Huron Consulting Group's Crash: Red Flags Abound

Some say the consulting biz is the only biz (to be in), providing the advice given to clients is appropriate, ethical and legal. In contrast, anything which rose from the ashes of Arthur Anderson might, to some, have the taint of damaged goods...or at least be viewed dubiously.

The restatement "bombshell" Huron's management dropped on Monday was a shocker indeed. In a post Sarbanes-Oxley world, who would have thought accountants-who-provide-expertise-to-other-accountants might be so wrong with their own ledgers?

Granted, the audit committee was right to spill the gruel (better late than never), but why now and where the hell was the board? More importantly, were there any clues in the financial statements leading up to this fiasco which might have flashed warning flags to investors?

We don't follow this company, but much of the current hubbub involves the treatment of "misreported" costs related to acquisitions. With that in mind, let's start with Goodwill.

Goodwill is an intangible asset and subject to annual impairment testing. Determining the value of goodwill is hazy at best, when you consider it's inclusive to patents, brand names, etc. above and beyond book value. Thus, consider goodwill as the cost of an investment in excess of book value.

In Huron's case, goodwill as a % of total assets (March 2008 through March 2009) averaged 50%. This is red-flag #1. Goodwill as a % of shareholder equity during the similar period averaged 137%, also a huge red flag.

Dual cash-flow analysis also revealed some troubling signs. Operating cash-flow turned negative in Sept. '08 and remained negative through March 2009. In contrast, balance sheet cash-flow skyrocketed in Sept. and remained elevated through March. This would suggest earnings were largely dependent on accounting maneuvers rather than cash-paying customers.

It was their use of accrual accounting however, which we believe provides the best reason to avoid HURN in the first place. In our model, accrual ratios greater than +5 should be avoided. Indeed, HURN's accrual ratios have been declining since Sept., but the average +17.31 ratio during the periods reviewed has SELL written all over it.

It would be so easy to say "we told you so", but this is after the fact. Besides, it's literally impossible to predict the timing of corporate events let alone be privy to every movement behind executive doors.

However, we can say with certain confidence that investors who pay attention to changes in a company's financial statements (over time), are far less likely to get caught with their pants down when poop-hits-the-fan.

Disclosure: No position

Comments

[Edith Orens...:]

Jason, although as you note your analysis of Huron is 20-20 hindsight, I thought your post describing red flags at Huron was very interesting (shocking even).

Aug 05 07:18 PM

[Francine Mc...:]

Great stuff Jason. Proper revenue recognition is the killer app for consulting firms. Interestingly enough, it was key to the downfall of another PwC audit client, BearingPoint. Isn't that precious?

Aug 05 08:33 PM

[Tom Colangelo:]

On Monday, after reviewing the issues at hand, the UBS analyst EXPERIENCED with HURN reiterated his BUY RECOMMENDATION with a fair mkt value of 25 in 9-12 months.

He could have taken the easy, safe way out and recommended a HOLD or SELL, but he said BUY.

Think about it, a guy who knows this firm inside and out says BUY when, if he's wrong, he gets his career blasted. Yet he says BUY.

I'm confident he knows more about this situation than any of the armchair analyst who gather charts from all over the web to piece together a fashionable presentation on something they only heard about yesterday.

This is like GE when all of the wannabe analysts jump on the bandwagon and declare thast this firm is in trouble, when nothing could be further fron the truth.

Aug 06 09:04 AM

[District Ba...:]

Tom -

There's one major flaw in your logic: the UBS analyst in which you seem to be abundantly confident had a 'buy' on the stock at $45... and it went to $15. Doesn't sound like a 'buy' to me. Now, he feels like an idiot and cant whipsaw his rating on the stock around ("buy at $45, hold/sell at $15"). Happens all the time on the sell-side.

Aug 06 10:11 AM

[Tom Colangelo:]

The BUY assumed no extraneous event that could adversly effect the price. Obviously when that event occured, his initial recommendation was null and void and he was free to make a fresh assessment.

I don't think that reflects on him at all. It happens all the time that an unexpected event changes an outlook and a forecast.

What the stock went down to (15) had nothing to do with his new assessment that put fair value at 25 in 9-12 months.

And lastly, I see no reason why he couldn't have whipsawed his rating since the firm's blunder gave him that out. And yet, after talking with HURON management during the weekend, he gave it a BUY.

In my opinion, that says it is very likely to blow over in a month or so.

On Aug 06 10:11 AM District Banker wrote:

> Tom -
>
> There's one major flaw in your logic: the UBS analyst in which you
> seem to be abundantly confident had a 'buy' on the stock at $45...
> and it went to $15. Doesn't sound like a 'buy' to me. Now, he feels
> like an idiot and cant whipsaw his rating on the stock around ("buy
> at $45, hold/sell at $15"). Happens all the time on the sell-side.

Aug 06 08:53 PM

[elipsemaster:]

Jason,
What do you mean by accural ratio?
Also are you saying that their cash isn't cash?
Their cash flows through 3/31/09 shows a positive 2,052,000. Are you saying this is not real?
Also their first quarter operating income shows a gain of 21,842,000.
I don't get what you are trying to say.
elipsemaster

Aug 15 10:46 PM

[Jason Merriam:]

elipsemaster,
Every company's earnings have both a cash and non-cash component. Suppose I report earnings of $500,000. However, cash-flow, the increase in my bank balance, shows $700,000.

The difference comes from "adjustments" - depreciation, changes in inventories and receiveables ( two-steps and one-step away from cash respectively), bad debt allowances, etc. Together, these are known as accruals.

Although most of our accrual data comes from balance-sheet items, you can look to the statement of cash flows for clues also.

Example: Start with reported net income, strip out changes in depreciation, goodwill impairment, and changes in capital spending. (Keep in mind that depreciation is a tax benefit, not an expense).

Negative accruals suggest a company is not fluffing up earnings with lots of non-cash charges. However, accruals have to be put in context to a company's size and assets.

And, accrual analysis doesn't work so well with banks and insurance companies. They are capitalized much differently, and as we have discovered, making sense of their financial statements is at best, a crap-shoot.

If you would like more information, we have links to articles on related topics in our website at merriamreport.com (click the product information tab). Hope this information helps to answer your questions. JM

Aug 18 01:47 AM