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Forum List » Value Ideas and Strategies Share and discuss value investing ideas and investing strategies.  
ADTRAN Inc: Where Are the Numbers? ($ADTN)
Posted by: Frank Voisin
(IP Logged)
Date: May 16, 2012 09:15AM
The market likes consistency in operations, but intelligent investors should also consider consistency in disclosures. The more consistent a corporation’s disclosures, the easier it is to make comparisons and determine the true state of the company’s performance. When companies suddenly change their disclosures without providing a concrete rationale for the change, investors should be worried that there is some bad news being covered up. Indeed, many of the accounting gimmicks covered in the excellent "Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports" (read my multi-part review here), are identifiable by those who watch for inconsistencies in disclosures, definitions and assumptions.
Consider the case of ADTRAN Inc. (ADTN), a provider of equipment and services for communications networks. I am always concerned when looking at companies in this niche because they tend to be overly reliant on a small number of major mobile network operators. Consequently, I pay close attention to disclosures about major customers and revenue concentration. I was quite concerned by what I found at ADTN. The company’s 2010 10-k includes this statement: Quote:This is exactly the kind of disclosure I look for: a clear and concise discussion of who its major customers are and what percentage of sales each accounts for. I usually track these figures over time, so when I checked the recently filed 2011 10-K, imagine my surprise when I found that this year, investors received this: Quote:How much of the company’s sales were attributable to AT&T? How about CenturyLink? From this statement only, there is no way to guess. The answers are elsewhere. I checked and the company has provided this information for each of its major customers in each of the previous eleven years. Suddenly there is a break in the consistency, and this should invite investor scrutiny. The information is provided (indeed, it has to be), but rather than being up front, it is buried down in Note 11 “Segment Information and Major Customers” near the end of the 10-K. The company even made the odd choice to bury the data under the heading “Sales by Geographic Region” when this information has nothing to do with geography. Here’s what they say (emphasis mine): Quote:Here we see that the company doesn’t provide information about which of its two major customers is the larger purchaser. Again, they’ve done this for every year since 1999, so why stop now? Perhaps because sales to one of these customers has plummeted. In 2010, Qwest (now CenturyLink) and AT&T comprised 38% of sales which were closely split between the two. In 2011, while the aggregate concentration of these two dropped to 35%, the gap between the two expanded from 3% to 15%. In 2010, sales to the second largest customer accounted for 18% of total revenues, or $109 million. In 2011, sales to the second largest customer accounted for 10% of total revenues or $71.7 million, for a decline of 34%. This is a dramatic decline in sales to its largest customer, but only those investors who found the strange lack of disclosure up front and hunted to the end of the 10-K could find this information. Otherwise, the offset in sales to the largest customer masked much of the decline. I decided to check out the company’s 2011 conference call transcripts to see what happened. First, in Q1, the company said this: Quote:Note that the customer request covers quarterly calls, not 10-K. The information is still in the 10-K, just buried and no longer specific to the customer. The company should stick to its track record of providing this important information up front. Later in the same call, the company said this (emphasis added): Quote:We get a vague discussion about not disagreeing with comments about a slowdown at a customer. There isn’t much here to raise an alarm that sales might be plummeting to one of the biggest customers. It wasn’t until Q4 that an analyst asked another question related to the 10% customers: Quote:Again, management was evasive, forcing investors to wait until the 10-K. Strangely, management says diversification has had a positive impact when in fact sales became less diversified (the top customer’s sales become more concentrated than in past years). I had hoped that in Q1 of 2012, there would be some follow up questions about what happened, and this is the closest we got: Quote:Did you catch that? Their second largest customer officially dropped below the 10% threshold, meaning that sales to that customer are continuing to deteriorate. Keep in mind that in first quarter 2012, revenues declined from $165 million in first quarter 2011 to $135 million in first quarter 2012, so this is not the case of sales to that party relative to other parties growing more slowly. This was a decline in an absolute sense. Note also that in first quarter of last year, the company had three customers over 10%. While the company’s explanation for no longer providing the 10% customer details by quarter could be accepted on face value, the subsequent change in disclosure presentation in the 10-K should be a warning. Upon further investigation (far more than would have been needed over the last eleven years!), we learn the true story. By moving key information from its traditional spot, management has made a key risk less noticeable to investors, namely that the company is becoming more reliant on its top customer and that sales to its second largest customer have collapsed. So what should management have done? While it evidently received requests to not disclose the percentage of sales to each major customer, it could have still provided this information without naming the customer (similar to what it ultimately did in the 10-K). Furthermore, the company should have been proactively discussing this in either its press release, 10-Q or opening statements to its conference calls, rather than waiting for analysts to ask the right questions. Once analysts asked the questions, they should have been far more forthcoming about the problems with its No. 2 customer and what it was doing about it. Finally, under no circumstances should management have changed the location of this key information. Here’s my takeaway: it is always worth an investor’s time to consider changes in presentation, assumptions or definitions when reading corporate filings. Any change in priority or wording from a long-standing tradition should demand greater scrutiny. More often than not, I think you will find that the change was motivated by a desire to lessen the blow of something negative. Whenever I find shenanigans like this, I assume there are more lurking in the background and so I stay away. What do you think of consistency in disclosures? Author Disclosure: None
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