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Income as Outgo
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (May 12, 1999) -- Herb Greenberg today wrote on TheStreet.com about Conseco Inc. (NYSE: CNC), the insurance underwriter that acquired Green Tree Financial last year. I disagree with the analysis, in that the company's interest coverage abilities look fine to me. But it did get to me to thinking about Conseco once again.
I've never been a fan of Green Tree. That's not because of its business activities and it's not really anything about the company I dislike (except that I never liked its disclosures and discussions). Part of it is really due to FASB 125, which I think is perhaps the most confusing accounting pronouncement ever to come out of an accounting standards-setting process. I think gain-on-sale accounting for securitizations totally distorts a company's net income and the balance sheets resulting from that. For example, look at the nearly three-quarters of a billion dollars in pre-tax impairment charges Green Tree has taken over the last two years that have resulted from that entire process.
I don't agree with the entire discussion of debt service ability in Greenberg's column. But, whatever, there's another issue I wanted to bring to the table on Conseco. I was reading a lecture in The Rediscovered Benjamin Graham this morning in which Graham discussed another way of checking a company's quality of reported earnings, going back through the year-over-year changes in the balance sheet (click here for the entire lecture excerpted below. Click here for all ten lectures). In Lecture Number Two, Graham states:
"Those of you who are familiar with our textbook know that we recommend the comparative balance sheet approach for various reasons, one of which is to obtain a check on reported earnings... Now, as to the procedure: First, the balance sheet comparison is a relatively simple idea. You take the equity for the stock at the end of the period, you subtract the equity at the beginning of the period, and the difference is the gain. That gain should be adjusted for items that do not relate to earnings, and there should be added back the dividends paid. Then you get the earnings for the period as shown by the balance sheet." (Janet Lowe, The Rediscovered Benjamin Graham; p. 162)."
Let's see how this works for Conseco.
($ in millions) Shareholders' equity 1998 year-end: $5,273.6 Shareholders' equity 1997 year-end: $5,213.9 Year-over-year change: $59.7 Add back: Dividends on common: $158.5 Dividends on preferred: $7.8 Share repurchases: $308.4 Deduct: Issuance of convertible preferred: $266.8 Issuance of common shares for debenture conversion: $67.4 Issuance of shares under options and compensation plans: $158.1 Tax benefit for share issuance: $63.1 Issuance of warrants: $7.7
That works out to negative $28.7 million, or just about zero economic income for the year. I assume no discretionary elections of increasing reserves coming from surplus. In other words, I don't think by overly conservative accounting policies that the company has understated net income.
Now, of course, cash flow is a different beast than net income, and you have to get through the period-to-period changes in the balance sheet by way of the cash flow statement. The company does show nearly $1 billion in cash flow. With an insurance company in highly regulated lines of business, however, this isn't distributable cash flow. A lot of it is encumbered.
Bottom line on Conseco is that you've got some weird accounting in there, where 43% of the company's operating income before extraordinary charges and writedowns is represented by gains from securitizations. If we back out those gains and change the accounting to an accrual basis, then we have to change the recognition of expenses in finance underwriting, as well. Backing out of the cash flows, the capital flows that obscure return on capital can be tough with this sort of company.
I offer Ben Graham's method just as something to think about. And I certainly don't believe I can master all this process on the basis of reading a short lecture from Graham. The implications of a period-to-period change in the balance sheet are somewhat limited, although I do think it serves its purpose as a "check" on earnings. I urge you NOT to rely on this as investment advice or as a qualified and competent evaluation of Conseco, Green Tree, or affiliated parties.
Have a good Wednesday, Go Sabres, and we hope to see you on the Boring Portfolio message board. A special thanks to everyone that has offered input on Veterinary Centers. Please keep it coming -- I really appreciate it.
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Stock Change Bid APCC - 1/8 34.25 BRKb -58 2448.00 CSL - 13/16 47.31 CSCO -1 1/16 117.69 GTW - 9/16 67.63
Day Month Year History BORING -1.32% 1.04% 6.00% 42.33% S&P: +0.26% 2.43% 11.57% 127.35% NASDAQ: -0.94% 1.54% 17.75% 148.04% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 117.69 391.28% 8/13/96 200 Carlisle C 26.32 47.31 79.72% 4/20/99 230 American P 28.95 34.25 18.29% 12/31/98 8 Berkshire 2244.00 2448.00 9.09% 2/9/99 100 Gateway 20 72.38 67.63 -6.56% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 26479.69 $21089.70 8/13/96 200 Carlisle C 5264.99 9462.50 $4197.51 12/31/98 8 Berkshire 17952.00 19584.00 $1632.00 4/20/99 230 American P 6659.25 7877.50 $1218.25 2/9/99 100 Gateway 20 7237.50 6762.50 -$475.00 CASH $999.27 TOTAL $71165.46
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