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7 stocks to shun -- or short
Insider selling and earnings quality questions are a deadly combination. Take a look at 7 companies that could be hit hard.
By Michael Brush
Its a one-two punch that would make Mike Tyson proud.
First comes the straightforward jab: heavy insider selling, a well-known negative signal for stocks. Then, from out of nowhere, comes the left hook: signs of trouble with earnings quality.
These two punches delivered together often weaken a stock, and sometimes they even send it down for the count.
Thats why this right-left combo serves as the formula behind a new list of stocks to avoid -- or short -- published by the Phoenix-based Camelback Research Alliance. Camelback is a research shop that X-rays corporate balance sheets for signs of earnings-quality issues. (It also provides the data for MSN Moneys StockScouter tool.)
According to Camelbacks measures, stocks with lots of insider selling plus signs of earnings-quality problems did worse than the market during the 1990s by 20% on average over 12 months.
By Camelbacks calculations, companies that Tyson might be able to eat for lunch include these seven standouts: Bed Bath & Beyond (BBBY, news, msgs), Brinker International (EAT, news, msgs), Corinthian Colleges (COCO, news, msgs), eBay Inc. (EBAY, news, msgs), Hollywood Entertainment (HLYW, news, msgs), Krispy Kreme Doughnuts (KKD, news, msgs), and NetScreen Technologies (NSCN, news, msgs).
The first punch: Insider selling
Insiders at these companies are on truly massive selling campaigns. Consider Wall Street darling Krispy Kreme. The purveyor of sugary doughnuts has seen Chief Executive Scott Livengood, former Chief Executive Joseph McAleer, Vice President John McAleer, a partnership controlled by senior managers (Jubilee Investments), and other top execs sell over $100 million worth of shares since last summer. Thats an astounding 5% of the current Krispy Kreme market cap.
Top insiders at eBay, including Chief Executive Meg Whitman and Chief Financial Officer Rajiv Dutta, have done nothing but sell -- tens of millions of dollars' worth of shares in the past two years.
Bed Bath & Beyonds Warren Eisenberg and Leonard Feinstein, who serve as co-chief executives, dumped 1.6 million shares worth around $58 million in the past several months alone.
Huge sales at these companies -- and the others on Camelbacks list -- are troublesome enough. But when you mix in potential earnings-quality problems brewing in the financials, they raise even greater worries.
The second punch: Earnings quality issues
Many of these companies rank high for questionable earnings quality simply because of a buildup of so-called accruals in the financials. That doesnt necessarily mean theres any accounting hocus-pocus.
But it does mean theres a growing gap between reported earnings and cash flow. And that disparity can lead to problems down the road.
Simply put, using accruals entails the booking of costs or revenues at a time thats different from the completion of corresponding transactions. The point is to match revenue with the spending that helped generate it.
Example: A retailer buying a summer line of clothes this week wont formally recognize the cost of the inventory until May or June, when it sells the clothes. It uses this accrual practice to smooth out the flow of reported earnings from quarter to quarter, a widely accepted practice that keeps earnings from bouncing around in a maddening way.
But theres a problem. Sometimes this accounting technique can lead to earnings disasters that can KO stocks. The retailers inventory, for instance, may go out of style before its sold. Or the retailer might buy too much, meaning it has to offer heavy discounts just to clear the warehouse. In either of these cases, the amount of revenue the company and Wall Street thought would be matched to those deferred costs this summer will fall short. Result: earnings miss.
More perniciously, of course, companies can bend the rules. They might delay the recognition of costs too aggressively, for instance, to keep up a string of positive earnings surprises that mask weakening fundamentals. Unless some miracle occurs, this will catch up with these companies in the end. And the result again: earnings miss.
We dont know for sure that these kinds of disaster scenarios are going to play out at any of the seven stocks on Mike Tysons potential lunch menu. But the heavy insider selling reveals a clear vulnerability.
Watch at earnings-announcement time
When? Thats the big challenge for anyone thinking of shorting these companies. Typically the reaction to a buildup in accruals is delayed, but it usually happens around the quarterly earnings announcement, says Donn Vickrey at Camelback. The company might miss its earnings forecast. Or it might make the number but do so through some low-quality gains that the market will recognize. Or else the company might meet its numbers, but guide lower.
Heres a quick look at the stocks on Camelbacks list.
Bed Bath & Beyond. The home-products retailer doesnt have a bad overall earnings quality score. It ranks a five on a scale of one to eight. Stocks have to slip down to three or below to be in the real danger zone. But accruals are much higher than at other companies the same size, and inventory turnover is slowing down. On the other hand, the company has an ironclad record for meeting or beating estimates. At around $23, the shares recently bounced off the low end of their recent trading range.
Brinker International. This casual-dining chains earnings-quality score is low at three, in part because the gap between reported earnings and free cash flow is so wide -- a product of both capital spending and acquisitions. But meantime, more than two dozen executives, including the chief executive and the chief financial officer, sold nearly 400,000 shares in the past four months. The company recently traded at around 26.50, the low end of its trading range for the past year.
Corinthian Colleges. While competitors such as ITT Educational Services (ESI, news, msgs) and DeVry (DV, news, msgs) have perfect earnings-quality scores of eight and low accruals that are falling, Corinthians earnings-quality score is lower at five because of unusually high accruals. About 27 top managers, including the chief executive and the finance chief, sold around 600,000 shares in the past three months. At a recent price of $36.60, the company trades just above support levels of $35.
eBay. One of the few big survivors of the dot-com era, eBays stock has been on a tear since October, rising more than 50% to around $77, thanks to strong earnings reports. Accruals are unusually high for a company its size, but earnings quality otherwise checks out. My gut feeling is in the short run they are not likely to have any significant issues, says Vickrey. But I am confident that their luck is going to run out. I just dont know when.
Hollywood Entertainment. This video-rental shop doubled from $10 when we recommended it as a turnaround play in July 2001 to hit $20 last October. Since then, the stock has reversed, trading recently at around $13.
Hollywood now looks cheap. But a big buildup in accruals -- combined with heavy insider selling -- suggests the stock may continue to struggle. Accruals were rising last year in part because the company is deferring the cost of aggressive spending to build new stores and put in Game Crazy video game divisions inside stores.
Theres nothing wrong with a successful company spending to expand its reach, says one shareholder who isnt selling. Thats true, unless negative trends ahead throw cold water on the plans. Among the trends that could do this:- Piracy. Now that DVD copiers are cheap, piracy threatens to hit revenues hard at video distributors -- just as it has over the past five years at music retailers, some of which are now flirting with bankruptcy.
- Cheap DVDs. As DVD prices come down, consumers are buying them more often instead of renting. If the trend continues, it may be difficult for video rental chains to compete with the likes of WalMart Stores (WMT, news, msgs) or Best Buy (BBY, news, msgs).
- Video on demand. This technology, which lets consumers rent movies whenever they want without a trip to the video store, is finally beginning to take off. Video-game business, meanwhile, has recently softened at Blockbuster (BBI, news, msgs) and GameStop (GME, news, msgs).
NetScreen Technologies. This security-software vendor has doubled to trade above $20 since last October on a string of standout upward earnings estimate revisions. Earnings growth is also on a roll, however, partly because of astronomically high accruals, says Vickrey. About 25 insiders, including the chief executive and chief of finance, have sold around 3 million shares in the recent run-up. The same insiders sold ahead of price declines earlier this year.
Krispy Kreme. The nations most fashionable doughnut maker offered shareholders a sweet Valentines Day surprise when it pre-announced a 35% increase in 2004 expected earnings.
The gift sparked a 14% rebound in just two days and helped slow down shareholder selling that kicked in during late January when Krispy Kreme announced plans to buy specialty bread retailer Montana Mills Bread (MMX, news, msgs). Given the huge insider selling, as well as hedging transactions that protect insiders against downside, plus growing potential earnings-quality problems, it looks like shareholders may soon have other things to worry about.
Like Hollywood Entertainment, Krispy Kreme has seen the gap between free cash flow and reported earnings grow wider as accruals build up. Whats more, accounts receivable, or the amount of money customers owe Krispy Kreme, have been rising compared with sales. As of early November last year, receivables were up 64% over the year before, compared to a 29% increase in sales. (The chains customer base extends beyond cash-and-carry doughnut fans to grocery outlets and convenience chains.) Along with a decline in allowance for bad debt, the change in suggests Krispy Kreme has to extend better terms to customers who may have trouble paying, says Camelback.
To be sure, Krispy Kreme has many things going in its favor that could help sweeten returns for shareholders, despite what might otherwise appear to be burgeoning problems. Like any of the firms on the Tyson lunch menu, Krispy Kreme could simply grow fast enough to outrun potential problems. Krispy Kreme doughnuts are such a hit with fans, for example, the chains plan to expand its current store base from around 230 to 1,300 in both the United States and abroad in the coming years could do the trick.
On the other hand, if a sluggish economy or changing consumer tastes blocks the progress by Krispy Kreme -- or any of these companies -- to outgrow financial shortcomings, Mike Tyson could be looking at a sweet lunch indeed.
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