Prospective analysis

Here's a link (on SSRN) to a chapter on Forecasting from IGNACIO VELEZ-PAREJA (Universidad Tecnologica de Bolivar School of Business) and JOSEPH THAM (Duke University - Duke Center for International Development in the Sanford Institute of Public Policy; Duke University - Center for Health Policy, Law and Management). From the abstract of the paper:

We discuss some ideas useful when forecasting financial statements that are based on
historical data.
The chapter is organized as follows: First we discuss the relevance of prospective analysis for non traded firms. In a second section we a basic reviews of subjects that will be needed for forecasting financial statements. We discuss the use of plugs for financial forecasting. We show an alternate approach to avoid such popular practice. The approach we propose follows the Double Entry Principle. This principle guarantees consistent and error free financial statements. We show with a simple example how the plug works and its limitations and problems that arise when using it.

Next, the reader will find what information is needed for the forecasting of financial statements and where and how to find it. We present the procedure to identify policies that govern the ongoing of a firm such as accounts receivable and payable, inventories, dividend payout, and identify price increases and other basic variables. We also deal with the real life problem of a firm with multiple products and/or services. We start with historical financial statements We include inflation rates, real increases in prices and volume and policies in order to construct intermediate tables that make very easy the construction of the pro forma financial statements. We use a detailed example to illustrate the method.
We derive the cash flows that will be used in the book to value a firm. This type of
models might be used by non traded firm for a permanent assessment of the value creation. Finally we show some tools to perform sensitivity analysis for financial management and analysis.

Accounting jobs

Looks like it's still a good time to be studying accounting. The latest research from the Dept of Education, Science and Training suggests that there will be an ongoing shortfall in accounting graduates. Keep studying!

Qantas

Just a bit more on the Qantas private equity bid. Given the recent profit upgrades, any shareholders who did sell out on the advice of the Qantas board have the right to feel aggrieved. Perhaps legally so. I wouldn't be surprised to see a class action commenced over this. John Durie comments here.

EPS targets

EPS (Earnings per share) is a commonly cited performance measure. Trouble is, it doesn't tell us that much. Recently, CSL Ltd effectively tripled its earnings per share by undertaking a 3 for 1 share split. Nothing about the future performance (cash flow or overall earnings) changed. Paul Kerin points out how managers focused on increasing EPS can do two bad things: (1) undertake investments when they shouldn't, and (2) not undertake investments when they should. So, what's a better measure? Kerin argues that we should focus on "cash and strategic logic". If you're looking for an overall performance measure, then Return on Equity (ROE) or Return on Assets (ROA) are going to be better than EPS, or EPS growth.

BHP / RIO

There will be masses of words written about this. The whole process is going to take some time. Here's a starting point: Bryan Frith.

Earnings quality / pro forma earnings

Here's an oldie but a goodie. Businessweek from 2001.
Key graphs:

Sometimes, as in the case of Enron, fuzzy numbers result from questionable decisions in figuring net earnings. More often, though, the earnings chaos results from a disturbing trend among companies to calculate profits in their own idiosyncratic ways--and an increasing willingness among investors and analysts to accept those nonstandard tallies, which appear under a variety of names, from "pro forma" to "core." (Enron offers its own such version. Before investors untangled the importance of Enron's first announcement, its stock rose briefly because it told investors that its "recurring net income" had met expectations.) The resulting murk makes it difficult to answer the most basic question in investing: What did my company earn?

Why calculate a second set of earnings in the first place? Because the numbers reached by applying generally accepted accounting principles (GAAP) are woefully inadequate when it comes to giving investors a good sense of a company's prospects. Many institutional investors, most Wall Street analysts, and even many accountants say GAAP is irrelevant. "I don't know anyone who uses GAAP net income anymore for anything," says Lehman Brothers Inc. accounting expert Robert Willens. The problem is that GAAP includes a lot of noncash charges and one-time expenses. While investors need to be aware of those charges, they also need a number that pertains solely to the performance of ongoing operations.

That's what operating earnings are supposed to do. But because they're calculated in an ad hoc manner, with each company free to use its own rules, comparisons between companies have become meaningless. "No investor--certainly not any ordinary investor--can read these in a way that's useful," says Harvey L. Pitt, chairman of the Securities & Exchange Commission. The SEC is examining whether new rules are needed to clarify financial reports and perhaps restrict use of pro formas.

What's badly needed is a set of rules for calculating operating earnings and a requirement to make clear how they relate to net income. In the end, investors need two numbers--a standardized operating number and an audited net-income number--and a clear explanation of how to get from one to the other.

Excessive pay deal?

John Durie on the back page of The Oz puts forward a suggestion: if the Telstra board ignores the vote against the proposed executive pay package (see SMH discussion here, then the logical step is to vote out the board. Heh. Let's see if the government (or the Future Fund) are prepared to do that!

Sub-prime stupidity

Dennis Berman in the Wall Street Journal calls it like it is.

The subprime realm has thus become a vital portal onto Wall Street, helping us understand just how upside-down the place has become. In this world, risk management is applied retroactively. CEO succession planning is, too.

Don't let those on Wall Street fool you by saying "this is the natural cycle of things." Does it really have to be? Unlike virtually any other industry, Wall Street shakes, twists, and hammers on its innovations until they break. What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?

Credit rating agencies / subprime / Citigroup

Still more on credit ratings. Turns out the mathematical models used by banks such as Citigroup to value securities like the securitized (sic) subprime mortgages (CDOs, or collateralised debt obligations) relies heavily on credit ratings. That led to the situation where (as we've discussed in class) a downgrade by a ratings agency becomes somewhat self-fulfilling. Wall Street Journal "Heard on the Street" article (via the Oz) here . [Note: this is one of the early benefits of News Corp buying Dow Jones. The Australian gets access to the Wall Street Journal. Goodbye AFR?

Pressure on security analysts

Do analysts ever wonder about the consequences of downgrading their recommendation on a firm? What if it's death threats? Yep. I think the analyst made the right call. As long as they're not, you know, actually killed.

Valuing mining companies can be tricky

Just ask shareholders in Ginadlbie Metals and Sundance Resources. An independent expert was unable to value the resources held by Sundance in Cameroon (see Oz article here). This is an example why I typically discourage students from choosing resource companies for the major assignment!

Value vs growth investing

Value investing (looking for low P/E, high dividend yield stocks) can be difficult in a bull market, with valuations on the rise. Anna French in The Australian explains what sorts of firms the fund managers are looking at. Note that the distinction between value and growth is not always clear:

Roger Montgomery, chairman of value manager Clime Asset Management, says value is hard to find but it is not the worst he has seen it. He also has a more flexible definition of value. "Value and growth are two sides of the same coin. You can't estimate the value of a business unless you can confidently assess its growth.

Tax implications for takeover targets

A couple of colleagues (Martin Bugeja and Ray da Silva Rosa) have a paper examining the impact of the change in tax treatment of capital gains in takeovers. From the abstract:

Prior to December 1999, shareholders that sold their shares into Australian takeovers have been taxable on capital gains irrespective of the form of payment. Subsequent to this date shareholders can elect to rollover gains when equity is received as consideration. We examine the effect of this regulatory change on the association between target shareholder capital gains and both takeover premiums and shareholder wealth. Inconsistent with the target shareholder taxation being important the results indicate that target shareholder capital gains are unrelated to takeover premiums and target firm abnormal returns. Additionally, we find that cash consideration increases target shareholder returns for reasons other than taxation.

SSRN link.

Value in mergers?

Where do the value in mergers come from? Here's a paper that has a crack at answering it.

We estimate that tax savings contribute only 1.64% in additional value, while operating synergies account for the remaining 8.38%. Operating synergies are higher in focused mergers, while tax savings constitute a large fraction of the gains in diversifying mergers. The operating synergies are generated primarily by cutbacks in investment expenditures rather than increased operating profits. Overall, the evidence suggests that mergers generate gains by improving resource allocation rather than by reducing tax payments or increasing the market power of the combined firm.

Mergers - how long till the benefits are realised?

We spoke in class this week about the time it might take for merger benefits to be apparent. This is relevant when trying to value any merger or takeover 'synergies', as well as when trying to 'measure' the benefits of mergers or takeovers (using say financial statement data). According to this article, the retail expert Wesfarmers has brought in to advise on the Coles merger thinks turnaround time will be at least 5 years. That seems reasonable to me.

Currency movements and earnings

The Australian dollar has been trending up against the U.S. dollar. That will impact on the Australian dollar value of U.S. earnings reported by companies such as CSL. The CSL chair at the recent AGM stated (link):

However, Ms Alexander said CSL had no plans to hedge its currency exposure, as exchange rate movements did not have an impact on the company's underlying performance.
"Given translation for reporting purposes does not reflect a cash flow, CSL does not consider it appropriate or economic to hedge these earnings," she said.

This implies that the U.S. earnings (or more correctly, the U.S. cash flows) are not 'repatriated' back to Australia, but rather 'kept' in the U.S. If the U.S. dollar cash flows were heading back to Australia, then CSL may be taking more of an interest in hedging.

Mergers and capital gains tax

We were talking in class this week about the tax implications of using cash vs shares in a takeover. Looks like the relative advantage of using shares (i.e., the deferring of a capital gains tax liability) is under threat. Jane Shultz in The Oz writes:

TAX experts expect a major slowdown in takeover activity due to a controversial change in tax law, despite the federal Government yesterday tweaking its announcement in a move likely to save the demerger of James Packer's Publishing & Broadcasting Ltd.

On Friday, Revenue Minister Peter Dutton suddenly announced changes to the tax consolidation regime that significantly increased the amount of capital gains tax payable when assets bought in a scrip-based takeover were on-sold.

Mergers, and Sovereign Wealth Funds

We've discussed in class this week the fact that regulatory requirements can limit merger and acquisition activity. The sorts of regulators involved are the competition regulator (ACCC) and the Foreign Investment Review Board (FIRB). The Group of 7 are currently considering a proposal to limit the investment activities of so-called Sovereign Wealth Funds (i.e., countries, especially those like Singapore and China, who are amassing extremely large amounts of money). Let's keep an eye on this...

Link to Australian article.

UPDATE (19/10/07): I didn't mention the Takeovers Panel (hey, check out the 'old-school' website feel) as one of the relevant regulatory bodies, but should have. One of their current tasks is to decide whether Pallinghurst or Palmary should end up owning Consolidated Minerals. Bryan Frith article on this here.

Earnings management and earnings quality

Kin Lo from the University of British Columbia has posted an easy-to-read (i.e., no statistical analysis) article about earnings quality and earnings management at this SSRN link.

* Photo of UBC by Kevin.Creamer - taken from his Flickr page.

Private equity - Michael Jensen's thoughts

Michael Jensen (Harvard Business School) has a set of slides available from SSRN concerning his thoughts on private equity: in short, he views it as part of a new model of management.

Slides at this link.

The stock market crash 20 years on...

inevitably leads to comparisons with market conditions now. It seems that most commentators think that conditions aren't (yet) as speculative as they were back then. Here's John Spalvins, former CEO of Adsteam:

There's no comparison between today and 20 years ago," says Spalvins.

"The economy is in great shape." Spalvins says that in the late 80s he was concerned about a share market crash a year before it happened.

"Interest rates are low.

"We have a resources boom ahead of us.

"People don't understand the meaning of the emergence of China and India. They think commodity prices will return to their long-term levels.

"But there is a new ball game in which commodity prices will operate at very high levels because of the ever-increasing demand from China and India."

In the Weekend Australian - link.

More commentary from Anna French:

With the 20-year anniversary of the 1987 share market crash fast approaching, a few investors are skittish about the parallels between then and now - particularly the length of the current boom and the huge share price gains in the lead-up.

During the tech boom it was described as "irrational exuberance" by Robert J. Shiller, who wrote a book of the same name.

Most say "it's different this time" because the resources companies driving the boom actually make money, but investors can still learn lessons from previous wealth-destroying episodes.

Michael West also gets in on the action:

Then, the Asian power funding US deficits was Japan, not China, although US deficits are now in the trillions, not billions.

Interest rates are lower now. They were 11 per cent then, not 7per cent. The price of bullion was lower too, ironically indicating less inflation in the pipeline than the gold price would now suggest.

Price-earnings ratios were 20 times then. Now we talk about EBITDA ratios - they make stocks feel cheaper. But on a like-for-like basis the resource stocks now trade on higher multiples, as do the banks, and the industrials are slightly lower. Then there are the growth stocks and the financial engineers whose PERs are well into the 20s.

Equity yields were lower then. They doubled after The Crash from 2.5 per cent. Now corporate balance sheets are cleaner, and with the exception of the financial engineers, gearing is lower.

Just as the Bonds and Skases were doing then, the Macquaries and Babcocks are doing now, refinancing and revaluing assets, ripping out fees, booking profits barely related to cash flows and wowing all with their brilliance.

Executive pay disclosure

orporations are falling short in explaining to investors how executives are compensated and for what, Securities and Exchange Commission officials said Tuesday in their first review of corporate filings since new pay disclosure rules were put in place.

The S.E.C. called on corporations to give investors more insight into how they made compensation decisions and to ensure that proxies were “clear, concise and understandable.” Corporate boards, regulators said, could also do a better job in discussing how they chose performance targets, severance packages and the peer companies they used as comparisons for their pay practices.

New York Times link.

The same issue continues to apply in Australia.

Equity risk premium in Australia

Here is a link to a paper that provides some information on the returns on stocks, bonds and the equity risk premium in Australia.

Takeovers and disclosures

Paul Kerin in The Australian writes about takeover bids and the fact that management should disclose any offers they receive to their shareholders, and if the bid is rejected, explain why. Ideally companies should have explicit policies in place to deal with these sorts of issues. Link

Collateralised debt obligations (CDOs)

Trying to understand how some of these new fancy financial instruments work? Here's a paper that tries to explain one of the newer things on our radar; the collateralised debt obligation, or CDO. SSRN link here.

From the paper's abstract:

Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs.

In this article, we discuss CDOs. We begin with the basics of CDOs and then discuss synthetic CDOs. The issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives, are also discussed.

Credit crunch losses

Looks like the losses on the recent 'credit crunch' have topped US$18 billion, according to a report in the Financial Times section of The Australian (link). Most of the major banks in the U.S. are reporting write-downs in the value of their loans. It will be interesting to have a look at the reports of these companies to see how they have gone about the valuation of their loans.

I wonder if things would have been different if the U.S banks had to file half-yearly (as in Australia) rather than quarterly. In particular, I wonder if the banks would have disclosed to the ASX the extent of their write-downs under the Continuous Disclosure obligations.

Wesfarmers, Coles and independent experts

Coles has released the independent expert's report commissioned for the Wesfarmers bid. You can find it at the ASX announcements page (link). You can find an example of the media reaction to it here. Crikey's Adam Schwab gets it about right when he states (link):

Grant Samuel’s full 187-page Independent Expert’s Report on Coles Group was finally released on Monday. The Report notes that while Wesfarmers’ offer “does not deliver a full premium for control” shareholders are better off voting in favour of the deal. Grant Samuel values Coles at between $16.21 and $18.23 per share. The only thing is, the Expert noted that “the valuation range exceeds the price at Grant Samuel would expect Coles Group shares to trade in the absence of the Wesfarmers proposal.”

In short, what Grant Samuel effectively said was that - “We think the company is worth $20 billion – the only problem is, no one who is actually willing to spend money to buy Coles shares thinks that.”

Grant Samuel’s valuation is based on both a discounted cash flow model (which is highly subjective and can be wildly affected by the forecast growth rates and discount rates assumed) and the capitalisation of earnings method (which involves a comparison of multiples such as EBIT, EBITDA and net profit with comparable companies).

We'll have a look at the expert report in detail in class 11.

Why group work?

Marcia Devlin writes in today's Australian (article helpfully not online) about the benefits of group work (timely given the group project is due in a few weeks). Marica is from the University of Melbourne, and has a number of articles at this link that points to her research. An article on group work in particular can be found at this link (14 page PDF).

Greenspan slams credit rating agencies

WSJ Online link.

Strategy, financial analysis, credit crunch, and TPI

TPI's recent strategy has been driven by acquisitions. At the end of this year TPI have to refinance about $2.7bn of debt. Given recent events in the credit market, this could prove interesting. More from Adele Ferguson here. Key quote that backs up what we keep discussing in class:

The ride has been exciting, with the share price going on a roller-coaster ride, and profits going through the roof. But analysing a company that makes a lot of acquisitions is tough, particularly one that has reclassified some of its businesses into different divisions and created new divisions.

More on Coles' profit

Elizabeth Knight in the Herald follows up on the Coles profit, and makes the point that I've made in class repeatedly: pro forma earnings numbers are problematic in that it is not clear what has been included and excluded from GAAP income, which makes it difficult to compare with both previous earnings numbers from (in this case) Coles, or to compare Coles with other companies.
Key quote:

And it is fair to say that this week's results support their views to the extent of the rot within the all important supermarkets business is greater than even the harsher critics had expected.

The variance in the analysts' views on the underlying profit also suggests that there is a lack of transparency in the earnings numbers and a lack of trust in how they were presented.

They all came to the conclusion that they were poor but were at odds about degree.

It seems that creating confusion, rather than clarity, appears to be one motivation for using pro forma numbers. Not always, mind you.

Always check the audit report...

It's easy to assume that the financial statements are 'in the clear' simply because they have been lodged with the relevant regulators and distributed in an annual report. Not so: the financial statements can still be issued with a qualified audit report. It's a quick thing to check if you're evaluating a company. Here's an example where we might see a qualification. This sort of thing (i.e. internal control issues) has been a big issue in the U.S. following the implementation of SOX.

AIFRS - all OK so far. Mostly

Two years after the introduction of the International Financial Reporting Standards in Australia [thus AIFRS], the adjudicating body hasn't yet heard a case. This is similar to what happened in the UK, where it took a few years before cases came through. Seems a good start, though.

Earnings quality - Coles

Elizabeth Knight in the Herald has a look at Coles' recent earnings announcement (you can find both the profit announcement and the media release on the ASX website here). The "underlying profit' (i.e. pro forma income) for Coles is just under $45m higher than their net profit. No surprise there. Here's how Elizabeth Knight describes them:

But here come the adjustments. Take off $34.5 million for accounting changes, adjust $55.9 million for ownership review costs, add another $23.9 million in advisory costs and $51.5 million in redundancy costs, then take out $53.5 million in property gains, then tax-effect it and, bingo, the end result is a profit 1 per cent down on last year. And this is not too far off the amount the company has indicated.

A more cynical analysis could come up with a result that was 16 per cent below last year, even after the adjustments.

Yep. That can happen. From the perspective of the Wesfarmers board, it's probably best for Coles to get as much 'bad news' out in the accounts now, so that WES can document improved performance going forward. Assuming that WES can find good managers, improving performance of the Coles stores shouldn't be beyond them!

Profitability analysis - Ipod

Each time Apple releases a new Ipod, folks out there will tear it apart to work out the likely profits per unit. Here's the latest report in BusinessWeek. Nice business line, Apple!

ASX - regulator and profit-maker

In Australia, the ASX is both the regulator of the stock exchange, as well as a for-profit entity trading on the exchange. It's obvious that there is a conflict of interest in these two roles. The conflict is nicely canvassed here.

A sub-prime primer

If you were wondering what all this 'sub-prime' stuff was about, here's a useful little article from the Sunday Telegraph (the U.K one, not the Australian one).

UNSW email down

Just in case you are trying to email anyone at the Australian School of Business, our email server (and indeed webpage) is down, and has been since last week. That's (one) reason why we have not replied to your emails.

Not fair or reasonable, but the only one you'll get...

More on the Wesfarmers takeover of Coles; the "independent expert report" (see prior discussion here) is in; the offer is apparently not fair, nor reasonable. However, with no realistic prospect of a better offer, the recommendation is for Coles shareholders to accept. Grant Samuel says that the Coles Group is worth $16.21-$18.23 a share (at time of posting this, CGJ is trading at $14.57 (up 6c for the day)). As Matthew Stevens says:

Let's be blunt here: the $930 million gap between the price Wesfarmers will pay and the Grant Samuel valuation is effectively the price Coles shareholders have to surrender to replace the company's crippled management.

The fact is, the board has been forced to accept an offer that undervalues Coles by at least $930 million because it has absolutely no other alternative.

We'll have a look at how they arrived at that valuation when the document proper is released to the market - hopefully in time for class 11 this semester (when we're discussing takeovers).

UNSW rail link

Now, I know this isn't directly related to my teaching or research, but it will be fun to keep track of how this is announced, then modified, then scrapped, then re-announced, then re-modified, then re-scrapped etc etc. Herald story here.

Key UNSW station quote:

Mr Staples's plan advocates an east-west underground metro-style line using single-deck carriages and running between Malabar and West Ryde, under Anzac Parade and Victoria Road.

It would ease congestion along Victoria Road, with stations at the University of NSW, Moore Park, Drummoyne, Gladesville and Ryde, all expected to attract large numbers of commuters.

I still say that the Airport rail link should have gone via Taylor Sq, the SCG/SFS, Randwick Racecourse, UNSW, Maroubra, Mascot, Airport. But oddly enough, I wasn't consulted on it. [$14 to go one way from the airport to Town Hall station? You cannot be serious.
/John McEnroe.

The value in Qantas...

The Herald is right: if the Chairman and board of Qantas didn't realise what the company was worth until the private-equity bid, then you really have to ask what on earth they are doing? Again, this highlights the trouble with leveraged buy-outs where the incumbent management team isn't going to be replaced. That is, there is an obviously conflict of interest that the managers face between 1) obtaining maximum value for the shareholders and 2) being able to buy the company cheaply to make more personal profits when the company is subsequently sold back to the public.

Accounting for sub-prime losses

The banks (especially in the U.S.) will be preparing their quarterly accounts at the end of September. One of the big issues they will be facing is how to treat their exposure to the sub-prime mortgages. Their assets should be 'marked to market', i.e., banks should determine the 'fair value' of the mortgages (and securitised tranches of mortgages etc). While there are rules as to what to do (i.e. fair value accounting), there is less guidance as to how to do it (i.e. value the mortgages). One of the issues with fair value accounting is the appropriate treatment when there is no active and liquid market (from an Oz article found here:

The banks are also facing losses on their holdings of complex securities where there is often no clear market price because of low trading volumes.

This highlights one of the key issues facing accountants in the future; are they going to take up the role of valuation experts, or will they subcontract out of that role and focus more on the straight 'bookkeeping'. With the move towards fair value accounting standards globally, there will be a dramatic increase in work for valuation experts.

Plagiarism

Paul Mathews in the Australian writes about plagiarism at universities. Giveaways include sentences of highly complex, technical language in the middle of an assignment with poor grammar and spelling generally. Tip for students: if you're using someone else's work, provide references. If you can google it, so can we. Paul is right when he says that we want to read your opinions, even if they are in 'bad' english.

Takeovers... Wesfarmers/Coles

Some readings for the latest in the Wesfarmers takeover of Coles: here, here and here
Something novel in the 'price protected shares'. I'd be hoping that WES shares are about $45 in 4 years...

How well will Coles have to perform to cover it's cost of capital: from John Durie (linked above):

The deal is one thing, the hard part is getting a $20billion deal to earn its keep over the next four years - and that's no easy task. On some estimates, Coles will earn $1 billion this financial year.

Wesfarmers' cost of capital with Coles will be around 10 per cent - which means Goyder will have to double earnings to make his cost of capital.

This won't be a walk in the park - but just for starters, there are some $400 million in costs that can be readily taken out of the business.

WES has a reputation for getting good managers into a business, and then letting them manage. If the Coles board accepts this revised bid, WES will be able to get on with the business of doing that.

ICAA program

You may know that the Institute of Chartered Accountants in Australia (ICAA), is one of the 2 professional accounting bodies in Australia (CPA Australia being the other). The ICAA have recently lowered its entry requirements to its professional program. You can now qualify for their professional program by completing only one 'financial accounting' unit (note: from 2008 this will be increased to three courses). This seems to be a response to the difficulties in accounting firms currently face in attracting graduates. Hmm. Part of the problem is that accounting graduates are extremely sought-after in the employment market, and in particular are able to earn significantly higher salaries from the investment banks and consulting firms than they can by going to a Big 4 accounting firm. I'm not convinced that lower entry requirements is going to solve the problem. Given the increasing complexity of business, this strikes me as going in exactly the wrong direction. More here and here.

Directors' fee disclosure

Stuart Wilson in the Australian warns shareholders to be careful of automatically approving increases in directors' fees. We know that fees are related to firm size, but Wilson notes that a company should be outperforming its peers if directors fees are higher than its competitors.

Disclosure timing

When should you look for bad news being dumped on the market? On the last day of a reporting period, that's when. Late filers are often (but not always) those with not the best news to report. This year's summary wrapped up by Tim Boreham and Michael West.

Equity Security Analysis

A sign that the market 'works' reasonably well is that it is hard for individual fund managers to consistently outperform the market index. The evidence out there is that this is in fact the case. Here's the latest media report of this. Key graphs:

Consistency - the ability to sustain good returns over time - is an important part of what makes a successful fund; as is persistence, the fund manager's ability to consistently add value and achieve above-benchmark investment returns.

Over any given period there will be some active managers who produce above-benchmark returns, but fund analysis consistently shows that most active Australian equity managers have a tough time producing persistently above-benchmark returns after fees.

It is very rare for a top-performing manager one year to sustain this performance over future years.

A-IFRS / Westpac

Many companies are claiming that the move to A-IFRS accounting standards has made it harder to 'understand' their financial results. In my opinion, it is therefore incumbent upon these companies to explain their results to the market. Westpac has done a good job of this with their Accounting Workshop presentation back in April 2007. It nicely explains how their results are calculated and presented under A-IFRS, and how this has changed from previous standards. It maintains Westpac's good record on disclosure matters. Hopefully we will see more companies doing this sort of thing. Link to pdf file of the presenation here.

Pro-forma earnings

Here's an example of how companies will highlight pro-forma profits when announcing their financial results:

RAMS Home Loans Group today said its 2006/07 pro-forma net profit was $43.5 milllion, up 49 per cent on the previous year.

RAMS said its fiscal 2007 profit was in line with its prospectus forecast and that it was monitoring the likely impact of revent events in global debt markets on its future performance.

Its statutory net profit was $15.11 million, compared to $29.97 million in 2005/06.

Here's the trouble: I don't know what sort of expenses have been excluded in the calculation of pro-forma net profit, so I don't know if it's important for assessing the future profitability (and therefore current value) of RAMS. I don't know if it's calculated consistently from year to year. But I do know that pro-forma profits are almost always higher than statutory profits. Funny, that.

Credit analysis

More discussion about the potential problems with relying on credit ratings agencies. Lawrence Summers argues:

There is room for debate over whether the errors of the ratings agencies stem from a weak analysis of complex new credit instruments, or from the conflicts induced when debt issuers pay for ratings and shop for the highest.

But there is no room for doubt that the ratings agencies dropped the ball. In light of this, should bank capital standards or countless investment guidelines be based on ratings?

Pay for, err, performance?

Concern about Telstra CEO Sol Trujillo pay package. Looks like lots of his so-called 'long-term' incentives vest in about 10 months. That doesn't sound like 'long-term' to me. The SMH article also highlights a problem with executive pay packages; i.e., who designs them. In this case, it looks like remuneration consultants who previously worked for US West, one of Trujillo's former employers. It's hard to determined whether these consultants are working for the shareholders, or the CEO. Nah, that's not true. It's not hard at all. Think about who engages these consultants.

Dividends and future profits

Looks like dividend payout ratios aren't on the increase. If you take dividends as a signal of future profitability, then that's not great news. John Durie (I can't find the article online; page 35 of the 24-25 Aug Weekend Oz) notes that in the current reporting period EPS is up on average 14.6%, sales growth up 9.4%, but payout ratios down to 64.5% (average in the last 8 years at 71%).

Qantas, Private equity and conflicts

Terry McCrann quite rightly takes a stick to Qantas' management over the recent failed private equity bid, highlighting the conflicts that exist when incumbent management (or board members) are part of the bidding team.

It's often the case that management will talk up the prospects of a takeover target so as to extract top dollar for the target shareholders, but in this case folks on the board of Qantas seemingly had a financial incentive to talk down the prospects, so that they could acquire the shares at a lower price. This would explain why Qantas seemed so reluctant to release its earnings forecasts, which showed that things were better than investors had been led to believe. Turns out even those forecasts were pessimistic. I'll have a look at the Qantas results soon - I'll be interested in whether Qantas seems optimistic or pessimistic with respect to its accounting estimates. I'm predicting pessimistic.

Earnings quality - banks

Where are the banks most likely to have issues with their 'quality of earnings'? Provisioning and doubtful debts, that's where. Here's The Australian's Adele Ferguson explaining things.

Takeovers, disclosure, conflicts

Yep, more from Bryan Frith. This time it's PCH, trying to stop a potential buyer talking to the actual shareholders. Oh, and possibly breaching continuous disclosure rules.

Financial policy decisions

Tim Blue in the Weekend Australian writes a nice article about BHP's upcoming decision about financial policies (especially dividends and buybacks - on market vs off market). Whether shareholders will want some of the spoils returned as a fully franked dividend, or as a buyback will depend on their tax preferences.

Markets don't like negative surprises. Especially now.

Another entry for the don't surprise the market readings list. From today's Australian

ANY company delivering profits even slightly under expectations will face severe punishment by the market, analysts warn.

Reporting season moves into full swing today against a background of market volatility and uncertainty.

A stream of major results are scheduled over the coming days, including Leighton, Qantas and Wesfarmers.

"Given the skittishness of the markets, those that only just make earnings estimates consensus or slightly disappoint will probably be penalised and their share price will be sold down," Macquarie Private Wealth division director Martin Lakos said yesterday.

Managers claim that their share prices 'overreact' to missing an earnings target or forecast. Doug Skinner and Richard Sloan show that is especially so for small, growing firms (in a paper published in the Review of Accounting Studies in 2002, Earnings Surprises, Growth Expectations, and Stock Returns or Don't Let an Earnings Torpedo Sink Your Portfolio).

Why I love Telstra

Each semester when we discuss management communication, I keep saying that it would be dumb to announce record profits and at the same time sack thousands of workers. Or lower forecast profits and higher executive pay. Semester after semester, Telstra keeps doing something like that. This time around, it's offering "prudent" guidance about future earnings and at the same time fattening the wallets of the management team.

More (possible) CDR breaches: Cellnet

This time it's Cellnet (ASX: CLT)
Reported by Michael West in The Oz.

This could turn into a long list...

Independent experts

Independent experts reports are often described as neither independent nor expert. A lot of these reports are required by law, and often seem to be a 'cover your a*** document for managers. The valuation methods used in them are often questionable (in terms of valuation methodology, valuation range etc). Paul Kerin makes similar points:

FAIRNESS opinions are primarily arse-coverers for boards. While they can help shareholders, competition helps more. Target boards should focus on maximising competition for their shareholders' shares and forget about fairness opinions -- unless legally required or sufficient competition can't be mustered.

Following a takeover bid, the target's board often commissions a "fairness opinion" from an "independent expert". The expert estimates a valuation range for the target, compares it to the bid and offers one of three opinions. "Fair and reasonable": the bid at least meets the lower valuation bound. "Not fair but reasonable": while the bid is under the lower bound, other factors lead the expert to believe that shareholders should accept. Otherwise, bids are deemed "not fair and reasonable". Half of Australian opinions are fair and reasonable; one-fifth are not fair and reasonable.

Kerin references some research that came out of Martin Bugeja's PhD thesis at Sydney University. Martin has a paper "The 'Independence' of Expert Opinions in Corporate Takeovers: Agreeing With Directors' Recommendations" published in the Journal of Business Finance & Accounting [Volume 32 Issue 9-10 Page 1861-1885, November 2005 if you're looking for it]. His abstract:

The impact of nonaudit services on auditor independence has been the recent focus of regulators worldwide. Using expert reports provided in Australian takeovers, this study investigates a context where the audit independence issue is reversed. As approximately a quarter of expert reports are prepared by the target firm's auditor, concerns have been expressed over the independence of the opinion provided. This paper finds that, relative to other experts, there is no difference in the rate at which experts with other business dealings with the target, including the target's auditor, provide an opinion that agrees with that of directors. However, the capital market reaction around the release of the report indicates that reports produced by auditors are viewed as nonindependent.

Martin finds that 50% of bids increase after a "not fair and reasonable" opinion, but only 14% of bids are increased if there is a "fair and reasonable" opinion issued. That doesn't surprise me.

Continuous Disclosure and Takeovers

There are lots of claims that companies don't comply with their continuous disclosure obligations (<- note: that's a link to a pdf file of ASX listing rules chapter 3), and especially so when takeover negotiations are in place. Here's a recent one that involves Flight Centre and its negotiations with Private Equity Partners.

THE ASX should make inquiries of Flight Centre to determine whether some directors knew several days before their controversial termination of the proposed joint venture with Pacific Equity Partners -- and ahead of receiving a report from the independent expert -- that the transaction was likely to collapse because it no longer had the support of the founding majority shareholders.

If so, that raises the question as to whether the company complied with the ASX continuous disclosure rule, which requires the immediate release of any information known to the company which a reasonable person would expect to have a material effect on the price or value of its securities.

By Bryan Frith in The Australian. I think that the breakdown of takeover negotiations is something that would be of interest to me as an investor. I'm not holding my breath waiting for action from ASIC.

UPDATE: Here's the Sydney Morning Herald's take on the same issue. Similar conclusions drawn.

Industry Analysis: Infrastructure

Here's an example of some industry analysis looking at the infrastructure industry. It makes forecasts about future growth levels, and attempts to relate it to industry competitive conditions.

Fund ratings. Any good?

Ideally fund ratings should give investors a guide as to the likely risk and return of a fund (i.e., investment). However there are plenty of anecdotal examples of where the 'system' doesn't work (err, Enron, Worldcom, HIH etc etc). From (you guessed it) The Australian:

David Gallagher, (a colleague of mine and) Associate Professor of finance at the Australian School of Business at the University of NSW, says the big question is: what does a ratings represent?

"Intuition says a rating should be predictive," he says.

"What is the point of having a rating if it doesn't help make better investment decisions?

"You have to expect that on average a five-star rating would perform in the future, but there is no evidence to suggest it is the case."

Hmm, if you're paying these investment rating agencies, then this is not good news. However it is consistent with the idea that it's difficult for anyone (even the ones you'd expect to) to consistently outperform the market [note: that's difficult, but not impossible. See Warren Buffet and Kerr Nielson]. It also suggests that even small retail investors, if they do a sensible business analysis, may be able to spot some sound investment opportunities.

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Still good buying?

Tim Blue in the Weekend Australian thinks that there are still some good buying opportunities in the Australian share market. Some industry analysis with a focus on Price/Earnings ratios.

Financial information in Australia

I mentioned in class how annoying and inconvenient I find the Australian Financial Review's online strategy - the AFR.com.au site is slow to load, and when it does load, it's full of subscriber only material (which means I by and large won't link to it on this site). The AFR has also removed its material from Factiva, which is one of the UNSW library databases that I regularly use (in my capacity as a researcher) for media searches. In effect, I've argued that the strategy seems to be "let's make The Australian the business newspaper of record)". [Similar to the New York Times "experiment" with TimesSelect].

Looks like Dow Jones agrees. They see a role for a free Australian equivalent of MarketWatch. I think that would be a great development.

Wesfarmers, Coles, strategy & takeovers

Nice little article from Matthew Stevens in the Weekend Australian (Aug 4-5; annoyingly I can't find an online reference) that links business strategy analysis with mergers & acquisitions. He's talking about the (currently) proposed takeover of Coles by Wesfarmers, and focuses on what happens if the bid doesn't go ahead. An interesting time forecast for Coles CEO John Fletcher and Chairman Rick Allert.

SOX 5 years on

The Economist takes a look at the Sarbanes Oxley Act (SOX) 5 years on. A response to corporate collapses (and particularly Enron), it's compliance costs have been accused of driving listing offshore, especially to London. An alternative view is that it is making U.S. investments safer. See an earlier post linking to research that shows that SOX may be resulting in lower cost of capital for US listed firms.

More dumb strategy decisions

Looks like the new owners of the airport rail line want it to go broke again. In the SMH, we get the following lede:

FOUR months after the Airport Rail Link was bought out of receivership by Westpac, fares on the already costly service will rise by as much as $2.

Despite speculation fares would fall after the buyout to entice more passengers, ticket prices will climb next Monday by between 20 cents and $1.30 for tickets from the city to Mascot and Green Square, and by up to $2 to the airport.

As best I can tell, that's a really really dumb strategy. [Mind you, the airport link should have incorporated the SCG, Fox Studios, UNSW, then down to the airport. Or at least have dedicated trains starting at the airport, so that passengers with their luggage can actually get on the train, and put their bags in a dedicated bag 'area'. Sheesh]

Qantas strategy update

Speculation that Qantas will announce a significant change of corporate strategy at their upcoming annual general meeting. I'm sure this will be followed by claims that they are simply responding to the strategy that was proposed by the private equity team that was bidding for Qantas. Note the competing interests of the capital and the product markets here. The capital market wants to know as much as possible about QAN's future plans and strategies, so that it can best guess at how QAN will perform going forward (i.e., so that they can price the equity and debt of QAN). On the other hand, QAN's competitors also get to see what the major player (in the domestic industry in any case) is planning. Competitors may need to adjust their own strategy in response. This is an example of the "proprietary" costs of disclosure - you are giving away (potentially) valuable information to your competitors.

Reporting earnings - GAAP vs "cash earnings"

Ernst and Young have recently released a report (pdf file link here) on how companies communicate their earnings information. They look at the top 20 ASX listed firms, and find that 18 of them report a different earnings figure in their media release to their statutory (GAAP) profit and loss figure in their accounts. They find variation in both the number of adjustments from GAAP and the type of adjustments. The companies themselves seem to be suggesting that the adoption of the international accounting standards (AIFRS) has led to a decline in the 'usefulness' of GAAP earnings, and that the reporting of something closer to "cash earnings" (however defined) will provide more useful information.

Google, IBM and business strategy

Even (especially?) for the high-tech companies, having a decent corporate strategy, and being able to communicate it clearly to investors is an important part of running the business. Stephen Ellis writes about the difference between Google (GOOG) and IBM (IBM), both of which having just reported for the latest quarter.

Or should you be studying dentistry?

Graduate starting salaries not on the rise, according to an AP report in the Herald:

UNIVERSITY graduates entering their careers with dollar signs in their eyes will be disappointed by starting salaries that have fallen in real terms from those of their immediate predecessors.

While their more experienced colleagues are enjoying increased wages as a result of the economic boom, university graduates under 25 earned an average $40,800 last year, up just 2 per cent from 2005, revealed the Graduate Careers Australia's annual survey, released today.

I'd guess that students graduating with accounting majors would have a higher median starting salary than the economics/business students overall ($40,000 for economics/business), though of course the article doesn't confirm this.* The median starting salary for UNSW undergraduate business students in 2006 was $45,000.

*UPDATE: According to the Institute of Chartered Accountants (quoted in the Oz), meadian starting salary for accounting graduates is $42,600.

UPDATE 2: Looks like the shortage is causing firms to try and grab students in high school (just like the Premier League teams, no?!).

Should you be studying accounting?

Why yes, yes, you should. Looks like the shortage of accountants is continuing.

UNIVERSITIES and big accounting firms are recruiting high school students for free accounting degrees in a desperate attempt to alleviate the skills shortage in the profession.

Talented Year 12 students are being offered part-time jobs and free university degrees by firms, even before they have applied for a university place.

First-year students are also being poached by companies to work full-time with incentives such as sign-up bonuses, rumoured to be as much as $10,000 for each student.

Now just think how valuable you'll be if you work hard and get good marks!! Why the shortage? It certainly appears to be demand driven - the supply of graduates with accounting degrees keeps rising. One of the reasons is that accounting "skills" are seen as useful regardless of what 'area' you'll actually end up working in (in much the same way as a law degree is seen as a useful 'general' qualification, even for those not actually practicing law. Another reason that demand is rising is increasing compliance requirements for companies generally (such as the SOX requirements in the United States).

Is cash flow king?

Liu, Nissim and Thomas have recently published a paper in the Financial Analysts Journal, (Vol. 63, No. 2, pp. 56-65, 2007 to be exact) that shows that earnings does a better job than cash flow of explaining share prices. Here's the abstract of the paper:

Contrary to the common perception that operating cash flows are better than accounting earnings at explaining equity valuations, recent studies suggest that valuations derived from industry multiples based on reported earnings are closer to traded prices than those based on reported operating cash flows. The question addressed in the article is whether the balance tilts in favor of cash flows when the following are considered: (1) forecasts rather than reported numbers, (2) dividends rather than operating cash flows, (3) individual industries rather than all industries combined, and (4) companies in non-U.S. markets. In all cases studied, earnings dominated operating cash flows and dividends.

This is of course what we would expect. If (accrual-based) earnings didn't do a better job of explaining value (and summarising business performance generally), then we'd see accrual accounting disappear.

Note: UNSW students should be able to access the Financial Analysts Journal through Sirius at the UNSW Library webpage. [It's at the bottom left of the linked page].

(Obligatory) Harry Potter post

The company that publishes the Harry Potter books doesn't appear to have taken advantage of their opportunities to grow their business. [The Australian] That's not smart.

Credit ratings - worth the paper?

Are the credit rating agencies doing their job well? Stephen Ellis, in discussing the 'sub-prime' mortgage market in The Australian, thinks not. Key quote:

And although S&P and Moody's seem to have been the victims of at least some fraudulent misrepresentation of mortgage quality by originating lenders, it seems fair to ask why they were not checking this information in the first place, given sub-prime mortgages were a startling 20 per cent of the entire US home mortgage market last year.

TPI, mergers and the ACCC

TPI's corporate strategy has been growth-focused. John Durie in The Australian suggests that the ACCC would like to know about some of TPI's proposed takeovers before they are announced. As Durie suggests, though, investors "like nothing better than a company that controls its market."

Wesfarmers and value creation

How will Wesfarmers make money out of buying Coles? Only by selling off part of the business, according to Paul Kerin in The Australian. A good article to read about trying to realise synergies in corporate acquisitions.

What happens if you get your audit wrong, then?

Well, if you're PWC and you did the Tyco audit, a fine of about $225million is the result: The Australian. This is an example of why research (especially audit research from the United States) assumes that the fear of litigation will help prevent auditors knowingly signing off on financial reports that don't comply with GAAP (the accounting rules).

Citibank and insider trading

A good day for Citibank; turns out that the Supreme Court did not think they were breaching 'Chinese Walls' with respect to their advice to, and trading on, Toll Holding during their takeover bid for Patrick: see SMH link here.

ASIC can't be happy about this. We'll see what their new Chairman, Tony D'Alosio does in response to this.

Disclosure, disclosure, disclosure

Stuart Wilson in The Australian points out that sometimes too much disclosure is required of our listed companies; in this case when a rights issue is on the table. A substantial volume of information is required to be disclosed, but none of it is likely to be new or price sensitive. Given that existing shareholders are the only ones able to participate in these sorts of rights issues, it would seem sensible to reduce the required disclosures.

Medical certificates for all!!

Hey, now this is a surprise. Apparently some doctors sign lots of medical certificates for uni students. Noooo, say it ain't so, doc. SMH story here.

That's why we're suspicious, students. Tip: don't turn up for the exam, and then lodge a Special Consideration form.

Present value tables

While I remember, you can download present and future value tables from this link.

Disclosure of Corporate Governance Practices

Are they or aren't they? Two reports on ASX-listed companies' Corporate Governance Disclosure Practices: one says it's all ok, the other, not so.

See The Australian 14 June 2007. Note that this is in the leadup to revised ASX corporate governance principles.

It's important to recognise that not all companies need the same corporate governance mechanisms, and that this should be reflected in what they disclose (i.e., a "one size fits all" approach is not likely to be optimal). A harder question to answer is 'does corporate governance matter?'. Folks over at Wharton have had a good look, and find that corporate governance is more likely to be related to future than current accounting (and stock market) performance. Link (pdf file)

SOX and cost of capital

Jeremy Grant in The Australian writes:

ALMOST three-quarters of the chief financial officers in the US believe that Sarbanes-Oxley should be "repealed or reformed" as the costs of the 2002 compliance law have outweighed the benefits, according to a survey.

The findings underscore the scale of frustration over the costs associated with implementing "Sarbox", even as regulators said that costs were expected to fall as new guidelines for the law were finalised.

In a survey of 484 chief financial officers by Duke University and CFO Magazine, almost 70 per cent said the costs of adhering to Sarbox requirements - principally its section 404 provisions on checking internal controls - "greatly outweigh its benefits".

Well, it might not all be bad. There's at least some research out there that purports to show that effective internal controls are associated with cheaper capital.

First test post

Let's see if this works. Text here.