Since joining Forager a few months ago, I’ve learned a lot about the benefits of scepticism. Sure, I knew to take management’s words and accounts with a grain of salt. But Steve and Alex open each financial report assuming it’s from the next Enron.
It didn’t take long to see why. The other week Steve spotted something dodgy in Greencross’s half yearly report. At the time of an acquisition in 2014, Greencross took an onerous lease provision related to the acquired company’s stores. In the latest half year report the (now former) management team reversed that provision, for a one-time boost in profits.
What’s more revealing is management also provided an ‘adjusted’ earnings estimate that neglected to adjust for this one-off boost. What should have been a 3% decline in underlying earnings per share (EPS) for the first half of 2018 magically became an 8% increase.
Taking a closer look
New management has taken charge since the half year report, and deserves credit for pointing out the issue. But I decided to take a closer look at the same accounts to see what else might be lurking. One flea is rarely the last. Indeed, it turns out they have been using a few more accounting tricks.
Here’s one. Take a look at Greencross’ software amortisation policy.
This table shows the accounting for software the company develops in-house. Developing or buying software costs real money. And there are two ways a company can account for such a cost. They can fully ‘expense’ it as incurred, meaning the cost flows through the profit and loss statement the year the software was bought or developed. Or they can ‘capitalise’ it, stick it on the balance sheet as an asset which then gets ‘amortised’ through the profit and loss statement over a number of years, in line with the expected useful life of the software.
Prior to 2014, Greencross seems to have expensed all software costs as incurred (if any), which is the most conservative treatment. Starting in 2014, they opted to capitalise and then amortise that cost over a period of years.
The period used to amortise such software, an asset which tends to become obsolete fairly quickly, jumps out most. Three to five years is typical. When Greencross started capitalising then amortising software in 2015, it opted to do so over a 10 year useful life. In a world of rapid software obsolescence, 10 years is an awful long time.
And in 2016 it lengthened that useful life from 10 years to 15 years. How many pieces of software that you bought in 2003 do you still find useful today?
The ‘Additions’ line above shows an almost 4-fold increase in cash spending on software between 2014 and 2017, and more than five-fold if you annualise the first half rate of spend. But the amount being recognised as a cost in the profit and loss statement was trifling. Making some downward adjustments to historic results seems in order.
As you can see in the table above, after excluding the onerous lease add back and assuming a 5 year software life, underlying earnings per share should have declined by 8% in the first half of the 2018 financial year. There would not have been any growth in the 2016 or 2017 financial years. If they fully expensed software costs, underlying earnings per share should have declined by 13% in 2017 and 22% the first half of this year.
Does a few million dollars here or there swing the dial on an investment decision? Maybe not on its own. And this should be a decent business. Spending on pets is growing and resilient and the opportunities for consolidation are significant. New management are clearly giving it a good bath. (The sceptics tell me the next step will be to write off those capitalised IT costs, non-cash of course). So don’t be surprised to see us own Greencross one day.
But it has been one of the most insightful lessons of my first few months at Forager: earnings clearly aren’t always earnings.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.