FOOL ON THE HILL
An Investment Opinion
Estee Lauder Wrongfully Accused Dale Wettlaufer (TMF Ralegh)
September 16, 1999
Yesterday, I wrote in my Boring Port slot about how TheStreet.com's columnist Herb Greenberg took to task cosmetics company Estee Lauder's (NYSE: EL) accounting. Since the audience for the Bore is a niche one compared to this column, I thought I would take this opportunity today to comment again on the matter, since I think it's both an interesting issue in security analysis and I think Greenberg and his source (Greenberg's columns most of the time don't include his own analysis, but that of his sources) should be taken to task for insinuating that the company is doing something wrong here.
The insinuation centers on a couple of things. One, that the company "made estimates" by reporting a "lower-than-expected" tax rate, and two, that the company "made estimates" by taking a provision for doubtful accounts that was "unexpectedly" low. The short seller feeding Greenberg information contends that the company's earnings per-share for fiscal 1999 came up two cents light because the company's allowance for doubtful accounts, as a percentage of gross accounts receivable, ended the year at 6.3% of receivables, down from last year's 8.1%. Here's the accounting basis of the contention:
The provision for bad debt is an expense or a contra-revenue item. Whichever method a firm chooses, it's a debit to earnings, which reduces earnings. Had the company taken a provision for doubtful accounts that would result in an ending allowance equal to 8.1% of gross accounts receivable, the expense would have been $37.95 million rather than the $27.8 million the company reported. That would have reduced net income to $266.61 million (using the reported tax rate) and net income for common stock to $243.21, reducing net income for common, on a diluted basis, to $1.01 per share rather than the $1.03 the company reported.
That's the short seller's contention. I think it's an unfounded one, and I think it's wrong to accuse a reputable company -- however much Herb Greenberg disclaims it as only a possibility that the company might have done it -- of engaging in accounting chicanery to fool investors. Sure, one should question things and the rewards are great enough to tempt many companies, even reputable companies, into using accounting skullduggery to "make their numbers." But Greenberg is relying heavily on someone who is talking up their position, someone who is short Estee Lauder based apparently on its valuation. He got a response to the short-seller's contentions from the company, but I think the "spokesperson" botched the explanation. They told Greenberg it's only a balance sheet issue and not an income statement issue, which is clearly wrong. It's an income statement issue if you lower your provision as a percentage of credit sales, directly so.
But this is where Greenberg should have used his own analytical abilities and this is where the short seller applies faulty logic to his (or her, I don't know which) contention. In assuming the company should have taken a provision that would result in a year-end allowance for doubtful accounts equal to 8.1% of gross receivables, the short-seller assumes THAT is absolutely the correct level of gross receivables that should be added to the reserve. As the following series shows, the year-end allowance for doubtful accounts is clearly anomalously high:
FY99 FY98 FY97 FY96 Gross receivables $569.70 $541.40 $508.10 $466.80 Ending allowance $36.00 $43.60 $36.40 $32.80 Net receivables $533.70 $497.80 $471.70 $434.00 Allowance as % of gross A/R 6.32% 8.05% 7.16% 7.03% Provision for doubtful accounts $27.80 $25.40 $23.60 $22.00 Charged off, net of recoveries $35.40 $18.20 $20.00 $20.00If the short seller is privy to Estee Lauder's general ledger, maybe he or she could say with more confidence that the provision this year was too light. The short-seller bases the contention of ill-doings on a look in the rearview mirror when he correctly notes that the "doubtful-account reserve also involves estimates for losses going forward." The basis of the argument and that observation contradict each other.
According to trend, the allowance for doubtful accounts (as a percentage of gross receivables) at year-end 1998 was clearly a spike, which could have been due to a number of circumstances such as a shift in the customer base (due to acquisitions such as Sassaby and Aveda) or problems with international customer accounts. Did this short-seller come forward and say the company was being overly conservative in 1998 by taking a much larger provision than normal? I doubt it. But if the short-seller wanted to base things purely on neat ratios that don't take into account the dynamic nature of the accounting issue, he might have.
I think Herb Greenberg has done this company a disservice by implying that this company MIGHT have misled investors. The smoking gun here, exhibit A in the short-seller's argument, has been analyzed poorly. The allowance reflects the company's forward look at things, and the character of credit sales made in 1999 might have been such that the ending allowance for doubtful accounts to get much closer to trend than the 1998 balance.
The ending allowance for 1998 was 13.5% (not percentage points, but percent) above the 1996-1997 trend, while the 1999 balance was 10.9% below trend. Even then, just plugging in the trend isn't going to magically produce the answer. Unless a management team shows signs of deception or has had a record of deceiving investors, then you have to give them some latitude to run their business the way a conscientious management team would.
There are many moving parts to the net accounts receivable balance. You have the credit quality of the customer mix, an estimation of forward losses, and an estimation of forward recoveries, among other things. There's every possibility that the company is estimating a higher than normal amount of recoveries in fiscal 2000. A recovery of a previously charged off receivable has the same effect on the allowance as a charge to the provision for doubtful accounts line on the income statement. They're both a credit to the asset contra-account, a component of the net accounts receivable line.
TheStreet.com also takes Estee Lauder to task for reporting a lower tax rate in 1999, like the company is hiding something or is doing this specifically to increase earnings. Since tax accounting isn't my bag, I'll leave that to someone else to explain, but here again, I think it's bogus to look at the provision as a percentage of reported pre-tax income and come up with the conclusion that the company is actively trying to deceive investors.
On the accounts receivable thing, though, I feel very good about my analysis of the issue. I think the hedge fund person is wrong and I think it's wrong for Herb Greenberg and TheStreet.com to call into question the integrity of a respected and well-run company based on this faulty analysis. I'm not going to go to any length to point out how much I like TSC and Herb Greenberg, as I did yesterday. Just because I have a specific criticism here doesn't mean I don't. But I don't think Herb would publish my criticism. Just because Herb has been right on many occasions doesn't mean he's always right.
I've read Herb for a long while and I know how wrong he and his sources can be. In fact, I could go on for a long time on the subject of how the market is a lot more complex than Greenberg's oftentimes income statement-centric analysis (America Online is one good case and another is the case here, since this washes out in the cash flow) contends, but that's a different discussion. I say none of this because I own Estee Lauder. I say it because it's flat wrong to imply strongly that Estee Lauder has engaged in deceptive practices when the analysis backing that implication is poor, at best.