Recent earnings quality links

Non-GAAP presentation and management incentives
What would make Jeff Gundlach bullish
Chinese accounting shenanigans at US listed companies
Accounting issues at Alibaba
The growing difference between GAAP and pro forma profits
More on non-GAAP games

Closing MFRM for now

Over the past week I’ve closed out my MFRM short position, as the share price has come more in line with the following company-specific and broader market realities:

• MFRM is a rollup acquisition model with exploding debt
• From a profitability standpoint, the company has yet to prove that this model has economies of scale
• Q1 earnings reports have been horrible for retailers

Finally, I’ve seen various short cases for MFRM put forward from others. While I am by no means turning bullish on MFRM, I do think that shares have started to price in much of the (still valid) risks to the story.


Here is a valuation table with updated figures based on MFRM’s 2016 guidance put forth in the Q4 earnings release.

With EV per store having fallen well below historical levels given the current stock price, the valuation here in the low $30’s has provided a nice return from the mid-$40’s where the short recommendation was initiated. While I do think it could easily go lower, the risk-reward has become more symmetric.

Recent earnings quality links

Non-GAAP reporting: a comparability crisis

The buyback binge: is it good for shareholders?

Myth Busting: Stock Buybacks aren’t Propping up the Stock Market

Short the HDGE ETF – I have actually had this trade on for a couple years in very small size, just out of pure curiosity

On the importance of free cash flow

Context on Corporate Profits

The Power Of Numbers: Base-Ten Threshold Effects In Reported Revenue

S&P 500 Earnings Expectations Over Time

Not really on the topic of earnings quality – but probably the most prolific source of investing wisdom one-liners (and life in general for that matter) is Charlie Munger

MFRM update

MFRM reported earnings for the quarter and full year ended January 2016 a few weeks ago. There were a number of interesting developments, though none that alter the general thesis. The initial write-up focused on MFRM’s acquisition roll-up model, profitability deterioration, liberal usage of non-GAAP reporting metrics, odd definition of comparable store sales, and wrapped up with some relevant valuation context.


In addition to reporting the Q4 and full year results, the earnings release also introduced MFRM’s FY 2016 guidance, provided some more detail around the additional debt financing driven by the acquisition, and announced a ‘real estate optimization’ plan.

Q4 earnings and revenue fell short of consensus expectations, while forward guidance for revenue slightly exceeded views, despite EPS missing consensus for 2016.


As noted in the recently filed 10-K, MFRM decided to postpone closing date for Sleepy’s acquisition until after the close of fiscal 2015. While it is entirely conceivable that all of the necessary work genuinely could not be completed in time to close the Sleepy’s acquisition prior to the fiscal year end, there is the obvious ‘benefit’ that in not doing so, MFRM did not have to disclose a balance sheet with the incremental debt load reflected.

Though anyone who follows the name closely should have a good idea of what the post-Sleepy’s balance sheet looks like, the company’s choice of acquisition closing date means that casual observers will not see the impacted balance sheet for some time (until the next 8-K or 10-Q).

Another interesting (curious) development came about as an analyst on the conference call asked a clarifying question around MFRM’s comparable store sales policy as it relates to newly acquired companies (emphasis added).

Analyst
Okay. And then just definitionaly, I guess as I recall, well, Sleep Train and the Chicago market just entered your comp base in the fourth quarter, just curious why with Sleepy’s you are including it right away is it just what’s the kind of the difference there in approach? What drives that?
MFRM CFO
Yes, so with every single acquisition that we've ever done, we’ve included the e-com and multi-channel sales businesses of the acquisition that we’ve completed. That's been our historical accounting methodology really since the start off when we’re a public company and so for Sleep Train for instance, we included those numbers, but those numbers were really small. It wasn’t as developed the business. And so it’s never been material enough to call out, but that’s been our accounting methodology since we started. And so we didn’t want to change from our historical methodology.
MFRM CEO
Yes, Dan just to clarify, the brick-and-mortars that will come in next year. And I think that’s maybe where the confusion, nature of your question is.
Analyst
I see. Okay. So in another words, the brick-and-mortar component of the comp for Sleepy’s well get the comp until let’s say year from now basically.
MFRM CEO
That’s correct.
MFRM CFO
We are expecting this month, yes.
Analyst  
Okay. And will you be going forward reporting your – will you be breaking out the brick-and-mortar portion of the comp as you report?
MFRM CFO
No, similar to our historical practice, we just wanted to call it out for you upfront because this is really the first time it made a material impact. We wanted to be very transparent with it.
Source: SeekingAlpha

MFRM’s policy, it seems, has been to immediately include acquired companies’ e-commerce revenue within comp store sales as of day one, while deferring acquired companies’ store revenue until the anniversary (as would be expected). This is very curious, and only raises more questions around the difference between MFRM’s reported comp store sales versus what would be expected from a revenue per average store type of calculation.

Finally, with the completion of fiscal 2015, the concern around the deterioration of the cash conversion cycle is somewhat alleviated. Although, this does appear to have come at the expense of margins, as gross margins declined for the fourth straight year.

Overall, the short thesis remains intact, as a multitude of red flags persist. As well, given the amounts of debt that have been piled on the company (when they are ultimately disclosed), the margin for error is getting smaller and smaller.

Recent earnings quality links

Hempton on Valeant Pharma

Elfenbein on the 'high quality ETF'

And Trainer on what it actually holds
 

Alcoa sets the tone for earnings season

 

A new accounting standard for lease accounting will affect reported balance sheets

 

An interesting discussion of lessons learned from Jim Chanos of Kynikos

 

 

 

 

 

 

Mattress Firm (MFRM) - Earnings Quality Shaky at Best

Mattress Firm (MFRM) is a mattress retail roll-up story that has doubled in value since coming public in 2011. MFRM is a posterchild for earnings quality analysis. A deep dive into the company’s accounts shows a reporting approach that is at best promotional, and at worst misleading.

 

A Serial Acquirer

In reporting its quarterly operating results, management makes liberal use of a wide variety of non-GAAP financial metrics, including (but not limited to) Adjusted EPS, Adjusted Cash EPS, EBITDA, and Adjusted EBITDA. The business model is fairly simple, so it’s not quite clear why so many varied metrics would be necessary in order to properly understand the business. Part of the rationale appears to be that the ‘Adjusted’ metrics leave off acquisition-related costs (as well as many other items). The only problem is that when you’ve done this many acquisitions (see below), then that is simply a part of your (possibly your entire?) business model. It’s hard to make the case that those costs should be excluded in order to properly reflect the business.

 

source: company presentation November 2015

Economies of Scale?

Presumably, MFRM’s roll-up strategy is predicated on the ability to extract value from the newly acquired stores over time. Possible sources of value creation could include cost reductions, revenue synergies, or opportunities for attractive CapEx investment. But a comprehensive review of MFRM’s operations calls into question whether the company’s acquisition roll-up strategy is actually creating value over time. A careful analysis shows that most of MFRM’s operational metrics have actually deteriorated since the 2011-2012 time frame. Whether via management discretion or purely incidental, MFRM’s business metrics built momentum and peaked shortly after the IPO in late 2011.

The first interesting metric is comparable store sales. This concept is an important one for all retailers. In some form or another, the purpose is to measure the performance for stores versus the year ago period for all stores that were open during both periods. It is designed to portray the underlying business performance exclusive of new stores (whether acquired or built). MFRM has a convoluted definition for its comparable store sales measure (see p. 35). Within its calculation of comp store sales, MFRM includes sales from relocated stores, as well as online sales. Management regularly reports and provides guidance on this basis. Yet the 10K also includes a measure called “average net sales per store unit”. Despite not being the metric that management regularly touts, it is actually closer to the expected definition of same store sales, capturing “sales for stores open at both the beginning and the end of the period, excluding e-commerce and multi-channel sales”. The chart below shows the trending of both of these metrics over time.

 

Notice in the final column that MFRM’s reported comparable store sales metric consistently exceeds the sales per store unit metric. Mechanically, this means that relocated stores and e-commerce sales serve to benefit the reported comps metric, although the company does not disclose any breakout of those components. Also note that the company has not reported a negative comp store sales year since the IPO in 2011. Yet the more conventionally calculated metric was negative in 2013.

Next we will go through the trends in various metrics for the business, using both the company’s preferred metrics as well as other conventional measures of profitability.

 

 

The first thing to note in the chart is the growth in store count. We know that MFRM is a retail roll-up story, but the sheer growth in stores is amazing. The company’s store footprint has grown over 5x since 2008. And the recently announced acquisition of Sleepy’s will add 1,066 stores. Despite this massive growth in scale, though, we are seeing deterioration in per-store economics and stagnation in company margins. The bottom of the chart shows the trend in management’s preferred metric of Adjusted EBITDA. 2014 marked the lowest Adjusted EBITDA margin since 2008, while Adjusted EBTIDA per average store had fallen back toward 2010 levels. This trend flies against the notion that MFRM’s massive scale expansion is leading to economic benefits.

If we then switch over from the company’s preferred metrics to more conventional measures, note that gross margin has basically stagnated for four years, after reaching 39%+ levels in 2011. Similarly, SG&A expense leverage has actually gone the wrong direction. The exponential rise in store count has resulted in SG&A % of sales approaching 33%, up from 29% earlier in MFRM’s history. Again, this is a discouraging result for believers in the company’s scaling roll-up strategy. On a per-store basis, MFRM earned only $57k per store in FY 2014, net of COGS and SG&A – a level not seen since 2009.

The next chart compares these profitability measures to MFRM’s cash flow trends.

 

Similar to the SG&A margin trends just mentioned, the chart shows that MFRM’s operating cash flow per average store in FY 2014 fell 30% to levels not seen since before 2010 – only $63k per store. Again, whether we use true operating cash flow or the company’s preferred Adjusted EBITDA metric, the trend is basically the same. As a final assessment of MFRM’s operating efficiency gains (or lack thereof) due to scale, the next chart shows the trend in cash conversion cycle.

 

 

In addition to margin stagnation and deterioration in per-store economics, MFRM’s cash conversion cycle trend is an indictment of the company’s massive expansion strategy. In 2008, the company was receiving cash from customers 9 days prior to paying its own suppliers. Fast forward to 2014, and we see a complete reversal of nearly 4 weeks, as payment from customers comes 18 days after the sale. That might not seem like much, but the directional trend is very concerning.

Valuation

All of the above is easily enough for me to consider MFRM as a short-sell investment, given the right price. So what is the right price? Well we know that MFRM just announced their pending acquisition of Sleepy’s. Their presentation shows the following valuation statistics for the transaction.

 

source: company presentation November 2015

So MFRM is paying $780 million for 1,066 stores – equating to an enterprise value per store of $732k. Since MFRM has a strategic interest in acquiring Sleepy’s (given synergy potential), it is logical that MFRM would value Sleepy’s higher than any other potential buyer. This provides a fresh, relevant data point for current market valuations.

The chart below shows historical valuation levels for MFRM on a per-store basis. The 2016 estimated store count gives effect to the 1,066 additional Sleepy’s stores (and the additional debt), and backs into the implied stock value if MFRM as a whole were valued near the $732k enterprise value per store.

 

So why would market enterprise values drop to the levels indicated in the chart? Well the process has already begun, and I believe the answer is leverage. MFRM shares are poised to end 2015 around $45. This would mark the first calendar year end for MFRM’s valuation to fall below $ 1 million per store. Given the increasing debt load and general credit conditions, the Sleepy’s transaction valuation level around $730k-$735k EV per store does not seem unreasonable. This would imply a $30 stock price, or roughly 33% decline from current valuation levels around $45.

 

Disclosure: author is currently short shares of MFRM

First Thing's First

Earnings Quality – what is it and why is it important?

          I’ll take it in reverse: EQ is important because earnings are the basis for valuing a stock. ‘Earnings’ here does not refer to net income specifically, but rather to whatever measure is used for valuing annual economic performance. Net income is a pretty bad measure for this, because it is impacted by and susceptible to such a wide variety of factors that are not going to be indicative of the underlying, ongoing economics of the business. Better measures include free cash flow to the firm (FCFF), net operating profit after-tax (NOPAT), or even operating cash flow less CapEx (if you want to rely on a third party source and not do any calculations yourself).

          So what is earnings quality? Quality of earnings measures the degree to which reported operating results accurately reflect the economic performance of the business. Put another way: to what extent can we accept management’s reported results at face value? There are many ways to assess and measure earnings quality (and those will be discussed extensively here in the future).


Application – micro and macro

          From an individual company perspective, the application for earnings quality analysis is fairly obvious. The process is basically:

          - how did reported results compare to consensus expectations?
          - were there earnings quality issues that could account for the positive or negative surprise versus expectations?
          - does the combination of stock price movement due to earnings surprise and the presence of earnings quality issues provide an opportunity to make money (long or short)?
 

          Another more subtle implication is that management intent is basically irrelevant for this analysis. For example, whether the quarterly reported sales exceeded consensus estimates due to aggressive accounting assumptions by management or due to the (appropriate) application of a new revenue recognition standard that was not fully understood by consensus views still drives the same conclusion for earnings quality analysis. Namely, the recently reported results were aided by an accounting or reporting phenomenon that was not discounted in the consensus view. This then requires assessment of whether such phenomenon is recurring and sustainable, or whether it constituted a non-recurring effect on results (which by definition is likely to reverse subsequently).

          From a macro perspective, I think there is an important and under-appreciated long-term trend affecting comparability of stock indices (such as the S&P 500) over time and the respective P/E multiples applied to them. The proliferation of non-GAAP earnings measures being reported by the vast majority of public companies currently creates a comparability issue with historical valuation measures. Although I have not done the formal work (not enough hours in my day), the hypothesis is that a larger and larger proportion of companies now utilize and report (and perhaps more importantly, Wall St sell-side analysts now base their coverage and estimates upon) some variation of ‘adjusted’ or ‘non-GAAP’ earnings. Increasingly, this typically just represents ‘earnings without the bad stuff’. Even when adjusted EPS appropriately only removes truly non-recurring items, the issue of comparability with historical periods still persists. This makes comparison of today’s market P/E multiple to that of previous cycles less and less relevant.


It’s a market of stocks

          So why do earnings quality analysis? Because the stock market is not (necessarily) the index. Sure, the right answer for many (most?) individual investors is to index. But for professional investors or individuals with the skill set, it is important and potentially very profitable to understand that it is a market of stocks – each an individual company with specific factors affecting value.

          By definition, any index is going to include a lot of losing stocks. Analyzing earnings quality is an important tool in identifying and avoiding (or shorting) those. The actual numbers might surprise you. Here is but one of many examples showing how high a proportion of stocks in the index are actually long-term losers, and by definition, how the index’s positive long-term returns end up being due to a select few stocks that massively outperform. This particular study looked at the period from 1983-2007, examining 8,054 stocks that would have qualified for membership in the Russell 3000 at some point in their lifetime. 39% of these stocks produced a negative lifetime total return, and 18.5% declined by 75% or more. 64% of stocks underperformed the Russell 3000 index. The bottom 75% of these stocks collectively had a total return of zero, while ALL the gains were attributable to the top 25% of stocks. “In other words, a minority of stocks are responsible for the majority of the market’s gains.” Del Vecchio mentions this study in his book, which is highly recommended.