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Analysis of earnings quality and the company

Analysis of earnings quality and the company

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Manufactured homes inc Manufactured homes inc Presentation Transcript

  • Etienne Bordeleau Pramod Jindal Zain Jafry Sean Ray
  •  Company description Significant accounting policies Analysis of Earnings Quality Financial Performance 1986-1987 Risks and Investment recommendation
  •  Sells manufactured homes to low income blue collars in the Southeastern U.S. ◦ Majority from outside vendors ◦ Some from manufacturing subsidiary Finance the purchase like a mortgage ◦ Sells the majority of those “mortgages” to financial institutions (securitization) with recourse ◦ Finance subsidiary for “lower quality” loans
  • Home Manufactured Customer Homes Down payment + Receivable (loan at 10% interest rate)Journal entries:Dr. Account receivables $10,000Dr. Cash (down payment) $1,000Cr. Sales $11,000Dr. COGS $8,000Cr. Inventory $8,000
  • Cash + Finance participation receivable Principal Financial Manufactured Cash Institution Homes Proportion of (10-6)% Receivable with Recourse Journal entries: Dr. Cash $10,000 + $300 Dr. Finance participation receivable $100 Cr. Accounts receivables $10,000 Cr. Finance Participation Income $400Note: Finance participation income and receivable represents the spread between the intereston the loan (10%) and the market interest rate (6%). Financial Institutions keep a portion of 10%-6%to mitigate credit risk.
  •  Major ◦ Revenue recognition ◦ Sale of receivables (FASB-77) ◦ Reserve for losses on credit sales
  •  Sales are recognized when the customer makes the down payment (around 10%) and enters an installment contract (i.e. mortgage) The rest is booked as a receivable and the customer pays in installments with an interest rate X%.
  •  To be recognized as a sale, the transfer of receivables with recourse must: ◦ Be surrendered unequivocally ◦ The obligations of the seller under recourse must be subject to reasonable estimation of:  The amounts of bad debt and the costs related to collection and repossession  Prepayment risk ◦ The seller cannot be required to buy back the receivables except if the recourse provisions are met.
  • Credit Quality Based on historical loss (as a % of total contingent liabilities as experience: guarantor) 2.50% ◦ Low default rates 2.00% High segment and geographical concentration 1.50% ◦ Higher credit risk 1.00% The recognition as a Sale under FASB-77 is contestable: 0.50% ◦ Receivables collection difficult to estimate 0.00% 1984 1985 1986 PCL Charge-offs
  • Characteristic Case Details Higher Quality EarningsRevenue Aggressive Revenue Recognition: All revenue Recognize revenue after the sale if theRecognition is recognized when a customer enters into an receivable collection is uncertain installment contract • Installment sales method • Cost recovery method Non-Cash Earnings - Credit sales represent a majority of the company salesReserves for MH appears to understate provision of losses Increasing Provision of Losses :Losses on Credit • Provides a greater cushion for futureSales Reserve balance of $3mm less than the actual losses losses $3.01mm in 1986 • Improves quality of net receivablesSales of Off-Balance Sheet Financing: Large contingent Treat contingent liability as a liability onReceivables liabilities($180mm in 1986) from the the balance sheet installment sales contracts sold with recourse to Financial Institutions
  •  The case presents unaudited Sep 30, 1987 interim statements Audited Q4 1986 ◦ $2M of repossession expense and interest chargebacks- reserves for credit losses increased to $3M on Dec 31,1986 ◦ Net loss of $1.3M  Losses on credit sales and other charges totaling more than $3M
  • 10,000,000 5,000,000  CFO and Earnings are starting 0 to diverge post 1986 1984 1985 1986 1987 (Sep 30) -5,000,000-10,000,000-15,000,000 CFO Earnings Probability of Earnings Manipulation 16.0%  Bemish Index 12.0% ◦ Probability of Earnings Manipulation increased 8.0% from 1986 to 1987 4.0% 0.0% 1986 1987
  • 21.4% 21.3% 7,700 21.2% 7,200 21.2% 6,700 21.0% 6,200Gross profit New unit sale 20.8% 5,700 20.6% 20.6% 5,200 4,700 20.4% 4,200 20.2% 3,700 20.0% 3,200 FY 1985 FY 1986 FY 1987* Units of new home sold Gross profit margin
  • 1986-1987: Annual Earnings driven by Finance Participation Income only Income Statement With finance participation Without finance participation 1986 1985 1986 1985 Revenue Net Sales 106 69 106 69 Finance Participation Income 12 10 0 0 Other Income 2 1 2 1 120 80 108 70 Cost and Expenses Cost of Sales 86 56 86 56 Selling, General, and Admin* 23 14 21 12 Other Costs 7 3 7 3 Total Costs 116 72 114 71 Earnings before taxes 4 7 -6 -1
  •  Home Sales ◦ Volume ◦ Price ◦ Overall, sales growth will be a concern going forward Finance Participation- Uncontrollable and expected to trend down ◦ Increased sales with no finance participation ◦ Interest rate spread subject to bank’s policy(policy changes reduced spread by 33% in 1986) ◦ Bank’s asking for irrevocable letter of credit ◦ Low interest rates leading to pre-payments
  •  Cost of sales ◦ Not much evidence in cost reduction due to the firm size ◦ Gross profit margin not expected to go up SG&A ◦ Tied to liability insurance rates on policy renewal( increased 40% in 1996) ◦ Have increased as a percent of net sales from 1985 onward Provision for losses ◦ Q4 1986 and 1987 suggest understating of the provisions Interest Expense ◦ Expected to increase when contingent liabilities($180M) is recognized as debt
  •  Sales and Marketing  Overall sales volume has been driven by the acquisitions  No evidence of consistent Same Store Sale increase Bulk purchasing power  Gross profit margin declining Financial participation income:  Historically good but now uncertain
  •  Manufactured Homes should not be included in the growth portfolio ◦ Quality of earnings: poor ◦ Revenue driver: home sales ◦ Profit driver: finance participation ◦ SCA does not seem to add value to shareholders ◦ Outlook:  Net sales expected to stay same or grow moderately  Expenses expected to go up substantially  Huge risks associated with the Net Earnings(finance participation)  Huge concern about the firm’s ability to service the debt
  • Q&A
  • Common-Size Balance SheetASSETS 1987 (Sep 30) 1986 1985Current Assets: Cash and Cash Equivalents 8.3% 3.1% 5.8% Contract Proceeds Receivable from FI`s (note 9) 15.5% 14.1% 10.2% Total Cash 23.8% 17.2% 16.0% Finance Participation receivable - current portion (note 2) 4.1% 3.3% 4.9% Deferred finance participation income -1.1% -1.0% -1.0% Net finance participation receivable 3.0% 2.3% 3.9% Installment Sales Contracts held for resale 2.1% 0.0% 0.0% Other receivables (note 4) 5.6% 4.6% 4.0% Refundable income taxes (note 11) 0.0% 1.0% 0.0% Inventories (notes 5 and 9) 37.0% 46.9% 50.3% Prepaid Expenses 0.5% 0.7% 0.8% Deferred income taxes (note 11) 0.9% 0.9% 0.9% Other Current Assets 46.1% 54.1% 56.0%Total Current Assets 72.9% 73.6% 75.9%Non Current Assets Net finance participation receivable 16.9% 15.0% 14.3% PPE (note 6 and 10) 8.2% 9.2% 10.7% Depreciation -2.8% -3.0% -3.1% Net PPE 5.4% 6.3% 7.7% Deferred income taxes 1.6% 0.0% 0.0% Excess of Costs over net assets of acquired co`s less amort (3) 1.9% 2.6% 1.9% Other Assets 1.3% 2.6% 0.2% Total Other Assets 4.8% 5.2% 2.1%Total Non-Current Assets 27.1% 26.4% 24.1%Total Assets 100.0% 100.0% 100.0%
  • LIABILITIES AND STOCKHOLDER`S EQUITYCurrent Liabilities Notes Payable 0.0% 1.4% 0.0% Long term Debt (note 10) 0.1% 1.0% 2.2% Floor Plans note payable (note 9) 25.1% 43.3% 53.9% Account Payable 7.3% 6.0% 4.3% Income Taxes (Note 11) 2.2% 0.0% 3.6% Accrued Expenses and other liabilities ( note 8) 4.8% 3.4% 2.4%Total Current Liabillities 39.4% 55.0% 66.4%Non-current Liabilities Long term debt (non current portion) (note 10) 38.2% 22.9% 2.1% Reserve for losses on credit sales (note 7) 4.3% 3.7% 3.7% Deferred income taxes (note 11 0.0% 1.0% 6.1%Total Non-current Liabilities 42.5% 27.6% 11.9%Total Liabilities 81.9% 82.6% 78.3%Stock Holders Equity (notes 10 and 12) Common Stock 1.7% 2.3% 3.4% Additional Paid in Capital 3.4% 4.3% 5.0% Retained Earnings 13.0% 10.8% 13.3%Total stockholders Equity 18.1% 17.4% 21.7% 0.0%Total Liabilities and Equity 100.0% 100.0% 100.0%
  • Consolidated Statements of Earning Consolidated Statements of Earning 1986 1985 1984 1986 1985 1984Revenue Revenue Net Sales 106,095,667 68,674,779 30,480,571 Net Sales 88% 86% 84% Finance Participation Income 12,084,108 9,715,558 5,221,279 Finance Participation Income 10% 12% 14% Insurance Commisions 721,758 413,282 231,618 Insurance Commisions 1% 1% 1% Interest 338,447 163,663 123,564 Interest 0% 0% 0% Other 1,024,974 558,706 138,770 Other 1% 1% 0%Total Revenue 120,264,954 79,525,988 36,195,802 Total Revenue 100% 100% 100%Cost and Expenses Cost and Expenses Cost of Sales 86,212,901 56,222,412 24,324,851 Cost of Sales 72% 71% 67% Selling, General, and Admin, 22,852,093 13,639,942 5,895,891 Selling, General, and Admin, 19% 17% 16% Provision for losses on credit sales (note 7) 3,777,900 793,497 253,004 Provision for losses on credit sales (note 7) 1% 3% 1% Interest 3,367,940 1,824,588 570,527 Interest 3% 2% 2%Total Costs 116,210,834 72,480,439 31,044,273 Total Costs 97% 91% 86%EBIT 4,054,120 7,045,549 5,151,529 EBIT 3% 9% 14%Income tax 2,020,695 3,327,224 2,457,000 Income tax 2% 4% 7%Earnings before change in accounting princ. (note 2,033,425 2) 3,718,325 2,694,529 Earnings before change in accounting princ. (note 2) 2% 5% 7% Changes in accnt principles (note 2 and 11) - - 504,571 Changes in accnt principles (note 2 and 11) 0% -1% 0%Net Earning 2,033,425 3,213,754 2,694,529 Net Earning 2% 4% 7%
  • Interim Statements of Earning (9 months Ended Sep 30th) Interim Statements of Earning (9 months Ended Sep 30th) 1987 1986 1987 1986Revenue Revenue Net Sales 126,599,392 76,396,868 Net Sales 85% 89% Finance Participation Income 18,895,975 8,629,223 Finance Participation Income 13% 10% Insurance Commisions 976,128 465,577 Insurance Commisions 1% 1% Interest 925,116 230,602 Interest 1% 0% Other 786,971 221,448 Other 1% 0%Total Revenue 148,183,582 85,943,718 Total Revenue 100% 100%Cost and Expenses Cost and Expenses Cost of Sales 101,997,757 61,554,367 Cost of Sales 69% 72% Selling, General, and Admin, 27,973,865 14,823,385 Selling, General, and Admin, 19% 17% Provision for losses on credit sales (note 7) 3,203,913 772,417 Provision for losses on credit sales (note 7) 2.2% 0.9% Interest 4,416,596 2,303,482 Interest 3% 3%Total Costs 137,592,131 79,453,651 Total Costs 93% 92%EBIT 10,591,451 6,490,067 EBIT 7% 8%Income tax 4,748,000 3,109,000 Income tax 3% 4%Earnings before change in accounting princ. (note 5,843,451 2) 3,381,067 Earnings before change in accounting princ. (note 2) 4% 4% Changes in accnt principles (note 2 and 11) - - Changes in accnt principles (note 2 and 11) 0% 0%Net Earning 5,843,451 3,381,067 Net Earning 4% 4%
  • 1986-1987: Interim Earnings driven by Finance Participation IncomeInterim Income Statement With Finance Participation Without Finance Participation 1987 1986 1987 1986Revenue Net Sales 126,599,392 76,396,868 126,599,392 76,396,868 Finance Participation Income 18,895,975 8,629,223 0 0 Other Income 2,688,215 917,627 2,688,215 917,627Total Revenue 148,183,582 85,943,718 129,287,607 77,314,495Cost and Expenses Cost of Sales 101,997,757 61,554,367 101,997,757 61,554,367 Selling, General, and Admin, 27,973,865 14,823,385 24,406,712 13,335,035 Other Costs 7,620,509 3,075,899 7,620,509 3,075,899Total Costs 137,592,131 79,453,651 134,024,978 77,965,301Earnings before taxes 10,591,451 6,490,067 -4,737,371 -650,806
  • Consolidated Statements of Earning 1986 1985 1984Cash Flow from operations Net Earnings 2,033,425 3,213,754 2,694,529 + Depreciation 946,858 556,236 210,699 Noncurrent deferred income taxes -2,197,061 78,637 1,412,812 Provisions for losses on credit sales 699,343 -217,402 134,614 Issuance of nonqualified Stock Options 142,000 206,000 0 Finance Participation income -12,084,108 -9,715,558 -5,221,279 Collections of finance participation receivables 7,503,502 8,725,359 3,316,397 Other 0 0 52,181 - Changes in WC -4,467,241 6,134,420 -540,601Cash Flow from Operations -7,423,282 8,981,446 2,059,352Cash Flow From Investing Net Assets addition of Acquired companies(note 3) 1,285,935 422,179 1,220,198 Additions to PPE 1,917,489 2,756,178 580,259 Decrease in other assets - 4,024 Additions to other assets and excess costs 1,813,191 0 9,054Cash Flow from Investing -5,016,615 -3,182,381 -1,809,511Cash Flow from Financing Proceeds from Long term Debt 18,396,000 1,651,822 400,000 Exercises of Stock Options 938,935 0 Current installments and Repayment of LTD 1,071,308 1,322,806 70,423Cash Flow from Financing 20,406,243 2,974,628 470,423Change in total cash 7,966,346 8,773,693 720,264
  • Consolidated Statements of Earning (interim) Dec 30th 1987 1986 1986Cash Flow from operations Net Earnings 5,843,451 3,381,067 2,033,425 + Depreciation 921,388 664,769 946,858 Noncurrent deferred income taxes -2,699,000 -345,000 -2,197,061 Provisions for losses on credit sales 1,850,000 -318,539 699,343 Issuance of nonqualified Stock Options 39,000 106,500 142,000 Finance Participation income -18,895,975 -8,629,223 -12,084,108 Collections of finance participation receivables 12,066,312 5,019,381 7,503,502 Other 0 - Changes in WC -9,786,526 -7,929,293 -4,467,241Cash Flow from Operations -10,661,350 -8,050,338 -7,423,282Cash Flow From Investing Net Assets 1,324,079 1,285,935 Additions to PPE 1,851,773 1,365,703 1,917,489 Decrease in other assets 662,876 - - Additions to other assets and excess costs 80,000 879,665 1,813,191Cash Flow from Investing 2,594,649 -3,569,447 -5,016,615Cash Flow from Financing Proceeds from Long term Debt 25,000,000 18,000,000 18,396,000 Exercise of Stock Options 304,563 1,060,805 938,935 current installments and Repayment of LTD 609,987 1,015,876 1,071,308Cash FlowfromFinancing 25,914,550 20,076,681 20,406,243Change intotal cash 17,847,849 8,456,896 7,966,346
  • 1987 (Sep 30) 1986 (Sep 30) 1986 1985 1984Earnings QualityAggregate Accruals 13,910,152 15,000,852 14,473,322 -2,585,311 2,444,688NOA current 65,004,536 54,813,291 54,813,291 5,077,554NOA prior 54,813,291 5,077,554 5,077,554 n/aAccrual Ratio 0.23 0.50 0.48Total Assets 112,603,681 81,377,803 81,377,803 50,944,924Cash 26,746,431 13,982,102 13,982,102 8,158,372Total Liabilities 92,249,548 67,210,684 67,210,684 39,892,165Total Debt 71,396,834 54,628,274 54,628,274 29,651,320Net Income 5,843,451 3,381,067 2,033,425 3,213,754 2,694,529CFO -10,661,350 -8,050,338 -7,423,282 8,981,446 2,059,352CFI 2,594,649 -3,569,447 -5,016,615 -3,182,381 -1,809,511GrowthRevenue 120,264,954 79,525,988 36,195,802 Revenue Growth 51%Accounts Receivables 27,142,010 17,132,927 9,210,172 A/R Growth 58% 86%
  •  Aggregate Accruals Aggregate Accruals ◦ Measures the discretionary16,000,000 component of earnings12,000,000 ◦ = NI – (CFO + CFI) 8,000,000 ◦ For good earnings quality, aggregate accruals should decline 4,000,000 ◦ MH’s aggregate accruals have 0 increased from 1985 1985 1986 1987-4,000,000