Orthodontic Centers of America (NYSE:OCA), which provides business services to orthodontists and dentists, announced changes to its accounting and preliminary first-quarter earnings yesterday. Prior to this report, superficial analysis of Orthodontic Centers' good long-term revenue growth, single-digit P/E, and large insider buying might have made you wonder whether the company was a candidate for Motley Fool Hidden Gems. Now, the valuation does not look so compelling.
Orthodontic Centers' recurring income under the new system falls to $0.14 in the first quarter, from $0.30 last year using the old one. In addition, Orthodontic Centers is taking a $1.44 charge to reflect the differences in how revenue is recognized under the two accounting systems.
There was foreshadowing that something was amiss at Orthodontic Centers. Almost half the float was short. Such a large number of shares short is neither a reason to buy nor a reason to sell. However, it is a sign that investors should clearly understand the short argument, lest the decision to invest come back and bite them like a disgruntled patient.
The core of the short argument, discussed on the Fool's Orthodontic Centers discussion board, revolved around Orthodontic Centers' nebulous accounting. First, upfront payments to help new affiliate practices get up and running were accounted for using an ill-defined "intangible" category. Second, loans to affiliates were being accounted for as receivables on the balances sheet, making it very difficult to determine what real revenue and expense were.
Third, a portion of the revenue that Orthodontic Centers was due to receive from a patient came at the end of the contract, and Orthodontic Centers was accounting for this revenue over the entire course of the contract. This resulted in the firm saying that it had revenue and income from that revenue possibly years before the patient was actually billed for that revenue. This accounting resulted in a convenient red flag for investors: accounts receivable growing at a disproportionately large rate compared to revenue.
The new accounting methods will likely result in Orthodontic Centers reporting lower income in the future. While this sounds negative, it's actually quite positive. Previously, the accounting made it difficult to determine how much the company actually made. These changes make the company much easier to understand and the accounting more representative of actual operations.
And there's hope for the future. Quality of earnings concerns have punished many companies, such as Krispy Kreme (NYSE:KKD) and MCI. But when those issues are resolved to the satisfaction of investors, as they seem to have been with Elan (NYSE:ELN), the rewards can be large.
Orthodontic Centers still isn't a stock to buy your mother. After all, one in seven client practices is involved in litigation against Orthodontic Centers, which the paranoid could interpret as a warning sign of customer dissatisfaction. But the company deserves credit for biting the bullet, taking the charges, and making it easier for investors to understand it.
Fool contributor Richard Gibbons owns Krispy Kreme, but none of the other securities mentioned in this report.
