We have all heard the proverb, "you cannot judge a book by its cover." Similarly, in the investing world, you cannot judge a company entirely by its reported earnings per share. Much has been written about companies whose operating cash flows do not match their net income, making the net income perhaps deceptive. Because of a 2009 accounting change, another net income deception can sometimes occur. The accounting change for acquisitions has had a significant impact on earnings per share for acquisitive companies who use contingent cash consideration as part of their purchase prices.
An acquiring company often agrees to pay cash subsequent to the acquisition if the company it acquired meets certain performance targets (i.e. 10% revenue growth, etc.). Under the previous accounting rules, the company would record goodwill at the time it made these contingent payments for whatever amount it paid. Under the new accounting rules, the acquirer is required to make assumptions about what it will pay and record the future liability owed to goodwill at it fair value. Each time it reports operations subsequently it is required to analyze its assumptions and records any changes in fair value to the income statement.
As a simple example, suppose Bobby Burger acquired Sally Sandwich for $10M plus up to $2M in 2 years based on certain targets Sally has to make. At the acquisition date, Bobby records a fair value liability of $1M. A year later, it becomes obvious that Sally is not going to be able to reach the goal. Bobby reduces the liability to $0 with the other side increasing income by $1M! Thus, Bobby has probably made a bad acquisition, yet he is seeing a short term bump in earnings. On the other hand, if after a year, it was clear Sally was going to exceed all targets, Bobby would increase the liability by $1M and record a reduction to income of $1M.
There were a number of stocks who have recently changed the fair value of their liability, which has impacted their earnings. Seven stocks are highlighted in this article. The first five adjusted the liability downward, which generally means two things. First, their earnings number is artificially high. Granted, it is cash they will not have to pay, but it is cash they also did not earn as part of their acquisition and it is non-recurring earnings. Second, the acquisition has not performed as well as they originally expected.
The final two companies adjusted their liability upward. Generally, this means their earnings number is artificially low, and the acquisition is performing better than original expectations.
For the companies below, I assumed a 40% tax rate if I could not find a relevant tax rate.
Willbros Group, Inc. (WG) -- for the quarter ended March 31, 2011, instead of a $44.4M loss, WG lost $48M as the earnout liability was reduced by $6M, $4.2M tax effected. WG expects to be profitable in 2012.
VSE Corporation (VSEC) -- this one felt the most deceptive. Hidden away at the end of note 8 of the Company’s 3/31/11 10Q, we find: "We recorded an adjustment of $603 thousand related to the change in the fair value of the earn-out obligations during the three months ended March 31, 2011 as a reduction of contract costs and other liabilities." This reduced the liability and decreased expense, increasing income by $603,000. Taken away this non-recurring event, after tax net income would be approximately $3.8M and EPS would be $.73, about a 10% decrease. Furthermore, one would expect an increase in the fair value of the earnout liability due to the impact of the present value of cash flows as it gets closer to the payment date, but the fair value of the liability actually is decreasing. Thus, the acquisition appears not to be living up the VSEC’s expectations.
VSEC appears to be starting to get desperate, as it recently acquired Wheeler Brothers, Inc., a supply chain management company, for $180M in cash with potential additional payments of up to $40M. This acquisition is more than VSEC is worth, so VSEC is becoming in large part Wheeler Brothers, Inc. VSEC had no cash to make the payments and thus must have financed the acquisition entirely through debt. On top of this, it just increased its dividend with cash it did not have. VSEC is probably a sell down to $25/share and then to be watched closely to see how the Wheeler Brothers acquisition works out.
Hologic, Inc. (HOLX) -- "During the second quarter of fiscal 2011 (ended March 26, 2011), the first earn-out period ended, and we adjusted the fair value of the contingent consideration liability for actual results during the earn-out period, for which the payment was made in the third quarter of fiscal 2011. In addition, we updated the revenue and probability assumptions for the future earn-out periods and lowered our projections. As a result of these adjustments, which were partially offset by the accretion of the liability, and using a current discount rate of approximately 17.0%, we recorded a reversal of expense of $8.0 million in the second quarter of fiscal 2011 to record the contingent consideration liability at fair value. At March 26, 2011, the fair value of the liability is $22.6 million." Company also recorded a charge of $2.7M related to another purchase, so the net amount to income was $5.3M. This changes diluted EPS by .01, which could be significant if one also backs out the intellectual property sale that occurred in HOLX’s Q2 (approximately 3% of diluted EPS with sale and 10% of EPS not including sale).
Resources Connection, Inc. (RECN) -- Through the 9 months ended February 26, 2011, more than half the Company’s net income relates to an earn-out adjustment downward. Ignoring the earnout adjustment, diluted EPS would be approximately $.22. Analysts expect $.10 for RECN’s final quarter, putting its recurring EPS for its fiscal year end forecasted at approximately $.32 and current P/E at 45. As mentioned above, this also means the acquisition has underperformed expectations.
SuccessFactors, Inc. (SFSF) -- Ignoring the earn-out adjustment, Company’s quarterly EPS would be $(.02) rather than the $.03 reported. Acquisition appears to have significantly underperformed expectations.
The Advisory Board Company (ABCO) -- This one is going in a positive direction; the liability increased. $1.5M to expense and reducing net income, as the acquisition has performed better than expected. Adjusted EPS is 1.18 for the fiscal year ended March 31, 2011, versus the original 1.13 the Company reported, bringing the P/E down to 42.5.
Asia Entertainment & Resources, Ltd. (AERL) -- This one also is going in a positive direction. The liability increased by $2.4M for the quarter ended March 31, 2011, as the acquisition is going better than expected. Ignoring this charge, EPS would be $.44 for the quarter. This stock appears to be cheap based on current and forward P/E. I plan on doing some additional research.
In summary, the earnings of the companies above and other acquisitive companies must be analyzed for their true recurring earnings. While not the only factor one should consider in buying or selling a company, fair value changes in contingent liabilities can have a significant impact on a company’s earnings, as noted with the companies above. Astute investors should open the book and read all the pages, whether those be press releases or company filings. Getting past the cover will enable them to determine recurring economic earnings and in turn to value a company properly.