Webjet claim in defence of their accounting treatment that it has the support of two of the big four audit firms. Therefore, despite BDO’s opinion, Webjet does not intend to change their accounting treatment, although they have subsequently revealed discussions with ASIC regarding this matter so this might change. Doubtless the accountants and ASIC will find all these debates about the correct accounting treatment fascinating. But for investors the accounting issues per se are irrelevant.
As we have highlighted before, the market is about stories and putting these stories into context. The general stories in relation to Earnings Quality are as follows:
- Is the Level of earnings quality an indicator of fundamental value?
- Does the Change in earnings quality provide earnings momentum indicators?
- Does the Nature of earnings quality provide risk indicators?
- Is the Perception of earnings quality a possible share price indicator?
… and each of these needs to be put into the context of:
- Where it fits in the individual investing framework?; and
- What else is relevant to that framework?
Let’s look at these question in the case of Webjet.
The Level of Earnings Quality – What are the fundamentals of the transaction?
Webject, quite correctly, point out that “this technical accounting matter does not in any way change the cash flows or economics of the … arrangements“. But what are these economics? On the one hand, Webjet are saying they have acquired a business, booking this as an intangible asset and then booking subsequent cash flows as earnings from the business. BDO, on the other hand, seem to be saying that this is more of a money swapping exercise. Webjet give Thomas Cook a pile of money and over time Thomas Cook pay it back, with presumably some surplus. BDO in effect seem to be saying the agreement has an element of the hamster transaction that Howard Marks described in his latest memo:
Two guys meet in the street. Joe tells Bob about the hamster he has for sale: pedigreed and highly intelligent. Bob says he’d like to buy a hamster for his kid: “How much is it?” Joe answers, “half a million,” and Bob tells him he’s crazy.
They meet again the next day. “How’d you do with that hamster?” Bob asks. “Sold it,” says Joe. “Did you get $500,000?” Bob asks. “Sure,” says Joe. “Cash?” “No,” Joe answers, “I took two $250,000 canaries.”
Well which of these two interpretations is it? Ulimately every investor needs to answer that for themselves and there are probably components of both arguments that are valid. One way to start thinking about it is that Thomas Cook will be re-paying Webjet around one third of the upfront consideration in the first twelve months. This would be a large amount if we were to think of all of these management fees as ongoing earnings.
The Change in Earnings Quality – An indicator of earnings momentum?
The revelation of this dispute means that earnings momentum isn’t as good as the company has previously indicated. Even if you believe that the fundamentals of the deal are as Webjet reports them, the deal has clearly been structured to front end earnings. Nevertheless, the question has reduced relevence given we now know what FY 17 earnings are. Whatever possible trends the front loading of earnings was meant to hide or enhance are now on full display.
As an aside, a detailed analysis of half year earnings might have given some indications that something was amiss – gross operating cash flow was down on pcp despite earnings being up and the “acquisition” was booked as a purchase of intangibles, not acquisition of business. But travel agent cash flows are notoriously volatile so its hard to say that whether we could have really picked these up ex ante rather than ex-post.