Our post, Genworth (GMA.AU) and the statistical significance of earnings focussed on how believable are reported earnings. In Genworth’s case, the multi-period nature of their insurance policies means we can have little confidence in the exactness of current period profits. This is one side of the earnings quality equation.
Another side of Earnings Quality has been on display in recent days with Webjet (WEB.AU). This is the question of how accurately do reported earnings match the economics of the business? The issue has come to light via a dispute between Webjet and its auditor:
“Webjet… wishes to advise the market of a disagreement with its auditor, BDO… on a technical accounting matter relating to its financial statements”
The disagreement concerns the treatment of an agreement between Webjet and Thomas Cook entered into in August 2016. Under this agreement Webjet paid Thomas Cook £21m for certain rights in relation to hotel contracts for their B2B division. In return Thomas Cook agreed to pay management fees to Webjet for a period of around 18mths and then to pay volume based fees going forward. Webjet think the deal should be treated like an acquisition and these management fees should be treated as revenue and profits. BDO disagree and essentially think the money should be treated as a loan from Webjet to Thomas Cook that is then repaid. The numbers involved are certaintly material to Webjet’s current year earnings.
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.
The Nature of Earnings Quality – What does the revelation tell us about Webjet?
Whatever you believe about the answers to the first two issues, it’s hard to deny that we now know something about Webjet that we didn’t know before. At the time this deal was announced, Webjet provided guidance of full year B2B EBITDA of >$11m, but made no reference to the fact that all of this would be contributed by the Thomas Cook deal. It is safe to assume that if investors knew this to be the case they would likely have placed a smaller valuation multiple on these earnings (and the group overall). Acquisitions made on headline multiples of 3x tend not to be valued at 20x.
Along with disputes around the treatment of this transaction, a few other points are worth noting:
- The updated FY 17 earnings provided in the acquisition deck (see slide 20) utilises the common trick of offsetting a gain on sale of a business (Zuji – $27m) with a series of “one-offs” – $5.5m for a change in accounting treatment with suppliers, $1.8m of miscellaneous and $0.9m for one off performance rights. ie. Webjet wants to include the $11m from Thomas Cook, but exclude these $8m of other costs from the markets view of earnings.
- The original presentation deck for this deal had a $7m error in relation to continuing revenue. This stuff happens, but it usually happens more when there is a lot of subjectivity around earnings and revenue recognition.
Investors might therefore be justified in asking the following questions:
- Was the Thomas Cook deal done purely to boost short term earnings?
- Is the acquisition strategy being used to mask poor trends in the core business?
- How much faith should investors have in the underlying earnings for the JacTravel acquisition, given these earnings are “constructed from JacTravel management accounts, adjusted by Webjet management based on its due diligence and to exclude non-recurring items“.
- What else don’t we know about the drivers of group earnings?
The answers to these questions might all be legitimate. Travel Agency earnings have a lot of subjectivity in them regarding incentives and timing of payments. Its worth noting that Corporate Travel (CTD.AU) benefitted from an optimistic revenue recognition policy which was subsequently reversed (to benefit earnings growth!). Since that time the share price is up four fold – so things that at the time appear material can subsequently be seen as trivial.
The perception of earnings quality – How will investors react to this news?
The stories that investors tell about companies are all based on fictions. Some of these fictions (like fundamentals) are more permanent than others. But the stories about whether a company and management are good or bad can be fickle. As a somewhat extreme example take the recenty troubled Quintis (QIN.AU). Despite years of terrible cash generation, the share price remained robust. Then suddenly a research report from a short seller saw the whole edifice crumble. Perceptions can change very quickly.
Not for a moment should Webjet be placed in the same basket as Quintis. But if Quintis was a poor company masquerading as an ok one, is Webjet a fair to good company masquerading as a great one? According to Bloomberg, Webjet trades on 27x current year earnings, with all analysts continuing to adopt the company interpretation of earnings. This is the sort of multiple that is subject to changes in perception. Will a restatement of the Thomas Cook deal be a trigger for such a change? At the very least there is a certain asymmetry to these sorts of perceptions.
Putting it into context
In summary, there are a lot of legitimate questions regarding what the Thomas Cook deal means for earnings quality. On balance the answers to these appear negative. But how relevant is earnings quality for investors in Webjet? Certainly there are many other important Frames to consider:
- Will this situation play out like Corporate Travel, where a successful roll up dwarfs these earnings quality considerations. Investors need to understand the operational frame to answer this question in detail.
- How relevant are current returns and balance sheet considerations for the company. Do these issues magnify or mitigate earnings quality considerations?
- Individual investors will also need to consider which elements of these are relevant to their own investment frameworks and investment processes.
While we ponder the answers to these questions, we wish the auditors and regulators the very best in their deliberations on how the accounting for this should play out.