Forensic Approach
to Company Analysis
Identifying Early Warning Signs of Business Deterioration
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1
Presenter
Dan Mahoney, CFA, CPA
Mr. Mahoney is the Global Director of Research for CFRA. In this capacity, he oversees the
entire global research product and he is also Head of Industrials Research. He joined CFRA
in 2003 as an analyst covering industrial companies. Prior to joining the company, Mr.
Mahoney spent four years with Deloitte & Touche’s audit and forensic accounting groups.
Mr. Mahoney holds an MBA from the University of Michigan and a BA in Economics and
Accounting from the College of the Holy Cross. He was appointed to serve as a
representative of the investor community on the Financial Accounting Standards Board’s
Financial Accounting Standards Advisory Council as well as on the International Accounting
Standards Board’s Capital Markets Advisory Committee.
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About CFRA

Since 1994, CFRA has been the recognized leader in forensic
accounting and quality of earnings research

Aggressive accounting practices can be used to mask business
deterioration

We uncover underappreciated differences between reported
financial results and underlying economic reality
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Overall Learning Objective:
Be able to spot red flags and identify accounting and financial reporting
treatment that results in a more favorable picture of financial health
than the underlying economics of the business support.
Overview:

Background – high level view of accounting risk

Red Flag identification through screening

Focus on manipulation of metrics most important to stakeholders:
 Revenues, Earnings, Gross Margin, Operating Margin, Non-GAAP metrics, Cash flows

Beyond Red Flags – using in depth analysis to identify problems
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Background on
Aggressive Accounting and Fraud
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Background: Accounting Fraud and Misstatements

Accounting requires judgment, estimates, and interpretation of rules

This leads to improper application of rules even if intentions are good

Even the experts get it wrong:
 Center for Audit Quality, An Analysis of Alleged Auditor Deficiencies
 37% of deficient audits from 1998-2010 involved
“Incorrect/inconsistent interpretation or application of
requirements of GAAP”
 Most prevalent issue related to revenues
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“cutting corners” is common…

Approximately 46% of global respondents in a recent Ernst & Young
Fraud Survey agree that company management is likely to cut corners
to meet targets*

CFOs are even more pessimistic agreeing 52%!
Total
23
CFO
19
26
Compliance
15
Internal audit
21
Legal
29
% Tend to disagree
13
25
29
32
% Strongly disagree
20
52%
10
25
24
20
17
46%
9
34
26
% Tend to agree
13
% Strongly agree
Source: Ernst & Young Fraud Investigation and Dispute Services, 12th Annual Global Fraud Survey
© 2014 CFRA. All rights reserved. This document may not be reproduced or redisseminated in whole or in part without prior written permission from CFRA..
Other Survey Findings
• When presented with a
list of possibly
questionable actions
that may help the
business survive, the
survey also found 47%
of CFOs felt one or more
could be justified in an
economic downturn
• Worryingly, 15% of
CFOs surveyed would be
willing to make cash
payments to win or
retain business and 4%
view misstating a
company's financial
performance as
justifiable to help a
business survive
7
7
…and “cooking the books” is costly

On average, firms lose 38% of their market values when news of
financial misconduct is reported
100%
25%
9%
3%
62%
Pre-Misconduct
Reputation Loss
Adjustment Loss
Legal Loss
Post-Misconduct
Source: “The Cost to Firms of Cooking the Books”, Jonathan M. Karpoff, D. Scott Lee, and Gerald S. Martin
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Identifying Red Flags
Through Screening
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Identifying Red Flags: Screening for Earnings Quality


Important Things to Consider with Screening

Seasonality

Impact of acquisitions (use cash flow statement as sanity check)

Relative importance of accounts to industry (deferred revs in Software)

Analysis must be done relative to both historic trends and forward expectations

Use end of period balances for balance sheet accounts
Excess Weight and Attention Should be Paid to Revenue Accounts

Revenue recognition by far biggest area for accounting related fraud

Pressure on management to show revenue growth vs. other performance areas

Benefit of leverage provides largest bang for buck from revenue manipulation
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Identifying Red Flags: Screening for Earnings Quality
Quantitative Quality of Earnings Metrics
 CFFO – Net Income
 Accounts Receivable (DSO)
 Deferred Revenues
 Inventory (DSI)
 DSI vs. Gross Margins
 DSI vs. Accounts Payable (DSP)
 Inventory to Forward Sales
 Allowance for Doubtful Accounts/Gross Accts. Receivable
 Bad Debt Expense/Sales
 Inventory Obsolescence Provisions
 Warranty Expense/Sales
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Accruals as a First Step: CFFO - NI
 These abnormal increases in
assets or decreases in liabilities
can be captured in total by
looking at accruals.
Adoption of
new rev.
rec rule.
 The most basic way to capture
these accruals is by looking at
Cash Flow from Operations
(CFFO) relative to net income.
 CFFO – NI is generally the first
layer of screening for nonfinancial companies.
 Should a company fail this
initial screen, we generally dig
in deeper for the cause of the
CFFO shortfall.
 Often helpful to track this
metric on a trailing 12-month
basis
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Other High Level Red Flags to Consider

High external financing needs

Point in cycle – fraud/misstatements tend to peak at end of boom

Pressure on managers to keep good times going

Investor, regulator complacency

Firm performance – tend to outperform prior to identification

Management Performance Factors/Incentives

M&A Activity

Auditor Changes
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Beyond Red Flags:
Identifying Manipulation and Deteriorating
Performance
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Part One: Revenue
“Since we established that goal, we made a business decision to offer selected customers
installment payments…”
-Company representative explaining a massive increase in unbilled DSO during the 3/06 2006 earnings call
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Boosts to Reported Revenue
 Transition to more aggressive revenue recognition policies and practices
 End of period ‘buzzer’ sales
 Extended payment terms / increased customer financing

Watch companies with financing arms that can “print their own top line”
 Change in critical revenue timing: sell in vs. sell through
 Deferral of revenue vs. provisioning when uncertainties exist
 Revenues recorded from pure book-keeping entries
 Percentage of completion project adjustments
 Revenue unbundling, or change in allocation of elements
 Change in provision estimates
 ‘Grossing up’ revenue
 Revenues that lack economic substance
 Recording revenues when the customer is not obligated to pay
 Concurrent negotiation of sales and supply agreements
 Giving customers something of value as a quid pro quo
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Revenue Accounts: Accounts Receivable (DSO)
•When receivables rise
relative to revenues, our
concern is generally not one
of receivable quality but
rather of more aggressive
revenue recognition.
Notice the relative seasonal increase.
DSO usually declines from Q1-Q2.
•This can be due to several
factors:
•More aggressive revenue
recognition policies.
•Stuffing the channel with
late quarter sales.
•Providing extended
payment terms to boost
sales.
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Revenue Accounts: Deferred Revenues
• Great indicator of potential revenue games and/or weak future revenues. Lower deferreds could mean:
• More aggressive revenue recognition that results in the “stealing” of revenues usually deferred.
• Failure to replenish recognized revenues with future stream of revenues.
• We screen for declines in deferred revenues as measured in days sales, DSDR.
• DSDR decline of greater concern when coupled with an increase in DSO.
• Make sure deferred revenue is being compared to related revenue. Some revenues may not flow
through deferred revenue
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Revenue Accounts: Deferred Revenues
• Always look at deferred
revenues relative to forward
expectations.
• If expectations for revenue
growth match deferred
revenue, concern is lessened.
• Always look at DSDR in
tandem with DSO as company
may be “grossing up”
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Trade Receivables – Software AG (SOW.GR)
In Q4 2012 DSO increased significantly. The Company did not discuss current
receivables but attributed the rise in the LT receivables to one transaction:
“So as you correctly said, this transaction exceeding one deal is a multi-year
maintenance contract which was paid to a trustee account. So as it is a trustee
account and we do not have direct access to that…we need to show those as
accounts receivable. That is the story behind it. So very easy.” – 4Q12 earnings call
EUR millions, except days
Trade receivables - current
Trade receivables - NC
Total trade receivables, as reported
Multi-year contract
Total trade receivables, as estimated
License and Service rev
DSO - current trade receivables
DSO - NC trade receivables
Total DSO, using reported figures
YoY change - days
Total DSO, using estimated figures
YoY change - days
4Q12
307
35
341
-13
329
177
158
18
176
27
170
21
4Q11
305
13
318
4Q10
338
13
351
4Q09
329
11
340
318
195
143
6
149
10
149
10
351
231
133
5
138
-11
138
-11
340
208
144
5
149
149
Software AG told CFRA that the contract only accounted for €13 million. Excluding
this item, DSO was up 21 days, suggesting the extension of payment terms.
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Extending Payment Terms and Late Quarter
Shipments – First Solar (FSLR)
In Q1 2009, DSO increased significantly:
2008 10-K
(
)
“We do not offer extended payment
terms or rights of return for our sold
products.”
3/2009 10-Q
“The increase in accounts receivable was
mainly due to the amendment of certain
customers' long-term supply contracts, that
extended our customers’ payment
terms from 10 days to 45 days, net as
well as the timing of shipments to
customers during the three months ended
March 28, 2009.”
Explanation
We extended payment terms as we are no
longer working capital constrained,
did not want to further stress
customers, and because we shipped more
from Malaysian factories and shipments
from Malaysian factories take longer time
than those from U.S. and German factories.
given to CFRA
FSLR’s extension of payment terms to customers suggested downstream weakness,
as customers needed support.
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Extending Payment Terms, Acceleration of Revenue,
Rebates – First Solar (FSLR)
First So lar Inc. (FSLR)
1-Jun-2009 to 30-Apr-2010 (Daily)
G IC S In d u str y: S e m ic o n du c tor s & S e m ic o n du c to r E q u ip m e n t
G IC S S e c to r: In for m a tio n Te c h no lo g y
G IC S S u b -Ind u s try: S e m i co n d uc to rs
Hig h : 19 6 .2 50
L ow : 9 8 .71 0
L a st: 1 4 3.9 8 0
200
4/13/10: Removal from
Biggest Concerns List
7/30/09: FSLR falls 11%
on Q2 earnings release.
180
160
2/18/10: FSLR falls 8%
On Q4 earnings release
140
6/10/09: CFRA Report:
“Revenue Growth at Risk”
120
10/28/09: FSLR falls 17%
on Q3 earnings release
100
Vo lu m e in Milli on s (m a x/avg )
13
3
Ju n
Ju l
Data Source: Prices / Exshare
Au g
Sep
O ct
No v
D ec
Ja n
Fe b
Ma r
Ap r
*Postscript: FSLR was added to our Biggest Concerns List again in 2011.
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Hiding Receivables Problems
Example: Velti PLC (VELT)
Where do you find receivables?
•
Look for A/R in accounts such as “other current assets” or “other long-term assets”
•
Also look for classifications such as “notes receivable” and “financing receivables”
•
VELT provided a DSO figure that included only trade receivables. At the same time,
other receivables and unbilled receivables were surging.
We estimated total DSO
increased from 128 days in
Q4 2010 to 184 days in Q1
2011
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Hiding Receivables Problems
Example: Velti PLC (VELT)
Curiously, under the Company’s own calculation, DSO declined to 86 days in
4Q11 from 121 days during 4Q10.

Velti’s DSO relates to trade receivables only.

Company DSO excludes:

accrued contract (unbilled) receivables,

other receivables (receivables waiting to be factored)

notes receivables (post-dated checks)
Thus, the Company’s presentation of its DSO was not indicative
of the true risk profile heading into 2012.
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Hiding Receivables Problems
Example: Velti PLC (VELT)
CFRA Report
CFRA Report
CFRA Report
CFRA Report: Elevated
Receivables Highlight Revenue
Risk
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Printing your own top line… Conn’s (CONN)
Curiously, CONN was delivering extremely “healthy” SSS while retailers
selling similar product were struggling:
Ticker^
CONN
BBY
RCII
Q3/2013
Q2/2013 Q1/2013 Q4/2012
35.1%
18.4%
16.5%
7.0%
0.3%
-0.8%
-0.6%
-1.6%
-1.3%
-4.3%
-1.4%
-0.2%
Q3/2012
Q2/2012 Q1/2012 Q4/2011
12.6%
21.5%
17.8%
12.1%
-5.1%
1.2%
-3.3%
2.8%
-5.2%
7.1%
-1.0%
2.7%
Q3/2011
Q2/2011 Q1/2011
18.9%
-12.8%
-3.9%
-0.3%
2.0%
-3.8%
-0.3%
-3.1%
0.1%
^CONN has a January year-end. BBY has a February year-end, and RCII has a December year-end.
Part of it could be explained by positive mix shift, but lending to drive
comp store sales was seemingly a bigger driver…
SSS
Receivables
yoy
Q3/2013
Q2/2013 Q1/2013 Q4/2012
35.1%
18.4%
16.5%
7.0%
944.8
843.1
773.4
741.5
38.2%
27.4%
21.8%
15.3%
Q3/2012
Q2/2012 Q1/2012 Q4/2011
12.6%
21.5%
17.8%
12.1%
683.7
661.7
635.2
643.3
12.9%
10.3%
1.6%
-4.8%
Q3/2011
Q2/2011 Q1/2011
18.9%
-12.8%
-3.9%
605.7
599.7
625.5
-10.5%
-15.1%
-10.7%
… especially when the “buyer” can borrow for free^:
Receivables
% promo
promo $s
Q3/2013
Q2/2013 Q1/2013 Q4/2012
944.8
843.1
773.4
741.5
33.4%
31.9%
30.6%
27.3%
315.6
268.9
236.7
202.4
Q3/2012
Q2/2012 Q1/2012 Q4/2011
683.7
661.7
635.2
643.3
23.5%
21.0%
17.7%
14.8%
160.7
139.0
112.4
95.2
Q3/2011
Q2/2011 Q1/2011
605.7
599.7
625.5
11.2%
9.2%
9.7%
67.8
55.2
60.7
^CONN offers six-month and 12-month interest free plans to further encourage buying
© 2014 CFRA. All rights reserved.
© 2014 CFRA. All rights reserved. This document may not be reproduced or redisseminated in whole or in part without prior written permission from CFRA..
26
26
Printing your own top line… Conn’s (CONN)
12/11/2013: CFRA continues
to caution that aggressive
lending is not sustainable.
Either sales or margins (or
both) must “give:”
2/20/2014: CONN preannounces Q4/2014 and
provides disappointing
guidance for F2015. Guidance
is based on slowdown in
electronics sales and
increased credit losses.
10/2/2013: CFRA adds CONN
to Biggest Concerns List as
sales are driven by
increasingly loose lending.
© 2014 CFRA. All rights reserved.
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27
Revenue on Long-Term Contracts - Saipem
(SPM.IM)
Unbilled percentage-of-completion (POC) receivables exceeded the overbilled POC
liability (deferred revenue) by €740m at June 2012.
In contrast, the POC liability exceeded the POC receivable by €154m at June
2011.
Cumulative revenue recognized on outstanding projects increased by 27% (to
€6,096m), while cumulative billings increased by only 9% (to €5,365m). Thus,
revenue growth significantly exceeded billings growth.
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Revenue on Long-Term Contracts - Saipem
(SPM.IM)
In fact, H1 2012 was the first time the POC receivable had exceeded the
POC liability in three years:
Saipem acknowledged timing issues and revenue recognized on change orders
and claims:
“…the increase of WIP [unbilled receivables] is due to the different lag time
between progress and invoicing milestone and to recognition of additional
revenue associated to change order/claim deemed probable and reasonably
estimated.” – communication with CFRA, emphasis added
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Saipem (SPM.IM)
Saip em S.p.A. (SPM-IT)
1-Jun-2012 to 14-Feb -2013 (Daily)
G IC S In d u str y: E n er g y E q ui pm e nt & S e r vic e s
G IC S S e c to r: E n e rg y
G IC S S u b -Ind u s try: O il & G a s E qu ip m e n t & S e rvi ce s
Hig h : 40 .1 2 0
L ow : 1 8 .61 0
L a st: 2 0 .8 5 0
40
36
9/10/12: Added to Biggest
Concerns List
32
28
1/30/13: Shares fall
34% after the company
issues a profit warning.
and sharply lower EBIT
guidance for FY13,
citing lower recovery
on claims for
additional
costs, more
conservative
Vo lu mapproach
e in Milli on s (m a x/avg )
to project margins and
execution and delays
to new awards.
12/6/12: Shares fall as
executives resign and
are suspended as the
company
investigates
fraud
in
Algerian
contracts.
24
20
52
2
Ju n
Data Source: Exshare
Ju l
Au g
Sep
O ct
No v
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D ec
Ja n
30
Part Two: Gross and Operating
Margin
“During the fourth quarter, we developed new information indicating that our exposure
to future warranty claims for units already sold would be much lower than anticipated.
Using this new information resulted in the reversal of…”
-BRLC representative discussing a warranty reversal during the 6/07 earnings call
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31
Gross & Operating Margin Benefits
 Use of more aggressive estimates for expenses
 Inventory excess and obsolescence
 Product warranty and returns
 Provision for bad debts
 Changes to revenue reserves
 Percentage-of-completion adjustments
 Depreciable Lives
 Hiding inventory problems

Over-manufacturing to keep lower per-unit cost basis
 Sales of previously written-down inventory
 Capitalizing normal operating costs – R&D, Marketing, etc.
 Excluding basic business expenses from pro forma results / EBITDA
 Cutting discretionary, but necessary spending
 Including one-time gains as a reduction of operating expense
 Gain on sale of assets
 Adjustments to prior period charges
 Pension Income
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32
Inventory (DSI)
• Inventory is generally screened first by looking at Days Sales in Inventory (“DSI”)
• Seasonality is important as certain companies build inventory prior to peak periods of
demand
• Inventory relative to forward sales is extremely important as companies will often
indicate that inventory is higher to meet future demand
• Mix of inventory is also important, look for higher finished goods
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33
Unsustainable Margins Supported by DSI Growth
– Joseph A. Bank (JOSB)
…Margins at JOSB were falling
despite big ramp in inventory.
…Company was guiding to
maintaining margin deterioration of
approximately 1-1.5%...
…AND promised to reduce
inventory levels
IS THIS POSSIBLE?
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34
Example: JOSB, cont.
…Well, no
…Inventory reductions generally
come at the expense of weaker
margins…
…On 10/12 earnings call,
management highlighted “additional
markdowns and promotional activity”
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35
Example: JOSB, cont.
And then things got worse…massive reduction in guidance for Jan 13 quarter
HAMPSTEAD, Md., Jan. 25, 2013 (GLOBE NEWSWIRE) - JoS. A. Bank Clothiers, Inc. (JOSB) announces that
net income for fiscal year 2012 is expected to be
approximately 20% lower than net income for fiscal
year 2011. Actual results will depend on, among other
things, sales for the remainder of the year, expenses
and normal year-end processing. Fiscal year 2012 is a
53-week year which will end February 2, 2013; fiscal
year 2011 was a 52 week year which ended January
28, 2012.
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36
Discretionary Expenses: Warranties
• Requires a substantial amount of management estimation and discretion
• Company must record warranty expense in the period the product is sold, not the period in which
the warranty claim is made
• Expense driven by expectation of future claims on current period sales rather than current claims
paid out on prior period sales (although prior claims are used to form estimate)
• Companies frequently make adjustments to warranties related to prior period sales
• Directly impacts gross margin
Warranty Exp. As % of Sales
Company
Apple Inc.
Ciena
Cisco Systems Inc.
Diebold Inc.
Dell Inc.
EMC Corp.
Hewlett-Packard Co.
Harris Corp.
Itron Inc.
Lexmark International
Netgear, Inc.
Seagate Technology
Western Digital Corp.
Xerox
Tkr
AAPL
CIEN
CSCO
DBD
DELL
EMC
HPQ
HRS
ITRI
LXK
NTGR
STX
WDC
XRX
Industry Group
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
Tech Hardware & Equip
2011
1.50%
1.06%
1.06%
1.76%
1.65%
0.87%
2.07%
0.31%
2.40%
2.16%
5.10%
1.80%
1.68%
0.13%
2010
1.38%
1.24%
1.17%
2.74%
1.70%
0.71%
2.09%
0.92%
1.71%
2.12%
6.86%
1.31%
1.88%
0.15%
2009
1.03%
2.96%
1.04%
2.48%
1.87%
1.04%
2.17%
0.87%
0.89%
2.28%
6.27%
2.40%
1.61%
0.22%
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2008
2.47%
1.70%
1.29%
1.57%
1.93%
1.08%
2.75%
0.48%
0.74%
2.23%
6.25%
2.19%
1.20%
0.22%
2007
0.95%
1.63%
1.46%
1.13%
1.92%
1.14%
2.51%
0.56%
0.96%
2.38%
6.24%
2.49%
0.97%
0.23%
2006
1.88%
2.57%
1.56%
0.93%
2.19%
1.42%
2.65%
0.68%
1.57%
3.49%
7.93%
2.09%
1.06%
0.27%
37
Dramatic Decline in the Warranty Returns Provision
Helen of Troy (HELE)
Constructing the quarterly movements in this account from roll-forward disclosure in the
footnotes showed a dramatic decline in Q4 2/2005:
5%
Warranty Return Provision/Revenue
4%
3%
2%
1%
0%
Q1,
5/03
Q2,
8/03
Q3,
11/03
Q4,
2/04
Q1,
5/04
Q2,
8/04
Q3,
11/04
Q4,
2/05
Question: If HELE under-accrued in Q4, what might happen in the next quarter?
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38
Dramatic Decline in the Warranty Returns Provision
Helen of Troy (HELE)
As we expected, this Q4 earnings boost was not sustainable as the warranty
returns provision actually hurt earnings in the subsequent quarter as it jumped to
an 8-quarter high:
5%
Warranty Return Provision/Revenue
4%
3%
2%
1%
0%
Q1,
5/03
Q2,
8/03
Q3,
11/03
Q4,
2/04
Q1,
5/04
Q2,
8/04
Q3,
11/04
Q4,
2/05
Q1,
5/05
Note: Although HELE’s warranty returns provision is an offset to revenue, its greater impact is on margins
and earnings.
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39
Dramatic Decline in the Warranty Returns Provision
Helen of Troy (HELE)
Helen of Troy Corp. (HE LE )
3- Jan- 2005 to 30- Dec- 2005 ( Daily)
2/22/05: HELE guides down
Q4 (2/05) revenue and
earnings expectations.
34
32
7/11/05: HELE
announces Q1
(5/05) earnings.
EPS misses
consensus.
5/16/05: HELE files
its 2/05 10-K
30
28
26
2/3/05: CFRA Report:
“Revenue Growth Aided
by Extended Payment
Terms in Q3 (11/04)”
5/26/05: CFRA Report: “Q4
Results Boosted by Drop
in Warranty Provision”
7/18/05: CFRA Report:
“Continued Concerns with
Core Growth,
Receivables, & Inventory”
11/2/05: CFRA
Report: “Bloated
Inventory May Hurt
Margins as
Revenue Falls”
24
22
20
18
10/11/05: HELE announces
Q2 (8/05) earnings. EPS
misses consensus.
Vo lu m e in T ho u s an d s (m ax /a vg )
16
4807
286
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Data Source: Prices / Exshare
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40
Discretionary Expense: Bad Debt Expense
• Bad debt expense should be relatively stable over time
• Changes may occur due to deterioration in credit quality of
customers
• Two ways to identify potential manipulation of these accounts:
• Allowance relative to gross accounts receivable
• Bad debt expense relative to sales
• Bad debt expense provides direct income statement impact…but
• Generally not available for screening
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41
Negative Bad Debt Expense – Lennox Intl. (LII)
In Q3 2010, LII recorded negative bad
debt expense (a reversal) of $1.1m,
compared to the quarterly average of
$3.4m in expense and $3.7m in the
year-ago period.

With this benefit, quarterly EPS grew
15%. Without this benefit, would have
been 7%.

With this benefit, quarterly operating
margin was 8.4%. Would have
declined to 7.7% without the benefit
(vs. 8.8% in prior year).
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42
Negative Bad Debt Expense – Lennox Intl. (LII)
LII told CFRA that the reversal was a
function of an improvement in market
conditions and credit outlook after the
downturn in housing.
Our Take: Whether or not a reversal
is justified, it is not a sustainable
source of earnings growth.
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43
Negative Bad Debt Expense – Lennox Intl. (LII)
Lennox Internatio nal Inc. (LII)
1-Nov-2010 to 1-No v-2011 (Daily)
G IC S In d u str y: B u ild in g P ro d uc ts
G IC S S e c to r: In d us tr ia ls
G IC S S u b -Ind u s try: B u ild in g P r od u c ts
Hig h : 54 .1 0 0
L ow : 2 4 .37 0
L a st: 3 1 .1 2 0
55
10/18/11: Removal from
Biggest Concerns List
50
45
4/26/11: Q1 2011 earnings
miss expectations.
40
35
12/10/10: Added to Biggest
Concerns List
7/26/11: Q2 2011 earnings
miss expectations. FY 2011
Guidance is lowered.
30
25
Vo lu m e in T ho u s an d s (m ax/a vg )
3 9 06
570
No v
D ec
Data Source: Prices / Exshare
Ja n
Fe b
Ma r
Ap r
Ma y
Ju n
Ju l
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Au g
Sep
O ct
44
Discretionary Expenses: Inventory Obsolescence

The reserve for obsolescence should stay relatively constant relative to gross
inventories

Also check the provision relative to cost of sales to gauge the direct impact of
changes in the reserve on earnings

Disclosure of this reserve is spotty and very rarely available on more than an annual
basis

Directly impacts gross margin
ASML
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No movement in
reserve despite
sharply higher
inventory.
45
Capitalization of Product Development Costs – ZTE
(763.HK)
 Deferred product development costs increased
notably.
 Area of discretion. Earnings are affected.
 Did not see the same increase at peers Alcatel-Lucent
and Ericsson.
 Another peer Huawei, decided not to capitalize these
costs.
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46
Capitalization of Market Development Costs – ZTE
(763.HK)
 Capitalization of market development costs began
in June 2011.
 No disclosure on what these costs are or why they
began to be capitalized in 2011. Only a brief mention.
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47
Capitalization of Costs – ZTE (763.HK)
ZT E CORP H (763-HK)
1-Feb-2012 to 30-No v-2012 (Daily)
G IC S In d u str y: C om m u n ic atio n s E q ui pm en t
G IC S S e c to r: In for m a tio n Te c h no lo g y
G IC S S u b -Ind u s try: C o m m u n ic a tio ns E q u ip m e n t
Hig h : 23 .8 5 0
L ow : 9 .2 30
L a st: 1 1 .7 0 0
24
22
20
10/15/12: Stock falls 16%
after a profit warning. Revenue
and earnings disappoint. Margins
decline significantly.
3/13/12: Added to Biggest
Concerns List
18
16
14
12
7/16/12: Stock falls 16%
after a profit warning. Revenue
and earnings disappoint.
10
Vo lu m e in Milli on s (m a x/avg )
67
8
Fe b
Data Source: Exshare
Ma r
Ap r
Ma y
Ju n
Ju l
Au g
Sep
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O ct
No v
48
Part Four: Non-GAAP Metrics
“There are no third-party standards or requirements governing the calculation of bookings.”
-Comment in ACN’s 2012 10-K
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49
Non-GAAP Metrics/Key Performance Indicators (KPIs)

Presentation and disclosure of KPIs gaining increased attention from regulators and
auditing profession

Metrics presented in earnings releases and MD&A are not audited

Changes in how metrics are calculated are often not highlighted
…during the November 5 earnings call with analysts, the then-CEO
announced a slight improvement in the “retention rate” (a key metric of
retained business often used to compare PBM companies), without
disclosing that CVS had changed how it calculated the rate, thereby
concealing the full extent of lost PBM business.
- SEC complaint against CVS Caremark Corp., filed April 8, 2014
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50
Non-GAAP Metrics/Key Performance Indicators (KPIs)


Non-GAAP Metrics by Sector

Industrials and Tech - Bookings, backlog, users, subscribers

Healthcare – Bookings, backlog, or measure of revenue runrate

Retail - same-store-sales, inventory per sq ft

Acquisitive Companies - pro forma growth, organic growth, etc.

Banking and Insurance – Statutory filing data
What are we Looking for with Non-GAAP Metrics

Changes in focus of management presentation

Non-traditional definitions of metrics

Inconsistent definitions of metrics

Divergence between Non-GAAP, GAAP and /or statutory data metrics
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51
Shifting Compensation from Cash to Stock –
Spreadtrum Communications (SPRD)
SPRD’s share-based compensation was increasing:
SPRD actually acknowledged a “voluntary salary deduction exchange
for shares program adopted in 2012.” (per the 20-F) Share-based
compensation is often excluded from non-GAAP earnings:
Shifting some employee compensation from cash to stock could boost nonGAAP earnings.
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52
R&D Capitalization – Elekta AB

Rising Cost Capitalization, what is the rationale?

Elekta’s 41.7% of its total R&D spend in Q3’14, up from 25.3% and 33.8% in
previous two Q3s

What is the rationale?

Company also changed KPI to EBITA from operating income because “it’s clearer on
the underlying performance of our business, particularly when we do a big R&D
project.”

Note, use of EBITA results in higher R&D capitalization never hitting KPI
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53
Unusual Organic Growth Rate – Li & Fung (494.HK)
H1 2011
conf. call,
August 2011
Li & Fung Management:
CFRA Analysis: Organic growth
Organic growth is 10-16%
is 3.8% in 2011
Question: “…if you could
clarify…what your organic growth
was in both the Trading and
Distribution businesses.”
Answer: “I have only overall for
the Company right now. It was
about 10%.”
FY 2011
“Our growth organically is between
conf. call,
10%, 15%, 16% organically.”
March 2012
Why the disconnect between Li & Fung’s estimates and our estimates?
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54
Unusual Organic Growth Rate – Li & Fung (494.HK)
Li & Fung told CFRA that the organic growth rate mentioned in the
conference call was calculated in the same way they presented organic
growth in a June 2011 analyst day presentation, which was a CAGR:
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55
Unusual Organic Growth Rate – Li & Fung
Problems with using a compound annual growth rate:

A 20-Year CAGR isn’t helpful. Li & Fung’s reference to a 20-year organic
CAGR doesn’t help us understand how fast the business is growing now.

Li & Fung wasn’t clear about it. Li & Fung’s discussion of organic growth in its
results conference calls did not explicitly acknowledge that the calculation was
a 20-year CAGR.
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56
Unusual Organic Growth Rate – Li & Fung
Li & Fung Ltd. (494-HK)
1-May-2012 to 1-No v-2012 (Daily)
G IC S In d u str y: D is tr ib u tor s
G IC S S e c to r: C o ns u m e r Di sc r e ti on a r y
G IC S S u b -Ind u s try: D is tri bu to rs
Hig h : 17 .2 8 0
L ow : 1 1 .46 0
L a st: 1 3 .1 0 0
8/9/12: Stock falls
as revenue growth
disappoints.
17
16
15
14
13
8/3/12: CFRA Report:
Revenue from Acquisitions
Obscures Weak Organic Growth
12
Vo lu m e in Milli on s (m a x/avg )
353
25
Ma y
Data Source: Exshare
Ju n
Ju l
Au g
Sep
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O ct
57
Unusual Organic Growth Rate – Li & Fung
Postscript: In H1 2012, Li & Fung added yearly organic growth in its
investor presentation, confirming that organic growth was 4% in 2011:
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58
An Increase in an Expense is “Exceptional” - Comba
Comba’s R&D expense increased by HK$151m in 2011: from HK$211m in
2010 to HK$362m in 2011. Comba said the increase was “exceptional”,
stripping it out of pro-forma earnings:
No suggestion that the
increase was really
exceptional. In fact, R&D
expense increased further
in 2012.
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59
59
Comba Postscript
 After 2012, Comba started capitalizing certain
development costs (from 2013 Annual Report):
During the Current Year, R&D costs decreased significantly by
45.0% to HK$207,158,000 (2012: HK$376,766,000),
representing 3.6% (2012: 5.9%) of the Group’s revenue. The
decrease in R&D costs was mainly due to the capitalization of
certain development costs. During the Current Year, a total of
HK$108 million development costs was capitalized (after
amortization). The Group has maintained an optimal level of
investment in R&D to stay ahead of the latest technological
innovation so as to take advantage of new business
opportunities. (emphasis added)
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60
Questions
?
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61
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ENTITIES SPECIFICALLY DISCLAIM ALL WARRANTIES, EXPRESS OR IMPLIED, regarding the accuracy, completeness or usefulness of this information. and
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62