As an investor, I really enjoyed working on the Chemical Financial Corporation case. This study not only helped me understand better the management’s treatment of the securities investment available-for-sale, but also reminded me of an unpleasant memory. I have an unforgettable investment experience with a small tech cap which lost a significant amount of money from investing derivatives greater than the amount of its equity. Until then the company’s earning had been decent but the share price went down quickly upon the news about the investment loss. I did not understand why the loss incurred out of sudden and the company had to be delisted. But through the case study, I know why. As a result, I lost about $30,000 USD 7 years ago. It was an invaluable lesson to me in my life especially when I was obsessive with stock investment.

“Mr. Ackman, head of Pershing Square Capital Management LP, publicly alleged that Herbalife was a pyramid scheme last year and announced a $1 billion short bet against the company. Although Herbalife, a nutritional-supplement maker, saw its shares dip after Mr. Ackman’s broadside, it has been one of the strongest gainers in the stock market this year. The Wall Street Journal reported last month that Mr. Ackman’s losses on the bet were more than $300 million. “

This article was intriguing. It is not much related to my personal experience and the Chemical Financial Corporation but gives insights about the unrealized losses in investments available for sale. Mr. Ackman is a successful investor with “an impressive track record and his main fund has averaged more than 20 percent per annum in gains since launching in 2004”. He has a strong conviction that Herbal Life is a pyramid scheme and shorted a $1 billion on the company. Unfortunately, the stock price went up very high, bringing Mr. Ackman hundreds of millions of loss. Herbal Life’s earning in 2012 rose to $1.20 per share from $0.73 in 2011. Its net income also has grown gradually; everything looks fine according to the Herbal Life’s 10K. Herbal Life’s business seems to be just promising to me. I spent a couple of hours searching for the company’s activities related to the pyramid scheme which Mr. Ackman claimed. But nothing has been found.

Reading this article, two thoughts just came up in my head. First, I was very curious about what really makes Mr. Ackman is so confident about his argument even bearing a huge risk that he might lose many of his investors. Second, I found admirable the transparency that the unrealized loss of Mr. Ackman’s company was disclosed public and the trust that his investors still keep their investments in him even after the unrealized loss was known.

Article:

http://online.wsj.com/news/articles/SB10001424052702304906704579112211607810806Referenced:

http://www.reuters.com/article/2013/10/29/hedgefunds-ackman-idUSL1N0IJ2JA20131029

Reference:

http://www.sec.gov/Archives/edgar/data/1180262/000119312513065327/d452887d10k.htm#tx452887_8

In the most recent discussion of “available for sale securities” (AFS) in the Chemical Financial Corporation case study, a heavy emphasis was placed on the analysis of the accounts and the criteria in which an investment security was classified as available for sale. The AFS securities in the case included US Treasuries, mortgage-backed securities and other conventional debt and equity securities on the balance sheet of the Chemical Financial Corp. Interestingly and surprisingly enough, the balance sheet of CHFC did not list stand-alone mortgages as available for sale investment securities, a common trend within the banking industry today.

In an article written for DailyFinance.com, Jordan Wathen of The Motely Fool, discusses the strategic implications of a bank treating its mortgages as “held to maturity” rather than “available for sale,” which, at first blush seems to be a subtle if not irrelevant  accounting quirk.  Of course, the devil is always in the details, and a bank shifting its loans to “held to maturity” from “available for sale” creates additional risk for the bank (and its investors), because the banks must hold these loans to maturity in an economic environment, marked by, if nothing else, rising interest rates. Rising interest rates could have calamitous effects on the net interest margin of these banks.

The available for sale account allows for banks to hedge interest rate risks by allowing them to sell securities with low yields.  The objective with this strategy would not be to capture return, as loans would likely have to be sold at a discount, but rather to limit losses.  Why would a bank allocate (and hold captive, for that matter) capital with a return of 4%, when its competitors are lending capital at 6%? The held-to-maturity account facilitates that type of strategic blunder, especially in today’s extremely sensitive interest rate environment.

In a somewhat puzzling comparison, JPMorgan Chase smartly holds nearly “all of its investment portfolio as available for sale” while its contemporary, Bank of America Corp, had over $55B in held-to-maturity investments, putting them in a vulnerable position if interest rates do rise. US Bank is following suit with BAC, adopting similar accounting practices, holding nearly 10% of its total assets in held to maturity.  In these bank’s defense, Wathen states that moving assets to held-to-maturity relieves some of the strain of capital requirements, and losses on the accounts are not covered under the jurisdiction of the Basel III regulations.

Whatever the case, these accounts must be analyzed with caution, and banks (and by association, its shareholders) must consider the implications of its accounting decisions relative not just to its own balance sheet and financial statements, but also to the economic climate surrounding its business.  Indeed, there had better be a very good reason why a bank would choose to hand-cuff itself by placing a liquid enough asset into a seemingly restricted held-to-maturity account.

Article: http://www.dailyfinance.com/2013/10/10/1-thing-bank-investors-should-watch-this-quarter/

When we refer to the financial statements of Chemical Financial Corporation we can clearly see on page 92 as to how the Available for sale securities are recorded on fair value based on a three-level hierarchy established by GAAP. The company  records it available for sale securities as per Level 2 which is defined in the company’s Annual report as follows:

“Level 2 Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Valuations are obtained from a third-party pricing service for Level 2 investment securities.”

Now let calculate the Original cost of available for sale securities as of 31 December 2012 .As per Note 3 of the financial statements the Market value of Available for sale securities is $586,809(in thousands) as discussed in class to arrive at the original cost of available for sale security we need to deduct the unrealized gains and in case of a unrealized loss we need to add it back   .As per the financial statements the original cost is   $580,234(in thousands) with an unrealized gain of $6575 (in thousands)

Since 1996 the mergers and acquisitions of the company are as follows:

1 branch of TCF financial corporation in 1998

1 branch of Standard Federal Bancorporation, Inc in 1998

2 branches of Old Kent Financial Corporation in 2000

Shoreline Financial Corporation in 2000

4 Branches of Fifth Third Bancorp in 2001

Bank West Financial Corporation in 2001

Caledonia Financial Corporation in 2003

2 Branches of First Financial Bancorp in 2006

O.A.K. Financial Corporation in 2010

21 Branches of Independent Bank Corporation in 2012

( Source: http://www.snl.com/irweblinkx/corporateprofile.aspx?IID=100200)

According to the article in the Wall Street Journal (http://online.wsj.com/article/PR-CO-20131031-914742.html?dsk=y) published on October 31,2013 regarding third quarter results of Bank of Commerce Holdings, it was interesting to see how the company financials were effected by the available for sale securities (AFS). The AFS securities were utilized as a secondary source of liquidity. These resources were used for funding commercial and commercial real estate loan when required. Available-for-sale investment securities totaled $209.6 million at September 30, 2013, compared with $218.5 million at June 30, 2013. During the three months ended September 30, 2013 the Company’s securities purchases were centered in asset and mortgage backed securities.

At September 30, 2013, the Company’s net unrealized losses on available-for-sale securities were $4.3 million compared with $692 thousand net unrealized losses at June 30, 2013. The unfavorable change in net unrealized losses was primarily due to decreases in the fair values of the Company’s municipal bond and mortgaged backed security portfolios. The decreases in the fair values of these securities were primarily driven by changes in market interest rates and or widening of market spreads.

When I saw this increase in the unrealized losses, I was curious to know how banking industry was trending about MBS securities and municipal bond at this point in time. And I found another article (http://www.zerohedge.com/news/2013-09-02/unrealized-losses-commercial-bank-available-sale-securities-plunge-2009-levels) that reiterated that ongoing rates blow out on commercial banks “available for securities”, and quoted a drop of $24 billion in unrealized gains in a month, being the biggest monthly drop, while at this time interest rates surged by 100 bps. The article also stated that “as of August 21 the formerly net profit has turned into a net loss of ($16) billion. The is the most negative the AFS number for the commercial banks operating in the US, has been since late 2009.”

In conclusion, the future changes in the value of the Mortgage back securities depends on their rate of interest and market volatility. This in turn will effect how AFS securities are distributed among various forms of short-term investment.

Neiman Markus announced their 2 year plan aimed at reinforcing the company’s image as a retail innovator. In the past the department store used to be the leading example of the retail industry as the first retail store to offer a customer loyalty program and as one of the first luxury retailers to start selling products online. Now they are trying to improve their online presence along with the in-store experience, with initiatives like ship-to-store delivery and free shipping and returns all year round both for online and in-store purchases. The project announcement comes just after the news of the company’s sale to the Ares Management and the Canada Pension Plan Investment Board.

Since 2011 Neiman Markus has been trying to match the online and the in-store experience, by incorporating some of the advantages of shopping online to it’s physical stores and vice versa. Their site has been redesigned so as to align with the layout of the quarterly publications, a “find in store” button has been added to help domestic clients find products in nearby stores and international clients can now see the prices in their local currency and enjoy free shipping as well. On the other hand many technical enhancements have been incorporated into Neiman’s physical stores so as to make the experience more satisfying. Associates carry with them smart phones in order to be able to assist clients with any type of request (alterations, deliveries, availability etc). Additionally iPads are available for the customers throughout the stores.

This initiate, that the retailer budgets at $100 million dollars, will help them resist the pressure of online retail giant Amazon that keeps innovating and attracting customers through even more channels. Their last effort includes a “register and pay with Amazon” service that became available through participating online stores. Neiman’s strategy of improving at the same time all channels (in store, online and mobile) will be vital to the company’s future and is an undertaking that will take 3 years to complete. The funds will be raised during the 2014 fiscal year and implementation of the project will start in 2016.

Sources: 

http://www.retailsolutionsonline.com/doc/neiman-marcus-takes-on-amazon-in-million-omni-channel-project-0001

http://www.retailsolutionsonline.com/doc/neiman-marcus-decides-that-free-shipping-is-not-just-for-the-holidays-0001

Nieman Marcus tried a new trick this season – selling a Mystery Box. It was a hit, with customers quickly snatching up $250 boxes filled with surprise items. A different kind of promotion, it was still pretty straight-forward, as each customer received the same thing, and they could count on Nieman Marcus to provide them with a quality collection worth well more than the sticker value of the box. On the accounting side, it seems pretty easy to deal with; recognize Revenue for 250/box, COGS at their true value, and then Retained Earnings need to be debited for the value of the difference.

However, this campaign seems to be a simple imitation of the Luck Promotions common in Japan and other Asian countries. In deals such as this one, customers purchase an item, having no idea of its value. Sometimes, the contents may be priced accurately, some times the contents are worth less than the ticket value, and other times they can be worth quite a lot more than their ticket value. In this case, how should a company account for their COGS?

On the one hand, Specific Identification would seem to be preferred, as each of these bags can have a radically different value. However, assuming this is impossible, what then? Pricing the COGS using a weighted average calculation seems the most appropriate. Not only is it an accessible method of inventory calculation, it seems to accurately reflect the value of the contents. After all, when a customer buys a “cheap” bag, they are not actually buying the contents of the bag, rather they are buying a possibility of receiving an expensive bag. Essentially, what they are buying is the expected value of the bag – or in other words, the Average cost of the contents.

This type of accounting may make sense locally, but it will need to be reconciled with the actual inventory count, and the inventory methods of the company. Therefore, an adjusting entry for a marketing cost will probably need to be made at the end of the promotion.

Those, who know Neiman Marcus, know that this merchant sells some grand items. It is not your next door Macy’s or TJMaxx; this retailer offers high-quality, premium goods that only few people can afford.

But today, Neiman Marcus didn’t offer another glamorous $300 sweater from a famous fashion designer; neither had it introduced another pair of shiny black shoes. It went higher than that, a move, I would deem epic in a way. This move is the introduction of one of a kind home gadget that only a selected few could ever afford: a 1.5 Million Dollar Outdoor TV!

What is so special about it? Well, this is waterproof and designed by a Porsche team! It is stored underground and emerges with a push of a button on your iPad. The screen’s diagonal is 201 inches and it is over 15 feet tall when in use. It also comes with DirecTV satellite, 300 built-in movies, and a Blu-ray DVD.

The inventory costs would reflect as follows:
Unit cost: 1.2 Million
Installation: 300K
Optional speaker upgrade: 1 Million

However, with this price tag, Neiman Marcus expects to sell only 25 items this year. One of the lucky buyers will be famous LA developer: Mohammed Hadid (partially seen on Real Housewives of Beverly Hills).

I presume at these price levels and quantities, outdoor TVs will be easy to calculate. I would recommend to stick with FIFO cost assumption method as TV prices (like any electronics) are rapidly falling in value. Thus, this natural deflation would help to report less money on the income statement (Net Income) and pay fewer taxes to IRS; thus, releasing capital for other business needs.

Source: http://news.cnet.com/8301-17938_105-57608184-1/neiman-marcus-offers-$1.5-million-outdoor-entertainment-system/

http://www.dallasnews.com/business/retail/20130909-dallas-based-neiman-marcus-sold-for-6-billion.ece

Neiman Marcus was founded in 1907. The company operates 41 Neiman Marcus stores, 2 Bergdorf Goodman locations, 36 Last Call stores and 6 Cusp Stores. Neiman Marcus also runs an upscale online retailing division under Neiman Marcus, Bergdorf Goodman, Last Call, and Horchow brands. On September 9, 2013 a Los Angeles private equity firm and Canada’s largest public pension fund announced that they are buying Neiman Marcus Group for $6 billion. The 2 parties hold an equal interest in the luxury retailer, and Neiman Marcus management led by CEO Karen Katz will retain minority stake. The final sale is expected to go through in the 4^th quarter of this year. Customers will not see any change of this buyout when shopping in Neiman Marcus stores because there has not been a lot of press coverage on this story.

Fort Worth based TPG and New York based Warburg Pincus have owned Neiman Marcus since 2005 as part of a $5.1 billion leveraged buyout. The parties were entertaining private buyers while the company was proceeding with plans for an IPO. Through this sale, the 2 buyout firms have reported a %150 profit on their combined $1.2 billion initial investment in Neiman Marcus. The parties are expected to receive about $2.75 billion in the sale on top of $400 million they got last year from a one- time dividend.  Part of the purchase price will be used to repay about $2.7 billion debt.

Neiman Marcus has been operating with a high debt-equity ratio. After 8 years of being owned by private equity firms, the business is used to operating with a reasonable amount of debt because the company has a lot of long-term investors who are not as concerned with quarter to quarter performance as with companies who publicly trade stock. Neiman Marcus’s new owners are expected to inject some capital into the business.

Finally, the article discusses how luxury retail is a challenging business because the business has to make a very select group of people happy. While Neiman Marcus has done very well with its online business it still needs showrooms to maximize their distribution and reach more shoppers.

Source: http://online.wsj.com/article/PR-CO-20131010-911027.html

La-Z-Boy recently acquired two franchised galleries of after their owners retired. What does this mean in terms of their business in general and, in particular, A/R management?

Well, La-Z-Boy corporate now owns these stores. Previously, they were managed by the franchise owners who would deal with daily management: A/R collections, payables, short-term funding, etc. As it works with most franchise businesses, the corporate offices provide basic services and the franchised stores pay an annual fee and/or a percentage revenues (or profits).

Now La-Z-Boy will have to install managers and fully integrate the accounting, purchasing, and distribution systems of these new locations to their existing systems. This, however, is the benefit of the franchise business model. Previously these two owners had to handle all these issues themselves. If customers aren’t paying, that is a meaningful loss to these private owners. But LZB corporate can diversify that risk over it’s entire store-base, which at this point is worldwide. This mitigates risk, allows them to access lower costs of financing, and essentially allows them to extend all their benefits of a large retailer to these two small locations.

Creating securities backed by cash flows from accounts receivable is a common activity in financial markets. Companies that have considerable balances on their accounts receivable and find it time-consuming to collect on them, often prefer to sell the receivables to a third party. By selling accounts receivable, the firm gets immediate access to cash.  The sale of the receivables transfers ownership of the receivables to the third party, indicating that the third party obtains all of the rights associated with the receivables.

Below is an example of two companies involved in buying and selling accounts receivable. Factual information is taken directly from the FBI website.

International Portfolio Inc. (IPI) and United Consulting were engaged in buying and selling accounts receivable, including medical debt portfolios since June 21, 2006. Another firm – Account Receivable Services LLC (ARS) invested in medical accounts receivable purchased from IPI using funds borrowed from investors interested in asset-based lending.

From December 2006 through June 2008, IPI paid more than $25 million to purchase over $4.1 billion in medical accounts receivable, comprising more than 3.8mm past due patient accounts that the hospitals and other entities selling the accounts had been unsuccessful in collecting. Beginning in June 2007, the two above mentioned firms began promoting an investment model to individual investors and investment fund managers.

They agreed that ARS, through IPI, would combine accounts receivable from IPI’s inventory into discrete debt portfolios with specified total outstanding account balances. These portfolios would then be offered for sale to investors. In addition, ARS and IPI would manage all the collection efforts for each debt portfolio IPI sold.

They made fraudulent representations and omissions regarding purchase prices, collection results, and resale values of IPI medical debt portfolios in order to persuade investors to invest in those portfolios. The firms negotiated and agreed upon two different purchase prices for each IPI debt portfolio that hedge funds and other investors financed on behalf of ARS. IPI agreed to kickback the loan proceeds in excess of the true purchase prices to ARS and characterized the kickbacks as a refund for any unqualified accounts in the portfolio, such as when a debtor was deceased or bankrupt. Between June 2007 and March 2009, IPI paid ARS kickbacks totaling approximately $8mm.

Finally, in order to urge investors to buy and/or maintain their investment positions in IPI debt portfolios, and to further conceal substantially lower than projected collection results, the owners fraudulently repurchased and resold investors’ IPI debt portfolios at artificially inflated prices that neither corresponded to a particular debt portfolio’s actual collection results, nor to an asking price from a purchaser in the debt-buying industry. Owners of IPI and ARS represented to investors that the IPI debt portfolios sold to them or used as collateral were comprised of medical accounts receivable that IPI had purchased directly from hospitals and medical providers after those institutions had exhausted their efforts to collect from their debtor patients.

Owners of the IPI and ARS have been indicted by a federal grand jury on charges of conspiracy and wire fraud, in connection with a scheme to defraud equity investors and asset-based lenders.

Reference

http://www.fbi.gov/baltimore/press-releases/2013/two-indicted-in-275-million-investment-fraud-scheme-involving-the-sale-of-medical-accounts-receivable-to-hedge-funds-and-other-investors