10/24/2010 How short-selling sleuths spot accounti…

WEEKEND INVESTOR
July 30, 2010, 3:29 p.m. EDT

Background check
How short-selling sleuths spot accounting gimmicks on financial reports
By Matt Andrejczak, MarketWatch

SAN FRANCISCO (M arketWatch) -- With the economy mired in a deep slump and sales slowing, many
companies found it necessary last year to reduce inventory.

Not Monsanto Co. Instead, the agricultural seed giant was building inventory. That raised questions among analysts
at the Center for Financial Research and Analysis, who dig through corporate financial statements with the detail of
a forensic expert.

Their goal: to tell institutional investors when stocks are worth

selling or avoiding altogether. In February 2010, CFRA put
Monsanto on its "biggest concerns" list.

"Most companies had been reducing inventories (in 2009), except

Monsanto," said Jeremy Perler, co-director of research at CFRA.
"Their inventories were building rapidly. That's a pretty powerful
flag for an investor."

As the 2010 second-quarter earnings season wraps up, CFRA and

It's too late to invest in gold other accounting sleuths are once again scouring the latest reports
Forget gold, says Wealth Adviser columnist James for disconnects between what company executives are telling
Altucher. He tells Dow Jones New sw ires' Veronica investors and what the numbers are saying.
Dagher w hy and w here investors should put their money
instead. "When there is something bad going on, they'll do whatever they
can to hide it," said Perler, who with Howard Schilit co-authored the
most recent edition of "Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports."

While not a simple task, spending a few hours combing a company's earnings release and more-detailed quarterly
and annual financial reports (10-Qs and 10-Ks) can make a difference in making money or losing your shirt.

Yet you don't have to be a forensic accountant to spot trouble on a financial statement. Here are several line items
on a balance sheet you should focus on to gauge a company's strength, including inventories, free cash flow, and
accounts receivable.

1. Inventories

Monsanto (NYSE:MON) had high hopes for two new seed products. Inventories of
MON 57.15, -0.75, -1.30%
SmartStax and Roundup Ready Two Yield seeds were growing at a healthy clip
MON through the fall of 2009 and into this year. The seeds were crucial to Monsanto's
stated plan to double gross profit margin by 2012, which would bolster overall

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10/24/2010 How short-selling sleuths spot accounti…
stated plan to double gross profit margin by 2012, which would bolster overall
100
corporate profit.
80
But Monsanto was having trouble convincing customers to buy existing products
60 that competitors sold for less. This forced the company to slash prices to clear older
40 inventory just after it stocked up on new seeds.
F A J A
As a result, Monsanto reported 17% year-over-year inventory growth for the quarter
ended in November 2009. Meanwhile, analysts had forecast Monsanto to grow sales
by 1% over the subsequent nine months, CFRA pointed out in a report.

Typically, inventories should rise at about the same pace as sales. If a company's inventories are growing faster
than sales or expected sales growth, it's a clue that products aren't moving. In that case, gross margins could get
squeezed.

The crunch soon caught up with Monsanto. The company rescinded its gross margin target, cut its profit outlook
twice, and shaved sales expectations for SmartStax and Roundup. And the shares plunged 32% from April through
May. By then, Monsanto had slashed its 2010 profit target to a range of $2.40 to $2.60 a share, down from $3.10 to
$3.30 a share a month earlier.

2. Free cash flow

Worldcom's meteoric rise in the telecommunications world came to a crashing halt in late June of 2002. Worldcom
took many by surprise when it restated five quarters of results, erasing a profit it had once presented to investors.
The company's demise was swift.

Weeks later, WorldCom filed for bankruptcy in what became an $11 billion accounting fraud. While WorldCom
portrayed itself as a profitable company, the company's free cash flow painted a picture of shaky enterprise, Perler
and Schilit wrote in "Financial Shenanigans."

In 1999, the company reported free cash flow of $2.3 billion. A year later, free cash flow was negative $3.8 billion.
Such a large swing in free cash flow is a warning sign.

A significant drop in free cash flow may occur when a company makes a big acquisition, buys new equipment, or
throws money behind a new product.

Companies don't always calculate free cash flow in their financial statements. Often, you have to do it yourself by
pulling "cash flow from operations" and "capital expenditures" from the cash flow statement presented each quarter.

Free cash flow is cash flow from operations minus capital expenditures.

Why is free cash flow important? It's the money left over at the end of each quarter after all the bills are paid. A
company can use this money to pay a dividend, trim debt, make an acquisition, or buy back stock.

"You want to see cash growing or what the companies are doing with the cash," said Eric Heyman, director of
research at the Olstein Funds. "Companies with cash on their balance sheet have lots more flexibility than a
company that doesn't, regardless of economic conditions."

3. Accounts receivable

Another area to check is accounts receivable, or payments due from customers. In addition to how much a company
is owed, receivables also tell when it expects to be paid.

To make this calculation, divide revenue by the number of days in the reporting period. Then divide the figure given
for receivables by this result.

What you don't want to see is receivables rising at a much faster pace than sales. This suggests a company is
shipping too much product into the channel and possibly extending collection payment terms.

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10/24/2010 How short-selling sleuths spot accounti…
Several years ago, receivables at Harley-Davidson Inc. (NYSE:HOG) raised
HOG 31.32, -0.02, -0.06%
eyebrows at research firm Behind The Numbers, which issues sell recommendations
HOG to its hedge fund and mutual fund clients.

60 "There were years Harley-Davidson sold more inventory to the distributor" than the
40
distributor could sell, said Jeff Middleswart, president of Behind The Numbers.

20 "They were financing the distributor as well," he said. "So essentially, Harley was
financing its own sales."
0
08 09 10
Investors didn't show Harley the same leeway. Sales and profit slumped, along with
Harley's shares. By April 2008, earnings expectations seemed enough in line with
reality for Behind The Numbers to lift its warning on the stock.

Other check points

Some additional warning signs to watch for:

Always making the number: Does the company have a history of meeting the
DELL 14.59, -0.02, -0.10%
consensus analyst earnings target each quarter? Dell Inc. (NASDAQ:DELL) had
DELL
that reputation.

18 The PC maker on July 22 agreed to pay $100 million to settle the Securities and
16 Exchange Commission's civil charges that it used improper accounting to cover
14 earnings shortfalls. The SEC said Dell would have missed Wall Street's profit target
12 for every quarter from fiscal 2002 through fiscal 2006. Dell, the SEC alleged, used
10 exclusive payments from Intel Corp. to mask its deteriorating business.
F A J A
Continual restructuring charges: Middleswart of
KFT 31.90, +0.08, +0.25%
Behind The Numbers says restructuring charges tell
KFT him a company made a mistake, especially when
they come up often.
34
32 "They are telling you they screwed something up,"
30 he said.
28
He pointed to Avery-Dennison Corp. (NYSE:AVY) as
26
a poster child for one-time write downs. He said the
10 M M J S
maker of consumer labels and adhesives once
booked restructuring charges for 13 consecutive
years. Companies on the firm's watch list now for this practice include Newell Rubbermaid Inc. (NYSE:NWL) and
Kraft Foods Inc. (NYSE:KFT) .

The thickness test: Can't lift the 10-K or 10-Q from your mailbox? Printer runs out of paper? This is another sign.
Sure, a company's 10-K is likely to be larger than normal if they've made a big acquisition or sold assets.

Otherwise beware: "If it's a big fat one," Middleswart said, "you know there is something going on."

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