More Than an Indestructible Bull Market

volume xvii issue 4

The Financial Accounting Standards Board (FASB) and the IASB (FASB’s international peer) jointly released Accounting Standards and Codification Rule 606 as a requirement for companies to report revenue, with a few exceptions, in the accounting period earned.  In other words, when the vendor is paid.  Heretofore, revenue smoothing techniques were allowed in certain industries, so that companies could record average income over several years.

ASC 606, aka “Revenue from Contacts with Customers” is widely considered the most significant change to accounting standards since Sarbanes Oxley.  606 has been in development for a decade.  It goes live January 1, 2018.

In January, when full-year earnings reports for 2017 come out, US stock prices will react poorly due to greater uncertainty in corporate earnings, than due to Republican/Democrat competition for new legislation, unease about President Trump’s domestic and foreign policy decisions, combined.

The Rule affects publicly traded companies reporting adjusted sales for the fiscal year ending in December 2017.  For privately held companies, the deadline for compliance is December 2018.  Companies must also be prepared to disclose more information about their contracts and order backlogs in notes to financial statements.

In a recent publication from Citigroup, "We expect that (the new rules) will cause significant investor confusion over the next 12 months to the financial analysis of companies ranging from small companies up to the largest, including Microsoft”.

And here’s why.

ASC 606 requires all industries to use the same reporting guidelines.  Companies like Yum Brands (owners of Kentucky Fried Chicken and Pizza Hut) and Proctor & Gamble (laundry detergent, toothpaste and paper towels) aren’t much affected by the Rule since consumer products manufacturing and retailers have no economic need to defer revenue.  Income at every stage in the supply chain is recorded at the point-of-sale.

But a lot of other multi-billion-dollar industries are affected.  Revenue smoothing is enjoyed by companies who have large, multi-year contracts with government and private industry.  Companies that build roads and bridges, data centers, manufacture aircraft, submarines, and rail engines are particularly impacted.  With defense industry contract labor, a dominant source of employment where I live in Washington DC, the current practice of recognizing order backlog can no longer be used to adjust reported revenue.

Here is an example:  Let’s say Company A sells contract labor for software development to the Defense Department.  Company A is awarded a contract with total revenue of $10M, earned over the five-year life, aka “period of performance”.  $2M is claimed (booked as revenue) per year with current smoothing methods, allowed by law.  Without smoothing, Company A must book revenue when it’s received, so maybe $3M in year one is recorded.  Then $1M in each of the following two years.

Let’s say further that up to $5M is forecasted to be received in years four and five, depending on performance incentives.  Standing alone, this contract would now show a revenue drop by two-thirds after the first year.  And maybe the government included provisions in the contract to cancel at any time after year two – not an uncommon caveat.

Contract cancellation can occur if the vendor doesn’t perform well, or if the government decides to change the scope of work, or wants new pricing.  Now the out-year revenue forecasts have become entirely a wildcard.  Those estimates cannot be included on the income statement.  Instead, the revenue risks are highlighted in notes to the financial statements with no material impact to the bottom line.

The math for calculating cash flow in the future is pretty simple.  To evaluate projects, Company A must apply a higher discount rate, maybe derived from higher borrowing costs, that reduces the likelihood or guarantee of sources of future income.  The result, and Wall Street analysts can run the numbers pretty quickly, is a lower valuation for the company, and in turn a lower share price.

Stock price targets in the most impacted industries need to be adjusted downward and the market will react to the change.  The effect is equally painful if the company wants to be acquired.  It won’t fetch as much in the M&A marketplace than it would have a year ago. M&A deals are valued on sales (more so than earnings), cash flow and working capital.

With software, entirely SaaS companies are expected to be the least affected among the industry group.  Once the application or an update is released, the vendor is paid monthly.  Thirty years of historical pricing with multi-year site license and user agreements – enterprise installations – will be a memory soon.  Have these accounting changes been anticipated by the software industry?  Do the changes support pricing via recurring revenue in the cloud? Look at Adobe.  Look at with Oracle nipping at their heels for the lion’s share of cloud revenue.  You bet it’s strategic!

So where are the profit opportunities?  ASC 606 is an accounting change to reporting requirements on financial statements.  ASC 606 is not a change of the underlying fundamentals and business opportunities of the company or the industry it's in.  So view this as a temporary uncertainty that could lower stock prices and present buying opportunities.

Earnings are a real concern in Q1 2018 for these affected companies, given the backdrop of a complacent US stock market immune to bad news.  Investors on the buy side benefit, provided they keep cash available and are willing to stomach the risk. Forget about the 24-hour news cycle.  We are way overdue for a market correction anyway.  Stay tuned for more volatility, and a little more drama in 2018.

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