Equity value is down while profits are up?

Accounting Shenanigans: The Case of Pier One

Published on:
September 16, 2018
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Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

A question: If the beginning equity balance was $494 million and the company earned $382 million in a period of five years, should the ending equity balance be higher or lower than the beginning balance of $494 million?

The equity should increase in time. But what is clearly logical in theory is often murky in real life. Traded on the New York Stock Exchange under the ticker symbol PIR, Pier One is the company in question. And to begin the essay with its end: management of publicly traded companies acts materially different than that of private ones.

Pier One

Based in Fort Worth, TX, Pier One is in the business of selling decorative accessories and furniture. It operates from over a thousand leased stores, of which 90% are located within the U.S.

Over the past decade the stock traded hands as low as $4 (in 2017) and as high as $39 (in 2015). And as I type these words, the stock price is less than $2 per share.

The recent decline in the stock price is attributed to trade wars. According to Pier One's most recent public filing, 59% of its products are purchased from China; 17% of the goods are purchased from India; and 16% of the goods are purchased from Vietnam. These three countries are affected by the new trade initiatives. And without getting into the specifics, because the cost to import goods is expected to materially rise, Mr. Market was upset.   

Yet correlation is not causation. Just because trade wars is now a popular news item more people googled the term "trade wars" this month than ever before. was not the reason, in my opinion, for the abrupt decline in the stock price.

I argue that the fall in the stock price of Pier One is related to its corporate governance over the past few years. To cut the politically correct language, I will say it bluntly: At the expense of its shareholders, management has made some terrible decisions over the past few years.

Bad decision number one

In April of 2014, Pier One's management decided that purchasing its own shares in the public market would be an intelligent course of action. The Board of Directors authorized a budget of $200 million for management to purchase its own shares. So, between 2014 and 2017, management purchased over 16 million shares at a weight cost of $10.58.

In March of this year, I wrote about the peculiar way FASB accounting rules treats treasury stock, which can be summarized as follows: As the company purchases its own stock, the equity balance decreases.

Pier One stock now trades hands for $1.85 a share; the stockholders lost, on paper, about $130 millions. I used the expression “on paper” because the loss is theoretical in nature. But you should understand that the $130 million could have been distributed as dividends (management distributed only $90 million in dividends during that time).

We are beginning to unveil how a company that generates revenue and profits showed a declining equity balance. Let us now focus the discussion on Pier One's right side of the balance sheet.

Bad decision number two

For the five years preceding 2015, the average balance of long-term stock stood at $9.5 million. But in the third quarter of 2016, management decided (without giving any detailed explanation to shareholders) that additional debt was needed. And the company ended the year with a whopping $205 million in long-term debt. Since that time, the average long-term debt has been over $200 million.    

Since the asset size of the company did not materially change in total during those years, the equity balance shrunk. In numbers: In 2014, for every dollar of asset, the company had 44 cents of liabilities. In 2017, for every dollar of assets, the company had 64 cents of liabilities. Another way to look at the company's increased level of leverage is to focus on total assets to total equity ratio. We observe deteriorating financials. In 2013 for every dollar of equity the company had 1.6 times the assets. In 2017 for every dollar of equity the company had 2.8 times the assets.  

A possible explanation

Because the nature of accounting rules is that management can reduce the equity book value by purchasing its own shares, management can artificially inflate the return on equity ratio, an earnings ratio highly guarded by Wall Street analysts. Also, evidently, with a lower equity balance, the earnings per share increases, another Wall Street favorite.

Pier One’s 2017 return on equity was 15% - at first glance, a noble achievement for a company selling a product with a 55% mark up (read: the company sells products that cost $100 at $160). But if management had not purchased its own shares, the return on equity would have been a subpar 5%.

The same calculation can be applied to the earnings per share ratio. The 2017 castles in the sky earnings ratio of $0.12 earnings per share would have been $0.003 if management had not purchased its own shares. In the world of earning multiples, it appeared that the stock was traded at 16 times the earnings per share. But as I argued in the preceding paragraph, the earnings multiple was 660 times.

Lesson learned?

According to a CFA Institute survey of fund managers, net present value calculation is one of the most popular investment tools. Net present value calculations estimate the exit price, which often is dependent on book value. My purpose in writing this meditation was to show that to find the book value, even for a profitable company, requires more effort than simply using what the accounting convention dictates.