A MOTLEY FOOL BIG SHORT SPECIAL REPORT

5 Red Flags --
how to find the
BIG short

Motley Fool
Big Short
TM

August, 2010
5 Red Flags -- How to Find the
Big Short
Brought to you by John Del Vecchio, CFA & Matthew Argersinger

“Each year, billions of dollars are pocketed by investors who

can identify financial chicanery BEFORE it escalates -- and
sell the offending companies short.”
Great managers somehow resist Wall Street’s demands for short-term results. In so doing, they create massive long-term wealth
for investors. Though be warned, they’re a lot rarer than you think.
More often, “beat the number” is the only game in town. Add stock options to the mix -- or lavish cash bonuses tied to short-term
earnings or stock price targets -- and the temptation to focus on quarterly results becomes irresistible.
It’s the same old story. Beat by a penny… “Congrats on a great quarter”… the stock price climbs… the pressure builds.
To keep the good times rolling, some managers get creative with their accounting. Others graduate to dishonest or misleading
tactics. The worst of the worst -- as Enron, Worldcom, and more recently, Satyam painfully taught us – are driven to outright fraud.
But here’s the thing: No business, no matter how great, can escape the business lifecycle. Eventually, all companies stumble.
Accounting trickery can disguise a decaying business, but only so for so long. And the cost to those left holding the bag can be
immense.

But the news is not all bad

Each year, billions of dollars are pocketed by investors and analysts who can identify financial chicanery BEFORE it escalates
-- and sell the offending companies “short.” The amount of wealth protected by investors who purge their portfolios of these
ticking time bombs is untold.
I know this first hand. I spent the past 15 years digging behind the “reported” numbers, both identifying potential short candi-
dates for some of the nation’s top-performing short funds and reviewing portfolio positions for successful long-only mutual funds.
I hope you agree that my track record speaks for itself.
From 2001 to 2002, I worked as a lead analyst at the Center for Financial Research & Analysis under Howard Schillit, a pioneer
in earnings quality research. The investment ideas I passed on to some of the nation’s top institutional investors (at $5,000 per
month), outperformed the S&P 500 by 26 percentage points on average. From 2003 to 2007, I produced “short” research for

Table of contents
5 Red flags that reveal BIG short opportunities Plus: First look at a new
Red Flag No. 1 -- Accelerating Revenue Recognition earnings-quality model
Red Flag No. 2 -- Weakening Cash Flow that pinpoints “short”
Red Flag No. 3 -- Unusual Changes in Profit Margins
ideas before the bottom
Red Flag No. 4 -- Highly Acquisitive Companies
Red Flag No. 5 -- Changes in Reporting
falls out

2 Motley Fool Big Short Special Report — August, 2010

David Tice’s Prudent Bear Fund, where my “short” ideas beat is not only managing to the stock price at the expense of the
the S&P 500 by 15 percentage points -- during a strong bull business, it’s sending us a clear signal that something is amiss
market. – and the clock is ticking.
Most recently, I managed the Ranger Short Only portfolio Accelerated revenue recognition particularly concerns
from 2007 to 2010, where I outperformed the S&P 500 by 40 me because revenue drives the income statement as well as
percentage points. In all, I’ve beat the market nine of the last the strength of the balance sheet. Moreover, because early
10 years, in bull and bear markets, alike. recognition tactics in effect pull revenue forward from future
quarters, the risk of a future shortfall or punishing earnings
Clearly, this has worked out well for the institutions I’ve miss increases dramatically.
worked for. But it never made sense to me that the best
research and techniques should be denied to the individual Here are a few clear signs of aggressive revenue recogni-
investor – who can least afford to be caught holding the bag. tion:
Well, no more. In the next few pages, I’ll pass along a few • An increase in days sales outstanding (DSO). DSO mea-
“tricks” I’ve honed over the years that have consistently led sures the number of days in a quarter it takes for a company
me to uncover ticking time bombs. Some have gone on to to collect on its bills. A higher DSO number is an indication
be profitable short positions; others have protected my em- of aggressive revenue recognition, poor cash management,
ployers’ assets from costly and embarrassing blow ups. or both.
I hope you enjoy and profit from the five “red flags” high- • Use of percentage-of-completion accounting. Under
lighted in this report. I’ve used all five with great success over this method, companies recognize revenue earned on long-
the years, and they feature prominently in my new proprietary term contracts in proportion to the work performed, even
“EQ-Scan” earnings quality model currently under develop- though the customer may have yet to be billed for the work.
ment. Managers may, willfully or not, overestimate the proportion
of work completed, providing a premature boost to revenue
Because you were kind enough to request my report, I’d and profits. Investors should watch for any sharp increases
love to tell you more about this new model – including how in unbilled receivables relative to revenue.
you can use it yourself to identify potential winning short can-
didates and to purge your portfolio of low-quality companies • Related-party revenue. Any time a company generates
– just as soon as it’s finished. an increasing portion of its revenue from an affiliated party,
it’s a cause for concern. Without knowing the true nature of
I’ll notify you by email in the next few weeks. For now, let’s the relationship, it’s impossible to determine the appropriate
begin with my first Red Flag… amount of revenue that should be accounted for in a given
period.
Red Flag No. 1 -- Accelerated revenue
recognition • Big swings in deferred revenue. Subscription-based
Investors usually don’t think of a company’s revenue as a companies or software firms often receive cash in advance
likely source of financial shenanigans. After all, with earnings of delivering the product or performing the service. A sharp
-- where managers have wide discretion and levers to pull and unexpected drop in deferred revenue will boost revenue
-- it’s wash, rinse, check for the desired number, and repeat. in the short-term at a potential cost to future quarters.
With revenue, it’s more like what you see is what you get, • Booking one-time gains or interest income in revenue.
right? Sometimes, companies will report gains from asset sales
Not necessarily. With top-line revenue, it’s all about recog- or interest income as part of revenues when they should be
nition. When demand starts to slow, aggressive management reported elsewhere on the income statement. Obviously,
teams can accelerate revenue recognition to give the appear- these types of gains aren’t an appropriate metric to measure
ance that end demand is still strong. the health of the company’s operations. A good analyst will
be sure to remove these artificial gains when measuring
For example, a company may extend payment terms to changes in revenue.
customers who agree to make a purchase today instead of at a
planned later date. Or it might begin to book revenue from a Case in point: Computer Associates, (NYSE: CA). In the
software license, even though the product hasn’t been deliv- late 1990s, enterprise software firm Computer Associates
ered to the customer yet. got into serious trouble with the SEC. Computer Associates
sold long-term licenses for use of its mainframe computer
Of course, when demand is strong, management doesn’t software.
need to engage in such tactics. When it does, management

Special Report — August, 2010  Motley Fool Big Short 3

 But the impressive results masked a serious deterioration in
its operating cash flows. In the second quarter of 2005, Helen’s
earnings climbed from $13.1 million in the prior year to $18.8
million, but its operating cash flow declined from $1.6 million
(already low in relation to earnings) to negative $19.3 million.
Helen’s business eventually hit the skids in 2005 and its stock
price declined sharply from a high of $36 in 2004 to nearly
$10 by 2008.

By the time the SEC crashed Computer Associates’

party, shares had already begun a quick 70%
plummet.

But despite the fact that some of these licensing contracts

had terms extending multiple years in length, CA would
recognize the present value of all licensing revenue for the
entire contract immediately. It turns out that CA prematurely
recognized more than $3 billion in revenue in the years 1998
- 2000. Investors could have spotted CA’s scheme by recog-
nizing its surging accounts receivable line and DSO.
If you caught on to Helen’s deteriorating cash
If you’re not an accountant, or some of this seems a little flow early, you could have sold short for over 72%
onerous, don’t worry. It’s not as difficult as it sounds, and I
gains.
have an intriguing solution I’ll tell you more about just ahead.
Red Flag No. 3 -- Unusual changes in profit
Red Flag 2 – Weakening cash flow
margins
Cash is king. Like the cash register at your local mom and
Strong profit margins tell us that a company manages its
pop grocer, cash flow is the ultimate measure of a company’s
costs effectively, enjoys a certain level of pricing power for
health and well-being. All the fancy numbers and metrics
its products and services, and is able to fend off competitors
in the world don’t amount to anything unless a company is
that might otherwise put the squeeze on its profits. A strong
generating the cash it needs to grow the business, pay down
profit margin is almost universally a good thing. Except when
debts, and return money to shareholders.
it isn’t.
Companies that consistently report strong earnings growth
A sharply higher profit margin could become a problem if it
on the income statement but slow-growing or negative
is not sustainable or is the product of one-time gains in places
operating cash flows usually have lower-quality earnings.
unrelated to the company’s normal operations. For example,
Non-cash accounting levers (or shenanigans) are being pulled
a company may have written off the value of inventory in one
to produce results that appear positive on the surface-but are
period and sold it in a future period, recording a huge gross
masking operational weaknesses.
profit boost. Or, it could have set aside a reserve in one period
To spot low earnings quality, investors should compare and reversed back into income in a future period, overstating
operating cash flow to net income in absolute and percentage the operating profit margin.
terms over time to analyze trends in the two metrics. Also,
Investors should watch for unusual changes in profit mar-
comparing EBITDA (which a lot of people falsely use as cash
gins, especially in conjunction with other red flags on the
flow) to operating cash flow can also point toward whether
balance sheet. In this context, it’s a strong sign of potential
management is pulling levers on the income statement to
earnings manipulation that could come back to haunt the
overstate earnings.
company in future quarters.
Case in point: Helen of Troy (Nasdaq: HELE). Throughout
(At this point, when looking at the interplay of multiple
2003 and 2004, beauty and health products maker Helen of
variables, the process might start to seem daunting. Having
Troy reported strong growth in earnings. As a consequence,
performed my analysis for a decade by hand, I sympathize.
the company’s stock price more than tripled from its 2002
This is a big reason why I spent five years developing my
lows.

4 Motley Fool Big Short Special Report — August, 2010

EQ-Scan model -- which constantly screens and applies my • It can liquidate the acquired company’s inventory and
proprietary analysis to thousands of publicly traded compa- collect on its receivables, providing a short-term boost to
nies every day. More on this just ahead.) operating cash flow. Yet, the cash used to acquire the business
is reported as an investing cash outflow.
Case in point. Computer and car manufacturers normally
bundle warranty plans with their products. These plans cover Furthermore, companies that play this game need to make
potential problems with the promise to fix or replace any de- bigger and bigger acquisitions in order to keep the game going.
fects over a predetermined number of years. Manufacturers Once access to capital dries up, as it did beginning in 2007 with
are required to record an expense and a liability reserve for the onset of the financial crisis, it becomes much harder to keep
expected future warranty costs at the time the product is sold. the train moving.
However, management can exercise considerable discretion Investors should be especially wary of highly acquisitive
about how much to set aside for future warranty costs. Reserve companies during periods of market exuberance, as capital tends
too little, and profit margins get a nice short-term boost at the to tighten up considerably during a bear market and economic
risk of higher warranty expenses -- not to mention lower profit downturn. As Warren Buffett famously said, it’s only when the
-- down the road. tide goes out that you discover who’s been swimming naked.
Case in point: Tyco International (Nasdaq: TYC). Perhaps
no company took advantage of shenanigans in acquisition ac-
counting more than Tyco. From 1999 to 2002, the safety and
security conglomerate purchased more than 700 companies for
nearly $30 billion. The massive string of acquisitions enabled
Tyco to constantly reload its reserves, boost operating cash
flow, and report stellar profit growth.

Dell shed 80% of its value over several years as

investors eyed shoddy earnings reports.

In 2007, computer maker Dell (Nasdaq: DELL) was required

to restate its earnings for several years because it improperly
accounted for warranty liabilities. Investors should monitor
changes in warranty reserves relative to revenue. If warranty
expenses decline relative to revenue, it could be a sign that a
company is inflating earnings by not properly accounting for Shares of serial acquirer Tyco plunged in 2002 when
warranty costs. investors finally caught on to top management’s
shenanigans.
Red Flag No. 4 -- Highly acquisitive companies
As is now well-known, Tyco’s creative accounting combined
Companies that make a lot of acquisitions make it difficult with management’s despicable use of the company’s cash for its
for investors to analyze the core growth of their business. More own piggy bank (remember CEO Dennis Kozlowski’s $6,000
worrisome, acquiring other companies gives management a golden shower curtain and his wife’s $2 million birthday bash?),
number of additional tools it can use to inflate earnings. landed the company into serious trouble with the SEC and the
• Management can take expenses off the income statement authorities. From the beginning of 2002 through early 2003,
and stuff them on the balance sheet by changing the good- Tyco lost more than 75% of its market value.
will account.
Red Flag No. 5 -- Changes in reporting
• It can put normal operating expenses into non-recurring Finally, when management no longer discloses financial
charges, boosting the operating margin. For companies that metrics that it previously did, or suddenly adds mysterious new
make regular acquisitions, we’ll call these “recurring” non- accounting lines to its financial statements, approach with cau-
recurring charges. tion. Changes are usually spelled out in the notes to the financial

Special Report — August, 2010  Motley Fool Big Short 5

statements that accompany each company’s quarterly SEC The Motley Fool BIG Short
filing.
I hope you enjoyed reading this report as much as I enjoyed
Sometimes, changes can result from the adoption of new ac- preparing it for you. The 5 Red Flags we’ve just discussed are
counting rules. This usually isn’t a worry, but investors should a small sample of the dozens of anomalies I look for when
pay attention to any improvement in profit margin as a result of assessing the earnings quality of a company – either to protect
complying with the new rules. Remember, any boost from this my long portfolio from a costly blowup or identify the next
change will be non-recurring, so investors should adjust for big short.
that when measuring a company’s operational performance.
Over the next four weeks, I will indentify a small number
The biggest reporting changes to watch for are changes in of Motley Fool readers who share my interest in forensic ac-
revenue recognition policy or a decision to begin capitalizing counting and are looking to profit by selling short the market’s
costs that were previously expensed. For example, a trucking most overpriced, misunderstood, or downright fraudulent
company that previously recognized revenue upon delivery companies.
to the customer may suddenly decide to recognize revenue at
pick-up. Because let’s face it: Companies that seek to artificially boost
their results (and stock prices) through accounting gimmickry
For long-haul truckers, this could boost revenue in an earlier are stealing profit from future periods, or worse, masking real
period at the expense of future periods. In another example, underlying problems in their business. Such stories never end
a film production company could decide to start capitalizing well for individual investors.
a portion of its advertising expenses, even though accounting
guidelines normally require that companies expense these But you can be protected (though again, my project – I call
investments as normal operating expenses. it The Motley Fool BIG Short – will be by necessity small and
low key). If you share my interest in forensic accounting, and
Case in point: WorldCom. In the late 1990s, telecom giant are interested in tactically shorting individual stocks for profit,
WorldCom paid fees to other carriers to use their networks. keep an eye on your inbox.
These fees were properly expensed on WorldCom’s income
statement. But beginning in 2000, as its business began to I’ll be in touch with more information shortly, including a
suffer from the fallout of the dot-com bust, WorldCom made second report I also want you to have with my compliments.
a subtle, yet significant change to its accounting policy. Kindest Regards,
Suddenly, it began capitalizing large portions of these line fees
on its balance sheet (a major red flag, Fools). From 2000 to
2002, this boosted WorldCom’s profit by billions and shaded
over a rapidly deteriorating business.
We know how this story ended. WorldCom eventually
imploded, and its long-time CEO Bernie Ebbers will probably John Del Vecchio, CFA
spend the rest of his life in jail. But investors could have been
clued in to WorldCom’s shenanigans long before the company
and its stock price came crashing down.
Despite continued profit strength, WorldCom’s free cash
flow plunged from $2.3 billion in 1999 to negative $3.8 bil-
lion in 2000. Remember, even though WorldCom was now
capitalizing those line expenses, it was still paying out actual
cash to the tune of billions to all of its telecom partners.
Investors could have also questioned WorldCom’s steep jump
in capital expenditures in 2000-2002 in light of the technology
slowdown during those years.
And of course, it all began with a seemingly simple change in
accounting policy in 2000, buried deep in WorldCom’s notes
in its financial statements. Investors recognizing that change
would have discovered the ultimate clue that WorldCom was
about to embark on a less-than-righteous course.

6 Motley Fool Big Short Special Report — August, 2010