Meredith Whitney and school buses

Meredith Whitney is an analyst famous for her superb call on Citigroup leading into the financial crisis and that they would cut the dividend and then wrong calling for a wave of municipal bond defaults. I wrote a piece at the time on why this prediction of defaults would be wrong and I proved prescient and you can read that piece here:http://kifcapitalmanagement.net/?p=209

Yesterday, Ms. Whitney was on CNBC stating the three most fiscally distressed states were California, Illinois and New Jersey. I would probably agree with her on this, but Illinois is distressed because of its public employee pension obligations and Medicare costs. Ms. Whitney told a story that Illinois is going to start charging kids for using school buses and the negative impact it would have on working mothers and the economy. You can see her whole interview here and the Business Insider story on this here: http://www.businessinsider.com/meredith-whitney-wildly-bullish-2012-4

The only problem is that Illinois said no such thing. The state for its part wants to change how it subsidizes school districts transportation costs from a fixed percentage of costs to reimbursing a state wide average. The concept is to make school districts more cognizant of costs, so that districts above the average can get their costs more in line with state wide averages. Of course, this might not always be possible as there are vast differences between Chicago and rural areas with different costs. But the decision whether to charge for school bus service will be left to the districts, it will not be state mandated. More importantly, any plan that charges kids to ride school buses will probably be susceptible to court challenges regarding equal access to education. Legally, it would be probably be easier to eliminate school bus service altogether, than have a user fee system, unless that user fee system is means tested.

This country is going to have to find a way to get state governments out from under its public employee pension obligations and the legalities of this will vary from state to state. Illinois recently raised its income tax 70%, though it is still considerably lower than California’s, New Jersey’s and Oregon’s.

Courts are going to have to grapple with states like California whose Constitution preclude it from filing a Chapter 9 bankruptcy to laws and perhaps state constitutional provisions that make public employee pensions inviolate with this reality. If you raise tax and cut services to where people flee and there is no tax base left, who is going to pay the pensions then? Whom will even pay the judges salaries?

Central Falls the smallest city in the smallest state of Rhode Island already filed Chapter 9 bankruptcy because of its pension obligations and was able to cut those pensions. Rhode Island Governor Chafee two days ago proposed more relief for localites from state mandates on public pensions.

 

 

 

What is Groupon’s real cash flow?

This morning CNBC had one of GroupOn’s early investors defending the company because despite its accounting problems it has strong cash flow. Does it?  Harvey Weller, the investor said Groupon had free cash flow last quarter of around $155 million. This is what Groupon stated in their press release, defining free cash flow as cash flow from operations minus capital expenditures. I assume they are using net cash flow from operations as it will appear on their cash flow statement when they file their 10-Q, but that line item which the SEC requires is flawed in its nomenclature.  In my investment career I have been stunned by the number of other professionals who do not know how to calculate operating cash flow analytically in a sound manner and this is another example.  The cash flow statement required by the SEC includes in “operating cash flow” changes in working capital. So if you are slow paying your bills, it helps the company’s working capital and hence the SEC defined cash flow from operations, but it is not a good sign. Changes in working capital are temporary, eventually vendors need to be paid or the company goes bankrupt. Groupon is not the first company to convice Wall Street that despite massive losses on a net income basis, they are really positive on a cash flow basis.

Groupon has a business model where the retail customer pay them up from for the deal, so they have massively positive working capital – this is alone is a very good thing because it means it does not need to finance its working capital needs like other businesses. But it also means this money is owed to merchants when the deal is redeemed.

Groupon has not filed in Q1 10-Q  yet so we cannot see the cash flow statement from last quarter, but we can use its annual to illustrate this.  In its last full fiscal year Groupon had cash flow from operation as defined by SEC of around $290 million; but $390 million of this was from accrued merchants payable and $189 million from accrued expenses and other liabilities (not paying one’s bills). Together these two items total $579 million, meaning Groupon actually lost close to $300 million from running their business if they settled up on all their accounts and went “flat”, which voila is what their reported net income was.

There are non-cash expenses that one can correctly analytically add back to net income to get net income with all its accounting distortions closer to real cash flow. These would be items like depreciation, stock compensation expense and deferred income taxes. Groupon for 2011 has net income of negative $297.7 million (-$297.7 million). If you add back these three non-cash items, it would make their net income close to a negative $140 million (-$140 million). Losing $140 million is better than losing $300 million, but hardly a ringing endorsement.

In other words Groupon’s real operating cash flow on an analytically  sound basis meaning if they paid all their bills and were flat on receivables and payables would be a negative $140 million (-$140 million) not a positive $290 million reported as cash flow operations in their SEC documents. While the SEC requires and should require companies to disclose the impact of changes in working capital on liquidity and cash flow, changes in working capital do not represent economic profits or losses and long term they have no impact on how much cash a company can put in the bank.

 

 

 

MPAA movie ratings are no better than credit ratings

The dispute over what the appropriate rating should be for the new film Bully can be used to illustrate why not only should we scrap the movie rating system, but problems when people and institutions become overly reliant on ratings including credit and/or bond ratings. Since the financial meltdown with AAA mortgage bonds defaulting or losing large parts of their values, a lot of blame is focused on that the issuer pays the rating agency, so it is not independent. But the core problem as exemplified in movie ratings and there are conflicts of interest here also as the ratings are a product of something controlled by the MPAA which is the umbrella lobbying organization for major movie studios., is not conflicts of interests but they are OPINIONS – ratings are not as accurate as determining temperature in degrees, they are more like asking people in the same room if they feel cold or hot and you will get different answers depending who you ask.

Bully received an R rating from the MPAA. In Canada which has a similar rating system except each province has its own ratings most of the Canadian provinces gave it a PG rating, but Quebec rated it a G. So we now have a situation where a 16 year old in New York cannot see a movie without a guardian that an 8 year old can see by themselves over the border in Quebec. I should point out that the producer can opt not to use the rating and release it unrated. But most movie theaters will not show an unrated film just like many mutual funds will not buy an unrated bond without regard to the underlying facts and circumstances. AMC has said it will show the film, but will require children to be accompanied by a parent or have a note from a parent. This is the first time I know of a theater chain accepting a note – children will not even need to forge the whole note, because AMC is making a standard note available on their website – they only have to forge their parent’s signature, actually they don’t even need to forge one – any signature from that says John Smith will do because the theaters have no idea who the kid’s parents are or what their real signature looks like. So it reality, AMC thinks the film should be exhibited for all to see, but wants the fig leaf to make believe they have involved parents in the process.

The dispute over the Bully rating has good arguments on both sides. On the side of the PG13 rating is that this is not a fiction movie, but a documentary showing real students in real life. That is because “bullying” is seen a social problem amongst children, it is children who will be most helped by seeing the consequences of bullying.  Then there is the long standing criticism of the MPAA ratings system that is puts too much weight on sex and the use of certain words like the F-bomb than on violence. The core issue for the R rating on Bully is language.  The other side of the argument is that ratings are simply advisory – theater chains do not have to follow them. Distributors can opt to release unrated as is the case here and parents who want their kids to see the film, can take them.

Here is another analogy between bond ratings and movie ratings – most mutual fund managers can buy unrated bonds if in their view the bond has a credit quality that they believe would get say some minimum rating like B+ if it were rated in their opinion, but most bond fund managers will not bother to court controversy and put themselves on the line this way. Similarly, movie theater chains and most parents are not going to spend the time to independently assesses the suitability of a film for children, it is just easier to say no.

The reason why the movie rating system should be scrapped is because it is a lie. In most places, teenagers can find some adult on the line who will walk them in, I did it when I was a kid. The kids who don’t see the film are the same ones who would not see it even if the theater would let them in because they respect their parent’s wishes.  But the bigger issue is the ratings are misleading. Most parents are unaware that there are programs on prime time television that they might find more objectionable than a film like Bully.  Take the hit show Criminal Minds which deals with people committing the sickest, most twisted violent crimes imaginable – but they don’t visually depict those, they just describe them verbally in graphic detail and this is considered OK, but the F-bomb would still be censored on prime time while a detailed discussion of necrophilia (sex with corpses) would not be and this makes sense to people?

The MPAA ratings has long been criticized for being more lenient with major studios than with independents. Who can forget the lobbying over the rating of Scarface in the 1980’s which three times was given a X rating (today would be NC-17), but made some very small cuts, still had tons of coarse language and managed to get an R rating. Why? Because the studio had $23 million invested in the film. Long time film critic Roger Ebert has criticized the system as have others for treating sex and language more harshly than violence. In some cases, the rating might be determined simply on the number of times the F-word is used. Here is something Roger Ebert wrote on the ratings system recently and he has written many others.  As Ebert points out there are now websites that provide better information to parents about film suitability than the MPAA ratings.

http://blogs.suntimes.com/ebert/2012/03/even_as_i_write_on.html