The fourth and final characteristic that we look for in an attractive short candidate we call Misperceptions. This type of short relates to the masking of a business’ true underlying economics, typically through the use of clever accounting techniques. CFOs are typically highly-skilled at twisting accounting rules to paint a better-looking picture of a company’s financials than perhaps the underlying economics of the business should warrant. An extreme case of Misperceptions is fraud.
A review of the first three characteristics that we look for in an attractive short can be found here:
Back to Misperceptions. There are numerous ways in which CFOs can make their accounts appear better than they should otherwise look. To name a few:
- Managers can acquire other businesses to create the perception of growth;
- Managers can write down the value of acquired assets to reduce future depreciation expense and increase future earnings;
- Managers can sell assets and book one-time gains in their income statement to create the perception of higher recurring earnings;
- Managers can reverse previously taken provisions in a period where earnings fall short;
- Managers can classify expenses as capital investment to avoid running them through the income statement to boost earnings; and
- Managers can and do create a litany of financial metrics that fall outside the guidelines of the accounting rules, and which are often more favorable to the company, to focus the attention of investors.
On this last point, your author is reminded of the almost farcical profitability metric created by pizza company Papa Murphy’s Holdings (NASDAQ: FRSH) upon listing in 2014:
Adjusted EBITDA is calculated as net income (loss) before interest expense, income taxes, depreciation and amortization as adjusted for:
- all non-cash losses or expenses (including, but not limited to non-cash share-based compensation expenses and the non-cash portion of rent expenses relating to the difference between GAAP and cash rent expenses), excluding any non-cash loss or expense that is an accrual of a reserve for a cash expenditure or payment to be made, or anticipated to be made, in a future period;
- non-recurring or unusual cash fees, costs, charges, losses and expenses;
- fees, costs and expenses related to acquisitions and debt refinancing costs;
- pre-opening costs with respect to a new store;
- management fees and expenses incurred under our advisory services and monitoring agreement with Lee Equity;
- fees and expenses incurred in connection with the issuance of debt under the new senior secured credit facilities and related transactions; and
- non-cash expenses resulting from purchase accounting adjustments made in accordance with GAAP with respect to acquisitions.
Of course, profit before expenses is going to look pretty good. But it’s not a particularly helpful reflection of the actual profit left over for shareholders.
In Montaka’s most recent quarterly letter (which can be found here), we discussed Penn National Gaming (NASDAQ: PENN) as a great example of a Misperceptions short. In our view, through the use of a clever restructure, the CEO has been able to extract substantially all of the business value into a new entity called Gaming and Leisure Properties (NASDAQ: GLPI). Of course, the CEO didn’t stick around at PENN, he instead became the CEO of GLPI and transferred his stock options from PENN to GLPI. As we showed in our analysis, we believe PENN is significantly understating the debt on its balance sheet, which significantly overstates the book value of shareholders’ equity (which is already negative).
Investors need to be aware of the various tricks that can be employed by CFOs; and have the discipline to spend the time to forensically analyze the accounts of the businesses in which they are investing. At Montaka, we analyze the accounting quality of all businesses we invest in, both long and short. On the short side, egregious cases of Misperceptions are opportunities where we can identify deteriorating business quality that market has likely missed.
Montaka is short the shares of Penn National Gaming.