Danger Zone: Investors Who Ignore The Footnotes

In the Danger Zone this week, investors who ignore the footnotes. Now, people who listen to me regularly know that we talk about specific companies, and a lot of the time, one of the key drivers of the Danger Zone call is the fact that we found something that we don't believe anyone else has found in the footnotes or the management discussion and analysis. And given how long filings are these days, we know a lot of investors, especially professionals, don't have time to read through the annual report, and we do this. And as opposed to just highlighting a couple companies, I want to highlight a couple of specific adjustments so that you can know what to look for if you want to go through the footnotes. The first one is non-operating income. These are unusual gains or income items that companies can bury inside of other operating items in order to boost their net income. A great example of this is Olin Corporation, ticker OLN. We found in the last fiscal year that they hid some recovery of legacy legal costs in their cost of goods sold. That item, along with several other items, totaled about $30 million and boosted Olin's net income by 12%. It made the company look a lot more profitable than it really was. Another good example is Hess Corporation. They included $1.9 billion in income due to the sale of foreign oil and Oil properties in their reported net income, and so that caused their NOPAT to be over $3 billion below net income. In other words, the NOPAT number, which was the real recurring cash flow number, and if you want more detail on how to calculate NOPAT, there's a tutorial for that, but the recurring cash flow number was $3 billion lower than the reported net income number when you took out these non-operating items. So it's a big deal. The key takeaway is you can't trust that net income. It can be overstated because of non-operating items buried in it. It's, in this case, non-operating gains. On the flip side, there's a lot of non-operating expenses, right? And typically, non-operating expenses will also be buried in cost of goods sold, SG&A, depreciation, other operating expenses. And you can only find these unusual charges in the footnotes and in the MD&A. And that means they're actually understating their profits. Understanding that profits can be good sometimes, but also can be bad. In the case of Duncan Brands, ticker DNKN, we found two fiscal years ago before we made our call recommending investors before we put Duncan in the danger zone, we found that they had thrown in a bunch of non-operating expenses in their 2012 numbers so that the growth in 2013 looked a lot better than it was. And when you normalize 2012 to be to remove the non-operating unusual charges, then the growth in 2013 wasn't as good as it appeared to be. And that was one of the main reasons we put Dunkin' Donuts in the danger zone. And the stock has been down, was down 10% alone in December, and about 13% since our initial call. So these non-operating items can make a difference. Another big adjustment is off-balance sheet debt. This is effectively just debt that companies can put off balance sheet because there's an accounting loophole in that. I'm actually working with FASB to fix this loophole. It's been a long, hard battle, and you'd be surprised how difficult it's been, because at the end of the day, these operating leases, which are off-balance sheet, are future claims on cash flows that companies have to pay, and they're effectively debt. And the line between treating it as off-balance sheet and on-balance sheet is super narrow. So companies can easily convert one to the other and back and forth. And the problem here is not just that you're missing a big piece of debt, but it's also that there's lack of comparability. For example, UPS and FedEx. One of those companies has a ton of off-balance sheet debt and the other doesn't. They both have very similar businesses, but their debt profiles are very different because one of them keeps a lot of the debt off balance sheet and the other one does not. So specific examples where off-balance sheet debt has made a big difference: Salesforce.com, ticker CRM. When you overlook the off-balance sheet debt or don't ignore it, you, you not only do you get a bad picture of how capital intensive the business really is, And it's more than you think. But really the big thing is the free cash flow because Salesforce.com likes to talk about free cash flow. They like to say that their free cash flow is positive. And they showed growth from $90 million in free cash flow in 2011 to over $567 million in 2014. When we adjust for off-balance sheet debt along with a few other items, we show that their actual free cash flow in 2014 was negative $2.5 billion. That's a huge swing from the $567 million that they claimed to achieve in 2014. On top of that, we showed that the free cash flow was negative every year since 2011. So can't trust what they tell you about cash flow. And the same is true for Amazon. Amazon had an overly simplistic formula for their free cash flow, and we actually wrote a great article on that, put them in the danger zone for the same reason. Myths About Amazon's Cash Flow. I recommend you check that out. Okay. and see how companies will actually try to show you performance is better than what it is. And look, let's face it, they've been in the business of doing that since the beginning of the market. Another example of huge off-balance sheet debt with Ox— and a company in the danger zone, Oxford Industries, ticker OXM. The balance sheet showed debt of $134 million. We uncovered an additional $320 million in off-balance sheet debt, or 45% of the company's market cap. We more than doubled the balance sheet based on what we found in the notes about off-balance sheet debt. So it matters. Another important disclosure is pension funds. We collect all kinds of data on pension funds. And, you know, as an example, we collect all kinds of data on all these items. And I forgot to mention, we collected or we found over $900 billion of off-balance sheet debt across the 3,000+ companies we cover. And that's the 3,000 most actively traded companies. It's a big number. It's material. As I've said in my tutorial about why data quality matters, it's important to look at everything. And we're not here just to throw bombs at people about data points. Everything we talk about has a material impact on at least one company. And you never know if that's the company you're looking at. That's the kind of diligence we bring to this. We like to believe you never know if that data point that you miss is the one that blows you up. That's the way we go through filings and that's why we're we believe we're so good at what we do. But another example of a big adjustment that you can only find in the footnotes is Navistar. Navistar, we found, had an underfunded pension of $1.4 billion, or 54% of the company's market cap. Pretty big number. Something you don't know about until you look in the notes. We also saw that they're increasingly dependent upon government, government, um, Mm-hmm. Revenue and contracts, which means that that's, you know, that's not a good sign of sales for the company. And that's the division of revenues and how that's broken up is also something you can only find in the footnotes. And that would get to tell you kind of what the competitive position of the company might look like. So if you want reports on all of these companies, feel free to click below. And otherwise, stay out of the danger zone. Do your homework and read the entire annual report, especially the footnotes.