FOOL ON THE HILL
Some customers invariably end up being deadbeats, so every company reports an "allowance for doubtful accounts." Unusual changes in the allowance for doubtful accounts might precede blowups at some companies. Whitney Tilson looks at three examples: Lucent, Gateway, and Manugistics.
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"Make no mistake -- the speculative party is over, at least until a new generation of investors forgets the lessons that are being all too painfully learned today." When I wrote these words in my column, Ulcer-Free Investing, last April (when the Nasdaq was nearly double what it is today), I got quite a few skeptical emails. Not anymore. All but the most rash -- and soon to be even further impoverished -- investors realize that the stock market will now reward those who do their homework, understand the companies they're investing in, and buy at an attractive price. These fundamental principles have always been true over long periods of time, and will continue to be true in the future. How sad that these principles had to be painfully learned by so many unsuspecting first-time investors who were lured into technology stocks at their peak by the promise of easy riches. I hope some people are ultimately held accountable for this massive fraud. A good place to start would be the investment banks and their merchants of hype, so-called analysts. On this topic, The New York Times recently published a damning expose, How Did So Many Get It So Wrong? (free registration required). Phew! Now that I've gotten that off my chest, let's move on. Doing one's homework starts with analyzing companies' income statements and balance sheets, which are usually released in quarterly earnings announcements. (Why some companies continue to release limited balance sheets -- or none at all -- when they report earnings is beyond me.) The next step is listening to conference calls, which are increasingly open to the public (kudos to the SEC!). Another important piece of the puzzle is reading SEC filings, especially quarterly and annual filings (10-Qs and 10-Ks, respectively). These filings can be quite intimidating, but there a few things to focus on. First, as I've preached again and again, go to the cash flow statement and follow the cash. Then, calculate the allowance for doubtful accounts. Allowance for doubtful accounts Some customers invariably end up being deadbeats, so every company reports on its balance sheet net accounts receivable, which is equal to total accounts receivable, minus an estimate for amounts the company believes it will never collect, called "allowance for doubtful accounts," or something similar. Note the word "estimate." Since no one knows exactly what percentage of accounts receivable will be impossible to collect, management has a fair amount of discretion in adjusting this number. Thus, it is one of the first areas I examine to see if a company might be giving its financials an artificial boost by lowering its estimate for doubtful accounts, which has the effect of increasing revenue and earnings. The allowance for doubtful accounts is easy to calculate. For example, go to Lucent's (NYSE: LU) recently released 10-K, and scroll down to the balance sheet. You will see that Lucent reported "Receivables less allowances of $501 in 2000 and $318 in 1999" (all figures in millions). Reading across, at the end of FY 2000, accounts receivable were $9,558, so the allowance for doubtful accounts was $501 divided by total accounts receivable ($501 + $9,558 = $10,059), which equals 4.98%. Similarly, at the end of FY 1999, accounts receivable were $8,799, so the allowance for doubtful accounts was $318 divided by $9,117, which equals 3.49%. Some (though very few) companies report this number directly on the balance sheet, many report it in the notes of their 10-Qs and 10-Ks, and some don't report it at all. Let's look at some companies to see what we can learn. Lucent Note that in both Q2 and Q3 OO Lucent was setting aside a decreasing amount for doubtful accounts at precisely the time many of its customers began to struggle, which would have warranted an increase. It hardly should have been a surprise, then, when Lucent announced on November 21st that it had overstated previously reported fourth-quarter revenues of $9.4 billion by $125 million, and then reported a month later that the actual figure was $679 million. To Lucent's credit, the substantial increase in the latest quarter is evidence that the company is now properly estimating the allowance. Gateway You can see that the allowance in the past two quarters (2.00% average) is quite a bit lower than the range of the previous six (2.56%). Had Gateway subtracted the same 2.95% last quarter as it did in Q3 99, net accounts receivable would have been $7.2 million lower and revenues would also have been lower by this amount. The after-tax impact on the bottom line would have been $4.6 million (1.4 cents/share), equal to nearly 3% of Gateway's profit for the quarter. That might not sound like much, but Gateway met analysts' estimates of $0.46 per share for the quarter. Without this adjustment, it would have reported $0.44 ($0.443 vs. $0.457, to be precise) -- and we all know the impact on a stock of missing estimates by two cents. The Q2 figure is one of the reasons I sold most of my Gateway stock at $56 in late September. (It's hard to believe that the stock is down by nearly two-thirds in only four months since then.) I emailed Gateway's investor relations department to ask why the allowance declined in Q2 and Q3 00. Here was the reply: "Our percentage is in line or higher then competitors. Second, we have taken measures to reduce [the] allowance. The two key things we have done is that we have put in a predictive dialer process to automate and ensure we contact delinquents accounts and second, we have increased our aggressiveness against our larger customers which has significantly improved our delinquents. Additionally in Q3 the timing of business sales favorably impacted [the] reserve %. Last, this does not include reserve on bad debt for consumer loans." Fair enough. Draw your own conclusions. Manugistics I have never seen such erratic figures. The average for the first seven quarters of this period was 8.0%; for the next three quarters, it was 4.4%, a period in which Manugistics' growth suddenly skyrocketed after four consecutive quarters of year-over-year revenue declines; then, it jumped back up in the latest quarter. I wish I could provide an explanation, but the company has not returned repeated calls and emails. Let's just say that if I were rash enough to own a company whose stock was trading at more than 10x trailing 12-month sales and approximately 150x estimated earnings for the fiscal year ending in Feb. 2002, I'd be really worried about this. Conclusion -- Whitney Tilson
When a company makes a sale, it often doesn't receive the cash immediately, so while the revenue is recognized on the income statement, the amount of the sale also appears on the balance sheet as an accounts receivable.
My three recent columns on Lucent's cash flow (Nov. 28, Dec. 12, and Dec. 19) showed how deteriorating free cash flows indicated troubles ahead. A further warning flag was that Lucent had been lowering its allowances for doubtful accounts at the same time that its receivables were soaring and it was extending more and more credit to Internet infrastructure companies that were facing increasing financial difficulties. Here are the allowances as a percent of total accounts receivable for the past nine quarters:Quarter Allowance
Q4 98 5.32%
Q1 99 3.63%
Q2 99 3.83%
Q3 99 3.98%
Q4 99 3.49%
Q1 00 3.62%
Q2 00 3.16%
Q3 00 3.16%
Q4 00 4.98%
Over the past eight quarters, Gateway's allowance for doubtful accounts has been the following:Quarter Allowance
Q4 98 2.61%
Q1 99 2.17%
Q2 99 2.70%
Q3 99 2.95%
Q4 99 2.49%
Q1 00 2.46%
Q2 00 1.99%
Q3 00 2.00%
Finally, let's take a look at Manugistics, the maker of supply chain planning software. (I have written more extensively elsewhere on this company; see my website for links.) Over the past 11 quarters, Manugistics' allowance for doubtful accounts has been the following:Quarter Allowance
Q1 99 5.7%
Q2 99 4.6%
Q3 99 7.8%
Q4 99 11.0%
Q1 00 7.1%
Q2 00 12.6%
Q3 00 6.9%
Q4 00 4.6%
Q1 01 5.0%
Q2 01 3.7%
Q3 01 7.1%
Perhaps it's just coincidence that unusual changes in the allowance for doubtful accounts preceded blowups at Lucent and Gateway (I tend to think not in the case of Lucent, and am not sure about Gateway). Will Manugistics be next?
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, click here.
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