Itron (ITRI): new idea up on Seeking Alpha

I've got a new idea posted over on Seeking Alpha.

Please take a look and let me know what you think.

A few links and new idea in the works

It has been awhile since I’ve been able to write here, but I wanted to share a few earnings quality links I came across lately. I’m also working on a new short sell idea, which I hope to be able to share soon.

Decent sites that are also working to cut through the accounting fog

The growing difference between GAAP and reported earnings is really important, and largely ignored

Another good discussion of this topic, with Valeant as a specific example

Warren Buffett wrote about this last year

Interesting take at the end of this one, looking at specific sectors getting particularly aggressive at the top of the cycle

MFRM: there's never just one cockroach

Yesterday, MFRM filed their 2016 Q1 10-Q. Buried at the very back of the document was this interesting disclosure:


"Even though management did not perform the evaluation of Sleepy’s internal controls over financial reporting, we became aware of the following material weaknesses that existed at the end of Sleepy’s fiscal year 2015 and are still unremediated:

• Sleepy’s does not adequately document its vendor agreements relating to incentives offered by vendors and does not document changes to its vendor agreements.
• Sleepy’s does not adequately document its agreed upon firm prices for, and does not timely bill for the sale of, damaged, clearance, outlet and obsolete inventory to third parties.

The Company intends to address these material weaknesses as part of its plans to integrate Sleepy’s processes and systems during fiscal 2016, but they remain unremediated at May 3, 2016."

During the first quarter of 2016, we identified a material weakness in our controls over financial reporting related to the accounting for significant transactions that occurred during the quarter.  Specifically, we did not design and maintain effective controls related to the recording of the expense for the flow through of the inventory step up fair value adjustment in the Sleepy’s acquisition.  We believe the financial statements included herein properly reflect the correct amount and proper classification of the flow through of the Sleepy’s inventory step-up adjustment."


Given the extent of other issues previously outlined at length around MFRM, this is yet another red flag that could potentially be quite significant. There's a lot of ambiguity around the way the above is worded, but basically it sounds like MFRM's diligence around Sleepy's 'missed' a few things related to Sleepy's treatment of clearance/obsolete inventory and vendor incentives. Given the significant downward revision to full year guidance that was rolled out with the Q1 release, putting the pieces of the puzzle together gives the impression that margins are going to suffer a previously unforeseen hit during FY 2016.


Despite the sharp move downward already, these developments could be a catalyst for a further move, now that momentum is squarely to the downside.

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.