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Accounting Analysis Identifying accounting distortions

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1 Accounting Analysis Identifying accounting distortions
caused by estimation error, bad GAAP, or management manipulation From a valuation perspective, Correcting the distortion = Forecasting the distortion’s reversal But you have to know the distortion exists! Accounting Analysis and Spreadsheets they allow FS to be manipulated and track the resulting changes in ratios (lots) and valuations (none). Two issues to illustrate: accounting distortions don’t affect valuation, BUT might influence your extrapolations of past.

2 the RI model and accounting distortions
suppose firm has 100 in SE, but you believe that 8 of their assets are worthless. you forecast 12 of NI next year, but only 4 in NI the year after when they will write off the worthless assets. now suppose that you restate accounting so that SE = 92. ADD that the firm only has a two-year life, or that its life is the same after year two regardless of this decision.

3 the RI model may be immune to accounting manipulation but are you?
beg. bkv earning FCF So, for example, you know up to the fs of 1999, all the blue stuff, and need to forecast the red stuff. So, if they distort earnings in 2001 you don’t care because it will wash in the AE model. But think about how YOU fill in the red forecast amounts. First, you look at the past blue stuff. IF you don’t understand that the good results they are reporting is due to an accounting distortion then you will fail to forecast its reversal in the future red stuff. This is the exercise of Boston Chicken -- they ignored the potential loan losses in the past so their financial performance looked good, but it reversed itself in the future, in the numbers we were forecasting. And think about how we can “fix” the financial statements. We can do it by anticipating the reversal in our forecast of BC’s future, or we can fix the beginning bkv amount that we start with. Which is easier to do will depend on the circumstances. But the MAIN POINT is that you don’t have to know what period the reversal will happen in your forecasts, just the amount. beg. bkv earning FCF beg. bkv earning FCF beg. bkv earning FCF beg. bkv earning FCF beg. bkv earning FCF beg. bkv earning FCF

4 Salton, Inc. Who are they? What is their strategy?
makers of the George Foreman Grill (1/3 of sales) and other small appliances. What is their strategy? manufacture in Asia sell to K-Mart, Wal-Mart etc. Can they sustain a competitive advantage? What do they make? Who do they sell it to? What’s the industry like? The small appliance industry doesn’t appear to be one that offers enormous sustainable abnormal profits. The barriers to entry are low, with many suppliers available in Asia and a technologically simple product, and there are already a number of firms in the industry. Further, the customers, typically large retail stores such as K-Mart and Wal-Mart, have considerable bargaining power. We wouldn’t expect them to leave much profit on the table for companies like Salton Inc. In Salton’s favor, however, is ownership of brand names that consumers appear to desire. So, while Wal-Mart could switch to a competitor brand of indoor electric grill, it wouldn’t be the George Foreman grill. The key strategic decision for Salton is deciding which brand names have such clout and how much to pay for them. The George Foreman brand name has clearly been a winner, but can management pick the next winning brand name?


6 load Salton into eVal close any open eVal files
browse to CD, “Salton” folder open file “Salton Benchmark Valuation” with students we simply pass them a raw data file to import under the “Input Historical Data” step on the User’s Guide. OR this is how we do it with students, as instructed in the case: open eVal on User’s Guide, hit Input Historical Data choose “from a saved file” choose “thomson research” format browse to CD, open file “Salton_TR_2000” go back to User’s Guide, hit Valuation Parameters, and set date to 9/30/2000. go to financial statements and move from intangibles to other assets.

7 Salton’s Past Performance
Wow! Have eVal loaded and show them the $1417/share, be sure that valuation date is set to 9/30/2002. (versus all time high of $40 and current price of 20). As we will see over and over, the two pillars of a great stock price are growth and profitability – and Salton has both. First let’s compare Salton to its own past: trends look good. lots of everything in the dupont model – a great rnoa, mostly due to increasing gross margin. Then, lots of leverage on a big spread. What can go wrong? what are the key ratios to watch for this company?

8 Now compare Salton to its competitors.
None of the competitors can touch Salton’s margins over the past three years, which have averaged almost 39% for the gross margin and almost 10% for the net operating margin Maytag approaches Salton’s level of ROE by running a much faster operating asset turnover, principally due to a faster working capital turnover.

9 The Deal with George Foreman
the old deal with George: 60% of gross profit approximately $64 million in 1999 the new deal with George: $122 million pmt , amortized over 15 years (after 8.1 amortization as of yr end) How will the deal change the financial statements going forward? Is this an accounting distortion? correcting the balance sheet today versus forecasting the correction in the future? So that’s Salton in a nutshell. Now let’s look at the big accounting issue. (show amt on bs). The brand name “George Foreman” may not strike you as being worth $122M, but when compared to the prior royalty arrangement, it indeed appears to have been a bargain purchase. Estimating that the Foreman line accounted for 33% of gross profit in fiscal 2000, and then giving 60% of this amount to Mr. Foreman, would be a payment of $65.8M for the one year alone (.60 of (.33)(332.4 total gross profit in 2000) = $65.8M). From an accounting perspective, one can certainly take issue with the 15 year amortization period for Foreman brand name. Beyond this, by amortizing the purchase price over a long period, the current period expenses are greatly reduced relative to the immediate expensing of royalty payments. Rather than recognizing the expense of the first payment to Mr. Foreman, which equaled $23.75M in stock and 22.75M in cash, they recorded amortization expense of $8.1M and interest expense of $6.3M (as discussed in the MD&A). SO part of increasing gross margin is the elimination of the royalty payment in exchange for the amort and interest payments. If we amortized the 122 over 3 years, would get 5X8.1=40.5M, or an increase of 32.4M in expense. This would lower the after-tax margin to 8.5% from 11%. Finally, note that royalty payments maintain a constant relation between the expense and sales, so forecasting SG&A as a percent of sales works well. In contrast, amortization expense is completely unrelated to sales. Is the 122M an asset? assets are suppose to represent future economic benefits. what are the benefits (aka cash flows) associated with the Foreman trademark? sales! real issue is whether this name will generate 122M more sales in future. And real issue for forecasting is the sales. (BUT, all his sons and ½ his daughters are named George! – see ). In 2003, the #1 sports endorser is Tiger Woods at $70M, #2 is Michael Jordan at $30M, and #3 is George at $27.5M.

10 accounting distortions
so don’t let the bad accounting mislead you. Can restate in eVal by subtracting from SGA, Intangibles and RE (use the benchmark valuation file since it has already separated out the intangible). point out that the student can trace the effect of accounting distortions on value if based on extrapolation. value goes from 1417 to 859 if lower SGA and Intanglibe asset and RE by Given that rnoa is less than 1, subtracting an equal amt from numerator and denominator makes ratio smaller in yr 1 Suppose Foreman Trademark has a 3 year life. Adjusted amounts based on amortization over 3 years = 40.5M/yr or 32.4M more than As Reported

11 removing the 113.9M asset benchmark price is $ (with 9/30/2000 valuation date). move $113,900K from Intangibles to Other Assets method 1: write off in year 1 put -8.5% for Other Income in 2001, 0 thereafter set Other Assets/Sales = 0% in 2001 and beyond results in value = $ note that debt/asset ratios are 19.9 and 38.1 method 2: remove asset in year 0 set Other Asset = $0 in 2000 lower Retained Earnings by $113,900K in 2000 note the debt/asset ratios (19.9 current and 38.1 LT) reset debt/asset ratios to 19.9 and 38.1 each year results in value = $ So value is the same in either case, BUT WHY DOES VALUE INCREASE? Now let’s “fix” the accounting distortion – suppose that the thing is worthless. see the three eval files with the benchmark case, the method 1 (write off next year) case and the method 2 (restate financials) case. Now let’s remove the asset, either by writing it off in year 1 (or year N) or removing it from the BS in year 0. (Do with eVal on screen). Stop after doing first one and ask why value increased? Stop ½ way through second method, when value is at 1600 something, and ask why, then show the debt/asset stuff. Why does value increase? Think about the cash flow changes associated with removing the asset. Don’t have to keep reinvesting in it, as the eVal defaults would do, so less cash outflow with no change in the cash inflows (sales). What you REALLY mean when you say the asset is worthless is that the sales will be lower in the future. Why do I need to reset the capital structure? Before we changed anything, eVal extrapolates the existing debt and equity in fixed proportions, so this implies a sequence of debt and equity offerings/retirements. Need to keep this sequence of payments constant as I change the method of getting rid of the trademark. However, when you write the asset off in year 0 you change the capital structure that eVal extrapolates, so would be changing this sequence. Hence, set it back to the original mix. How would I make the change so that value doesn’t change at all? I would need to stop the extrapolation. (but, to match earlier RI example of P=92, this is right exercise).

12 Salton Redux what was the point again?
accounting distortions influence on valuation when we correct doesn’t matter the asset writeoff in year 0 or year 1 but don’t let a distorted past influence your forecasted future margins were artificially improved by the long amortization period what does it mean to say the asset is “worthless”? extreme valuation caused by naïve extrapolation of past sales growth overstatement of profitability

13 what happened? (so far) Recession in 2001 hurt them, and they said that customers switched to lower price products which have lower margins as well. (6% decline in margin!). Sales of White-Westinghouse and Rejuvinque (FDA action brought against facial masks product!) declined, but Foreman grill actually increased sales for next two years yet again. Also, customers started places smaller, more frequent orders, so shipping costs increased. Left holding lots of inventory, so turnovers got screwed. thru 2001 and 2002 they increased advertising significantly (partly due to new introductions in europe) which hurt the operating margin. In 2003 there was a 6% decline domestically, offset by new european sales. The domestic sales drops were partly due to price concessions. In fact, the most recent quarter (feb 2004) showed a 18% decline in domestic sales! They are offsetting this with increases in international sales of the Foreman grill. While this grill be a hit overseas? Use data center to load 2002 data to see details. or load the 2003_tr file.

14 Wanna buy?

15 sales growth mean reverts quickly

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