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This article originally appeared on The DIV-Net on October 6th, 2009.
Recently, we talked about the need for investigating capitalized expenses. Now, let's illustrate that with a current example.
Formula Systems (FORTY) is a software and technology company engaged in software consulting services, developing software products and providing computer-based business solutions. Software development means paying software programmers to write code. The end product is the virtual concept of software.
As of the end of 2008, FORTY had a reported book value of $170M and has been trading in the last four months between $84M and $122M. At first glance, it seems like a bargain.
According to the company, FORTY capitalizes "development costs of software which is intended for sales that are incurred after the establishment of technological feasibility of the relevant product". They also start to amortize capitalized software development costs "when the product is available for general release to customers". Typical amortization period is 3-5 years.
Sounds reasonable. Until one thinks about the nature of software. Unlike a building or a factory, as in our previous example, software has a dynamic nature that is unpredictable -- a new one can quickly obsolete the old one, much faster than 3-5 years.
Also, software development costs vary widely. What one company paid to develop one can seem like fortunes to another, more efficient developer. It's unlikely that a software without a moat such as Windows or Google Search can fetch a lot of money if sold to an informed buyer, especially since new programming technology can also change the cost of building new applications.
Going back to its most recent annual report, FORTY had at the end of 2008, $46M of capitalized costs and other deferred charges listed as "Other Assets".
It also had $143M of goodwill from two acquisitions that are not amortized since 2002 but instead tested for impairment every year. Moreover, the value of these assets is calculated based on future cash flows expected in the future, like our sprocket factory example in Part I of this article. We concluded then as we conclude now, that this type of valuation can be very misleading, since the future is unknown.
So, what's FORTY worth without capitalized costs? Let's subtract all the capitalized costs and assume the software is worthless at liquidation: $170 - 46 = $124M. That's more inline with its current market value.
Now assume that we don't fully trust the company's estimate of the fair value of their goodwill. If we subtract $143M, the company is worth nothing. Of course, it must be worth something or they would have been out of business by now. But figuring out what portion of these $143M are inflated is an exercise I prefer not to engage in, especially because what's left after subtracting capitalized costs is already too small a margin for my taste.
For now, I'm passing on FORTY.
Disclosures: None.
Showing posts with label accounting. Show all posts
Showing posts with label accounting. Show all posts
2009-10-03
On Capitalizing Expenses
Expenses are costs to the company and as such they are typically recorded as a charge against revenues or sometimes surplus. But in some cases, expenses are capitalized. That is, the costs incurred are not charged against revenue or surplus, but instead built into the balance sheet as assets.
Sounds backwards? But there are valid and legal reasons for this. Imagine that you build a factory, that costs $1M to build over two years. Some expenses incurred can be capitalized because the factory you built is now an asset that is worth something if sold in the market. That's what capitalize means -- to convert into capital.
The problem starts when one needs to decide how much of the total cost should be capitalized. If the factory when ready is worth in the market $2M, then an argument can be made that $2M is what should be capitalized when the factory is ready. But if out of your building cost of $1M, some $300,000 went into buying new equipment that was stolen during construction, then an informed buyer of your factory wouldn't need to repay you that much, since he could rebuild the factory himself for only $700,000. So an argument could be made that the asset is worth only $700,000.
Moreover, if this factory is used to build sprockets that can be sold for $15 each and it can build them for $5, at the rate of 10,000 per year, then one could use the $10 spread, times the volume built to value this factory as one would value a bond or a dividend-paying stock. For the sake of the exercise, with a 9% discount rate and depreciating the factory over a period of 20 years, the fair value of this factory would be $912,854. Such projections can be misleading and are not proper accounting methods, but it illustrates how widely one can value assets.
So, what's the fair value of this hypothetical factory? In my mind, I would treat the monthly expenses for the two years it takes to build it as just that, expenses. The income statements and the balance sheet should both reflect the costs incurred. After all, it's hard to value a partially-built factory and if bad times happen and the company needs to raise cash, it will find itself in a precarious position and unable to sell the factory for what it has paid thus far. After construction, I'd call an appraiser and have the market value of the factory be reflected on my balance sheet.
Of course, this is being very conservative and is very lumpy, especially at the end. Most companies don't do it this way, but instead capitalize some or all expenses as they are incurred.
But an investor should be on the look out for abuses. AOL, during the dot-com boom, once capitalized advertising expenses, as they argued that the money used would soon be reflected in the form of new customers and increased revenues. Another company capitalized its Christmas party, under the excuse that it would reap the benefits of increased morale.
In another post, I will discuss a likely undervalued company that has many capitalized assets that need some intricate adjusting.
Sounds backwards? But there are valid and legal reasons for this. Imagine that you build a factory, that costs $1M to build over two years. Some expenses incurred can be capitalized because the factory you built is now an asset that is worth something if sold in the market. That's what capitalize means -- to convert into capital.
The problem starts when one needs to decide how much of the total cost should be capitalized. If the factory when ready is worth in the market $2M, then an argument can be made that $2M is what should be capitalized when the factory is ready. But if out of your building cost of $1M, some $300,000 went into buying new equipment that was stolen during construction, then an informed buyer of your factory wouldn't need to repay you that much, since he could rebuild the factory himself for only $700,000. So an argument could be made that the asset is worth only $700,000.
Moreover, if this factory is used to build sprockets that can be sold for $15 each and it can build them for $5, at the rate of 10,000 per year, then one could use the $10 spread, times the volume built to value this factory as one would value a bond or a dividend-paying stock. For the sake of the exercise, with a 9% discount rate and depreciating the factory over a period of 20 years, the fair value of this factory would be $912,854. Such projections can be misleading and are not proper accounting methods, but it illustrates how widely one can value assets.
So, what's the fair value of this hypothetical factory? In my mind, I would treat the monthly expenses for the two years it takes to build it as just that, expenses. The income statements and the balance sheet should both reflect the costs incurred. After all, it's hard to value a partially-built factory and if bad times happen and the company needs to raise cash, it will find itself in a precarious position and unable to sell the factory for what it has paid thus far. After construction, I'd call an appraiser and have the market value of the factory be reflected on my balance sheet.
Of course, this is being very conservative and is very lumpy, especially at the end. Most companies don't do it this way, but instead capitalize some or all expenses as they are incurred.
But an investor should be on the look out for abuses. AOL, during the dot-com boom, once capitalized advertising expenses, as they argued that the money used would soon be reflected in the form of new customers and increased revenues. Another company capitalized its Christmas party, under the excuse that it would reap the benefits of increased morale.
In another post, I will discuss a likely undervalued company that has many capitalized assets that need some intricate adjusting.
2009-04-25
Accounting Shenanigans at Closed-End Mutual Funds
I had a position a while back in PCN -- PIMCO Corporate Income Fund -- a bond fund. It appreciated 60% in a matter of weeks and I sold it. It dropped and it hasn't recovered since. Nonetheless, it still trades for a whopping 18% premium to NAV.
Today, I took another look at it to see what's going on and whether or not it still is a good investment, despite the ugly premium. Its yield is certainly attractive: 14%.
My first concern about it was whether or not it was eating into principal in order to support its high yield. Many closed-end funds do that. Of course, that's not a sustainable strategy nor is it profitable for the investor.
So I took a look at its most recent quarterly report (note: I only trust the report on the SEC website). And as usual, I also went back to its previous quarterly report.
I was flabbergasted by what I found out.
Care to take a wild guess why? Search on both reports for "Fair Value Measurements". The fund recently adopted FAS 157 and switched the bulk of their portfolio fair value estimation to Level II.
Level I determines that securities are valued on the basis of market prices (mark-to-market, if you will). Level II uses "other significant observable inputs" and Level III is pure witchery.
Why would they adopt FAS 157?
One reason is the market dried up for corporate bonds. However, is this really true? There are still bid and ask prices out there for almost all securities, certainly more than 0.97% of their portfolio, which is the amount they claimed they could use Level I quotes for, and 98.6% for Level II and the rest for Level III.
Does this seem reasonable to you?
My brokerage still shows me quotes for most of PCN's portfolio, including widely traded bonds such as those of GE, C, F, GS.
Even worse is the fact that they report $33 million in Treasury Bonds which accounts for 5.5% of the portfolio. How can treasury bonds not be quoted at Level I?
Something smells fishy.
To be sure, using Level II doesn't mean the securities became more risky, it only means they became harder to value. And while I can believe that the current market environment doesn't make things easy, I strongly doubt using Level II for 98% of a corporate bond's portfolio is warranted, especially when there are such large positions in very liquid securities.
I also checked IQC, a California Muni fund I currently own. They too adopted FAS 157 recently and switched the bulk of their portfolio to Level II. CIF, another popular corporate junk bond fund, has been on Level II for a few quarters now.
Given that I don't understand why the radical switch nor why Level I quotes are impaired, I prefer to stay away from these funds for now. I will need to make a decision about my IQC position soon.
Today, I took another look at it to see what's going on and whether or not it still is a good investment, despite the ugly premium. Its yield is certainly attractive: 14%.
My first concern about it was whether or not it was eating into principal in order to support its high yield. Many closed-end funds do that. Of course, that's not a sustainable strategy nor is it profitable for the investor.
So I took a look at its most recent quarterly report (note: I only trust the report on the SEC website). And as usual, I also went back to its previous quarterly report.
I was flabbergasted by what I found out.
Care to take a wild guess why? Search on both reports for "Fair Value Measurements". The fund recently adopted FAS 157 and switched the bulk of their portfolio fair value estimation to Level II.
Level I determines that securities are valued on the basis of market prices (mark-to-market, if you will). Level II uses "other significant observable inputs" and Level III is pure witchery.
Why would they adopt FAS 157?
One reason is the market dried up for corporate bonds. However, is this really true? There are still bid and ask prices out there for almost all securities, certainly more than 0.97% of their portfolio, which is the amount they claimed they could use Level I quotes for, and 98.6% for Level II and the rest for Level III.
Does this seem reasonable to you?
My brokerage still shows me quotes for most of PCN's portfolio, including widely traded bonds such as those of GE, C, F, GS.
Even worse is the fact that they report $33 million in Treasury Bonds which accounts for 5.5% of the portfolio. How can treasury bonds not be quoted at Level I?
Something smells fishy.
To be sure, using Level II doesn't mean the securities became more risky, it only means they became harder to value. And while I can believe that the current market environment doesn't make things easy, I strongly doubt using Level II for 98% of a corporate bond's portfolio is warranted, especially when there are such large positions in very liquid securities.
I also checked IQC, a California Muni fund I currently own. They too adopted FAS 157 recently and switched the bulk of their portfolio to Level II. CIF, another popular corporate junk bond fund, has been on Level II for a few quarters now.
Given that I don't understand why the radical switch nor why Level I quotes are impaired, I prefer to stay away from these funds for now. I will need to make a decision about my IQC position soon.
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