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Why a company would intentionally underreport earnings...

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June 10, 2010 – Comments (4) | RELATED TICKERS: HLX

Management who feel secure in their positions can use all sorts of non-cash tricks and trinkets to lower their company's reported earnings.  Why on Earth would a company's executives, who are constantly under pressure from shareholders to increase earnings, intentionally try to make their company's earnings look bad?  Management can kill two birds with one stone by making this sort of move.

First off, companies that have high levels of debt often try to make their reported earnings appear as low as possible so that they can reduce the amount of money that they have to pay Uncle Sam in the form of taxes.  Doing so provides them with greater cash flow that they can use to pay down their scary debt load as quickly as possible.  The famous investor Mark Mobius actually mentions this technique in his textbook, Equities:

"...majority owners may try to minimize net income to decrease taxes and free resources to service debt."

Not only does underreporting earnings enable a company to pay down its debt more quickly, it enables a company's management...who know that their company's current ability to generate cash is much greater than what is being reported as earnings...to load up on shares on the cheap. Helix's CEO has been loading up on his company's stock lately (see: Helix Energy CEO's $1.5 Million Buy & HLX Insider Transactions)

Let's take a look at an example of this situation that I believe is happening right now.  The company that I'm talking about is Helix Energy Solutions Group (HLX).  Helix's main business is providing support to offshore oil and gas drillers.  It is a global company that operates all over the place, including the North Sea, Asia Pacific, and West Africa regions.  Of course, the company also has operations in the Gulf of Mexico.  These operations even involve deepwater rigs.  Not surprisingly, HLX's stock has been absolutely destroyed over the past several months, dropping from $17 to just over $10:

 

The very real potential exists that the company's deepwater rig business in the Gulf of Mexico will be on hold for an extended period of time.  What makes this situation even scarier is that Helix has a TON of debt...$1.35 Billion.

As I mentioned, it appears as though Helix has been attempting to make its earnings look worse than they really are lately.  Let's take a look at what Helix has done with its reported goodwill and depreciation over the past three years:

As you can see, Helix has written down the goodwill on its books from $1,089,758 in 2007 to only $78,643 in 2009.

Furthermore, the company has depreciated the value of the "Property, Plant, and Equipment" on its books from $3,419,590 in 2008 to $2,863,706 today.

In these two areas alone, HLX has taken non-cash charges versus earnings of more than a billion and a half dollars.  Now that these items have been substantially written down that's another billion plus dollars that the company can report as earnings in future quarters.  That's enough to turn the quarterly loss that the company has reported over the past three reporting periods very positive.

Over the past several years Helix has spent heavily on acquisitions (Remington for $1.75 billion in 2006) and new equipment (including three new ships that cost $900 million which recently went into operation).  It appears as though management plans to slow down its spending and focus on paying down that huge chunk of debt.  The sooner it does, the less afraid of this company Mr. Market will become.

While the Gulf of Mexico disaster has caused investors to flee this stock, in the short run the company is actually profiting some from it.  Helix's state-of-the-art Q4000 is actually one of the rigs that BP is using in an attempt to capture oil that is leaking from its ruptured well (see article: BP Says 2nd Oil-Recovery System to Start Testing This Weekend).

 

Another potential catalyst beyond a slowing in the writedown of non-cash earnings is the company is has just or is about to begin producing oil and gas from a new well that it actually owns.  The company's new Phoenix field is about to begin producing hundreds of thousands of dollars worth of oil and gas per day.

Is there a lot of uncertainty surrounding a company that supports the drilling for oil offshore today? Absolutely.  That's actually a good thing.  Mr. Market hates uncertainty and it punishes the share prices of stocks in such situations.  Does anyone really think that the entire world is going to stop drilling for oil after this tragic disaster in the Gulf of Mexico?  I certainly don't.  I don't even think that drilling in the Gulf itself will stop for longer than a couple of months.

I am very busy with a few projects that I am working on today, so I'm going to have to cut this write-up a little short.  I have not completed nearly enough due diligence on HLX to purchase shares of it in real life, but this is a good starting point for anyone who is interested.  I'd love to hear the thoughts of anyone who is familiar with this company.  I plan on adding shares of HLX to my CAPS portfolio this afternoon at around $10.50/share.

Deej 

4 Comments – Post Your Own

#1) On June 10, 2010 at 3:35 PM, allstarvulture (< 20) wrote:

Great post all around, Deej.

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#2) On June 10, 2010 at 5:04 PM, ozzfan1317 (78.55) wrote:

Nice post been looking to add to my energy exposure will give them a look.

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#3) On June 10, 2010 at 8:31 PM, TMFDeej (99.24) wrote:

Thanks everyone.

Deej 

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#4) On June 14, 2010 at 10:23 AM, florinochiana (< 20) wrote:

Really great post and great analysis. 

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