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AGNC analysis of the income account> earnings of subsidiaries

We need to examine American Capital Agency Corp’s (AGNC) earnings statements and balance sheets to make sure there are no misleading artifices in their income account.  Today we will check to make sure they didn’t manipulate their earnings by padding their income account with some subsidiary sleight-of-hand.  This is easy since AGNC has no subsidiaries.  No adjustments are necessary.

 

Please read this excerpt from Securities Analysis on the topic and apply it to stock you own or are considering to purchase with subsidiaries.

 

 

On comparatively rare occasions, managements resort to padding their income account by including items in earnings that have no real existence.  One flagrant corporation did the following during the Great Depression:

 

“An examination of the balance sheets discloses that during these two years the item of Good-will and Trade-marks was written up successively from $1,000,000 to $1,600,000 and then to $2,000,000, and these increases deducted from the expenses for the period.

 

These figures show a reduction of $1,600,000 in net current assets in 15 months, or $1,000,000 more than the cash dividends paid. This shrinkage was concealed by a $1,000,000 write-up of Good-will and Trademarks.  No statement relating to these amazing entries was vouchsafed to the stockholders in the annual reports or to the New York Stock Exchange in subsequent listing applications. In answer to an individual inquiry, however, the company stated that these additions to Good-will and Trade-marks represented expenditures for advertising and other sales efforts to develop the business of Tintex Company, Inc., a subsidiary.

 

The charging of current advertising expense to the good-will account is inadmissible under all canons of sound accounting. To do so without any disclosure to the stockholders is still more discreditable. It is difficult to believe, moreover, that the sum of $600,000 could have been expended for this purpose by Park and Tilford in the three months between September 30 and December 31, 1929. The entry appears therefore to have included a recrediting to current income of expenditures made in a previous period, and to that extent the results for the fourth quarter of 1929 may have been flagrantly distorted. Needless to say, no accountants’ certificate accompanied the annual statements of this enterprise.”

 

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High dividend stocks – Analysis of AGNC’s income account Part 1

 August 23rd, 2010

 

AGNC’s income statement must present a fair and undistorted picture of the year’s operating results if we are to use it as a basis for investing our capital.  We all still remember the lies of Enron, MCI WorldCOM, and the entire banking industry’s loan write-downs.  You can’t just trust the income statement just because they were audited.  Enron was audited by the spineless liars such as Arthur Anderson.  You may need to critically examine and adjust the numbers with respect to three important elements:

·         Nonrecurrent profits and losses

·         Operations on subsidiaries or affiliates

·         Reserves

 

Remember that our purpose of analyzing the income statements is to learn:

What are the true earnings of AGNC for the period studied (May 2008 – present)

What indications does the earnings record carry as to the future earning power of AGNC?

What elements in their earnings exhibits must be taken into account, and what standards followed, in endeavoring to arrive at a reasonable valuation of AGNC’s shares?

 

AGNC’s management has considerable leeway in the method of treating nonrecurrent items.  Accounting procedure allows this.  Transactions applicable to past years (2008 and 2009 for AGNC) should be excluded from current 2010 income and entered as a charge or credit direct to the surplus account.  However, there are many kinds of entries that may technically be considered part of the current year’s results, but are nonetheless of a special and nonrecurrent nature.  Accounting rules permit AGNC’s management to decide whether to show these operations as part of the income or to report them as adjustments of surplus.  The following are a number of examples of entries of this type:

1.       Profit or loss on sale of fixed assets.

2.       Profit or loss on sale of marketable securities.  (This surely applies to AGNC.  We will have to examine this portion of their income statements carefully.)

3.       Discount or premium on retirement of capital obligations.

4.       Proceeds of life insurance policies (This is probably not applicable to AGNC).

5.       Tax refunds and interest thereon (We’ll check to see if they received any tax refunds and interest)

6.       Gain or loss as a result of litigation (We’ll find out if there is any).

7.       Extraordinary write-downs of inventory (Maybe).

8.       Extraordinary write-downs of receivables (I don’t think this has happened yet.  But, definately if Fannie and Freddie can’t guarantee MBS principal and interest payments to AGNC)

9.       Cost of maintaining nonoperating properties (not applicable – this happens more with manufacturing and mining)

 

Our object is to segregate all these items from the ordinary operating results of the year.  We really want to learn from the annual report and 10-K filings what AGNC’s indicated earning power is under the given set of conditions.  All these extraordinary items need to enter properly into our calculation of earning power as actually shown over a period of years in the past.  AGNC started operating its business in May 2008, so there isn’t much history for this company.  One of its competitors Annaly Capital (NLY) has been around much longer.

 

AGNC has no controlled or affiliated companies, so we don’t have to adjust reported earnings for this category of analysis.

 

Lastly, we must give critical attention to the matter of reserves for depreciation and other amortization, and reserves for future losses and other contingencies.  If the government changes the laws regarding Fannie Mae and Freddie Mac or the FED buys or sells MBSs, then AGNC can suffer huge future losses on the value of their agency securities.  We need to check this out carefully.

 

If you missed the beginning of the analysis of AGNC, then please visit www.myhighdividendstocks.com to read the last couple of posts.  I selected AGNC for high dividend stock analysis because it has a whopping 20% dividend yield.  Should you buy it, sell it, or stay away?  You’ll find out if you stick around for the next few weeks.

 

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High dividend stocks - Words before we begin analyzing AGNC's earnings

In my last post I covered American Agency Capital Corp.’s (AGNC) dividend rate and record.  You can read that post and catch up on my analysis of AGNC by clicking here: http://tinyurl.com/3624qch.

 

Words before we start our analysis of the income account – copied extensively from Security Analysis chapter 31.

I recommend that you value AGNC [and any company for that matter] as you would if you were going to purchase the entire company in a private transaction.

 

Given sufficient information you shouldn’t go astray in your valuation of AGNC.  Their 2009 annual report, most recent 10-K filing with the SEC, and earnings conference call audio recordings should contain the information necessary for analysis of AGNC’s business.

 

You should arrive at intrinsic values similar to that which bankers evaluating the credit worthiness of the enterprise would arrive at.  Basically, I’m saying that you should analyze both corporate earnings and the corporation’s assets (balance sheet).  We should not rely on a single earnings test to determine if an investment in AGNC it prudent.  A single earnings test would be less dependable than the two fold earnings and balance sheet tests.   Earnings statements are subject to more rapid and radical changes than the changes which occur on a balance sheet.

 

Lastly, earnings statements can be more misleading in their presentation by company management and can contain more mistaken inferences than the typical balance sheet when scrutinized by an experienced investor.

 

Keep in mind as we begin the analysis of the earnings statement that the meaning of AGNC’s income statement cannot be properly understood without reference to the balance sheet at the beginning and end of the earnings period.

 

Here is a simplified statement of Wall Street’s method of appraising common stocks:

1.       Find out what the stock is earning.  (This usually means the earnings per share as shown in the last report.)  AGNC earned $1.23 per share in the most recent quarter.

2.       Multiply these per-share-earnings by some suitable “coefficient of quality” which will reflect:

a.       The dividend rate and record.

b.      The standing of the company – its size, reputation, financial position, and prospects.

c.       The type of business (e.g., a technology company will sell at a higher multiple of earnings than a slow growth consumer staples manufacturer).

d.      The temper of the general market.  (Bull market multipliers are larger than those used in bear markets.)

 

The foregoing may be summarized in the following formula:

 

Price = current earnings per share X quality coefficient.

 

Current price ($26.98) = current EPS last four quarters ($6.97) X quality coefficient (3.87)

 

Graham’s “quality coefficient” is commonly known as “price/earnings ratio” today.

 

The result of this procedure is that in most cases the “earnings per share” have attained a weight in determining value that is equivalent to the weight of all the other factors taken together.  The truth of this is evident if it be remembered that the “quality coefficient” is itself largely determined by the earnings trend, which in turn is taken from the stated earnings over a period.

 

AGNC’s earnings not only fluctuate, but they are subject to arbitrary determination by the company’s management.  It will be illuminating if I summarize at this point the various devices, legitimate or otherwise, by which per-share earnings may at the choice of those in control be made to appear either larger or smaller.

1.       By allocating items to surplus (retained earnings) instead of to income, or vice versa.

2.       By over-or understating amortization and other reverse charges.

3.       By varying the capital structure, as between senior securities and common stock.

4.       By the use made of large capital funds not employed in the conduct of the business.

 

I don’t know if AGNC’s management has manipulated any of their earnings statements yet.  We will discover that as I perform analysis on AGNC’s income statements in upcoming posts.

 

Significance of the foregoing to the analyst and to you

These intricacies of corporate accounting and financial policies undoubtedly provide a broad field for the activities of the securities analyst (that’s me).  There are unbounded opportunities for shrewd detective work, for critical comparisons, for discovering and pointing out a state of affairs quite different from that indicated by the publicized “per-share earnings”.

 

That this work may be of exceeding value cannot be denied.  In a number of cases it will lead to a convincing conclusion that the market price for AGNC is far out of line with intrinsic or comparative worth and hence to profitable action based upon this sound foundation.  But it is necessary to caution the analyst against over confidence in the practical utility of my findings [Graham is warning me].  It is always good to know the truth, but it may not always be wise to act upon it, particularly on Wall Street.  And it must be remembered that the truth that I uncover if first of all not the whole truth and, secondly, not the immutable truth.  The result of my study is only a more nearly correct version of the past.  My information may have lost its relevance by the time I acquire it, or in any event by the time the market place is finally ready to respond to it.

 

With full allowance for these pitfalls, it goes without saying, nonetheless, that security analysis must devote thoroughgoing study to AGNC’s corporate income accounts.  It will aid in our exposition if we classify this study under three headings:

1.       The accounting aspect.  Leading question: What are the true earnings of AGNC for the period studied?

2.       The business aspect.  Leading question: What indications does AGNC’s earnings record carry as to the future earning power of the company?

3.       The aspect of investment finance.  Leading question: What elements in AGNC’s earnings exhibit must be taken into account, and what standards followed, in endeavoring to arrive at a reasonable valuation of the shares?

 

Read all about my valuation of AGNC and other topics affecting your investment portfolio at www.myhighdividendstocks.com

 

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