Analysis of earnings quality and the company

1. Etienne Bordeleau
Pramod Jindal
Zain Jafry
Sean Ray

2.  Company description
 Significant accounting policies
 Analysis of Earnings Quality
 Financial Performance 1986-1987
 Risks and Investment recommendation

3.  Sells manufactured homes to low income blue collars in the Southeastern
U.S.
◦ Majority from outside vendors
◦ Some from manufacturing subsidiary
 Finance the purchase like a mortgage
◦ Sells the majority of those “mortgages” to financial institutions (securitization)
with recourse
◦ Finance subsidiary for “lower quality” loans

4. Home
Manufactured
Customer
Homes
Down payment
+
Receivable (loan at 10% interest rate)
Journal entries:
Dr. Account receivables $10,000
Dr. Cash (down payment) $1,000
Cr. Sales $11,000
Dr. COGS $8,000
Cr. Inventory $8,000

5. Cash
+
Finance participation receivable
Principal
Financial
Manufactured Cash
Institution
Homes Proportion of (10-6)%
Receivable with Recourse
Journal entries:
Dr. Cash $10,000 + $300
Dr. Finance participation receivable $100
Cr. Accounts receivables $10,000
Cr. Finance Participation Income $400
Note: Finance participation income and receivable represents the spread between the interest
on the loan (10%) and the market interest rate (6%). Financial Institutions keep a portion of 10%-6%
to mitigate credit risk.

6.  Major
◦ Revenue recognition
◦ Sale of receivables (FASB-77)
◦ Reserve for losses on credit sales

7.  Sales are recognized when the customer makes the down payment
(around 10%) and enters an installment contract (i.e. mortgage)
 The rest is booked as a receivable and the customer pays in
installments with an interest rate X%.

8.  To be recognized as a sale, the transfer of receivables with recourse
must:
◦ Be surrendered unequivocally
◦ The obligations of the seller under recourse must be subject to reasonable
estimation of:
 The amounts of bad debt and the costs related to collection and
repossession
 Prepayment risk
◦ The seller cannot be required to buy back the receivables except
if the recourse provisions are met.

9. Credit Quality
 Based on historical loss (as a % of total contingent liabilities as
experience: guarantor)
2.50%
◦ Low default rates
2.00%
 High segment and geographical
concentration
1.50%
◦ Higher credit risk
1.00%
 The recognition as a Sale under
FASB-77 is contestable: 0.50%
◦ Receivables collection difficult
to estimate 0.00%
1984 1985 1986
PCL Charge-offs

10. Characteristic Case Details Higher Quality Earnings
Revenue Aggressive Revenue Recognition: All revenue Recognize revenue after the sale if the
Recognition is recognized when a customer enters into an receivable collection is uncertain
installment contract • Installment sales method
• Cost recovery method
Non-Cash Earnings - Credit sales represent a
majority of the company sales
Reserves for MH appears to understate provision of losses Increasing Provision of Losses :
Losses on Credit • Provides a greater cushion for future
Sales Reserve balance of $3mm less than the actual losses
losses $3.01mm in 1986 • Improves quality of net receivables
Sales of Off-Balance Sheet Financing: Large contingent Treat contingent liability as a liability on
Receivables liabilities($180mm in 1986) from the the balance sheet
installment sales contracts sold with recourse
to Financial Institutions

11.  The case presents unaudited Sep 30, 1987 interim statements
 Audited Q4 1986
◦ $2M of repossession expense and interest chargebacks- reserves for credit
losses increased to $3M on Dec 31,1986
◦ Net loss of $1.3M
 Losses on credit sales and other charges totaling more than $3M

12. 10,000,000
5,000,000  CFO and Earnings are starting
0
to diverge post 1986
1984 1985 1986 1987 (Sep 30)
-5,000,000
-10,000,000
-15,000,000
CFO Earnings
Probability of Earnings Manipulation
16.0%  Bemish Index
12.0%
◦ Probability of Earnings
Manipulation increased
8.0%
from 1986 to 1987
4.0%
0.0%
1986 1987

13. 21.4% 21.3% 7,700
21.2% 7,200
21.2%
6,700
21.0%
6,200
Gross profit
New unit sale
20.8% 5,700
20.6%
20.6% 5,200
4,700
20.4%
4,200
20.2%
3,700
20.0% 3,200
FY 1985 FY 1986 FY 1987*
Units of new home sold Gross profit margin

14. 1986-1987: Annual Earnings driven by Finance Participation Income only
Income Statement With finance participation Without finance participation
1986 1985 1986 1985
Revenue
Net Sales 106 69 106 69
Finance Participation Income 12 10 0 0
Other Income 2 1 2 1
120 80 108 70
Cost and Expenses
Cost of Sales 86 56 86 56
Selling, General, and Admin* 23 14 21 12
Other Costs 7 3 7 3
Total Costs 116 72 114 71
Earnings before taxes 4 7 -6 -1

17.  Home Sales
◦ Volume
◦ Price
◦ Overall, sales growth will be a concern going forward
 Finance Participation- Uncontrollable and expected to trend down
◦ Increased sales with no finance participation
◦ Interest rate spread subject to bank’s policy(policy changes reduced spread by
33% in 1986)
◦ Bank’s asking for irrevocable letter of credit
◦ Low interest rates leading to pre-payments

18.  Cost of sales
◦ Not much evidence in cost reduction due to the firm size
◦ Gross profit margin not expected to go up
 SG&A
◦ Tied to liability insurance rates on policy renewal( increased 40% in 1996)
◦ Have increased as a percent of net sales from 1985 onward
 Provision for losses
◦ Q4 1986 and 1987 suggest understating of the provisions
 Interest Expense
◦ Expected to increase when contingent liabilities($180M) is recognized as debt

19.  Sales and Marketing
 Overall sales volume has been driven by the acquisitions
 No evidence of consistent Same Store Sale increase
 Bulk purchasing power
 Gross profit margin declining
 Financial participation income:
 Historically good but now uncertain

20.  Manufactured Homes should not be included in the growth portfolio
◦ Quality of earnings: poor
◦ Revenue driver: home sales
◦ Profit driver: finance participation
◦ SCA does not seem to add value to shareholders
◦ Outlook:
 Net sales expected to stay same or grow moderately
 Expenses expected to go up substantially
 Huge risks associated with the Net Earnings(finance participation)
 Huge concern about the firm’s ability to service the debt

21. Q&A

22. Common-Size Balance Sheet
ASSETS 1987 (Sep 30) 1986 1985
Current Assets:
Cash and Cash Equivalents 8.3% 3.1% 5.8%
Contract Proceeds Receivable from FI`s (note 9) 15.5% 14.1% 10.2%
Total Cash 23.8% 17.2% 16.0%
Finance Participation receivable - current portion (note 2) 4.1% 3.3% 4.9%
Deferred finance participation income -1.1% -1.0% -1.0%
Net finance participation receivable 3.0% 2.3% 3.9%
Installment Sales Contracts held for resale 2.1% 0.0% 0.0%
Other receivables (note 4) 5.6% 4.6% 4.0%
Refundable income taxes (note 11) 0.0% 1.0% 0.0%
Inventories (notes 5 and 9) 37.0% 46.9% 50.3%
Prepaid Expenses 0.5% 0.7% 0.8%
Deferred income taxes (note 11) 0.9% 0.9% 0.9%
Other Current Assets 46.1% 54.1% 56.0%
Total Current Assets 72.9% 73.6% 75.9%
Non Current Assets
Net finance participation receivable 16.9% 15.0% 14.3%
PPE (note 6 and 10) 8.2% 9.2% 10.7%
Depreciation -2.8% -3.0% -3.1%
Net PPE 5.4% 6.3% 7.7%
Deferred income taxes 1.6% 0.0% 0.0%
Excess of Costs over net assets of acquired co`s less amort (3) 1.9% 2.6% 1.9%
Other Assets 1.3% 2.6% 0.2%
Total Other Assets 4.8% 5.2% 2.1%
Total Non-Current Assets 27.1% 26.4% 24.1%
Total Assets 100.0% 100.0% 100.0%

23. LIABILITIES AND STOCKHOLDER`S EQUITY
Current Liabilities
Notes Payable 0.0% 1.4% 0.0%
Long term Debt (note 10) 0.1% 1.0% 2.2%
Floor Plans note payable (note 9) 25.1% 43.3% 53.9%
Account Payable 7.3% 6.0% 4.3%
Income Taxes (Note 11) 2.2% 0.0% 3.6%
Accrued Expenses and other liabilities ( note 8) 4.8% 3.4% 2.4%
Total Current Liabillities 39.4% 55.0% 66.4%
Non-current Liabilities
Long term debt (non current portion) (note 10) 38.2% 22.9% 2.1%
Reserve for losses on credit sales (note 7) 4.3% 3.7% 3.7%
Deferred income taxes (note 11 0.0% 1.0% 6.1%
Total Non-current Liabilities 42.5% 27.6% 11.9%
Total Liabilities 81.9% 82.6% 78.3%
Stock Holders Equity (notes 10 and 12)
Common Stock 1.7% 2.3% 3.4%
Additional Paid in Capital 3.4% 4.3% 5.0%
Retained Earnings 13.0% 10.8% 13.3%
Total stockholders Equity 18.1% 17.4% 21.7%
0.0%
Total Liabilities and Equity 100.0% 100.0% 100.0%

24. Consolidated Statements of Earning Consolidated Statements of Earning
1986 1985 1984 1986 1985 1984
Revenue Revenue
Net Sales 106,095,667 68,674,779 30,480,571 Net Sales 88% 86% 84%
Finance Participation Income 12,084,108 9,715,558 5,221,279 Finance Participation Income 10% 12% 14%
Insurance Commisions 721,758 413,282 231,618 Insurance Commisions 1% 1% 1%
Interest 338,447 163,663 123,564 Interest 0% 0% 0%
Other 1,024,974 558,706 138,770 Other 1% 1% 0%
Total Revenue 120,264,954 79,525,988 36,195,802 Total Revenue 100% 100% 100%
Cost and Expenses Cost and Expenses
Cost of Sales 86,212,901 56,222,412 24,324,851 Cost of Sales 72% 71% 67%
Selling, General, and Admin, 22,852,093 13,639,942 5,895,891 Selling, General, and Admin, 19% 17% 16%
Provision for losses on credit sales (note 7) 3,777,900 793,497 253,004 Provision for losses on credit sales (note 7) 1%
3% 1%
Interest 3,367,940 1,824,588 570,527 Interest 3% 2% 2%
Total Costs 116,210,834 72,480,439 31,044,273 Total Costs 97% 91% 86%
EBIT 4,054,120 7,045,549 5,151,529 EBIT 3% 9% 14%
Income tax 2,020,695 3,327,224 2,457,000 Income tax 2% 4% 7%
Earnings before change in accounting princ. (note 2,033,425
2) 3,718,325 2,694,529 Earnings before change in accounting princ. (note 2)
2% 5% 7%
Changes in accnt principles (note 2 and 11) - - 504,571 Changes in accnt principles (note 2 and 11)
0% -1% 0%
Net Earning 2,033,425 3,213,754 2,694,529 Net Earning 2% 4% 7%

25. Interim Statements of Earning (9 months Ended Sep 30th) Interim Statements of Earning (9 months Ended Sep 30th)
1987 1986 1987 1986
Revenue Revenue
Net Sales 126,599,392 76,396,868 Net Sales 85% 89%
Finance Participation Income 18,895,975 8,629,223 Finance Participation Income 13% 10%
Insurance Commisions 976,128 465,577 Insurance Commisions 1% 1%
Interest 925,116 230,602 Interest 1% 0%
Other 786,971 221,448 Other 1% 0%
Total Revenue 148,183,582 85,943,718 Total Revenue 100% 100%
Cost and Expenses Cost and Expenses
Cost of Sales 101,997,757 61,554,367 Cost of Sales 69% 72%
Selling, General, and Admin, 27,973,865 14,823,385 Selling, General, and Admin, 19% 17%
Provision for losses on credit sales (note 7) 3,203,913 772,417 Provision for losses on credit sales (note 7)
2.2% 0.9%
Interest 4,416,596 2,303,482 Interest 3% 3%
Total Costs 137,592,131 79,453,651 Total Costs 93% 92%
EBIT 10,591,451 6,490,067 EBIT 7% 8%
Income tax 4,748,000 3,109,000 Income tax 3% 4%
Earnings before change in accounting princ. (note 5,843,451
2) 3,381,067 Earnings before change in accounting princ. (note 2)
4% 4%
Changes in accnt principles (note 2 and 11) - - Changes in accnt principles (note 2 and 11)
0% 0%
Net Earning 5,843,451 3,381,067 Net Earning 4% 4%

26. 1986-1987: Interim Earnings driven by Finance Participation Income
Interim Income Statement With Finance Participation Without Finance Participation
1987 1986 1987 1986
Revenue
Net Sales 126,599,392 76,396,868 126,599,392 76,396,868
Finance Participation Income 18,895,975 8,629,223 0 0
Other Income 2,688,215 917,627 2,688,215 917,627
Total Revenue 148,183,582 85,943,718 129,287,607 77,314,495
Cost and Expenses
Cost of Sales 101,997,757 61,554,367 101,997,757 61,554,367
Selling, General, and Admin, 27,973,865 14,823,385 24,406,712 13,335,035
Other Costs 7,620,509 3,075,899 7,620,509 3,075,899
Total Costs 137,592,131 79,453,651 134,024,978 77,965,301
Earnings before taxes 10,591,451 6,490,067 -4,737,371 -650,806

27. Consolidated Statements of Earning
1986 1985 1984
Cash Flow from operations
Net Earnings 2,033,425 3,213,754 2,694,529
+ Depreciation 946,858 556,236 210,699
Noncurrent deferred income taxes -2,197,061 78,637 1,412,812
Provisions for losses on credit sales 699,343 -217,402 134,614
Issuance of nonqualified Stock Options 142,000 206,000 0
Finance Participation income -12,084,108 -9,715,558 -5,221,279
Collections of finance participation receivables 7,503,502 8,725,359 3,316,397
Other 0 0 52,181
- Changes in WC -4,467,241 6,134,420 -540,601
Cash Flow from Operations -7,423,282 8,981,446 2,059,352
Cash Flow From Investing
Net Assets addition of Acquired companies(note 3) 1,285,935 422,179 1,220,198
Additions to PPE 1,917,489 2,756,178 580,259
Decrease in other assets - 4,024
Additions to other assets and excess costs 1,813,191 0 9,054
Cash Flow from Investing -5,016,615 -3,182,381 -1,809,511
Cash Flow from Financing
Proceeds from Long term Debt 18,396,000 1,651,822 400,000
Exercises of Stock Options 938,935 0
Current installments and Repayment of LTD 1,071,308 1,322,806 70,423
Cash Flow from Financing 20,406,243 2,974,628 470,423
Change in total cash 7,966,346 8,773,693 720,264

28. Consolidated Statements of Earning (interim) Dec 30th
1987 1986 1986
Cash Flow from operations
Net Earnings 5,843,451 3,381,067 2,033,425
+ Depreciation 921,388 664,769 946,858
Noncurrent deferred income taxes -2,699,000 -345,000 -2,197,061
Provisions for losses on credit sales 1,850,000 -318,539 699,343
Issuance of nonqualified Stock Options 39,000 106,500 142,000
Finance Participation income -18,895,975 -8,629,223 -12,084,108
Collections of finance participation receivables 12,066,312 5,019,381 7,503,502
Other 0
- Changes in WC -9,786,526 -7,929,293 -4,467,241
Cash Flow from Operations -10,661,350 -8,050,338 -7,423,282
Cash Flow From Investing
Net Assets 1,324,079 1,285,935
Additions to PPE 1,851,773 1,365,703 1,917,489
Decrease in other assets 662,876 - -
Additions to other assets and excess costs 80,000 879,665 1,813,191
Cash Flow from Investing 2,594,649 -3,569,447 -5,016,615
Cash Flow from Financing
Proceeds from Long term Debt 25,000,000 18,000,000 18,396,000
Exercise of Stock Options 304,563 1,060,805 938,935
current installments and Repayment of LTD 609,987 1,015,876 1,071,308
Cash Flow
from
Financing 25,914,550 20,076,681 20,406,243
Change in
total cash 17,847,849 8,456,896 7,966,346

29. 1987 (Sep 30) 1986 (Sep 30) 1986 1985 1984
Earnings Quality
Aggregate Accruals 13,910,152 15,000,852 14,473,322 -2,585,311 2,444,688
NOA current 65,004,536 54,813,291 54,813,291 5,077,554
NOA prior 54,813,291 5,077,554 5,077,554 n/a
Accrual Ratio 0.23 0.50 0.48
Total Assets 112,603,681 81,377,803 81,377,803 50,944,924
Cash 26,746,431 13,982,102 13,982,102 8,158,372
Total Liabilities 92,249,548 67,210,684 67,210,684 39,892,165
Total Debt 71,396,834 54,628,274 54,628,274 29,651,320
Net Income 5,843,451 3,381,067 2,033,425 3,213,754 2,694,529
CFO -10,661,350 -8,050,338 -7,423,282 8,981,446 2,059,352
CFI 2,594,649 -3,569,447 -5,016,615 -3,182,381 -1,809,511
Growth
Revenue 120,264,954 79,525,988 36,195,802
Revenue Growth 51%
Accounts Receivables 27,142,010 17,132,927 9,210,172
A/R Growth 58% 86%

30.  Aggregate Accruals
Aggregate Accruals ◦ Measures the discretionary
16,000,000 component of earnings
12,000,000 ◦ = NI – (CFO + CFI)
8,000,000
◦ For good earnings quality,
aggregate accruals should decline
4,000,000
◦ MH’s aggregate accruals have
0
increased from 1985
1985 1986 1987
-4,000,000