There are many different accounting red flags that can signal a problem internally with a company. Some consist of asset tricks while other are earnings distortions. When managers artificially tailor their business to the bottom line 10Q numbers, they leave an accounting trail in other places. Microsemi (NASDAQ:MSCC) shows some red flags in its accounting.
One of the easiest things that I like to look for is sales manipulations. What happens is companies will use aggressive Sales Recognition in their accounting system to keep growth rates high for quarterly releases. In turn, the growth and momentum players jump on board and push the stock higher, increasing the price of the stock. The problem is when the growth starts to slow (not even decline), the mini-ponzi scheme cannot be fed anymore. What you see is inventories and accounts receivable build up a sales growth slows down. Let's look at some graphs for Microsemi.
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When sales were growing above 20%, inventories were stuffed in 2006 at a growth rate of 58%. From this, they tapered off to 30% and then 5% with sales at 19% and 16% growth rates. Then in 2010, we saw inventories grow at 32.3%. Accounts Receivables growth at 25.9%, but sales only grow at 14.4%. This is showing a blocked sales channel as inventories and A/R build up. We also see that the Sales are not carrying through to earnings.
Another problem I see with MSCC are the asset write downs, which destroy value of the firm. The 10K filed for 2010 states:
During 2009, we recorded a held for sale impairment of $1.7 million related to the real estate and building for our closed manufacturing facility in Broomfield, Colorado and a held and used impairment of $4.5 million for the anticipated closure of our manufacturing facility in Scottsdale, Arizona to reflect our long-lived assets at their lower fair value.
These assets impairments are allowable using GAAP, but not upward. In other words, as they are impaired, then can be revised downward, but should they increase in value again, management can leave them at a reduced carry value on the balance sheet, inflating profitability ratios.
The company has also increased its Long-Term debt load recently, which increases its financial leverage. While this helps ROE during good times for the company, it can destroy earnings in a flash once the sales channel slows down.
On the technical side, MSCC is right on the line of going bearish. It has formed a full reversal Dark Cloud Cover on the weekly chart. Failure to make new highs over this pattern could be the beginning of a double top. Also, re-entry into the congestion zone would be bad for MSCC as it just broke over it. The RSI is sitting atop its trend line weighing heavily, and looks as if it's about to break it.
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On the daily view, we see that the strong trend line has already been broken. As a security rises and comes out of its markup stage, it begins to move linearly with its moving averages. When this happens it can be a sign that distribution is beginning to take place. We see a long-term divergence as RSI makes lower highs, and weakness beginning to form in the Force Index (a volume adjusted view of price). A breakdown from its current consolidation would be an entry into this stock for the short side. The risk is that many momentum players are watching this and could push it up even further. Preempting this trade would not be advisable, but a good entry with a tight stop could offer large profits.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.