Like it or not, companies are judged by flawed standards.
Generally Accepted Accounting Principles sometimes misrepresent business realities. Let’s use this fact to generate some alpha.
Starting with the first note, we’ll start by examining revenue recognition, the cash conversion cycle, and free cash flow.
“Revenue” isn’t revenue, it’s the timing of the contract.
Revenue is recognized when a contract between a company and a customer is fulfilled.
Here’s how it works according to the FASB:
Revenue recognition process
1. Define the contract with the customer.
2. Define performance obligations (promises) in the contract.
3. Determine the transaction price.
4. Allocating the transaction price to the performance obligations in the contract.
5. Recognition of revenue when (or when) the reporting organization satisfies a performance obligation.
There are many areas where GAAP revenue recognition can hit a snag and you can find opportunity.
1. Multilateral transactions
In multilateral transactions, “revenue” can mean the total dollar revenue in a transaction or subset that is recognized as the net revenue of a single company. Your last $20 Uber trip likely generated $16 in net revenue for the driver and $4 in net revenue for Uber.
The bottom line can be distorted when multiple parties transact before the end customer receives a product. Imagine that a drug manufacturer controls a distributor and the distributor increases orders in anticipation of end customer demand. These new orders inflate the manufacturer’s net revenue numbers. But what if the final customer request is not fulfilled? The manufacturer’s reported organic revenue growth may drive future revenue forward and stuff it into the distribution channel. These category definition games can present traps for growth investors and potential alpha for the shorts.
2. Changes in performance standards
When performance standards change, reported revenue can become an unstable metric. For example, selling the same software can result in different GAAP revenue numbers depending on whether it is structured as a license or a subscription. Subscriptions show lower GAAP profits early on but may reduce customer disruption over time. Shrinking GAAP yields is not a good outlook in the public markets. This is why the perpetual license transition to SaaS is such a popular private equity game: You can take a company private to change its accounting standard out of the spotlight, then take the company public with freshly cleaned books and a new story. Companies that make this kind of transition while public, like Adobe, can offer meaningful alpha opportunities to investors who understand how future accounting will play out.
3. Multi-year contracts
Does it matter if the transaction is recognized on December 31st or January 1st?
Companies want to report strong year-over-year growth for each period. Smart customers wait until the end of the quarter and then request a discount to book a transaction before the period ends. It’s the same as buying a used car after Christmas from a salesperson desperate to get his share at the end of the year. In a bad scenario, the company could be caught pulling in reduced demand each quarter just to chase last year’s numbers. In the worst case, future demand for that company will run out and its sales pipeline will decline.
But GAAP doesn’t make it easy to distinguish between temporarily withdrawn futures contracts (the noise) and increased customer demand (the signal). It’s also true the other way around – GAAP revenue doesn’t differentiate between slow customer demand (signal) and temporary sales delays (noise).
Private investors can look at what I will call the “hold term structure”.
Contract term structure
What you really want to see in GAAP is the Annual Contract Value (ACV) and Total Contract Value (TCV). ACV is the amount of work currently under contract for that year – whether it has already been recognized as revenue, billed but not performed, or contracted but not yet billed. TCV includes contracts and bills for future years. With ACV and TCV, you can see revenue recognition in the context of the full sales picture.
But any FASB proposal to add a contract term structure to GAAP would meet stiff resistance. School will be a lot easier if you can classify your homework. Imagine a high school student’s motivation to give their parents “strong guidance” for that semester report card. Even the best students like to keep their performance a secret – so why tell the competition about your performance? So the contract term structure will likely remain hidden and, therefore, would be an excellent place to look for opportunities.
Revenue is just a GAAP contract timing. As long as public investors overestimate these reported numbers, spotting contracts for revenue should remain a repeat alpha source.
The cash conversion cycle should be measured as a percentage and include deferred revenue.
The Cash Conversion Cycle (CCC) measures how long each dollar of working capital is invested in the production and sales process of an average transaction.
The idea is to track working capital efficiency from cash paid to suppliers to cash collected from customers.
Cash Conversion Cycle (current version)
CCC is a small return on equity (ROE). Each driver can be optimized in order to increase return on working capital. But unfortunately, there are two flaws in the current CCC scale.
The first problem is that CCC is calculated in days. What we really measure is the efficiency of capital over a period of time, usually a year. This is a ratio. Nobody calculates percentages in days. We should measure CCC as a percentage.
The second and more important problem is that the term is missing. CCC currently includes Accounts Receivable (cash owed to customers), Accounts Payable (cash owed to suppliers), and Inventory (cash paid in advance to suppliers).
What is missing is current deferred revenue (cash collected in advance from customers). It’s easy to see CCC oversight when we look at other working capital line items related to customers and suppliers:
The cash conversion cycle must include deferred revenue
CCC update makes light business easier to identify.
Companies that collect cash from their customers prior to contract performance (deferred revenue) can be highly cash efficient. But if CCC excludes deferred revenue, investors may overlook that these companies can expand on GAAP net income losses without increasing diluted equity. This omission may explain why SaaS and consumer subscription companies miscalculated five years ago. If you can find the comparison today, you’d be like the public SaaS investors of 2016, ahead of the curve.
The updated CCC also makes it easier to flag the dreaded SaaS death spiral. Fast-growing companies can be very fragile when they rely on deferred revenue to meet ongoing cash needs. If their GAAP revenue growth falters, they could quickly find themselves in a cash shortfall. Oddly enough, these companies can show excellent GAAP revenue numbers while teetering on the brink of bankruptcy. If the CCC doesn’t include deferred revenue, you can’t see the canary in the coal mine.
“Free cash flow” isn’t free cash flow, it’s a cumulative measure.
“Free cash flow” doesn’t always equal the actual cash generated by the business.
This raises a problem in academic finance because the cornerstone model for equity valuation is John Burr Williams’ discounted cash flow (DCF) analysis. You might ask, if investors cannot measure free cash flow (FCF) reliably, how can they discount and value these cash flows reliably? Good question.
Here’s the standard definition of free cash flow:
The standard free cash flow formula
|+ Cash flow from operating activities||Statement of cash flows|
|+ interest expenses||income statements|
|– Tax shield on interest expenses||income statements|
|capital expenditures (capital)||Statement of cash flows|
(cash flow from investing activities)
|= free cash flow|
This all seems obvious until you look at how much appreciation goes into accrual numbers for a given period and how much those cumulative numbers affect FCF.
Why “free cash flow” may not be free cash flow
Intangible assets developed internally are the risk area in today’s market. Most investors agree that we should take advantage of a portion of our R&D and S&A expenses, but no one is sure how long these intangible assets will last. Google’s search engine must survive in some form for decades to come; Ask Jeeves, probably not. How can we come up with a consistent rule to consume Google and AskJeeves pre-engineering efforts?
To make matters worse, intangible capital expenditures may be hidden in items not included in FCF accounts. If you look closely, the company’s acquired intangible assets and financed leases may just be capital expenditures in disguise. Proper accounting for internally developed intangible assets is perhaps the most important unresolved problem in GAAP.
Investors who focus on free cash flow return often compare dividends, rightly or wrongly, to bond coupons. But because the current FCF is full of such accrual assumptions, we cannot naively predict the current FCF to estimate the normalized FCF. Companies have a strong incentive for perceived stock coupon injection. The yield of squeezed FCF is similar to the high-yield vibrating bond, also known as the sod yield.
Alpha opportunity is to determine when the natural FCF will differ significantly from the current FCF. Stocks in which the company needs to lower its dividend yield — whether it’s a dividend, share buybacks or debt payments — can be good sells. Long opportunities can arise when a significant portion of current capital expenditures, research and development, or sales is flipped into a depreciable fixed cost. The real difficulty is making sure the fixed asset you’re betting on isn’t about to become stuck – lest you end up backing AskJeeves instead of Google.
Moving on to the balance sheet
Here’s how the puzzle pieces start to fit together for the long and short and entrepreneurs:
We can recharacterize the balance sheet as well. From there, we can revisit the weighted average cost of capital as well as the market value of shares and stock-based compensation.
More ideas from Luke Constable can be found at Lamba’s Capital Library.
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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