Egregious accounting fraud in retail

I’ve been thinking a lot about how somebody could commit fraud in retail.  In my opinion, accounting fraud in retail is a bad idea.  Fraudsters cannot both (A) avoid jail and (B) inflate earnings by a meaningful amount or otherwise significantly mislead investors.  Smart fraudsters gravitate towards mining, oil & gas, pharma, etc.

While fraud is a bad idea in retail, some fraudsters are crazy enough to commit fraud even if there is significant risk of jail time.  I think some people are biologically wired to steal and cheat even if it doesn’t make sense.

For investors, detecting accounting fraud in a retailer may be extremely difficult.  I have not figured out reliable methods of independently verifying a retailer’s numbers.

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The restructured HLSS/NRZ deal is good for OCN and ASPS

On April 6, 2015 HLSS and NRZ announced that they have restructured the Feb 22 merger agreement between the two companies (press release).  The new deal:

1. Reduces the value received by HLSS shareholders.
2. In the near term, HLSS has agreed not to transfer subservicing away from Ocwen.  Ocwen has given up a little bit of value to reduce some of its unusual risks.

Google Trends

Google Trends may be an interesting tool for investors.

1. It allows investors to gather data on a company that’s fresher than the last quarter’s earnings release.  This can be helpful in turnaround situations such as Aeropostale (ARO) and Cafepress (PRSS).
2. Having leading earnings indicators can be helpful for manufacturing companies (e.g. RGR, SWHC) where there is not much data on consumer demand due to fluctuating inventory at the retail and distributor level.
3. In rare cases where fraud is suspected, Google Trends may provide some indications about actual revenues.

Here is an example of Google Trends in action:

RH may be a bad short in the near term

My theory is that RH’s capex guidance telegraphs what future earnings will be.  The latest guidance is for 27-45% higher capex than last fiscal year ($140-160M versus $110M).

1. If RH is the real deal, then the growth investments should generate high returns on invested capital.  If so, RH should rapidly grow earnings.  (Of course, anything can happen and RH may see poor or negative returns on its new investments.)
2. Suppose you believe that RH has been aggressively capitalizing costs that should more appropriately be expensed.  Such accounting practices would inflate earnings.  The high capex guidance may telegraph high reported earnings.

In either scenario, earnings will increase in the short term.  My theory (and it’s just a theory) is that short sellers may wish to wait until the company guides capex lower.

*Disclosure:  Short RH via common shares and put options.

RH sales returns Part 2: Do they make sense?

I did a quick look at a few other retailers that post their actual sales returns in their SEC filings (WSM, AEO, and NILE).  The pattern among those three is that sales returns as a percentage of revenue fluctuates very little.  The rapidly-growing online retailer NILE shows the most variation of the three, ranging from 9.11% to 10.60%.  RH’s range is from 4.43% to 7.47%.  Without the error disclosed in RH’s latest 10-K, the range is from 10.22% to 11.14%.

RH: How much does the company actually import?

On LinkedIn, a Restoration Hardware employee states that their department (ocean freight operations) has a consistent annual growth of 12%.  This is much lower than the company’s reported revenue COGS growth (20%+).  I would note that RH has been increasingly sourcing more and more of its product from overseas:

• (EDIT: 4/2/2015) The 2011 S-1 states: Based on total dollar volume of purchases for fiscal 2010, approximately 73% of our products were sourced in Asia, the majority of which originated from China, 16% from the United States, 8% from Europe and the remainder from other regions.
• The FY2013 10-K states: Based on total dollar volume of purchases for fiscal 2013, approximately 69% of our products were sourced in Asia, the majority of which originated from China, 26% from the United States and the remainder from other regions.
• The FY2014 10-K states: Based on total dollar volume of purchases for fiscal 2014, approximately 84% of our products were sourced in Asia, the majority of which originated from China, 10% from the United States and the remainder from other regions.

Adjusting for the lower domestic sourcing would suggest that RH’s total overall buying may have grown at less than 12% annualized.

RH sales returns

Restoration Hardware’s financial statements paint a picture of very high growth.  In the past, the financials were more or less internally consistent.  Numbers with a relationship to revenues (taxes paid, contingent rent, actual sales returns, employee count) largely tracked the growth in revenue growth.  What’s curious in the latest 10-K is that actual sales returns no longer track reported revenues due to an error identified for FY2013 and FY2012.