Boring Portfolio

Boring Portfolio
Finishing Up Estee Lauder
Plus, the 1999 Costco model

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Oct. 1, 1999) -- OK, let's just wrap with Estee Lauder (NYSE: EL) today. Long story short --'s Herb Greenberg's source says the company took a credit loss provision for fiscal 1999 that was too low. I disagreed on the basis of the source's argument, which posited that the credit loss provision for 1999 should have been such that the ending allowance for credit losses equaled over 8% of gross receivables. My contention is that 1998's provision was aberrationally high and possibly due in part to a huge uptick in international sales and earnings in 1997 that weren't fully reserved for in that fiscal year. Remember, Estee Lauder's fiscal year ends in June and the "Asian contagion" hit in the third calendar quarter of 1997.

My entire point has to do with giving management some leeway to report financials as a rational business owner would. Until they've been shown to be shady, then they deserve that. The short's contention lacks this allowance of leeway and is flawed if it's based on the belief that provisions for credit losses should always be higher than charge-offs. As I said the other day, there are a couple moving parts to the problem. You have the balance sheet asset "receivables." Then you have an asset contra account called "allowance for credit losses" or "allowance for credit uncollectibles." The income statement expense "provision for credit losses" increases the asset contra account, which then decreases the net amount of the asset account.

You then have another moving part, the net charge-off, which itself is made up of two moving parts, "gross charge-offs" and "recoveries," which lead to "net charge-offs." When you charge off a receivable, you decrease the gross asset account as well as the asset contra account, and when you make a recovery (meaning you expect that the receivable will be made good), you increase both of those accounts. So when you look forward on the income statement entry, you have to take in these other balance sheet dynamics as well. The income statement provision frequently moves out of synch with the changes in the concurrent year's balance sheet -- both because the income statement provision is forward-looking and because it can be backward-looking when past provisions were not adequate.

Look at Wells Fargo's experience in the 1990s, for instance. Income statement provisions were well above charge-offs for a number of years as the company correctly forecasted the future non-performance and deterioration of credit performance. As the economy righted itself in 1992 and 1993, the two items came into line until the provision actually went to zero in 1995, as the company judged the balance sheet allowances to reflect sufficiently its expectations of future performance. From 1994 through 1996, net charge-offs were running above provisions for credit losses. Note that the 64% increase in recoveries in 1996 came in the year after the company took no provision for credit losses. You can see the trends move together, but not 100% in synch.

Therefore, I think the fund that is short Estee Lauder based on its provision for credit losses is talking its position. It's just not a strong point at all. You have to have the company's general ledger and aging schedules, know the character of the receivables, and at least give some discussion as to future credit loss trends to make a full assessment of the provisions. That a ratio this year doesn't line up with a ratio last year, especially when the last year was abnormally high, doesn't mean the company is fudging things. Further, if Estee Lauder wanted to make its numbers, it has enormous latitude to do so with its operating expenditures without leaving a trail of evidence in the reserves it discloses. You're talking about a company with under $4 billion in revenues that has over $2.5 billion in SG&A expenses to play with. If it wanted to pick up $10 million in additional operating income somewhere by deferring spending, it could very easily do so.

So, I disagree with Herb Greenberg's source on this one. I think it's picking a very minor point to talk the position and I think the short's own reasoning is contradicted by his or her own explanation. It's a forward-looking thing and there's no one RIGHT ending allowance. But hey, I'm the first to point out how often Herb is right on in his analyses and in identifying which hypotheses are best to put forth in his columns. More people should learn how to pick these things apart and learn securities analysis -- Herb Greenberg is an intelligent and valuable contributor to the discipline.


I've been working on the Costco model some more, but I've been caught up in moving (I finished that last night), so I still have some stuff to do with modeling fiscal 2000. Fiscal 1999 is pretty much done, though there are some tweaks to the cash flow that I want to do. As I said above, unless you have the general ledger, you're never going to know all differences between tax accruals and financial accounting accruals, so that's going to effect your balance sheet and cash flow. It usually takes a few quarters after doing your model to see how things progress versus the way you understand the model. Hopefully, that leads to an improvement in the model going forward. Here's the model (Excel 95/97) -- see what you think and please post any thoughts you might have on it on the Boring board.

Have a good weekend.

Fools Wanted: Apply Within.

 Recent Boring Portfolio Headlines
  10/30/00  American Power Conversion's Ugly Earnings
  10/23/00  Cisco's Formidable Challenge
  10/16/00  Cisco, Apple, and Probabilities
  10/09/00  Perils and Prospects in Tech
  10/02/00  Learn From Mistakes
Boring Portfolio Archives »