Archive for the 'Case Studies' Category

Asset Retirement Obligations – US Cellular Case Study

As of December 31, 2006 US Cellular Corporation (USM) reported long-term debt of $1.0 billion and total assets of $5.7 billion, resulting in a debt/assets ratio of 17.5%. It also recorded interest expense of $94 million and Earnings Before Interest and Taxes (EBIT) of $407 million, resulting in interest coverage of 4.3x.

In US Cellular’s 10K, the following disclosures are made regarding asset retirement obligations:

U.S. Cellular is subject to asset retirement obligations associated primarily with its cell sites, retail sites and office locations. Asset retirement obligations generally include obligations to remediate leased land on which U.S. Cellular’s cell sites and switching offices are located. Also, U.S. Cellular is generally required to return leased retail store premises and office space to their pre-existing conditions. The asset retirement obligation is included in Deferred Liabilities and Credits in the Consolidated Balance Sheets.

During the third quarter of 2006, U.S. Cellular reviewed the assumptions related to its asset retirement obligations and, as a result of the review, revised certain of those assumptions. Estimated retirement obligations for cell sites were revised to reflect higher estimated costs for removal of radio and power equipment, and estimated retirement obligations for retail stores were revised to reflect a shift to larger stores and slightly higher estimated costs for removal of fixtures. These changes are reflected in “Revision in estimated cash flows” below. The table below also summarizes other changes in asset retirement obligations during the year ended December 31, 2006 and 2005.


We can use this disclosure to adjust the financial statements and treat the ARO as equivalent to financial obligations. Since there are no offsetting trust funds, the process is as follows:

  1. Reduce the $128 million ARO as of 12/31/06 by the company’s 38.5% tax rate, to $79 million.
  2. Add the $79 million to reported long-term debt of $1 billion.
  3. Add the $7 million accretion expense to both EBIT and Interest expense.

As a result of these adjustments we can recalculate the ratios as follows:

Debt/Assets = (1.0 + 0.08)/5.7 = 18.9%
Interest coverage = (407 + 7)/(94 + 7) = 4.1x

The resulting ratios are noticeably different from the unadjusted ratios, but in this instance probably would not significantly impact the evaluator’s opinion.

Posted on 25th May 2007
Under: Accounting, Adjusting Reported Financial Statements, Case Studies, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Analyzing Company Press Releases: Reading Between the Lines

Companies frequently put out news releases, and these can often send clues to the investor who reads between the lines. One example of this type of work originally appeared at Stock Market Beat and is reprinted here with the author’s permission.

We’d venture to guess that not too many people follow both small-cap headset maker Plantronics (PLT) and large-cap enterprise software vendor Oracle (ORCL.) We do, which is probably the only reason we noticed this little gem. Both companies recently issued remarkably similar press releases, each extolling the other’s virtues.

Oracle Standardizes on Plantronics Wireless Headset Systems to Optimize VoIP Communications

“We evaluated numerous headset offerings to complement Oracle’s VoIP deployment, and the Plantronics Voyager 510-USB is clearly ahead of the pack for audio performance, ease of use and style and comfort,” said Mark Sunday, Senior Vice President and CIO, Oracle. “We are also very impressed with Voyager’s performance with Oracle Collaboration Suite. Now employees have a single wireless headset for all of their voice and data communications.”

Plantronics Standardizes Global Operations on Oracle(R) … – Yahoo! News (press release)

“We get a great deal of value and cost savings out of the Oracle system,” said Plantronics Vice President of Finance and Worldwide Corporate Controller Susan Fox. “The external auditors we work with have experience using the Oracle E-Business Suite and have developed proven methodologies for testing and verification. That expertise allows us to reap the benefits of economies of scale and avoid the process of educating auditors on the nuances of our system.”

Now, it’s quite likely that this was simply a way to share cost-free favors (talking each other up in a press release) as each business negotiated a standard supply contract. However, it is always something that should draw attention when two parties enter an agreement that may not be arms-length. It would be better to look at it and decide nothing is wrong than to overlook something that could potentially be a warning.

In Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, Second Edition (aff. link) Howard Schilit has this to say about such deals:

On October 5, 1999 Microstrategy (MSTR) announced in a press release that it had signed a deal with NCR Corporation…. Under the agreement, MSTR invested in an NCR partnership and NCR returned the favor and purchased MSTR’s products. We refer to that practice as a “boomerang.” (p. 44)

Later, Schilit elaborates:

A two-way transaction means that you both buy from and sell to the same party. Questions should be raised about the quality of the revenue recorded on such transactions….

If, as a condition of making a sale, the buyer receives something of value from the seller (in addition to the product) the amount of revenue recorded becomes suspect. This may involve a barter exchange, offering the customer stock or stock warrants, or investing in a partnership with the buyer. (p. 80).

In the cases of Plantronics and Oracle, there were no specifics regarding the size of the deals or time frame over which they extend. Neither is a major (10%) customer of the other, so there is some limit as to how much the deal could help one or the other. Questions investors may want to pursue include:

  1. Were the agreements similar in size? Revenue recognized from barter agreement is of lower quality (less likely to recur) than cash revenue.
  2. Given that Oracle’s fiscal quarter ends in November, the arrangement could have allowed them to book last-minute revenue. If their revenue for the quarter misses or only slightly exceeds analyst estimates when they report next Monday, a good conference call questioner could ask how much this agreement contributed (particularly with respect to license revenue.)
  3. Given that Plantronics is much smaller, they could potentially benefit more from the deal than Oracle but they are potentially in a less favorable bargaining position. Their investors might want more information regarding the size of the agreement for that reason.

Or, as we suggested earlier, it could all simply be PR fluffery. But even in that case it is best if investors know all the details.

Disclosure: At time of publication author is long Plantronics (PLT) call options and short Plantronics put options.

Posted on 28th February 2007
Under: Analyzing Press Releases, Case Studies, Fundamental Analysis, Investing in Stocks | No Comments »

Corporate Governance: A Silicon Laboratories Case Study

When you own your own business you can make sure that any managers working for you are acting in your interest. It is different for public companies, where management is not directly answerable to shareholders. In corporate governance terms, this is called the agency problem. How can a shareholder be sure management, who acts as the shareholder’s agent, is acting in the shareholder’s interest? In theory this is done through the Board of Directors.

For the board to be an effective guardian of shareholder interests, it should strive to mitigate conflicts of interest between stakeholders, and in particular between management and shareholders. Managers left to pursue their own agendas unchecked can grant themselves excessive pay, use shareholder funds wastefully, engage in nepotism and do many other things that could potentially be harmful to the shareholders.

Long-standing best practices and recent regulatory changes under the Sarbanes-Oxley act require that the board be independent from management, have the appropriate expertise to evaluate management performance and have the authority to act independently from management when necessary. However, independence can be subjective and difficult to judge. McEnally and Kim (CFA Institute, 2006) suggest that factors indicating a lack of independence include:

  • Former employment with the company
  • Business relationships
  • Personal relationships
  • Interlocking directorships (serving on multiple boards together, particularly if executives of one firm serve on the compensation committee of another board member’s firm)
  • Ongoing banking or other creditor relationships

Based on these criteria, we have concerns over the relative board independence at Silicon Laboratories (SLAB). Of eight board members, three are company executives or founders. Of the five classified as independent, four are either venture capitalists or investors, three were former executives at companies ultimately acquired by Hewlett Packard (and thus likely have personal relationships outside the Board of Directors) and 2 attended the Massachussetts Institute of Technology.

Any particular one of these relationships would not necessarily be sufficient cause for concern. Furthermore, it is possible that the ownership stakes held by the investor and venture capitalists make them treat their board responsibilities more like shareholders. All told, board members and executives hold more than 11% of the shares outstanding, which itself serves to link their interests to those of shareholders. However, according to the Silcon Labs proxy statement:

Silicon Laboratories believes that the backgrounds and qualifications of the directors, considered as a group, should provide a diverse mix of experience, knowledge and skills.

As diverse as any collection of venture capitalists can be, we suppose.

The other concern we have also relates to the share ownership, much of which is derived from option grants. Each director is granted 30,000 options upon joining the board, and each year every non-executive board member receives an automatic option grant of 5,000 shares and a discretionary option grant of 5,000 shares (which has always been granted.) Our concern is that, since responsibility for granting the discretionary options appears to fall to the CEO and one of the co-founders, these board members have reason to believe that they work for management rather than the shareholders.

While companies ignored any cost for options until recently and Silicon Labs still reports their value as the amount they are currently “in the money” (have exercise prices below the current share price) in the proxy statement, all one needs do is call up a quote to realize they are quite valuable. For example, as of yesterday’s close the July 2007 call options with a $35 exercise price (slightly out of the money) closed at $5.10 each. With 10 years to expiration and issued at-the-money, Silicon Labs directors options are clearly much more valuable than those quoted. Still, even at $5.10 each the directors receive a discretionary grant worth $25,500 each year (about the same as their cash compensation.) This is on top of an equal-size grant that is automatically awarded. In all, between cash and options the directors receive compensation worth at least $90,000 per year (equivalent to $10,000 for each board meeting attended.) And that is not counting the initial option grant, which is worth hundreds of thousands of dollars.

To be sure, some boards pay far more than that. But Silicon Labs is a relatively small company, with less than $500 million in annual sales. For example, newsprint manufacturer Bowater (BOW) only offers 1,500 shares of restricted stock (although it pays slightly more in cash compensation.) Bowater has annual sales of $900 million. Apparel retailer Buckle (BKE) has approximately $500 million in annual revenue and pays only $22,000 in cash compensation and 3,000 stock options. The level of director compensation at SLAB in comparison is another indicator that their interests are not completely independent from management.

The last bit of concern we have over the governance being provided results from their high level of CEO turnover recently (3 CEOs in as many years.) The initial candidate hired to replace the founders, Dan Artusi, was let go after a relatively brief stint. While it is true that things sometimes do not work out, his separation package allowed him to collect $165,000 in cash plus immediate vesting of options he was able to cash out for $2 million. These options, purportedly issued as “long term incentives” ended up rewarding a very short term indeed.

Posted on 21st February 2007
Under: Case Studies, Corporate Governance, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | No Comments »