is realized, it’s booked immediately, but a gain is dripped into income. The company can choose either a capital lease where the gain is spread evenly over the lifetime of the lease, or an operating lease which is similar to rental, with the gain each year in proportion to the rent. The GAAP rules effectively give management control over if and how gains are realized, and management can’t be forced to restate earnings for following GAAP. The rules for lease accounting should be changing, see “Operating lease obligations – billions or trillions to land on balance sheets” below. Management can distort PPE through the depreciation expense, and sale/leaseback gives them an alternative way to exploit PPE to adjust the income figure.

Even bond debt can be manipulated, because the company’s bonds are not valued at the market price, so early retirement of the bonds will see a gain or a loss booked, which management can time to smooth earnings. There’s no gain or loss when new bonds are issued apart from fees and admin costs, so new bonds can be issued at the same time as old bonds are retired without affecting the gain or loss booked on the bond retirement. Swapping one debt for another can have economic benefits, and SunEdison recently issued $1.2 billion worth of convertible notes which they used to pay off debt carrying a higher interest rate. Eastman Chemical arranged a term loan for an acquisition, and reduced the loan quickly using cash from operations and new debt because the term loan was expensive. Even when the gain or loss booked is the same as the economic benefit, management control the timing, although I’m not accusing the companies I’ve mentioned, and SunEdison have been particularly adept with their financing.

Deals as described above are hard to prove as earnings manipulation unless they obviously make no economic sense. When the manipulation is in the timing of a transaction, the reporting is likely to be accurate, with no need to restate the accounts. While that isn’t ideal, at least there’s not much risk of the SEC or auditors requiring a restatement of the accounts and causing the share price to fall. The gains or losses on the transactions described here should be reported outside of operating income.

If Female Health Co had any such deals, the gain or loss would be under the heading “Non-operating income (expense):”. Ignoring the “Foreign currency transaction loss”, the other category under the heading is “Interest and other income (expense)” which for 2013, 2012 and 2011 was $245,545, $362, and $2,109. Because the company has $8,922,430 cash and no debt, it will earn rather than pay interest, so net other income for 2013 can’t be over $245,545. If net other income for 2013 was zero, the interest rate on the cash would have to be $245,545 / $8,922,430 = 2.752%. That doesn’t leave much scope for net gains or losses. Even with zero interest earned, the 2013 net other income would be $245,545 or only 1.712% of Net income (of $14.3 million), or 2.511% of operating income. The same figures work as a cap on the maximum possible other expense, if the interest earned is at twice 2.752% or 5.504%. I’ve used an unfeasibly low interest rate of 0%, and an unfeasibly high rate of 5.504%, to contain the maximum possible net other income and net other expense, the only category that non-operating net gains and losses could be in (not counting currency gains). It’s safe to say that Female Health have not done the kind of deals listed above which can be timed to manipulate earnings, to any material degree. There’s more scope to time a non-operating loss in 2012 and 2011, but not enough to worry about.

As well as checking the income statement, sales of investments, subsidiaries and assets for cash should be described in the ‘Liquidity and Capital Resources’ section of a 10-K. Female Health call it “Liquidity and Sources of Capital”, and there were no asset sales described in the section in their 10-K for 2013.

It’s worth checking “Other comprehensive income”, because that’s where ‘fair value fraud’ is likely to hit the accounts. Female Health’s 10-K has “In fiscal 2013, 2012 and 2011, comprehensive income is equivalent to the reported net income.”. Because Comprehensive income is the sum of Net income and Other comprehensive income, it follows that Female Health had no Other comprehensive income.

Beneish tried incorporating several ratios into the M-Score, and rejected them because they did not improve performance. One of them was the ratio of net non-operating income to income before extraordinary items. I prefer the ratio Operating income / Net income, because it mirrors the ‘quality of earnings’ ratio which is Cash from operations / Net income, but I suppose it doesn’t matter which version of the ratio he rejected. Operating income / Net income would treat non-operating gains and tax benefits as low quality, in the same way that Cash from operations / Net income treats accruals as low quality. One complication is that the ratio needs a ceiling close to 1, because a company which regularly has supposedly one-off charges probably has or had low quality management rather than high quality earnings. The ‘one-off’s could be from big accidents, losing legal cases, or asset impairments due to a deteriorating market, poor investment, poor maintenance or over-optimism meeting reality. A relatively simple score can’t be expected to check the regularity of non-operating losses, and the conservative position is to assume they are regular.

Other rejects include Unusual items / Pretax income, Cash from operations / Debt service, an index like DSRI (Days Sales in Receivables) but based on inventory instead of receivables, ratios using the amortization of intangibles and pension funds status, and changes in capex and tax expense / income before tax. The statistical tests stop the M-Score from filling up with junk, but IMO there’s a risk that the evidence-based approach leaves holes in the net.

There doesn’t seem to be much on the balance sheet that’s immune from manipulation. The actual cash balance is fairly safe, but it can be the result of manipulating cash flows, and the definition of Cash and cash equivalents is often woolly. Marketable securities need researching to check the value is reliable (find “multiple failed auctions” above). Debt could be off the balance sheet, and a bank loan could be disguised as the sale of receivables. Liabilities including debt can be manipulated in the ways I’ve described, but most of them and all of the debt still have to be paid one way or another.

Each quantity on the balance sheet could change for a genuine reason, and it’s harder to identify the result of earnings manipulation when the areas affected can’t be narrowed down much. Imagine how easy it would be if earnings manipulation always showed up in Accounts receivable. It’s still useful to have indexes which highlight the areas with the most change.

See also “Flaws in the M-Score – no check on non-current liabilities” above.

What are accruals and do they matter?

Accruals are income not backed by cash, but there’s disagreement about how accruals should be defined and measured. Accruals matter theoretically because they underlie the accounting system that incorporated companies are required to use, and they matter in practice because the cash which accruals say is on its way, doesn’t always arrive. High accruals indicate relatively lower earnings in the near future. These days the lower earnings are anticipated and are in the share price, but there’s disagreement about that as well. For small companies, the pricing-in could be sporadic, causing price volatility. The pricing-in is recent and is likely to make the M-Score less useful, particularly for predicting share price performance.

The definition of accruals which academics use is that accruals are the result of subtracting Cash from operations from Net income. That’s the simplest definition, in my opinion it’s the most useful and it could also be the most common. I’ll call it the NIMCFO definition (Net Income Minus Cash From Operations), but no-one else names their definition because they think their’s is the only one in town. The NIMCFO definition uses the same variables as the quality of earnings ratio, which is Cash from operations / Net income.

The whole point of accruals-based accounting is that cash by itself does not tell the whole story. For instance, many liabilities have to be paid, such as Accounts payable, and if accounts payable build up in a period, Cash from operations will be higher as a result, but the bills will have to be paid in cash, and probably soon. (Against that, an increase in Accounts payable could signal that growth can be financed without needing to raise as much working capital as otherwise, but I’d still like to see the figures.) Accruals-based accounting includes many estimates made by management. The receivables figure depends on the policies for revenue recognition and recognizing when the debt is bad. The depreciation figure depends mostly on the useful life assigned to items of property, plant and equipment. Management decide on how inventories are valued, and when stock is obsolete or damaged etc. In particular, Net deferred tax assets depend on long term projections.

The ‘accruals anomaly’ is the supposedly surprising claim that accruals are of lower quality than other earnings. ‘Lower quality’ is about the same as ‘less sustainable’, so it’s no surprise that lower quality earnings indicate lower earnings in the future, but I don’t mean to minimize the work on accruals which was greeted with skepticism but has been proved in the market:

Accounting anomaly gets traded to death, proving its existence” December 16, 2011 (foster.washington.edu)

Academic Mark Soliman worked on showing that companies where accruals are a high proportion of earnings had lower earnings in the future. He published a paper outlining a trading strategy based on the observation. Few believed him, and other academics disputed the finding, so he traded, profitably. Belief grew, believers made profits, but as a result markets became so efficient that the high-accruals companies became fairly priced on average, and the trading strategy doesn’t work any more (but find “small companies with high accruals” below).

That’s about NIMCFO-based accruals, but accruals by other definitions will also have less predictive power for share prices.

There’s now general agreement that the accruals anomaly exists, but disagreement over whether it has been arbitraged away. Arbitrage trading is supposed to be when traders buy in one market and sell in another where the price is higher, with the effect of equalizing the prices in the markets, but the term now includes many of the trading strategies used by hedge funds. See “Arbitrage” (Wikipedia).

The accrual anomaly: Why investors should care about accruals & earnings quality” Dec 31 2011 (stockopedia.com)

According to Stockopedia, the anomaly has not been arbitraged away, supposedly because the shares affected were too volatile to make arbitrage trading safe. I have my own theory about the volatility, find “high enough to attract short sellers” below.

Earnings Quality Revisited” by Jennifer Bender and Frank Nielsen, The Journal of Portfolio Management Summer 2013, Vol. 39, No. 4 (iijournals.com/)

The measure of earnings quality they look into combines the size of accruals and how fast they are growing or shrinking. This stopped being predictive but made a comeback in 2008. While it’s an unusually pure signal of future out-performance, it doesn’t work as a risk factor. I’ve only seen the short abstract, but it might be out of date or conflict with other writing unless they’ve found a superior metric.

If you google:
“accruals anomaly” arbitraged away
and limit the search to the past year, there are plenty of results for further research.

Overall it’s not clear if the accruals anomaly is currently arbitraged away or not, but it won’t be ignored to the extent it used to be, and the M-Score is likely to be less effective as a result. I’m more convinced by the first story, about “Academic Mark Soliman …”, where the anomaly was pronounced dead in 2011.

If management were rarely dishonest or over-optimistic, the accruals anomaly would never have been as big, but could still exist because cash now is better than cash in the future.

Here’s a possibility which I haven’t seen mentioned. Suppose liars fiddle the cash figures, and accruals are honestly reported. That would reduce the accruals anomaly, and it’s something to bear in mind if you read that the accruals anomaly has shrunk, which is not the same as whether it’s priced-in or not. Manipulating cash flows has benefits for management because some investors don’t realize it’s possible.

YCharts give the NIMCFO definition of accruals. They mention the Beneish M-Score, and imply that a consistently large excess of Net income over Cash from operations indicates a low quality of earnings.

Beneish originally used an index called “ACCRUALS”, which I write as:

    (Income – Non-recurring items – Cash from operations) / Total assets

which is the same as

    (Accruals – Non-recurring items) / Total assets

using the NIMCFO definition of accruals.

In 1999 Beneish replaced ACCRUALS with TATA, the Total Accruals to Total Assets index, but he and and other authors reverted to ACCRUALS in “The Predictable Cost of Earnings Manipulation” (already linked to). Here’s a reminder of how I write TATA:

    (this year’s Non-cash working capital – the previous year’s Non-cash working capital – Depreciation) / Total Assets

    where Non-cash working capital = Current assets – Cash & cash equivalents – Marketable securities under current assets – Current liabilities + Short term debt

    and everything is ‘this year’ unless labeled ‘previous year’.

I’ve kept the 1999 definition of the M-Score which uses TATA, even though it’s less in line with the term “accruals”, because websites with material about the M-Score use TATA, and because investors who have wised-up to the low quality of earnings which accruals represent are most likely to look at ‘NIMCFO’ accruals.

For more about how ACCRUALS covers areas already covered by other indexes, but fills a gap, find “Flaws in the M-Score – no check on non-current liabilities” and “The M-Score’s coverage of the balance sheet”, above.

The wising-up of investors to accruals affects the predictive power of the M-Score regarding share prices. The predictive power of the M-Score regarding earnings restatement or fraud will also be affected, as management are less likely to risk earnings manipulation that distorts the balance sheet without the benefit of keeping the share price up. Less earnings manipulation will mean fewer correct indications of earnings manipulation, and therefore a higher proportion of false positives (companies with high M-Scores that have not manipulated).

There are two issues here for the usefulness of the M-Score: 1) How much the score depended on accruals, and 2) the investment areas where unsophisticated investors buy a high proportion of the shares.

1) In “The Predictable Cost of Earnings Manipulation”, it’s claimed that accruals did not account for all of the M-Score’s usefulness. That’s not surprising if the indexes for gross margin, sales growth, SG&A expense and leverage are any use at all, since GMI, SGI, SGAI and LVGI deal with the pressure to manipulate, which has nothing to do with accruals. It’s also claimed that the accruals anomaly existed largely because earnings manipulation inflated accruals, and that the M-Score “subsumed” accruals, meaning the accruals are efficiently incorporated into a larger system. This leaves some hope that the M-Score is still useful. If I’m right about two signs being wrong, a corrected M-Score would be improved, in areas not connected to accruals.

2) It’s possible that small companies with high accruals are bid up by unsophisticated investors, until the overvaluation is high enough to attract short sellers. If so, the process creates volatility, but without the short selling the share price would go higher and have further to fall when investor-expectations are not met. Management might not mind attracting unsophisticated investors, who blame short sellers rather than management when the share price dives, although I’m not sure how common that is in the U.S. (it’s rife in the U.K., which has the low-governance AIM market, and investment forums where short sellers can be blamed). After the vesting period, volatility gives management an opportunity to time how they realize their stock or option compensation.

It’s worth knowing about accruals even when they are in the share price. Learning about accruals would particularly benefit any investors who think they have a portfolio of bargains, when they have a portfolio of fairly-priced companies with low quality earnings.

Companies with high accruals have more cash tied up in the business. That could mean the business soaks up too much capital, making profitable growth more difficult, but it could mean instead that cash has been put into the business to drive growth. Other factors need to be considered, because the cash tied up could be compensated for by low needs for capital expenditure (for plant, equipment etc.), or aggravated by the need to hire and train ahead of expansion, for example.

To show how that works, suppose a company increases inventories to prepare for higher sales. If the inventory is valued at cost, the build-up does not affect Net income. If the company has to pay cash to build up the inventory, then Cash from operations is reduced. More cash is tied up in the business, and accruals are increased, because there’s less Cash from operations to subtract from Net income. I’ve simplified, and there’s more to valuing inventory than just saying “at cost”, but the principle applies to real companies. However, not all increases in inventories are to prepare for higher sales. If sales were lower than expected, an increase in inventories is a likely result. Obsolete, surplus or out-of-fashion stock could accumulate in inventory and create accruals, until the value is written down and the stock is sold at a discount or disposed of.

Laser company IPG Photonics are vertically integrated and have a short lead time of only two to four weeks, during which they assemble the lasers. The company say they test their lasers thoroughly, but it looks as if much of the time is spent testing the parts before orders arrive. The vertical integration is good for cost, quality and ensuring an adequate supply of parts, and the short lead time and thorough testing are good for sales, but those factors mean the company hold a lot of inventory.

IPG’s inventories are built up ahead of anticipated sales, particularly when new models are launched and sales ramp up. That contributes to accruals, but it hasn’t stopped IPG from having a good history of growing free cash flow per share, which I’ve charted in my two previous blog posts. Some investors will be concerned by the accruals, and analysts seem to give too much weight to the gross margin which falls slightly with growth. I list the most relevant figures because I want to show the difference between accruals as a kind of short term investment and accruals as low quality income. The distinction is rarely made so I’m probably in a minority. For IPG Photonics:

    (in thousands)
    2013, 2012, 2011
    $648,034, $562,528, $474,482 – Net sales
    $155,780, $147,744, $121,009 – Net income
    $119,367, $175,276, $87,351 – Net cash provided by operating activities
    $75,886, $55,257, $79,099 – Net cash used in investing activities
    $172,700, $139,618, $116,978 – Inventories
    52.5%, 54.2%, 54.2% – Gross margin

The figures suggest that accruals are low when investment is low, but I haven’t checked for other years. When accruals (and some expenses) are similar to short term investment, they are based on an expectation of demand, and for IPG Photonics there’s currently some risk if sanctions restrict trade with Russia, a market where there’s likely to be growing demand for IPG’s laser systems.

The M-Score was not meant for financial companies. I’ve read that financial companies have high accruals, but I’d say the state of the balance sheet usually matters more than NIMCFO accruals, and banks are known for keeping liabilities off the balance sheet.

The alternatives to the NIMCFO definition of accruals seem to apply to smaller or private businesses, and there could be some international variation in the definition. Some accountants might think of accruals as the things on the balance sheet with “accrued” in the label, like “Accounts payable and accrued liabilities”, which is different to NIMCFO accruals.

Some sites describe accruals as revenue earned and expenses incurred that have not been paid. The meaning is narrower than the NIMCFO definition, as a change in the value of an asset has no cash effect, so when the change is included in Net income (instead of Other comprehensive income), it’s an accrual according to NIMCFO, but there’s no revenue involved, so it’s not an accrual according to definitions based on revenue and expense. The same revenue-and-expense based definitions tend to imply that the accruals persist until cash is paid, so the Accounts receivable at the start of the fiscal year would be accruals. Because NIMCFO accruals = Net income – Cash from operations, the accruals must start the year at zero, and so they can’t include the starting value of any assets, such as Accounts receivable. Instead, only the change in assets or liabilities can count as accruals. (Reminder – NIMCFO is my abbreviation of Net Income Minus Cash From Operations.)

The ‘Dummies’ publishers describe an accrual as a paper transaction, in “Understanding Accounting Methods” (dummies.com).

Wikipedia list some accruals – accounts payable, accounts receivable, goodwill, deferred tax liability and future interest expense. It looks like Wikipedia wouldn’t reset accruals to zero at the start of the accounting period, whereas accruals are reset to zero in NIMCFO and Beneish’s ACCRUALS. The same applies to TATA because it’s the change in Non-cash working capital that’s used. Wikipedia distinguish between accruals, where there is more certainty about payment and timing, and provisions, where payment or timing are more doubtful. NIMCFO makes a different distinction, for instance if Female Health increased their ‘Provision for obsolete inventory’ by $1 million, their NIMCFO accruals would be decreased by $1 million, as the provision only reduces Net income, and not Cash from operations (but with some complications).

This is short, simple, not NIMCFO, and agrees mostly with ‘Dummies’: “What are accruals?” (accountingcoach.com)

I prefer to ignore Beneish’s use of the word “accruals” and say instead that TATA catches distortions in Non-cash working capital adjusted for depreciation, just as DSRI, AQI and DEPI catch distortion in their own areas.

It doesn’t matter which definition of accruals an author uses, so long as you know which definition the author is using. Taking that approach saves working out which websites can be trusted and who their information is intended for. Investors hoping to learn about accruals might have only read a single source, and the ones I’ve listed can’t all be exactly right.

With the accruals anomaly generally priced-in, management could react by fiddling cash or tailoring non-GAAP measures to their aims. High accruals need to be noted and understood, but now they could be less likely to be the result of earnings manipulation. Investors who want to be thorough can use the M-Score, but also need to look at the cash situation to see if it’s either poor or manipulated. There’s a section about fiddling cash in the excellent free PDF you can find with “Shenanigans”. My previous piece (about cash3 companies) includes “The trouble with cash” with much about cash-based deception.

Accruals on Old School Value

Jae Jun, the founder of oldschoolvalue.com, uses the NIMCFO definition of accruals (NIMCFO is my abbreviation of Net Income Minus Cash From Operations). There’s plenty of material about accruals, although like myself he generally prefers to look at cash.

You Need to Determine Earnings Quality Through Accruals” December 12th, 2011 (oldschoolvalue.com)

Checking Financial Accruals of a Company in 5 Minutes” December 27th, 2011 (oldschoolvalue.com)

Jae Jun had problems finding evidence that high accruals predicted a poor share price performance, and he suggested that instead of just checking for high accruals, a company’s accruals should be compared with competitors’ accruals. I’m not against comparing a company to competitors, but the problem might be the awareness of investors, or at least the big investors. Scroll up to “What are accruals and do they matter?” for the initial skepticism and later acceptance and pricing-in of the “accruals anomaly”. There’s also my point that in some cases high accruals could be the result of building up inventories in preparation for growth.

My opinion is that if cash flows look good, accruals are less important but are worth looking into. That’s the case with Female Health Co, where the growth of free cash flow has been good (though volatile), the cash alone is bigger than the sum of Total liabilities plus the contractual obligations, and there are no off-balance sheet arrangements. The non-cash tax benefits have generally produced more income than cash from operations, in other words, accruals. Small investors don’t seem to realize that much of the company’s net income has been unsustainable (although I’ve tried telling them). I can’t predict how they’ll react, but at least I know the possibilities.

Could You Have Predicted Diamond Foods Accounting Fraud?” January 30th, 2012 (oldschoolvalue.com)

The article above is about applying three methods, including measures based on accruals, and the Beneish M-Score, but not with very much detail about the M-Score.

The Old School pieces are best read in order. I’m not convinced that the complicated accruals-based measures are worth understanding now that sophisticated investors price-in the information about accruals.

Operating lease obligations – billions or trillions to land on balance sheets

Accounting rule changes could add $1.3 trillion of operating lease obligations to corporate balance sheets, according to Wikipedia in “Accounting for leases in the United States“.

The next link says “trillions” but the rules could be softened for two reasons:

    1) Fear of the consequences of making the information easier to find.

    2) The cost of accounting for the thousands of leases a company might have for small items like office equipment.

Companies set to win lease accounting concessions” by Huw Jones, Jan 27, 2014 (uk.reuters.com)

I’ve already said that for Female Health, “the total for Contractual Obligations is $2,147,677, all for lease obligations”, while only $66,799 of Deferred rent appears on the balance sheet. I dug out the obligations for three companies in my previous blog post. That eliminates some surprise, but how badly markets will react if or when the big weight lands on the world’s balance sheets is another matter. In a rational world, share prices would move according to how the amounts disclosed compare to rational expectations, plus a positive factor for the removal of uncertainty. Investment is supposed to be inhibited by uncertainty, but some interests seem to think or argue that markets can’t bear the truth.

There are many different ways to structure a lease. A retailer might have a ‘kicker’ in the lease agreement where more rent is paid if revenue exceeds a threshold. That might be good in the sense that less rent is paid in poor years, but kickers are likely to surprise many investors when they kick in.

There’s a strong suspicion that companies choose operating leases rather than capital leases so they can keep the lease obligations off the balance sheet, rather than for economic reasons. I haven’t found reliable and up-to-date sources for the current rules about lease accounting, because search engines find the proposals for change which businesses object to strongly.

Do deferred tax assets benefit income when they are used?

I believe the answer is “no” when you don’t include the “deferred income tax valuation allowance” as an asset (which it isn’t). I’ve found supporting evidence, but not definitive evidence.

According to “Corporate Tax Reform, Deferred Taxes, and the Immediate Effect on Book Profits” by Jana S. Raedy, Jeri Seidman, Douglas A. Shackelford, July 2011 (editorialexpress.com), if the value of deferred tax assets decreases, the company needs to make “an immediate charge to current period accounting earnings”. The problem with the quote is that the subject was the effect of a reduction in the maximum U.S. corporate income tax rate from 35% to 30%, not the normal use of tax assets. The reason for reducing deferred tax assets shouldn’t affect the accounting treatment, so when Utilization of NOL carryforwards drains the deferred tax assets, the “immediate charge” as above should still apply, canceling the benefit to Net income from the utilization. The benefit and immediate cancellation isn’t recorded in financial reports, at least it wasn’t for Orbital Sciences (next).

From Orbital Sciences Corporation’s 10-K for 2012:

    “Income Tax Provision – Our income tax provision was $30.8 million, $20.6 million and $17.6 million in 2012, 2011 and 2010, respectively. The effective tax rate for 2012, 2011 and 2010 was 34%, 23% and 27%, respectively.”

    “We utilized net operating loss carryforwards that substantially offset taxable income in 2010 through 2012. As a result, our cash payments for income taxes, which primarily related to alternative minimum taxes, were equal to approximately 3%, 3% and 4% of pretax income in 2012, 2011 and 2010, respectively.”

The point here is that the company paid tax at the effective rates 34%, 23% and 27%, so far as the income statement is concerned, but the cash payments for income taxes were only 3%, 3% and 4% of pretax income.

From “Orbital Sciences Management Discusses Q4 2013 Results – Earnings Call Transcript” Feb. 13, 2014 (seekingalpha.com)

    “Our full year 2013 GAAP effective tax rate was 34% while our full year 2013 cash tax rate was 10%, reflecting the utilization of NOL and tax credit carryforwards.”

The NOL carryforwards didn’t do much for the GAAP effective tax rate, even though there was a considerable benefit to the cash tax rate.

That’s the situation I expect Female Health are approaching now the valuation allowance is under $3 million and the utilization of NOL carryforwards will soon have to come out of the Net deferred tax assets.

When tax accounting blinds

When large reductions in corporation tax are proposed, there’s concern about weakening the balance sheets of companies holding tax assets. In my opinion, that’s based on a misunderstanding, or on the consequences of other people’s misunderstanding. Tax assets can’t be sold separately (they can come with an acquisition), and can’t be used when there are no taxable earnings. In addition, the assets have to be reversed into the valuation allowance when earnings are below the expectations the tax assets were based on. Therefore they are unlikely to be much use in hard times, which is a key function of a strong balance sheet. They aren’t unique in that respect, for instance a coal mine could have a large value on the balance sheet, and be worth very little if the price of coal dropped permanently below the production cost. In both cases the value of the asset depends on future earnings.

I’m not denying the importance of perceptions, and maybe companies make acquisitions or return cash to investors based on what they think is a strong balance sheet, and maybe the fiction is maintained by others sharing it, but I don’t intend to invest in such perceptions. A company which suffered a big loss due to a lower tax rate affecting the tax assets, will pay less tax in future, not more, and the benefit to income and free cash flow could last indefinitely if the tax rate isn’t raised, whereas the tax assets only benefit free cash flow, and will run out. If you want to see genuinely strong balance sheets, check my previous ‘cash3’ blog post.

Here’s a hypothetical case to make my point. Imagine a small company with:

    1) $30 million of NOLs (Net Operating Losses) which never expire
    2) $10 million income before income tax every year
    3) The company utilizes as much of the NOLs as it can, every year.

Suppose the tax rate starts at 40%. Each year, the tax would be $10 million * 0.4 = $4 million, but the tax payable is canceled by offsetting the $10 million income before tax with $10 million of the NOLs, which equates to $4 million utilization of NOL carryforwards. The NOLs will all be used in three years, with a benefit of $4 million each year, so the total benefit = 3 * $4 million = $12 million. Assuming the company has not made a sudden turnaround, year 1 starts with $12 million worth of Deferred tax assets, and nothing in the valuation allowance.

The tax actually paid is:

    Year 1 – 0
    Year 2 – 0
    Year 3 – 0
    Year 4 – $4 million
    Year 5 – $4 million
    Year 6 – $4 million
    Year 7 – $4 million
    Year 8 – $4 million

    8-year total of tax paid = $20 million

The first three years of zero tax will benefit Cash from operations, but not Net income (as I’ve explained previously, find “Conclusions about Female Health’s tax assets” above). For each year:

    Net income = Income before income taxes * (1 – the tax rate)
    = $10 million * (1 – 0.4)
    = $10 million * 0.6
    = $6 million

    8-year total of Net income = $48 million

Now suppose at the start of year 1, the tax rate is halved to 20% and stays there. Each year, the tax would be $10 million * 0.2 = $2 million, but this is canceled by offsetting the $10 million income before tax with $10 million of the NOLs, which equates to $2 million utilization of NOL carryforwards. The NOLs will all be used in three years, with a benefit of $2 million each year, so the total benefit = 3 * $2 million = $6 million. The value of Deferred tax assets immediately drops from $12 million to $6 million, a $6 million reduction in value, as a result of the tax cut. For year 1:

    Taxable income $10 million
    Statutory tax -$2 million
    Utilization of NOL carryforwards $2 million
    Deferred tax assets utilized -$2 million
    Decrease in value of Deferred tax assets due to lower tax rate -$6 million
    Net income $2 million

So Net income is only $2 million as a result of the tax cut, 66.7% less than the $6 million without the tax cut. The Deferred tax assets end the year at only $4 million, when they would have been worth $8 million without the tax cut.

The tax actually paid is:

    Year 1 – 0
    Year 2 – 0
    Year 3 – 0
    Year 4 – $2 million
    Year 5 – $2 million
    Year 6 – $2 million
    Year 7 – $2 million
    Year 8 – $2 million
    8-year total = $10 million

Each tax payment is halved, compared to the previous schedule.

With the new tax rate staying at 20%, Net income has one bad year, as explained, followed by better years, indefinitely, like this:

Net income following a tax cut from 40% to 20%:

    Year 1 – $2 million
    Year 2 – $8 million
    Year 3 – $8 million
    Year 4 – $8 million
    Year 5 – $8 million
    Year 6 – $8 million
    Year 7 – $8 million
    Year 8 – $8 million
    8-year total = $58 million

Without the tax cut, Net income stays at $6 million a year, and the 8-year total is only $48 million, but $6 million accrues earlier. I say “accrues” because it isn’t cash, and the $6 million can’t be invested to earn a return, so there’s no real advantage to accruing the $6 million earlier. There could be a relative advantage regarding perceptions of the company.

In this simple model, the fall in the tax assets was only $6 million, which is less than the taxable income. A real company could have a much bigger fall if it had much bigger tax assets, but I assumed a massive cut from 40% to 20% tax, and a smaller cut would have less effect on the value of tax assets. A company with large tax assets and with total assets only slightly above total liabilities before a tax cut, could have total assets less than total liabilities after the tax cut. It’s possible that a real effect is generated as a result of the illusion, if debt covenants are triggered or perceptions of credit risk are worsened.

I assumed that the tax cut is permanent. If the cut is temporary, the company can benefit in some circumstances, and is never worse off than if the cut never happened (not counting any macro effects). It takes too much space to give examples showing that a lower tax rate for longer can be better and is never worse, but it could be demonstrated by testing scenarios on a spreadsheet.

The value of an asset is either what it can be traded for, or the benefit it provides over it’s lifetime, and tax assets cannot be traded. A tax asset really does provide less benefit over its lifetime if the tax rate is cut, but the effect is more than made up for by the benefit arising from the lower statutory tax rate each year. There could be some relative effects, because companies without tax assets benefit more from a tax cut than companies with tax assets.

The benefit arising from lower statutory tax each year cannot be capitalized as an asset. That explains how a real improvement causes a year with lower Net income and a lower value for the tax asset. The real improvement is the lower tax actually paid in the future. Investors should be aware that financial reporting can blind as well as illuminate.

The valuation allowance, management’s predictions, and earnings management

Regulators and accounting standards don’t encourage management to share their forecasts with investors. The one exception is when allocating the Gross deferred tax assets between the Deferred income tax valuation allowance and Net deferred tax assets, and projections based on a 50% probability threshold are a GAAP requirement.

Predictive Ability of the Valuation Allowance for Deferred Tax Assets” by Jung, Do-Jin; Pulliam, Darlene, Academy of Accounting and Financial Studies (questia.com)

The article above doesn’t show the full text, but from what’s visible, the case is based on argument rather than data. IMO one snag is that when a lower allowance shows optimism, the tax benefit is pre-booked into Net income. If the projections turn out to be too optimistic, the tax benefit could be reversed as some of the tax asset is reversed back into the valuation allowance. Because of that, the best situation is probably the one I explain in “FHCO – Female Health’s deferred tax assets imply management’s forecasts have been conservative” below. While improving prospects combined with tax assets based on conservative projections are attractive, the quality of earnings is likely to be low, with Net income losing the tax benefit earlier and Cash from operations losing the tax benefit later.

The article linked to above points out that the required forecasts offer an opportunity for earnings management.

The paper “Looking at Accounting for Income Taxes: Do Managers Play “Truth or Dare” with Tax Accruals?” (PDF) by Carlos E. Jiménez-Angueira, University of Texas San Antonio

cites …

“Is Deferred Tax Expense Useful in Detecting Earnings Management in Earnings Restatements” by Badertscher, B., J. Phillips, M. P. K. Pincus, and S. O. Rego. 2006.

… in a sentence which implies that the answer to the title is “Yes.”, but it isn’t all that surprising if an earnings restatement throws up evidence of earnings management, especially if the restatement was required by the SEC or by auditors.

The google search “valuation allowance” “earnings management” finds plenty of academic papers, most of which are not free.

What a Company’s Tax Disclosures Reveal About Its Quality of Earnings” 7 Dec 2010 (taxand.com)

The last two paragraphs are about the valuation allowance. Investors are warned that the release of the valuation allowance causes an increase in earnings which is low quality.

Tax and the liability method

The liability method is a GAAP requirement when there’s a tax asset or liability. More technically, the Asset-Liability Method is a GAAP requirement when there’s a temporary difference between the period of financial reporting and the period in which the tax is payable.

Under the method, the balance sheet is seen as primary and the income statement as secondary, with the implication that the cost of keeping the balance sheet useful and accurate is that the income statement could be misleading to unwary investors.

The Gross deferred tax assets equal the value that would be derived from the Net Operating Loss carryforwards if they were all used. This is split between the Deferred income tax valuation allowance and the Net deferred tax assets. I’ve read that potential tax assets go into the valuation allowance if the chance of expiry before utilization is greater than 50%, but as Female Health Co look ten years ahead, I expect their deferred tax assets only include the benefit of NOLs likely to be used in the next ten years. The requirement to apply a 50% threshold rules out being deliberately conservative, but I don’t expect the SEC to take much interest in conservative estimates, see “FHCO – Female Health’s deferred tax assets imply management’s forecasts have been conservative” below.

The Asset-Liability Method of Interperiod Tax Allocation” By Maire Loughran from Intermediate Accounting For Dummies

Wikipedia’s “Tax expense” is less clear than Dummies.

See also “The valuation allowance, management’s predictions, and earnings management” above, for the thoughts of some academics on the subject generally.

Links for the U.S. corporate tax rate

The U.S. Corporate tax rate is high at about 35% but with deductions and complications. Companies that supply software or cloud-based services etc. are particularly well placed to pay little tax if they operate internationally. Companies have very different effective tax rates, and somewhere at the upper end, metrology company Nanometrics estimate a tax rate band up to 38% for 2014. It’s possible that revisions of open years (the last three years in the U.S.) could produce higher rates. Many companies minimize the repatriation of cash held overseas, to avoid paying withholding taxes.

Corporate tax in the United States” (Wikipedia)

A list of 2013 U.S. corporate federal tax rates. (en.planiguide.ca)

U.S. Corporate Tax Rate Fails to Move with Competition” By Ellen Kant, March 20, 2013 (taxfoundation.org)

This is 100% politics: “Update: U.S. Corporate Tax Reform Likely On Hold Until November 2014” by Joe Harpaz, 1/10/2014 (forbes.com)

Share price performance and fundamental analysis

Every tool of fundamental analysis might also predict share price performance, but their usefulness for prediction depends on enough investors ignoring them, both explicitly and regarding the quantities the tools are based on. Taking the Altman Z score, which indicates the risk of bankruptcy, as an example, suppose it is under-used, and so are any equivalent or superior alternatives. Then a mechanical share-picking system could outperform the market by using the score to avoid companies in the Altman Z ‘distress zone’. If the Altman Z score became fully appreciated, the companies flagged as being risky would become fairly priced, and the score would not predict risk-adjusted share price performance, although it could still be useful to risk-averse investors. At least, that’s one theory. Warren Buffett’s advice would be to avoid the risk of a permanent loss of capital, and risk-averse investors can still exercise their stock-picking skills within the stocks in the Altman Z safe zone.

There’s a study which went beyond the usual link between fundamental analysis and share price performance, by comparing markets in two countries, the United States and India. This links to the 12 page research abstract (a PDF):

An examination of future firm performance and fundamental analysis” by Chris Luchs, Suneel Maheshwari and Mark Myring

The study showed that predicting stock price performance from fundamentals in India needed different indicators to prediction in the United States. The conclusion is that investors priced-in different information. If the information priced-in can vary between countries, IMO it’s possible that the information priced-in can vary over time in the same country, and old studies relating fundamentals to stock price performance could be out of date.

Investors valued each dollar spent on R&D as being worth the same as a dollar of tangible capital, at the start of the 1980s, but the valuation of R&D capital fell to only 0.2 to 0.3 times the value of tangible capital by 1990. (See “The Value of Intangible Corporate Assets: An Empirical Study of the Components of Tobin’s Q.” by B. Hall, University of California, 1992.) It’s possible that companies’ R&D became much less effective, but it’s more likely that perceptions changed, and if investors were right at one end of the decade, they were wrong at the other end. A well informed investor could either have avoided companies with high R&D in 1980, or invested in companies with high R&D in 1990. According to “The market valuation of knowledge assets in US and European firms” by Czarnitzki, Hall & Orian, 2005 (berkeley.edu), one dollar of additional R&D spending adds slightly less than a dollar to market value, the equivalent of capitalizing the R&D spend and depreciating it by a bit more than 15% a year. I haven’t found a recent estimate. If investors’ valuation of R&D can drop 70% in a decade, other perceptions of fundamentals can drift. See also “The Altman Z Score improved with age but has critics”, below.

Old studies are not systematically re-tested or re-optimized. Academics might think it wouldn’t help their careers, but research into the durability of investment-related studies would be useful, original in its own way, and shouldn’t be too hard for anyone who understands the original work.

The incentives academics face might explain why they are keen to expand the theory in a piecemeal fashion, and have no scheme for regular updates, in stark contrast to the way in which antivirus software is updated (although there are a lot more new viruses than the restatements of accounts relevant to the M-Score, or bankruptcies relevant to the Z Score). Life could be different at the sharp end, and firms that charge for forensic accounting services might update their analysis tools as soon as new information allows it.

Academics write papers where theories or proposals are supported by evidence, often in the form of statistical tests. That’s good, but for fundamental analysis, investors need to know if the results still apply, and if the information has become priced-in. For forensic analysis, there’s a risk of over-weighting old abuses and leaving gaps for future abuse. The first rule of making a good fishing net is to make sure the fish can’t pass through. Academics could forget that objective by demanding evidence that every scrap of material used is necessary.

The M-Score was specifically designed to indicate the risk of a restatement of accounts required by auditors or the SEC. That under-represents any form of earnings manipulation with a low risk of being caught. There’s reason to suspect gains included in non-operating income when they make up for a drop in operating income (see “Beyond the scope of the M-Score” above), but the reporting is likely to comply with GAAP, so there’s little chance of a restatement of accounts being required. It might be possible to relate future share price performance to swings from operating income to non-operating income, and to design an index to warn of the low quality income, but forcing the index into the M-Score would create problems as there’s no clear way to optimize the coefficient of the new index. One possibility, now that the M-Score is touted as predicting share price performance, is to create a variant optimized for share price performance and earnings persistence, but still only using indexes likely to catch earnings manipulation.

Beneish’s 1999 paper improved on his work dated 1997, but before Beneish devised the M-Score, Lev and Thiagarajan wrote about twelve signals to measure earnings quality, in “Fundamental Information Analysis” by Baruch Lev and S. Ramu Thiagarajan, 1993. Much of the paper is fairly readable, but the data covered 1974 to 1988 and IMO the signals are due a re-test.

Some of Lev and Thiagarajan’s measures were similar to indexes in the M-Score, for instance signal 2 is:

    Growth in accounts receivable – Growth in sales

Compare that to the M-Score index DSRI (Days Sales in Receivables), which boils down to the growth of the ratio:

    Accounts receivable / Sales

although L&T based their growth numbers on growth above the average for two previous years.

Beneish rejected some of Lev and Thiagarajan’s measures of earnings quality when they didn’t improve the performance of the M-Score. The rejects involved changes in these – the receivable provision (for customers not expected to pay up), capital expenditure, tax expense / taxable income, and sales per employee. Another reject depended on whether or not inventory was valued using LIFO (Last In First Out). The signal based on a qualified audit report (meaning the auditors found something dubious) has nothing like it in the M-Score, but it wouldn’t have been useful to auditors, and might have displaced signals that anticipated a qualified audit report. L&T were interested in stock returns and the quality or persistence of earnings over one, two and three years, and their signals could not all be expected to improve the performance of a score aimed at earnings manipulation.

Lev and Thiagarajan recognized the ambiguity of popular indicators, including the fact that while unusually high inventory generally indicates a problem, the inventory could be held because higher sales are expected. A complicated model could look for signs like increased investment and no slump in sales, to see how to interpret the information about inventory, but L&T kept the model simple, or ‘parsimonious’, and the high inventory is just seen as bad in their formal scheme. The M-Score is also parsimonious, which is one reason why it’s worth checking that a warning is the result of a genuine problem. A non-parsimonious model (‘profligate’?) is likely to be more complicated and have more coefficients which need to be optimized for the data set. That in turn needs more data to be sure that the model gives statistically significant results. There probably aren’t enough restatements of accounts to enable a much more complicated version of the M-Score, limiting any benefit from a non-parsimonious version. It’s more feasible to have a non-parsimonious model when the model is optimized for share price performance, as there’s much more data.

The Altman Z Score improved with age but has critics

The Altman Z-Score: Is it possible to predict corporate bankruptcy using a formula?” Apr. 13, 2011 (businessinsider.com)

The title is answered with ‘Yes’, but be aware that the original version applied to manufacturing companies, and a modified version applies to non-manufacturers. There’s also a version for private companies which omits the term with market capitalization. The different scores need different interpretations. The accuracy of the Z Score for predicting bankruptcy was initially measured at 72% in 1968, but this increased to between 80% and 90% in the years to 1999. That could be due to the data accumulating, or a change in the bankruptcy risk.

This PDF is the source of the 80% to 90% accuracy figure: “PREDICTING FINANCIAL DISTRESS OF COMPANIES: REVISITING THE Z-SCORE AND ZETA® MODELS” by Edward I. Altman, July 2000 (pages.stern.nyu.edu). To be more exact, 80% to 90% of the companies which went bankrupt were flagged by the Z score. However, the ‘false positives’ flagged as a bankruptcy risk but which did not go bankrupt, grew over the period to 15-20% of the companies flagged. A company was flagged if its Z score was under 1.81.

In 2009, the Z-score was used with European companies to show that companies with weak balance sheets had poor share price performance from 1990 to 2008, with the worst performance in bear markets and recessions. While I’m all in favor of strong balance sheets, there will be times when markets turn from ‘risk off’ to ‘risk on’ and companies with weak balance sheets are likely to outperform, which may have been the case in the “dash for trash” rally after the credit-crunch. The companies assumed to have weak balance sheets were companies with a Z score less than one.

Suppose an academic tested an old score using data from 1995 to 2005. The academic could pick the threshold that gives the best result. Anyone investing during that period would not know that threshold. If there was a single best threshold that stayed constant, academics would not use different thresholds for studies of the same score. Academics could be choosing thresholds for good reasons, but the variation isn’t helpful for investors.

The Z score is affected by bull markets and bear markets, as the company’s stock price is in the score and is affected by the overall market. Market sentiment is also likely to affect the ability of distressed companies to raise capital.

Stop Using the Altman-Z Score.” by wes, July 23, 2011 (blog.empiricalfinancellc.com)

The blog-piece above is about a research paper called “Predicting Financial Distress and the Performance of Distressed Stocks” by John Y. Campbell, Jens Hilscher, and Jan Szilagyi. While the abstract, formulas and statistical tables are quoted, the style is informal. A new score with eight components is proposed. Six of the components depend on valuation by the market, through the market capitalization, the share price, and the share price volatility, so there isn’t much in the score that’s purely about fundamentals.

Forecasting Bankruptcy More Accurately: A Simple Hazard Model” by Tyler Shumway, 1999 (personal.umich.edu)

Shumway finds that about half of the accounting ratios used to predict bankruptcy are not statistically significant. My view is that having net cash and good cash flow is a reliable indication that bankruptcy is far from imminent, even if a weak balance sheet and poor cash flow does not reliably indicate bankruptcy. In the second case, signals from the market are important, and can be monitored more frequently than financial reports. So far as I know, the critics of the Z-Score have not proved that investing in companies in the Z Score’s safety zone is a bad strategy. The original formula for the Z-Score is:

    Altman Z Score =
    1.2 * Working capital / Total Assets
    + 1.4 * Retained earnings / Total Assets
    + 3.3 * Earnings Before Interest and Taxes / Total Assets
    + 0.6 * Market Value of Equity / Total Liabilities
    + 0.998 * Sales / Total Assets

    Distress zone < 1.81 < Gray zone < 2.99 < Safe zone

Shumway finds that only EBIT / Assets, and Market equity / Total liabilities are statistically significant. Altman naturally thought all his ratios were statistically significant, and Shumway's explanation is that the Altman Z Score suffers from a statistical bias because samples of healthy and bankrupt firms were not chosen randomly.

Working capital is Current assets – Current liabilities. A few websites write "market capitalization" instead of "Market Value of Equity".

For non-manufacturing companies:

    Altman Z Score =
    6.56 * Working capital / Total Assets
    + 3.26 * Retained earnings / Total Assets
    + 6.72 * Earnings Before Interest and Taxes / Total Assets
    + 1.05T4 * Market Value of Equity / Total Liabilities

    Distress zone < 1.22 < Gray zone < 2.9 < Safe zone

The coefficients are very different and asset turnover (Sales / Assets) is dropped. Altman might have been thinking of consultancies where compensation is high and capital costs are low, rather than capital intensive businesses like server farms and airlines. Physical assets can be leased, which brings up whether it’s how assets are financed that matters or how tangible the product is, when choosing the Z Score formula. Asset turnover can be very high for a service industry, or in any industry if the assets used are on the books at a low value.

Synchronoss Technologies, Inc (SNCR) provide a service to telecoms carriers, but have a low asset turnover, mostly due to the intangibles they carry. For 2013 (in thousands):

    Total assets $527,019
    Cash $63,512
    Non-cash assets $463,507
    Revenue $349,047

    asset turnover = $349,047 / $527,019
    = 0.66 times, or 66%
    turnover on Non-cash assets = $349,047 / $463,507
    = 0.75 times, or 75%

    Property and equipment, net $106,106
    Goodwill $137,743
    Intangible assets, net $101,963

Ubiquiti Networks, Inc. (UBNT), 2013 (in thousands):

    Total assets $292,340
    Cash $227,826
    Non-cash assets $64,514
    Revenue $320,823

    asset turnover = $320,823 / $292,340
    = 1.10 times, or 110%
    turnover on Non-cash assets = $320,823 / 64,514
    = 4.97 times, or 497%

Ubiquiti put their own logos on their own designs, and are probably classed as manufacturers of communications equipment, but their outsourcing allows high asset turnover, several times higher than service-provider Synchronoss. An online Z score calculator might not tell you much about the version of the Z Score it uses for a company.

I prefer to strip out the cash from Total assets for businesses with no need to turn the cash over. An online Z score calculator probably just throws in Total assets, and if it doesn’t, it might not tell you.

Some companies can operate with negative working capital, which is usually considered to be an advantage, but they are likely to get low Z Scores due to the high coefficient of 6.56 for working capital. Some companies could have high working capital as a result of high inventory, which could be due to low sales, while another company could have the same amount of working capital but made up mostly of cash.

"Bankruptcy Prediction with Industry Effects" by Sudheer Chava and Robert A. Jarrow, revised 2004 (wu-wien.ac.at)

The paper starts by using an expanded bankruptcy database to show that Shumway's 2001 model (above) beats Altman's (1968) and Zmijewski's (1984).

In "The Power of Cash Flow Ratios” by John R. Mills and Jeanne H. Yamamura, October 1998 (journalofaccountancy.com), the authors argued that auditors should catch up with Wall Street and look at cash flow ratios when deciding if a company is a going concern.

Altman considered using the cash flow to debt ratio in the Z score, but the cash flow data wasn’t always available in 1968. While the Altman Z Score is convenient and seems to have tested well, it still doesn’t look at cash. The cash ratios in the link above might be an improvement, but they look at aggregates and averages, and could miss the effect of a big debt repayment just beyond the one year range of current liabilities. A more thorough check is much less convenient: in a spreadsheet, make a schedule of all cash obligations (including debt repayment), and to start with, see how much headroom there is if cash from operations stays constant. You can leave out Operating lease obligations, and any other regular payments that are an expense deducted from Net income and therefore from Cash from operations. Check “Contractual obligations”, and look under “Financing activities” for anything that looks like an unavoidable regular payment, like “Payments on capital lease obligations”. The schedule of debt repayment is known as the ‘debt profile’. I prefer to include any payments that aren’t already included in Cash from operations.

Growth, bloat, decline and recovery

When a company has high sales growth, falling gross margin, or increasing SG&A expense as a proportion of sales, it might be worth reading this section to see if any of it applies to the company. I hope the cases I’ve cited are interesting, although an editor would delete the entire section for being too miscellaneous. Skip to “The Dodd-Frank Act – clawing back performance awards” if you like.


There are many reasons why a company’s growth could slow, including – a change in fashion, product obsolescence, market saturation, competition, scarce resources within the company, scarce resources in the market, getting too big to grow fast, recession, government policy, labor disputes, poor management, and increasing bureaucracy if management don’t address the organizational issues that size brings. The ‘scarce resources’ items include everything from skilled personnel to finance. To varying degrees, these are areas which investors can research and make a judgment about before investing, and consider when thinking about a warning from SGI.

If market saturation is reached, it’s worse for durable goods where demand could fall to replacement levels. In a recession, consumers will delay buying cars but not cut down much on bread, and car-makers will still pay for electricity but will buy much less welding equipment. There are details and exceptions, for instance some capital spending could be driven by regulation aimed at reducing pollution, rather than by the state of the economy.

There are some general differences between consumer and business markets, with businesses more likely to be conservative about buying new products, and to look at the specification. Professional buyers or purchasing managers can feel they’re punished for mistakes more than they’re rewarded for buying a better product. A business customer might insist on trials and then regard them as their least urgent activity. Safety-critical products from drugs to airplanes can take a long time to prove, and sometimes the technology looks dated by the time it’s approved. Small companies trying to grow can depend on relatively large contracts with a few customers, and a single delayed or canceled contract can have a big effect on results.

Consumers can also be conservative, for example many won’t change their preferred cola or sports team, but they also buy new products with a cool image, which isn’t usually relevant when choosing the office photocopier. Sales are likely to be at least maintained, for services and ‘consumables’ where the customers are conservative, meaning less risk from a high SGI.

Early in this interview, a value-oriented professional investor describes how he liked the business model of used car dealers CarMax, but waited until they tried to expand too fast and hit problems, before buying shares at much less than their IPO price: “Markel Manager Tom Gayner Interview with GuruFocus in Omaha” May 08, 2013 (gurufocus.com).

Krispy Kreme Doughnuts, Inc had EPS growth of 80%, 67%, and 47% following their IPO in April 2000. The growth figures were fairly synthetic due to earnings manipulation, but it’s not surprising that high growth is followed by such a decline. Investors might regard the figures as declining compound growth, but I’ve calculated from the percentages that after the 80% growth, a model of growth based on simple interest of 80% rather than fixed 80% compound interest is 13.5% more accurate, and investors who thought about increasing simple-interest based growth would need to factor-in less adjustment than investors who thought about decreasing compound-interest based growth. (Simple interest just takes the absolute ‘dollars and cents’ rise in EPS that occurred in the first year, and grows EPS by that amount every later year.)

I also looked at extrapolations for the two growth schemes, for Female Health Co, based on the growth from 2006 to 2007, the first two years with positive income. The simple growth or linear extrapolation was surprisingly accurate, but this was a fluke as using the growth between other pairs of years was inaccurate. The percentage growth between 2006 and 2007 was a very high 502.81%, which extrapolated to a ridiculous EPS of $3,078 in 2013 using compound growth, compared to the actual EPS of $0.4993. The percentage growth in EPS over the previous year, from 2007 to 2013, was: 502.81%, 176.61%, 32.42%, 0.42%, -21.04%, 183.74%, -5.58%.

Krispy fiddled the figures, and Female Health have lumpy orders, but I’d still suggest not being over-impressed by high reported growth (or by projections beyond the next year, usually). Instead, ask if there’s an economic moat (next bit) and if the price is right, and consider other factors including the most relevant ones in this section. When companies are floated, investors pay for growth. The amount of cash raised is obviously important when the owners time an IPO, and it’s worth asking why they haven’t waited a year or two.

Economic moat

An economic moat is a sustainable competitive advantage, which could be the result of a durable brand, excellent management, being the biggest when there are economies of scale, the business model, innovation, or a network effect. The moat gives a company pricing power. Growth might not be fast, but it can be maintained with a good margin.

I have alternative definitions –

1) An illusion held by investors who lack the imagination to see how success can be undermined. A town’s local newspaper used to benefit from the network effect for local advertising, because the paper was where people looked to find items for sale locally, so that’s where they were advertised, so that’s where you had to look, etc. That and other services have been undermined by the internet. The internet might have looked very unthreatening in the early days and after the Dotcom-crash. Moats or apparent moats can be destroyed by innovation, a radical change in consumer preferences, incompetent management, and government policy including breaking up monopolies. Before deciding a moat is safe, learn or think about disruptive innovation. Even geography can change, and the Suez Canal is likely to lose some business if the Arctic thaws enough.

2) An advantage to be squandered by management. GEICO is a classic case from the value-investing literature. They were insurers who only insured government workers, who generally had low accident rates. Targeting government workers meant GEICO didn’t need the expensive advertising required by other insurers. Value investors saw the value of the model, bought in, and exited with a big profit. Then GEICO’s management expanded the business until it became more like other insurers, and got into trouble. Warren Buffett decided the new CEO was competent and working to put GEICO back on the right track, and GEICO became part of Buffett’s Berkshire Hathaway.

5 Ways to Identify Wide Economic Moats” by Daniel Sparks, August 20th, 2012 (oldschoolvalue.com).

The first of the five ways gives Apple Inc as an example, citing fanatical loyalty among other good points. Blackberry also had fans. Right now Google’s Android seems to have a moat, but I’m not committing myself. IMO it’s usually hard to be sure that an advantage is permanent enough to be a moat, especially in high-tech markets.

WD-40 is a spray for lubricating metal parts and preventing rust, and is a product with an enduring economic moat. The brand is known and trusted. Because use is infrequent, it isn’t worth customers trying alternatives, often on items that would be expensive to replace or repair if the alternative caused damage. Because most customers want WD-40 and turnover is low, it often isn’t worth small outlets stocking alternatives. The company even developed a superior product but couldn’t sell much of it, because customers preferred the WD-40 they knew and trusted. Because growth isn’t fast and the market isn’t enormous, it isn’t worth competitors spending a large amount on promotion in an attempt to grab market share, and there are easier markets to target.

Warren Buffett wants long term performance, so this is relevant: “This is How Buffett Interprets Financial Statements” by Jae Jun, May 21st, 2012

In “1995 Berkshire Hathaway letter to shareholders” (already linked to), Warren Buffet said:

    ‘In business, I look for economic castles protected by unbreachable “moats.” Thanks to Tony and his management team, GEICO’s moat widened in 1995.’

GEICO’s moat derived from it’s business model. Strong brands are frequently cited as supporting economic moats, and some of the writing about economic moats could leave you thinking that brand recognition is enough.

Daimler sees profit rise as new models catch on” by Edward Taylor, Feb 6, 2014 (uk.reuters.com)

From the article above, luxury car makers Mercedes-Benz, BMW and Audi all had operating margins under 10%. That’s not a high margin, given the investment required, although volumes are high. In 2012, margin targets were scrapped at Mercedes-Benz after a series of disappointing results. Mercedes-Benz is a well known and respected name in the luxury car market (and the article “Stop Using the Altman-Z Score.” above, has a picture of a gold-plated Mercedes). Whether you say the brand is strong due to recognition and appeal, or the brand is weak because margins can be low, indicating little pricing power, it’s a mistake to assume that brand recognition and appeal amount to an economic moat. Customers who want a luxury car from a recognized luxury brand still have a choice of brand, and can demand value, even if the value is superficially different to the value of keenly-priced own-brand groceries.

Many publications have struggled to find a way to monetize their once-mighty brand online.

This article is about a book from 1967 where the concept of the economic moat was understood well before Warren Buffet mentioned “economic castles protected by unbreachable moats”: “Economic Moat: A Look Back in Time” by David Foulke, Oct 21 2013 (turnkeyanalyst.com). One old moat example is Polaroid. Anyone could copy the expired patents, and the book-author stressed qualities such as talent rather than technology. Polaroid were floored by digital technology a few decades later. Another example is Avon Cosmetics, who’s moat is the unique and hard-to-copy “army of women” who sold the cosmetics door-to-door. That may be a good moat, but door-to-door selling is not invulnerable. In the U.K., the long-forgotten ‘man from the Pru‘ (‘Pru’ was short for ‘Prudential’) collected regular payments for insurance policies, savings plans etc., and used the visits to make new sales. That might have gone out even before the internet became popular. The book-author (who uses the name “Adam Smith”) emphasized the importance of price. Buying at a high valuation requires high growth or above average growth for many years to be sure of a good return, and some moats won’t last long enough. (BTW if “army of women” sounds odd these days, there was worse in the 1967 book.)

Since I mentioned the U.K., grocery retail stocks plunged recently as one of the smaller grocers decided they had to compete on price with the discount retailers, who have 7.5% of the market. Insurance companies that sell annuities have been hit by deregulation. Previously, there weren’t many options for a personal pension except to buy an annuity, and the providers have been accused of selling ‘rip-off annuities’ to naive customers. Consumers were exploited in both cases, for decades, but not forever.

You can find your own profound quote about change, to remember every time you hear about a company with a moat.


Big companies can suffer from accumulated bloat, which strangles profitability, innovation, the ability to react, and the kind of growth you want. (I probably shouldn’t write about bloat in a piece this long 🙂 )

Streamlining spans and layers” March 16, 2010 (bain.com). Bain imply that AT&T had 14 layers of management before drastically cutting them. Former Hewlett Packard CEO Mark Hurd found that the cause of many problems was 11 layers of sales management, which he cut to 8.

Can A Big Company Move Fast?” April 25, 2013 (linkedin.com). IBM’s management realize there’s a problem but fall short of saying the company needs to streamline and cut time-consuming procedures. The CEO blamed sales staff for poor sales, and supports a drive to have customer questions answered in 24 hours.

How IBM bypasses bureaucratic purgatory” By Anne Fisher, December 4, 2013 (cnn.com). IBM employees can use an internal crowdfunding system called iFundIT to bypass the company’s bureaucracy. A good initiative, but it would be better to trim the bureaucracy than to find ways to bypass it.

After reading the next link, the CEO’s response to losing sales seems superficial. As well as bureaucracy, the determination to hit an EPS target seems to have undermined IBM’s service to clients, giving clients exactly what they specify, which usually isn’t what they need. There are already overseas companies that can supply to specification competently, and IBM won’t be able to charge a premium in that area indefinitely if they provide nothing extra.

The massive recent project failures at IBM strike at the heart of why outsourcing fails” by Andrew Pollack, 08/08/2013 (thenorth.com)

I expect management will be well rewarded when the EPS target is hit, but you don’t clear a roadblock by putting a pot of money further down the road.

IBM can still make a good margin on their own software, especially if they can successfully commercialize Watson (the knowledge system that won a game of Jeopardy on TV).

Bloat is not only about layers of management. When CEO Bruno Cercley returned to rescue ski manufacturers Skis Rossignol, they had about 400 different products. No-one understood the rational for the product range, which confused customers, retailers and the company’s own employees. The range was quickly reduced to 200. Rossignol’s crisis resulted from warm winters, skiers preferring to rent skis instead of buying their own, and high sales in Japan slumping when customers switched to virtual skiing on screens. The crisis was painful but the CEO has said it was good for the company. The recovery depended on suppliers extending credit, which can’t always be guaranteed, and it’s obviously better to cut the rot before growth stops or markets turn.

Rossignol had enjoyed decades of growth through innovation, Olympic winners using their equipment, product diversification, and the penetration of new markets. The company produced the world’s first all-metal skis, which were used by the winner of the Olympic downhill event in 1960. Fiberglass skis and plastic skis followed. Rossignol began selling in the U.S. in the 1970s, and in the 1988 Winter Olympics, most of the wins were with Rossignol equipment. Product diversification got going in the 1990s with ski boots, bindings, snowboards and clothes. When about two million Japanese took up skiing, the business would have looked like a successful company dominating an attractive niche with valuable brands, and therefore able to grow within a moat. They were bought for $560 million in 2005, and sold for $147 million in 2008 to the former CEO. While Rossignol had decades of success, they seem to have lacked a coherent management system or a business model that could have helped to keep them on track as markets, management and ownership changed.

It’s partly because of such cases that I prefer companies with plenty of cash and good free cash flow, to companies which only have the cash flow, many of which have net debt. While it’s worth learning what you can about a company’s prospects, the efficiency of the organization, and the rationality of the product range, checking the net cash position and the history of free cash flow is easier and more objective. (I wrote about the benefits and risks of cash piles in my previous blog piece.)

Jack Welch was CEO of General Electric from 1981 to 2001. While highly effective, he was noted for ‘brutal candor’, and fired the worst performing 10% of managers each year. IMO that would not be good for all companies, but he solved GE’s bloat problem. GE later faced a serious problem through its financial arm, when bad debt emerged during the financial crisis. In this old interview, Welch describes how he cut out layers of management and time-wasting procedures, and generally made GE leaner and fitter: “Speed, Simplicity, Self-Confidence: An Interview with Jack Welch” by Noel Tichy and Ram Charan, September 1989 (hbr.org).

Jack Welch saw business as essentially simple but burdened with the complications that people impose on it, such as complicated hierarchies and waiting for long and complex reports to be completed. The interview above has cases where deals were completed quickly, but this was only possible because managers were trusted, well informed, and knew what was expected of them. I see some similarity with Warren Buffett’s approach, find “He called me after the match and in five minutes I basically had a deal.” in this 1998 lecture by Warren Buffett (PDF). Buffett already knew the business (shoes), I think the key word in the quote is ‘basically’, and the accounts would have been examined for a lot more than five minutes. He also wanted a quick decision when he offered to bail-out Long-Term Capital Management: “Warren Buffett gave Meriwether less than one hour to accept the deal;” (Wikipedia).

Whether or not business ought to be simple, some businesses aren’t, and Warren Buffett famously puts them on the ‘too hard’ pile if he doesn’t understand them.

This shows simplicity in action, for real estate. “Buffett’s annual letter: What you can learn from my real estate investments” February 24, 2014 (fortune.cnn.com).

Speed and decisiveness are not at the expense of prudence. From the 2013 Berkshire Hathaway letter to shareholders:

    “Berkshire Hathaway Reinsurance Group, managed by Ajit Jain. Ajit insures risks that no one else has the desire or the capital to take on. His operation combines capacity, speed, decisiveness and, most important, brains in a manner unique in the insurance business. Yet he never exposes Berkshire to risks that are inappropriate in relation to our resources. Indeed, we are far more conservative in avoiding risk than most large insurers. For example, if the insurance industry should experience a $250 billion loss from some megacatastrophe – a loss about triple anything it has ever experienced – Berkshire as a whole would likely record a significant profit for the year because of its many streams of earnings. And we would remain awash in cash, looking for large opportunities if the catastrophe caused markets to go into shock. All other major insurers and reinsurers would meanwhile be far in the red, with some facing insolvency.”

While it should be possible to grasp a business or investment case quickly, I don’t think anyone is suggesting that due diligence can be skipped, that 90% of a 10-K filing can be safely ignored, or forensic analysis is of no use.

Buffett also knows quickly when a deal doesn’t interest him, although with a large amount of capital to invest, he’s likely to have received too many investment proposals to be able to consider each one for very long.

It’s worth asking if a successful company functions through teamwork, or if it’s driven by a “genius with a thousand helpers”. The phrase is probably from the book “Good to Great: Why Some Companies Make the Leap…and Others Don’t” by Jim Collins, HarperCollins Publishers, 2001. This links to a short PDF by LtCol B.B. McBreen, with notes on the ‘Good to Great’ book.

The single genius is good (until the genius leaves), but a great company needs teamwork. There’s a lot more in the book than the popular phrase. Jim Collins studied companies that had outperformed their competitors by enough to be judged as changing from ‘good’ to ‘great’. Among the common features was a diligent, low-profile CEO, who got on with the transformation without even giving it a name.

Going from great to abysmal, you’ll have heard about this: “57-cent part would have fixed General Motors ignition switch linked to 13 deaths” by Associated Press, April 01, 2014 (lehighvalleylive.com). It looks like mindless cost-cutting. I hope the investigation throws some light on how it happened.

Companies can become inefficient through size, time, relatively easy profit, and complacency when they are the market leader. A company that survives a crisis can emerge fitter and better oriented to the market. A similar principle can extend to individuals: ‘1930: The year when Benjamin Graham re-discovered “Margin of safety”‘ Monday, July 19, 2010 (catalign.in), is about how Benjamin Graham, known as the father of value investing, had early success, but had to rethink his ideas about his lifestyle and investment after the crash of 1929. After the crash, Graham gave up his ten room apartment. I was sure he had also employed a butler, but trying to confirm that only shows that many people called Butler have written about Graham, too many to exclude in a search. The linked piece includes a good story about an old man who told Graham to sell all his stocks.

I believe that companies that stick to a pervasive discipline are less susceptible to bloat. Illinois Tool Works (ITW) are a conglomerate that have used ’80-20’ for many years. This is the “Pareto principle” (Wikipedia), which is often stated as “80% of the effects come from 20% of the causes”. The percentages don’t always add to 100%, but in management it’s good if 80% of profit comes from only 10% of the customers, because a powerful effect can be achieved by addressing the needs of only 10% of the customers.

If the customers not in the ‘80% of profit’ category aren’t happy, ITW are prepared to lose them. The process can’t be taken too literally or too far, because if they actually lost half the secondary customers, that could be a large percentage of sales disappearing every year, and companies in the ‘80% of profit’ category would shift out of it, until the principle no longer applied, which might leave very few customers. A similar argument applies to losing the worst-performing subsidiaries. I’ve read claims that Microsoft operated like that, losing the lowest-performing employees, leading to employees seeing each other as rivals rather than colleagues to cooperate with, and (allegedly) rivalry and a silo mentality within the company.

ITW are also nearly half way through a restructuring aimed at having fewer, bigger subsidiaries, with high and sustainable margins. While they are centralizing some sourcing, ITW are preserving their decentralized decision making, which I believe is possible because using ’80-20′ is a discipline applied at every level of the business. Crucially, ITW’s restructuring was not forced by a crisis. Other companies might benefit from other systems, such as lean manufacturing.

An integrated IT system could help to keep the parts of a company working together, but I’m not sure if that would give the same focus as ITW’s ’80-20′. You could try “What is SAP (System Applications Products)” (saponlinetutorials.com), about connecting modules for Sales and distribution, Human resources, etc. Big Data company Tibco would say their real-time systems are what’s needed. They recently announced an EPS target aimed at improving sales, which sounds horribly IBM-like.

IMO an excellent management system allows decentralization by referring to the system instead of going up the hierarchy. There’s no perfect system with all the benefits of decentralization without the risks.

Bloat can also be avoided through a lean business model. Ubiquiti Networks have a low headcount relative to their sales and income, because they outsource manufacturing, distribution and sales, and concentrate on research and development. Their internet community plays a key role in support, guiding the development of new products, and ‘word of mouth’ recommendation. One benefit of concentrating a high level of talent in the R&D team rather than increasing the size, is that it’s easier for everyone to keep in touch. Ubiquiti’s headcount is so low that a normal acquisition would be a problem, due to the massive increase in staff for any reasonably sized acquisition, though companies that haven’t gone beyond the R&D phase would be less of a problem. Successful outsourcing depends on managing it well, and in Ubiquiti’s case the critical areas include counterfeiting by contract manufacturers (where they had a problem previously) and maintaining quality. The model isn’t appropriate for every company, and IPG Photonics benefit from their vertical integration.

I heard about Skis Rossignol on BBC radio, and they don’t keep programs online for long so I haven’t given a link. The U.K.’s BBC has “layer on layer” of management, but no-one seems to know how many layers there are. They spent £98 million ($163 million) on their Digital Media Initiative, which they axed when they decided the money was wasted, and archived material has to be physically transported between locations as a result. See “BBC bosses ‘did not have a grip’ on doomed IT project which wasted £98million” by sao paulo, January 29th, 2014 (tvlicenceresistance.info). The BBC sent 437 employees to China for the Beijing Olympics, outnumbering British competitors. See also “Does the BBC really need a team of 175 to cover the U.S. presidential election?” November 04, 2008 (tvlicenceresistance.info). The BBC are also widely accused of a cover-up, search for “Jimmy Savile” if you’re interested, but it isn’t pleasant. It seems to be unclear who is responsible for what, when things go wrong, and previous ‘Director General’s (top management) who had to appear before parliament were keen to avoid blame.

This is on forbes.com and fairly advert-heavy: “A Bug’s Life: What Managers Can Learn From Ants” by Rick Wartzman, 5/07/2013 (forbes.com). The article relates ant behavior to decentralization, the division of labor, and the views of Peter Drucker (Wikipedia), who studied and wrote about organizations. Drucker popularized the idea of the “knowledge economy” in 1969, crediting the phrase to economist Fritz Machlup.

I haven’t read much of Drucker’s work as there’s too much vision and anecdote for my liking. The author of this book review is more enthusiastic: “The Practical Drucker” John Pearson’s Buckets Blog, January 18, 2014 (urgentink.typepad.com)

British civil servant and naval historian Cyril Northcote Parkinson (Wikipedia) wrote books and essays about bureaucracy. He successfully predicted in 1958 that the Royal Navy would eventually have more admirals than ships. According to the Daily Mail online newspaper, the Royal Navy had 40 admirals, 260 captains, and 19 ships in October 2013. There could be some blurring due to captains of smaller vessels that support 19 warships.

In World War II, the U.S. navy had one admiral for every 30 ships. See “Enlisted sailors forced out while Navy has more admirals than ships” by Mike Mather, May 2, 2013 (wtkr.com), for the number of generals and admirals, with entourages.

Parkinson’s observations include “Parkinson’s law” (Wikipedia), “work expands so as to fill the time available for its completion”. Jack Welch wanted managers to be short of time so they had to become business leaders rather than managers, and he didn’t want them to have time to defend their fiefdoms or engage in office politics.

In my opinion, some middle-managers can have valuable experience, but using them as a link in a long chain is not the best use.

The problem with government bureaucracies might be that they don’t have the “streamline or die” pressures that businesses occasionally face, and they lack the focus which making a profit brings. Bureaucratic units are more likely to be closed down for political reasons than because they are wasteful, and they illustrate just how inefficient organizations can become. Here’s some good news: “New York Department of State Awards Local Government Performance and Efficiency Program Awards” June 19, 2013 (dos.ny.gov). The profit motive isn’t guaranteed to produce perfect results, as General Motors’ lethal penny-pinching shows.

The Dodd-Frank Act – clawing back performance awards

Earnings manipulation could become less popular due to legislation. The Dodd-Frank Act of 2010 requires companies to have a “clawback” clause, so if a company has to restate its financial results, performance awards are recalculated, based on the restated results, and excess awards are clawed back. This applies to performance awards made in the previous three years, and with no need to prove intention, which is one way in which Dodd-Frank is tighter than the Sarbanes-Oxley Act of 2002.

Companies are still waiting for guidance from the SEC, and while Female Health have a “clawback” clause, it requires intention: “.. in the event of fraud or intentional misconduct that materially contributes to a restatement of financial results …” and the company acknowledge the clause might have to be changed to comply with Dodd-Frank. In my opinion the company would be demonstrating a higher standard of governance if they didn’t wait for the SEC to push them. Also IMO, management have little risk of financial loss by attempting earnings manipulation, and clawing back 150% of the difference instead of 100% would help to fix that, even though dishonest CEOs would still benefit from asymmetric risk. It won’t happen.

Clawback” (Wikipedia)

Executives: beware of Dodd-Frank compensation clawbacks” by Steven Salky, February 28 2013 (lexology.com)

Revenue Enhancement

The SEC’s New Financial Fraud Task Force: Part III, Cases Following the Speech – Revenue Enhancement” by Thomas O. Gorman, 08-19-2013 (lexisnexis.com) (already linked to above)

The piece lists some cases from 1994 to 2012. Cases are grouped into these categories:

    Falsification of revenue
    Sham transactions
    Channel stuffing
    Premature recognition (of revenue)

Well known companies featured:

    Time Warner Inc
    American International Group (AIG)
    General Re Corporation
    Bristol-Myers Squibb Company
    Lucent Technologies Inc.
    Raytheon Company

The site is a source for other forms of mis-statement.

More with less

Detecting Financial Fraud” By Colleen Kearney Rich, March 29, 2013

When a company reports financial growth, such as in revenue, earnings per share etc., but physical contraction, as in unit sales, the number of employees or how much floorspace is used for production, the explanation could be increased efficiency, or fraudulent financial numbers. An experiment at North Carolina State University showed that when investors were shown the physical information in a normal text format, they were more likely to assume the reason is increased efficiency, but if the information was tabulated to be consistent with the accounts (like the income statement or the balance sheet), investors were more likely to believe the reason was fraud.

When a company reports financial growth with physical contraction, investors need to weigh the likelihood of inefficiency that could be reduced, the will and ability to reduce it, the incentive to manipulate earnings and how well management might resist the incentives. The usual checks such as looking at cash and reading the ‘Liquidity and Capital Resources’ section of a 10-K, could help.

Who commits fraud?

Most Likely to Commit Fraud: Finance Executives” by Marie Leone August 19, 2011 (CFO.com)

Don’t expect surprises.

Cheat sheet

Forensic Accounting For Dummies” by Frimette Kass-Shraibman and Vijay S. Sampath (dummies.com)

13 signs are listed under “Spotting Business Financial Statement Fraud”.

Free and fantastic

Financial Shenanigans” by Howard Schilit and Jeremy Perler
Fully revised and updated third edition, with copyright dated 2010.

The free PDF book covers the manipulation of earnings, cash flows, and key metrics. The authors Howard M. Schilit, Ph.D., CPA, and Jeremy Perler, CFA, CPA, are evidently qualified, and their careers include forensic accounting. What you might not expect is that they are excellent communicators, and write in a style a complete world away from anything in the PDFs I’ve linked to which were written for academics. As usual for forensic analysis, they focus on nailing the bad guys. The authors operate at the sharp end of forensic accounting, and I’m not holding my breath waiting for academics to publish anything as intelligible and make it free.

The terms limit readers to keeping a single copy, but I can’t quote the terms of use without breaking them.

Neutral scores for no change or steady growth

This part and the next two are purely technical. Skip them if you like because they aren’t going to make you rich. You might want to check “that doesn’t read like a shocking headline, but”.

I’ve calculated what I call the neutral M-Score which is the result when there is no change from one year to the next. It’s a simple benchmark and academics are unlikely to approve. There’s some complication from the TATA index, and as a result I’ve calculated two neutral M-Scores which should bracket most likely cases, although ‘likely’ is relative as neutral M-Scores are only intended as a theoretical benchmark. All the indexes except TATA equal 1 when there is no change, for example:

    SGI = this year’s sales / the previous year’s sales = 1

… and when calculating the term for SGI in the M-Score:

    term = coefficient * index
    = 0.892 * 1
    = 0.892

and the term will always equal the coefficient when the index is for one year divided by the other for a quantity or ratio that hasn’t changed. This means that one approximation of the neutral or ‘no change’ M-Score is just the sum of the constant and the coefficient of every index except TATA.

    Approximate neutral ‘no change’ M-Score = -4.84 + 0.92 + 0.528 + 0.404 + 0.892 + 0.115 – 0.172 – 0.327
    = -2.480

When there is no change, there is no increase in non-cash working capital, so the increase drops out of TATA leaving:

    ‘no change’ TATA = -Depreciation / Total assets

I’ve only calculated that ratio for four different companies, so my results are fairly rough-and-ready, and likely to be biased, for example they all hold a decent amount of cash. I haven’t been consistent about the units (in thousands or not) between companies as I only needed a sample of the contributions to the M-Score. 4.679 is the coefficient for TATA.

    Company, Depreciation / Total assets = ratio, * coefficient = contribution to the M-Score
    Female Health Co, -556,304 / 35,169,953 = -0.0158, * 4.679 = -0.074
    Lattice Semiconductor, -20,807 / 447,876 = -0.0465, * 4.679 = -0.217
    Repligen Corporation, -3,508,592 / 97,010,163 = -0.0361, * 4.679 = -0.169
    Synchronoss Technologies, -41,126 / 527,019 = -0.0780, * 4.679 = -0.365

There’s quite a range, with the most negative being -0.365 from Synchronoss Technologies.

I get a low version of the ‘no change’ M-Score by adding the -0.365 to the previous approximation:

    Low ‘no change’ M-Score = -2.480 + -0.365 = -2.845

That score is based on the 7.8% Depreciation / Total assets calculated for Synchronoss Technologies, the highest ratio out of the four I calculated. The result and the previous approximation should bracket most of the likely ‘no change’ M-Scores, in other words the ‘no change’ scores should be between -2.845 and -2.480.

It’s reasonable to ask: is there a neutral M-Score for a company growing at a steady rate, with everything growing in proportion? There is, but it isn’t simple. Only two indexes are systematically affected by such steady growth: SGI, the Sales Growth Index, and TATA, Total Accruals to Total Assets. Steady growth is not a reason for days sales in receivables to change, for the gross margin to change, etc..

If a company grew steadily at 8% per year:

    SGI = this year’s revenue / the previous year’s revenue
    = the previous year’s revenue * 1.08 / the previous year’s revenue
    = 1.08 / 1
    = 1.08

and the effect on the M-Score = coefficient * change in index

    = 0.892 * (1.08 – 1)
    = 0.892 * 0.08
    = 0.071

More generally, the effect through SGI = 0.892 * the growth rate, where a growth rate of 5% (for example) translates to the number 0.05.

A company growing at a steady rate, with everything growing in proportion, gets a complicated term for TATA. I’ll leave out the worst of the arithmetic, and write:

    TATA = growth factor * Proportion of non-cash working capital – Proportion of depreciation

    where growth factor = r / (1 + r)
    r is the growth rate (r = 0.05 means growth of 5% pa)
    and both ‘Proportions’ are relative to Total assets

The ‘growth factor’ scales back high growth, so 10% (which is 0.1) is scaled back slightly to 9.0909%, and 100% is scaled back to 50%.

The formula makes a kind of sense, because a fast growing company with a high proportion of non-cash working capital needs more cash to fund its growth. However, that’s concerned with the pressure to manipulate. TATA is supposed to measure an area of balance sheet distortion, and by the definition I’m using, ‘A company growing at a steady rate, with everything growing in proportion’, growth in proportion is not evidence of distortion (although it could mask distortion, for example if 50% of receivables were always fake). While the formula I’ve given is accurate regarding the value calculated for TATA, the result which TATA ought to give is the same as for no change. Therefore, in some circumstances, it’s reasonable to ignore the effect of steady growth on TATA and say:

    The neutral steady-growth M-Score is in between:
    0.892 * growth rate – 2.845
    0.892 * growth rate – 2.480

where I’ve used the previous results for ‘no change’, of -2.845 and -2.480, which should bracket most of the likely range. A growth rate of 5% is represented by 0.05, for example.

I’ve been using my own terminology, and I haven’t seen Beneish or anyone else writing about neutral M-Scores.

If you think I stretched the meaning of “simple”, bear in mind that academics write about alphas from Fama regressions when they aren’t hanging subscripts off Greek letters.

M-Score thresholds, probabilities, and sensitivity to sales growth

I said that an M-Score above -2.22 is commonly supposed on various websites to indicate a serious risk that a company’s earnings have been manipulated. I haven’t seen Beneish or any academics even mention the threshold, but I could have missed it.

30% sales growth gives SGI = 1.3, which is 0.3 above the ‘no change’ value of 1. Multiplying by the coefficient of SGI:

    extra on M-Score = 0.892 * 0.3 = 0.2676

Adding that onto the high ‘no change’ M-Score of -2.480 (which I calculated in the previous section) gives:

    30% sales growth M-Score = -2.480 + 0.2676
    = -2.2124

which is above the threshold of -2.22. That means, 30% sales growth is enough to trigger a warning if the score isn’t pulled down by the other indexes, except that -2.480 is too high to be a reasonable ‘no change’ M-Score. I also calculated a ‘too low’ value, of -2.845, so cases could be bracketed. Using that value, 70% sales growth is enough to trigger a warning if the score isn’t pulled down by the other indexes. Putting that into something like English:

    The sales growth required to trigger an M-Score warning based on the -2.22 threshold is probably between 30% and 70%, depending on the company. The growth rate is enough to trigger the warning if the other indexes don’t collectively pull the M-Score down, relative to the effect if they all represented no change, with every index except TATA equal to one.

Some readers might be thinking that growth of 30% to 70% is very high, but my reaction is that the -2.22 threshold is quite sensitive to sales growth, since high sales growth is usually welcomed and nothing else is required to trigger the warning. For some mature companies, 30% to 70% sales growth is unfeasible and could arouse suspicion. If that’s a flaw in my analysis, it’s common to other measures, and the M-Score wouldn’t ask “Is that a feasible growth rate for Exxon?”.

While the Sales Growth Index (SGI) has a high coefficient of 0.892, the coefficient is the result of the data, the model and statistical procedures, and it looks like the threshold of -2.22 is responsible for the sensitivity. The sensitivity is reasonable because the cost of owning shares in a company that has to restate its earnings is high, but the sensitive threshold means excluding many companies that are innocent, if you don’t follow up the score by noting the indexes with the warning signs and investigating to see how genuine the warnings are.

From Table 3 in “The Predictable Cost of Earnings Manipulation” (already linked to), it looks like:

    An M-Score of -1.89 means a 1 in 40 chance of earnings manipulation.
    An M-Score of -1.78 means a 1 in 20 chance of earnings manipulation.

although I’ve translated relative mis-classification costs into probabilities to get the results.

If a company has sales growth of 78.5%, the amount added to the M-Score above the ‘no change’ value is:

    extra on M-Score from 78.5% sales growth = 0.892 * 0.785 = 0.7.

Adding that to the high version of the ‘no change’ M-Score:

    78.5% sales growth M-Score = -2.48 + 0.7
    = -1.78

which hits the 1-in-20 threshold, implying a 1 in 20 chance of earnings manipulation.

A similar calculation shows that sales growth of 66.2% is enough to give a 1 in 40 chance of earnings manipulation.

In the previous section I calculated the contribution that the ratio Depreciation / Total assets makes to the M-Score for four companies, and came up with a low version of the ‘no change’ M-Score of -2.845, based on the Depreciation / Total assets of 7.8% for Synchronoss Technologies, the company with the highest ratio. I now have two ‘no change’ M-Scores which can be used to bracket most of the likely range of possibilities:

    -2.845 – Low ‘no change’ M-Score, assuming a high Depreciation / Total assets of 7.8%
    -2.480 – High ‘no change’ M-Score, assuming negligible Depreciation / Total assets (so TATA = 0)

Now if a company grew it’s sales by 107.1%, had depreciation equal to 7.8% of its total assets, and no change in anything else:

    107.1% sales growth extra on M-Score = 0.892 * 1.071 = 0.955.

Adding that to the ‘low’ or ‘depreciation at 7.8% of assets’ no-change M-Score:

    M-Score for 107.1% sales growth, depreciation at 7.8% of assets, and no change elsewhere = -2.845 + 0.955
    = -1.89

which hits the 1-in-40 threshold, implying a 1 in 40 chance of earnings manipulation.

The equivalent result where the depreciation term in TATA was considered to be negligible, was:

    M-Score for 66.2% sales growth, negligible depreciation term in TATA, and no change elsewhere = -2.48 + 0.59
    = -1.89

implying a 1 in 40 chance of earnings manipulation (or a 2.5% chance).

Between the two extremes of depreciation, from negligible to 7.8% of total assets, sales growth between 66.2% and 107.1% is required to signal a 1 in 40 chance of earnings manipulation, without other indexes pulling the M-Score down more than they would (in aggregate) for no change.

That doesn’t read like a shocking headline, but it suggests that 2.5% of companies would manipulate their earnings after sales growth between 66% and 107%. Since high growth does not always create trouble and the pressure to manipulate, the proportion of companies with management willing to manipulate seems to be more than 2.5%. If half of the companies had the growth without the trouble and pressure, then 5% of management cave in to the pressure. You shouldn’t believe that fast growing companies rarely hit trouble, and nearly all management are honest, at the same time. While relatively few companies manipulate earnings, it looks like a lot more of them would if they faced some more pressure to manipulate. However, I can’t be too confident about the conclusions as I might have oversimplified a complex matter. The analysis could be improved by finding a more representative range for the ratio Depreciation / Total assets.

Summing up the results for no change except sales growth and the effect of constant depreciation:

    Probability, M-Score, Sales growth for negligible depreciation, Sales growth for 7.8% depreciation
    unknown, -2.22, 30%, 70%
    1 in 40 or 2.5%, -1.89, 66.2%, 107.1%
    1 in 20 or 5%, -1.78, 78.5%, 119.4%

Or in more-like-English:

    The threshold of -2.22 which is on many websites but not used by academics, will signal a warning for companies with sales growth above 30% to 70%.

    The threshold of -1.89, where the risk of earnings manipulation is 1 in 40, or 2.5%, will signal a warning for companies with sales growth above 66.2% to 107.1%.

    The threshold of -1.78, where the risk of earnings manipulation is 1 in 20, or 5%, will signal a warning for companies with sales growth above 78.5% to 119.4%.

In each case, a range is given for the minimum sales growth required to trigger the warning signal. The precise sales growth that triggers the warning depends on the ratio Depreciation / Total assets. The top end of each range of sales growth is only a rough ceiling, and if a company’s Depreciation / Total assets ratio is over 7.8%, the ceiling is busted, meaning that an above-ceiling growth rate is required to trigger a warning.

This is all about the sales growth required to trigger a warning, without any help from the other indexes in the M-Score. In other words, even if every index other than SGI had its ‘no change’ value, SGI would tip the M-Score above the threshold being considered. The complication arises because TATA does not have a simple ‘no change’ value. For every other index, the ‘no change’ value is one. The results quantify how a company can be flagged as an earnings-manipulation risk solely because of high sales growth.

It’s possible that if the M-Score could be improved, some of the weight would be taken off SGI, the Sales Growth Index, and the M-Score would be less sensitive to it.

I can’t translate M-Scores into the probability of earnings manipulation for a range of scores. While Beneish wrote about thresholds, they are based on assumptions about the costs of mis-classification (of manipulators as non-manipulators, and the other way around), and it’s hard to derive many probabilities. YCharts have some limited information about the probabilities associated with some M-Scores.

About fixing scale-sensitive ratios

I’ve said how A / B = 4 can be fairly meaningless for practical purposes, for instance if A = 0.004 and B = 0.001 and they represent leverage for this year and the previous year. There’s a first step to a solution, which I call an “impact function”.

impact = (A – B) / square root of (|A| + |B|)

The function is half-way between subtraction, where only absolute amounts matter, and division, which loses information about the absolute sizes involved.

|A| just means if it’s negative, you make it positive, so |-4| = 4, and |4| =4. Now for A and B where A = 0.004 and B = 0.001:

impact = (0.004 – 0.001) / square root of (|0.004| + |0.001|)
= 0.003 / square root of 0.005
= 0.003 / 0.07071
= 0.0424

which is small, as it ought to be.

For the same percentage increase, from a base big enough to matter:

A = 0.8
B = 0.2

impact = (A – B) / square root of (|A| + |B|)
impact = (0.8 – 0.2) / square root of (|0.8| + |0.2|)
= 0.6 / square root of 1
= 0.6 / 1
= 0.6

which is 14.15 times as big as the 0.0424 impact calculated for a rise from 0.001 to 0.004, or 0.1% to 0.4%.

That seems more appropriate, for a scale sensitive ratio such as the change in leverage.

One problem with using impact functions for the M-Score indexes is that the whole model would need recalibrating. There’s also a problem because impact functions as defined here are too symmetric. The result of that is like a system which ignores a warning about an airplane’s engine because another engine is in excellent condition. The problem is easily fixed, but I expect academics could come up with better solutions if they recognized the problem with scale-sensitive ratios and the possibility of better fixes than Winsorizing.

Rolling quarterly results to get trailing twelve month data

The M-Score was meant to be used with annual data, and while quarterly data could be stuffed into a spreadsheet, it would be more noisy, the resulting score would not be calibrated (so hard to interpret), and the exercise has no statistical foundation. So use quarterly data if you want to, but don’t trust the result much.

One general advantage of looking at the quarterly 10-Q forms is that companies can arrange their fiscal year so it ends when they naturally hold the most cash. In such cases, the Accounts receivable and inventories could be lower than their average value, and much lower than their peak value. The Accounts payable reported could be above their average value and further above their lowest point. That won’t systematically affect the M-Score, as the score looks at how ratios have changed over a year, rather than what they are.

Any readers with access to trailing twelve month financial data that’s good enough for an M-Score, won’t need to read the rest of this section.

Trailing twelve month (ttm) data is actually data for the most recent four quarters. Depreciation is needed for the DEPI index, and it’s unlikely to be disclosed in earnings releases, or under headings such as “Quarterly Financial Data (Unaudited)” in a 10-K. It should be in the quarterly ’10-Q’ SEC filings, but you might want to check the first 10-Q has the necessary figures before downloading all the 10-Qs you need.

This spreadsheet shows ttm results up to 1Q 2014 for The Female Health Company:
Female Health - results ttm to 1Q 2014

To get ttm results up to a second quarter, using the period 2Q 2014 and Revenue as an example, if the 10-Q had results for the first six months, the ttm revenue would be

    Revenue 1H 2014
    + Revenue 2013
    – Revenue 1H 2013

where ‘1H’ means the first half (the same as the first two quarters). Using individual quarters, the ttm revenue would be …

    Revenue 2Q 2014
    + Revenue 1Q 2014
    + Revenue 2013
    – Revenue 2Q 2013
    – Revenue 1Q 2013

… which is obviously more work.

For a third-quarter 10-Q, you can save work by doing the same kind of thing with nine-month figures if they’re given, as in Revenue ttm = Revenue first-nine-months-of-2014 + Revenue 2013 – Revenue first-nine-months-of-2013.

You can probably save more work when the latest results are for the third quarter, by using figures from the fourth quarter earnings release, or fourth quarter figures under a heading like “Quarterly Financial Data (Unaudited)” in a 10-K. These probably won’t show Depreciation, but will have most of the figures needed, although you need to avoid using non-GAAP figures. For those figures, the calculation is like this:

    Revenue first-nine-months-of-2014 (from the 3Q 2014 10-Q)
    + Revenue 4Q 2013 (from the 4Q 2013 earnings release, or 4Q 2013 figures under “Quarterly Financial Data” in the 10-K for 2013)

For depreciation and any other quantity not disclosed for the fourth quarter, revert to the previous method.

The ‘hybrid’ method involves less copy-and-paste, but might need more thought and some more searching within documents.

M-Score definitions

M-Score =
+ 0.92 * DSRI (Days Sales in Receivables Index)
+ 0.528 * GMI (Gross Margin Index)
+ 0.404 * AQI (Asset Quality Index)
+ 0.892 * SGI (Sales Growth Index)
+ 0.115 * DEPI (Depreciation Index)
– 0.172 * SGAI (Sales General and Administrative Expenses Index)
– 0.327 * LVGI (Leverage Index)
+ 4.679 * TATA (Total Accruals to Total Assets)

Index definitions –

DSRI – Days Sales in Receivables Index (+0.92)
this year’s Days Sales in Receivables / previous year’s Days Sales in Receivables

GMI – Gross Margin Index (+0.528)
previous year’s Gross Margin / this year’s Gross Margin

AQI – Asset Quality Index (+0.404)
this year’s ratio (Non-current assets – Property plant and equipment) / Total assets
divided by the previous year’s ratio

SGI – Sales Growth Index (+0.892)
this year’s Sales / previous year’s Sales

DEPI – Depreciation Index (+0.115)
previous year’s ratio Depreciation / (Depreciation + net Property plant and equipment)
divided by this year’s ratio

SGAI – Sales General and Administrative Expenses Index (-0.172)
this year’s ratio SGA expense / Sales
divided by the previous year’s ratio

LVGI – Leverage Index (-0.327)
this year’s ratio Total debt / Total assets
divided by the previous year’s ratio

TATA – Total Accruals to Total Assets (+4.679)
(this year’s working capital other than cash – the previous year’s working capital other than cash – Depreciation)
divided by Total Assets

and everything is ‘this year’ unless labeled ‘previous year’.

It’s useful to break some of the indexes down so it’s easier to plug numbers into them –

this year’s ratio Accounts receivable / Sales
divided by the previous year’s ratio

this year’s ratio Gross profit / Sales
divided by the previous year’s ratio

this year’s ratio (Total assets – Current assets – Property plant and equipment) / Total assets
divided by the previous year’s ratio

this year’s ratio (Long term debt + current liabilities) / Total assets
divided by the previous year’s ratio

I prefer to use Total liabilities / Total assets, for leverage, but that’s unconventional, and it’s reasonable to exclude the liabilities which probably won’t incur a cash payment, from the top. Find “It would be reasonable to exclude Deferred grant income” above. I also prefer to net-out the cash, which can result in negative leverage.

(this year’s Non-cash working capital – the previous year’s Non-cash working capital – Depreciation) / Total Assets

where Non-cash working capital = Current assets – Cash & cash equivalents – Marketable securities under current assets – Current liabilities + Short term debt

and everything is ‘this year’ unless labeled ‘previous year’.

Build an M-Score spreadsheet

The M-Score spreadsheet is not available for downloading, but there are instructions for making it under the “Re-alert” tab. Find “Build an M-Score spreadsheet” there. The instructions are for four copy-and-paste operations, from the text, into a blank spreadsheet. The first two pastes involve the Text Import dialogue. After that the spreadsheet needs formatting.

The Female Health Company – 1Q 2014 results release

The Female Health Company Reports First Quarter Operating Results” (femalehealth.investorroom.com)

In my opinion the results are poor but probably explained by the lumpiness which management attribute to “public sector purchasing patterns”. The bright spot is revenue up nearly 40% quarter on quarter. The comparisons are affected by the previous quarter being bad and the quarter a year ago being good with record revenue. 1Q 2014 ended December 31, 2013.

The worst sequential declines are due to having an Income tax expense of $98,875, instead of an Income tax benefit of $4,879,728 in 4Q 2013 (from the 4Q and full year 2013 results release). I haven’t calculated the NOL carryforwards and Decrease in valuation allowance for the previous quarter, but for year-on-year comparison:

    Utilization of NOL carryforwards was $125,982, down from $565,278.
    Decrease in valuation allowance was $292,932, down from $321,247.

If you missed why those are important, find “Conclusions about Female Health’s tax assets” above (it’s complicated).

This shows the Income tax expense for the latest quarter, in context. The quarter couldn’t be expected to change the tax situation significantly, and hasn’t, even though the comparisons show a big percentage gain, and a big percentage switch from a benefit in the previous quarter.
Female Health - results 1Q 2014

The fourth quarter was disappointing, generally at about half-speed compared to 4Q 2012. See:

The Female Health Company Reports Fourth Quarter and FY2013 Operating Results“(femalehealth.investorroom.com)

    “… unit sales decreased 52%”

Gross profit fell 60% to $2.3 million, from $5.8 million in 4Q 2012.
The gross profit margin fell to 48% of net revenues, from 58% in 4Q 2012.
Operating expenses fell 79% to $0.5 million, from $2.6 million in 4Q 2012.
Operating income fell 45% to $1.7 million, from $3.2 million in 4Q 2012, due mostly to lower unit sales.
Net income fell 19% to $6.6 million, or $0.23 per diluted share, from $8.2 million, or $0.29 per diluted share, in 4Q 2012.

There was a net tax benefit of $4.9 million, versus a $5.1 million benefit in 4Q 2012.

FHCO – the backlog

I haven’t checked the data to see if the backlog is useful for predicting revenue.


    Unfilled product orders totaled $2,940,710 at November 29, 2013 and $11,382,572 at November 30, 2012. Unfilled orders materially fluctuate from quarter-to-quarter, and the amount at November 29, 2013 includes orders with requested delivery dates later in fiscal 2014. The Company expects current unfilled orders to be filled during fiscal 2014.” (10-K for 2013)

That’s a 74.2% fall in the backlog, or a fall from 32.5% of 2012 revenue, to 9.3% of 2013 revenue. Comparing both backlogs to 2013 revenue, the fall is from 36.2% to 9.3%.

I couldn’t find “unfilled”, “backlog” or “pipeline” in the 10-Qs or quarterly earnings call transcripts I looked at, so there might be no more information about the backlog until the 10-K for 2014.

FHCO – risk

Risks include:

1) High customer concentration (find “To illustrate the customer concentration” above).

2) The reaction when shareholders learn that Net income won’t benefit from the tax assets, which I’ve written about.

3) Competition. Female Health are the clear leaders. From the 1Q 2014 10-Q:

“None of these female condoms marketed or under development by other parties have secured FDA approval. FDA approval is required to sell female condoms in the U.S. or through USAID. The Cupid female condom became the second female condom design to successfully complete the WHO prequalification process in July 2012 and be cleared for purchase by U.N. agencies.”

Even so, there are issues.

a) A big maker of male condoms might invade the market. If they acquire Female Health, some of the gain will go to management with “up to three years of compensation” (see “Anti-takeover provisions” below), and management might not be incentivized to hold out for a good price. They could, instead, talk about what a wonderful fit the companies are, and the benefits to stakeholders. Customers would probably prefer to see a big company develop its own products, bringing some serious competition into the market. I don’t expect a big company to acquire one of Female Health’s competitors, at least not while Female Health is a viable acquisition target and the competition is small. Very small acquisitions (by headcount) tend to be for proven intellectual property, and research teams or other talented personnel, rather than nascent low-tech businesses (in my experience, anyway).

b) Do they and will they make the best female condoms?

‘Best to the users’ might not be the same as what the agencies think is best, and it’s likely there won’t be a single ‘best’ condom. There’s a little information later about the female condoms women prefer.

In 2013, 2012 and 2011, only $4,745, $5,277, and $10,929 was spent on research and development. The expense is included in selling, general and administrative expenses.

c) How strong is product loyalty?

I can’t gauge how reluctant the women using the condoms might be to switch to an alternative product, how years of use would affect that, or how much notice the agencies involved would take of any reluctance to switch. However, Female Health’s patents mean that designs which avoid the patented features will need their own instructions. The company mention education and training as if it’s a big deal for competitors, and maybe it is. I don’t understand why a substantial market can’t be addressed with well designed printed material and online services. If Ubiquiti Networks (see my previous blog piece) can provide support for communications equipment through an online community, maybe one of Female Health’s competitors could develop an online community to help women who have relevant questions or problems. Even if that’s an inferior service, sometimes innovation survives an inferior service (it’s practically in the definition of ‘disruptive innovation’). Whatever percentage of the market could be backed by online support, the percentage is likely to rise. However, that’s all just my opinion. I’m thinking of all the times people get by with inadequate instructions, from assembling flatpack furniture to inserting SIM cards, and maybe that’s the wrong way to look at it.

At least some of the ‘education’ part of education and training will not be product-specific, and will educate about the advantages of female condoms generally.

I expect the big customers won’t have much loyalty to products or suppliers, but would need to be convinced that other female condoms match Female Health’s on quality and reliability, and have sufficient stock or production capacity, before ordering meaningful quantities. It’s less risky for the big customers to deal with a company they know and trust, but they might want to nurture competitors. It’s possible that if one agency brags about allowing women to have a choice, other agencies won’t want to look as if they refuse to allow women a choice.

d) How much will price matter to customers if the competitors develop?

I have no picture of likely demand at various price points, but I expect big customers to use competition to lever prices down when they can, or to extract better terms.

Overall, my problem regarding future competition is that Female Health’s FC2 is probably not the best possible female condom, if there even is a ‘best’, but it’s still their only product with no plan to develop a range. Women won’t be deprived of a choice forever, no matter how strong the company’s current position. Female Health benefit from FDA and WHO approval, their relationship with the big customers, and the company’s reputation, reliability, and production capacity. Shareholders like to see their company in a dominant position, but one possibility is that Female Health’s dominance could be seen as an obstacle to choice, with action taken to help competition. I’m only suggesting that because I can’t rule it out, due to little understanding of how opinion forms within gender politics and the agencies concerned.

There are plenty more risks in the 10-K under “Item 1A. Risk Factors”.

FHCO – Competing products are not inferior

At least, competing products aren’t inferior by objective criteria according to this research summary by nine authors:

Performance and safety of the second-generation female condom (FC2) versus the Woman’s, the VA worn-of-women, and the Cupid female condoms: a randomized controlled non-inferiority crossover trial” (thelancet.com)

The summary says nothing about what the women in the crossover trial thought of the products. I’m thinking, why didn’t they ask for opinions when women had completed the trial? (if they did, I didn’t see it in the summary).

FHCO – Conventional and unconventional female condoms

This BBC web page …

The return of the female condom?” By William Kremer BBC World Service, 15 December 2013 (bbc.co.uk)

… is very informative, with information about the various female condoms including radical designs available now or soon.

I’ve also linked to a highly unconventional design under “And finally …”.

FHCO – Some information about the female condoms women prefer

This and the BBC piece are all I could find (after much searching) about which female condoms women prefer:

Female Condoms: the spaghetti sauce principle” by Saskia Hüsken and Sille Jansen from UAFC, September 16, 2013 (condoms4all.org)

Women don’t all like the same condoms (just as people don’t all like the same spaghetti sauce, apparently). Most women liked Female Health’s FC2. The research is from South Africa, and it’s possible it won’t be representative of other areas. By the article’s “spaghetti sauce principle”, Female Health should be making a range of ‘sauces’, and could lose their first-mover advantage if they stick with a single product. The principle isn’t proven,
but even if it’s wrong it doesn’t follow that the FC2 is the best design or will be the most enduring design.

The BBC piece linked to above mentions a study from 2010 involving 170 South African women. The Women’s condom (from an NGO called Path) was the most popular, with Female Health’s FC2 placed second, and most of the women chose to carry on trying new condoms rather than stay with their preferred condom. The ‘spaghetti sauce’ piece cites a paper dated 2011, which implies there were two studies in the same country, unless there was a single study with some confusion about the dates and two different recent interpretations. Two studies are not enough to be sure unless one of them is very big and well conducted. I haven’t seen any research papers or authoritative critiques of the studies, and I don’t know if the studies were independent and well conducted.

It might support the ‘spaghetti sauce principle’ that male condoms are differentiated in a variety of ways, though with no variation in the fundamental design, that I know of.

It’s likely that the women who gave their opinions did not pay the full price of the condoms. In markets where price is a factor, personal preference alone won’t account for market share, although the male condom is likely to stay the cheapest option.

One possibility among many is if about twenty different products survive in the market, and Female Health’s only product (or only viable product) is still the FC2. The FC2 might not be number 1 by women’s preference, but the company could cling to market leadership through their connections with the public health agencies. I wouldn’t regard a position like that as being secure in the long term, although the company might have many years of growth before the situation materialized. Unless a big company moves in, it’s likely to be a long time before a competitor makes serious inroads into Female Health’s sales to their major customers. It would presumably have been much more difficult for Female Health if they had a superior condom but faced an established competitor when they were starting out, although there would have been less need to engage in education. I still wish Female Health wasn’t a one-product company, with the risk of being innovated into a small niche by competitors.

South Africa does not rely on external funding. This article implies that the South African government pays for the condoms, when the government is criticized for distributing less female condoms than male condoms due to their higher cost:

SA’s National Strategic Plan: female condom needs to play a bigger role” (genderjustice.org)

The article isn’t dated, but couldn’t have been written before July 2010. The non-reliance on international agencies is confirmed in the earnings call transcript (find “CEO Discusses F1Q 2014 Results”, below), if you check through the instances of “South Africa”, and find the paragraph where deliveries of the competing Cupid condom are downplayed.

Maybe it’s not a coincidence that women’s preferences were studied in a country that doesn’t rely on big international aid agencies for their condom supply. In any case, it’s as if the women in the studies were being treated as representing consumers instead of as aid targets or lab subjects. I expect the aid to include choice eventually, even if becoming consumer-oriented would be too far a stretch for big agencies. I don’t mean to diminish the practical benefits of improving choice from no female condoms to one kind of female condom. Offering a choice of female condom to aid-recipients would increase the complexity of operations and affect costs, but is likely to increase the take-up, partly because some women won’t like the FC2 but like an alternative, and also because people feel good about being offered a choice (or should I say, they would be ’empowered’).

FHCO – some thoughts

I like the history of free cash flow per share in one of the charts at the end (find “illustrate good growth”). Apart from the tax situation (find “Conclusions about Female Health’s tax assets” above), if future per-share growth is similar to the history, then Female Health should be an excellent investment, but the ‘if’ depends on the issues I’ve mentioned. To give some idea of the potential:

“The global male condom market (public and private sector) is estimated to be $3 billion annually. The global public health sector market for male condoms is estimated to be greater than 10 billion units annually. The private sector market for male condoms is estimated at 3 billion units annually. UNAIDS estimates that the annual public health sector demand for condoms, both male and female, will reach 19 billion units by 2015.” (the 10-K)

For comparison, Female Health’s Net revenues were $31.5 million in 2013.

Sales in the U.S. could help to reduce dependence on a few big customers. This is encouraging:

    “FC2 is being distributed as part of New York City’s Female Condom Education and Distribution Project being conducted by the Bureau of HIV/AIDS Prevention and Control. As of September 30, 2013, FC2 was available in 1,436 locations in New York City, as compared to 1,001 at September 30, 2012, including both community based organizations and the N.Y.C. Department of Health and Mental Hygiene units.” (the 10-K)

Los Angeles/LA County have started a similar program.

If the funding is ever cut in the U.S., there’s probably more chance of sales continuing than would be the case in less developed countries.

I believe there’s a big opportunity, but Female Health could be throwing it away by sticking to a single product and having a very low R&D spend. R&D needs to be spent effectively, and if they don’t have ideas, they could find out why some women don’t prefer the FC2 and find people who can design for their needs (although I’m making it sound too easy).

Female Health’s incentive payments are linked to unit sales and operating income, and really are lower in the ‘down’ years. That’s probably good, but the incentive payments aren’t broken out and are high enough to increase SG&A as a proportion of sales in the good years. Apart from reducing the upside for investors, there could be too much motivation for short term goals at the expense of long term objectives. There’s also the ‘2008 Stock Incentive Plan’, but no options were granted under it in 2013, 2012 or 2011.

The shares offer diversification for investors, as the business depends on the funds available to the big customers rather than directly on the world economy or a part of it.

FHCO – Female Health’s dividend cover and covenant restrictions

This is about the terms of the Loan Agreement:

    “Dividends and share repurchases are permitted as long as after giving effect to the dividend or share repurchase the Company has a ratio of total liabilities to total stockholders’ equity of no more than 1:1.” (10-K for 2013)

At the end of Female Health’s 2013, the ratio of total liabilities to total stockholders’ equity was 3,766,996 : 31,402,957 = 0.12 (as a proportion) or 12%, and $31,402,957 – $3,766,996 = $27,635,961 could be returned to shareholders without breaking the covenant. The company had $8,922,430 cash, but for dividends the limiting factor is likely to be the dividend cover. Free cash flow covered the dividend 1.46 times. That’s with free cash flow defined as Cash from operations – Cash invested, which equals $11,793,081 – $302,198 = $11,490,883, which is 1.46 times the dividend payment of $7,863,915.

Removing the unsustainable components of the Income tax benefit, which are Utilization of NOL carryforwards and Decrease in valuation allowance, 2013 Net income would only have been $6,426,651. The dividend cover from “Net income before tax asset related benefits” (my term) is 0.817.

My guess is that one or other measure of dividend cover will limit the dividend. If not, the limiting factor will be the company’s $8,922,430 cash, which is well below the $27,635,961 set by the covenant described above. If the stockholders’ equity keeps growing, the covenants might never be the limiting factor for the dividend.

The free cash flow cover of 1.46 times is overstated IMO, as the $1.4 million increase in Cash from operations (to $11,793,081) came from lower incentive payments, and cash collection that can’t be repeated (find “The increase of $1.4 million”, above). Net income depended on tax benefits to cover the dividend. Some growth would make the dividend safer, and with lumpy orders and lumpy cash collection, I can’t predict growth in the near term.

FHCO – Anti-takeover provisions

I’m not going into much detail, but the company list six Anti-takeover provisions. There’s the usual authority to issue preferred stock to dilute the would-be acquirer’s stake, making a hostile takeover unlikely, and:

    “change of control agreements we have entered into with four of our employees which provide for up to three years of compensation following a change of control as defined in the agreements” (10-K for 2013)

The generous three years of compensation obviously reduces the price that an acquiring company would be willing to pay, and management’s gain would be the shareholders’ loss.

FHCO – Indemnification of directors and officers

The info is in the 8-K “Report of unscheduled material events or corporate event” dated May 22, 2013.

There could be more up-to-date information in a later 8-K, but if there isn’t, you’d have to open all the later 8-Ks to be sure. There is no mention of indemnification in the 10-K or the DEF 14A (about the annual meeting). Publicly quoted companies don’t shout about the fact that they offer wider indemnification to officers and directors than is generally the case for private equity, but Female Health couldn’t have hidden it better. Other companies at least leave clues in the 10-K.


    “(a) The rights of directors and officers of the Corporation provided in this ARTICLE VIII shall extend to the fullest extent permitted by the Wisconsin Business Corporation Law and other applicable laws as in effect from time to time.”

The coverage is for all kinds of proceedings, including action started by the company:

    “”proceeding” means any threatened, pending or completed civil, criminal, administrative or investigative action, suit, arbitration or other proceeding, whether formal or informal, which involves foreign, federal, state or local law (including federal or state securities laws), and which is brought by or in the right of the Corporation or by any other person.”

“expenses” doesn’t seem to miss much out, and includes proceedings started by a director or officer.

Liabilities covered include paying a judgment, settlement, forfeiture, or fine, including excise tax related to employee benefit plans, plus costs, fees, and surcharges.

There are exceptions:

    (1) A willful failure to deal fairly with the Corporation or its shareholders in connection with a matter in which the director or officer has a material conflict of interest.
    (2) A violation of criminal law, unless the director or officer had no good reason to think they were breaking the law.
    (3) A transaction from which the director or officer derived an improper personal profit.
    (4) Willful misconduct.

Admitting guilt or “no contest” or losing the case doesn’t mean a director or officer can’t be indemnified.

A clause avoids paying if someone else has already indemnified the director or officer.

The company has the option to insure the indemnity, but I’ve seen no indication that any of the liability is insured, so the liability could be uninsurable or very expensive.

That’s all my own summary. Anyone who needs to be sure about the company’s indemnification needs to do their own research.

Wide indemnification of officers and directors is common for publicly quoted companies. The usual excuse is that it’s needed to attract the necessary quality of applicants.

FHCO – Related party transactions

These are found under “Transactions with Related Persons” in the SEC filing ‘DEF 14A Official notification to shareholders of matters to be brought to a vote (“Proxy”)’ dated Jan 28, 2014.

Two fairly recent retirements were with consultancy agreements.

    Mary Ann Leeper, Ph.D
    Senior Strategic Adviser of the Company
    Retired on December 31, 2013
    consulting fees $6,000 a month

    Donna Felch
    Vice President and Chief Financial Officer
    Retired on December 31, 2012
    consulting fees $100,000 per year
    plus health and other similar benefits, plus 22,500 shares of unvested restricted stock continued to vest on December 16, 2013
    Donna Felch was appointed Director in November 2012, and is nominated for election to the Board of Directors at the AGM on March 20, 2014.

The company acknowledge that Donna Felch and two other directors are not independent. Five directors are listed as being “independent under the listing standards of the NASDAQ Stock Market”.

None of the directors were paid just for being on the board, but two were paid $10,000 and $11,000 for committee work, and six (of the nine) had combinations of stock awards and other compensation, making the total director compensation $513,855.

Karen King became President and CEO in January 14. There’s a “clawback” provision in the King Employment Letter, which might have to be amended to comply with the Dodd-Frank Act, as mentioned above.

What I like about the section is the clarity, although I’d have preferred a clear statement that there were no other transactions with related persons or parties. (For a complete contrast, find Gazprom Neft’s related party transactions.)

There are no loopholes as in Ubiquiti Networks’ “We did not have any transactions… in which the amount involved exceeded or exceeds $120,000 and in which any of our directors, executive officers …”. It wouldn’t take many of those to make a substantial sum.

Clarity doesn’t prove accuracy, but I prefer clarity to fog that leaves me wondering what’s hidden in it. I also don’t like to see contracts going to relatives, officer’s other companies, etc. Clarity and nothing too bad is good enough.

FHCO – on Seeking Alpha

There have been good articles about The Female Health Company on Seeking Alpha. I’ve tried to bring a different focus.

Unfortunately this ‘Pro’ article has disappeared behind Seeking Alpha’s paywall: “The Female Health Company: Fundamentals & Commitment” by Joseph P. Porter, Jan. 17, 2014 (seekingalpha.com). I commented (as ‘fnoobler’) that the valuation allowance was low, and described the effect on Net income, but I might not have described the complicated issues clearly enough.

The latest two transcripts are:

The Female Health Company’s CEO Discusses F1Q 2014 Results – Earnings Call Transcript” Feb. 3, 2014 (seekingalpha.com)

The Female Health’s CEO Discusses F4Q 2013 Results – Earnings Call Transcript” Dec. 3, 2013 (seekingalpha.com)

FHCO – A website featuring Female Health’s condoms

This page is titled “Support” then “FC2 information & education”. Among other items, there’s an animation.

Training for whom?” lists five categories, starting with Health care providers.

There are two downloads of training materials from “Training programs“. The FC2 training manual is 62 pages and 2,317 KB.

FHCO – Investor Relations links

Press Releases, SEC filings

FHCO – Some thoughts about program-funding

It’s unlikely that the Bill and Melinda Gates Foundation will run out of money for a while yet, and Bill Gates is currently the world’s richest person. I don’t pretend to understand politics much, but I don’t expect governments to backtrack on their commitments. The U.K. government backtracked on subsidizing solar panels on rooftops when take-up was more than expected, but their $1.5 billion commitment (for HIV/AIDS, TB and Malaria) is fixed, and probably small relative to the outcry and reputational damage if it’s cut. It’s more likely that a cut would be found in aid with an older commitment, less commitment, less need, or vulnerable to corruption (the reason that would get the most popular support). One possible risk is funding cuts in reaction to some African governments killing or jailing gay people. My guess is that economic aid is more likely to be cut than programs aimed at improving health and reducing mortality. I hope the programs aren’t hit by violence, but vaccination workers have been killed, and family planning advocates in Pakistan have had fatwas issued against them, see “Nigeria: Extremists gun down nine women giving polio vaccines to children” By Mike Pflanz, West Africa Correspondent, Feb 08, 2013 (telegraph.co.uk) and “Family planning advocates face fatwas from fundamentalists in Pakistan” by Sumitra Deb Roy, Dec 5, 2013 (indiatimes.com).

FHCO – Female Health’s deferred tax assets imply management’s forecasts have been conservative

There’s a chart above titled Tax assets, Net income and Cash from operations, to 2013 (find “when they become aware of the tax situation”). The light blue line showing Net deferred tax assets is not just rising, but has curled upwards since 2007, the first year where it’s visible and reasonably meaningful. That indicates managements’ continued expectation of growth, which has allowed them to increase their estimate of the amount of tax losses they will be able to offset against taxable income.

The red line shows the growth in Cash from operations, which has been more noisy than the smooth growth in the tax assets. The smooth blue line shows that management have looked beyond the noise created by lumpy orders when making the estimates that the tax assets are based on. Other charts show that Net income has grown even faster, but Net income is not reliable here as it includes the effects of managements’ forecasts. The insight into managements’ expectations can’t have more than one future update, at least not in a good way, as there isn’t much left in the valuation allowance to transfer into deferred tax assets. (Find “Conclusions about Female Health’s tax assets” above, for the issues around the tax assets. It isn’t simple.)

In principle, the size of the Net deferred tax assets should allow a calculation of total income before tax over the next ten years. The calculation gives a disappointing result, of only $9,530,715 a year Income before income taxes on average, compared to $9,933,854 in 2013 and $10,792,023 in 2012. This begs the question, how can disappointing estimates of future income be consistent with the continuous expectation of growth, when both are derived here from the tax assets, with future income derived from the current size of the assets, and the continuous expectation of growth inferred from the smooth and fast growth of the tax assets?

I believe the answer is that management estimates have always been conservative. Conservative estimates are against the GAAP requirement to use a 50% probability threshold, but proving that management have deliberately applied some conservatism to the rapidly rising curve would be very difficult, and the SEC probably have better things to do. This argues against the possible first impression that the rising Net deferred tax assets could be the result of earnings manipulation. This is a tricky area, I don’t like having to consider over-estimation one minute and under-estimation the next, and I expect management would like my considerations even less.

When management made ten-year projections to base the size of the tax assets on, they must have projected taxable income over the ten year period. What I do next is reverse-engineer their projections of taxable income, from the size of the Net deferred tax assets. I can’t do that for individual years, but I can estimate the ten year total (of management’s projected taxable income). My estimate is based on:

    The ratio of Utilization of NOL carryforwards to Income before income taxes for the past three years. If management expected the ratio to drift over the next ten years, the reverse-engineering becomes less accurate.

I assume:

    NOLs are only represented in Net deferred tax assets if management expect they can be realized within ten years. I expect that to be true, because management use a ten year horizon, and even though the U.K. NOLs never expire, my charts show they were not immediately booked into the Net deferred tax assets, because that would not be consistent with the rising blue line mentioned above.

First, I use data from the last three years to get the ratio “Utilization of NOLs / Income before tax”.

    Total, 2013, 2012, 2011

    Income before income taxes
    $23,957,852, $9,933,854, $10,792,023, $3,231,975

    Utilization of NOL carryforwards
    $4,681,905, $2,070,947, $1,637,205, $973,753

    Utilization of NOLs / Income before tax
    0.1954, 0.2084, 0.1517, 0.3012

It’s the ratio 0.1954 which is important, the other ratios show the wide range of variation, from 0.1517 to 0.3012.

Now using:

    Utilization of NOLs = 0.1954 * Income before tax


    Utilization of NOLs over 10 years = Deferred tax assets

which follows from management’s ten year horizon, and the definition of the tax assets. It follows that:

    Income before tax over 10 years = Deferred tax assets / 0.1954
    = Deferred tax assets * 5.1177
    = $18,623,018 * 5.1177
    = $95,307,154

That’s only $9,530,715 a year on average, which is not an exciting prospect as Income before income taxes was $9,933,854 in 2013, and $10,792,023 in 2012. There’s room for error, and I probably ought to write “$9.5 million a year” instead of implying accuracy to the nearest dollar. The error could be up or down.

The effect of no more NOLs from Malaysia is insignificant, as the NOL carryforwards only amounted to $125,000 as of September 30, 2010, and that’s only the amount of income they could offset.

I explained above why I believe this unexciting result reflects conservatism by management rather than poor prospects. In fact, lower is better, because if my estimate of management’s estimates is correct, income would need to be below $9.5 million a year before it’s necessary to reverse the deferred tax assets back into the valuation allowance, creating a tax expense which would hit Net income. However, that’s based on aggregates and could be spoiled by variation in the timing and the tax jurisdictions of income.

Applying the same method to the previous three years,

    Total, 2010, 2009, 2008

    Income before income taxes
    $13,478,149, $4,224,132, $5,050,111, $4,203,906

    Utilization of NOL carryforwards
    $3,505,750, $1,087,410, $1,331,340, $1,087,000

    Utilization of NOLs / Income before tax
    0.2601, 0.2574, 0.2636, 0.2586

It’s the ratio 0.2601 which is important, the other ratios show the range of variation, from 0.2574 to 0.2636.

Now using figures as at 2010:

    Utilization of NOLs = 0.2601 * Income before tax
    Utilization of NOLs over 10 years = Deferred tax assets,
    2010 Deferred tax assets = $5,931,000

    Income before tax over 10 years = 2010 Deferred tax assets / 0.2601
    = $5,931,000 * 3.8447
    = $22,802,768

That’s only $22,802,768 total Income before income taxes projected from 2010 over the following ten years. I calculated above that the sum over the following three years (2011, 2012, 2013) was $23,957,852.

By my estimates, management’s projections in 2010 for the next ten years were more than achieved in the next three years. That’s extremely conservative, but I expect management were in a difficult position. GAAP required using a 50% probability threshold, but orders are very lumpy, and I’d also say that taxable income over the next three or four years was hard to predict, even if good long term growth seemed likely. Looking too conservative is not as bad as the appearance of deliberately inflating earnings, so it’s understandable if management erred on the side of being too conservative when making difficult long term projections. If the tax assets had to be reversed into the valuation allowance, many shareholders would not appreciate that applying the 50% probability threshold to ten year projections makes such reversals quite likely even in a steady business, as I’ve never heard of a business with ten year earnings visibility.

My reverse-engineered estimate of $22,802,768 total Income before income taxes projected from 2010 over ten years, is only $2,280,276 a year on average, compared to the actual 2013, 2012 and 2011 figures of $9,933,854, $10,792,023 and $3,231,975.

As a quick-and-dirty robustness check, I take the ratio Utilization of NOLs / Income before tax, and plug the value calculated over 2011, 2012 and 2013 into the 2010-based calculation, so for 2010 instead of calculating:

    Income before tax over 10 years = 2010 Deferred tax assets / 0.2601

as above, I calculate:

    Income before tax over 10 years = 2010 Deferred tax assets / 0.1954

to get

    Income before tax over 10 years = $5,931,000 * 5.1177
    = $30,353,078

which is higher than the more natural estimate of $22,802,768, but the result is still a very conservative ten-year projection from 2010, given the $23,957,852 total for 2011, 2012 and 2013.

I don’t expect the under-estimation to be at all consistent, but if it was, using ‘U’ for the underestimation ratio:

    U = Average yearly projected Income before tax / Average Income before tax over the next three years

basing the calculation of U at 2010:

    U = $2,280,276 / ($23,957,852 / 3)
    U = $2,280,276 / $7,985,951
    U = 0.2855

If that value of U holds for 2013:

    Average Income before tax over the next three years = Average yearly projected Income before tax / U
    = $9,530,715 / 0.2855
    = $33,382,539

I’ll repeat that I don’t expect the under-estimation to be at all consistent, so don’t expect that much pre-tax income, but given previous under-estimation, my reverse-engineered management projection of only $9,530,715 before tax per year for ten years, should be seen as conservative rather than as anything to worry about, and the conservatism indicates that earnings have not been manipulated by inflating the Deferred tax assets. Instead, the Deferred tax assets are likely to be under-estimated, although there wasn’t much left to transfer to the category. However, any risk to income before tax is also a risk to the Deferred tax assets, although the tax assets have survived lumpy orders and customer concentration since the company achieved positive income in 2006.

I’ll repeat that management don’t disclose the projections they base the Deferred tax assets on, which is why I’ve estimated the projections with some ‘reverse engineering’ arithmetic.

See also “The valuation allowance, management’s predictions, and earnings management” above for a general treatment.

FHCO – the benefit from two programs

The first spreadsheet shown below is about estimating how funding from two big projects will drop down into Female Health’s Net income, cash from operations, and dividends. The spreadsheet is complicated due to the tax-related calculations. Apart from those calculations the model is very basic, and can only give a rough indication, at best.

The projections are in the big table below row 28, which has the wide beige cell starting “Derived from $4.6 billion”. The projections are aggregate numbers, not per year.

The project funding is $4.6 billion announced at the London Summit in July 2012, which is mostly for increasing access to contraceptives, and $1.5 billion from the U.K. government targeting HIV/AIDS, TB and Malaria.

I don’t know how much of the funding will find it’s way into the company’s revenue, so I’ve given a wide range of assumptions. It’s extremely unlikely that Female Health will see the higher percentages of the funding, which I’ve included for completeness.

I’ve lumped the two funding pools together, but there’ll probably be less of the U.K. government’s $1.5 billion heading to Female Health as the program targets TB and Malaria as well as HIV/AIDS. If you can estimate the revenue from both programs, you can look up the nearest figure in the Revenue column, to the right of the column with percentages.

A better model would separate the fixed costs from the variable costs. Then, there would be a revenue ‘pivot’ where profit-related numbers would be the same as in the spreadsheet, but numbers would get smaller below the pivot, and bigger above the pivot. Operating leverage is implied by:

“Since the product’s primary market is currently the public health sector, the Company incurs minimal sales and marketing expense. Thus, as the demand for FC2 continues to grow in the public health sector, the Company’s operating expenses may grow at a much lower rate than that of volume.” (the 10-K)

Much of the complication in the spreadsheet is because of the need to remove the tax benefit in order to get representative ratios, then subtract normal tax from income before tax, and then add back the tax benefit from the Deferred income taxes asset, to Cash from operations. Only the tax asset under ‘Other assets’ is added to Cash from operations, which excludes tax assets under Current assets and the valuation allowance. The exclusions could be too conservative.

The model leaves out revenue that is not from the two funding sources, and adds as much of the tax assets as the income before tax allows, to the cash flow that comes from those two sources. For the lower-revenue scenarios (under 4%) there won’t be enough income derived solely from the two funding sources to justify adding the full amount of the tax asset. That’s included in the calculation. If 4% or more of the funding goes into Female Health’s revenue, the income produced is enough to use all the Deferred income taxes to reduce the tax payable, but it’s possible that the income would not be produced early enough and some of the tax loss would expire. There’s an underlying assumption that the income is in the right tax jurisdictions to qualify for using the tax assets, and it’s likely that more than 4% of the funding has to hit revenue before all the Deferred income taxes can be used as a result.

As well as the limitations of keeping the model simple, the accuracy depends on three ratios holding up. They’re the numbers in red borders on the sheet, for Income before tax / Revenue, (Cash from operations – Utilization of NOLs) / Revenue, and Dividend per share / Earnings per share. Each of the ratios is based on three-year sums, so the first is the sum of all the Income before tax for 2013, 2012 and 2011, divided by the sum of all the revenue for 2013, 2012 and 2011. In favor of the ratios, the three years include a bad year (2011), an excellent year (2012) and 2013 was a bit of a drop-off from 2012. While income and cash from operations can go separate ways in a single year, there are limits on the size and duration of the divergence (for an honest company), although there could be a relatively constant lag for a growing company. I’m hoping that three years are enough to smooth out the noise. The systematic difference between income and cash flow historically, due to net income benefiting from releasing the valuation allowance, has been taken into account. Charts further down show how Net income and cash from operations have diverged and caught up with each other (more or less) over many years. The ‘cumulative’ chart shows how negative net income sagged under the small negative cash from operations until 2005, but has grown faster than the growth in cash-from-ops since (due to recognizing the tax benefits in advance).

Although I calculated the payout ratio in cell S26 using ‘per share’ figures, the projections are not per share, and not per year. Keeping the historic payout ratio based on net income will produce a lower ratio based on Cash from operations in future, as Net income will drop relative to Cash from operations, due to the tax issues described in this piece (find “Conclusions about Female Health’s tax assets”, above).

The model also takes no account of time. From the UK government’s website:

    “Making lifesaving contraceptives available to an additional 120 million women and girls by 2020.”

The quote is from “Family planning: London summit, 11 July 2012” (gov.uk)

It seems fairly likely that the funding covers the ramp up until 2020, after which new funding will probably maintain the supply. I might be taking the word ‘ramp’ too literally, but these hypothetical funding flows from 2013 to 2020 ramp up linearly and add to $4.6 billion:

    $128, $255, $383, $511, $639, $767, $894, $1022 (in millions)

That’s only meant as a very rough approximation, at best. Staff costs will come out of the funding but won’t get into Female Health’s revenue, and they are likely to be fairly constant rather than ramp up.

The education and training Female Health pledged at the Summit was for the period 2013 to 2018.

There’s a little more info on “Family planning: Historic breakthrough for 120m women

To put the figure of 120 million women into some kind of perspective, Female Health’s unit sales going back from 2013 were: 54,759,925, 61,649,997, 32,872,570, 38,919,262, 40,192,600.

In principle, you could estimate the impact of reaching the Summit’s target for contraceptives if you knew these ratios:

    1) Proportion of the 120 million women whose contraceptives included female condoms
    2) Proportion of female condoms supplied by Female Health
    3) Rate of use, per woman
    4) Revenue per condom

In my opinion, the big funding available to international agencies poses a question about how management are likely to respond to incentives. Management are rewarded for performance, and incentive payments are lower in the less profitable years. If they are motivated to achieve short term goals, this could translate to pulling in as much from the well funded agencies as they can, using the existing FC2 product. So long as this provides a good reward to management, there could be little financial incentive to secure the company’s long term future by developing a range of products. Only a shareholding big enough to outweigh formal incentives can align management’s financial interests with that of ordinary shareholders taking a long term view. Present management might not be present if and when competitors gain serious market share. See “FHCO – Competing products are not inferior” and “FHCO – Some information about the female condoms women prefer”, above.

FHCO – Charts

For info about the spreadsheet in the first image below, see “FHCO – the benefit from two programs” immediately above. There are many simplifications, and the spreadsheet could be improved, but would be more complicated. If the numbers are too small to read, in Firefox, right click, select “Open link in new tab”, and use the magnifying glass.

Female Health - Dropdown from revenue - spread

Female Health - Dropdown from revenue - formulas

In the table below, the heading ‘Shares’ means Diluted weighted average common shares outstanding.
Female Health cash walk to 2013 spread

These walk-charts illustrate good growth in cash from operations with relatively little cash needed for investment, but with plenty of noise.
Female Health cash walk to 2013

The heading ‘Shares’ means Diluted weighted average common shares outstanding.
Female Health non-cash walk to 2013 spread

Female Health income and cash walk to 2013

Female Health income and cash to 2013

Female Health cumulative income and cash to 2013

Below, the Income tax benefit is what Female Health have booked instead of a tax expense, although the actual cash paid is from the company to the IRS. Deducting the two components related to the tax assets leaves the tax expense that would have been booked without the tax assets, allowing an estimation of the ‘normal’ tax rate.
Female Health - Normal tax etc - spread

The spreadsheet below shows results for the latest quarter, compared to the previous quarter sequentially and the quarter from a year ago. It was used above, find “shows the Income tax expense for the latest quarter”
Female Health - results 1Q 2014

A chart showing Net income and decreases in the valuation allowance can be found with “the big decreases were not abnormal”.
Charts showing how the falling valuation allowance has driven the increase in tax assets and contributed to income and cash flow, can be found with “Although the boost to the tax benefit is fizzling out”.
The M-Score spreadsheet is shown above “Female Health’s only product is the female condom”, near the top.

And finally …

Designers Turn Female Condoms Into ‘Fashionable’ Dresses” By John Yong, 15 Jul 2013 (designtaxi.com). When I saw the page, the dresses looked sensible compared to some of the fashion items on the right, including a fishbowl handbag shown with goldfish in it.

The highly unconventional condoms in the next link have a serious point: “Anti-Rape Underwear in India, condoms with teeth in South Africa – protecting women and girls, but at what cost?” by Emma Saloranta, April 24, 2013 (girlsglobe.org). It’s a balanced piece about the issues rather than the product design, but it doesn’t mention possible misuse.

This link is only here because I can’t stay serious for too long. You need to magnify the diagrams: “Apparatus for facilitating the birth of a child by centrifugal force US 3216423 A” (google.com/patents).

Copyright ©2014 sinksmith

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

Three cash3 companies

Disclosure – I own shares in IPG Photonics Corporation (IPGP), Repligen Corporation (RGEN), and Ubiquiti Networks, Inc (UBNT). Also EMN, GE, HPQ, QCOM, TIBX (links to Seeking Alpha)

‘Cash3’ is my term for companies that pass three cash-related tests, intended to catch:

1) More cash than every possible liability
2) More cash from operations than cash going into investment
3) Free cash flow per share will grow at a faster than average rate

These three companies might qualify:

IPG Photonics Corporation (IPGP)
Repligen Corporation (RGEN)
Ubiquiti Networks, Inc (UBNT)

If you want to skip the theory, use the three lines above to search down and find my writing about the companies. Anyone too rushed to read can find “All the charts again” at the end.

Many investors will be unfamiliar with how companies massage cash-based figures, indemnify so widely that they are warned it might not be enforceable, have anti-takeover provisions that would make management unaccountable, can be exempt from audits of internal control over financial reporting, and more. That’s mostly what I write about until I get to the companies.

The tests in full are:

1) More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.
2) Cash from operations has to be positive and generally bigger than the cash that goes into investment.
3) A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

Other factors still matter

In math terms, I’m looking at cash and its first and second derivative, but in simpler language, it’s like reading the height, velocity and acceleration of a rocket that you don’t want to fall to earth. You still want to know about other factors like the guidance and communications systems and if it’s going to hit anything.

There’s a case for preferring ‘cash3’ companies (find “possible alpha” and “low-risk anomaly” below), but risks still count, such as dependence on government, customer concentration, a single supplier, new technology making products obsolete, management greed or incompetence, and increased competition.

Valuation still counts, and an overpriced cash3 company will not be a good investment, while a value-style investment or an excellent company at a fair price can be good investments without meeting cash3 requirements.

‘Cash3’ companies have cash available for investment, but the opportunities to invest will vary. If a company stops being cash3 due to a large investment, there will usually be more risk and more reward.

Make easy checks first

You don’t want all the work of checking the obligations, commitments and contingencies, and the relevant accounting policies, only to find that cash doesn’t exceed liabilities, or the company generally invests more cash than it gets back through operations, or the market is near saturation. The hard work belongs in test 1 logically, but leave it til last. Also see “Use information found already or found later” and “Read forms once and make notes” below.

If a company fails a test, it could still be worth further research, whether the research follows the cash3 framework or not.

Judgment, effort and confidence

Test 3, “A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.”, involves judgment, although some investors might formalize the test with projections.

Test 2, “Cash from operations has to be positive and generally bigger than the cash that goes into investment.” is not a mechanical test. A history of positive free cash flow will sometimes be enough, but not when major changes are imminent. The expiration of a significant contract or royalty stream will have a definite negative effect, but new sources of cash flow will usually be less certain.

The obligations, commitments and contingencies in test 1 present a problem. Some, like future lease payments, are usually easy to find, but knowing that you’ve probably found all the important items isn’t easy. Checking the accounting policies is hardly trivial. At some point the investigation has to stop, limits on time and experience have to be accepted, and confidence in the conclusions has to be judged. While it’s been said that investors should only invest in businesses they understand, I don’t think that meant every bit of every form filed with the SEC (Securities and Exchange Commission).

The research required to make the tests can be more important than the result. If you find something bad enough, it doesn’t matter if the company is cash3 or not, if you don’t want to invest in it.

In short, ‘cash3’ is not a mechanically determined condition, and getting the ‘cash3′ stamp is not all that matters about a company.

If you get through all of this piece and believe it makes sense, I suggest you assimilate the methods gradually. The concept is unproven, the research takes a lot of time, and I can’t be sure that the cash3 approach is an efficient use of investors’ time.

Next I describe some issues around making the tests, followed by ‘Reasons for the tests’.

Test 1, “More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figure.”

Checking that cash exceeds the Total liabilities only requires finding them in the balance sheet and comparing.

Obligations, commitments and contingencies

I’ve put “Finding obligations, commitments and contingencies” in the “REFERENCE SECTION” near the end. When I mention 10-K, 10-Q, 14A or S-1, they are company filings which I describe in “Forms filed with the SEC (Securities and Exchange Commission)”.

Starting with indemnification by the company, it’s usually impossible to quantify the risk or the maximum amount payable, but there are important differences between companies’ indemnification policies which can be noted. There are two main kinds of indemnification:

1) A distributor is sued for patent infringement, and the company pays for the legal defense and any award the distributor has to pay, because the patent is embodied in the company’s product. The same principle applies to other partner companies, such as contract-manufacturers.

2) A company officer (CEO, CFO etc.) or a director is sued or prosecuted, and the company pays for the legal defense and any award or fine the officer or director has to pay. The indemnity can be be extended to employees, agents and many more.

There should also be provisions for settlements (agreeing on a payment to drop the case).

That description misses out huge chunks, and a company’s indemnification can cover a few pages in an S-1.

1) is reasonable, for example you can’t expect a contract-manufacturer to bear the risk of patent infringement. What matters is not usually the details of the policy, but the exposure to litigation-happy business areas such as digital technology and communications.

2) is probably inevitable, but the terms vary. When the risk is not insured, it might be uninsurable or very expensive to insure, and the best that investors can hope for is information asymmetry, that management know the risk is small but somehow insurers can’t know the same information. It’s also possible that there could be doubt about the indemnification being enforceable (the SEC might dispute it), and there’s less point in paying for insurance that might be unusable. Companies routinely bear uninsured risks such as product obsolescence or a change in government policy, but because Ubiquiti insure their officer and director indemnity, the absence of such insurance by the other two companies indicates risk.

See under “Common failings” below, about the indemnification by the three cash3 companies.

Pensions – you might be lucky and find an unequivocal number for the pension commitment, or a clear statement of no pension liability, or no significant liability. Otherwise, for example, if the biggest number connected to pensions is half a million dollars paid in Sweden, it’s likely to be reasonable to ignore the pension commitment, even though a big commitment can’t entirely be ruled out.

Legal proceedings – A company that puts a conservatively high upper limit on the cost of a court case could fail the cash3 test 1 as a result, while a company that downplayed the risk or the maximum likely expense could pass, which isn’t ideal but you can only work with the information you can find.

I usually add the obligations, commitments and contingencies (OCCs) without discounting them to a present value, even though they can spread long into the future. That keeps the calculations simple, comparable, and avoids picking a discount rate. Investors can discount the OCCs if they prefer.

Off-balance sheet financing and special purpose entities

The condition “including material off balance-sheet items” is simpler when you find a statement like this, “We do not have any special purpose entities or off-balance sheet financing arrangements as of September 30, 2013.“, which is from Repligen’s 3Q 2013 10-Q. Otherwise, you need to quantify what you can, and avoid double-counting items already included under Obligations, commitments and contingencies. If there’s a significant amount of off-balance sheet financing, check that there’s a good reason for it being off the balance sheet, and that management are not afraid to mention the off-balance sheet financing, otherwise it signals that management want to hide it.

There might a good reason for any special purpose entities, but very often, little is disclosed. They can be used by multinational companies to pay less tax, to keep patent ownership secret, and sometimes have a role in securitization schemes. When Apple acquired the iPad trademark from Chinese company Proview, they used the British shell company Application Development Limited (IPAD Limited) to hide their identity and get a better price. (It went wrong and ended up in court.) If management say there are no special purpose entities, that’s clear, if they describe their special purpose entities, you have information to consider, and if they don’t mention special purpose entities, you can see if keyword searches pick anything up (‘entity’, ‘entities’, ‘special-purpose’, ‘vehicle’).

See “How Enron used the offshore system to hide millions” By Lucy Komisar, San Diego Union, Jan 23, 2000 (thekomisarscoop.com).

Dairy company Parmalat (Wikipedia) were sometimes called “Europe’s Enron”, and their fraud involved obscure offshore entities. Auditors Deloitte & Touche warned they were unable to certify some transactions involving the ‘Epicurum’ investment fund based in the Cayman Islands, in 2003. Parmalat would have made a loss if it wasn’t for the profit on a contract with Epicurum. Epicurum was “linked to Parmalat” (Wikipedia), or a fraudulent offshore entity according to other sources. Later, Bank of America stated that €3.95 billion in Parmalat’s bank account was forged. This related to Parmalat’s Bonlat subsidiary in the Cayman Islands. It became clear that Parmalat had huge debts instead of net cash. See also: “There Were Earlier Signs of Trouble at Parmalat” By DANIEL J. WAKIN, January 14, 2004 (nytimes.com)

It’s possible that auditors are now more aware of how shady entities can be abused, and that measures to counter money laundering have reduced the risk to investors, but I wouldn’t assume everything’s fine now.

Dubious accounting policies

The condition “and with no accounting policies that cause significant doubt about the cash figures” is fuzzy in the sense that investors will vary in their ability to detect and weigh dubious accounting policies, and experienced investors won’t all agree about the policies. Unfortunately, omitting it leaves loopholes.

I don’t want to be too strict, especially about common abuses. If the company seemed honest enough, I’d note the vagueness as a minor offense, rather than disqualify the company, because I haven’t found a perfect company yet. ‘Cash and cash equivalents’ illustrates this. It’s worth checking the definition, but the value of the check is reduced by the common use of woolly definitions. If a company included junk bonds (not investment grade) or anything with more than three months to maturity, the company ought to fail the test, but companies can avoid standing out by using a woolly definition instead. See under “Loose definition of Cash and cash equivalents” below.

If a policy raises some doubt but you think it probably isn’t too serious, check previous SEC filings to see if it’s new. I wouldn’t necessarily disqualify a company from being ‘cash3’ if the revenue recognition policy seemed a bit loose, but I’d need to check that cash from operations wasn’t inflated, and I’d note the policy and bear it in mind when making an investment decision. If the policy had been loosened in the latest quarter, it’s a very different matter, as it’s natural to ask why management would want to change it, with deception high on the list of motives. The same principle applies to other slightly dubious policies. See if they’re new, and if they are, ask why.

There’s more under “The trouble with cash” below, including links to cases and links about what to check.

The following headings are about checking for dubious accounting policies:

Audits of internal control over financial reporting
Cash and cash equivalents definition
Short-term investments definition
Revenue recognition policy

Audits of internal control over financial reporting

Having good accounting policies is no guarantee if the company lacks the internal financial controls that alert to policy breaches. Some companies are exempt from external audits of financial controls under the JOBS Act (JOBS – Jumpstart Our Business), and the lack of such audits increases risk to investors.

Open a company’s latest 10-K and find the auditor. Search for “Independent Registered” or “Accounting Firm”, or try these:


Either search for the name until you get to the signature, like:

/s/ Deloitte & Touche LLP
Boston, MA
February 28, 2013

or search for “Independent Registered” until you see a heading like:


The auditor’s piece should be between the heading and the signature. The punchlines are likely to be one or two paragraphs above the signature, or not far below the heading. You want something like:

“In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of …”

While there, you might as well check the more general audit. You want to see something like:

“We have also audited, … the consolidated financial statements … and our report … expressed an unqualified opinion on those financial statements.”

Anything other than an unqualified opinion is bad, but auditors don’t always include the phrase ‘unqualified opinion’ when their opinion that the accounts are fair is unqualified. When you’ve got the big OKs, don’t bother reading the legalistic verbiage.

Like many things in finance, what’s bad is bad, and what’s good is not reliable. The big four auditors were the big five until Enron went bust and their auditors Arthur Anderson lost all credibility. There’s been plenty of audit failure since. The firm doing the audit has an incentive to keep or gain tax and consulting work.

So far as I know, that’s all you need. The audit committee might do vital work but I don’t see the point of reading about it. Don’t read the “Certification of Chief Executive Officer” because the CEO isn’t going to say the quarterly report is a load of garbage.

Cash and cash equivalents definition

Check the definition can’t include anything illiquid, unsafe or maturing in more than three months. Money market funds are probably alright. Apart from the U.S. government, securities should be spread across counterparties rather than risk one of them going bankrupt. I excuse woolly definitions because they are common (find “Loose definition of Cash and cash equivalents” below).

Short-term investments definition

Short-term investments don’t feature in the ‘test 1’ calculation, but they are defined near the Cash and cash equivalents, so you might as well check the definition. Check that only investments maturing within a year are included. Check the risk, as most companies shouldn’t be dealing in risky short-term investments. Companies without short-term investments don’t usually define them.

Revenue recognition policy

By itself a loose revenue recognition policy doesn’t usually affect any cash figures, but it can inflate cash from operations when Accounts receivable are sold or disguised (‘receivables’ represent cash not yet collected from customers). The key point with goods is that ownership should be transferred before revenue is recognized. If the customer can easily return the goods for a refund, or does not need to pay for a long time, investors need to be sure that this is a reasonable policy intended to encourage sales over the years, rather than bring sales forward to inflate results in the short term. Delivery to warehouses controlled by the company is a red flag if revenue is recognized at that point. That’s different to managing the customer’s inventory, which can be part of a customer’s ‘just in time’ policy, and helps to keep the customer. Some services and projects are supplied over a few years. Ideally, the revenue booked should be proportionate to how much of a contract has been delivered, but it’s common for the recognition of revenue from services to be weighted ‘up front’ rather than spread evenly.

Sometimes the usual terms of a sale are circumvented with a ‘side letter’, granting a longer payment period or broader rights to return products that aren’t wanted. While the recognition of revenue should be determined by the policy and not by a side letter, I wouldn’t rely on the revenue figure when side letters are used.

Recently-raised equity

A company can’t pass test 1 by borrowing, but it can do so by raising equity (issuing shares, including when warrants are exercised, through employee stock purchase plans, or when convertible loans are converted to shares). I wouldn’t normally exclude a company that only passed test 1 by recently raising equity, as the cash raised or the debt reduction is real. It might indicate that the company hasn’t generated enough cash, but that shouldn’t usually be a problem if the other two tests are passed, although there’s room for opinion about it.

Cash held overseas

Bear in mind that some or most of a company’s cash could be held overseas, and the company would have to pay tax if it repatriated the cash, e.g. to fund dividends. This might explain why some companies with plenty of cash still have debt. I ignore this and treat all the cash as the same in my assessments.

Test 2, “Cash from operations has to be positive and generally bigger than the cash that goes into investment.”

I would not exclude a company that made a big investment in the latest period, if the cash from operations generally exceeded cash into investment. My ‘walk charts’ of the two cash flows over several years, make this clear when there is enough history. A normal time-series chart of cash from operations minus cash into investment (one definition of ‘free cash flow’) would also show if investment produces more cash than goes into it, but with less information and less scope for identifying patterns. This is for IPG Photonics, up to 2012.

IPG walks for cash from ops and into investment

That’s from a blog post of mine: “IPG Photonics – growth, cash, markets and technology” September 27, 2013. Repligen is a different case, as the transition to bioprocessing means that old history is less relevant, so I’ve looked into recent income statements to check that free cash flow is sustainable.

Test 3, “A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.”

Sources and prospects

This is the test where the easy reading is most relevant, to gauge the company’s prospects. That includes presentations, transcripts on Seeking Alpha, articles, and often some technical background to understand the business. These sources might not say much about the competition. If there are no better leads, search the 10-Q and 10-K SEC filings for the “Competition” section.

Past and future

I like to see a solid foundation, such as a cash flow walk chart showing a history of free cash flow growth. Repligen don’t have that, and I make do with the growing bioprocessing market and other factors. I believe that a good history with no strong reason to expect it to stop is generally more reliable than reasons to expect a bad history to turn good, though it isn’t something I could prove.

Blips allowed

The expected growth doesn’t have to be relentlessly positive, every year. In the chart above, the distance of a point above the green diagonal line corresponds to cash from operations minus cash invested. There are years where the quantity was down or negative, but the overall growth was excellent.

I regard Repligen as passing the test, even though their cash flow will drop due to expired royalties, because they are now focused on bioprocessing where revenue and cash flow are likely to grow. Articles by Smith On Stocks on Seeking Alpha describe the business model and provide rough projections which indicate growing free cash flow.

Faster than average rate

I leave open, what the benchmark ‘average rate’ of growth of cash from operations might be. In the case of Ubiquiti, the recent growth rate is very high, my chart makes it obvious, and there’s no point in worrying about which rate the growth should be higher than. For IPG Photonics, the growth is less extreme, but I still expect growth of cash from operations higher than for the average company over a long enough period. I’m not too concerned with the growth relative to the sector. If I learned that a competitor achieved higher growth of cash from operations, and also higher margins, I would take a serious look at the competitor. IPG’s CEO has remarked on a trade-off between margin and growth.

Investors need to decide exactly how to implement test 3. In my case, it’s more ‘I know it when I see it’, which is highly subjective. Most of the cash3 considerations are subjective, with the risk that I’ll make the test fit the company if I already like the company too much, if I’m not careful.

Use information found already or found later

An investor should only give tests 2 and 3 a conditional pass, until the accounting policies have been checked. Those checks are logically part of test 1, but the hard work should be left to last. When considering if the revenue recognition policy is too loose, or when reading the Liquidity and Capital Resources section of a SEC filing, bear in mind that the reliability of cash flow figures could be affected. Also see “Read forms once and make notes” below.

A version of free cash flow

I could have shortened the definition of test 3 by using ‘free cash flow per share’ instead of ‘cash from operations minus cash invested, per share’, as free cash flow is often defined in that way, but it’s also defined as cash flow from operations above the investment needed to maintain the business. There can be a big difference between the investment needed to maintain the business, and what is actually invested. Warren Buffett has claimed that many companies reinvest too much of their cash from operations, and he likes to take them over and put the cash generated to better use. It’s also hard for ordinary investors to estimate the investment needed to maintain the business. To avoid confusion, I’ve avoided making test 3 shorter.

Reasons for the tests

Here are the tests again:

1) More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.
2) Cash from operations has to be positive and generally bigger than the cash that goes into investment.
3) A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

It’s fairly obvious that a company is better when boxes 2 and 3 are ticked, meaning that more cash comes in from operations than is required for investment, and the excess is expected to grow above the average rate. It’s also true that more cash in the bank is good, in the sense that you wouldn’t want any of it to just disappear, but there are complications around the question –

Should a company have net cash or net debt.

In favor of net cash, it’s a safety net, allowing unforeseen expenses to be paid with less pain, and allowing major restructuring in order to adapt to permanent changes, with no borrowing or less of it. When there’s a problem, net cash might help to prop up the share price, allowing some investors to get out at a better price.

Cash: Can A Company Have Too Much?” By Ben McClure on September 05, 2010 (investopedia.com)

One point Ben McClure makes is that cash can allow carelessness.

This is about a British company with a cash pile that was ruined after a management coup:

From blue chip to ‘right bloody mess’” July 08 2001

The manager who hoarded the cash was prudent, and it was the new management, not the cash, that caused the waste. For years people were asking “When will they spend the cash?”, and not “Will new management botch a radical restructuring?”, showing that sometimes the obvious question isn’t the right one.

This piece from 2010 is about how Hewlett Packard’s big buyback was meant to reassure investors that they weren’t going to squander the cash pile on ‘overpriced baubles’ …

HP tries big buyback to quell investor discontent” By Robert Cyran, August 30, 2010 (blogs.reuters.com)

… and in 2012 HP were suing, claiming they’d been misled into overvaluing their expensive Autonomy acquisition.

The lesson is that ‘cash3’ is not sufficient grounds for ‘buy and forget’ or ‘hold forever’, instead, watch out for squandering, and don’t trust new management too much when they can make a mark by splashing the cash. Over-hoarding is also not ideal.

It’s entirely normal for a company to fund investment by borrowing, when the return on the investment is expected to be sufficiently above the interest paid on the debt. I’m not saying all companies should stop that, or that investors should always avoid such companies, although there are risks and costs with debt-funded investment. Warren Buffett prefers companies which grow their cash flow with little requirement for capital and therefore no need for debt, although the growth of such companies tends to be steady rather than spectacular, and he also likes insurance companies which provide a ‘float’, which has been described as providing leverage. My cash3 tests allow high investment, and IPG Photonics fits cash3 even though they’ve invested a substantial amount of cash, because their cash from operations has generally exceeded the cash into investment, and has grown well over several years. In a sense, IPG Photonics provides the whole package, because the cash generated can be usefully reinvested to develop the business. While strategic acquisitions have been made to acquire technology or achieve vertical integration, there isn’t a pressing need to find a use for surplus cash.

There’s a case for loading up with debt in some circumstances, such as when earnings are predictable, but there could be a temptation to overdo the debt when interest rates are low, or in order to keep increasing earnings per share or dividends.

There’s currently some controversy in the UK over water companies where 70% to 80% of the balance sheet is debt. The debt reduces the tax bill because tax is paid on the income that’s left after paying interest, but there’s concern that with tighter price control their credit ratings will drop and they’ll lose their licenses. It’s alleged that the companies have become too cash-hungry, with poor customer service, a reluctance to invest, and low innovation. Innovation can have some risk and reward attached, and maybe investors have enough risk and reward already through the leverage. Management claim the only problem is getting the ratings agencies to understand why the risk is low. Maybe management are right, or maybe they kept improving the appearance of results by a little more debt every year and didn’t know when to stop. The companies started debt-free in the 1980s.

Accountants know the tax advantages of debt, including British insolvency specialists RSM Tennon Group plc, who were named ‘national firm of the year’ at the British Accountancy Awards 2011 for their build-it-on-debt strategy. They couldn’t pay the debt, and were sold in a “pre-pack” deal which left shareholders nothing, in August 2013.

Eastman Chemical are a case where earnings are not predictable, and their general lack of pricing power makes them vulnerable to rising input costs, although they have some protection through diversification. They have expertise (without super-high compensation), good cash flow and earnings growth, and a load of debt. In the event of a downturn, Eastman’s shares are likely to be hit by concern over their ability to repay debt, even if the company survives in relatively good shape. Although the debt has been coming down, it’s likely to increase to fund acquisition. I’m long Eastman Chemical, but because of the debt it’s a small shareholding which I regard as speculative.

Sometimes dividend-paying companies borrow to buy back their own shares, which reduces the total costs of paying the dividends. This usually makes more sense when the company expects the dividend to grow. The debt created might be justified, but I’d usually prefer to invest in a company that could buy back its shares without having to borrow.

Non-recourse debt is generally better than ordinary debt. It means that the lender has a claim on a particular asset or set of assets, but not on the company. SunEdison have financed some of their solar projects with non-recourse debt, and if a few of those projects fail, the remaining projects and other sources of income are not affected, although the financing of future projects could be difficult. The financing allows capital to be recycled more quickly to fund new projects. The use of non-recourse debt is only possible because the projects are seen as predictable and unlikely to fail. There’s more about this in my “MEMC Electronic Materials – Debt Fueled Growth Is Good” and “SunEdison still set for growth and profit” under the Index tab (MEMC changed their name to SunEdison). SunEdison has other long term debt.

If I found a company that would be cash3 if non-recourse debt was excluded, I would think of it as being in the ‘cash3 excluding non-recourse debt’ category, and check the details, including the use of such debt in recycling capital. If, as in SunEdison’s case, the non-recourse debt is not amortized as it is repaid, then the debt is overstated and an adjustment could bring a company into the regular cash3 category, although the adjustment could be hard to gauge.

The low-risk anomaly

‘Cash3’ might be supported by the ‘low-risk anomaly’, that low-risk companies give higher returns. Sometimes ‘risk’ is replaced by share price volatility (or ‘beta’), which is a complication, as I agree with Warren Buffett when he doesn’t equate risk with beta.

Risk and beta can be very different when a company loads up reserves in good years to draw down in bad years in order to smooth earnings, which is likely to make the share price less volatile (or ‘low beta’). I can’t find a brilliant example, but the state-backed Federal Home Loan Mortgage Corporation (aka Freddie Mac) attempted that when an earnings windfall from an accounting change threatened their slow-and-steady image. See “Freddie Mac, Four Former Executives Settle SEC Action Relating to Multi-Billion Dollar Accounting Fraud” Sept. 27, 2007 (sec.gov). They still reported unsteady earnings growth of 63% and 39% in 2001 and 2002. The company certainly wasn’t safe, needing a federal takeover when the financial crisis hit. It can be tempting for managers to smooth performance as a sharp improvement followed by a sharp fall somehow looks worse than if the results were smoothed.

For an analysis which is mostly beta-focused, see:

The Paradox of Low-Risk Stocks” subtitled – Gaining More by Losing Less, (PDF), by portfolio managers Kent Hargis and Chris Marx (I think), February 2012 (alliancebernstein.com)

How that applies to cash3 companies seems complicated. My opinion is that being cash3 is still good for companies in steady markets. In cyclical markets, cash3 companies are likely to survive downturns in better shape, and could emerge with fewer or weakened competitors depending on the competitors’ financial strength before the downturn.

Earnings manipulation

I believe that cash3 companies are likely to be less prone to earnings manipulation. Earnings manipulation might be rare, at least as measured by the number of companies the SEC takes action against, or require to restate their accounts. The best information I’ve found about the level and trend of SEC actions is in this –

Making Accounting Enforcement a Priority: The Case for an SEC Financial Accounting Fraud Specialized Unit” by Martin S. Wilczynski, April 29, 2013 (securitiesdocket.com)

The most up-to-date chart is the last one, from 1998 to 2012, for the SEC’s enforcement actions. There doesn’t seem to be a clear long-term trend in the number of companies that the SEC takes action against.

While restatements or SEC enforcement provides objective measures of financial reporting failures, they miss the effect of undetected cases, or various levels of manipulation below the SEC’s threshold. Messod D. Beneish, who devised the Beneish M-Score for earnings manipulation, claims that the M-Score predicts share price performance over a wide range of M-Scores (though not perfectly, obviously). I believe the claim suggests a wide range of levels of manipulation, including levels below the SEC’s threshold. (IMO, the M-Score is useful but flawed.)

This is where the possible alpha comes in. To the extent that fooling investors works, companies with less honest management are overvalued, and companies with honest management are relatively undervalued. If you believe a strong enough version of the efficient market hypothesis, then too few investors are fooled to inflate share prices, there’s no alpha here, and management have little incentive to fool investors (and pigs might fly).

If the Beneish M-Score is the best possible measure of management deception, then the ‘cash3’ concept loses some theoretical support. I don’t believe the premise, but the M-Score has statistical support, whereas ‘cash3’ and the other factors I look at, only have my opinion and reasoning.

Companies passing the first two cash3 tests have less need to raise capital, and therefore less pressure to manipulate their earnings. Cash3 companies are likely to have good GAAP results (GAAP is Generally Accepted Accounting Principles). When you can make a good case without fudging, it’s not worth spoiling it with fudge.

Because test 1 excludes non-cash assets, the test is not bypassed by inflating non-cash assets. For example, if a company inflates its earnings by under-depreciating physical assets, the net value of its physical assets will be inflated. No amount of such inflation can turn the company into a ‘cash3’ company, because the inflated earnings and asset values are not cash inflows or cash held. (I check the ‘Useful life’ used to depreciate assets, but the check is not part of the cash3 tests.)

A company can induce sales by taking on obligations. These might be unreasonably onerous in order to increase sales or bring them forward, to make the accounts look better. This can inflate cash from operations, but the extra cash held will be balanced by the obligations, which ought to be disclosed in a 10-K. The obligations should be found when making test 1, and the cash from operations can be adjusted for them, although the research should usually be stopped if there isn’t a very good reason for the policy.

Companies passing test 1 are likely to be strong financially, provided the off balance-sheet items are disclosed and found. Altman Z scores are likely to be high into the safety zone, and are almost superfluous.

Test 3 means we are considering growth companies. These are particularly prone to earnings manipulation when they need to borrow or issue shares to fund their growth, and need to keep up appearances in order to raise capital on favorable terms. That’s less likely for cash3 companies.

Until I write about earnings manipulation and supply links, some readers will need to do their own research to confirm or refute some of my claims.

The trouble with cash

People used to say “The camera never lies” without irony, long after Sir Arthur Conan Doyle was fooled by photographs of fairies (Wikipedia). Some day there might not be many investors left saying “Cash can’t lie.”. Fictitious cash flow dates back at least as far as the 1920s and 1930s, when McKesson & Robbins’ cash was circulated to create the illusion of cash received from customers (See “The Greatest Frauds of the (Last) Century” by Paul M. Clikeman, Ph.D., CPA, University of Richmond). When judging a company by cash, you need to be sure about the cash, which is why this section is long, and not long enough.

Some cases of deception involving cash can be found on the SEC’s site, and much of the material is fairly readable, after a paragraph or two of legal language, or after the word “alleges”. For instance:

“When Peregrine booked the non-binding contracts, and the customers predictably did not pay, the receivables ballooned on Peregrine’s balance sheet. To make it appear that Peregrine was collecting its receivables more quickly than it actually was, a senior officer entered into financing arrangements with banks to exchange receivables for cash. Peregrine improperly accounted for these financing arrangements as sales of the receivables and removed them from the company’s balance sheet. There were several problems with this. First, because Peregrine had given the banks recourse, and frequently paid or repurchased unpaid receivables from them, Peregrine should have accounted for the financing arrangements as loans and left the receivables on its balance sheet.”

That’s from the third paragraph of the first link in this list:


SEC charges Adelphia Communications Corp and Rigas Family July 24, 2002.
Rampant self-dealing, hiding liabilities in off-balance sheet affiliates, etc.

SEC Charges Delphi Corporation and Nine Individuals Oct. 30, 2006
Charges include disguising a loan as the sale of inventory, which inflated cash from operations. Delphi’s non-GAAP “Operating Cash Flow” had little relation to GAAP Cash provided by operating activities. (When I use “cash from operations”, or “cash from ops” etc, I mean the proper GAAP measure.)

SEC charges Time Warner Inc. March 21, 2005
The charges against Time Warner involved “roundtrip transactions”, where the company funds the customer’s purchases. Such trades lack economic substance, and inflate cash from operations when the funding is included under financing or investment. The next two cases also involve “round-trip” trades.

SEC charges CMS Energy March 17, 2004

SEC charges Dynegy September 24, 2002. “… Dynegy portrayed as operating cash flow what was essentially a loan.”

SEC Sues Former Tyco CEO Kozlowski, Two Others for Fraud September 12, 2002
The CEO and others helped themselves to company funds. Acquisitions are an opportunity to manipulate earnings and cashflow, which Tyco took advantage of when they acquired over 700 companies.

SEC charges WorldCom June 27, 2002.
WorldCom pretended that operating expenses were investment, inflating cash from operations, and cash invested. They also exploited acquisitions, writing off the costs and creating reserves to draw down into income later. It all fell apart when their acquisition of Sprint was disallowed on antitrust grounds.

SEC charges Satyam April 5, 2011. (An Indian company, with American depository shares.)
Includes “… fraudulently overstating the company’s revenue, income and cash balances by more than $1 billion over five years.” and “Satyam employees created bogus bank statements to reflect payment of the sham invoices.”

There’s plenty more on “Accounting scandals” (Wikipedia). Many of them will be more about non-cash fraud. The list shows a peak in 2002, possibly due to the fallout of the earlier Dotcom crisis. I don’t believe the lack of notable recent U.S. cases means we can trust management and relax.

There are a few tips on spotting the fakery here: “How Companies Fake It (With Cash Flow)” by Matthew Argersinger, Jul 27th 2011 (dailyfinance.com)

If you can bear Investopedia’s adverts, this has a few tips – “Detecting Financial Statement Fraud” By Arthur Pinkasovitch on September 28, 2011 (investopedia.com)

This link is a bit old and on a horrible marble background. FORENSIC INVESTING: RED FLAGS

Where to find cash info

Get the latest form 10-Q or 10-K.

The cash flow statement is the obvious place to start.

Read the “Liquidity and Capital Resources” section.

Search for “Cash flow information” or “Cash flow disclosure” (in a 10-Q or 10-K form), to find variations on “SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:”. The heading varies, and might not exist or only be a few lines in the cash flow statement.

Search for “Non-cash”, “Noncash” etc. to find “Non-cash transactions” where you might find payment by installments that makes expenses or investment look like repayment of debt.

Search for “promissory” (as in promissory notes), “trade” (trade accounts), or “notes receivable”, to see if the company has transformed Accounts receivable into something else, like short term investments.

Search for “customers request”, and look out for variations. Looking after customers is good, but the phrase is a multipurpose excuse, and is more suspicious when attached to anything that involves cash.

The income statement can have information about unsustainable income, one-off charges, etc. Some of these will affect cashflow, although the cash might not be collected or paid yet.

Some of the searches above will often lead to the same information.

Note anything which might be suspicious and see if there’s a good reason for anything odd.

I don’t mean the rest of the form can be safely ignored. Please feel free to copy this part for reference if you like.

Revenue and receivables

It’s generally easier to spot earnings manipulation when cash is not manipulated, as a non-cash asset on the balance sheet is likely to bulge, or (less often) a non-cash liability will shrink. If all the company does is to use inducements to stuff the sales and distribution channels, with easy returns and long payment periods, the fakery in the income statement shows up as increased accounts receivable, and revenue not matched by cash flow. If they also sell receivables (at a discount) with recourse (keeping the liability when the cash isn’t collected), the receivables are kept at a reasonable level and the figure for cash from operations gets closer to the revenue figure (find “When Peregrine booked”, above). The balance sheet bulge and the cash shortfall disappear, and to find the manipulation, you have to find disclosures about the sale of accounts receivable and the sources of cash. See “Where to find cash info” above.

When a company has more cash than its liabilities and OCCs, and generates cash, management might be under less pressure to create fake revenue, or to sell receivables to hide the effects of fake revenue, but it’s still possible that management could do this to meet expectations or trigger bonus payments. The practice would not help a company to pass the cash3 test 1, because the increase in cash held would be matched by the obligation to pay when the receivables sold aren’t collected.

That check fails when the good part of the receivables is sold without recourse. This means that the buyer (usually a bank) is satisfied with the credit-worthiness of the customers, and the terms regarding collection, and if a customer doesn’t pay on time, the bank suffers the loss, with no recourse to the company. In this case, there is nothing in the cash3 test 1 calculation which directly identifies the manipulation or compensates for it. The extra cash held is real, and there may be no extra cash obligations. The company could fail part of test 1 (“no accounting policies that cause significant doubt about the cash figure.”), due to its revenue recognition policy, or the terms offered to customers. Those terms are not officially an accounting policy, but they can signal the problem I’ve described. Check for a recent loosening of revenue recognition or terms offered to customers.

If the problem described above is not picked up in test 1, it should be picked up in test 2, “Cash from operations has to be positive and generally bigger than the cash that goes into investment.”, and test 3, that the excess cash flow should grow (see “Use information found already or found later”, above). That’s because selling receivables is not a sustainable cash flow. Look for sales of accounts receivable. See “Where to find cash info” above. The next step is to add the receivables sold to the receivables remaining, and see if the Days Sales Outstanding (DSO) calculation (below) gives a higher than usual figure. If there are different categories of receivables, make sure they’re all included. Likely categories are current or billed, accrued or unbilled. and long-term or installment. Then, if for example the total receivables (sold plus remaining) is $100 million higher than would be expected if DSO had stayed the same, subtract $100 million from the revenue and from cash from operations, to get figures adjusted for excess receivables. In some cases it’s reasonable to decide the company is not a safe investment, and finish the investigation without making all the calculations. Otherwise, bear in mind the company’s policies and the adjusted figure for cash from operations when making tests 2 and 3.

Days Sales Outstanding or DSO is usually calculated with the formula:

DSO = Number of days in the period * Receivables / Sales in the period

For a quarter, that’s usually DSO = 91.25 * Receivables / Sales in the quarter.

If you can’t remember the formula, these are closer to common sense:

Sales per day = Sales in the quarter / 91.25
DSO = Receivables / Sales per day

or replace the first formula with:

Sales per day = Sales in the year / 365

The result is more reasonable when any week in the quarter is just like any other week in the quarter. Otherwise, $100 million of receivables could be 90% dating from the last week in the quarter, or 90% dating from the first week of the quarter. Although that’s an extreme possibility, for the same level of sales, the two cases would give the same result for DSO, even though the collection of cash from the customer has already taken many days longer in the second case. In practice, a big jump in calculated DSO is a red flag that needs looking into, but it could be reasonable for a company with lumpy sales, after making a big sale late in a quarter.

It’s a similar situation when companies encourage customers to swap a bill from the company for a loan to the customer or a security from them, which could appear as investments instead of in Accounts receivable. This is hard to detect. See “Where to find cash info” above, particularly the search for “promissory”, “trade” (trade accounts), and “notes receivable”.

Ideally, the change in obligations, commitments and contingencies (OCCs) between the start and end of the accounting period, would be looked into and calculated, and a big jump would need investigating. Unfortunately it’s a lot of work to calculate OCCs, and I don’t think finding them twice for each company is practical for many investors.

Quarterly manipulation cycle

It’s possible that the “Liquidity and Capital Resources” section could reveal a pattern that repeats each quarter, which minimizes the appearance of being short of cash. I can’t find a confirmed case, so this is hypothetical, and could be more extreme than anything you are likely to see.

1) Buy inventory at the start of a quarter and run it down, aiming to end the quarter with as little inventory (and as much cash) as possible.

2) Offer customers terms that allow payment near the end of the quarter, until the payment period becomes unreasonably short.

3) Payment of suppliers might as well be prompt at the start of a quarter, or early if a discount is offered. Further on, delay payment until the start of the next quarter.

4) Near the end of the quarter, offer attractive terms to customers, including payment near the end of the next quarter.

5) Near the end of the quarter, sell receivables (at a discount, or no-one will buy). The best quality receivables could be sold without recourse. Selling receivables with recourse allows more to be sold, but some investors will spot “with recourse” and realize that the transaction is a loan dressed as a sale.

The cycle boils down to three end-of-quarter aims: getting cash in, not letting cash out, and booking revenue even on poor terms. Because business operations can be conducted fairly normally for much of the quarter, there is less damage than if the company operated a cash-starved regime all the time.

The maximum distortion actually requires cash to fund it, and as the companies under the most pressure to distort won’t have the cash, you might never see maximum use of all five items at once. They still illustrate some of the methods and principles of an area of manipulation.

The possibilities show how the accounts provide limited information. Because accounts don’t show the action within the quarter, investors can’t always understand the flows from the income statement and the cash flow statement, or understand the balance sheet ‘snapshot’ fully, when they only read the accounts. The flows reported are sums over the period, and the balance sheet only shows the state at the end. The problem with both is that management know the dates. A balance sheet taken on a random date could not be manipulated in this way, but that’s not a practical proposition.

You won’t see anyone admit they manipulate inventory to report higher cash and low inventory in the quarterly accounts, but you might see a disclosure that higher cash and low inventory were the result of the company’s business cycle. A genuine quarterly business cycle only seems likely when a company’s customers have a quarterly business cycle.

Diverting cash flow from investment to operations

There are ways for management to divert cash flows into the category they prefer. If a shipping company sold a ship and recorded the sale as revenue, when the cash came in it would contribute to cash from operations, when it’s really cash from investment. That would be serious enough to disqualify the company from being ‘cash3’, even if the tests would be passed if the error was corrected. The transgression might be found by finding a disclosure about the sale of the ship, rather than by finding an accounting policy that allowed the practice. See “Where to find cash info” above.

Diverting cash expense to investment

This can be done by simply capitalizing an expense such as R&D, turning it into investment and inflating cash from operations. A more complex method involves ’roundtrip transactions’ where revenue or cash comes back to where it started, through reciprocal purchases, or “You buy our stuff and we’ll buy yours.”. This inflates revenue, but the unwanted purchase can then be classed as investment. It wouldn’t be practical to take delivery of anything bulky or toxic, but unwanted software is an ideal purchase when a company wants to disguise funding a customer’s purchases as legitimate investment. Sales, cash from operations, and investment are all inflated, but the dodge can’t create an excess of cash from operations over cash into investment (one definition of free cash flow). See “Where to find cash info” above. In my cash flow walk charts, reciprocal purchases would move a point ‘north east’, but would not affect the free cash flow shown (which is how far up minus how far right a point is, when the axes are scaled equally). That would stay true even if a ring made detection harder (A sells to B sells to C sells to A).

Diverting cash investment to finance

A particularly devious trick inflates the excess of cash from operations over cash into investment. Imagine a car-hire company which buys cars and pays in installments over a few years. The payments are classed as repayment of debt, and reduce the net cash flow from financing. There’s no outflow that reduces cash from operations, or increases cash into investment, and the effect is to increase cash from operations (if the car-buying would have been an expense), or to decrease cash into investment (if the buying would have been an investment). Either way, the practice fakes-up an excess of cash from operations over investment.

The trick can usually be ruled out as a serious concern when the amounts under Non-cash transactions are small. Anything like “Demonstration units transferred from inventory to other assets” is OK as it’s an internal transfer with no cash to pay in the future.

If you see “contingent consideration” there, it should be OK, as any payments shouldn’t be classed as debt repayments or go under the financing heading. These are usually part of the terms of an acquisition where extra payments are made if targets are hit. Possible targets include sales and R&D milestones such as a successful clinical trial.

The trick tends to be used when purchasing intangible assets such as intellectual property and contracts. It’s possible that the rights to a drug which hasn’t completed clinical trials could be bought in installments, combined with milestone payments, so “contingent consideration” isn’t necessarily a complete ‘all clear’.

Genuine revenue or profit-sharing partnerships are OK, for instance if a patent troll monetizes a patent with a “you give us the patent, we’ll split the royalties” deal, because it would look odd if the payments were treated as repayment of debt.

The Non-cash transactions will often be part of the “Consolidated Statements of Cash Flows” and nowhere else, but could be mentioned in a Note to the accounts under something like “SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION”. In the Note, look for “long-term” in front of “obligation” or possibly “commitment” or anything that boils down to paying much of the price over a few years, with unconditional or minimum amounts. Big amounts, and repeated use of a dubious policy, magnify any red flags.

When significant expense or investment could be diverted into finance, my cash flow walk-charts may be less reliable. Below I argue why the charts will still be good when the cash3 test 1 is passed with a big excess of cash, and the company has had substantial growth. If the installment obligation is big enough, the company will fail my cash3 ‘test 1’ anyway. When the policy is obviously dubious and the amounts are significant, it will usually not be worth continuing the investigation. If there’s doubt, the free cash flows need to be confirmed by evidence that the company could have accumulated the cash.

Confirming growth of free cash flow with ‘before’ and ‘after’

It’s blindingly obvious that CPU-maker Intel has grown enormously since it was a start-up, and the growth couldn’t have been all due to fakery. While obvious, it’s not a directly useful observation because it doesn’t say anything about the last five or ten years, and companies can go bad. Fortunately, the argument can be scaled down to shorter periods. There’s no fixed period here, because ten years of 20% growth p.a. might be as hard to fake as 30% p.a. over five years, and there are other factors like how much of the growth was organic (as opposed to through acquisitions). The argument is tightened by looking at free cash flow per share. Here are two statements:

1) The company is bigger, better, and better per share, than it was several years ago.
2) Free cash flow per share has seen high growth over the same period as in 1).

When each statement seems to be reliable, they confirm each other. See “Ubiquiti’s big size change” below, for an example.

Customers request …

Think about anything which “customers request” if the main impact is financial or on the accounts, because “customers request” is a multipurpose excuse. Consider if the accounts would be distorted if the company was pushing the option on to customers. If customers are requesting delayed payment or financing, they could be in poor financial shape and likely to default, or the company could be offering generous terms to make up a sales shortfall, and claiming falsely to be responding to customers’ requests.

Unsustainable cash flows

The “Net cash provided by operating activities” is usually arrived at through a reconciliation where Net income is adjusted to give the cash from operations. This should include changes in non-cash working capital items such as inventories and accounts payable. When the non-cash working capital goes down, there’s a contribution to cash from operations. That might indicate increased efficiency, and the cash gain could be repeated in the next period, but it can’t be repeated indefinitely (except in a few business areas where negative working capital is normal). Therefore the cash gain shouldn’t be regarded in the same way as a cash gain which dropped down from revenue growth.

Some of Ubiquiti’s recent cash flow increase has been due to lower days sales outstanding. Management expect DSO to return to the higher target range. I adjust the latest quarter’s cash from operations under “Ubiquiti Networks – test 2 and 3”.

Asset sales such as selling subsidiaries or real estate can’t be repeated indefinitely. Such sales ought to reduce the cash flow into investment, which increases free cash flow (by the ‘from-ops minus into-investment’ definition), and investors who don’t identify the source won’t realize the free cash flow is unsustainable. The investing cash flows should be broken down to categories like “Purchases of property, plant and equipment” and “Acquisition of businesses, net of cash acquired” under a heading like “CASH FLOWS FROM INVESTING ACTIVITIES:” in the cash flow statement. Also see “Where to find cash info” above.

Disclosures missing from the cash flow statement

The income statement can’t be ignored because disclosures could appear in the income statement and not in the cash flow statement. This includes sources of cash which are one-off or unsustainable, such as jury awards. For other places with info about cash, see “Where to find cash info” above.

The problem is that in practice, cash from operations is calculated by adding non-cash charges back to Net income and subtracting non-cash gains from Net income (a reconciliation known as the ‘indirect method’), rather than itemizing and summing the cash inflows and cash outflows (the ‘direct method’). Investors who aren’t careful won’t realize when an increase in cash from operations is not sustainable.

In 2004 Microsoft settled an antitrust case and paid Sun Microsystems nearly $2 billion, $1.6 billion of which went into Sun’s Net income. In Sun Microsystems’ 10-K for the year ended June 30, 2004, if you search for “Settlement income”, it’s clearly stated as $1,597 million in “ITEM 6. SELECTED FINANCIAL DATA”, which is what they called their income statement. There, it’s obviously a one-off, and if an investor saw it and didn’t know what it was, searching for “Settlement income” would easily find the explanation. That’s all fine, but there’s no mention of the settlement in their “CONSOLIDATED STATEMENTS OF CASH FLOWS”. At the bottom of the cash flow page, the “Supplemental disclosures of cash flow information” includes the payment of $26 million net interest, but there’s still no mention of the $1.6 billion settlement.

An investor who only looked at Sun’s cash flow statement wouldn’t realize that $1.6 billion of the $2.2 billion cash from ops was a one-off from the settlement. The pitfall wouldn’t exist if companies used the ‘direct method’ where the sources and uses of cash would be listed, but that’s not going to happen.

The information needed could be hidden in a footnote. IBM sold their Global Network business in 1999, and the $4 billion sale was somehow included as a reduction in their Sales, General and Administrative expense. That inflated their Net income. See “IBM’s Accounting Tricks” By Whitney Tilson, February 20, 2002 (fool.com). I haven’t checked IBM’s cash flow statement, but if any company pulled that trick and received cash in the same period, there would be no non-cash gain to subtract from the Net income when arriving at cash from operations.

Unsustainable cash flows in a chart

Any unsustainable cash flows in a period, wherever they are disclosed, would affect the period’s point in a chart showing cash flows, but it’s less likely that free cash flow growing over several years could be the result of a series of increasing ‘one-off’ gains (see “Confirming growth of free cash flow” above). A thorough check would be to read the relevant parts of several previous 10-K forms. That’s a lot of work, and there might be less need for it when rising free cash flow is broadly matched by Net income, or when the operations and investment cash flows in the latest 10-K and 10-Q aren’t dominated by one-offs or unsustainable sources. Look for positive items under “Cash Flows From Investing Activities” or negative items under “Cash Flows used in (provided by) Investing Activities” (the heading varies), then check the income statement for one-off gains, and then it’s most of the rest under “Where to find cash info” above.

Once found, it’s usually obvious that unsustainable cash flows coming in are unsustainable, but I’d be wary of adjusting for frequent one-off or temporary cash flows in the other direction, at least until I found a good reason like exiting the business area that threw them up.

The trouble with underinvestment

Defining free cash flow as cash from operations minus cash into investment, management can create rising free cash flow by under investing, with consequences later when they fall behind the competition. Research and Development is usually accounted for as an expense, and cutting the R&D budget increases free cash flow through cutting the expense. The same consequences flow later if they fall behind the competition. You need to know there’s a good reason for cutting either investment or R&D. Repligen’s R&D cost has fallen due to the recent focus on bioprocessing and cutting the R&D in other areas, by reducing the R&D in each area until a partner is found who will fund it. So long as Repligen don’t underspend on R&D for bioprocessing, the increased cash flow is a positive result.

Poor capital allocation

British retailer Tesco plc invested heavily in large out-of-town stores. Then they invested overseas and neglected the domestic operations. Tesco have since pulled out of Japan and the U.S.A. They used to be the most successful British retailer, but now many of their stores in Britain are too big and in the wrong place. With hindsight, if Tesco had returned cash to shareholders instead of committing to expansion in Japan, China and the USA, it’s likely they would have managed their domestic operations better. This shows:

1) Success can fade due to poor capital allocation (even when a chart objectifies a history of success).
2) Low investment and low management attention can undermine the ability to adapt (as for the British stores).
3) Low investment can undermine a business segment even when total investment is high.

Investors need to be sure that a new direction or the next stage of expansion will produce a sufficient return on cash, rather than be a permanent cash drain, even when the market thinks management can walk on water.

Readers Digest may have followed a similar path, annoying readers with intensive marketing while neglecting their core magazine, although it was probably going out of fashion anyway.

When all the cash from operations is reinvested

A company which reinvests all its cash from operations can be worth buying shares in, but it’s not as clear as when there’s a positive and growing excess of cash from operations over cash into investment. There might be more clarity if the investment is in marketable securities, real estate or anything with a more reliable value than acquisitions or capital equipment. Otherwise, as a minimum, total reinvestment should generally produce obvious and high sales growth over at least a few years.

Sometimes companies have low capital expenditure needs, and investment is hard to distinguish from expense, for instance when new sales staff are hired and it takes a few years for them to build relationships and reach a normal level of sales. Then, total reinvestment looks like revenue growth which is not matched by income or cash from operations (like Enron Corp.’s results, but they were faking, not reinvesting).

In both cases, one question to ask is, could the company make a profit and have net cash coming in, by reducing the investment. Sometimes there’s a race to be the biggest, when there are economies of scale such as a network effect, and reducing investment would risk losing the race. That’s a subject in itself, but probably more knockouts are delivered by the model than in a race between near-equals. It can pay to bet on the winner, even if the company invests heavily to get ahead, but IMO it’s generally safer to invest in a cash3 company, provided it isn’t in such a desperate race or isn’t likely to lose.

Other considerations

Here I ignore the common and obvious considerations such as financial ratios and different approaches to valuing a company, which are well covered by many sources. I’m not saying that investors should ignore conventional measures, but they are more likely to be in the share price already, and I give links for getting up-to-date Altman Z scores which indicate bankruptcy risk. My list is generally unorthodox and I don’t know of any data which might support it, although some items such as related-party transactions feature in writing about fraud.

The headings I use for each company are:

Off-balance sheet financing and special purpose entities *
Cash and cash equivalents definition *
Short-term investments definition
Revenue recognition *
Audits of internal control over financial reporting *
GAAP only
Related-party transactions
Useful life (that physical assets are depreciated over)
Visual exaggeration in charts
Potential CEO dominance
Poison pills and severance

* Items marked like this * are logically part of the cash3 test 1, but it’s convenient to have a single list of the qualitative things to hunt for in the SEC filings. The Short-term investments definition does not relate to cash3 tests but it’s easy to check while checking the cash definition.

Off-balance sheet financing is included in test 1, but it belongs here with a different focus. The question here is, are management trying to hide liabilities.

The checks might seem over-cautious or distrustful, but I like to know when I’m speculating rather than investing. Warren Buffett has said he has no more good ideas than other investors, just fewer bad ideas, and that’s motivation for finding unattractive indications in areas where management don’t expect investors to look.

The likely result of these checks is to show that a good company is well off being perfect. Digging for dirt is probably more interesting for short sellers, who can pick companies likely to be hiding plenty of it. It’s less fun when you check a cash3 candidate while hoping there’s little to find. I think of this stuff as the company undergrowth, which I see as in-between the main accounts and scuttlebut.

GAAP only

GAAP is Generally Accepted Accounting Principles.

non-GAAP is more or less whatever management prefer, usually omitting stock-based compensation and some ‘one-off’ items. The non-GAAP ‘EBITDA’ measure is Earnings Before Interest, Tax, Depreciation and Amortization. Non-GAAP metrics usually make earnings look bigger or smoother.

There are some limits to non-GAAP, as the SEC objected to Delphi Corporation’s misleading non-GAAP “Operating Cash Flow”, but that’s a rare case and the SEC might not have bothered if Delphi hadn’t committed other offenses.

While non-GAAP measures have their uses, I believe that one of those uses is to frame the information that investors use to evaluate the company, in the same sense that a stage magician frames the audience’s attention. Some managements risk manipulating GAAP quantities, and it’s likely that there’s more deception in non-GAAP measures where management can use the definitions they find most convenient, with little risk from regulators. Argument about non-GAAP metrics is unlikely to be resolved soon or by facts. I haven’t checked for changes in the non-GAAP metrics, and it signals trouble when management change the ruler so they can read off the number they want. Out of the first three companies I’ve identified as cash3 possibilities, two (IPGP and RGEN) stick to GAAP, which is intriguing, although a sample of three is too small to draw a conclusion. Ubiquiti’s non-GAAP only excluded stock-based compensation and a tax adjustment, which is minor compared to many companies, such as door maker Masonite International (for example) who’s Adjusted EBITDA magics loss into profit with a long list of exclusions.

Ubiquiti’s older non-GAAP reconciliations had higher share counts which are more accurate when used to calculate fully diluted per-share quantities. Find “higher share counts than are used in the income statements” below. This shows that useful information can be put in the reconciliation, although IMO it would have been better to include fully diluted figures in the income statement.

Related party transactions

Check related party transactions for anything big and suspect. There could be more information in a Schedule 14A filed with the SEC. There ought to be a policy for conducting ‘arms-length’ related party transactions. You want to see something like:

‘… which were ordinary course of business transactions conducted on an “arm’s length” basis with the Company …’

for each material related party transaction.

Useful life

Checking the ‘Useful life’ assumptions in the 10-K could reveal manipulation of earnings by under-depreciating physical assets. I’m less interested in the Useful life of buildings, as this is long and variable, and the condition of some buildings can depend on design and maintenance rather than age. ‘Useful life’ doesn’t affect cash, but it’s a quick and easy check for aggressive accounting.

Visual exaggeration in charts

Designed to mislead

I like to see if a company’s charts are an insult to the intelligence of investors. The exaggeration is not a crucial or a conventional indicator, but I can’t help noticing it anyway when I look at a presentation. Charts in presentations often give an exaggerated impression of growth by starting the Y-axis well up from zero, and when only two vertical bars are shown, a one percent rise in the figures can be a massive rise visually, limited only by the number of vertical pixels used.

Door maker Masonite International are far from being cash3, and they have a chart which makes a 25% rise look like a 247% rise. (I counted the pixels and did the math.) You can get the truth by reading the narrow-font numbers on the chart, but if you have to do that, what’s the point of the chart? The chart is for Adjusted EBITDA, on page 12 of the Q2 2013 Earnings Presentation Final pdf. You’d think that all the exclusions in Adjusted EBITDA would be enough, but apparently not.

For comparison, I checked a presentation from IPG Photonics (Needham conference, August 2013), and of the 16 charts with a Y-axis, every one of them starts with Y set to zero where it meets the X-axis. Apart from one minor offense by IPG Photonics, I haven’t seen any misleading charts for the three possible cash3 companies, although in Ubiquiti’s case, I didn’t find any charts with axes to fiddle.

Potential CEO dominance

By ‘Potential CEO dominance’ I don’t mean a CEO who is overbearing personally, which I wouldn’t usually know about. A CEO who is a founder, long serving, has seen the company through a crisis or a period of high growth, has high ownership, or holds too many offices such as chairing the company or also being the CFO, is more likely to be hard to disagree with, and able to get their own way when they shouldn’t, although they might never take advantage of their excess power. When they’re good, there’s a ‘key personnel’ risk, especially when they’re old.

In my own experience, companies with potential CEO dominance have generally done well (Acacia Research was an exception), but that’s based on a small sample.

One risk to watch out for when the CEO is very dominant, is the CEO becoming more interested in a ‘new baby’ or smaller company which allows the CEO to revert to a more entrepreneurial style. It could be more than just the CEO’s attention that walks. Key staff could move, and I’d pay close attention to related party transactions and anything that affected both companies. I see no immediate cause for concern for the three companies I’m writing about, but it’s generally a risk to watch out for rather than a risk that can be ruled out for years ahead.


Nevada, Delaware and sometimes Wyoming are supposed to offer greater secrecy and tax advantages to companies incorporated there, than other states. Delaware is popular for many kinds of company, and this article argues that it’s not a particularly lax state for company registration, although incorporation is quick and easy.

Nevada ups the ante on Delaware’s tax status” by Michael Knigge, April 16 2013 (dw.de).

IPG Photonics, Repligen and Ubiquiti are all incorporated in Delaware.

Going by the last two paragraphs of the article, incorporation in Nevada is a huge red flag to investors, as company officers and directors have major exclusions from liability when they don’t act in the interests of shareholders. (That applies to the company you invest in rather than the subsidiaries they own.)

The article is light on the Delaware laws that allow anti-takeover provisions.

When states compete for incorporation business, it’s about tax advantages, ease and speed of incorporation, and allowing management to get away with more. Imagine that competing to make management more accountable gained more incorporations, and you’re imagining a very different world where shareholders have more power.

In practice, checking ’14A’ forms and finding disclosures about the Certificate of Incorporation and the Bye laws, is likely to be more useful than just finding the state of incorporation, although it’s a lot of work and you’re likely to find that a company is as bad as most (see ‘Common failings’, below). Searching a 10-K for ‘Delaware’ or whichever state, can turn up some of the things that a company doesn’t brag about.

This article shows how complicated the legal situation is, if nothing else: “Delaware must fix state takeover law now, law professor warns” by Frank Reynolds, Nov 26, 2013 (blog.thomsonreuters.com)

Searching a 10-K for “Incorporation” sometimes finds ‘get-outs’ that undercut claims about the standard of governance, such as IPG Photonics being able to have a board with only one director.

Poison pills

Technically, it’s the broader category of anti-takeover provisions that I look at, although I find the provisions poisonous enough.

The provisions are usually triggered when a shareholder accumulates a set percentage of the company’s shares, normally in the range 15% to 25%. When the provisions are triggered, the board is typically authorized to issue stock (usually preferred stock), and the stock won’t be issued to the shareholder who triggered the provisions. Various provisions make the board unaccountable to shareholders, and there can be a provision requiring a ‘supermajority’ to change the provisions, meaning that 51% of shareholders won’t be enough.

Two academics show evidence that companies with more anti-takeover provisions are likely to be more transparent and more honest about earnings (providing the market with more information, and with higher earnings quality, one measure of which is Cash from Operations / Net Income). “Anti-Takeover Provisions and Corporate Disclosure” by Huijing Fu and Mark H. Liu, May 2008 (gatton.uky.edu). That’s different from the effect on shareholders if the poison pills are taken, and the paper doesn’t show that the provisions encourage good management in other ways.

Anti-takeover provisions might limit the influence of activist shareholders (Wikipedia), because without voting power all they can do is litigate and irritate, but I can’t find evidence. The activists seem to be popular with investors, and I approve when they want to cut undeserved CEO compensation, or fix other wrongs, but they can want a short term gain that could cause long term damage, such as cutting R&D. Some investors are hoping that an activist will make big data company Tibco Software Inc. spin-off the Business Optimization unit, with the corporate engineering needed to preserve the software stack. I prefer management to stay focused on strategic issues and the details that matter without distractions.

This is a short balanced piece about the inventor of the ‘poison pill’ challenging supporters of activism: “Lipton Takes on Bebchuk over Shareholder Activism” by Gregory J. Millman, September 30, 2013 (blogs.wsj.com). My opinion is I’m not convinced by pro-activist statistics, or by assertion from the opinionated poison pill inventor. Management can be self-serving but care about the long term, while activists can want a short term profit that some investors are happy to share. An activist is no substitute for good management.

I haven’t found any good examples of shareholder losses due to anti-takeover provisions being triggered, probably because the provisions effectively deter hostile takeovers. The cost to shareholders will be the cost of entrenched management, with the power to negotiate agreed takeovers that suit themselves if they want to. I also believe the anti-takeover provisions and the policy on indemnification of officers, directors and others, says something about management’s attitude to themselves and shareholders.

There’s more under “Anti-takeover provisions against shareholders’ interests” and to be found by searching for “Poison pills”.

Severance payouts

It would be consistent to include the maximum possible severance payouts in the obligations, commitments and contingencies, but I don’t think it’s a good idea in practice. I believe the severance terms for executive officers are worth checking, mostly to see if they are excessive in the event of the company being acquired, and I use the sub-heading ‘Poison pills and severance’. In the case of Costa, Inc., payouts relating to management incentives were at least big enough that an author felt the need to explain the effect on the offer price. The article is now behind the ‘Alpha Rich’ paywall. “Costa Buyout Price Is Too Low, Fair Value $24-28” by Dr Hugh Akston, Nov 11 2013 (seekingalpha.com).

Choose your factors

There are many other factors which could be considered, and investors are likely to have their own favorites.


It’s possible that when a company ticks the cash3 boxes, some non-cash quantities in the accounts are not quite as important, at least in comparison to companies with net debt, negative cash from operations, or negative free cash flow. Bear in mind that ‘one-offs’ adding to cash from operations will probably be disclosed in the income statement and not in the cash flow statement. Ratios like the quick ratio or current ratio don’t seem relevant to cash3 companies, and the quality of earnings ratio (Cash from Operations / Net Income) looks less relevant. However, I’m wary of saying that anything can be safely ignored, even though investors have limited time, because in the worst cases management can be very slippery.


I’ve quoted some risks from Form 10-Ks in my writing about companies below. The risk section of a 10-K usually contains a tedious list of every possible eventuality, and readers need to decide if I’m making too much of the risks I quote. Something I haven’t done, purely because I don’t have the time to do everything, is compare each company’s risk lists to earlier versions. A new risk or an amended risk could signal trouble, if it isn’t obviously reasonable, but I think you are more likely to see the risk-change red flag for a company with cash trouble than for a company which is cash3 or not far off.

About gurufocus’s scores

There are links to gurufocus for each company. I once happened to notice their scores changing a lot over a weekend without any news I could find, although it was for quite a small and controversial company with an OTC listing (Ecosphere Technologies). I suggest checking the chart at the bottom for the M-Score and Altman Z score, as well as the number. They also have an explanation of the M-Score. The service is free but you can’t do much without getting a sign-up page which you need to close. I also think they are probably too enthusiastic about red flags, which you can’t find out about without signing up.

Common failings

Wide indemnification

Find “There are two main kinds of indemnification” for a general description of companies’ indemnification. If needed, refer to “Forms filed with the SEC (Securities and Exchange Commission)”

IPG Photonics and Repligen seem to indemnify anyone and everyone for everything, and hold no-one liable for anything, then put in exceptions, then complicate it. Sometimes the indemnification looks simpler and more reasonable in a 10-K than on other SEC filings (usually S-1 forms, sometimes when they have the Certificate of Incorporation), but I don’t feel particularly reassured by the 10-K. If the end result is that management can do what they like without personal consequences, it doesn’t stop companies from bragging about high standards of governance. See ‘IPGP – Indemnification’ below, for how indemnification can be so extreme that it might not be enforceable. IPG claim:

“We believe that these provisions, the indemnification agreements and the insurance are necessary to attract and retain qualified and experienced directors and officers.” (S-1 SEC filing, November 14, 2006)

I found no evidence of such insurance in IPG’s latest 10-Q and 10-K filings.

Ubiquiti’s indemnification looks wide enough, but unlike the other two, apart from business partners such as distributors and OEMs (which is reasonable and necessary), they seem to only indemnify directors and officers, and “have a director and officer insurance policy that limits our potential exposure.” I can’t be sure the other two companies don’t have equivalent insurance just because it’s not mentioned (or I missed it) in recent 10-Q and 10-K SEC filings, but if they don’t insure, and it’s because the insurance is unavailable or very costly, it suggests that the associated risk is either very high or too hard to estimate.

While indemnities and not holding persons liable, add to the contingencies-risk, in practice it isn’t quantifiable. Statements that the liabilities have been minimal are not a reliable guide to the future, because the first big case or wave of cases will be a shock, unless the company has a very bad history. Banking is the most obvious area where the cost of managers’ lack of ethics and diligence falls on many parties including shareholders but not much on themselves. This is on advert-intensive Investopedia: “10 Most Shameful Bank Scandals Of 2013” By Investopedia on December 31, 2013.

This famous case shows how impulsive management can be: “Head of AOL fires employee during conference call” By Jena McGregor, August 12, 2013 (washingtonpost.com).

This is old, British, and about a private company, but it’s relevant because while the gaffe nearly sunk the company, it was not committed in bad faith, and illustrates the kind of disaster that would not be excluded from indemnification: Gerald Ratner (Wikipedia) made disparaging comments about his jewelery firm’s products, not realizing how much publicity he would get. His remarks included that some of the earrings were “cheaper than an M&S prawn sandwich but probably wouldn’t last as long.”.

Companies claim that indemnification is needed to attract quality, but somehow much of private equity gets along with the low quality people they have to make do with as a result of offering less indemnity. See “For Executives Seeking Absolution, a Double Standard” By STEVEN M. DAVIDOFF, November 23, 2010 (dealbook.nytimes.com)

Anti-takeover provisions against shareholders’ interests

IPG Photonics and Ubiquiti Networks have anti-takeover provisions that seem potentially bad for shareholders, beyond the effect of deterring acquisition attempts. It’s not clear if Repligen Corporation replaced the anti-takeover provisions in their Shareholder Rights Plan which was due to expire last year. Anti-takeover provisions MIGHT work out well if a 15% stake results in all the other shareholders getting stock, which effectively takes some of the 15% ownership and spreads it around. But, I haven’t seen anything that I would like to rely on, to indicate anything other than potential harm to the interests of ordinary shareholders.

Readers with the time and interest can use links I provide to start looking into the indemnification and anti-takeover provisions.

Loose definition of Cash and cash equivalents

IPG Photonics say “Cash and cash equivalents consist primarily of highly liquid investments …”. The ‘highly liquid investments’ get a safe definition, but what does ‘primarily’ mean in practice? Would the person responsible have any regrets if ‘primarily’ turned out to mean 51%, or 50%, or 49%? Probably not, because if there isn’t enough wiggle-room in the word, everyone is indemnified and no-one is held liable, as above. IPG’s short-term investments have ‘remaining maturities greater than three months’, in other words they might not be short-term at all and still meet the definition. IPG bought $25.5 million short-term investments in 2011 and they matured in 2012, so they weren’t long term, but the definition still leaves leeway for future use. I give IPG the benefit of the doubt because they seem reasonably honest by other measures, but there’s room for opinion.

Ubiquiti also use “primarily” in their definition, and leave a loophole (see “UBNT – Cash and Cash Equivalents definition” below).

Repligen at least say “high credit ratings” without fudging the issue with “primarily”, but there’s no information about maturity or what exactly the “financial instruments” are. See “RGEN – Cash and Cash Equivalents definition”.

Companies seem incapable of just saying what cash and cash equivalents are, and that nothing else qualifies.

It’s cash3. What’s next?

After all the research, an investor should have a good understanding of the company, and if anything bad enough had been found, the research should have been stopped.

A summary like the ones I’ve made for each company might be useful.

Apart from saying that valuation needs to be considered, I don’t want to tell anyone how to make their investment decision.

At this point, it’s worth thinking about asset sales that would add value. The assets could be unused or underused real estate, or part of the business that could be spun off. The critical factor here is that the capital could be allocated better, and there should be a reason to expect the reallocation to happen, or a rough estimate of the probability (as in possible, likely, probably etc.). The same principles apply to possibilities other than sales, such as employing the assets in joint ventures or licensing technology.

Another category that can add to the value of a company is ‘spare liquid assets’ such as marketable securities. Assessing the value added means deducting the value of any income the securities produce from the market value, or possibly an estimate based on the likely return if the cash was reinvested in the business, including buying back shares. Marketable securities don’t need a catalyst or a plan to have their market value, and anything else sufficiently liquid to have that characteristic can be included in the ‘spare liquid assets’ category if it could be sold without affecting the normal business operations.

Obviously these considerations would be too restrictive for companies focused on the value of assets such as real estate, but those companies aren’t going to be ‘cash3’. The considerations exclude the value of capital assets used in normal business operations, such as machinery. I explain why with a model –

Suppose companies A and B have results as identical as possible, except that company A has $1 billion of plant, property and equipment (PPE) while company B only has $1 million of PPE, and for both companies all the PPE is needed for production. Company A has the biggest liquidation value, but for growing businesses the liquidation value is (hopefully) irrelevant (except for the ability to provide collateral for debt). Company B’s advantage is that it can expand production with much less capital.

If you don’t agree about the potential of that advantage to translate into growth, see the walk charts under “Ubiquiti Networks – test 2 and 3”. There are counter-arguments, such as high capital costs are supposed to deter entry (although steel, shipping etc. regularly have over-capacity). If IPG Photonics had a vast land bank they could sell, I’d be interested, but if the fair value of all IPG’s PPE increased by 20% next year, there wouldn’t be much cash benefit, and if the increase was the result of general global price movements, expansion would be more expensive and reduce the return on investment.

IPG would have got nowhere without high capital expenditure, and capex increases the PPE value, but it’s even better when high growth can be achieved with low capital expenditure, which IMO is why a high PPE can’t be assumed to add to the fundamental value of a company.

If company C was like my hypothetical company B except it owned and used a building worth $50 million, and could move to a cheaper building costing $20 million without affecting its business except for $1 million moving costs, then it’s potentially worth $29 million more than company B. How you include or discount the the $29 million is another matter, but you’d need to know how likely the move was to actually happen.


IPG Photonics Corporation (IPGP)

Share price $74.23, Market cap $3.8 billion, Price/Earnings (ttm) 25.3, No regular dividend. As at January 17, 2014. The figures are approximate.

IPG sell lasers and laser systems. In “IPG Photonics – growth, cash, markets and technology” September 27, 2013, I looked into their long term cash flows, and their liabilities, obligations, commitments and contingencies.

To get up to date to 3Q 2013:

IPG Photonics Reports Record Revenue Achieved in Third Quarter 2013
IPG Photonics’ SEC filings (ipgphotonics.com)
IPG Photonics’ CEO Discusses Q3 2013 Results – Earnings Call Transcript” Nov 1 2013 (seekingalpha.com)

Read this if you like but I don’t think it’s very relevant “Insiders Are Selling IPG Photonics” Oct 25 2013 (seekingalpha.com)

Seeking Alpha’s “Is IPGP a buy?” page.

(“IPG Photonics – Power To The Last Mile” is a Seeking Alpha ‘pro’ article, for subscribers only.)

Beneish M-Score for IPG Photonics (IPGP) (gurufocus.com)
Altman Z score for IPG Photonics (IPGP) (gurufocus.com)
See “About gurufocus’s scores” above.

IPG Photonics have grown mostly by developing fiber lasers for industrial use. Competitors were skeptical about the progress of fiber lasers, but have been forced to reconsider and develop their own fiber lasers in recent years. IPG have the advantage of a high degree of vertical integration. One growth area is high power fiber lasers, where IPG are rapidly increasing the power. Although the power is dwarfed by super-lasers (e.g. used for fusion research), these don’t have the commercial potential of IPG’s lasers.

The seam-stepper laser system used for welding could have growing sales in automotive production, with the advantage of not needing an expensive light-tight safety cell. IPG expect good demand for new ultraviolet lasers with semiconductor-related applications. The company has supplied lasers used in additive manufacturing for several years, with the growth of metal-based applications recently outpacing the plastics applications. Further growth is expected as IPG’s higher-power lasers are used to additively manufacture bigger metal parts.

IPG are also competing more at the low end, where cheap lasers from China are used for marking. The company expects new low cost fiber lasers to replace some YAG lasers, which are cheap to buy but require frequent lamp replacement. There are possible threats from emerging laser technologies (see my piece on this site, linked to above). IPG’s gross margin is kept in the 50% to 55% range, well above competitors’ margins.

IPG Photonics – test 1

Test 1 – More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.

From the 3Q 2013 10-Q, as at September 30, 2013, in thousands:

Cash and cash equivalents $398,355

Total current liabilities $105,807
Total liabilities $134,109

+ $398,355 Cash and cash equivalents
– $134,109 Total liabilities
= $264,246 Cash and cash equivalents net of Total liabilities

Next I see which possible future costs not already included, can be quantified and included in obligations, commitments and contingencies.

Obligations, commitments and contingencies

    IPGP – Indemnification

Wide indemnification and holding harmless isn’t unusual, but this shows how far IPG go:

“We also maintain general liability insurance which covers certain liabilities of our directors and officers arising out of claims based on acts or omissions in their capacities as directors or officers, including liabilities under the Securities Act. Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers, or persons controlling us pursuant to the foregoing provisions, we have been informed that in the opinion of the SEC such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable.” (my italics) (Form S-1 dated November 14, 2006)

In other words, IPG’s indemnification has gone so far that the SEC believes it couldn’t be enforced. While the quote is old, it’s not the kind of thing that gets updated regularly.

The only ‘insurance’ I found in the 10-K for 2012 was under “Environmental Regulation” and nothing to do with indemnification. The rest of this part is fairly standard.

From “EX-3.2 FORM OF SECOND AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF THE REGISTRANT” (sec.gov), which is old but is referenced from the 10-K for 2012:

“SIXTH: Indemnification and Advancement of Expenses

Section 6.1. Right to Indemnification. The Corporation shall indemnify and hold harmless, to the fullest extent permitted by applicable law …”

just about anyone … “director, officer, employee or agent of another corporation or of a partnership, joint venture, trust, enterprise or nonprofit entity, …”

However there are so many ‘ifs’ and ‘buts’ I lose track of whether a nested clause means more or less indemnification.

An old S-1 dated November 14, 2006, lists exceptions to the indemnity and holding harmless, for directors:


“breach of the director’s duty of loyalty to us or our stockholders, (2) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (3) in respect of unlawful dividend payments or stock redemptions or repurchases or (4) for any transaction from which the director derived an improper personal benefit.”

I can’t promise that’s still current. IPG admit:

“These provisions may also have the effect of reducing the likelihood of derivative litigation against directors and officers, even though such an action, if successful, might otherwise benefit us and our stockholders” and investors are hit “… to the extent we pay the costs of settlement and damage awards against directors and officers …”. (the S-1).

The indemnification of OEMs against third-party infringement claims is reasonable (going by the 10-K for 2012).

    IPGP – Legal proceedings

Under “12. COMMITMENTS AND CONTINGENCIES”, IPG are being sued,

“… for misappropriation of certain trade secrets, unfair trade practices, and correction of inventorship on a patent owned by the Company related to beam couplers and beam switches. The plaintiff seeks damages in an unspecified amount, double damages for misappropriation of trade secrets and treble damages for unfair trade practices. The Company has filed to dismiss the trade secret misappropriation claims. The Company intends to vigorously defend the claims. At this time, no loss is deemed probable and no amounts have been accrued in respect of this contingency.”

I can’t put a figure on the legal action, so it doesn’t feature in test 1. Nothing else is mentioned under the section.

    IPGP – Pension commitments

I found no mention of pension commitments. Only a 401(k) retirement savings plan and the employee stock purchase plan (at a discount) are listed under ‘EMPLOYEE BENEFIT PLANS’. I regard them as expenses rather than commitments, and for 2012 the 401(k) cost $848 and the benefit plans corresponded to $452 of compensation (in thousands). From the 14A dated 04/15/2013, about the top five officers, “None of our Named Executive Officers participates in or has an account balance in qualified or nonqualified defined benefit pension plans sponsored by us.” They say they might adopt a defined benefit pension plan in the future, but might only be leaving open a remote possibility.

    IPGP – Interest obligations

To get the interest obligations associated with long term debt, I use the 10-K figures to calculate the Long-term debt and subtract it from the debt + interest (in thousands):

Current portion of long-term debt $1,505
LONG-TERM DEBT = $15,519 (from adding the figures above)

Long-term debt obligations (including interest) $16,127
– LONG-TERM DEBT $15,519
= $608

which is fairly negligible.

Some of the interest on the debt is variable. Under the ‘MARKET RISK’ section, “we do not believe that a 10% change in market interest rates would have a material impact on our financial position or results of operations.”, so it’s unlikely that IPG are vulnerable to interest rate rises, especially as they have much more cash than debt. (It would be odd if they were contractually unable to pay off long term variable-rate debt without a big penalty, when they hold so much cash, although I haven’t checked where the cash is held).

Note, the figure for ‘Long-term debt obligations (including interest)’ can’t be used directly, because the debt is already in the ‘Total liabilities’ figure.

    IPGP – Contractual Obligations

From the 10-K for 2012 (in thousands):

Operating lease obligations $11,774
Purchase obligations $8,921
(commitments to buy)

From the 3Q 2013 10-Q (in thousands):

Contingent consideration $375
(payments to previous owners of acquired companies, depending on performance)

The Contingent consideration might be on the balance sheet but I saw no specific indication. From the 10-K for 2012:

“Total possible additional payouts under these earn-outs are $18,500. The Company has accrued a liability of $2,452 related to these contingencies.”.

I could say, the liability is accrued so it should already be on the balance sheet, or I could say, the most conservative estimate is the 2012 “Total possible additional” $18,500. The consideration fell massively between the 10-K and the 10-Q, and the $18,500 maximum might have fallen proportionately. I’m going to stick with $375, but feel free to adjust my figures if you disagree. The $18,500 maximum is small compared to the $242,568 ‘test 1 surplus’ I calculate (still all in thousands).

    IPGP – Quantified obligations, commitments and contingencies

See “IPGP – Interest obligations” and “IPGP – Contractual Obligations” above. Most of the sum is from the 10-K from 2012.

(in thousands)

Interest obligation $608
Operating lease obligations $11,774
Purchase obligations $8,921
Contingent consideration $375

Total obligations, commitments and contingencies = $21,678

    IPGP – Cash, net of everything quantified

To sum up for IPG Photonics (in thousands):

$398,355 Cash and cash equivalents
$134,109 Total liabilities
$21,678 Total obligations, commitments and contingencies


$398,355 Cash and cash equivalents
$264,246 Cash and cash equivalents net of Total liabilities
$242,568 Cash and cash equivalents net of Total liabilities, Obligations, commitments and contingencies

That’s over $242 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify. This isn’t easy, and please feel free to check my deductions and look for more.

See also “IPGP – Unquantified” under “IPG Photonics – Summary”.

IPG Photonics – test 2 and 3

Test 2 – Cash from operations has to be positive and generally bigger than the cash that goes into investment.
Test 3 – A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

IPG cash from ops and into investment - spread

IPG walks for cash from ops and into investment

IPG walks per share for cash from ops and into investment

The height of a point above the green diagonal corresponds to cash from operations minus cash into investment, which is one definition of free cash flow. The second set of charts are per share, because it’s easy to increase free cash flow by raising equity and investing it with a low return, but raising equity dilutes the free cash flow per share.

I would describe the competition in IPG’s markets as serious, but with IPG’s gross margin over 50% it’s hardly cut-throat on price. I don’t see any reason for the market for industrial lasers to stop growing, although any kind of equipment used in production is likely to see sharp falls in demand during major economic downturns. Therefore I see no likely reason for IPG Photonics to have negative cash from operations, or to slow to permanently below average growth of cash from operations minus cash into investment. My cash flow walk charts show positive cash from operations every year, with only one year of decline. The cumulative free cash flow was much more positive by 2012 than it was negative in 2007 and 2008. Negative free cash flow is often taken as a warning sign, or even a sign that cash flows are being manipulated, but in IPG’s case the performance after 2008 shows that the investment produced a good return.

My “IPG Photonics – growth, cash, markets and technology” September 27, 2013 (already linked to) has a table showing the compound annual growth rate (CAGR) in cash from operations per share for any pair of different years from 2004 to 2012. The growth between 2004 and 2012 is equivalent to 39.1% CAGR (compound annual growth rate), with a -60% blip down from 2006 to 2007. Growth has not tailed off, with 89.6% from 2011 to 2012.

In recent quarters, increased R&D, inventory, and SG&A have affected results. I believe that given their history and their statements, the most likely reason is that IPG are investing for growth, which is not all through capital expenditure or accounted for as cash into investment. There’s a risk that I’m wrong, and a risk that demand won’t materialize to justify the investment. IPG hold a lot of inventory because they test their lasers and laser systems thoroughly, which adds to the expense ahead of expansion, and to the cost if the expansion doesn’t materialize, although I’m confident that it will.

IPG Photonics – other considerations

This is a selection, not ‘everything else’.

    IPGP – Off-balance sheet financing and special purpose entities

IPG don’t declare they have no off-balance sheet financing or special purpose entities (as Repligen helpfully do), but I didn’t see any sign of either. I searched the 10-K for 2012, and the 3Q 2013 10-Q, for key words and phrases, with no hits for ‘off-balance’ or ‘off balance’. The word ‘entity’ had some innocent uses, with nothing worse than a small related party transaction in 2010. The only ‘entities’ were customers such as universities, ‘special-purpose’ meant equipment, and ‘vehicle’ was the kind you drive.

IPG list thirteen subsidiaries, with none of them in the Cayman Islands. The incorporation locations are Delaware, U.S.A. (twice), Germany, United Kingdom, Russia, Italy, Japan, India, South Korea, Hong Kong, China, Alabama, U.S.A., Turkey, and all are 100% owned by IPG. The list corresponds to IPG’s operations and the locations of acquisitions. I’d like to know what IPG Investment Corp. Delaware, U.S.A. do, but there’s no explanation in the 10-K (companies don’t have to break down their activities by subsidiary).

    IPGP – Cash and cash equivalents definition

As mentioned above, “Cash and cash equivalents consist primarily of highly liquid investments …” contains the vague word ‘primarily’.

    IPGP – Short-term investments definition

As mentioned above, IPG’s short-term investments don’t have to be short term to meet the definition.

    IPGP – Revenue recognition

“We recognize revenue in accordance with Financial Accounting Standards Board (“FASB”) Accounting
Standards Codification (“ASC”) 605. Revenue from orders with multiple deliverables is divided into separate units of accounting when certain criteria are met. These separate units generally consist of equipment and installation. … Equipment revenue generally is recognized upon the transfer of ownership which is typically at the time of shipment. Installation revenue is recognized upon completion of the installation service which typically occurs within 30 to 90 days of delivery. Returns and customer credits are infrequent and are recorded as a reduction to revenue. Rights of return generally are not included in sales arrangements.”

(from the 10-K for 2012)

That’s probably acceptable, although I doubt if anyone would be jailed if “generally is recognized upon the transfer of ownership” turned out to mean only 60% of the time. ‘the time of shipment’ is not the same as when the equipment is on the customer’s premises, but that shouldn’t matter so long as ‘transfer of ownership’ has occurred.

    IPGP – Audits of internal control over financial reporting

“In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, …”

Deloitte & Touche LLP

IPG also get “an unqualified opinion on those financial statements.”, the best review accounts can get from auditors.

    IPGP – GAAP only

IPG stick to GAAP, and I’ve only seen them use EBITDA when disclosing information about covenants. Lenders usually insist on borrowers agreeing to covenants, where the terms change if the covenants are breached. It’s common for covenants to involve EBITDA.

    IPGP – Related-party transactions

Related-party transactions are not big enough to be a major concern, in my opinion. The biggest figure (in thousands) is in “The payments made for such services totaled $3,973 of which $3,967 were made prior to that outside director being appointed to the Company’s board.”

    IPGP – Useful life

Asset category / IPG Useful life in years
Buildings / 30
Machinery and equipment / 3 to 5
Office furniture and fixtures / 3 to 5

To show how conservative that is, here’s door maker Masonite International’s numbers:
Buildings / 20 to 40
Machinery and equipment / 5 to 12
Fixtures and fittings / 10 to 12

    IPGP – Visual exaggeration in charts

The only graph I’ve seen by IPG with Y above zero where the X axis met the Y axis, was for gross margin, in a Schedule 14A. The numbers were clear and the offense isn’t serious.

    IPGP – Potential CEO dominance

From the 10-K for 2012, the CEO, Dr. Valentin P. Gapontsev, is also the chairman, and through three trusts he created and a UK company, he controls about 35% of the votes. Dr. Valentin P. Gapontsev is also the key founder of the company. For more, find “and have a significant influence on the outcome of director elections” in the 10-K.

    IPGP – Governance

“We endeavor to maintain high governance standards with respect to the oversight of our executive compensation policies and practices.” (the 14A dated 04/15/2013).

From the 10-K for 2012:

“The Company’s Certificate of Incorporation provides that the size of the Board may be from one to eleven directors.”

See also ‘IPGP Indemnification’, above, and ‘IPGP Poison pills and severance’, below.

IMO the best guarantee shareholders have is that the CEO benefits financially from his large shareholding.

From “Valentin Gapontsev, Worcester’s aging billionaire” By Peter S. Cohan, Dec 2 2012, (telegram.com), Valentin was 73 years old then.

    IPGP – Poison pills and severance

From the 10-K for 2012:

“Anti-takeover provisions in our charter documents and Delaware law could prevent or delay a change in control of our company, even if a change in control would be beneficial to our stockholders.”

“These provisions include:

• authorizing the issuance of “blank check” preferred stock;
• establishing a classified board;
• providing that directors may only be removed for cause;
• prohibiting stockholder action by written consent;
• limiting the persons who may call a special meeting of stockholders;
• establishing advance notice requirements for nominations for election to the board of directors and for proposing matters to be submitted to a stockholder vote; and
• supermajority stockholder approval to change these provisions.”

It’s presumably management’s interests that are above stockholders’ interests when they admit “… even if a change in control would be beneficial to our stockholders.”

The word ‘include’ means that shareholders who are heavily invested in IPG should look for more, possibly starting with the S-1/A document I link to below.

The key questions are who would be offered the preferred stock, on what terms, are the terms fair to all shareholders except the would-be acquirer, and do all the answers depend on whatever management decide. I don’t know the law well enough to say. Please comment if you can clarify the situation.

The provisions and the CEO’s control of 35% of the votes are probably enough to deter any hostile acquisition of IPG.

This may be intended to cover the retirement or death of the CEO:

“Provisions of our certificate of incorporation and by-laws, including certain provisions that will take effect when Dr. Valentin P. Gapontsev (together with his affiliates and associates) ceases to beneficially own an aggregate of 25% or more of our outstanding voting securities, may discourage, delay or prevent a merger, acquisition or change of control, even if it would be beneficial to our stockholders. The existence of these provisions could also limit the price that investors might be willing to pay in the future for shares of our common stock.”

The quote doesn’t tell me exactly how shareholders will be affected when Gapontsev’s gone, and I don’t find it reassuring.

This S-1/A document from 2006 describes the classified board (the second provision) on page 70. If a shareholder reaches 25% ownership, only a third of the board is re-elected each year, meaning a hostile acquirer can’t get control as quickly. There’s also a fuller description of the provisions under “Anti-Takeover Effects of Provisions in Our Certificate of Incorporation and By-laws” on page 92. My interpretation is that in practice the board ceases to be accountable to ordinary shareholders, due to consequences such as the necessity and impossibility of calling meetings.

I can’t promise the S-1/A is up to date, but it’s referenced from the 10-K for 2012. “AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF IPG PHOTONICS CORPORATION” (sec.gov) (already linked to). It has details I haven’t seen elsewhere, but is very legalistic.

From the Schedule 14A Definitive Proxy Statement filed 04/15/2013, there’s a column showing the payments to executives that would have been triggered if a change in control (take-over) had happened on December 31, 2012, headed “Termination Without Cause or For Good Reason Following a Change in Control”. The payments add up to $16,096,225, with the CEO getting less than half the average of the other four officers included. The figures are based on the end-of-year share price of $66.65. If IPG had been acquired then, it would have been at a higher share price, increasing the payout to management. The CEO’s main benefit would be from his shareholding, which aligns his financial interest with shareholders (he won’t be there forever, though). I wouldn’t expect payments of the type included, to deter a take-over, or drastically reduce the price offered or agreed.

The benefits comprising the payouts are: Salary, Severance and Benefits Continuation; Incentive Plan Severance; and Equity acceleration. The Equity acceleration seems to include restricted stock units and options. (Options that management are rewarded with are usually delayed, but ‘vest’ or become active immediately if IPG are acquired.)

The over $16 million payout, even if doubled to cover a large share price rise, is not massive compared to the $242.6 million cash ‘net of everything’ which I estimated, and if triggered would be small compared to the market capitalization.

Directors also benefit from the immediate vesting of options. That isn’t included in the payout figure.

IPG state “no payments are automatically made to executives upon a change in control (i.e., “single-trigger” arrangements)”, as one of fourteen bullet points under “Corporate Governance Highlights Relating to Compensation”. If automatic payments are a possibility that IPG have chosen to rule out, it suggests the possibility of payments that are not automatic but may be authorized, at least until a relevant limitation is known.

Some companies give existing shareholders more shares without giving any shares to the shareholder that triggers the anti-takeover provisions. That increases the ownership of ordinary shareholders. The situation is sometimes disclosed clearly (although I can’t promise ‘accurately’). If IPG’s blank check preferred stock is fair, or increases the ownership of ordinary shareholders, they ought to disclose the situation clearly.

Slightly off-topic, the CEO is encouraged to use company provided aircraft for security. He reimbursed the company for $268,839.

    IPGP – Not on the list

Under “Liquidity and Capital Resources”, IPG say they received cash for a 10% interest in their Russian subsidiary in 2011, and repurchased a 22.5% redeemable noncontrolling interest in it for $55.4 million in 2012. That might have been to fund investment in Russia in the short period between the sale and repurchase, without international transfers of cash. I’m only mentioning it because to me it looks like the least ‘business-as-usual’ item in the section.


I’ll choose “The 2006 Plan, as amended, expressly forbids the repricing or cancellation of underwater stock options.” (the 14A filed 04/15/2013)

IPG Photonics – Summary

Note – the summaries are selective and are in my own opinion.

$242.6 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify.

Long term growth is most likely to continue.

The anti-takeover issuance of “blank check” preferred stock is an unknown risk to most investors, until it’s adequately explained.

IPG admit “… even if a change in control would be beneficial to our stockholders.” about anti-takeover provisions.

‘generally is recognized’ makes the revenue recognition policy for equipment loose.

‘primarily’ is vague in the definition of Cash and cash equivalents.

IPG’s definition of short-term investments does not require they are short-term.

The CEO could potentially dominate.

    IPGP – Unquantified

The $242.6 million ‘net of everything’ excludes: Alleged trade secrets theft and unfair trade practices related to beam couplers and beam switches. The risk of infringing intellectual property. The potential cost of indemnifying OEMs against third-party claims of intellectual property infringement. General generous indemnification and not holding liable, with exceptions. Defined severance for senior management.

Possible errors include obligations, commitments and contingencies (OCCs) I didn’t find, double-counting an OCC which is included in liabilities, and I might have missed a clear statement that all indemnities are fully insured.


Repligen Corporation (RGEN)

Share price $12.63, Market cap $403 million, Price/Earnings (ttm) 18.1, No regular dividend. As at January 17, 2014. The figures are approximate.

You can get the ‘Repligen Presentation at Piper Jaffray Healthcare Conference 12/3/2013’ here. (BTW I could only view the PDF in Firefox.)

Repligen – My Projections For The Income Statement: 2013-2019” by Smith On Stocks, Nov 24 2013 (seekingalpha.com)

How Will the Bottom Line Change for Repligen in 2014?” By Maxx Chatsko, January 11, 2014 (fool.com)

Repligen’s SEC filings (repligen.com) with useful short descriptions of what each form is about.

Repligen Management Discusses Q3 2013 Results – Earnings Call Transcript” Nov 7 2013 (seekingalpha.com)

Seeking Alpha’s “Is RGEN a buy?” page.

Beneish M-Score for Repligen Corporation (RGEN) (gurufocus.com)
Altman Z score for Repligen Corporation (RGEN) (gurufocus.com)
See “About gurufocus’s scores” above.

Life-science company Repligen used to be more focused on developing novel therapeutics and an imaging agent, which was a cash-consuming and uncertain business, with possible high rewards. In 2012, Repligen changed their focus to selling products used in the production of biopharmaceuticals, a market with a more reliable income, high margins and good growth.

Once a therapeutic product has passed clinical trials, changing the production method could mean that long and expensive trials have to be repeated. The risk isn’t usually worth any savings, so the customer is very likely to keep ordering the same inputs for the lifetime of the product. Because of this, Repligen’s market is described as ‘sticky’.

Currently, most of Repligen’s sales are for several forms of ‘Protein A’, used to separate and purify monoclonal antibodies. The other main market is for chromatography columns.

    RGEN – Reducing non-bioprocessing costs

In 2012, Repligen out-licensed their spinal muscular atrophy (SMA) program to Pfizer, who will bear most of the costs of the clinical trials and getting approval from the U.S. Food and Drug Administration (FDA). Repligen have completed their obligations, which included a stage of a Phase I trial.

Repligen are looking for partners to support (and fund) their “HDAC” program (class I histone deacetylase inhibitors targeted at Friedrich’s ataxia). In a Phase 1 study, one of their HDAC compounds showed a dose-dependent improvement observed via a disease biomarker, but produced compounds which could be metabolized into toxins, and one of their other HDAC inhibitors might be better.

Their imaging agent RG1068 is a synthetic human hormone. It’s for patients with pancreatitis (and possibly other diseases of the pancrease), and leads to better results from magnetic resonance imaging. The FDA wanted “additional clinical efficacy” and safety trial data. Repligen expect that any additional development will be mostly funded by someone else.

The FDA’s response about RG1068 was in 2Q 2012, and some time later in 2012 the FDA said what they’d require in an “additional registration study”. Repligen seem hopeful that the information will help them get support from a partner. “additional clinical efficacy” looks like a lack of evidence that the agent is good enough to justify the risk of using it. If anything happened in 2013, it hasn’t made it into the 3Q 2013 10-Q. I won’t be surprised if Repligen don’t find support for the imaging agent, but that’s just my two cents and I’m only going by the disclosures in the 10-Q and 10-K.

A submission to the European Medicines Agency in the first quarter of 2012 was withdrawn due to the focus on bioprocessing.

There’ll be scientists disappointed that their hard work and enthusiasm for RG1068 is going nowhere, but Repligen are doing the right thing and if the imaging agent really has promise, they’re likely to get backing, as much of the work has been done.

    RGEN – Royalty expiration

Repligen’s results will be hit by the loss of royalties that expired on December 31, 2013, and were approximately $12,956,000 for the nine months ended September 30, 2013. From the 3Q 2013 10-Q:

“The expiration of the royalty payments under the Bristol Settlement is expected to have a material and adverse effect on our revenue and operating results. If we are unable to replace the royalty revenues with alternative sources of revenue, we may need to use our existing cash on hand to finance our operating activities, which will have a material and adverse effect on the liquidity of our operations.”

In my opinion, the ‘if’ isn’t all that likely, given the investment case around bioprocessing. If I’m right, and if Repligen are conservative or quiet about their prospects, there may be a better buying opportunity soon, due to the royalty expiration. That depends on various factors which I can’t predict. I don’t know how analysts will react, how long they will take, how well-informed investors are, or if short sellers will be brave enough or see investors stop-losses that encourage them to short-sell the shares. (If the price drops enough, I’ll probably add to my holding.)

The ‘if’ in the quote above isn’t actually contradicted by this quote from the 10-Q, but may be tempered by it:

“Absent acquisitions of additional products or intellectual property, we believe our current cash balances are adequate to meet our cash needs for at least the next 24 months. We expect operating expenses in the year ending December 31, 2013 to decrease as we invest less in therapeutic drug development and simultaneously improve gross margins through greater optimization of our two production facilities and other process improvements we have developed internally.”

The quote is followed by an outline of probable investment in bioprocessing.

Also see “How Will the Bottom Line Change for Repligen in 2014?” By Maxx Chatsko, January 11, 2014 (fool.com) (already linked to)

    RGEN – Customer concentration

From the 10-Q, Bioprocessing Customers A, B and C accounted for 28%, 10%, and 20% of revenue. The now-expired royalties accounted for 26% of revenue, and the expiration will tend to increase the concentration of remaining customers. The percentages for Customers A, B and C varied a lot year on year, for either the third quarter or ‘Nine months ended September 30’, but the overall concentration stayed high. Find “Revenue from significant customers” in the 10-Q for more detail. This is described under ‘Concentrations of Credit Risk and Significant Customers’, and the risk of a big customer ordering less or nothing is acknowledged in the 10-K for 2012 (find “a limited number of customers”). The Piper Jaffray presentation spins customer concentration as a positive which reduces costs (on page 5).

The risk may be less than the customer concentration suggests, due to the advantages of the OPUS range, the need to avoid changing the production process, and long term supply agreements (which it’s likely that customers insist on before using the products).

    RGEN – Chromatography

Chromatography works on the principle that different compounds diffuse through a medium differently. Back when people used ink and blotting paper, this could be demonstrated by dropping black ink onto blotting paper, and seeing different colors round the edges as the blot spread. The technique is used with an appropriate medium to separate substances such as proteins, usually with several stages needed to reach the required purity. From the 3Q 2013 Form 10-Q:

“In the expanding area of flexible biomanufacturing technologies, we have developed and currently market a series of OPUS® (Open-Platform, User-Specified) chromatography columns for use in clinical-scale manufacturing. These pre-packed, “plug and-play” columns are uniquely flexible and customizable to our customers’ media and size requirements.”

“uniquely flexible” may be true, but I’ve seen exaggerated product claims often enough from various companies. If the uniqueness is genuine, there’s no guarantee how long it will last.

The columns can also be swapped in and out to minimize disruption to production.

A column for liquid chromatography is like a pinball machine designed to let a particular kind of ball pass straight through, while other balls get stuck. There are four main kinds of columns, and sometimes mixing them helps to get a higher purity. ‘Affinity’ uses the fact that some things stick together, like antibodies and antigens. In ‘ion exchange’, the acidity of the solution can be tuned to speed either positively or negatively charged proteins through the columns. ‘Hydrophobic’ exploits the tendency of parts of a protein to move out of water if they can. ‘Size exclusion’ means small proteins pass through pores in the matrix and get stuck, while big proteins carry on down the column.

The solution can be pumped into a column or gravity-fed, and a few columns use spin. One trend in analysis is for porous particles in the medium to get smaller, with higher pressure needed to get the solvent into the column at the same rate. There are also columns used for analysis where the medium consists of particles with a porous shell around an impermeable core. There seems to be more variation in chromatography used for analysis than for production, and more written about it, possibly because more substances need to be detected and measured than are produced in quantity, or due to lower concentrations sometimes going into the columns.

This is partly conjecture, and I only write it because small investors might not get anything better on the subject for free. It’s my impression that new techniques are pioneered at small scales and adopted by pharmaceutical scientists, then used in quality control, and later some are applied to production depending on the economics of scaling up. If so, the fact that Repligen’s range starts at ‘bench’ level is an advantage (though not unique), as new techniques can be applied there and moved up the scale as far as is feasible. Advances published in the scientific literature are likely to provide a pipeline of techniques that Repligen and their competitors in chromatography can borrow from, and some new techniques could be available for a license. If the field is as dynamic as I think it is, Repligen will need to keep up its chromatography R&D to win new business in the future.

Here’s some science. I expect less plain English the more academic references there are at the end, and I believe these pieces are surprisingly clear in places considering the number of references.

Newer Developments in HPLC Impacting Pharmaceutical Analysis: A Brief Review” by Michael W. Dong, Ph.D. and Davy Guillarme, Ph.D., July 05, 2013 (americanpharmaceuticalreview.com). 43 references

Protein Purification” by Caroline Ritchie Ph. D., Iowa State University (labome.com). 126 references

Chromatography software is especially useful for optimizing the process, due to the many variables to optimize over. OpenChrom is Open Source, with customization and support provided with the Enterprise version. Like much chromatography software, it’s integrated with mass spectrometry. OpenChrom can handle various data formats, including proprietary formats, and to the extent that OpenChrom is good enough, the need for each chromatography column supplier to provide or develop their own software is less pressing. Relatively cheap, comprehensive, and easy to use software would probably help smaller facilities to optimize their chromatography, reducing the economies of scale and reducing the incentive to outsource column-packing. I haven’t found any software offered by Repligen.

    RGEN – Chromatography competition

Repligen acknowledge “The bioprocessing market is intensely competitive, …” in the 10-K for 2012.

This is essential reading:

Disposable Chromatography: Options Are Increasing” by Eric S. Lange, Dec 10, 2013 (genengnews.com)

I won’t give away genengnews’s figures, but Repligen are number two in market share, well behind the leader, though reasonably well ahead of the rest.

Biggest market share first:

GE Healthcare ReadyToProcess columns (gelifesciences.com). GE Healthcare like to talk about “start to finish technologies” for biopharmaceutical manufacturing.

Repligen OPUS columns (repligen.com) with assurances about performance after shipping. You can attend ‘Dr. OPUS’s Column Fitting Class’, and download a poster if you give some details including company name, and answer a question about what makes changing to disposable chromatography difficult.

Atoll Bio MediaScout columns (atoll-bio.com)

If you google “Scalable Method for Packing Chromatography Columns” you should get to a PDF poster (you’ll see plenty of other results and adverts). I’m not sure how cool the poster would look on a wall, but the method is suggested as useful for clinical and manufacturing scale, though currently it might only be used with Chromabolt columns for early clinical stage manufacturing. The Chromabolts are on castors, and EMD Millipore make much of the ergonomics and testing that the units survive shipping. EMD like massive URLs that don’t work as links.

As the second biggest supplier, Repligen would be the obvious beneficiary of the requirement for a second source of supply, but I haven’t seen such a requirement mentioned during my research. It’s possible that dual sourcing could add some complication to clinical trials.

    RGEN – General competition

“Many of our competitors are large, well-capitalized companies with significantly more market share and resources than we have.” (10-K for 2012)

“We have limited sales and marketing capabilities.” (10-K for 2012)

That wouldn’t matter so much if Repligen had a business model or other factor which gave them a sustained competitive advantage. I’d be glad to learn of an ‘economic moat’, but I don’t see one, apart from management and staff that seem capable. While their sales are ‘sticky’ and their market is growing, that doesn’t guarantee increased or steady market share in the long term.

    RGEN – Pre-packed chromatography columns – prices, margins and competition

Efforts to reduce healthcare costs might make customers more conscious of the cost of their inputs. The pressure on costs could include legislation, following the America Affordable Health Choices Act of 2009. Lower prices erode margins, but would also encourage potential customers to give up in-house column packing in favor of pre-packed disposable columns. If so, then Repligen’s efforts (with some success) to increase production efficiency will become more important.

Against the possibility of future pressure on margins, there’s less incentive for established suppliers to reduce prices generally, as they’ll have customers locked-in for some of their end-products. It’s hard to be sure that suppliers could compete on price for new business while keeping prices up for locked-in customers, and it could depend on the terms of long term supply agreements.

GE Healthcare dominate and have more profit to lose if they compete on price, but may bundle products if it’s not too obviously anti-competitive. Intellectual property rights can get complicated, and GE Healthcare might be in a position to sue Repligen over patents. Repligen may need to sue GE Healthcare over intellectual property, and I wouldn’t be overjoyed to hear it.

However, it’s my impression that General Electric’s industrial segment (i.e. not the financing arm) is more focused on cutting costs and improving margins than on market share. A sufficient return on investment or return of capital to shareholders is also a priority. This may be partly because the CEO was in charge when GE Capital (the financing arm) suffered huge losses. The previous CEO, Jack Welch, was Fortune magazine’s ‘Manager of the Century’, and a tough act to follow. Targeting market share at the expense of profitability wouldn’t go down well. But, GE are keen on new product introduction, which they call NPI and repeat many times. In particular they like to shorten development time (and use the time saved to talk about it 🙂 ). You can download a GE presentation from here (December 18, 2013).

So long as Repligen doesn’t threaten the GE Healthcare profit, GE Healthcare seem likely to stay focused on their profitability and on their “start to finish technologies” for biopharmaceutical manufacturing. With most of the disposable chromatography column market, GE Healthcare might be cautious about anything that could trigger antitrust action. In an expanding market, there will be room for at least the two biggest suppliers to grow profitably, though obviously I can’t guarantee that GE won’t get aggressive.

Investors should still consider the risk of chromatography columns becoming low margin commodity products. Complexity alone is not enough to keep margins up (e.g. many digital devices), but I believe the business-critical nature of the product, the customization and supporting services, and generally high margins in the sector suggest that margins should stay high. I don’t put much faith in sustained product differentiation. I don’t know of a product which Repligen’s columns could purify and GE Healthcare’s columns could not purify, and I can’t be sure that Repligen will have a technical lead over GE Healthcare in chromatography in five or ten years time.

    RGEN – The monoclonal antibodies market

The chart on page 6 of the Piper Jaffray presentation shows how Repligen expect double digit growth of the monoclonal antibodies market over three years, from existing products, with additional growth from any new products. That’s a market where Repligen supplies some of the inputs. IMO Repligen’s Protein A products aren’t likely to fall short of the market growth by much, although I haven’t checked for future patent expirations. I expect increasing market penetration for the new OPUS chromatography columns. Market research estimated that monoclonal antibodies were about 32% of the $160 billion biologics market in 2011 (from the 2012 10-K).

    RGEN – Protein A

Protein A is used to separate and purify monoclonal antibodies because it binds readily to antibodies. I haven’t found a good simple description of Protein A, but this description of antibody binding is fairly simple: “What Is Antibody Binding?” (wisegeek.com).

“Since some of our U.S. patents covering recombinant Protein A have expired, we may face increased competition, which could harm our results of operations, financial condition, cash flow and future prospects.” (10-K for 2012)

However, in the same 10-K Repligen claim trade secrets and know-how relating to the manufacture of recombinant Protein A. The U.S. patent “Nucleic Acids Encoding Recombinant Protein A” was granted in 2010 with a term extension that keeps it in effect until 2028. In living cells, sections of DNA act as templates for making RNA sequences which produce specific proteins. Repligen’s patent looks like it’s for a molecule which does RNA’s protein production job, and the protein is a well known Protein A molecule used in bioprocessing.

GE Healthcare used to make Protein A under license from Repligen (or that’s how it looks), until 2010 according to this old agreement: “Repligen and GE Healthcare Expand Protein A Supply Agreement“.

In “Protein A ELISA Kits” Repligen claim to be the only Protein A maker to provide kits for enzyme-linked immunosorbent assay (ELISA) (Wikipedia), a test that uses antibodies and color change to identify a substance..

    RGEN – Expanded production

Repligen Completes Expansion of U.S. Manufacturing Facility” Company Release – 11/01/2013 07:30

The expansion more than doubled the capacity for producing OPUS pre-packed chromatography columns, with space to expand various activities.

    RGEN – See other sources

Repligen and it’s situation are described well in the Piper Jaffray presentation, Smith On Stocks’ articles on Seeking Alpha, the “MANAGEMENT’S DISCUSSION …” section of the Form 10-Q, and in transcripts on Seeking Alpha. (Smith On Stocks also has a website with some free material about Repligen, but the new pieces are only available to subscribers).

Repligen Corporation – test 1

Test 1 – More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.

From the 3Q 2013 10-Q, as at September 30, 2013, in thousands:

Cash and cash equivalents $42,244

Total current liabilities $8,784
Other long-term liabilities $2,696
Total liabilities $11,480 (my addition)

+ $42,244 Cash and cash equivalents
– $11,480 Total liabilities
= $30,764 Cash and cash equivalents net of Total liabilities

Repligen also have $24,851 of Marketable Securities, with $20,747 due in 1 year or less, and $4,114 due in 1 to 2 years, at fair value (all in thousands).

Next I see which possible future costs not already included, can be quantified and included in obligations, commitments and contingencies.

Obligations, commitments and contingencies

    RGEN – Indemnification

Repligen indemnify Pfizer regarding a licensing agreement for the spinal muscular atrophy program, which Pfizer are now funding, in relation to Repligen’s employees and other matters (with some indemnity from Pfizer in return). I can’t put a limit on the amount.

Repligen “indemnify any and all”, which seems to be directors, officers, employees and agents, “to the fullest extent” permitted by Delaware law. I found nothing about this being insured in the 3Q 2013 10-Q, or the 10-K for 2012, SEC filings. (‘insurance’ only crops up regarding the deal with Pfizer, and a licensing agreement with Families of Spinal Muscular Atrophy.)

Technically, this isn’t indemnification, but it’s about not claiming from directors who’s actions cost the company or its shareholders. I had to go back to a 10-Q from 1999 to get the details for this and the indemnity above. While this looks bad …

“EIGHTH. A director of the corporation shall not be personally liable to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director,”

… the exclusions look good. Paraphrasing, directors can’t get away with disloyalty to the company or shareholders, deliberately not doing things they know they should do, and getting an improper personal benefit. Another exception would need more research. In full, this carries on from the previous quote:

“except for liability (i) for any breach of the director’s duty of loyalty to the corporation or its stockholders, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of the General Corporation Law of the State of Delaware or (iv) for any transaction from which the director derived an improper personal benefit.”

However, directors can be let off the hook by changing the provisions, but can’t be made liable for previous wrongs by changing the provisions.

I found the 10-Q because it contained the Certificate of Incorporation I was looking for. Find “This is how I found Repligen’s Restated Certificate of Incorporation” below (under “Forms filed with the SEC (Securities and Exchange Commission)”).

It’s likely that the old 10-Q is up to date about the Certificate of Incorporation, as it was referenced from the 10-K for 2012, but I can’t promise.

    RGEN – Pensions etc.

I haven’t included any figures for obligations to staff. The 10-K for 2012 lists $532 thousand paid, regarding a pension plan in Sweden, and not much else.

    RGEN – Legal proceedings

Repligen expect to win a tax dispute with the Commonwealth of Massachusetts, and have not recorded a reserve. If they lose, appeals could take several years. The cost of losing is estimated at $2.5 million, there is no specific reserve for it, and I include the figure in my OCC calculation.

Apart from the tax dispute, Repligen aren’t aware of any proceedings or claims that would have a material adverse effect on their business, finances or operations. The only ‘lawsuit’ I found was the patent case they started, and settled in 2008.

    RGEN – Contractual Obligations and Off-Balance Sheet Arrangements

All from the 3Q 2013 10-Q –

“We do not have any special purpose entities or off-balance sheet financing arrangements as of September 30, 2013.”

Under “Contractual obligations” (In thousands):

Operating lease obligations $14,537
Purchase obligations $2,978 (mostly raw materials)
Contingent consideration $1,593

The Contingent consideration relates to acquisitions. It’s recorded in accrued expenses and long term liabilities on the balance sheet, so I won’t include it in the sum here. Adding the lease and purchase obligations gives $17,515.

    RGEN – Possible omissions

It’s possible I’ve missed an obligation connected to licensing agreements, or a material penalty if clinical trials are discontinued.

    RGEN – Quantified obligations, commitments and contingencies

(In thousands)

Operating lease obligations $14,537
Purchase obligations $2,978
Tax dispute $2,500

Total obligations, commitments and contingencies = $20,015

    RGEN – Cash, net of everything quantified

To sum up for Repligen (in thousands):

$42,244 Cash and cash equivalents
$11,480 Total liabilities
$20,015 Total obligations, commitments and contingencies


$42,244 Cash and cash equivalents
$30,764 Cash and cash equivalents net of Total liabilities
$10,749 Cash and cash equivalents net of Total liabilities, Obligations, commitments and contingencies

That’s about $10.75 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify. This isn’t easy, and please feel free to check my deductions and look for more.

In addition, Repligen hold $24.85 million of Marketable Securities.

See also “RGEN – Unquantified” under “Repligen Corporation – Summary”.

Repligen Corporation – test 2 and 3

Test 2 – Cash from operations has to be positive and generally bigger than the cash that goes into investment.
Test 3 – A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

My claim that Repligen passes test 2 is not supported by the history since 2003, as you’ll see in the charts. 2012 saw an excess of cash from operations over cash invested ($13,440 – -$2,841 = $16,281 – in thousands) and with three quarters in, 2013 is on track to beat 2012. My cash flow walk chart shows an encouraging recent results-breakout (from a meandering walk), but this is partly the result of recent growth in royalty revenue which expired on December 31, 2013. The latest quarter, 3Q 2013, also benefits from “… favorable changes in various working capital accounts, in particular the collection of $5 million due from Pfizer pursuant to our collaboration agreement.” (the 10-Q). You shouldn’t extrapolate a mixture of normal revenue and milestone payments in the same way you might extrapolate normal sales. This shows the weakness of focusing on cash flow over short periods, and I include charts showing recent revenue and costs after the cash flow charts.

If all goes well, milestone payments from Pfizer are expected for Phase I, II and III clinical trials and then for successful commercialization. A milestone from an early stage trial could be reached late in 2014, but that’s from an old transcript: “Repligen Management Discusses Q4 2012 Results – Earnings Call Transcript” Mar 7 2013 (seekingalpha.com). (Search the transcript for ‘Pfizer’ or ‘milestone.) Success all the way through to commercialization is far from guaranteed, and it’s safer to regard any milestone payments as a bonus rather than a basic part of the investment case.

In the spreadsheet below, everything is in thousands except for ‘per share’ amounts and dates. (Repligen’s transition document gives two end dates for 2011, and I hope I’ve understood the document correctly.)

Repligen cash flows to 3Q 2013 spread

Repligen does not have a steady history of cash flow growth, and to include recent quarters, the cash flow walk chart shows quarters 1, 2 and 3 after multiplying by 4 to approximate an annual equivalent (which I admit is a bit dubious).

Repligen cash walks per share to 3Q 2013

This time series chart shows the quarters with and without annualization.

Repligen cash flows per share to 3Q 2013

The peak in 2008 was probably the result of settling a patent case against ImClone Systems for $65 million, or about $40 million net. Removing that one-off would make the recent improvement an even bigger contrast to previous performance.

Repligen acquired bioprocessing operations from Novozymes at the end of 2011. The acquisition doesn’t make a spike in the chart at the ‘Nine Months ended December 31’ 2011, because the $26.9 million cash impact was closely matched by the $26.3 million sales of marketable securities. This shows how charts of the broad cash flow categories don’t reveal crucial details about the nature of cash invested, although they still show the general effectiveness of investment. Big acquisitions affect financial results, and even with the best of intentions, the working capital acquired can affect cash flow, increasing it for a while when positive working capital is acquired.

I’ll repeat that the cash flow charts are deceptive due to royalty revenue which has now expired, and high cash collection that’s unlikely to repeat.

Repligen recent revenue and costs - spread

Repligen recent revenue and costs

Ignoring 2011 and the royalties revenue, the clearest trend is the declining R&D. The decline contributes to income and cash from operations, but I’d be concerned to see it reduced by much more. The chart is consistent with growing revenue from bioprocessing, but I’m wary of concluding much from a series showing two ups and one down of about the same size. I made a ‘walk chart’ to see if a relationship between bioprocessing revenue and cost can be observed.

Repligen walk chart of product cost against revenue

The three quarters in 2013 so far have each had higher bioprocessing revenue and margin than the 2012 average, although the latest quarter was a step in the wrong direction. There’s a limit to what you can conclude from just a few points. The chart is consistent with profitable growth in bioprocessing since the acquisition, but isn’t shouting about it, at least not at this point. The gross margin on bioprocessing is shown by the angle of the line from a point to the origin. It’s likely to have been affected by the product mix, costs which stay fixed as revenue increases, increases in efficiency, and currency movements.

The investment case is about reasons to expect bioprocessing revenues to grow, with expanding margins and relatively low needs for capital expenditure. While it’s expected that Repligen could accumulate cash (if they wanted to), they are likely to combine some organic investment with acquisitions. The quality of future acquisitions will be a major factor in Repligen’s future value. The Piper Jaffray presentation gives the kind of synergies Repligen expect from acquisitions, which also indicates that they are likely to stick to bioprocessing.

Repligen Corporation – other considerations

This is a selection, not ‘everything else’.

    RGEN – Off-balance sheet financing and special purpose entities

“We do not have any special purpose entities or off-balance sheet financing arrangements as of September 30, 2013.” (3Q 2013 10-Q)

    RGEN – Cash and Cash Equivalents definition

(figures in thousands)

The Cash Equivalents are not obviously defined, but seem to be or include $9,189 of money market funds. Find “fair value hierarchy table” in the 10-Q, where the other two items add up to the Marketable securities figure of $24,861, which is separate from the Cash and Cash Equivalents of $42,244. I expect the money market funds are safe enough.

Most of the Marketable securities ($19,179 of them) is in Corporate and other debt securities, the valuation of which is complicated but I saw nothing suspicious.

From the 10-K: “… cash equivalents and marketable securities are invested in financial instruments with high credit ratings and credit exposure to any one issue, issuer (with the exception of U.S. treasury obligations) and type of instrument is limited.”

Repligen don’t hedge their foreign exchange risk, and the 10-K says they have no investments with foreign exchange risk. The operations of Repligen Sweden create exposure to the Swedish kronor, British pound sterling, and the Euro.

I hope I’m not being gullible for saying the cash looks safe, even though they don’t explicitly define cash equivalents beyond ‘high credit ratings’ and the statement about exposure.

    RGEN – Short-term investments definition

There’s no specific mention of short-term investments, but $20,739 thousand of Repligen’s marketable securities are classed as short term and are due in one year or less. I’ve written about marketable securities under ‘Cash and Cash Equivalents definition’ above.

    RGEN – Revenue recognition

The policy is reasonable and uncomplicated.

“… The Company’s product revenues are from the sale of bioprocessing products to customers in the life science and biopharmaceutical industries. Revenue related to product sales is recognized upon delivery of the product to the customer as long as there is persuasive evidence of an arrangement, the sales price is fixed or determinable and collection of the related receivable is reasonably assured. … The Company has a few longstanding customers who comprise the majority of revenue and have excellent payment histories and therefore the Company does not require collateral. The Company has had no significant write-offs of uncollectable invoices in the periods presented.”

“… Sales returns and warranty issues are infrequent and have had nominal impact on the Company’s financial statements historically.”

    RGEN – Audits of internal control over financial reporting

Repligen get a clean bill of health for their internal control over financial reporting, and their accounts, from auditors Ernst & Young, in the 10-K for 2012:

“In our opinion, Repligen Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the COSO criteria.”

“We also have audited, … the consolidated balance sheets … and the related consolidated statements of operations and comprehensive income (loss), stockholders’ equity, and cash flows … of Repligen Corporation and our report dated March 15, 2013 expressed an unqualified opinion thereon.”

The statements covered various relevant periods.

    RGEN – GAAP only

I’ve not seen Repligen use non-GAAP figures.

    RGEN – Related-party transactions

“There were no related party transactions during the fiscal year ended December 31, 2012.” (10-K)

    RGEN – Useful life

Leasehold improvements – Shorter of the term of the lease or estimated useful life
Equipment 3 to 8 years
Furniture and fixtures 3 years

I’d say that’s reasonable and conservative.

    RGEN – Visual exaggeration in charts

I only checked the ‘Repligen Presentation at Piper Jaffray Healthcare Conference 12/3/2013’ I mentioned above (which you can get here). The only relevant chart (on page 6) was OK, with y=0 where the X and Y axis meet.

    RGEN – Potential CEO dominance

This is all based on the Form 14A dated 5/9/2013, and is ‘as of March 22, 2013’.

Walter C. Herlihy, Ph.D., held numerous research positions at Repligen from 1981 to 1993, becoming Senior Vice President of Research and Development before leaving to join Glycan Pharmaceuticals, where he was President and CEO. He stayed President and CEO when Glycan and Repligen merged in 1996. Repligen also has a Chairperson (and a CFO and Chief Accounting Officer). Herlihy owns 1,844,253 shares, or 2.3% of the Common Stock.

The CEO is required to acquire shares equal to his base salary, over five years. His base salary is $433,000 (11% below the 50th percentile). Assuming the share price matters in the calculation, at $10 the CEO needs to own 43,300 shares, and at $20 he needs to own 21,650. His ownership of 1,844,253 shares is well above the requirement. Other insiders have different minimum shareholding requirements, and insider ownership isn’t high, at 6.3%.

The only co-founder of Repligen I can find is Alexander Rich, M.D.

Overall, considering that the CEO has overseen a successful (so far) transition to bioprocessing, with the integration of the Novozymes Biopharma Business, I’d say he’s in a position to dominate if he wanted to, although he’s not in as strong a position as the CEO’s of IPG Photonics and Ubiquiti who were more obviously involved in founding the company, and who have much bigger shareholdings.

    RGEN – Poison pills and severance

Repligen may have a ‘Shareholder Rights Plan’, which means that if a shareholding reaches 15%, other shareholders would get new shares. It’s in old 10-Ks under ‘Stockholders’ Equity’ / ‘Shareholder Rights Plan’. The sentence “The Rights will terminate upon the earlier of the date of their redemption or March 2013.” means the plan can’t exist without having been amended, and there’s nothing like it under ‘Stockholders’ Equity’ in the 2012 10-K. However, the form has this:

“Provisions in our certificate of incorporation and by-laws may delay or prevent an acquisition of us or a change in our management. These provisions include the ability of our board of directors to issue preferred stock without stockholder approval.”

What really concerns me is the word ‘include’, which I believe management generally love when they aren’t keen about disclosing, although there could be cases when it avoids tedious details. For comparison, IPG Photonics itemize seven of their anti-takeover provisions.

To find details of the board’s powers to issue preferred stock, find “This is how I found Repligen’s Restated Certificate of Incorporation” below (under ‘Forms filed with the SEC (Securities and Exchange Commission)’). If necessary, the board can indemnify and remove liability after the fact, presumably within some legal limits.

In practice, any effective anti-takeover provisions give management the power to agree a takeover either on terms that suit shareholders or on terms that suit themselves.

A disatisfied investor in 2011 claimed the Shareholder Rights Plan made management look ‘entrenched’ and discouraged institutional investors. If so, I think institutional investors have the right idea, at least generally. The investor, Ronald L. Chez, is Repligen’s biggest, with 9.2% of the Common Stock as of March 22, 2013. Maybe the plan was allowed to lapse due to embarrassment about it or pressure from the biggest investor, but not finding anti-takeover provisions isn’t the same as knowing there aren’t any.

From the Form 14A dated 5/9/2013:

“Upon termination of employment, with or without cause, or upon a change in control of the Company, 50% of the unvested stock options held by such executive officers shall vest immediately.”

(For ‘vest immediately’, find “accelerated vesting” in Vesting (Wikipedia).)

The 50% vesting seems reasonable and is probably ungenerous to management compared to other companies. If a change of control and termination had taken place on December 31, 2012, the benefit would only have been $96,000, compared to $6,153,000 Salary Continuation Upon Termination.

There’s more under ‘Equity Awards’, which I believe to be favorable to management, but I don’t know if they’re more favorable than the usual, or significant to shareholders.

The terms regarding salary seem reasonable, so far as I can tell.

    RGEN – Not on the list

Repligen have used stock promoters several times, with May 2012 the latest date. If this long URL doesn’t work, go to stockpromoters.com and put ‘RGEN’ in the ‘Search by Symbol’ box. Personally, I associate stock promotion with pump’n’dump shares. Maybe there’ll be no more stock promotion, as Repligen shouldn’t need to raise capital. If the share price is pumped up through stock promotion, it might be time to take some profit, with a chance of buying back at a lower price when the promotion wears off. If stock promotion raises the share price, it might also affect the value of stock-based compensation, although I’m sure that management keep to any rules that might apply in this area.


I’ll just mention the lack of related party transactions.

Repligen Corporation – Summary

Note – the summaries are selective and are in my own opinion.

$10.75 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify. In addition there’s $24.85 million of Marketable Securities.

Repligen are focused on a growing market with ‘sticky’ sales, probably with good management, but I haven’t seen reasons to believe there’s an ‘economic moat’ to protect growth.

The investment case is forward looking, without a long or striking history of success.

Future performance depends on the use of cash, and the quality and execution of acquisitions. I also believe that R&D around chromatography columns is a vital factor to drive market penetration and avoid falling behind competitors, especially GE Healthcare.

While there are operational risks, and government efforts to reduce the cost of healthcare, the biggest risks are probably from the dominant competitor, GE Healthcare.

Substantial royalties expired at the end of 2013.

Some of the U.S. patents covering recombinant Protein A have expired. (Listed as a risk in the 10-K for 2012)

I don’t know what happened regarding anti-takeover provisions that became outdated.

The CEO could potentially dominate, but he’s not an obvious founder or a major shareholder.

Relatively low insider ownership.

Some investing professionals and big investors will be able to talk to customers and competitors to find the scuttlebut, especially on GE Healthcare, Repligen, and their products.

    RGEN – Unquantified

The $10.75 million ‘net of everything’ excludes the potential cost of indemnifying Pfizer, and generous indemnification and not holding liable of directors and officers, with exceptions for particularly bad behavior (which can be removed later).

Possible errors include obligations, commitments and contingencies (OCCs) I didn’t find, double-counting an OCC which is included in liabilities, and I might have missed a clear statement that all indemnities are fully insured.

Repligen Corporation – A chart

There’s a spreadsheet and 3D chart showing the net present value of Repligen shares, based on various assumptions. I don’t give much weight to the chart, and generally prefer the overall investment case, but if you want to see it, it’s at the end of my “Discounting future value with a real example“. It’s based on two numbers, projected cash and projected income, from an article by Smith On Stocks, “Repligen Promises To Be A Cash Flow Machine” Apr 2, 2013 (seekingalpha.com). Smith On Stocks makes it clear that Repligen are unlikely to just hoard the cash, and explains his reasons for projecting cash as if it will be accumulated. The projections were probably conservative at the time, and since then the prospects for the OPUS columns have improved. The numbers will also become too low as time goes on and there is less time to discount each future figure over. There’s a link for downloading the spreadsheet, but it might be easier to set one up from scratch than to download and adapt it.


Ubiquiti Networks, Inc (UBNT)

Share price $43.77, Market cap $3.8 billion, Price/Earnings (ttm) 36.4, No regular dividend. As at January 17, 2014. The figures are approximate.

Ubiquiti’s SEC filings (ubnt.com)

Ubiquiti Networks Management Discusses Q1 2014 Results – Earnings Call Transcript” Nov 7 2013 (seekingalpha.com)

This was good but it’s gone behind Seeking Alpha’s “pro” paywall: “Ubiquiti Networks: Another Big Year Ahead, Get In Now On The Short Term Sell-Off” by Matthew Dow, Dec 7 2013 (seekingalpha.com)

The most recent freely available article on Seeking Alpha: “Bull Of The Day: Ubiquiti Networks” by Zacks Investment Research, Nov. 14, 2013

Seeking Alpha’s “Is UBNT a buy?” page.

Beneish M-Score for Ubiquiti Networks (UBNT) (gurufocus.com)
Altman Z score for Ubiquiti Networks (UBNT) (gurufocus.com)
See “About gurufocus’s scores” above.

Quoting from their Q1 2014 CEO/CFO Commentary, “Fiscal first quarter 2014 revenues were up 28% from the prior quarter, and up 111% over the same period in the prior year.”.

Ubitquiti’s revenue is mostly from communications equipment designed to use unlicensed spectrum, which needs techniques to cope with interference from cordless phones, baby monitors, microwave ovens etc. The use of unlicensed spectrum is particularly suitable for remote locations and countries which are less developed or have large sparsely populated areas. Ubitquiti can provide solutions for less developed countries where ‘the last mile’ is a problem that would normally require heavy investment.

    UBNT – Products

Ubiquiti’s product info

Service Provider Technology platforms (73% of revenue, 1Q 2014)

airMAX – outdoor wireless with a firmware architecture (find “firmware” below).
CASE STUDY – Sling Broadband. One event featured is the Volvo Ocean Race, Miami.
airMAX accounted for 47% of total revenue in 1Q 2014. The revenue share used to be above 50% but newer products have grown faster.

airFiber – radio platform for backhaul, with high throughput (1.4 Gig/second, range up to 13km). Backhaul connects to a more central network, usually the Internet backbone (Wikipedia).

EdgeMAX – routers

Enterprise Technology platforms (27% of revenue, 1Q 2014)

UniFi – indoor wireless LAN, with a software controller (instead of the traditional hardware controllers). The CEO believes that wireless networks can replace wired networks “everywhere but the data center”.

mFi – machine to machine (there’s more below)

airVision – surveillance system with a web-based interface. Can be monitored with the airVision interface on iOS or Android mobile devices. You can connect Ubiquiti’s IP (Internet Protocol) cameras to the airVision system.

    UBNT – Business model

Ubiquiti outsource production and sales, and concentrate on research and development, marketing, and engaging with end users through a user community on the internet with forums, a wiki and a newsletter. The community provides support, and users discuss what they need and what needs to improve. The feedback and Ubiquiti’s flexibility mean that designs can be iterated quickly, and if a product isn’t good enough, a much improved version is likely to be on the market before too long. The ‘quickly to market’ strategy has risks, and Ubiquiti recalled their Titanium Rocket products early in 2013. The business model allows Ubiquiti to sell cheaper than competitors while keeping good margins, and allows growth driven by R&D and user enthusiasm without the need for high capital or marketing expenditure. From the latest 10-Q:

“Our business model is driven by a large, growing and highly engaged community of service providers, distributors, value added resellers, systems integrators and corporate IT professionals, which we refer to as the Ubiquiti Community.”

“Word of mouth referrals from the Ubiquiti Community generate high quality leads for our distributors at relatively little cost.”

Ubiquiti’s user forum is mostly very technical, but there’s a ‘Business Talk’ area under ‘General Discussion’, with this topic as an example “UBNT vs Competitor. Excerpt from Credit Suisse Annual Tech Conference 2013” started by jaf.

    UBNT – The Ubiquiti World Network initiative

The Ubiquiti World Network initiative should help to make WISPs (Wireless Internet Service Providers) more aware of Ubiquiti by helping them with their marketing, at a relatively low cost of about $1 million per quarter.

    UBNT – Marketing chief quit

There are well-informed comments under this short Seeking Alpha market-currents story: “Ubiquiti slumps after disclosing marketing chief’s departure” Monday, Nov 25 (seekingalpha.com). The marketing chief was probably brought in to market the airVision surveillance system, a small part of Ubiquiti’s business. The dip shows how the share price can be vulnerable to any bad news after a sustained rise.

    UBNT – Thinking about the future

Looking far ahead, at some point, Ubiquiti are likely to hit what I’ll call ‘model saturation’ in their current markets, although this could mean slower growth with the market, rather than no growth, if Ubiquiti stay within their existing markets. To attempt to maintain high growth, Ubiquiti could either change the model or target new markets where the model can be applied, though neither will be easy.

While users like universities are usually happy to pay a low price and use the community for support, big corporations generally require support and are used to paying for it. That seems unlikely to change. The problem might not be from increasing performance, which doesn’t necessarily mean that new answers are needed for new questions, so much as changing technology and new communications standards. In addition, tech-users generally use a variety of equipment, and frequent software updates can affect how the parts of a system work together. However, it’s because support is necessary that the company gains from the support available on the Ubiquiti community. Providing vendor-support to big enterprises could make Ubiquiti too much like other companies, with no obvious advantage over competitors already selling to the big enterprises. If Ubiquiti take that route, it’s likely to be with some reluctance over the expense, and because they believe their products are sufficiently superior.

Breaking into a new market could be difficult if it’s not an adjacent market. It needs to be a market where support is required, with potential customers who prefer the combination of low price and support from a community, without the need being met well enough already. There also needs to be very little chance of a competitor disrupting the market with products requiring minimal support.

    UBNT – Risks of new markets or changing the model

Under “Our profitability may decline as we expand into new product areas.” (10-Q):

“As we expand into new product areas, such as enterprise WLAN, video surveillance equipment, wireless backhaul and machine-to-machine communications, we may not be able to compete effectively with existing market participants …”

“We may also be required to add a direct sales force and customer support personnel to market and support new or existing products, which would require us to accept substantially lower product margins or increase our operating expenses. … and may not be successful.”

I see the “new product areas” mentioned, as being reasonably adjacent to the old product areas. Bigger problems with expansion could occur further into the future, but a high valuation needs a lot of growth to justify it, after which Ubiquiti would be much bigger. Many companies fail to diversify successfully when a new market is too big a leap, and companies often fail when they stray from a successful business model (insurance company GEICO is a classic case from the value-investment literature). If Ubiquiti are able to apply the model to new markets, they will maintain high growth for longer, until growth slows as model-saturation in their addressable markets is approached (when they can’t sell much more without a sales force). The CEO is enthusiastic about the model and I expect that new markets are more likely than a sales force.

    UBNT – Machine-to-machine

The machine-to-machine (m2m) market is fragmented and I have to admit I find it confusing. There’s General Electric pushing the Industrial Internet, which might be machine-to-cloud rather than m2m. Google have recently acquired Nest Labs who make innovative smoke alarms and thermostats, which apparently belong in the ‘Internet of Things’ category. Texas Instruments abandoned competing with Qualcomm’s chips for phones to concentrate on embedded processing and analog, using their big sales force to sell tailored products into the fragmented market. Telecoms companies want their slice, with Canadian telco Rogers Communications providing a selection of m2m solutions including home automation, and Vodafone wanting to monitor drivers so careful drivers can get cheaper insurance. There’s Arduino, Zigbee (Wikipedia), and Xbee which I think cater for school projects and small projects, but Texas Instruments takes ZigBee (at least) seriously as an industrial standard, in the low-power RF (radio frequency) bracket. The hobby and small-scale end seems to be well served by forums, and I’d guess Atmel’s AVR Freaks community isn’t aimed at mega-corporations, judging by the T-shirt. In the 10-Q, EnergyHub, Motorola and AlertMe.com are listed as the main m2m competitors. (See EnergyHub’s grinning management here.)

Google’s Motorola want modular phones where you click-in a third party module and you’ve got a medical scanner or other device. “Motorola’s Project Ara: The Age of Modular Computing” by Doug Mohney, November 22, 2013 (mobilitytechzone.com). You’ll need to click away the unwelcome screen.

Ubiquiti’s mFi platform probably doesn’t make up much of the 27% of revenue that comes from the Enterprise Technology segment, but there’s plenty of potential if the model works in that area. Their machine-to-machine page has plenty of pictures, graphics and screenshots. It looks like mSensors plug into mPorts and incoming data can result in power from mPower sockets being switched on or off, according to rules set through the intuitive front end of mFi software. The mSensors sense motion, temperature, current and open doors or windows.

The Ubiquiti device reviewed here allows mains power from three sockets to be switched on or off over a wireless network, and the power usage monitored:

Ubiquiti Networks mFi mPower Wi-Fi Power Strip Review” by Ganesh T S on November 21, 2013 (anandtech.com)

The conclusion is on the 5th page, here. It’s a favorable review, with ‘Excellent value’ in the first ‘pro’ point. Some points from the comments are (in my words): It’s no good because TVs and other devices have a low standby current / It’s more use in the enterprise / It’s hackable so I can write code for it to control a fishtank / If you’re going to write code, why not just get a microcontroller board. Other suggestions for things to turn on and off remotely include space heaters, and power-cycling a crashed server.

Wi-Fi might not be ideal for low data rate, short range and low power needs. It’s hard to be sure due to variation in the various wireless standards, and technical progress.

This gets technical: “Difference between Bluetooth and WiFi” (engineersgarage.com).

This (by Stacey Higginbotham, August 30, 2013. gigaom.com) is like a review of ZigBee, and with the comments there seems to be quite a few minor standards or protocols.

The piece “Qualcomm gets serious about Low-Power Wi-Fi with new chips” by Lee Ratliff, September 6, 2013 (isuppli.com), is about the Atheros chipset which Ubiquiti depends on, and the low-power needs of some Internet of Things applications. Atheros features hostless operation and a wake-up manager, which can reduce the average power requirement.

There are some technical points raised in this topic on Ubiquiti’s mFi forum:

What is the mFI end goal? Here are some of my thoughts and questions

    UBNT – The counterfeiting crisis

Ubiquiti had a big problem with counterfeiting in 2012, which Matthew Dow described in his first article about Ubiquiti:

Ubiquiti Networks: Significant Upside Potential In 2013” Jan 20 2013 (seekingalpha.com)

The 10-K for 2013 has a paragraph headed:

“We have experienced, and may in the future experience, reduced sales levels and damage to our brand due to production of counterfeit versions of our products.”

but it doesn’t say much except they are now more vigilant and legal action will cost money. Ubiquiti have made an impressive recovery.

    UBNT – Growth problems

Ubiquiti occasionally have problems keeping supply up with demand. One problem is that demand can rise quickly but with little visibilty to allow preparation. It’s possible that resellers and distributors don’t keep enough margin to encourage them to keep much stock. Because low cost is a feature, there isn’t an easy solution, but when customers reserve their orders the kit usually gets made and distributed without a huge backlog building up. This is confirmed to some extent in the topic “Re: Serious UBNT stock problems ?” but with a lot of chit-chat.

Most hitches and glitches are harder to sort out when growth is high and the visibility of future demand is poor. It might be harder to maintain quality control, and counterfeiting could re-emerge as a serious problem, although those are more tenuous risks than delivery problems. Ubiquiti acknowledge that enforcing IP is often difficult in China and South America. Also, from the 4Q 2014 10-Q:

“We rely on a limited number of contract manufacturers to produce and test all of our products, …”

“… contract manufacturers, which are primarily located in China …”

“… it would take approximately three to six months to transition manufacturing … to new providers. Relying on contract manufacturers for manufacturing and quality assurance …”

This might be efficient but it concentrates risk: “Beginning in the quarter ended December 31, 2012, we began using a third party logistics and warehousing provider in China to fulfill the majority of our worldwide sales.”

“We have limited experience and personnel to manage our supply chain, our contract manufacturers and our third party logistics services provider, which may cause us to experience lower product margins, impair product quality and result in our inability to fulfill demand for our products and solutions.”

As I said near the top, you have to decide to what extent the risk section in a 10-K is just legal boilerplate. To ensure quality, Ubiquiti have ‘internal quality assurance resources’, and development involves the sites of selected contract manufacturers, with full scale production at the same sites when quality reaches a satisfactory level.

There’s a risk that the Ubiquiti World Network initiative is extremely effective at a time when supply is already tight, resulting in frustration and disappointment. Then maybe analysts and investors will be very understanding and see the high demand as positive, or maybe some would question the business model and the lack of control over the supply chain, or more likely question the wisdom of timing an excellent marketing push when supply is tight. Management have a difficult task trying to hit a moving target, and overproduction also has costs.

    UBNT – Six risks for Ubiquiti

1) Dependance on a single supplier, Qualcomm. From the Safe Harbor: “… our dependence on Qualcomm Atheros for chipsets without a short-term alternative;”. Qualcomm won’t want to abuse their power in any way that would deter customers, but it would still be better if the chips could be dual-sourced. To check the power Qualcomm’s customers might have, I looked at the customer concentration. In 2012, Samsung Electronics accounted for more than 10% of Qualcomm’s revenue, and so did “Hon Hai Precision Industry Co., Ltd./Foxconn, its affiliates and other suppliers to Apple Inc.” (from the Qualcomm 10-K filed 11/07/12. Check here for a more recent 10-K).

Qualcomm usually report some customer concentration, with changing names each year. In 2011 and 2010, HTC and LG Electronics accounted for over 10% of Qualcomm’s revenue. None of those are major competitors to Ubiquiti, and in any case, Qualcomm have the size, profitability and intellectual property that makes them hard to push around. If Ubiquiti ever get on Qualcomm’s 10% list they’ll be even safer. The worst that Qualcomm are likely to do on purpose is to raise prices or push Ubiquiti towards a higher priced successor to Atheros, but they’re not likely to risk alienating Ubiquiti or pushing them to a competitor. Many programmable logic chips feature onboard digital signal processing (and ARM processors, if needed), although that might be a last resort.

2) Ubiquiti’s kit uses unlicensed spectrum, and in the U.S., big companies that benefit from licensed spectrum lobby for more of it. See:

The Underdog Internet Providers Head to Washington” By Brendan Greeley, November 21, 2013 (businessweek.com)

At the same time, consumer devices make increasing use of the unlicensed spectrum, and Ubiquiti’s devices would presumably interfere with each other in some circumstances. Ubiquiti has expertise in coping with interference, but there are limits and trade-offs involving range and throughput.

3) There’s a key-personnel risk as it’s hard to know how well the company would perform without the CEO, operationally and strategically.

4) Don’t rely on incumbents only competing on price and performance if they have other options. From the 10-Q:

“increased competition from providers of wireless broadband equipment may result in fewer vendors providing complementary equipment to our products, which could harm our business and revenues. Broadband equipment providers or system integrators may also offer wireless broadband infrastructure equipment for free or as part of a bundled offering, …”

As a possible guide to Cisco’s style, according to Maureen O’Gara in “Dell Joins OMG to Eclipse Cisco’s Daylight” March 15, 2013 (soa.ulitzer.com), Cisco got some big names into a consortium to develop software defined networks, stitched them up with an agreement not to join any similar consortium, shut them up with non-disclosure agreements, started their own secret project called Insieme, and left the original consortium to rot. The consortium found a way out, which you can read about in Maureen O’Gara’s blog. BTW if software defined networks are a growth area, traditional routers (including Cisco’s) will lose sales. Ubiquiti’s UniFi platform replaces some hardware with software, and the AirMAX platform uses firmware (Wikipedia), which is a bit like software in a chip so it doesn’t need loading but can still be modified or updated.

5) Government regulation for safe electromagnetic emissions and privacy could be difficult to comply with or increase costs. However, the World Health Organization doesn’t seem too concerned about Base stations and wireless technologies, and believes Electromagnetic hypersensitivity [December 2005] is not caused by wireless technologies.

6) The two biggest customers, probably distributors, each accounted for 10% of revenue.

There are other risks in the Safe Harbor, and more in the Form 10-K under the heading “Risk Factors”.

    UBNT – Normal acquisitions are unlikely

From “Ubiquiti Networks Management Discusses Q1 2014 Results – Earnings Call Transcript” Nov 7 2013 (seekingalpha.com), the CEO is well aware that a normal acquisition makes no sense, as most companies of about the right size would have many more staff but less revenue and income than Ubiquiti. However, he says “There might be some opportunities for acquisitions overseas, but they would not be traditional acquisitions. They’d be more out-of-the-box type of things.”. Unbelievably (or perhaps not), analysts didn’t ask what kind of out-of-the-box type things. (If they want ‘out-of-the-box’, maybe they should find the ‘tricorder’ link in my “IPG Photonics – growth, cash, markets and technology” piece [already linked to].)

    UBNT – Good news

Gartner believe Ubiquiti’s UniFi revenue has jumped over 200% from the previous quarter. December 27, 2013 (seekingalpha.com)

Ubiquiti: Street Likes Ingram Deal; JMP Dismisses Block Trade Concern” By Tiernan Ray, January 15, 2014 (blogs.barrons.com)

    UBNT – My investment approach

I like Ubiquiti a lot, but there are risks and I’ll take some profit if they hit a sky-high valuation. I might follow a ‘buy low, sell high’ (relatively) strategy, to make some gain from volatility, while keeping at least half my original investment, for as long as it seems reasonable. I don’t want to have no shares so long as there’s a reasonable chance of the model driving high growth. I’m not saying anyone should copy me.

If I had no shares in Ubiquiti now, I would only buy a little, and add if the shares got cheaper. That risks a lower profit if the price keeps rising, but I’d prefer that to the risk of a large buy followed by a big fall. Investors will have their own style and shouldn’t be too influenced by this section. I’ve no wish to convince an investor who doesn’t like the shares at the current price or a lower price.

Ubiquiti Networks – test 1

Test 1 – More cash and cash equivalents than total liabilities plus obligations, commitments and contingencies, including material off balance-sheet items, and with no accounting policies that cause significant doubt about the cash figures.

From the 4Q 2014 10-Q, as at September 30, 2013, in thousands:

Cash and cash equivalents $279,729

Total current liabilities $67,810
Long-term taxes payable $12,385
Debt – long-term $69,874
Deferred revenues – long-term $2,514
Total liabilities $152,583

+ $279,729 Cash and cash equivalents
– $152,583 Total liabilities
= $127,146 Cash and cash equivalents net of Total liabilities

Obligations, commitments and contingencies

Next I look into possible future costs which aren’t already included. The only significant quantified costs are below under ‘Contractual Obligations and Off-Balance Sheet Arrangements’, after I describe some possible costs which I can’t quantify.

    UBNT – Illegal export to Iran

Under “Export Compliance Matters”, there’s a complicated case about illegal export to Iran. Ubiquiti are cooperating and there seems to be little dispute about the facts. It looks easy to accidentally break the regulations by not communicating properly with logistics companies and distributors, which they seem to have done twice. They also failed to keep adequate records for the required five years, which probably happened when they switched to NetSuite software for order management and financial processes.

The original case was closed with a warning, after which Ubiquiti filed a voluntary self-disclosure with the U.S. Department of the Treasury’s Office of Foreign Asset Control (“OFAC”).

The upper limit of any fine is twice the value of the transactions involved, with a $250,000 minimum. Ubiquiti are waiting to hear from OFAC, “… and we cannot currently assess the nature and extent of any fines or other penalties, …”.

I’m not putting a figure on the maximum liability, but it seems to be limited to twice the value of Ubiquiti’s exports to Iran from 2008 to March 2011. They recorded an expense of $1.6 million in 2010, when only one violation was known.

Compliance generally is easier for big companies than small companies growing fast, but Ubiquiti are aware of the need, for instance in 2011 they hired an employee who makes sure spectrum use requirements are complied with.

    UBNT – Risk of infringing intellectual property

From the 10-Q for Q1 2014: Under ‘Item 3. Legal Proceedings’ / ‘Intellectual Property’, Ubiquiti are “subject to” legal proceedings over intellectual property. I think that means generally rather than right now, although letters asserting patents (claiming infringement) are frequent. Communications IP is a patent-rich area where aggressive patent assertion and litigation is common. They also say “There are numerous patents and patent applications …” before explaining why they don’t usually conduct patent searches. This affects many companies that Ubiquiti deal with, including suppliers, OEMs and distributors. Find “We operate in an industry with extensive intellectual property litigation.” in the 10-Q. There’s a trend in the U.S. for legislation to limit the activities of ‘patent trolls’ which could reduce some of the risk.

This 81 page pdf is UK-centric and not an easy read, but it pulls many studies together: “A Study of Patent Thickets” commissioned by the Intellectual Property Office, 2013 (ipo.gov.uk). Using the density of ‘triples’ (where each of three firms have prior art which limits the claims in patents held by the other two), telecoms is a thicket-infested zone (not their term!) with over fifteen thousand triples. Digital communication and computer technology have thousands of the triples, and basic communication processes have nearly five hundred. See the table on page 41 of the pdf for the triples in 33 areas of technology. A model gives the counter-intuitive result that opposition to a patent after it is granted is actually lower inside a patent thicket, but high on the fringes, and empirical support is claimed. Ubiquiti’s patents could be on the thicket fringes, but I can’t give a useful opinion about it.

When patent trolls spot infringement, they’ll usually assert their patents through a letter from an obscure patent-owning LLC where the ultimate ownership is hidden. Then they could wait for years letting uncollected royalties pile up before starting legal action. This is particularly likely for narrow patents that could be designed around.

There’s plenty about patent assertion and litigation in the second half of my Acacia Research – a privateer, and what happens at sea May 22, 2013.

A cash-pile is a deterrent against litigation, or at least a cash shortage makes a company vulnerable. If Ubiquiti had to repatriate cash to pay legal costs or settlements, they would have to pay tax.

    UBNT – Indemnification

From the 10-Q for Q1 2014: Ubiquiti are likely to indemnify distributors and OEMs without a limit, regarding liabilities for patent, copyright or trademark infringement. This seems like accepting normal business risk, as partner-companies can’t be expected to take on such liability when they aren’t responsible for design.

Ubiquiti indemnify directors and officers for any kind of actual or threatened proceeding, with some exceptions. From the 10-Q: “We have a director and officer insurance policy that limits our potential exposure.”. Insurance policy premiums are an expense which belongs in the accounts, not here. The potential exposure is not disclosed, and the rest of this part might not be very relevant, depending on the remaining exposure.


“… the corporation shall indemnify, to the fullest extent permitted by the DGCL …” a director or officer. (Then it gets complicated about who else is covered.) But only “… if such person acted in good faith …”

There’s no indemnity …

For “disgorgement of profits”.
If Ubiquiti want a bonus returned.
For anyone suing Ubiquiti or anyone connected with Ubiquiti (with exceptions, including ‘unless authorized’).
If the indemnity would be illegal.

The indemnity doesn’t stop when a director or officer leaves Ubiquiti (but only for things done or not done while at Ubiquiti).

That’s inexpertly condensed from four pages in this: “EX-3.2 3 dex32.htm FORM OF THIRD AMENDED AND RESTATED CERTIFICATE OF INCORPORATION” (sec.gov) (originally filed June 24, 2010), under “ARTICLE VIII – INDEMNIFICATION”.

Historically the costs have been low, but I don’t expect such costs to be stable or predictable. From the 10-Q: “Based upon our historical experience and information known as of the date of this report, we do not believe it is likely that we will have significant liability for the above indemnities at September 30, 2013 .”

The indemnity seems to cover less than for the other two companies, but it’s complicated.

    UBNT – Shareholder Class Action Lawsuits

Ubiquiti are accused of “… issuing false or misleading statements regarding the sale of counterfeit versions of our products.” My impression is that any time a company has bad news or the share price dives, some shareholders are likely to get lawyers involved, or maybe some lawyers are likely to get shareholders involved. Ubiquiti claim the case is without merit, and because the case is at a very early stage they can’t estimate the cost if they lose.

    UBNT – Tax uncertainty

Most of Ubiquiti’s cash is held overseas.

“As of September 30, 2013 , we held $253.8 million of our $279.7 million of cash and cash equivalents in accounts of our subsidiaries outside of the United States and we will incur significant tax liabilities if we decide to repatriate those amounts.” (the 1Q 2014 10-Q)

That’s a little odd as about 25% to 33% of the revenue has come from North America since 2011, nearly all of it from the United States (search the 10-Q and 10-K for “North America”). Working backwards from 2013, the ratio of Ubiquiti’s Provision for income taxes / Income before provision for income taxes, has been 12%, 17%, 20%, 204%, and 45% tax. While the pre-tax income grew 311%, the provisions for tax grew 40%. One possibility is that some cash is not in the United States due to tax management (possibly involving the subsidiaries in the Cayman Islands), although some of the cash in the United States will be consumed by HQ expenses, which will be more than the expense of overseas sites.

In any case, Ubiquiti warn “The final determination of our income tax liability may be materially different from our income tax provision.” and say “Significant judgment is required in determining our worldwide provision for income taxes.” in the 10-K for 2013. International taxation is complicated (and controversial), with opportunities for paying less or little, but with the risk of getting a big unexpected tax bill. That might be the explanation for the 204% tax provision in 2010, but I haven’t checked.

    UBNT – Contractual Obligations and Off-Balance Sheet Arrangements

These are in thousands (Ubiquiti forgot to say so, on the 1Q 2014 10-Q, page 24).

Operating leases $7,154
Debt payment obligations $75,000
Interest payments on debt payment obligations $4,806

The Debt payment obligations ought to be on the balance sheet already. To check:

From the 1Q 2014 balance sheet:
Debt – short-term 5,015
Debt – long-term 69,874
total debt = 74,889 (my addition)

which is close enough to $75,000. As there’s no material discrepancy, the Debt payment obligations will be on the balance sheet as they should be, so they aren’t included in the OCC calculation (see “Quantified obligations, commitments and contingencies”, below).

Some of the interest on the debt is variable. From “Interest Rate Sensitivity” in the ‘Market Risk’ section, a 2% increase in interest rates would cost $1 million over 12 months if they didn’t react. It would be odd if they are contractually unable to pay off long term variable-rate debt without a huge penalty, when they hold so much cash, although there’s the tax they would have to pay if they moved some cash to the U.S.. As they hold cash, have low capex requirements, and their options for acquisitions are limited, it’s unlikely that Ubiquiti will be vulnerable to interest rate rises. Regarding the return on their cash holdings: “The fair value of our cash and cash equivalents would not be significantly affected by either a 10% increase or decrease in interest rates due mainly to the short-term nature of these instruments.”

There’s some foreign currency risk because sales are in dollars and operating expenses are in currencies local to the operations. In 4Q 2014, a 10% movement in the dollar’s rate of exchange would not have had a material impact.

    UBNT – Possible omissions

I don’t think Ubiquiti have any off-balance sheet tax liabilities, but you can find the short paragraph with “$12.3 million of unrecognized tax benefits” to start your own investigation.

    UBNT – Quantified obligations, commitments and contingencies

(In thousands)

Operating leases $7,154
Interest payments on debt payment obligations $4,806

Total obligations, commitments and contingencies = $11,960

    UBNT – Cash, net of everything quantified

To sum up for Ubiquiti (in thousands):

$279,729 Cash and cash equivalents
$152,583 Total liabilities
$11,960 Total obligations, commitments and contingencies


$279,729 Cash and cash equivalents
$127,146 Cash and cash equivalents net of Total liabilities
$115,186 Cash and cash equivalents net of Total liabilities, Obligations, commitments and contingencies

That’s over $115 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify. This isn’t easy, and please feel free to check my deductions and look for more.

See also “UBNT – Unquantified” under “Ubiquiti Networks – Summary”.

Ubiquiti Networks – test 2 and 3

Test 2 – Cash from operations has to be positive and generally bigger than the cash that goes into investment.
Test 3 – A reasonable expectation that cash from operations minus cash invested, per share, will grow at a faster than average rate.

Ubiquiti is fairly obviously a cash generating company with high growth expected unless something goes badly wrong.

In my spreadsheet and charts for Ubiquiti, the cumulative figures might be superfluous as the excess of cash-from-ops over investment is clear. I accumulate first, then divide by the number of shares. The charts use the diluted share count in the non-GAAP reconciliation which is bigger than the count in the income statement, until 2013. Find “higher share counts than are used in the income statements” below.

Ubiquiti cash walk to 2013 spread

Ubiquiti cash walks per share to 2013

Comparing the latest quarter to previous results:

Period ~ Cash from operations ~ Cash into investing ~ Weighted-average shares (diluted) (in thousands)

1Q 2014 ~ $51,880 ~ $460 ~ 89,473
1Q 2013 ~ $23,695 ~ $2,349 ~ 92,925
2013 /4 ~ $32,973 ~ $1,341 ~ 90,259 (2013 average per quarter)

There are a few accounting complications here, which are likely to occur when looking at cash flow over short periods. Part of the increase in cash from operations will be the result of faster cash collection, with a record low Days Sales Outstanding of 25 days. Ubiquiti expect the DSO to move back to their 45 to 50 days target range, which will tend to reduce the cash flow. The cash effect of the difference of 20 to 25 days is roughly a quarter of a quarter’s revenue, but Ubiquiti seem to imply that the DSO will increase gradually. See under “Balance Sheet” in the 1Q 2014 CEO / CFO Commentary.

In thousands, with 1Q 2014 revenue = $129,687
revenue per day = $129,687 / 91.25 = $1,421.227 per day
50 days revenue = $71,061
25 days revenue = $35,531

Calculating 2013 DSO using DSO = Number of days in the period * Receivables / Sales in the period
2013 DSO = 365 * 35,884 / 320,823
2013 DSO = 40.8

The DSO for 1Q 2014 was 25 days, and if it had been 41 days (as for 2013), that’s an extra 16 days, worth 16 * $1,421.227 = $22,740, and the quarter’s cash from operations would have been:

(in thousands)
$51,880 – $22,740
= $29,140

which is less than the 2013 quarterly average of $32,973 (dividing 2013 cash from operations by 4).

However, while it’s the DSO that stands out, and the Chief Financial Officer draws attention to it, it’s better to look at all the non-cash working capital.

Ubiquiti non-cash working capital 2013 - 1Q 2014 spread

Non-cash working capital fell from $6,363 to -$4,038 (from end 2013 to end 1Q 2014), a fall of $10,401. When non-cash working capital can swing from positive to negative, it makes less sense to calculate a normal requirement of non-cash working capital / revenue, for a short-term calculation. Instead, I’ll adjust the 1Q 2014 cash from operations by the absolute fall of non-cash working capital.

Adjusted 1Q 2014 cash from operations = $51,880 – $10,401 = $41,479

Period ~ Cash from operations ~ Cash into investing ~ Weighted-average shares (diluted) (in thousands)

1Q 2014 ~ $41,479 ~ $460 ~ 89,473 (cash from operations has been adjusted)
1Q 2013 ~ $23,695 ~ $2,349 ~ 92,925
2013 /4 ~ $32,973 ~ $1,341 ~ 90,259 (2013 average per quarter)
2013 /4 ~ +25.8 % ~ -65.7 % (increase from 2013 average per quarter)

That’s a 25.8% increase in cash from operations, from the 2013 average to the 1Q 2014 amount adjusted for the absolute change in non-cash working capital. (The share count also reduced slightly.) The 25.8% increase is not per year, it’s per 7.5 months (taking the mid-points of the periods) and is the same compound rate as 43% per year (because both result from 0.09786% per day).

Because there are some complications around the cash figures and I’ve written about a short-term change, it’s worth giving income-based figures.

Earnings per share (diluted)
1Q 2014 $0.45
1Q 2013 $0.14
2013 $0.89
2012 -$0.12
2011 $0.07
2010 -$0.08

Although the history is short and there are some accounting complications, Ubiquiti generates cash from operations well above investment needs, with fast growth.

Ubiquiti’s big size change

The fact that Ubiquiti was a lot smaller and had less per share confirms the free cash flow growth, because there’s no feasible other way they could have gained their success. I’m not using this to check Ubiquiti so much as illustrating the principle, because Ubiquiti’s growth is obviously real.

(in thousands)

Ubiquiti’s cash from operations was $131,891 in 2013, and cumulatively $250,536 since 2010.
Subtracting cash into investment, free cash flow was $126,528 in 2013, and cumulatively $240,769 since 2010. Ubiquiti have $279,729 Cash and cash equivalents, and above I found that they have $115 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify.

Those are very big numbers compared to older numbers:

Total assets 2010 $82,090, 2008 $12,820
Cash and cash equivalents 2010 $28,415, 2008 $5,936
Revenue 2010 $82,404, 2008 $10,942
Net income 2010 -$5,456, 2008 $4,697
Cash from operations 2010 -$25,985

Meanwhile the share count has gone down:

Weighted average shares Diluted 2013 90,259, 2010 105,109
(Using the diluted share count in the non-GAAP reconciliation. Find “higher share counts than are used in the income statements” below.)

I included 2010 because that’s when the cash flow figures start.

The difference between Ubiquiti in 2008 or 2010 and now is massive. That difference, and the growth in free cash flow, support each other as being genuine, and it’s very hard to imagine it’s all fake. I’d be less confident if I based a comparison on revenue, for example Enron Corp. had suspiciously high revenue growth for a few years, without much growth in cash from operations.

Using cash net of Total liabilities and OCCs closes loopholes that could allow cash to be increased at the expense of greater OCCs, which would not show up in the liabilities or the share count. The $115 million ‘net of everything’ is more than Total assets in 2010 ($82.1 million), and more than the 2010 revenue ($82.4 million). That’s big solid growth which couldn’t be faked through manipulation. Any company could fake fantastic numbers if they are prepared to forge documents on a massive scale, but that’s very risky and understandably rare compared to the various tricks I’ve mentioned.

Ubiquiti Networks – other considerations

This is a selection, not ‘everything else’.

    UBNT – Off-balance sheet financing and special purpose entities

“As of June 30, 2013 and 2012 , we had no off-balance sheet arrangements other than those indemnification agreements described above.”

I described the indemnification earlier.

Ubiquiti have two subsidiaries in the Cayman Islands, Ubiquiti Cayman Limited and Ubiquiti International Holding Company Limited, with no further information in the 10-K. It could be something to do with tax, and with no off-balance sheet arrangements there shouldn’t be anything to worry about. I found nothing listed as a special purpose entity or anything similar.

    UBNT – Cash and Cash Equivalents definition

“The Company considers investments purchased with a maturity period of three months or less at the date of purchase to be cash equivalents. … The Company deposits cash and cash equivalents with financial institutions that management believes are of high credit quality. The Company’s cash and cash equivalents consist primarily of cash deposited in U.S. dollar denominated inter-bearing deposit accounts.”

“inter” looks like a typo for “interest”.

The statement “All investments with a maturity period of three months or less are cash equivalents” does not imply that all or even 1% of cash equivalents are investments with a maturity period of three months or less, any more than “all tigers are animals” implies that many animals are tigers. “The Company considers investments …” leaves open whether it’s some or all the investments maturing in 3 months or less, that are C&CE. Maybe management expect form-readers to breath in the mood music and ignore logic.

If ‘primarily’ means 50% or more (is deposited in U.S. dollar denominated interest-bearing deposit accounts), the worst case is that half of the C&CE is the riskiest thing that can be deposited with financial institutions of high credit quality, with no other upper limit on maturity.

The best reassurance for the maturity of the portion not covered by ‘primarily’ is not from the definition, but under “Interest Rate Sensitivity” in the 1Q 2014 10-Q:

“The fair value of our cash and cash equivalents would not be significantly affected by either a 10% increase or decrease in interest rates due mainly to the short-term nature of these instruments.”

A large holding of bonds with a long time to maturity would be sensitive to interest rates.

    UBNT – Revenue recognition

The “Recognition of Revenues” section in the 10-K is too long to quote in full, but seems reasonable so far as I can tell. It includes:

“We recognize revenues when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and the collectability of the resulting receivable is reasonably assured.”

Customers have no “… provisions for cancellation, returns, inventory swaps or refunds that would significantly impact recognized revenues.”, which should mean that revenue figures are reliable.

    UBNT – Audits of internal control over financial reporting

The auditors, PricewaterhouseCoopers, give the accounts and the internal controls a clean bill of health, with “… in conformity with accounting principles generally accepted in the United States of America.”, and “Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2013.”.

That’s good enough, and it isn’t Ubiquiti’s fault that the auditors don’t use “unqualified opinion”, and complicate the fact that they found the accounts to be fair. If only they could say ‘The accounts are true and fair in our unqualified opinion. The internal control over financial reporting is adequate. BTW we checked the Cayman Island companies.’

    UBNT – Non-GAAP reporting

Ubiquiti use non-GAAP reporting. In my opinion, the level is mild, and the reconciliation in the 1Q 2014 10-Q only deducts Stock-based compensation from GAAP Net income, and adjusts for the tax effect, to get non-GAAP Net income. Here I’ve summed their compensation breakdown:

1Q 2014 (in thousands)

GAAP Net income = $40,528
Stock-based compensation = $1,167
Tax effect of non-GAAP adjustments = -$467
Non-GAAP net income = $41,228

If stock-based compensation is a necessary cost, it shouldn’t be magicked away.

“Income from a coexistence licensing agreement” would also be excluded if any existed.

The non-GAAP figures are often shown near the GAAP figures.

The CEO and CFO Commentary statement that “Reconciliations of the adjustments to GAAP … are provided below.” is not true, unless “below” means “in another document”. It’s a common trick, but even Masonite International who are low on my trust-list managed to put a proper reconciliation at the end of a presentation.

Ubiquiti’s non-GAAP reconciliations have higher share counts than are used in the income statements, until 2013. The higher share counts include Series A convertible preferred stock (which paid interest and could be converted to shares). Because Ubiquiti had been buying in their Series A stock, the share counts in the reconciliations have been generally coming down, whereas the amount of common stock has generally gone up. By 2013, all the Series A stock had been bought in or converted. While including the Series A stock improves the trend of the non-GAAP ‘per share’ figures, it’s justified. I don’t know why they couldn’t include “fully diluted” numbers in the income statement.

    UBNT – Related-party transactions

Ubiquiti had no related-party transactions in 2013 exceeding $120,000, as at October 28, 2013. That information was hard to track down, and would cover a hundred transactions for $120,000 each, with no information for investors to judge if they were appropriate, although I expect it meets the SEC’s requirements to the letter. See “CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS” in DEF 14A filed with the SEC 10/28/2013.

    UBNT – Useful life

Testing equipment 3 to 5 years
Computer and other equipment 3 to 5 years
Furniture and fixtures 3 years
Leasehold improvements shorter of lease term or useful life

IMO that’s very conservative yet not too short. With only two years leeway on the first two categories, and none on the third, there’s little scope to manipulate earnings to fall earlier or later.

    UBNT – Visual exaggeration in charts

None – I haven’t found any charts.

    UBNT – Potential CEO dominance

Robert J. Pera is the CEO and founder of Ubiquiti, and has seen the company through high growth and a crisis. He owns 65.40% of the common stock, as of September 30, 2013.

Officers and Directors own 73.80%, for details see “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT RELATED STOCKHOLDER MATTERS” in the 14A I linked to earlier.

The CEO gets zero Total Compensation, including Salary, Bonus, Stock Awards, and Option Awards. For comparison, the CFO, Chief Marketing Officer, and General Counsel and Vice President of Legal Affairs, get $1,994,043, $1,596,506 and $1,474,515.

    UBNT – Poison pills and severance

“Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.

… These provisions include:

§ providing for a classified board of directors with staggered, three year terms;
§ authorizing the board to issue, without stockholder approval, preferred stock with rights senior to those of our common stock;
§ prohibiting stockholder action by written consent;
§ limiting the persons who may call special meetings of stockholders; and
§ requiring advance notification of stockholder nominations and proposals.”

In other words, just as bad as IPG Photonics, even though the young CEO has a majority shareholding. I didn’t notice any sign of these in the latest 10-K, but traced them through the Exhibits in the 10-K. “… preferred stock with rights senior to those of our common stock” means that without finding further information, the common stock could be worth less, with no obvious limit on how much less. The other question is, who gets the preferred stock, and on what terms.

There might be more information in these legalistic filings:

EX-3.4 5 dex34.htm FORM OF AMENDED AND RESTATED BYLAWS OF UBIQUITI NETWORKS, INC.” (sec.gov) (initially adopted on June 25, 2010)

EX-3.2 3 dex32.htm FORM OF THIRD AMENDED AND RESTATED CERTIFICATE OF INCORPORATION” (sec.gov) (originally filed June 24, 2010) (already linked to above)

S-1 1 ds1.htm REGISTRATION STATEMENT ON FORM S-1” (sec.gov) (As filed on June 17, 2011)

The “Potential Payments upon Termination or Change of Control”, “Within 24 Months After Change of Control”, add to $4,045,070 (i.e. over $4 million). Most of that is to Craig L. Foster, including $1,929,400 of Acceleration of restrictive stock units. $2,806,400 of that depends on the share price and was based on $17.54 per share in June 30, 2013. The price is currently $43.77 and could be a lot higher if the company was acquired. This all affects the price an acquiring company would pay. Overall, management would probably not be rewarded above average, and the CEO gets nothing automatically. His majority shareholding prevents a hostile acquisition, and his financial interests are aligned with shareholders. He also seems to be committed to the company, and I’m not keen on seeing Ubiquiti acquired.


The director and officer insurance policy that limits potential exposure. It’s good, but without hard information I don’t know how good.

The voluntary self-disclosure about illegal export to Iran could be an indication of honesty. Not doing so would have been very risky after a warning for a previous case, but having read about some appalling management I expect some companies would have kept the matter quiet.

Ubiquiti Networks – Summary

Note – the summaries are selective and are in my own opinion.

$115.2 million ‘net cash’, which is net of Total liabilities and every obligation, commitment and contingency I could find and quantify.

The definition of Cash and cash equivalents has a logical loophole.

Potential for many years of growth, and high growth for some of them.

Not easy to satisfy growing demand with low visibility.

In a contentious area regarding patents.

Non-GAAP reporting, but only excluding stock-based compensation.

Reporting of related party transactions leaves questions.

The CEO could potentially dominate.

    UBNT – Unquantified

The $115.2 million ‘net of everything’ excludes illegal exports with guilt admitted, a Shareholder Class Action, some uncertainty about taxes, and the potential cost of indemnifying distributors and other business partners.

Possible errors include obligations, commitments and contingencies (OCCs) I didn’t find, double-counting an OCC which is included in liabilities, and I might have missed further information about the indemnity insurance.


Different models

IPG Photonics and Ubiquiti Networks have opposite business models. IPG are highly vertically integrated, while Ubiquiti Networks outsource production and sales. Both companies have been very successful, which shows the importance of having a model which fits the market (or targeting markets which fit the model), although other factors are involved than just the business model. Repligen has no over-arching model that I can see, but they are completing an astute move from the glamor of life sciences to the steadier ‘picks-and-shovels’ business of supplying bioprocessing inputs. The three companies which I identify as being ‘cash3’ are diverse on many levels, but share real financial strength.

Closing thoughts on cash3

Many growth companies consume more cash than they generate. This pushes the return of cash to shareholders into the future, and creates financial risk, which in turn produces pressure to ‘accentuate the positive’ (lyrics and ringtone) through everything from manipulated cash flows to the horrors of adjusted EBITDA. Companies that pass the cash3 tests still have market risk and other risks, but the financial risk is minimal. Management could still tweak the financial results to increase their compensation when their interests are not aligned with shareholders, but the pressure to deceive to survive or to generate unrealistic optimism before raising capital, is absent, at least until circumstances change. Because deceit results in overvaluation, honesty is relatively undervalued.

The pressure to keep up appearances is also pressure to make short term gains at the expense of strategic objectives.

Cash3 companies have the resources to survive setbacks and avoid a permanent loss of capital for their shareholders, but they are not invulnerable, and new management or new circumstances could result in the cash being spent unwisely. None of the arguments in favor of the cash3 approach amount to empirical evidence.

Trying to be fair

While I aim to be fair and accurate, I’ve covered some complex areas and it’s likely that I’ve been unintentionally unfair to a company or office-holder. Relevant facts and opinions are always welcome in the comments, but here I especially welcome a factual correction to any unfair remarks I’ve made.



Read forms once and make notes

The aim here is mainly to avoid looking through a 10-Q or 10-K form too often.

Start with headings in a text document. For my list find “The headings I use for each company are” above, or make your own list. Then make notes under the appropriate heading as you read, adding new headings if anything stands out that needs one. If you find something really bad, there’s no point in continuing, just reject the company. Also see “Make easy checks first” above.


This is to help with further research.

IPG Photonics (from the 10-K for 2012)

High-power CO YAG and disc lasers – Fanuc, Rofin-Sinar Technologies, Inc., Trumpf GmbH + Co. KG
Mid and low-power CO solid-state lasers – Coherent, Inc., GSI Group Inc., Newport Corporation, Rofin-Sinar Technologies, Inc.
Direct diode lasers – Laserline GmbH
Fiber lasers – Rofin-Sinar Technologies, Inc., Trumpf GmbH + Co. KG, GSI Group Inc., Coherent Inc., Hypertherm, Inc., Newport Corporation, The Furukawa Electric Co., Ltd., Keopsys SA, Mitsubishi Cable Industries, Ltd., Miyachi Unitek Corporation, Raycus Fiber Laser Technologies Co. Ltd., Maxphotonics Co., Ltd., JDS Uniphase Corporation

“Several competitors recently introduced fiber lasers or announced plans to introduce fiber lasers that compete with our high-power products.”

In the communications market –
Mid-power fiber amplifiers and DWDM systems – Oclaro Inc., the Scientific-Atlanta division of Cisco Systems, Inc. (Scientific-Atlanta), Emcore Corporation, JDS Uniphase Corporation and MPB Communications Inc.

In the materials processing, advanced and medical applications markets, IPG also compete with end users that produce their own solid-state and gas lasers as well as with manufacturers of non-laser methods and tools, such as resistance welding and cutting dies in the materials processing market and scalpels in the medical market.

Repligen Corporation

GE Healthcare.

Repligen don’t name their competitors. The 10-K for 2012 ‘Competition’ section includes “… range in size from large, multi-national companies to small, private emerging growth companies.”, before warning of the risk of existing and new products being made obsolete.

The legal boilerplate has “We face competition from numerous competitors, most of whom have far greater resources than we have, …” and much more of the same, but some of it might be a hangover from before the focus on bioprocessing.

For more useful info but only about chromatography, find “RGEN – Chromatography competition” above, and the first link there has more names.

Ubiquiti Networks, Inc (from the 1Q 2014 10-Q)

Integrated radio – Motorola, Trango
Integrated radio 900MHz – Cisco, Proxim
Embedded radio – Mikrotikls, Senao
Backhaul – Ceragon, DragonWave, Mikrotikls
Microwave backhaul – Cambium, DragonWave, SAF Tehnika, Trango
Customer Premise Equipment – Mikrotikls, Ruckus, TP-LINK
Antennas – PCTEL, Radio Waves
Enterprise WLAN – Ruckus, Aruba Networks, Cisco
Video surveillance – Vivotek, Axis Communications, Mobotix
Machine-to-machine communications – EnergyHub, Motorola, AlertMe.com

Sources of financial information

I divide the information needed into 1) prospects, 2) financial, and 3) OCCs, accounting policies and governance. The most reliable and comprehensive sources are the forms which companies are required to file with the SEC, though less so for 1) prospects. The SEC filings are described in the next section.

1) The prospects part provides the easiest reading, including presentations, transcripts on Seeking Alpha, and articles, although it could involve making your own projections if you already do that. The information feeds in to ‘test 3’, which is about growth.

2) The financial part is at least easy to find in the annual 10-K and quarterly 10-Q forms filed with the SEC, available from their archive of historical EDGAR documents. The forms are also nearly always available on the company’s website. The financial part is simplified by focusing on cash, with less need to examine quantities like inventories or accounts payable, although the income statement can reveal unsustainable sources of cash. Some history of cash flows will usually be relevant to tests 2 and 3, about free cash flow and its growth.

3) OCCs, accounting, rules and governance – this is the beast. The information applies to the tricky phrases in test 1 – “obligations, commitments and contingencies, including material off balance-sheet items”, and “with no accounting policies that cause significant doubt about the cash figure”. Like the financial part, this draws on the forms filed with the SEC, but requires more types of form, and exhibits, each of which is associated with a form. Even when the form is found, getting sense out of it isn’t always easy.

I also use 3) for some of my ‘Other considerations’, which are not an integral part of cash3. Delving further into the accounting policies and governance etc gives me some idea of how far I can trust management. Also, I might as well make further use of the sources I’ve found for the cash3 tests, for example the 10-K is usually needed for test 1, and the “Related-party transactions” are in the same 10-K.

Forms filed with the SEC (Securities and Exchange Commission)

The forms are available from the archive of historical EDGAR documents (already linked to) and are nearly always on the company’s website.

Annual financial filing, with the accounts, notes to the accounts, and more. When I say “10-K for 2012” I mean that 2012 is the fiscal year the form covers. It could have a filing date in early 2013, if the company’s fiscal year matches the normal calendar year.

Quarterly financial filing, like a 10-K but shorter.

Proxy statement, which invites shareholders to attend the annual meeting, and has information relating to the company’s officers and directors.

IPO Registration (IPO is Initial Public Offering). It contains a prospectus for a public offering of shares. The prospectus has information to help an investor decide if they want to buy the shares.

An amendment, so S-1/A means it’s an amendment to the previous S-1.

I’ve kept it simple. A company will file different forms if it was incorporated on a Thursday (I’m joking, but it gets a bit like that). See “Guide to SEC Filings” (research.thomsonib.com) and “SEC filing” (Wikipedia)

Much of the accounting policies and governance information is in the Form 10-K in the notes to the accounts, but some could be in a more recent 10-Q.

Also see “Where to find cash info” (in 10-Qs and 10-Ks). It’s above, but it’s quicker to search down.

Exhibits, and how to find them

Sometimes the information needed is in an exhibit, such as the Certificate of Incorporation, which you hunt down by finding an associated form. The exhibit can be included in the form, or have a link on the same page as the form, on the SEC’s EDGAR database. Exhibits are usually legalistic and can be even harder to make sense of than 10-Ks and 10-Qs.

This is how I found Repligen’s Restated Certificate of Incorporation. I searched their 10-K for 2012 for “Incorporation”, and found this in the “Exhibits” section:

“Restated Certificate of Incorporation dated June 30, 1992 and amended September 17, 1999 (filed as Exhibit 3.1 to Repligen Corporation’s Quarterly Report on Form 10-Q for the quarter ended September 30, 1999 and incorporated herein by reference) (SEC File No. 000-14656).”

It might have been easier to get the 10-Q from Repligen’s site, but I found it from here. Then I searched the 10-Q for “Incorporation”, until I found “EXHIBIT 3.1 RESTATED CERTIFICATE OF INCORPORATION”, the title for four pages. That’s followed by amendments, about the number of shares Repligen can issue.

It’s likely that the old 10-Q is up to date about the Certificate of Incorporation, as it was referenced from the 10-K for 2012, but I can’t promise.

The last part of the method doesn’t always work, because sometimes the exhibit is not included in the form (the 10-Q in the above case). For example, Ubiquiti’s S-1 dated 06/17/2011 did not include the exhibit 3.4. Following the link in the search results on EDGAR, the S-1 was the top item in a list, like this except the headings (in bold) were column headings in a table:

Seq 1
Document ds1.htm
type S-1

The document with exhibit 3.4 was listed like this, on row five:

Seq 5
Document dex34.htm
type EX-3.4

To find the By-laws (for example): search a 10-K for ‘By-laws’ until you find a clue to follow, such as an entry under ‘EXHIBITS’ which gives a form-code and a filing date. If that doesn’t work, try earlier 10-Ks, or ask the company’s Investor Relations. The filing date won’t always be an exact match, and you might have to check more than one file to make sure you have the right document. The trail can usually be followed for any search that ends up in EXHIBITS on a 10-K. There are exceptions, for instance Repligen’s 10-K for 2012 reproduces an agreement with Pfizer, with confidential provisions omitted, so you get the document immediately instead of a trail to follow.

Finding obligations, commitments and contingencies

This might sound too demanding, but if you have the time, go through the 10-Q first (if it’s more recent) and make notes, then go through the 10-K and add anything relevant that wasn’t in the 10-Q.

As a guide for what to look for, the Obligations, commitments and contingencies (OCCs) I’ve written about for the three companies are:

Quantified –

Interest obligations
Operating lease obligations
Purchase obligations (commitments to buy)
Contingent consideration (but they could be included in liabilities already)
the liability if a tax dispute is lost

Unquantified –

Legal proceedings (intellectual property / Illegal export to Iran / Shareholder Class Action Lawsuits)
Pension commitments (probably minimal)

They don’t each apply to all three companies.

Three of the ‘quantifieds’ will usually be under a head like (or starting with) “Contractual Obligations”, they are:

Operating lease obligations
Purchase obligations
Contingent consideration (likely to be already included in liabilities)

Under the same heading, you might also see “Long-term debt obligations” which should be already included in liabilities. This: “Long-term debt obligations (including interest)” can be used to calculate the interest obligation if it isn’t disclosed separately.

There are five time-saving principles, but they are specific to the cash3 approach and specific to only getting the Obligations, commitments and contingencies, and I can’t be sure they’re safe. a) Avoid irrelevant sections. b) Skip trivial amounts. c) Assets are irrelevant. d) Liabilities on the balance sheet are irrelevant. e) If debt is low, ignore anything about the period’s income or cash flow.

For a), irrelevant sections include any general description of the business, and the regular accounts. The cash flow statements concern the other tests (2 and 3).

For b), note what the Cash provided by operations is (find the cash flow statement or search for “Cash provided”) and decide on a threshold below which amounts are too too trivial to bother with. If cash from ops is $100 million, and you set your threshold to $0.5 million, remember that $600 could be ‘in thousands’, i.e. $600,000. (This would scale up for a big company). This could fail if too many figures are below the threshold.

For c), the value put on inventories, buildings etc. has nothing to do with the OCCs.

For d), if liabilities are understated, that comes under “accounting policies that cause significant doubt”, or shows up as a matching obligation (if there aren’t any clues, something is seriously wrong).

For e), if debt is significant, the income statement matters and so can the cash flows. The reason is that debt usually comes with covenants (agreements which lenders insist on), with conditions, and penalties such as higher interest. A common condition is that an income measure like EBITDA should not fall below a threshold amount. Search the 10-K for ‘covenant’ or check the “Liquidity and Capital Resources” section. If the covenants are based on EBITDA, check that EBITDA looks healthy enough. This example from IPG is based on cash flow: “The debt service coverage covenant requires that we maintain a trailing twelve month ratio of cash flow to debt service that is greater than 1.5:1. Debt service is defined as required principal and interest payments during the period.” With their cash and cash flow, the covenant is not a serious concern, although it’s when a big shock causes a covenant to be breached that the penalty is particularly unwelcome.

At this stage, the income statement should already have been checked for ‘one-off’ gains which could be included in cash flow, and the relevant cash flows should already have been found and considered (see “Make easy checks first”, above).

Please note, I can’t be sure that a) to e) are safe. I’m trying to take investors’ limited time into account, but (as I’ve said) in the worst cases, management can be slippery.

Indemnification is an awkward OCC because it’s safest to look for it in the 10-Q first (if it’s more recent than the 10-K), and then in the 10-K (which might have more detail), and then outside the 10-K, probably in either an S-1 or the latest version of the Certificate of Incorporation.

I’ll repeat that this section is specific to getting the Obligations, commitments and contingencies. Outside of that, ideally, most of the 10-Q and 10-K should be read. I didn’t read much of Repligen’s long contract with Pfizer. I don’t bother with the audit committee because I just want the auditor’s opinion. I skip anything about company officers certifying documents.

Signing off

No-one has endorsed this blog post and I’m the only person who’s checked it before posting. A piece this big is bound to have mistakes. According to IBM, 5.2% of spreadsheet cells contain errors (see under “Spreadsheets and reliability” in my Correlation and regression with a real example July 16, 2013). I hope I’ve done a lot better than that.

I haven’t systematically compared forms filed with the SEC to previous forms. Looser accounting policies and new risks are red flags, and I hope to compare forms when new 10-Ks are filed, if I have the time.

Thank you for reading this piece. If you read most of it – very well done!




January 18, 2014 – I’ve made small changes and added some paragraphs. There are no factual corrections or changes of opinion. To find paragraphs added or changed, find:

Many investors will be unfamiliar
One risk to watch out for when the CEO is very dominant
UBNT – Tax uncertainty
Closing thoughts on cash3

January 19, 2014 – Matthew Dow’s December article about Ubiquiti has gone behind Seeking Alpha’s paywall, so I’ve removed most references to it and described the key personnel risk myself.

All the charts again

IPG cash from ops and into investment - spread

IPG walks for cash from ops and into investment

IPG walks per share for cash from ops and into investment

Repligen cash flows to 3Q 2013 spread

Repligen cash walks per share to 3Q 2013
In Repligen’s cash flow charts, the recent rise is partly the result of recent growth in royalty revenue which expired on December 31, 2013. The latest quarter, 3Q 2013, also benefits from changes in working capital that can’t be sustained.

Repligen cash flows per share to 3Q 2013

Repligen recent revenue and costs - spread

Repligen recent revenue and costs

Repligen walk chart of product cost against revenue

Ubiquiti cash walk to 2013 spread

Ubiquiti cash walks per share to 2013

DISCLAIMER: Your investment is your responsibility. It is your responsibility to check all material facts before making an investment decision. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Furthermore, you should read all transaction confirmations, monthly, and year-end statements. Read any and all prospectuses carefully before making any investment decisions. You are free at all times to accept or reject all investment recommendations made by the author of this blog. All Advice on this blog is subject to market risk and may result in the entire loss of the reader’s investment. Please understand that any losses are attributed to market forces beyond the control or prediction of the author. As you know, a recommendation, which you are free to accept or reject, is not a guarantee for the successful performance of an investment.

IPG Photonics – growth, cash, markets and technology

Company: IPG Photonics Corporation (IPGP)

Disclosure: I’m long IPGP.

Company website: http://www.ipgphotonics.com/

Morningstar quote / Yahoo quote / Seeking Alpha IPGP page

Valuation September 27 2013 – Price $57.33 / Market cap $3 billion / Forward P/E 15.3 to 15.9 (sources vary) / no regular dividend

Trailing twelve month ratios: P/E 19.90, Price/Sales 4.91, Price/Cash Flow 16.40
Price/Book (Most recent quarter) 3.68

Projected EPS Q4 2012 to Q3 2013 = $2.903 to $3.003
Projected P/E Q4 2012 to Q3 2013 = 19.09 to 19.75
(See ‘Valuation’ at end.)



I’ll be quoting from:

IPG Photonics’ CEO Discusses Q2 2013 Results – Earnings Call Transcript“, Jul 30 2013, seekingalpha.com

which I’ll refer to as “the transcript”.

IPG’s SEC filings are on this page on their website, with links for other reports on the left. The presentation pdf “Needham 2nd Annual Advanced Industrial Technologies Conference” and the Prepared Remarks for the Conference Call can be downloaded from the company’s Events & Presentations page.


IPG’s main business is making fiber lasers for industrial applications. The ‘materials processing’ segment includes marking and engraving, cutting and welding, and accounts for 88% of sales, leaving Telecom, Advanced and Medical which make up the other 12%. The company is pushing its laser technology into high power, fine processing, micromachining, semiconductor, low cost replacements for cheap flash lamp pumped lasers, and advanced laser systems. For many years, that technology was fiber laser technology, but IPG have more recently acquired excimer laser and diode pumped solid state laser technology. The company now produces direct diode lasers, where the beam is from the laser diodes instead of using them to optically pump a gain medium such as active fiber. IPG have also acquired Photonic Crystal Fiber technology, described later.

There’s some history and general background including IPG’s vertical integration, in a previous post: IPG Photonics – growth, a miss, opportunity and threat March 10, 2013, mostly near the beginning.


Results were reported on July 30, 2013, and they were generally good:

Revenue Q2 2013 $168.2 millionup 22% from Q2 2012
Revenue Q2 2012 $137.9 million

Gross margin Q2 2013 53.5%down 0.8% from Q2 2012
Gross margin Q2 2012 54.3%

Operating income Q2 2013 $59.9 millionup 11% from Q2 2012
Operating income Q2 2012 $56.4 million

Operating margin Q2 2013 35.6%down 5.3% from Q2 2012
Operating margin Q2 2012 40.9%

Net income Q2 2013 $41.7 millionup 11% from Q2 2012
Net income Q2 2012 $37.7 million (after subtracting $2.1 million attributable to non-controlling interests)

Earnings per share (diluted) Q2 2013 $0.80up 11% from Q2 2012
Earnings per share (diluted) Q2 2012 $0.72

R&D Q2 2013 $10.5 millionup 45% from Q2 2012
R&D Q2 2012 $7.2 million

There’s more detail in this table, including how some costs have risen as a percentage of revenue:

IPG Photonics Q2 2013 Income

Guidance for Q3 2013

Guidance for Q3 in the Q2 2013 earnings call transcript is for EPS of $0.77 to $0.87 per diluted share (or $0.82 plus or minus $0.05). That compares to $0.81 in Q3 2012. The mid point is only slightly above a 1% increase, which is only a fifth of the implied variation of $0.05, and a y.o.y. fall from $0.81 to $0.77 is within guidance.

Expected Q3 revenue is $165 to $175 million, with the $170 million midpoint 9% above Q3 2012.

Outlook for Q3 2013

Solid demand, a small backlog (book-to-bill was over 1), not much change in OpEx, gross margin 53 to 54% (from the Prepared Remarks and the transcript).

The cost of expansion

The 5.3% drop in operating margin is mostly explained by the rise in Research and development costs and General and administrative costs, as a percentage of revenue. The rises faster than revenue are probably a kind of investment. That’s obvious in the case of R&D (see UV lasers below), and from the Management Comments in the quarterly results:

    “Excluding foreign exchange rate gains, operating income grew by 12.6%. While this was lower than the growth in revenue, it reflects our investment in operating expenses to support IPG’s future growth.”

That might not seem consistent with the 10% rise y.o.y of inventories, compared to the 22% rise y.o.y in revenue. In thousands:

Inventories Q2 2013 $154,093 – up 8% from Q1 2013 – up 10% from Q2 2012
Inventories Q1 2013 $142,096
Inventories Q2 2012 $139,618

unless high inventories a year ago were in preparation for the revenue growth. Year-on-year, the ratio inventory / revenue has fallen from 1.01 to 0.92, implying that if revenue over the next year is correlated with inventories, revenue growth will be less than 22%. I don’t expect a tight correlation, and the R&D expense increased through the Mobius acquisition should add to revenue over the next year and beyond.

IPG has relatively long lead times, low turnover and high inventories, which would generally imply some expense ahead of expansion. From the 2012 10-K:

    “Given our vertical integration, rigorous and time-consuming testing procedures for both internally manufactured and externally purchased components and the lead time required to manufacture components used in our finished products, the rate at which we turn inventory historically has been low when compared to our cost of sales. Also, our historical growth rates require investment in inventories to support future sales and enable us to quote short delivery times to our customers, which we believe provides us with a competitive advantage. Furthermore, if there is a disruption to the manufacturing capacity of any of our key technologies, our inventories of components should enable us to continue to build finished products for a reasonable period of time. We believe that we will continue to maintain a relatively high level of inventory compared to our cost of sales.”

Relatively long lead times, low turnover, and high inventories, sound like what they teach you not to do in business school, but as the 10-K explains, there are advantages for IPG’s customers, as products are thoroughly tested and are more likely to be in-stock. The benefits to the customer have a cost to IPG. Continuing from the 10-K:

    “As a result, we expect to have a significant amount of working capital invested in inventory. A reduction in our level of net sales or the rate of growth of our net sales from their current levels would mean that the rate at which we are able to convert our inventory into cash would decrease.”

There’s also likely to be some extra hiring ahead of expansion, with a lag between recruitment and payback. (Danaher Corporation’s ChemTreat subsidiary has an estimated three-year payback period for new sales employees, see “Danaher’s Management Presents at Morgan Stanley Industrials and Autos Conference (Transcript)“, Sep 16 2013, seekingalpha.com.)

The effects of a downturn would be amplified by the high inventory. If it happened after preparation for expansion, inventory would be higher and recruitment would add to costs. The charts further down show the dip in 2007 and the sharp recovery.

Capital expenditure was $16.5 million in the quarter, in line with the $60 to $70 million expected for 2013 (in the 10-K for 2012). It’s a volatile number annually, and for 2010 to 2012 was $32,559, $79,099, $55,257 (in thousands).

From the transcript:

    “…we expect next quarterly year for revenue a year with a very big growth…”

I think that means big growth over the next four quarters. The quote is relatively straightforward, but I don’t understand a lot of what the CEO is transcribed as saying. You might be better than I am at following a webcast.

This article on Seeking Alpha makes some points about growth:

IPG Photonics Looking To Innovation And Integration” by Stephen Simpson, Aug 27 2013. seekingalpha.com

Gross margin and Cost of sales

The 0.8% drop in gross margin is explained by acquisition costs, product mix, and the mix of customers and regions sold to. In my opinion there must also be some impact from lower pricing to encourage sales of some new models and high power lasers. The rise in Cost of sales by 24.17% exceeds the rise in Revenue of 21.93% by 2.24%. That looks worse than the 0.8% gross margin drop. The numbers here are related by using the same variables, and the 2.24% is a different way of measuring the effect of the same factors that affect the gross margin. I didn’t notice any analysts asking about the faster rise in Cost of sales, possibly because analysts are used to looking at margins.

Q3 2013

The EPS guidance, large operating margin fall and maybe the small gross margin fall or the faster rise in Cost of sales, could explain some of the share-price under-performance.

The unexciting guidance might be explained by a continuation of “investment in operating expenses”. ‘OpEx’ is expected to hold steady at the Q2 2013 level, which gives a 16% y.o.y rise:

Total operating expenses (in thousands)
Q3 2013 – $30,047 – up by 16%
Q3 2012 – $25,952
increase $4,095

Opinion about investment and margins

While some excellent companies (the kind Warren Buffet likes) have slow and steady growth with little investment, there is also a case for companies that can absorb high investment and produce a good return on it, which IPG seems capable of. ‘Invest when the company invests’ might be worth considering when the investment seems to be under-appreciated by the market, which may be more likely when much of the investment looks like rising costs rather than capex. I’ve only just invented the phrase and haven’t had time to test the principle, and there are exceptions. In support, Danaher claim their ChemTreat subsidiary’s expansion through sales recruitment is hard for competitors to copy, because the three-year payback would cause temporary margin dilution and too much pressure from investors. This has let ChemTreat grow about 10% pa (mostly organic) in a market growing about 2% to 3% pa. How far the case generalizes towards investors over-weighting margin without considering the context, is a matter of opinion or experience.

In this and the previous Earnings Call transcript (and maybe more), I have the impression that when analysts ask about margin, they give high margin a high priority. IPG’s officers reply by explaining that high revenue is also good. The principle can be explained with simple math, although there are complications in practice. If you half the margin and double the number of items sold, profit stays the same. If you half the margin and the number of items sold triples, profit increases by 50%. Pricing depends on economies of scale and the sensitivity of demand to price. Some good businesses have high margins (sometimes relatively) and inelastic demand, while at the other end, retailers in price-sensitive markets have successfully used the low margin, high turnover and low cost model. IPG are somewhere in the middle but in a good position, with high margins that are also higher than competitors’ margins, combined with price elasticity. This time the CEO told analysts that a margin of 60% to 65% could be achieved for a while, but at the cost of sales growth.

High and stable margins might be seen as evidence of pricing power, but from what I’ve read about pricing power in relation to value-investing, it’s the ability to raise prices with little effect on demand. When IPG price at a lower margin to encourage demand, by implication they don’t have pricing power in that area, but pricing power is not necessary for a good business. The ability to add a big margin on to costs is an excellent substitute. With high gross and operating margins, and growth, a lower margin on some products to encourage take-up is not a negative. It would be different if margins were relentlessly driven lower by competition.

Some markets such as medical diagnostic equipment have had high margins for a long time, but if lasers are different and margins fall through competition, the best defense is to expand into new applications now, even if the expansion is sometimes helped by lower margins.

If you believe that margins are falling due to competitors catching up in fiber, or competing more effectively by whatever method, it’s your money and I can’t actually prove you wrong.

A long look back

I like charts showing the cash that’s gone into investment and the cash produced by operations. These cash flows are balanced by the cash provided by financing activities, and the net effect on the cash balance.

IPG cash from ops and into investment - spread

IPG cash from ops and into investment

These ‘walk’ charts show the same information as the time-series chart above. The format is unconventional but I find it easier to spot patterns in them.

IPG walks for cash from ops and into investment

My interpretation is that over time, IPG have reinvested most of their cash from operations. The fact that over time, more cash has been produced by operations than has been put into investment, plus the generally bigger steps, indicates that the investment has produced good results. Substantially higher investment in 2007 was followed by two years of substantially higher cash from operations, and substantially higher investment in 2011 was followed by a year of substantially higher cash from operations, although the chart doesn’t actually prove any cause-and-effect. To check that the benefit has not been reduced too much by stock compensation, I repeat the charts on a ‘per share’ basis.

IPG walks per share for cash from ops and into investment

This table allows a conservative assessment of the long term growth in cash from operations per share. While the growth rate from 2004 to 2012 is 39% CAGR, 2004 was a low year and 2012 saw 90% growth over 2011. Looking at the columns for 6, 7 and 8 years ahead, the lowest figure is 25.9%, which is the CAGR growth rate from 2005 to 2011. So, even when choosing the worst of the six longest periods in the range 2004 to 2012, the CAGR growth rate in cash from operations per share was 25.9%.

IPG cash from ops growth - spread

Growth often tails off as a company gets bigger. The healthy figures in the bottom three rows, for 2009, 2010 and 2011, show that hasn’t happened to IPG. The numbers here are more variable, as they only span one, two or three years.

The three negative numbers are in a diagonal, and are the result of the downturn in 2007, which was followed by a sharp recovery.

Balance sheet and commitments

All dollar amounts here are in thousands.

As at March 31, 2013:

Cash $355,715
Total current assets $649,371
Property, plant and equipment, net $218,995
(I haven’t bothered with goodwill, intangibles etc.)

Total liabilities $119,033

In the 10-Q, under ’12. COMMITMENTS AND CONTINGENCIES’, only disputes and legal proceedings are mentioned, with an assurance of no material effect.

Taking the figures from ’10. COMMITMENTS AND CONTINGENCIES’ in the 10-K for 2012 (so, as at December 31 2012):

Commitments for Operating Leases $11,774
Contractual Obligations (construction) $8,921
Legal proceedings (no material effect) $0
Total $20,695

The terms of “…employment agreements with certain members of senior management.” are not disclosed, but include ‘defined severance’.

Adding the 2012 commitments ($20,695) to Q2 2013 Total liabilities ($119,033) gives $139,728.
That equals only 39.28% of the $355,715 cash.

Defined benefit pensions used to be a headache for employers in the UK, but I didn’t see evidence of anything like that in the 10-K.

The balance sheet is strong, and not undermined by anything under ‘COMMITMENTS AND CONTINGENCIES’.

Financing activities

All dollar amounts here are in thousands except for per share amounts.

Net cash provided by financing activities, for 2012, 2011, 2010:
$82,087, $31,885, $37,764
Total: $151,736

The 2012 figure includes +$167,928 raised by a public offering, and -$33,353 from a special dividend of $0.65 per share in December 2012.

Given the $355,715 cash after Q2 2013, the $384,053 at the end of 2012, and the healthy cash flow, management seem to be even more paranoid than I am about IPG needing cash if there’s a downturn, although they might have wanted cash for acquisition opportunities.

The borrowing has not eroded the net-cash position, and the public offering has not stopped the ‘per share’ performance from looking good, in the ‘per share’ walk chart or the growth table shown earlier.

It’s not surprising that IPG have cash, given the charts above and the financing.

Customer concentration

From the 10-K for 2012.

    “Net sales derived from the Company’s five largest customers as a percentage of its annual net sales were 16%, 17% and 19% in 2012.”

    “Sales to the Company’s largest customer accounted for 7%, 8% and 7% of its net sales in 2012, 2011 and 2010.”

Relative size

From the 10-K for 2012, under ‘Competition’:

    “Many of our competitors are larger than we are and have substantially greater financial, managerial and technical resources, more extensive distribution and service networks, greater sales and marketing capacity, and larger installed customer bases than we do.”

Competitors such as Mitsubishi Cable Industries and the Scientific-Atlanta division of Cisco Systems, are parts of much bigger companies. However I’ve seen Trumpf and IPG described as the giants of industrial lasers, or something like that. When I looked into Trumpf in February, they were a private company and didn’t break out revenue for their laser division. I haven’t checked since then. There’s a different view of market share in:

Rofin-Sinar Looking To A Cyclical Recovery And Fiber Share Gains” by Stephen Simpson CFA, Sep 19 2013. seekingalpha.com

where Rofin-Sinar Technologies are top of the pecking order, with IPG well down the list.

Guessing the future

A story title claims that by 2018 the market for laser-cutting will be worth $3.77 billion. You can confirm that here, but you aren’t likely to learn much more without buying an expensive report. For some context, IPG’s 2012 Net sales were $562,528,000 in 2012.


One concern I have is the Chinese market, which suffers from chronic oversupply supported by loans to further politicians’ careers. Companies affected can go bankrupt when the politicians can’t supply enough finance, or lose interest in the company. This shouldn’t directly affect non-Chinese companies that produce or sub-contract in China, and no-one will force IPG to take a loan and fill a warehouse, but some of their customers could be affected. IPG have been successful in China, with sales up 54% year-on-year to $58.5 million, and a “strong backlog”. They claim to be diverse there, so a single bankruptcy shouldn’t have too much effect. IPG realize that credit can tighten fast, and keep an eye on the situation. ‘prepayments’ are mentioned in the transcript, and I expect they have a fairly good idea of who will be able to pay and who won’t. I couldn’t say IPG are overdependent on China, as much of the world’s production takes place there.

There’s more about China and U.S. automotive under the ‘Stories’ tab. The first link, (“Reality dawns on the China-growth myth” By: Merryn Somerset Webb, 27/08/2013), reports that the official rise in sales of passenger vehicles in the first half of the year, does not tally with the experience of dealers.

North America

The automotive industry is picking up in the U.S.A., and from the transcript:

    “The materials processing business in North America for automotive and other applications is continuing to perform well.”


Russia was weak due to low demand from telecoms, offset slightly by an improvement in laser-systems. IPG don’t trust anyone else’s distribution network, due to corruption, so they̵