Wednesday, March 28, 2012

Equitable Group: Earnings Over Cash

When companies make investment decisions with their capital, such decisions should be based on the cash flows the investment is expected to return. Because cash flows are volatile, earnings calculations are a useful way of measuring how successful such investments have been. Unfortunately, this creates a management incentive to invest in a manner that maximizes earnings rather than cash flow, which does a disservice to shareholders.

Consider Equitable Group (ETC), a mortgage lender to single families and commercial interests. Equitable operated under Canadian GAAP for many years, but has now been forced to transition to IFRS due to regulations.

Because IFRS treats certain types of Equitable Group's transactions more conservatively than did Canadian GAAP, Equitable has actually decided to curtail such activities:

"Given the changes to the manner in which these mortgages are accounted for under IFRS, however, the Company intends to reduce the volume of mortgages securitized relative to previous years."

The company also decided to change how it hedges some of its positions as a result of how IFRS treats those hedges.

This is a giant red flag! Instead of making decisions that maximize cash flow, the company appears to be maximizing earnings (at the necessary expense of cash flow).

When the choice of accounting method affects investment decisions, it's unlikely that returns to shareholders are being given priority. Real, cash returns are being sacrificed in order to make the numbers look better than they otherwise would. Shareholders may wish to avoid such companies, opting instead for companies that make decisions in the best long-term interests of shareholders.

Disclosure: No position


Anonymous said...

Hmm SVU stock price continues decline it makes me wonder that is there something which i should know? There is no any new SEC-fillings or news but company has lost almost 10 % of price in one month.

- tooki

Andrew Moor said...

While the general point that any business should be run to maximise the present value of cash flow is well made in your comments, I do believe that Equitable’s management team has been focused on maximizing shareholder value and not compromising this priority by trying to improve short term accounting outcomes in priority to longer term present value.
Equitable is a regulated financial institution that, like other banks and trust companies, is required to maintain sufficient capital levels to maintain confidence in the institution. With this type of business, earnings flow directly to the capital of the business and from there are distributable to shareholders as dividends. This type of business means that there is a very close correlation between accounting earnings and cash flow distributable to the shareholders.
As the author points out, the transition to IFRS has made securitization a less attractive business for Equitable – and other similar institutions. The important point to note is that not only is this an accounting change, but, also impacts the regulated financial ratios under which the Company operates. The fundamental point is that the change in accounting approach negatively impacts the present value of the capital generated by this securitization activity. We served shareholders well when securitization activities were accounted for under GAAP and continue to optimize our activities for the benefit of shareholders under IFRS.
I am also completely confident that the hedging approach adopted under IFRS accounting is good for shareholder value in terms of protecting the capital position of the industry.
I can assure you that Equitable’s management team is completely focussed on running the business for the benefit of its shareholders. This focus includes a rigorous approach to capital allocation within our various businesses and making sure we focus on real added-value to our shareholders.

Andrew Moor
President and CEO
Equitable Group Inc.