Introduction to financial statement

analysis – Study cases

1. Unidentified Industries: Australia
In this case we are asked to associate given companies to unidentified balance sheets and income
statements using financial ratios. These given compagnies are the following:

1) Airline 8) Engineering & Consulting Services

2) Commercial Bank 9) Food Retail
3) Computer and Electronics Retailer 10) Online retailer of Designer Clothing
4) Department Store (completed IPO in 2014)
5) Distiller & Vintner 11) Restaurant Chain
6) Diversified Metals and Mining 12) Trucking & Logistics Services
7) Electric and Gas Utility (Transportation Services)
First breakpoint
First, we can split our unidentified industries in two groups regarding their type of industry, that is
services VS industrial. To do so, we’ll have to check the “inventory” account.

 Unknown firms
o Service = inventory < 1% or “NA” (Not applicable)
 Firms B, J, F &
 Given firms
o Sometimes “services” in the name’s firm or is an obvious “service” provider.
 Airline, Engineering and Consulting Services, Commercial Banks, Trucking &
Logistics

Differentiate the service firms.

We will consider the following aspect to sort our 4 services fimrs:

 Commercial Banks Firm B

o 99% of its asset is financial (95% in similar compagnies)
o PPE varies depending on the strategy (amount of offices)
 Engineering & Consulting services – Firm L
o Very little fixed assets, not PPE intensive (main asset is workforce, but not present in
a balance sheet)
o High receivables (Clients); customers pay after the consultation is given
 Airlines – Firm J
o High PPE; fleet of airplanes
o Low receivable: airlines firms deal with individual customers that have to pay rapidly.
 Trucking & Logistics Services – Firm F
o High level of PPE similar to Airlines (trucks)
o High level or receivable (B2B usually consist of grouped order with longer collection
period)

Second breakpoint
For the 8 remaining firms, there is 5 retail industries. This industry has a common aspect, low
account receivable (sell mostly to individual customers that pays with cash or card)

Differentiate the retailing industry.

We will consider the following aspects among others to differentiate them:
  Online retailer (IPO) – Firm H
o High Liquidity (recent IPO)
o Long receivable period (possible to pay online through a settlement plan)
o Little PPE (Online retailing -> No stores)
 Restaurant – Firm D
o Fast inventory period (sizeable portion of inventory is perishable)
 Food retail – Firm K
o Rather fast inventory period (similar to restaurant)
o Slow inventory period compared to Restaurant as “liquor & Petrol” division accounts
for 79% of sales (alcohol less perishable)
o Higher PPE than restaurant (refrigeration assets)
 Computer & Electronics Retail – Firm E
o Higher value inventory (-> High asset turnover ratio because inventory represents
portion of the assets)
o Goods constrained by age (faster obsolence of inventory)
 Department Store – Firm G
o Lastly, “firm G” is the closest from “Food Retail”, we then sort them out regarding
the “inventory turnover rate” (a mall sells general goods -> less perishable)

Differentiate the 3 remaining firms.

We must finally associate the Electricity/Gas Utility, Metals Mining & Distiller & Vinter industries.

 Electricity & Gas Utility – Firm A

o Low inventory period (hard to store lot of gas/electricity -> Directly distributed after
being produced)
 Distiller & Vinnter – Firm I
o High inventory period and value (Aging wine gains value)
 Diversified Metals/Mining – Firm C
o High PPE (due to high fixed cost of equipments)
o High gross margin (due to high fixed cost -> little extraction variable cost)

2. Accounting Turbulence at Boeing

Program accounting
Program accounting (in opposition to nit accounting) is only allowed for selected industries in US
GAAP only. It is used when the cost of producing a program/model will be reduced over time due to
volume efficiencies and learning effects. The idea is to allow the company to expense estimated
average cost instead of actual production cost. It is only possible if the overall project is profitable.

First, the company must estimate the number of units sold

every year over the program as well as the average selling
price and average gross margin among others.
These estimates are made by the management of the company and can be complex due to their
dependance on many factors with high uncertainty.

Technically, it consists of smoothing cost through creating and then adjusting an asset called
“Deferred production cost” that will modify the amount of expenses in the balance sheet in a way
that the percentage of net income is the same as the average estimated income. After some years
there is a burn-off of “DPC” (starts decreasing) due to the actual cost being lower than the average
estimated cost. The Cash-flows remains unchanged.

Here’s a comparison of the two methods:

Pros of
Program accounting
1) Align Incentives between long-term investors and management.
a. Use of avg gross margin
b. Management and compensation based on long terms achievement.
2) Better reflects business model.
a. Manufacturing/conception is a long term process.
b. Production requires huge investment (R&D, facilities, management, control)
c. Take into account production scaling and the learning effects curve.
3) The program is the right unit of analysis.
a. Logic, thousands of individual units in the program
b. Unit accounting would result in huge losses in the beginning, not reflecting the
profitability of the program (≠ economic reality)
 Avg gross margin is better then.
Cons of Program accounting
1) Uncertainties due to estimations
a. Estimates difficult to make given long horizons.
b. Total demand, revenue volatile
c. Future costs, learning efficiencies potentially unreliable.
2) Possible manipulations
a. Management could abuse their factor estimation ability in their favor.
b. Extremely hard to audit, program relies on assumption of the management.
3) Unit-cost accounting reflect actual costs for an airplane.
a. COGS represents expenses and then profitability of a specific unit of production.
4) Program accounting decreases comparability to Airbus
a. Difficult to compare its performance with competitors, which is a problem for
investors and analyst
5) Learning efficiencies are not unique to compagnies using program accounting.

How would Boeing increase trust in its program accounting?

 Additional disclosures
o Show profitability as well under unit accounting.
 Being conservative in its assumptions
 Frequent adjustments
o Change the estimated gross margin of the program.
o If the program is deemed unprofitable, a “reach-forward loss” liability account is
created by decreasing the income. If the assumption change, this account can be
reverted.

Mechanism to effectively govern Program Accounting

 Good Corporate Governance
 External checks and audit
o helps to temper abuse from gouvernance
 Potential investigations and lawsuits
o Mistakes could result in SEC investigations.
 Aversion of media scandals
o Creates reputational cost.

Long time investor’s preference on accounting method

For using program accounting:
 An Asset is a promise of future benefits.
o A firm can be held accountable for this performance.
o Informative for investors to assess the firm’s productivity
o Consequences of a reach-forward loss (due to not delivering) can be significant.
 Better measurability of performance
o Huge expenses in the beginning (R&D) makes it difficult to assess performance.
 Increased stability in earning
o Low volatility in earning is sought by investors.

Against using program accounting:

 Complexity of understanding financial statement
 Fear of potential earnings manipulation or incompetence in forecasting
o Potential earning is a risk.
 o Hard to audit.
o Errors and bias in error  unreliable/misleading estimations
 Doesn’t reflect actual reality of the company in a certain short reporting period.
o Net income under unit-cost accounting reflects cash more closely

3. Mike Mayo Takes on Citigroup.

Deferred Tax Assets & Liabilities
Tax differences come from:
 Effective tax rate ≠ statutory rate
o Permanent difference
 Tax expenses never paid in the same period.
o Temporary differences
 Deferred tax assets (paid earlier)
 Deferred tax liability (paid later

These temporary differences exists because taxes are paid using Cash Accounting not Accrual
accounting.

Exemple 1:

Here, the taxes are paid when the cash flows are realized (left table). Thus, the tax difference will be
in the DTA (or DTL) account, here the income is realized in t = 1 The cash account should always
represent the sum of the cash flows minus the “cash accounting tax expense.”
Exemple 2
Exemple 3: Depreciation

In T = 0, XYZ acquires PPE for $100, which XYZ depreciates over 5 years. Tax officials depreciate it
over 2 years. XYZ has stable revenues of $100 from T = 1 until T = 5.
The tax rate is 20%.

« DTL » comes from the different amortization/depreciation period. Tax administration usually use
short period amortization period because the possibility to totally deduct an asset in a short period
of time gives incentives to compagnies for buying the latter. (consumption).

There can also be a “DTL” if the company use a straight-line (constant) depreciation while the tax
administration uses a “double declining balance” balance because it shifts depreciation schedule
forwards, resulting in have a lot of tax reduction in the beginning.

If tax rate changes through time, that might result in a “DTA/DTL” that could remain permanently ->
Allowance to be done

Allowances
 Allowances are contra-assets accounts, meaning they decrease the total assets.
 They are the estimation of the probable non-realization of deferred tax assets. Likely losses
are to be recorded during the current period (Conservative approach)

Mike Mayo’s concerns and Citigroup reluctance to follow his advice.

To take fully advantage of a net DTA, taxable income must be big enough:

Future Taxable Income (on a given period of time) x Tax percent ≥ net DTA.

Mayo believe that Citigroup cannot reach this condition since the future taxable income (per year) is
about the same as Citigroup’s current losses. Thus, he thinks that Citigroup should increase the
“valuation allowance” account so the condition can be met with a lower “DTA”

On the other hand, Citigroup argues that it will be sufficiently profitable through selling part of their
business at a price that would generate sufficient taxable income to take full advantage of its DTA

Sell-side Analyst Industry

Sell side Analyst job consist of making buy/seller recommendations and sell their investment
recommendation. Their role in society is to check firms’ price, provide new detailed information on
firm and confidence in markets as well as checking firm management.
These analysts must maintain very close relationship with firm’s Senior Management to get
information. So, analysts are incentivized to provide positive forecast. Moreover, they might be
penalized if their negative forecasts turn out to be wrong, they are also subject to pressure from
other analysts who follow the consensus.

Citigroup’s specific Deferred Tax assets

Credit Loss Deduction

Le fisc autorise la
déduction d’impôt
pour les pertes sur des
prêts, mais ne
reconnaît que la perte
effectivement réalisée
(actual loan loss), ainsi
seul 50 peuvent être
absorbés par la
réserve.

 Il s’ensuit que la perte nette à reporter est plus élevée pour le fisc. Ainsi, on pourra avoir une
plus grande déduction d’impôt grâce au carry-forward, d’où la création d’un « DTA »

Tax credit and net operating loss Carryforwards/Carry-forwards

Operating Loss Carry-Back and Carry-forwards: when a firm makes losses it does not pay taxes but
instead can carry either:
 Carry-back its losses to offset taxable income reported in 2 previous years an get a refund
(not allowed in Switzerland)
 Carry-forward the loss for up to 20 years in order to offset future taxable income
(Switzerland 7 years)

Grâce au report de la perte (400),

l’entreprise économisera
400*30%=120 en impôt la période
suivante, d’où la création d’un
« DTA »

Conlcusion

Although Citigroup was right and was able to generate sufficient income in the years after the crisis,
which would have allowed it to make use of its DTA, having not taken any valuation allowance
against its DTA contrary to Mike Mayo’s calls, it did have to finally take a large sudden valuation
allowance against its DTA in 2017.
Although the creation of an allowance was not directly linked to Citigroup’s ability to generate
sufficient income, but rather to a change in the tax regime. It does highlight the importance of
conservative accounting practices as future income can never be certain especially in an uncertain
post financial crisis setting. Moreover it showcases the danger of external factors such as tax
changes that can impact its DTA.
Given that Citigroup has a history of bad risk management as highlighted by the financial crisis, not
taking a valuation allowance made it much more risky and its financial statement did not accurately
reflect the fair value of its asset given that it strongly assumed a fast recovery.

4. Microsoft x aQuantitative
Discuss the pros and cons to acquire aQuantive.

Purchase does not affect the Income

Statement -> Might lead to manipulations.

How does Microsoft’s purchase price allocation (PPA) differ from aQuantive’s last
balance sheet (BS) prior to acquisition? Why is it different?

All assets and liabilities are re-evaluated during M&As at their “fair value.” Here’s how PPA
calculation is done:

1. Mark the assets to their fair values, i.e. price received (paid) to sell (transfer) an asset
(liability) on the market at the measurement dates.
a. Market approach: price/info in last transactions
b. Income approach: Discounted cash flows (with current estimations)
c. Cost approach: cash needed to replace asset’ service capacity.
2. Value and add unincluded intangibles asset that meet recognition criteria.
a. Ex: Customer list, brand value, Trademarks, Domain names, Employment contracts,
Noncompetition agreements.
3. Allocate difference between Purchase price and fair value of (in)tangibles to Goodwill.
a. On BS, Goodwill = PPA – NAV of reevaluated acquired company (A-L = E)
Using ONLY the data available in the table below, and assuming USD 6 Billion all-
cash acquisition, compute the merged accounts of the “new” Microsoft after the
aQuantive acquisition. Detail your computations.

 Total cash: is affected by transaction.

 Total Assets: Must add transaction goodwill (old goodwill already included in each individual
goodwill) and deduct the purchase price since it affects cash.
 Equity: We mustn’t include the one from the acquired company
 Goodwill: Must add the transaction Goodwill (the difference between the purchase price and
the net acquired assets) to the old ones

Why did Microsoft pay so much more than the market value of the assets on
aQuantive’s accounting records? Moreover, why did Microsoft pay more than
aQuantive’s stock price?

They paid 9.81 times more than the NAV under book value (before reevaluation), here’s why:
 Some assets are worth more than historical value.
o e.g. Real Estate
 Some assets are not on the BS
 Some assets could be worth more considering their combination with others.
 Liabilities may be discharged below their book value

Also, there are reason for them to pay a 85% premium on stock price:
1. Synergies between acquirer/target assets
a. Revenues Synergies (cross selling, less competition, new markets)
b. Cost Synergies (less employees, shared info sans resources, marketing strategies)
c. Financial Synergies (tax optimization, cheaper financing)
2. Premium for control (the highest the premium, the better chance for current shareholder to
accept the acquisition
3. Paying too much during completive bidding – the winner’s curse!
a. Winning bid > auctioned assets: incomplete infos, emotion, other factors
What does the goodwill on Microsoft’s balance sheet generated from the aQuantive
acquisition represent? What do you do with goodwill after it is on the balance sheet?

Since a Goodwill is an asset, it is expected

to provide a future benefit. So when a
company wants to acquire another one, it
must increase its ROA, that is increasing
more its net income than its total assets.

Every year at least or when FV < Book

value, every unit composing the Goodwill
(who cannot be amortized/depreciated) is subject to an impairment test. A Goodwill is likely to be
written off when firm operates poorly, its CEO has been fire or when there’s bonus unlikelihood.

5. Political Risk at AES ( Voir les tableaux dans la solution du cas)

How do you think AES adds value as a company? What risks do you see in AES’
business model?
 Types of businesses (mainly in US and Brazil)
o Power generation (main business: selling energy to intermediaries
 PPA contracts: long term power purchase agreements
 Short term contracts
o Utilities (selling energy to end-customers)
 Income statement
o Stable revenue
o High operating cost (-> Low operating margin)
o 17-20% ROE (EBT after 30% tax / Equity)
o Minority local shareholders receive high profits due to better local risk management.
 Balance sheet
o High receivable (30-40% Current Assets)
o Very high PPE (capital intensive industry)
o Very high debt (high leverage -> high insolvency risk)
o High minority interest share (40% equity -> local risk manager partners)
 Risks
o Most of revenues come from developing countries.
o High volatility of unusual items (impairments) part in EBT (due to high assets
impairments)
 Les gouvernements de pays développés ne se soucient pas du prix auxquels
sera vendu l’électricité, car le temps que la centrales se construise, ils ne
seront peut-être plus en place, mais auront récolté les fruits de la conclusion
du contrat. Les gouvernements suivant se rattraperont en baissant les prix 
création des « impairement ». Donc les firmes font exprès de négocier des
prix élevés dans l’anticipation de leur baisse futures.
 Étant donné que ce genre d’entreprises sont des monopoles, ils ont
également de incitations à corrompre les gouvernements locaux, pour
maintenir cette situation très profitable
 Key income drivers
o Emerging markets (lack of capital and infrastructures)
o Efficiency
o Managing Developing country risks (strong competence developed)
How do AES’ experiences in the Dominican Republic and California inform its
decision to create an allowance for bad debt expense and record an impairment in the
case of Maritza? If you were to record a bad debt expense in this case, how would you
do it?

Impairment of a PPA
Impairment is frequent in PPA.

 The difference is decreasing the PPA directly or through a contra-asset “allowance” account. This
allowance is an estimation, if it is seen as likely, we record it in the current period (conservative
approach)

Bad Debt Expense/Allowance

 When the loss occurs, the allowance is credited instead of receivables.

The case of Dominican Republic

Huge receivable from the government (collection risk). No allowance created, end up with a 6%
write-off. Even if this country had a worse credit rating than Bulgaria, they kept paying bill in fear of
deterring foreign investment.

 But in our case, Bulgaria is of a higher importance since it account for 20% of its revenues and
considering that NEK has high bargaining power (because the power plant is new), a small change in
non-payment of this revenue can have a significant impact on the firm.

The case of California

In the case of California, clear directives about new regulation helped AES to conduct accurate
impairment tests, whereas Bulgaria’s regulation demand (regarding the price decrease) were not as
persistent and still likely to be negotiated. Also, the coming shut-down of some power plants helped
calculating the impairment (in comparison to fair value through discounted cash-flows method) more
accurately (for Bulgaria, the period is 40 years).

 Smaller impairment for Bulgaria (that is positive!)

As AES’ CFO, should your expectations about the outcome of a renegotiation affect
whether you record an impairment, or would you wait until the negotiations are
completed to conduct an impairment test? Why?
Due to financial difficulties and public pressure, NEK want to renegotiate the current long-term
contract to decrease its past-due payment toward AES and returning to positive Cash flows. To do
so they would:
 Reduct full-capacity price of 30%
 Exclude one of AES energy units of its PPA (through selling it on spot arket)

Effect of Negociations Expectations

It is likely that negotiation will occur since NEK and the regulator are state controlled and AES is not
willing to accept the 30%.

AES need to anticipate the outcome of these

negotiation to determine the value of its assets
(affected by price through discounted cash flows).
The management could use a probability distribution
to determine the negotiation outcome in terms of
price reduction  However, one single value can be
reported on the financial statement.

However, a small price change will not have a sensitively impact due to a long-expected lifespan of
40 years.  Impairment unlikely. Moreover, taking impairment would signal to the government that
AES is ready to take a loss.

What should the CFO do

 Impairement
o Accounts receivable: Allowance/write-off between 0-30% (reasonable) (they also
want to reduce the price on the receivable)
o LT Assets (forced to be sold): Impairment
o LT Assets (forced to reduce prices by 30%): Proportionate impairment.
 Do nothing
o Improve your negotiating power (conservative financial accounting and truthful
disclosure leads to permanent losses when the counterparty is acting in bad faith).
 Do not show you intentions (conservative accounting) when dealing with
scumbags

What other kinds of risks (other than political risk) do companies face? How might
these risks affect the likelihood of the impairments?

Potential business risks

Operating in a market where the counterparty is both your client as well as the regulator posses
many risks especially when operating in emerging market. :

 Collection risk: risk that customers will not pay e.g. Dominican Republic
 Regulatory risk: change in regulation might negatively affect the company’s
 Technological risk: new technology can make existing investments obsolete
 Operational risk (including taxes and labour): cost overruns and bad operational decisions
 Environmental risk: related to regulatory and technological risk; actions that negatively
affect the environment can create large losses for a firm
  Commodity risk: changes in fuel prices may adversely affect profitability
 Foreign exchange risk: changes in exchange rate fluctuations

AES’s Risk management

 Global portfolio (diversification)

 Price risk into their contracts
 Internally monitoring events that could affect them negatively
 Focus on investing in countries where they have a seat at the table
 Leaving countries where they have little control and cannot manage risk adequately
 Looking for local investors in order to better monitor and manage their risk (e.g. their Chilean
subsidiary is listed on the stock exchange in Chile)
 High pay-out for minority shares also indicates that they partly outsource their investments
and thereby their risk by partnering up with other investors

Conclusion

The case has shown us the importance of communicating risk through financial statements
The related risk and benefits of operating in emerging markets
Accounting for Bad Debt
Accounting for Asset Impairments
The limitations of accounting numbers when the distribution of asset values has large tails

6. Mattel
Big Four, Independence and control

“Audit is vital to trust in financial information, and it’s this trust that turns the wheels of the capital
markets system. It is the independence that auditors bring, the objective scrutiny, which gives the
business community confidence in the numbers.” - KPMG in “Value of Audit”

In the UE and the US, public compagnies are required to have their FS (Financial statement) reviewed
by independent audit professionals. Following Enron’s scandal, the”SOX” law establishes audit
standards limiting conflict of interest. Concretely, it prohibits registered external auditor from
providing certain non-audit services to its public companies audit clients.

Not only external control is sufficient, but internal control also plays a key role, since it has different
goals:
 External control (audit)
o Assess FS consistency with GAAP.
o Increases credibility of FS by reviewing samples
o Attest to the quality of
 Internal control (management) assures
o Reliable, Accurate informations
o Compliance with law and regulation
o Reliability of FS
o Safeguarding of assets
o Economical/efficient use of resources
o Accomplishement of operation/program goals
Should Mattel retain PwC as its auditor going forward? What are the costs and
benefits of doing so?
PWC’s misconduct
 Failing reviewing Mattel’s internal control
o Didn’t pursue more rigorous audit and didn’t issue material deficiency on internal
control despite their long experience with Mattel.
 Serious breach of independence (complying with management)
 Minor possible breaches of independence (recommendation on senior management,
providing other services)

Refer to Exhibit 9. In Q3, 2017, Mattel understated both its valuation allowance and
tax expense by about $109m. How does this affect the financial statements? Is this
material?

Management has incentives to deliver consistent good performance. To achieve this, they might
bend result in their favor if actual earnings doesn’t suit management through several techniques:
 Inflating revenue through credit sales (attractive postpone payment conditions)
 Mischaracterizing expenses (as non-recurring while being recurring)
 Stock buybacks (increases EPS through decreasing the number of shares)

It is obvious that all compagnies manage their earnings, but only reporting earnings withing 5% of
true earnings will result in not being caught. It helps look better, survive, increase bonuses or share
price, assure employees/supliers/clients.

Materiality
The concept of materiality can be defined as the magnitude of an omission/misstatement in the FS
making it probable that someone relying on these would be influenced by the information in its
judgements.

It can be:
 Quantitative: An amount > 5% of pre-tax income
o For Mattel, its DTA is 8% of asset -> Recognizing the allowance could material.
 Qualitative: for a statement impacting an investor’s decision

In the end the recognized a valuation allowance of $ 109 million, which was material.
Why did Mattel fail to avoid the scandal that it faced? What could management and
the board have done differently?

Despite that FS fraud is less recurrent than other types of fraud, it causes a lot of losses; using
whistleblowing is the best way to spot fraud, because it award between 10-30 % of the monetary
sanction to the whistleblower.

Internal Control Failure at Mattel

What could have the CEO done?

 Investing more in technology to maintain records and improve controls (a lot was stored on
paper)
 Establish more honest code of conduct and disclosure at the top.
 Create a compliance and whistblower system.
o Helps employee’s concern to be heard an to resolve problem at low cost.
o Empowers employee to report problems through ensured anonymity.
 Create a transparent system of communication between top management, the board, and
the auditor.
o Involving every actor prevents one from pushing others to go towards a cover up.
Put yourself in the shoes of the new Audit Committee chair, Diana Ferguson. What
steps would you take going forward to revamp the integrity of the financial reporting
process?
 Set up a schedule of regular meetings with the auditor and the management, and always
want to be in loop on important financial reporting decisions
 Clearly lay out materiality thresholds for the auditor to report to the audit comittee
 Perhaps consider not approving any non-audit services. If we do approve them, we need to
have stronger oversight on the auditor.
 Make sure that the internal audit team and personnel in other relevant departments have
the expertise needed.
 Invest in training sessions showing various departments how to use internal control systems
in place and have training sessions on ethical themes to foster a culture of integrity.
 Invest in hotlines and other systems to support whistleblowers. Make sure whistleblowers
have the ability to directly report to the audit committee and/or the board. Ensure they are
aware of the different ways in which they can come forward, that can preserve their
anonymity, and offer rewards to those who choose to come forward.
 Revisit the composition of the audit committee. Ng has been on the board since 2006.
There needs to be a discussion on whether that is too long a tenure and could affect director
behavior.

7. Cracker barrel
What is your assessment of Cracker Barrel’s performance over time? What stands out
to you about Cracker Barrel’s business model? (Hint: Use relevant metrics from
exhibits and the excel spreadsheet and interpret them, don’t just list them!)
Overview of DuPont Analysis
Classic DuPont Formula :

Do you agree with Biglari’s critique of the company’s performance? Which aspect of
his argument resonate the most with you? Do you think his solutions will help Cracker
Barrel?
Biglari’s arguments
 Week Strategy, Poor Execution
o Management shouldn’t have open new restaurants when current ones are
performing poorly.
o Strategy should completely change; expanding internationally and adopting
franchising model
 Lack of Transparency
o Retail and restaurants segments should have their own figures to assess how well
each strategy is executed. (However, there is synergies between the store and the
restaurant in the overall consumer experience. Thus store’s profitability is not
necessary important)
 Aging board (30Y+), inappropriate incentives
  Overall Lackluster Performance
o Cracker Barrel’s performance is subpar, such as poor sales growth and low NOPAT
margins.

Biglari’s solutions
 Adjusting Menu prices (bring it back to its lower levels to attract more consumer)
 Moratorium on Opening New Stores (focusing on current stores losing traffic)
 International Franchising (maximize Cracker barrel’s brand value with low investments)
 Revamping the Board and reviewing compensation (align incentive with shareholder
interest, thus motivating management and improving performance)

Do you agree with Biglari’s choice of peer companies? If not, what peer group would
you choose and why?
Benchmarking consists of comparing a company to a peer group to assess its management or
strategy. The selected comparing companies must be similar in size, business model and customer

base.

Biglari’s peer group’s (Chipotle, McDonald’s, Starbucks, Yum !, …) characteristics are:

 Large (market cap)  CB is only a S&P mid-cap index company.
 International  CB is only established regionally (south-east US)
 Quick service  CB is a full-service restaurant.
 Franchised  CB owns all its restaurant; different business model in terms of cash-flows and
capital expenditures.

Biglari might have selected these really different companies because he could have wished to switch
strategy to the peer groups, he might have manipulated the benchmark to discredit the management
or maybe he is just incompetent

How does Cracker Barrel’s performance compare to your peer group? (Use relevant
metrics!)
Alternate DuPont Analysis (2011)
 NOPAT Margin Cracker Barrel was at 5.1%, Biglari’s group was at 12.0%, and the small & mid-
cap group was at 7.0%.
 ROA Cracker Barrel’s ROA was 15.4%, whereas the ROA for the small & mid-cap group was
20.8% and the ROA for Biglari’s group was 33.9%.
 ROE Cracker Barrel and Biglari had similar numbers, 44.4% and 41.4% respectively, whereas
the small & mid-cap group was at 15.0%.
 Overall Cracker Barrel was performing below size comparable firms in terms of profitability
and operating pe-rformance. However, it made up by having a significantly higher amount of
leverage.

Stock Returns, Valuation Multiples and Revenue Analysis

 Long-term returns are in sync with the peer group The 1-year return for Cracker Barrel was
poor compared to the small & mid-cap group, but the returns over a longer time period were
 in line with or better than the small & mid-cap group. Biglari’s peer group exaggerated
Cracker Barrel’s underperformance.
 Valuation Multiples are lower for Cracker Barrel In 2011, Cracker Barrel’s valuation ratios
were lower than its peers. A lower Price-to-earnings multiple could suggest that investors did
not believe Cracker Barrel’s performance was sustainable. This could be due to earnings
being driven by the high level of leverage. Moreover, valuation ratios over time shows that
for EV/EBITDA, Cracker Barrel had been in line with the small & mid-cap group and below
Biglari’s peer group. For P/E, Cracker Barrel had been consistently below its peers.
 Sub-par revenue Growth... The 1-year revenue growth figure for Cracker Barrel was 1.2%
whereas it was 4.2% for the small & mid-cap group and 12.4% for Biglari’s group.
 ...and unimpressive same store sales growth Cracker Barrel also had lackluster same store
sales growth compared to its peers. In 2011, same store sales growth was 0.2% for Cracker
Barrel, 1.9% for the small & mid-cap group, and 5.9% for Biglari’s group
 Overall Cracker Barrel’s performance was unimpressive when compared to its peers’
performance, although Biglari’s comparison group exaggerated the underperformance.
Even without the bias in Biglari’s analysis, the sales underperformance becomes clear with
this analysis.

Profitablity Analysis (2011)

 Better Gross Margins, but worse EBITDA, EBIT and NI Margins Cracker Barrel’s gross
margins are better than the peer group margins but below Biglari’s group’s margins.
However, other profitability ratios also underperformed Biglari’s peer group and our peer
group.

Other Ratios (2011)

 Inventory Turnover In FY 2011, the inventory turnover of the companies listed in size-
matched peer groups ranged from 42.29x to 96.14x. Although many quick-service
restaurants were excluded in the benchmark groups, we note that the quick-service
restaurants had a much higher inventory turnover compared to Cracker Barrel. It is also
worthy to highlight that Cracker Barrel’s inventory included its retail inventory, so the
numbers weren’t comparable.
 Debt/Equity As seen in our previous analysis, we note that that Cracker is highly levered,
more than its competition and the Biglari peers.

Imagine the new CEO hires you as her advisor. What suggestions would you have to
improve the performance of the company? (Don’t be shy, be creative!)
 Improve board governance (already ongoning)
 Greater transparency (reporting both reaturant and retailing store appart)
 Better constructed incentives (senior management wasn’t motivated)
 Increasing same store sales growth through better pricing or marketing?
 Franchising? Cutting retail? (could alienate loyal customers)

How would you have voted on Biglari’s election – for him or against him?
8. Novastar
Key concepts
Subprime mortgage loan:
 Subprime: Label given to borrowers with poor credit rating.
 Mortgage: Loan used to buy real estate (house, land) where the latter is used as collateral.

Securitization:
Process of selling the rights to future cash flow streams from financial assets to outside investors.
This provides an immediate source of cash for assets that would otherwise pay out a cash flow
stream over time. In the context of this case, NovaStar pooled loans together and sold them to
outside investors.

value estimate:
Value of a financial asset derived by discounting the projected future cash flows. This method of
valuation implies important assumptions (discount rate, default rate, prepayment speed) made by
the NovaStar’s management.

Short selling
Payoff

Margin accounts and margin calls

1. What are the key business risks faced by NovaStar?

2. What accounting estimates allow you to assess these risks? How do you think
NovaStar is performing based on these accounting numbers?

 Hausse de prêts détenus, car ne peu plus en revendre autant à cause de marché en déclin.
Engendre en conséquence une augmentation des provisions pour pertes sur crédit (mais pas dans la
même proportion dû à manipulation)

 Hausse du levier (donc plus de risque) et encore un fois provisions sous évaluées
Augmentation des « impairments » en proportion des prêts à vendre, plus de dividendes que de
revenus & Gain on sales

3. Do you agree with Cohodes’ assertion that NovaStar was a fraudulent business?
Which parts of his thesis resonated the most with you?
4. What is your assessment of the SEC’s and analysts’ response to Cohodes research?

5. Why do you think Cohodes was unsuccessful for over four years in his short-sell
thesis? If you were in Cohodes’ shoes, would you have persisted with the short sale?
6. What do you think about the attractiveness of short selling as an investment
strategy?