Filing Season Finds: Week Of February 26 - March 3 - A Euro Big Bank - Hedge Fund Alpha (formerly ValueWalk Premium)
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Filing Season Finds: Week Of February 26 – March 3 – A Euro Big Bank

Our latest featured stock is a consumer finance company with significant hidden non-operating income and material weakness in its internal controls.

Check out our H2 hedge fund letters here.

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We pulled this highlight from last week’s research of 593 10-K filings, from which our Robo-Analyst technology collected 92,555 data points. Our analyst team used this data to make 14,753 forensic accounting adjustments with a dollar value of $4.2 trillion. The adjustments were applied as follows:

  • 6,332 income statement adjustments with a total value of $329 billion
  • 6,000 balance sheet adjustments with a total value of $1.7 trillion
  • 2,421 valuation adjustments with a total value of $2.2 trillion

Figure 1: Filing Season Diligence for Week of February 26-March 3

Sources: New Constructs, LLC and company filings. 

Every year in this six-week stretch from mid-February through the end of March, we parse and analyze roughly 2,000 10-Ks to update our models for companies with 12/31 and 1/31 fiscal year ends. This effort is made possible by the combination of expertly trained human analysts with what we call the “Robo-Analyst.” The Robo-Analyst uses machine learning and natural language processing to automate much of the financial modeling process.

A Fiduciary Level of Diligence

Our technology enables us to deliver fundamental diligence at a previously impossible scale. We believe this research is necessary to fulfill the Fiduciary Duty of Care. Ernst & Young’s recent white paper, “Getting ROIC Right”, demonstrates how these adjustments contribute to materially superior models and metrics.

Only by reading through the footnotes and making adjustments to reverse accounting distortions can advisors go beyond the suitability standard and provide a fiduciary level of service to their clients.

One Company to Watch in 2018

Based on our analysis of Santander Consumer USA Holdings’ (SC) 2017 10-K, we have downgraded the stock from Neutral to Unattractive. Analyst Eric Roll identified three significant red flags buried in the footnotes.

On page 119, SC reported a $678 million tax benefit (57% of GAAP net income) due to the revaluation of its deferred tax liabilities as a result of tax reform. This non-cash, one-time benefit allowed SC to report an effective tax rate of -44%. We adjusted for this non-operating item to keep SC’s tax rate at its average of ~35%.

On page 100, the company disclosed a $148 million decrease to its credit loss allowance (12% of GAAP net income). This decrease in reserves artificially inflated SC’s reported net income in 2017.

Finally, on page 79, SC’s auditor, Pricewaterhouse Coopers, stated its opinion that SC “did not maintain, in all material respects, effective internal control over financial reporting.” Specifically, PwC raised concerns over the models SC used to estimate its credit loss allowance.

Any material weakness in internal controls should be a red flag for investors as these weaknesses are correlated with an increased risk of a stock price crash. In SC’s case, the red flag is even larger due to the fact that its material weakness is related to the change in its credit loss allowance that artificially boosted net income by $148 million.

In total, we made the following adjustments to Santander Consumer USA Holdings’ 2017 10-K:

Income Statement: we made $805 million of adjustments, with a net effect of removing $796 million in non-operating income (12% of revenue). You can see all the adjustments made to SC’s income statement here.

Balance Sheet: we made $3.4 billion of adjustments to calculate invested capital with a net increase of $3.3 billion (43% of reported net assets). Aside from the credit loss allowance referenced above, our largest adjustment was to add back $86 million in off-balance sheet debt. You can see all the adjustments made to DFS’s balance sheet here.

Valuation: we made $988 million of adjustments with a net effect of decreasing shareholder value by $988 million. The largest adjustment to shareholder value was $897 million in deferred tax liabilities. This adjustment represents 15% SC’s market cap.

After making all these adjustments, we found that SC’s return on invested capital (ROIC) decreased from 10% to 4% in 2017, even as its GAAP net income increased by 55%. These misleading earnings make SC a high-risk stock for investors.

This article originally published on March 5, 2018.

Disclosure: David Trainer, Eric Roll, and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

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Article by Sam McBride, New Constructs


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