Case Study on Earnings Quality-HBS

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Click on the above link to download the HBS Case Study. Can you determine the earnings quality? Please answer concisely the two questions on page 6. The prizes will be awarded by the end of the week. Good luck.

10 responses to “Case Study on Earnings Quality-HBS

  1. It’s difficult to know what to focus on, so I have a feeling I’m going to win a date with your ex on this one, but here goes …

    1. Quality of 2002 earnings.

    What is apparent is a change in the tone of the narrative to the stockholders in the 31 Jan 2002 compared with 31 Jan 2003. For 2001, we were given, may I say, somewhat grandiose statements about contributing to the good of mankind, and some quote by Albert Einstein. Not to mention “It was the most successful year in National history”. Job well done, bonuses all ’round, I would say.

    Then, for 2002, stockholders might have been surprised to hear “heavy losses in FOUR subsidiaries and SEVERAL joint ventures”. Oh, what happened there then?

    From a purely qualitative view, I predict that the 2002 quality of earnings is poor. Comparing the quarterly income statements, it seems that that Q1 and Q3 were looking a little strained, and then suddenly we had some kind of crunch in Q4.

    Seems to me that the narrative and the Q4 numbers point to management deciding to take a bath on the 2002 numbers.

    2. Operating/financial difficulties

    The levels of long term debt to equity and net debt to sales for 2002 look about average for the company, so it doesn’t look like it is in financial difficulty. Operating margins for 2002 are obviously way below 2001, but it’s difficult to know whether the decline is innocent or an ominous portent.

    I suspect I’m missing EVERYTHING though.

    • Dear McTurra:

      I forgot to add….a trick might be to look at the financial statements FIRST and then read the narrative. As humans we love stories and can be easily influenced. You are on the right track–you averted a date with the Ex.

      Practice will help.

  2. 1. Cash conversion (NI to CFO) is extremely poor in 2002 and versus 2001. the company posted a conversion rate of 22% in 2002, which is low on its own, but relatively to 171% in 2001 is extremely low. I am sure there are more issues, but that one was pretty obvious.

    2. Inventories & Receivable are growing faster than sales, but management cut back on capex this year. Management is artificially stuffing the channels. The company increased its debt significantly and trades at 4x from 2.9x Net Debt to EBITDA, even as profitability remains difficult.

    Not a complete answer, but wanted to join the conversation. Wish I had more time.

  3. Dear Warren:

    You have a handle on many of the issues. The management is doing everything to boost their compensation in the short-term–driven by incentive based bias. I will await more replies. I won’t send out prizes until after Turkey Day/Next week.

    The CEO is a poster boy for a non-shareholder friendly manager. How about these managers?

  4. 1) Yes. The quality of earnings are poor given the poor cash flow relative to earnings (exhibit 10) caused by poor AR and Inventory trends. There might be writeoffs of inventory and AR in future. Also the finance sub’s loan balance has increased a lot in 2002 relative to sales, pointing to potential aggressive financing behavior. Another sign is that depreciation is a lot lower than capex. Seems like company’s earnings might be overstated as its equipment base is low on a book basis, and it needs to spend more to maintain its PPE relative to book depreciation. It seems like the company consistently spends more capex than depreciation historically, so the company’s earnings is overstated for historical periods as well.

    2) Obviously some difficulties. feels like earnings has been managed and company doing too many things that are unrelated to its core business. Financial ratios are not interesting even prior to 2002. Good thing is that a lot of the debt is ring fenced in the finance sub. they do have almost $500M of short term debt at the operating subs that need to be refinanced. don’t think it should be too difficult.

    • Dear Wei:

      You have zeroed in on the essentials. Plus the ROIC is consistently low.

      There is research showing that companies with high accruals underperform the market.

  5. I estimate that the average ROE over the last 6 years is 9.8% – not very good, actually.

    I’m a bit confused by the management incentive scheme.

    I do note that Burke says that he is “trying to get National’s stock up” (do executives really say these things publicly?). The most obvious way of doing this is juice up the earnings so that investors will attach a PE to them.

    Warren picked up on the debt, which I thought was OK, so I decided to take another look at it. I notice that customer receivables are up 30%, whereas sales are up 20%. Hmm, how so?

    I also calculate net debt for 2002 to be 828.5m for 2002 and 478.5, for 2001 – that’s a whopping increase of 73%. Looking at the cashflow statements, the big standout is the big decrease in cashflow from operations caused by increased customer receivables and inventories. To pay for all this, the company has bumped up its short term debt massively, and borrowed more on a long-term basis. I hope the customers pay their bills, and the inventories are saleable, or else shareholders are in for a nasty surprise.

  6. 1. Earnings Quality
    It seems to me that earnings quality is low, due to the high accruals and divergence between accounting earnings and cash flow in ex. 10. Just looking at it a/r grew much faster than sales did in the core business. Revenue recognition is loose by recognizing on shipment and allows for a lot of discretion with the percentage of completion methods for the other lines, etc. Depreciation is consistently below capex, implying higher ongoing expenses to keep the business going than depreciation implies, you can also see this in the difference between the expense taken on their tax books vs. financial books (the tax books show a much higher expense).

    NCC provides something of a grab bag as well. Residual values on leases are estimates and the language on provisions for doubtful account has qualifiers that create the opportunity to manage earnings.

    I agree with mcturra, i don’t fully understand the compensation scheme, but what’s clear is that management’s incentive is to basically show high accounting profits.

    2. Operational/Financial Problems
    Clearly some operational problems, the company has many divisions and problems in them. It all seems unwieldy, actually. Margins in general have been weakening. The quote from the article about tightening of auditing implies weak controls. Cash flow turned negative and financial leverage has increased materially.

  7. This seemed topical given the case study.

    The company’s deferred taxes also vary materially from 2001 to 2002.

  8. I will post answers/analysis next week. A friend has to present on this case this Sat. so I will refrain until the following week.

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