I recently wrote a post on how stocks fall off Wall Street’s radar. One bullet point focused on financial notes, which are the least investigated yet most important part of finding quality stocks. Andrew at 101Centavos said this would make for a good future post, so let’s not upset him!
Think about notes as the guide to reading a financial report. The notes tell you how the company accounts for various line items, which may or may not distort the actual values listed in financial reports.
Problems with Financial Notes
The notes are the solution guide to financial statements. Think about it like this: the company has financial data, it twists and turns the data through the notes, and then this data is reported publicly. This public information is then listed on sites like Google Finance, Yahoo Finance, Morningstar, etc. as truth. In reality, that information is just a twisted version of what’s really going on.
Here’s how the notes fit in translating financial data: (Pardon my MSPaint skills)
A few months ago, Radioshack was all over value-oriented blogs and contrarian investing sites as a potential investment. Few analyses looked into the notes. I couldn’t believe it. So now we’re going to go back in time to see why Radioshack wasn’t as cheap as it appeared in stock screeners or in public stock data.
Two Huge Liabilities Hidden in RadioShack’s Financial Data
Radioshack’s most important notes are only included in annual filings, not quarterly filings. The quarterly filings point investors to the annual report. This just goes to show that before you invest in any company, you should read at least one quarterly and annual report.
As I was reading through the financial notes, I uncovered two very big liabilities that were not included in public financial reports.
Here’s a screenshot of RadioShack’s notes on its leases and purchase orders:
There are three very important things to notice and to consider:
- Radioshack has considerable operating leases – Its operating leases are for retail stores in malls, shopping centers, etc. which it operates out of and which it pays an on-going monthly or yearly rate in rental payments. Minimum non-cancelable leases will require $577.5 million in cash from the company over the next few years.
- Radioshack has material purchasing commitments – Radioshack has on-going purchase orders which require the company to buy inventory from suppliers. Basically, Radioshack has agreed to purchase some kind of inventory in the future, and that agreement will have to be fulfilled. Radioshack has contracts requiring it to buy $332 million of future inventory and advertising.
- These are off balance sheet liabilities – The company discloses that these are off-balance sheet liabilities, meaning that they are not accounted for on the balance sheet.
Stop to think…
As you read through the information disclosed in the notes, you see that Radioshack has $577 million in lease “debt” of sorts. The leases are non-cancelable. Operating leases are usually included in bankruptcy as debts. Non-cancelable operating leases are the closest thing to a debt that you could ever have.
But…in accounting, operating leases are an on-going concern. Therefore, future payments on operating leases are not counted as a debt on the balance sheet. Lease payments are accounted for as an operating expense on the income statement as they are paid. Basically, Radioshack’s income statement reflects the cost of its leases when it pays for them, but it does not account for any future need to make lease payments by recording them as a debt on the balance sheet.
Purchase orders are an on-going concern which are treated the same as leases bankruptcy and which are essentially a debt. Furthermore, should Radioshack plan to stay in business and stay on the good side of suppliers, it will have to purchase this inventory. There’s no other way around it.
So, basically, in combining required inventory purchases and operating leases, we find that the company has a total of $893 million in future expenses that must be paid to stay in business. Again, neither of these are accounted for on the balance sheet.
RadioShack’s Balance Sheet
As of the same 2011 report from which I gathered this financial data, Radioshack reports stockholder equity at $753 million. This coincides with free information I find on Morningstar, which is in the image below:
Now, if we only use the public reported information, information which is used on stock screeners and on financial sites like Google Finance or Morningstar, Radioshack looked like an incredible bargain.
As of February, when the annual report came out, the company was selling for roughly $710 million, which basically valued the company at just 95% of stated book value of $753 million.
The business could liquidate and investors would get at least $1.04 back on their dollar if a turnaround was unsuccessful. That made it worth a flyer for a lot of people who didn’t bother to read the financial notes.
We have to be smarter than that. We have to read the financial notes and make adjustments as is necessary to get a true liquidation value for Radioshack.
If we add the full cost of future operating leases to the balance sheet as a debt of $577.5 million (they are non-cancelable, so they really are debt) then stockholder equity PLUNGES from $753 million to $175.5 million. So there goes 80% of Radioshack’s publicly-reported book value. It’s gone! There goes any possible discussion about Radioshack’s liquidation value being even remotely equal to the company’s market value.
But we still have to adjust for Radioshack’s purchase orders, and we can do a rough adjustment. Elsewhere in the notes, we find that Radioshack values its inventories at the lower of average cost or the market value.
The 10-K says:
Our inventory consists primarily of finished goods available for sale at our retail locations or within our distribution centers and is recorded at the lower of average cost (which approximates FIFO) or market. The cost components recorded within inventory are the vendor invoice cost and certain allocated freight, distribution, warehousing and other costs relating to merchandise acquisition required to bring the merchandise from the vendor to the location where it is offered for sale.
That’s normal. No sweat.
So, if we add the purchase orders in as a debt, and add the inventories to the asset columns at their cost, then there is no change to shareholder’s equity. Assets go up and liabilities go up by the same amount. So we’re still at $175.5 million in shareholder equity, down from $753 million after adjusting for two very important off balance sheet liabilities hidden in the notes: operating leases and inventories.
Keep in mind that although our adjustment for inventories does not affect shareholder’s equity, it does change the importance of Radioshack’s ability to move inventory. Radioshack has more debt in the form of purchase orders, and more (likely electronic-related) inventories which are rapidly depreciating in value.
Hence the logic follows that if Radioshack needs to have a closeout sale to move inventory because it has too much inventory, we would expect that Radioshack might have to sell goods at a price lower than cost. That’s not good at all, and it could negatively affect Radioshack’s book value as I calculated it.
After making two simple adjustments to RadioShack’s public data we find that:
- Liquidation value is substantially lower than tangible book value.
- Book value of $753 million is really more like $175.5 million in a liquidation scenario. Thus, book value as a backstop is worth roughly 1/4th as much as the financial data would tell you.
- RadioShack could not easily close unprofitable stores because it had on-going leases and significant future purchase orders for inventory that would need to be liquidated, thwarting at least one suggested turnaround opportunity.
- RadioShack’s financial well being and recoverable liquidation value is increasingly levered on rapidly-depreciating consumer electronics inventory.
None of this is Sketchy
If there is one thing I want you to remember, it’s that all of this is legal. In fact, Radioshack is just following accounting as any accountant would. None of this is meant to hide information. None of it is meant to be misleading.
However, publicly-available information on Google Finance, Yahoo Finance, whatever, will be misleading if you do not read the financial notes. The financial notes are not on the aforementioned sites, and thus whatever you glean from them is unimportant and unworthy of analysis. These sites would tell us that Radioshack traded at .95x book value. In reality, Radioshack traded at more than 4x actual liquidation book value when adjustments were made for the off balance sheet liabilities.
Every Radioshack analysis ever cited the safety in buying it at less than book. In a liquidation event, the source of a margin of safety, Radioshack offered at most 25 cents on the dollar to any investor.
All financial data is relative to the reader, however:
- If you’re a perma-bull on the failed business model of mall-based electronics retail, you’d say that Radioshack’s leases are not a concern and Radioshack will continue to operate profitably, so the operating leases are not important. That’s an extreme stretch, though, since off-balance sheet liabilities do limit the company’s ability to downsize as a way to generate larger profits and it is well known that Radioshack was unprofitable.
- If you’re someone who like me, someone who likes to have a huge margin of safety when making an investment, then you absolutely have to include these off-balance sheet liabilities into your analysis. In doing so, you discover that Radioshack doesn’t trade at .95x liquidation value, but more like 4x liquidation value. For a company that is unprofitable, that’s far too steep of a price to pay as of February 2012.
Making Money on Financial Notes
Some of my all-time favorite picks have come from information in the notes. In some cases the notes reveal how asset values are reported (inventory at LIFO; bank assets at a mark-to-market discount with a less than perfect mark, real estate is worth more than reported because real estate is not marked-to-market in the US, etc.). These can lead to tremendous values as a particular line-item is understated rather than overstated. For the purposes of this article, I stuck with off balance sheet liabilities, since they are present in probably 99.999% of all financial reports.
Honestly, my favorite notes are those which turn me away from a company. This happens a lot – and I’d say my biggest wins from financial notes are in the form of savings of lost investment capital because the notes turned me away.
Allow me to introduce you to David Einhorn, undoubtedly the best analyst of notes to the financial statements. His hedge fund, Greenlight Capital, kills it when it comes to undiscovered information in stocks he wants to short.
Listen to Einhorn’s forensic accounting handywork with Allied Capital. In his speech, he details how he compares Allied Capital’s notes to the notes in reports of other public companies. He shows how Allied Capital’s assets are marked up significantly to their actual value. Allied capital later goes bankrupt, and Einhorn becomes the new king of The Street after killing it on a short position:
David Einhorn’s Greenlight Capital rocks it with a historical 22% annualized return. Einhorn’s personal net worth is now north of a billion dollars, much of it earned from gritty details in financial notes. That alone is reason enough to pay attention to the notes on any financial report. (And it more than makes up for his nerdy-sounding voice!)