Carson Block, a founding partner of Muddy Waters Research, a Wall Street group that specializes in identifying accounting and business fraud, lamented in a May CNBC interview that the next big market crisis could be driven by investor losses in companies that mislead investors with hyped financial statements.
Block said, “What I see at my ground-level view when I look at companies is that more and more of them are using very aggressive accounting to create financial statements that are actually really misleading as to what is going on with the company’s economic health.” He pointed out, “Companies are creating what appears to be profit but it is really accounting-driven profit that is often linked to debt piling on the balance sheet.”
“Aggressive accounting” appears to be alive and well in America’s national building supply industry as income reports include special vocabulary and reasons to try to convince investors that all is financially wonderful. It seems that some companies are treating special expenses as financial statement exceptions and justification for adjusting EBITDA. So much for Generally Accepted Accounting Principles (GAAP)—it looks as if new rules are being made up with each report.
The spinning of earning reports is nothing new. My old company, Wickes Lumber, was the master of it. Consider these two statements from the Wickes Lumber earnings report for the first quarter of 1997, in which it lost $5.2 million. It first stated, “For the quarter, the company reported an improved loss from operations of $2.2 million compared to an operating loss of $2.7 million reported in the first quarter of 1996.” It also stated, “We have reported improved operating income over the past three quarters and this quarter we also reported increases over last year in both total sales and same-store sales.” Of course the CEO said, “We continue to be pleased with our quarterly operating results.” Seriously, he was pleased with a quarterly loss of $5.2 million? Some seven years later Wickes Lumber was essentially gone, and the last locations carrying any semblance of the name were closed in 2008.
In the end, a lot of people who invested in Wickes Lumber lost a lot of money and not one person got in trouble for spinning financial tales. My concern is that in today’s financial environment the old Wickes earnings statements look sedate compared to some of the fiction that is being written. Many in the industry have serious doubts as to the validity of numbers being reported because they do not add up when compared to the realities on the ground.
Despite new terms and spins on earnings reports, the chickens of real losses and high debt will always come to roost. In the building supply universe, the multiple advantages in buying, expenses, and labor are not much between the largest national suppliers and the independents. Independents have a much better handle on hard costs than national providers, and when an independent loses an order by double-digit margins there is little doubt someone is losing money.
Investors should do a much better job reading and understanding numbers on financial statements instead of words. At some point, GAAP standards have to be mandated at all levels of public company reporting. Bankrupt corpses of many national companies fill the graveyard of this industry—and all had similar ways of spinning results and reporting earnings.