Value Microcaps Motherboard

[jtomm]

abh3vtand, Researcher and all,

First, I'll just say that this will be my final post on the accounting issue. Everybody views things differently and I'm sure the accounting stuff bores many people. I definitely want to keep it a stock board ("Tell me if the dang thing's goin' up or down, that's all I care about!") and not turn it into an arcane accounting discussion board.

But here's my response to some of the issues raised (I was gone most of the day today).

Firstly, whether you look at it as more shares or more debt, we can all agree that it's pretty deceptive. I would agree that another way to look at the preferred is as $12m more in debt, and mentioned that possibility in my first post on the subject:

http://www.investorshub.com/boards/read_msg.asp?message_id=8410573

In fact, in most circumstances I would say that is the better way to look at it and the by-the-book way to look at it. But again, what I'm looking for as an investor is economic reality, not GAAP rules. And it seems to me that greater outstanding shares is more realistic. Either way, I think it's more or less making the same argument, as I'll get to below.

The non-expensing of stock options by tech companies, for example, was totally in conformance with GAAP, FASB, everybody. Yet you could use those rules to fleece the public by taking a money-losing company and turn it into one that had great EPS, just by issuing stock options to everybody. The whole point was to boost the eps reported to the public. GAAP and FASB rules provided the perfect cover for everyone -- executives, employees, auditors. They were using the rules with the intent to make the EPS look higher, not to give a fair representation to the public.

With AEY, the biggest thing to me is that these guys already control the common. So to say the preferred stock is non-voting is pointless. They control the vote already. They can do anything they want. These preferreds are them too. They issued the preferreds to themselves. The preferreds don't represent money that was lent to them by an investor, nor were the preferred purchased by an investor. If they were, then I would totally agree that the economic reality is more like $12 in subordinated debt.

But that's not the case here. It's all them. They "owe" it to themselves. How much control do they need, for crying out loud? Why pay dividends when you could be paying interest, which is deductible as someone pointed out? At the snap of a finger they could also issue a pr saying, "in order to align management's interests with shareholders', we've decided to eliminate the preferred shares and convert them to common to put management on an equal footing with common shareholders, not above them." Why couldn't it have been just everybody owning common from the outset? They could have issued themselves any number of common shares they wanted. Why all the rigamarole?

And that "stated value" nonsense, what is that all about? Why issue 300,000 preferred shares at $40, instead of 4,000,000 at $3, or whatever the price was at the time? The stock has never traded near $40. Management set this up and gave these preferreds to themselves, a disinterested third party did not buy them. I would contend that the reason you'd do that is precisely so that you could use the rules to say the preferred is anti-dilutive. A quick glance at the balance sheet also makes it look better (300,000 shares is a lot less than 4m), and those shares can never be counted against earnings, on purpose.

That's the same reason you would make them non-voting (a ridiculous term when you already control the common), and non-convertible. Precisely so they couldn't count in dilution. Again, I'm not arguing GAAP, I'm arguing economic reality. And again, why weren't these all just common shares from the start? I'm always very leery when someone opts for confusing over simple. There's usually a reason.

One more working-backward example to illustrate the point. Forget AEY for now, and again look at the bigger point of economic reality.

Let's start with a company with no preferred, only common. Let's say the company does $100m revenue and net income of $10m. No debt. Legitimate numbers, legitimate business. It has 10m shares outstanding for EPS of $1. Let's say the stock has a p/e of 15, and therefore trades at $15. So the market values this company at $150 million. Let's further say 2 insiders own 70% of the stock (7m shares). Then let's say they generously agree to exchange 1.5 million of their common shares for just 100 preferred shares, each with a stated value of $2 million. For simplicity sake, and to stay away from the argument about the dividend's effect on EPS, let's say the preferreds have no dividend, non-voting, non-convertible.

In economic reality, hasn't management just wiped out the common holders entirely, and yet get to announce an increase in earnings per share? The company was only worth $150m before. Now it's got a $200m liability in addition to the $127.5m market cap (8.5m common shares at $15).

If those number are still too close, let's get even more absurd and say the 100 preferred shares each have a stated value of $2 billion. Now there's no doubt. Yet, the more common shares management exchanges, the better the eps gets!

Yes, the financials still attribute the earnings to the common holders, but that's not reality -- that's by design, because this is a self-dealing transaction, not a third-party investor. The company was only worth $150m to begin with, yet earnings now look better even though the investor is paying for the market cap AND the unbelievably massive liability. To own the business free and clear, the investor would have to pay both. Since p/e only focuses on the market cap of the common, it's a total deception. You're eliminating the common shares on purpose, and transferring them to a different security that doesn't dilute the common, on purpose. All so you can boost the eps reported to the public, on purpose. The investor now owns something not worth owning, but doesn't know it.

To compare it to a $100k rental house, it's either like paying $100k for the rental house and then finding out that there's 20 jillion additional owners who all own the same amount of the house as you do (the dilution method), or it's like you own the $100k house by yourself, but don't realize you owe $20 jillion in debt against it, and are instead encouraging your neighbors to buy one too! (the hidden liability method). Either way, you wouldn't buy the house if you truly knew what was going on.

Whether you view it as more shares or more debt almost becomes immaterial. The point is the p/e vastly, vastly understates what the investor is paying for the company (or the house), and yet the whole point of this paper-pushing is to pump up the EPS.

Back to the example, management of such a company would of course announce the increase in EPS in the headlines and mention their magnanimous exchange to the preferreds down towards the bottom of the press release. But quite a few in the public wouldn't notice or understand what's going on. At quick glance, and to the average investor, it would appear the stock is a much better bargain. Only 8.5m common shares out, instead of 10m. Same earnings, so earnings per share went up! This company's really moving! Buy! Buy! Buy!

And the example doesn't really change much if you set the company up that way from the start, rather than convert to preferred mid-stream. In fact, it's better because you never have to answer questions about why the conversion from common to preferred.

-Bottom line, I just don't see many legitimate reasons to set things up like this. I'm always leery when the company owes money to top management, and is doing incestuous deals, and owes themselves on a preferred, etc.

Think about that preferred structure. Why make things so complicated for yourself? How come so many companies can get by with just common shares, and all shareholders in the same boat? How come so many companies can issue preferred shares at the market price, but these guys somehow have to use a "stated value"?

Welp, that's about all I've got. That's the way I see things. But right now my bladder's getting full and I've got a Monopoly game to play, so everyone have a good night.