Lies, Damn Lies and Accounting Shenanigans: Earnings Notes on CBI, ABGB and WAC
So that was an eventful Q2 earnings season, resulting in the selling of two stocks I thought I would hold for at least a year: Silicom (SILC) and Walter Investment Management (WAC). This was my first earnings cycle where I was 100% invested in small and mid-cap stocks and I learned a few lessons. Most notably, my CFA designation may come in handy in this space as you can’t always rely on what management teams are telling you. I scratched my itch to dig into the footnotes of some 10-Qs and here are a few learnings on Chicago Bridge & Iron (CBI), Abengoa SA (ABGB) and WAC:
CBI: A Closer Look at the Damage Done by the Accounting Shenanigans
I bought CBI last week and wrote a blog post on Tuesday and then immediately went back and re-read the short thesis from Prescience Point to make sure I wasn’t missing anything. Prescience Point certainly had a good point – CBI did use GAAP purchase accounting to inflate Contracts in Progress (CIP) and therefore hid what would have been a large write-down (probably one-time) at Shaw Group, or ultimately CBI. They pretty much avoided running that through the income statement, but it did run through the cash flow statement, creating an almost $800M cash drain in the first half of 2014.
I think Prescience Point nailed it, but it’s in the past now. As I pointed out in the blog post Tuesday, CBI management is expecting operating cash flow to turn positive in the second half of 2014, and based on some digging in the financial statements, I have every reason to think they are right.
The digging I did in CBI’s financials was two-fold: 1) I wanted to verify that the current CIP balance of $2B is no larger than historical levels, and 2) I wanted to make sure CBI’s current margins aren’t inflated relative to historical levels.
On #1: From December 2013 to June 2014, the CIP balance decreased from $2.7B to $2.0B. That is what (at least from a financial statement standpoint) created the large cash drain in the first half of 2014. Prescience Point is anxious to call the CIP account a ‘slush fund,’ and in all fairness it may have been something like that as of December 2013. But at $2.0B today, it isn’t a slush fund. At the end of June 2013, a year ago, that same account was $2.1B. At CBI and Shaw Group combined at the end of June 2012, the account was also $2.1B. I’ve looked further back and the CIP account seems to be consistently somewhere around 20% of LTM revenue. CBI is on pace for $13B in revenue this year meaning by the end of the year the CIP balance should be somewhere around $2.6B. So I’m expecting a big rebound in operating cash flow in the second half of this year.
On #2: I don’t see any evidence that CBI’s margins are inflated right now relative to historic levels, such that I would worry that we’re set up for a big decrease in the coming quarters. If you back out the $63M in inflated revenue which I highlighted in my blog post, gross margin in the first half of 2014 are 10.0%, right in-line with combined gross margins in the first six months at Shaw Group and CBI in 2012, prior to the merger. After doing a similar adjustment on operating earnings, I get an operating margin of 6.3% in the first half of 2014, which is 0.9% higher than the combined operating margin prior to the merger. That uptick in operating margin though all appears to be from lower S,G&A expense, which you would absolutely expect following a big merger like that - so margins all appear to be normal despite some accounting shenanigans.
I’d also like to point out the CBI has 19 analysts following them and the lowest estimate next year is $5.51/share. Prescience Point has failed to convince even one of the 19 analysts that they are right and CBI’s margins are set to implode. All in all, I’m very happy with the buy and still think there is 30% upside right now in CBI.
ABGB: Mixed News in the Financial Footnotes
The Abengoa Q2 earnings release was a mixed bag right from the start with 31% EBITDA growth resulting in only 3% net earnings growth. Abengoa management doesn’t provide pro forma earnings metrics so I was left to my own devices to try and figure out if 31% or 3% was more representative of YOY performance.
The ABGB income statement is a mess, and after approximately 100 adjustments I got to pro forma earnings in the first half 2014 of 57M EUR, or 0.07 EUR per diluted share. In the same period last year I got to an adjusted loss of 4M EUR. Most of the YOY gains seem to have come from the biofuels unit. In contrast to my expectations, the concessions (owned utility assets) segment contributed to increased cash flow YOY but was a drag on earnings, due mainly to a big increase in interest expense from a reduction in capitalized interest.
From an earnings standpoint, that’s OK at best. I also dug into the balance sheet and came up with a nasty surprise: the net debt number that management includes in the earnings presentations treats “Financial Investments” as an offset to debt, as if it’s cash. But in the footnotes, they detail Financial Investments and it appears to be something called long-term receivables, which would imply it’s more of an operating item than a financial (cash) item. So that’s improper. They also bury an operating expense called “Outsourcing of Payables” in a finance expense line and therefore exclude it from EBITDA. That’s also improper. Making those two adjustments in my earnings model, I get a per share value of $30-$35/share, which is quite a bit less than the $40+/share I was calculating in previous posts.
The good news is that ABGB is consistently generating solid operating cash flow in the range of 400M EUR per year, when you back out working capital changes. I was worried when they issued 500M EUR in new debt earlier this year, but it appears to be completely because of a nasty 738M EUR drawdown in working capital (probably because a couple of big projects like Solana wrapped up). Absent that, you can see how cash flow will work at that company going forward and it’s pretty exciting. They are set up like an accidental leveraged buyout and can very easily enter a virtuous cycle where solid operating cash flow leads to lower debt which leads to lower interest expense which leads to better operating cash flow and so on. The end result is repaired balance sheet, lower debt and a much, much higher share price. So I still like ABGB a lot at $26/share and think it is a very solid long-term buy and hold.
WAC: Earnings were Good, but For the Wrong Reasons
When I bought WAC about four months ago it was because they were attempting to transition from a risky business model based on mortgage originations to a much more stable business model based on fee based income, mainly from servicing mortgages and acting as an advisor on managing distressed mortgage portfolios. The basic idea was that they would use the earnings from the current HARP refinancing activity, which is kicking off cash and earnings like a fountain, to finance the equity portion of MSR (mortgage servicing right) acquisitions from the big banks, who are backing away from mortgage servicing as quickly as possible. Since then, regulators have come down like a hammer on the mortgage servicing industry and have basically stopped all MSR transfers. WAC management used to disclose a ‘pipeline’ number every quarter, which was basically the volume of MSR transfers they were in discussions with various parties. It’s telling that they stopped disclosing the ‘pipeline’ number this quarter.
As a result, the expected transformation in the business model simply isn’t happening, and in fact the reliance on origination activity (almost all HARP) has only gotten worse. In Q2, earnings in the Servicing unit was $20M and earnings in Originations unit was $70M. Since the HARP program goes away at the end of 2015, that’s $70M per quarter management needs to replace with ‘boots on the ground’ origination activity.
WAC management doesn’t sound terribly confident that they can replace $70M per quarter, or anything close, and in the last two earnings calls they’ve talked about a ‘cautious’ approach to building out their retail originations channel. That complacency is odd considering that we’re talking about 80% of their Q2 earnings. WAC management also made a cryptic comment about industry consolidation in the Q2 earnings call. To add to the intrigue, the CFO made an open market purchase of 7500 shares following the call. Based on all of the above, I think WAC is probably looking to sell, possibly to OCN or NSM. (In the mathematics of cryptic management comments: No business model going forward + comments on industry consolidation + open market purchases = We’re selling the damn thing).
I was lucky enough to sell at $29/share at basically the open on Monday following the earnings release because inexplicably the stock price went up for 20 minutes before crashing the rest of the day. I feel lucky to be out – that business model is just far too risky. Although I also wouldn’t be surprised if they managed to sell the company at north of $30/share.
Happy hunting everyone! Bonus YouTube clip on shenanigans: