Companies that slash distributions often see their share prices decline by half, making them dangerous for client portfolios.
Enerplus, for instance, dropped 57% in the six months after we warned about its dividend last December.
When looking for income-oriented names, focus on dividend sustainability and the potential for future increases in distributions. Dividend sustainability and growth are rooted in cash-flow sustainability and growth, which means that companies’ accounting must be checked when assessing cash-flow results.
We encourage advisors to look at potential accounting problems in the context of an accounting issues pyramid.
The top is fraud, the middle is management manipulation, and the bottom is investor interpretation. The top represents the most serious allegations of fraud, which are fewest in overall number — think Livent and Sino-Forest (see “Fraud slipping past Canadian regulators,”). The middle includes considerably more cases, including those where management uses vague accounting requirements, or is otherwise muddying the financial reporting with non-standard practices.
The bottom of the pyramid represents the largest cohort and includes situations where investors tend to misinterpret weak or confusing accounting rules. Keep in mind accounting guidelines are often vague, making it difficult to properly compare figures between companies. Better voluntary disclosure by the companies would go far in clearing up investor confusion.
Source: Accountability Research Corp.
Understanding the difference between the bottom two levels of the pyramid is made easier with examples taken from our Accounting Impact list (see chart, right). All companies on the list employ accounting practices that could result in a material impact on target price.
Without a quantified impact on target price, an accounting warning is useless to advisors and clients. Worse, investors run the risk of avoiding decent companies due to immaterial accounting issues. This hurts most when such stocks continue to increase in value over several years, or worse, get acquired at a significant premium.
The bottom: weak accounting rules
The bottom of the accounting pyramid includes many situations where investors run the risk of misinterpreting cash flows due to weak or confusing accounting rules.
We mentioned in July AER (“Companies hide billions in pension liabilities”) that due to vague pension accounting rules for mandating discount rates, BCE is able to keep billions in liabilities off its balance sheet. We believe the company has delayed recognizing $1.6 billion in pension liabilities. Once they’re acknowledged, they could hamper dividend increases post 2013.
Other missing pension liabilities exist in companies such as Metro, Loblaw, and UPS in the form of deficits for multi-employer pension plans. Weak accounting rules allow companies to not disclose these liabilities, for which they are ultimately responsible. These deficits are not only missing from the company’s balance sheet, but also go unreported in the notes to the financial statements.
Another accounting practice that has a material impact on cash flows, and therefore target prices, is the requirement to recognize asset retirement obligations. In the energy sector, many producers in the oil sands are not recognizing sufficient liabilities for future cash amounts that will be needed to decommission their operations and restore the oil sands environment.
Unfortunately, the old accounting approach still pervades to a certain degree: if management believes it is too difficult to come up with an estimate for the future cash cost of the remediation efforts, it does not recognize a liability at all. In addition, under the new accounting rules, there can be problems with management’s chosen discount rates, which can swing the estimated amount of the liabilities by billions of dollars.
The reason this issue is a persistent problem in the sector is because of the longer life of oil sands assets versus more conventional operations. The downside for investors is that some companies are not recognizing all of the cash costs of producing oil, thereby inflating share prices.
These examples generally fall into the category of investors misinterpreting the strength of the accounting guidelines, and underestimating the leeway that management has within the rules, whether in projecting future cash costs, selecting discount rates, or ignoring certain liabilities altogether.
The middle: Pushing the envelope
Moving up the pyramid, the middle level includes examples of companies that push the envelope of already vague accounting rules, which could direct investor attention away from unattractive results.
Just Energy Group is a good example where the company’s practices can confuse investor interpretation of cash flow and dividend sustainability.
While some sell-side analysts and the company disagree, our analysis says Just Energy’s dividend is not sustainable over the longer term and is only being supported by the market’s perception of strong cash-flow results. These perceptions are based on the company’s non-standard use of its own measure of earnings.
The company encourages analysts and investors to use its Adjusted EBITDA measure as the basis to assess the sustainability of its dividend. In September, Just Energy’s stock yielded over 11%. In our opinion, some of the add-backs to Adjusted EBITDA represent expenses that are part of everyday business, and should not be excluded from the company’s main performance measure.
We also believe Just Energy is facing a further cash squeeze in the form of higher interest expenses, and that its balance sheet is in a poor state due to high debt levels, high intangible asset levels, and negative shareholders’ equity.
The company recently restarted its dividend reinvestment plan after cutting it earlier in the year. By enrolling in the plan, Canadian investors can receive their dividends as additional shares instead of cash.
This allows Just Energy to pay more dividends with less actual cash. But longer-term, it means there are more shares outstanding that need to be paid dividends as well. In other words, that strategy can’t be carried on indefinitely.
On the whole, advisors can serve their clients well by focusing on dividend and cash flow sustainability and growth. This can be done by adjusting the target prices of companies whose accounting does not stack up to peers, and by avoiding companies whose results look worse when measured by standard accounting rules.
Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE, run Accountability Research Corp., providing independent equity research to investment advisors across Canada. www.accountabilityresearch.com