Tag Archives: earnings statement

Message From Enforcement: Metrics Matter!

Hot Topic, , , , , , , , , , , , ,

Metrics, measures of performance drivers outside the financial statements, have become a larger part of how companies communicate with investors in recent years. As with all communication tools, a carefully planned, balanced presentation is important. Well-designed metrics can provide greater insight into the fundamentals of a company’s operations.

As with other elements of financial reporting, metrics can be misused. A metric could be poorly designed and not really correlate with financial performance. A metric could also be misstated or manipulated.

Poorly Designed Metrics

Many tech companies have complex and hard to understand revenue models. Measures such as “daily active users” and “monthly active users” can help users understand a company’s performance. That said, the link between the metric and performance needs to be clear. The CorpFin Staff has written many comments about this issue. Here are a couple of examples:

  1. In your various quarterly earnings calls, we note your discussion of the performance of your business in terms of the “add/quit metric” and “uniform wearer losses” (based upon changes in the number of uniform wearers within particular sectors of your customer base). We further note this is your fourth consecutive quarter of negative uniform wearer losses. Please expand your MD&A to include this information as well as a discussion of any trends or uncertainties. Additionally, the add/stop metric appears to have a meaningful impact on operating margins and growth rate. Please expand your disclosure to provide a complete picture of the relationship between the add/quit metric, operating margins, and growth rate for each material sector of your customer base. Please refer to Item 303(a)(3) of Regulation S-K and Section III.B.1. of SEC Release 33-8350.

 

  1. We note your statement that your results are highly dependent on comparable store sales. We further note that your comparable store sales have declined over the last three years and within each year have generally declined each quarter. We also note your statements that your comparable store sales are difficult to predict in the current competitive landscape and may get marginally worse before they get better. Given the importance of this metric to your results and its significant decline over the last three fiscal years, please tell us and disclose in more detail the factors that contributed to this decline, such as any significant declines in prices, including significant increases in your promotional activity, any significant declines in the volume of items sold, any change in the mix of products being sold or any other material factors that had a significant impact on the decline in your comparable store sales. While this decline in comparable store sales may ultimately be driven by your competitive environment, we believe a more detailed discussion of changes in intermediate factors such as price and volume will provide more transparency to your investors as to how you are affected by this competition, any steps management has taken to mitigate the impact of this competition and the success of management’s strategies. Refer to Item 303(a)(3)(iii) of Regulation S-K and SEC Release No. 33-8350.

 

Misstated Metrics and Enforcement

When companies present metrics, they should be very careful to use a balanced approach to the information and use the metric consistently to avoid presenting potentially misleading information. We discussed many of these issues in our One-Hour Briefing about Non-GAAP Measures and Metrics. You can find the briefing at:

 

www.pli.edu/Content/Non_GAAP_Measures_and_Metrics_Getting_it/_/N-1z10vnyZ4n?ID=282910

 

One really “old school” example metric would be the financial ratio gross margin. It is not a non-GAAP measure so long as it is computed using the revenues, cost of sales and gross margin lines on a company’s income statement. For retailers, it is a crucial measure of performance. Gross margin trend over time can have a significant impact on how investors view a retailer.

In a recent enforcement case the SEC fined a large outdoor products retailer and its CFO for manipulating their gross margin and then misstating why gross margin changed. The source of the issue was a fee the company charged to its wholly owned banking subsidiary. In the retailer’s financial statements the fee was used to reduce cost of sales and thus increase gross margin. Such a fee would normally be eliminated in consolidation. Here though, the company failed to eliminate this intercompany transaction. As a result, in the consolidated financial statements the net income of the financing part of the business was understated and the gross margin of the retailing part of the business was overstated. Additionally, the company did not disclose that this intercompany fee had increased their gross margin and actually attributed the increase to other causes.

 

Here is a quote from the enforcement order:

This in turn increased ——– merchandise gross margin percentage, a key company-specific financial metric that signaled the profitability of the company and was referenced by the company in earnings releases and analysts calls.

 

The end result: Enforcement!

And, a clear message, manipulating metrics can get a company into just as much trouble as manipulating the financial statements!

You can read the enforcement release at:

www.sec.gov/litigation/admin/2016/34-77717.pdf

 

As always, your thoughts and comments are welcome!

Known Trends in the News

Uncategorized, , , , , , , , , ,

In this period of earnings releases we always watch for interesting disclosure examples. Microsoft has provided us with a great example of the “forward looking” disclosures about “known trends and uncertainties” that we discuss in our workshops.

As a reminder, this S-K Item 303 MD&A disclosure requirement says:

(3) Results of operations. (i) ………..

(ii) Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations. If the registrant knows of events that will cause a material change in the relationship between costs and revenues (such as known future increases in costs of labor or materials or price increases or inventory adjustments), the change in the relationship shall be disclosed.

In their most recent earnings release Microsoft reported a $7.5 billion goodwill impairment related to its acquisition of Nokia’s “Devices and Services” business, which they refer to as NDS. At issue here of course is that such an impairment rarely would ever come out of the blue in an unexpected way during the current quarter. In fact, the risk of impairment would almost always be known well before actually recording the impairment. And, if the company “reasonably expects” there will be an impairment in a future quarter, the company must disclosure this risk in MD&A.

On April 29, 2014 Microsoft completed the acquisition of substantially all of Nokia Corporation’s (“Nokia”) Devices and Services Business (“NDS”), which they reported in a new Phone Hardware segment.

Microsoft, which has a June 30 fiscal year end, said this in their Critical Accounting Estimates disclosure in their June 30, 2014 Form 10-K, which was of course shortly after the acquisition.

Goodwill

We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit.

(some text omitted)

The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the business. In this highly competitive and volatile market, it is possible that we may not realize our forecasts. Given the value assigned to goodwill in the purchase price allocation, we will closely monitor the performance of the business versus the long-term forecast to determine if any impairments arise.

They also had a robust risk factor disclosure which you can find in the 10-K.

This disclosure was essentially repeated in their first quarter Form 10-Q for the quarter ended September 30, 2014.

For the second quarter ended December 31, 2015, the disclosure was adjusted a bit to focus on the Phone Hardware segment:

The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the business. In this highly competitive and volatile market, it is possible that we may not realize our forecasts. Given the value assigned to goodwill in the purchase price allocation, we will closely monitor the performance of the business versus the long-term forecast to determine if any impairments arise in our Phone Hardware reporting unit. Except as clarified above, we determined that none of our reporting units were at risk of impairment as of our most recent annual goodwill impairment testing date.

And, in their Form 10-Q for the third quarter ended March 31, 2015, this “known trend or uncertainty” became a bigger risk and was addressed directly:

“Goodwill

(Some text omitted)

We determined that none of our reporting units were at risk of impairment as of our most recent annual goodwill impairment testing date. The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the Phone Hardware business. In this highly competitive and volatile market, it is possible that we may not realize our forecast. Considering the magnitude of the goodwill and intangible assets in the Phone Hardware reporting unit (see Note 8 – Business Combinations of the Notes to Financial Statements), we closely monitor the performance of the business versus the long-term forecast to determine if any impairments exist in our Phone Hardware reporting unit. In the third quarter of fiscal year 2015, Phone Hardware did not meet its sales volume and revenue goals, and the mix of units sold had lower margins than planned. We are currently beginning our annual budgeting and planning process. We use the targets, resource allocations, and strategic decisions made in this process as the inputs for the associated cash flows and valuations in our annual impairment test. Given its recent performance, the Phone Hardware reporting unit is at an elevated risk of impairment. Declines in expected future cash flows, reduction in future unit volume growth rates, or an increase in the risk-adjusted discount rate used to estimate the fair value of the Phone Hardware reporting unit may result in a determination that an impairment adjustment is required, resulting in a potentially material charge to earnings.”

(Emphasis added)

Blunt words to forewarn investors of the risk of impairment!

As always, your thoughts and comments are welcome!