The market likes consistency in operations, but intelligent investors should also consider consistency in disclosures. The more consistent a corporation’s disclosures, the easier it is to make comparisons and determine the true state of the company’s performance. When companies suddenly change their disclosures without providing a concrete rationale for the change, investors should be worried that there is some bad news being covered up. Indeed, many of the accounting gimmicks covered in the excellent Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports (read my multi-part review here), are identifiable by those who watch for inconsistencies in disclosures, definitions and assumptions.

Consider the case of ADTRAN, Inc. (NASDAQ: ADTN) a provider of equipment and services for communications networks. I am always concerned when looking at companies in this niches because they tend to be overly reliant on a small number of major mobile network operators. Consequently, I pay close attention to disclosures about major customers and revenue concentration. I was quite concerned by what I found at ADTN.

The company’s 2010 10-k includes this statement:

Single customers comprising more than 10% of our revenue in 2010 include Qwest Communications International, Inc. at 20%, AT&T Inc. at 18%, and Verizon Communications, Inc. at 11%. The revenues from all of these customers are reported in both the Carrier Networks and Enterprise Networks segments. No other customer accounted for 10% or more of our sales in 2010.

This is exactly the kind of disclosure I look for: a clear and concise discussion of who its major customers are and what percentage of sales each accounts for. I usually track these figures over time, so when I checked the recently filed 2011 10-K, imagine my surprise when I found that this year, investors received this:

Single customers comprising more than 10% of our revenue in 2011 include AT&T Inc. and CenturyLink, Inc. The revenues from both of these customers are reported in both the Carrier Networks and Enterprise Networks segments. No other customer accounted for 10% or more of our sales in 2011.

How much of the company’s sales were attributable to AT&T? How about CenturyLink? From this statement only, there is no way to guess. The answers are elsewhere. I checked and the company has provided this information for each of its major customers in each of the previous eleven years. Suddenly there is a break in the consistency, and this should invite investor scrutiny.

The information is provided (indeed, it has to be), but rather than being up front, it is buried down in Note 11 “Segment Information and Major Customers” near the end of the 10-K. The company even made the odd choice to bury the data under the heading “Sales by Geographic Region” when this information has nothing to do with geography. Here’s what they say (emphasis mine):

Single customers comprising more than 10% of our revenue in 2011 included two customers at 25% and 10%, respectively. Single customers comprising more than 10% of our revenue in 2010 included three customers at 20%, 18%, and 11%, respectively. Single customers comprising more than 10% of our revenue in 2009 included three customers at 22%, 19%, and 11%, respectively. No other customer accounted for 10% or more of our sales in 2011, 2010 or 2009.

Here we see that the company doesn’t provide information about which of its two major customers is the larger purchaser. Again, they’ve done this for every year since 1999, so why stop now? Perhaps because sales to one of these customers has plummeted.

In 2010, Qwest (now CenturyLink) and AT&T comprised 38% of sales which were closely split between the two. In 2011, while the aggregate concentration of these two dropped to 35%, the gap between the two expanded from 3% to 15%. In 2010, sales to the second largest customer accounted for 18% of total revenues, or $109 million. In 2011, sales to the second largest customer accounted for 10% of total revenues or $71.7 million, for a decline of 34%. This is a dramatic decline in sales to its largest customer, but only those investors who found the strange lack of disclosure up front and hunted to the end of the 10-K could find this information. Otherwise, the offset in sales to the largest customer masked much of the decline.

I decided to check out the company’s 2011 conference call transcripts to see what happened. First, in Q1, the company said this:

Sanjiv Wadhwani – Stifel, Nicolaus & Co., Inc.

Jim, could you talk about the 10% customers for the quarter?

James Matthews

Sanjiv, Yes. As you know in the past, historically, we have given a 10% breakout customers on the quarterly calls. We have recently received letters from certain customers requesting that we not do that any longer. Therefore, that’s the practice that we’re going to take going forward. However, we did see three 10% customers in the quarter. And that’s the extent that we can talk about it at this point, Sanjiv, because of customer request.

Note that the customer request covers quarterly calls, not 10-K. The information is still in the 10-K, just buried and no longer specific to the customer. The company should stick to its track record of providing this important information up front. Later in the same call, the company said this (emphasis added):

Ehud Gelblum – Morgan Stanley

Okay, that’s cool. Now when you look at some big customers. And I know certainly after you got these letters, you don’t want to talk about customers all that closely. But again, we have CenturyLink, Qwest, and we have a slightly different merger going on with AT&T and T-Mobile, which sort of really have nothing to do with you. But there’s been some thought out there that possibly AT&T may be slowing down expenses, or slowing down spending deployments, based on that. Are you seeing any, at either of these two mergers, are you seeing any difference in spending patterns? And if you feel like generalizing to a more general comment, that’s fine as well.

Thomas Stanton

Yes, I mean that — and I will tell you that the tone of, from customers, around talking about their business is probably as loud as it’s ever been, so we really don’t want to talk too much. If I must set the market in general, and if I talk about it from a product-line basis, maybe that’s a better way to look at it, our Broadband piece did very well. That included performances pretty much across the customer base that we would expect to see at this point in time. And so really, no surprises there. I’m not sure of much more I can tell you.

Ehud Gelblum – Morgan Stanley

So it doesn’t sound like you’re seeing any change in buying behavior from your customers.

Thomas Stanton

Well, I’ve heard the same thing that you were talking about with one of the largest carriers, and I’m not sure if we really commented about that in Q4, but I know there was a lot of talk about kind of delayed purchases and things like that. And we didn’t disagree with those comments. And we fully kind of understood what they were doing and how they’re doing things, and fully expected them to — those things happen from time to time when you see a slowdown and then a pickup.

Ehud Gelblum – Morgan Stanley

And have you seen slowdowns?

Thomas Stanton

Here again, I’ve probably delved too much into a specific customer. I would say that the comments that are out there, we haven’t commented or deemed necessarily incorrect.

Ehud Gelblum – Morgan Stanley

Interesting. Helpful.

We get a vague discussion about not disagreeing with comments about a slowdown at a customer. There isn’t much here to raise an alarm that sales might be plummeting to one of the biggest customers. It wasn’t until Q4 that an analyst asked another question related to the 10% customers:

Nikos Theodosopoulos – UBS Investment Bank, Research Division

Just a couple of questions here. Maybe you guys can comment on, now that the year is done, what was — how many customers you actually had that that were 10% customers and who they were, I mean, given the growth in international and Tier 1, Tier 2? Just trying to get a sense of how customer diversification has changed over the course of the year. …

James E. Matthews

Sure, Nikos. Diversification has certainly, we believe, had a positive impact during the year. For the year, we see two 10% customers. And again, our policy is to comment only on those in the 10-K when we publish that.

Nikos Theodosopoulos – UBS Investment Bank, Research Division

Two 10% customers. Do you have like — okay, so in terms of how big they were, are you going to wait for the K or can you give any color on that?

James E. Matthews

We’ll wait for the K.

Nikos Theodosopoulos – UBS Investment Bank, Research Division

All right.

Again, management was evasive, forcing investors to wait until the 10-K. Strangely, management says diversification has had a positive impact when in fact sales became less diversified (the top customer’s sales become more concentrated than in past years). I had hoped that in Q1 of 2012, there would be some follow up questions about what happened, and this is the closest we got:

Nikos Theodosopoulos – UBS Investment Bank, Research Division

Just a couple of quick questions. Can you comment on 10% customers in the quarter? …

James E. Matthews

Nikos, this is Jim. We had one.

Did you catch that? Their second largest customer officially dropped below the 10% threshold, meaning that sales to that customer are continuing to deteriorate. Keep in mind that in Q1 2012, revenues declined from $165 million in Q1 2011 to $135 million in Q1 2012, so this is not the case of sales to that party relative to other parties growing more slowly. This was a decline in an absolute sense. Note also that in Q1 of last year, the company had three customers over 10%. 

While the company’s explanation for no longer providing the 10% customer details by quarter could be accepted on face value, the subsequent change in disclosure presentation in the 10-K should be a warning. Upon further investigation (far more than would have been needed over the last eleven years!), we learn the true story. By moving key information from its traditional spot, management has made a key risk less noticeable to investors, namely that the company is becoming more reliant on its top customer and that sales to its second largest customer have collapsed.

So what should management have done? While it evidently received requests to not disclose the percentage of sales to each major customer, it could have still provided this information without naming the customer (similar to what it ultimately did in the 10-K). Furthermore, the company should have been proactively discussing this in either its press release, 10-Q or opening statements to its conference calls, rather than waiting for analysts to ask the right questions. Once analysts asked the questions, they should have been far more forthcoming about the problems with its #2 customer and what it was doing about it. Finally, under no circumstances should management have changed the location of this key information.

Here’s my takeaway: it is always worth an investor’s time to consider changes in presentation, assumptions or definitions when reading corporate filings. Any change in priority or wording from a long-standing tradition should demand greater scrutiny. More often than not, I think you will find that the change was motivated by a desire to lessen the blow of something negative. Whenever I find shenanigans like this, I assume there are more lurking in the background and so I stay away.

What do you think of consistency in disclosures?

Author Disclosure: None

Talk to Frank about ADTRAN, Inc

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The following lecture by Kathryn Staley, author of The Art of Short Selling was passed along via twitter. She covers her start in short selling and the things she looks for in finding good short sale candidates. She also gives a number of great examples from her experience shorting.

One thing I found interesting is that she said most of her positions are for at least two years and some have been for as much as ten years. This is an expensive proposition given the borrowing costs, and it would take a lot of conviction to make margin calls during interim bull runs.

The discussion of things to look for is extremely useful and worth your time, regardless of whether you short (I don’t).

What do you think of this?

Author Disclosure: None

Talk to Frank about The Art of Short Selling

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Yesterday, Spanish telecommunications juggernaut Telefónica SA (NYSE: TEF) announced that it will be giving its shareholders the choice between accepting the upcoming dividend in cash, or in shares as a scrip dividend. Normally, I wouldn’t make note of something this mundane, but I was caught off guard by this statement by the company’s Chairman (emphasis mine):

Over the course of the Shareholders’ Meeting, which was held in Madrid, the Chairman of Telefónica and its Board of Directors, César Alierta, presented a report in which he described as exceptional the dividend yield offered by the Company, stating that it is “the highest return of the world’s top one hundred companies by market capitalisation, underlining our Company’s steadfast commitment to its shareholders.”

This statement is disingenuous at best, intentionally misleading at worst. A dividend yield has two components, one being the actual dividend payment and the other being the market price of the company’s equity. The Chairman is implying that the company is so committed to its shareholders that it has chosen to pay out a shockingly high dividend as reward.

This is not the case.

Instead, the reason for the company’s high dividend yield is that the company’s share price has tanked by 42% over the last year. If you hold the dividend payout steady, this has the effect of increasing the yield (due to a lower denominator). None of this implies a “steadfast commitment to shareholders.”

Making matters worse is the fact that the company’s actions are diametrically opposed to what the Chairman is suggesting; the company is actually cutting its dividend from the prior year! 

I am not suggesting that the company shouldn’t be cutting its dividend (given the price decline, I would favour eliminating the dividend and diverting that capital toward share repurchases), but I am suggesting that transparently misleading investors about the company’s largesse is wrong.

One more thing from the company’s marketer-in-chief (emphasis mine):

According to César Alierta, this dividend “translates into a 13.3% yield at the current share price(*), which means that Telefónica remains an excellent investment opportunity even in the challenging current economic circumstances.”

The emphasized statement does not logically flow from the discussion of yield, which on its own is an insufficient measure of an investment (there needs to be consideration for the sustainability of that dividend!).

It worries me to see a company’s Chairman make misleading statements like these, seemingly with the purpose of fooling investors. What do you think?

Author Disclosure: None

Talk to Frank about Telefónica SA

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A Modern Approach to Graham & Dodd Investing

By Thomas Au

Today I am reviewing A Modern Approach to Graham & Dodd Investing. Read my other book reviews here.

Thomas Au is a value-focused portfolio manager who, like many value investors, found his calling by reading the original Graham and Dodd classics, Security Analysis and The Intelligent Investor. Recognizing the changes that have taken place since the time these books were published, Au sought to update their methodology to account for modern realities. 

Some of you might be doubtful that there is much to add to Graham and Dodd; I certainly was. But Au does an excellent job supporting his thesis. For example, Graham focused largely on asset value and paid particular attention to dividends. This due to the fact that in his time this was really the best data available. According to Au, the income statements of Graham’s time were at best skeletal versions of their current incarnations, with only a very brief summary which did not lend itself to robust analysis, and the statement of cash flows didn’t even exist in the 1930s (I was unaware of this). Thus, given the evolution of these statements, there have been a number of new ways of assessing companies which should be considered in light of Graham and Dodd.

Au accomplishes his task by beginning with the basics, which comprise Part One of the book. Here, he goes right to the fundamentals of the time value of money, evaluating investment projects, and an introduction to financial statements. All but the absolute beginner can safely skip this section, and had I edited Au’s manuscript, I would have suggested that anyone buying the final copy would be advanced enough to find this unnecessary.

Parts Two and Three of the book cover fixed income and equity investments. In these sections, Au discusses new products (such as inflation-linked bonds) as well as shifts in focus (like the increase in LBOs post-Graham and the use of Off Balance Sheet Assets and Liabilities ). Part Four discusses investment vehicles like mutual funds, as well as diversification through international investments and real estate. In Part Five, he discusses portfolio management and in Part Six he discusses what he calls ‘contemporary issues’ such as the components and performance of the Dow as a measure of the broader market, and his fears over credit growth. In each section, Au begins with the basics and works his way up to more complex concepts. At times this can be tedious, as Au does not appear to allow for much prior understanding on the part of his readers.

The book ends with his comparison between the current (as of 2004) era versus what he believes is the closest historical analogy: the 1930s, when a recession turned into a deep depression. His fear is that we share a similar fate. From page 314:

[F]undamental factors seem to be deteriorating worldwide. Hence, the U.S. economic recovery in 2002-2003, which seemed to be built around a false foundation, was not reassuring. If that’s the case, the market retreat – and it was no worth than that of 2000-2002, would be a dress rehearsal for something far worse in 2004-2006.

In the present context of the Great Recession, this has turned out to be eerily accurate (though slightly early). Interestingly, Au calls China the “nouveau riche country of our time,” comparing it to Nazi Germany of the 1930s. He warns that China “will probably take an ‘opportunistic’ foreign policy, which, if opposed, could lead to war” (page 319).

My complaint with the book is that, rather than updating Graham and Dodd (which I have always viewed more as philosophical treatises meant to inform the use of modern methods), it feels more like a general investment textbook which attempts to explain the modern methods of security assessment and valuation. Viewed as an investment textbook, Au did an okay job, but he faces stiff competition in this space. A far better way to learn the modern methods is to read the gold standard Principles of Corporate Finance by Brealey & Myers, or better yet, complete the CFA curriculum. Unfortunately, I can conceive of no scenario where I could recommend this book in place of either of these alternatives, even with Au’s explicit discussion of Graham and Dodd and various value concepts throughout.

If you’ve read A Modern Approach to Graham & Dodd Investing, leave your thoughts below.

Buy This Book Here

Talk to Frank about this Book

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For some Friday fun, I thought I’d take a look at the returns on investment for each Monopoly tile. The first chart shows the purchase price, cost to build a house and hotel, and the associated rents of each property:

Monopoly Base Case

With this starting point, we can then calculate the return at each level of investment. I have added a heat map to each column to help suss out any interesting patterns.

Monopoly Property ROI

I was surprised by the results. I would not have guessed in advance that Connecticut Ave with a hotel produces the greatest ROI achievable in the game, nor would I have guessed that this return would be a staggering 6410 bp greater than the lowest performing property with a hotel. In general, the gap between the best and worst performer in each improvement category is far greater than I expected. 

I was also surprised to see that the more expensive properties produce significantly greater returns. For example, Boardwalk with no improvements trades for just 8x its rental income, whereas Mediterranean Ave trades for a whopping 30.3x. 

This remains generally true as you build houses however there are notable exceptions which the heat map illustrates. As we move down the columns, we see that there are anomalies where it makes more sense to build houses on lower priced properties instead of on the higher priced properties. For example, Virginia Ave (purple) has a significantly higher return than North Carolina Ave (green) beginning at 3 houses. As more is invested in these properties, the gap grows.

It is interesting to note that two properties at polar opposites on the value scale, Mediterranean Ave and Boardwalk, act as clear outliers from the others. Is this because they are the most memorable to players and thus most inefficiently priced? Mediterranean produces about 1/2 the returns of its nearest neighbour, Baltic. An unimproved Mediterranean and an unimproved Baltic produce returns that are 334bp apart, whereas Baltic and the second most expensive property on the board, Park Place, are an equivalent 333bp apart. A similar gap exists between Park Place and Board Walk at the high end of the spectrum. Mediterranean is a classic value trap, whereas Baltic appears to be a good value opportunity.

There are a few properties which should be considered highly desirable as they produce outsized returns for their neighbourhoods. New York Avenue is one, and the yellow properties of Atlantic, Ventnor and Marvin Gardens as well. These may be benefiting from abnormal demand from police and correctional officers on high government salaries.

Two groups of properties exhibit “crossover” in that they move from relatively strong (weak) performers to relatively weak (strong) performers. The blue properties become great investments as you invest in more houses, whereas the green properties do the opposite. Is this because people want to live near free parking, but not near crime that is so reprehensible that you are sent directly to jail without due process?

What are your takeaways from these Monopoly property ROIs?

Author Disclosure: Long one Monopoly set

Talk to Frank about Monopoly

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CNN has a good story covering the rise of Muddy Waters and his success in finding Chinese frauds. Here’s the tidbit I like:

Some clear warning signs Block watches for?

“Too many mergers and acquisitions at one company are definitely a red flag,” said Block. “Companies trying to raise cash when they appear to have a lot on their balance sheet is also an issue.”

Block has also found it useful to scrutinize members who sit on the board of directors at Chinese companies, as well as those who are major investors — a tactic Block used to formulate his short position on Focus Media.

Finally, Block says he also watches to see how companies respond to criticism — whether it be accusations of fraud or otherwise.

“If a company responds to a short seller’s claims by brushing them off and saying that it will continue to run its business and in turn, void any investor concerns, it generally turns out that the short seller is wrong,” said Block. “But when a company starts buying back shares, that’s not necessarily a positive.”

Block is wary of share repurchase programs because they only act as a “Band-Aid” in terms of boosting a company’s stock. They also force the company to “squander” a portion of its cash, he said.

Read the full story here.

Author Disclosure: None

Talk to Frank about Muddy Waters

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Short seller extraordinaire, Jim Chanos of Kynikos Associates, was recently interviewed for Columbia Business School’s Graham & Doddsville newsletter. He shares his history as a short seller and some valuable lessons, as well as some current short positions. I have embedded the newsletter below (if you can’t see it, come to the site).

Talk to Frank about Jim Chanos

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This Bloomberg Businessweek article details the absolute mess that is the French labour code:

Here’s a curious fact about the French economy: The country has 2.4 times as many companies with 49 employees as with 50. What difference does one employee make? Plenty, according to the French labor code. Once a company has at least 50 employees inside France, management must create three worker councils, introduce profit sharing, and submit restructuring plans to the councils if the company decides to fire workers for economic reasons. …

Companies say the biggest obstacle to hiring is the 102-year-old Code du Travail, a 3,200-page rule book that dictates everything from job classifications to the ability to fire workers. Many of these rules kick in after a company’s French payroll creeps beyond 49. …

“For the 100 employees we have in France, we have 10 employee representatives, for whom we have to organize weekly meetings even when there is nothing to discuss,” Haan says. “Every time a social security contribution changes, which is frequently, we have to update software and send our HR people for training. We can’t fire anyone without exorbitant costs.”

As much as elected officials believe they can legislate away market realities, it never works. I’ve always found it strange that the population supports these short sighted measures at the expense of the well-being of future generations.

(h/t Jeffrey Walkenhorst via twitter)

Author Disclosure: None

Talk to Frank about France

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Following up on my previous post, What Austerity?, I thought I’d share this great chart:

Perhaps we shouldn’t give up on austerity until after we’ve actually tried it.

Source: Cafe Hayek

Author Disclosure: None

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Mark Perry posted a great (short) video lecture of Milton Friedman discussing the myth of the free lunch. It is worth watching so I thought I’d share it here:

Author Disclosure: None

Talk to Frank about Milton Friedman

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