Stocks and Shares

Essential lessons from the latest bankruptcy

GT Advanced Technologies Inc. (NASDAQ:GTAT) had it all. It was a high tech growth company, with an impressive sounding name, that was expected to have great prospects. Amongst other things it makes some kind of widget used in the iPhone 6, the latest hot gadget to fly off the shelves of Apple Inc. (NASDAQ:AAPL). But GTAT just announced that it’s seeking bankruptcy protection, and the share price has fallen 93% in one day. This tale carries essential lessons for investors.

GTAT does all sorts of impressive sounding stuff.

It’s the “established polysilicon merchant market leader”, providing “SDR reactors” and “hydrochlorination TCS equipment”.

It sells the leading “multicrystalline ingot growth furnace” and something else that is “driving critical transition to higher efficiency, n-type monocrystalline materials”.

Another product provides “flex tolerant tabbing for cell interconnect”, and yet another is “the world’s highest power versatile ion implanter”.

Not to mention GTAT’s capability in “boron neutron capture therapy”, or “silicon carbide sublimation technology”.

But wait, there’s more. I almost forgot the “LED deposition technology” featuring “PVD AIN Nano column technology”.

Phew! That sounds like really impressive stuff!

What does it all mean? I have absolutely no idea at all. The company may as well have written its corporate propaganda in Martian for all the difference it would make to my comprehension of what they actually do.

No doubt there are scientists, engineers and technology specialists who can make sense of it all. But they’re better humans than me. To a humble investment analyst it’s just a load of gobbledegook. Jargon-filled gibberish that would take years to fully understand.

But wait! They’re selling stuff to Apple that goes inside the new iPhone 6! This is hot! Everyone should buy this stock!

…Jim Cramer, the loud mouthed US television stock pundit….recommended GTAT shares as an excellent growth prospect….

At least so thought Jim Cramer, the loud-mouthed US television stock pundit.

He recommended GTAT shares as an excellent growth prospect on 26th August this year in a segment on CNBC, the television channel. You can see the video clip here (note: you may need to turn the volume down).

That day the share price closed at US$18.60, giving the company a market capitalisation of US$2.6 billion (the value of all the shares at the market price). That’s not an insignificant company.

At the time of writing GTAT stock is trading at US$0.80, a loss of over 96% since Cramer shouted about it. By anyone’s standards, that’s a pretty impressive fall in just six weeks.

To be fair to Cramer he did describe GTAT as speculative. And just beforehand the company had reported that it had US$333 million of cash at the end of June. And GTAT management had said to expect US$400 million of cash at the end of the year. So it didn’t look like it was going bankrupt any time soon.

In fact a bullet point in a corporate presentation, dated August and shown on the company website, describes the company thus: “Solid balance sheet with proven track record of productively employing capital”.

So how is it that this high-growth prospect – with all it’s impressive sounding capabilities, blue-chip lead customer, growing cash pile and productive use of capital – has suddenly filed for bankruptcy? And how has that cash pile shrunk to just US$85 million by the end of September, according to the company press release?

Well, we still don’t know. Further details are expected to be forthcoming from the company. But I took a quick look through the last annual report and quickly found plenty of red flags. This is not an exhaustive list, just some of the things that I spotted right away. I’m sure more time and more digging would yield more problems. But let me show you some of the things I found.

First up, sales revenues at this “growth” company collapsed 59% between 2012 and 2013, from US$734 million to US$299 million. They also plummeted 65% between first half 2013 and first half 2014, from US$226 million to US$81 million. Collapsing sales don’t exactly bode well.

This collapse in sales meant the company reported a loss of US$83 million in 2013, down from a profit of US$183 million in 2012. Hmm….loss making as well. Not looking great.

(Actually the two years are not exactly comparable. The company has changed its reporting period from the year to March 2012 to the year to December 2013. There’s a nine month gap in between the end of the first year and the start of the second, but you get the point. It’s fairly unusual for a company to change its reporting period. So maybe this was also a small warning.)

But all sorts of things can happen on profit and loss statements. What really matters is cash flow. Was the company generating cash or not?

But all sorts of things can happen on profit and loss statements. What really matters is cash flow. Was the company generating cash or not?

Oh dear, more bad news. Operating cash flow went from positive US$218 million in 2012 to negative US$159 million in 2013. In other words, cash flow was even worse than reported profit.

In fact, my first glance at the cash flow statement, without even looking at the numbers, threw up a red flag. Cash flow statements show all the cash coming into and heading out of a company during a period of time. The first part of the statement adjusts reported profits for various factors to work out a figure for operating cash flow. That’s the cash earned from or drained by the normal core business of the company.

(The rest of the statement looks at investing and financing activities, such as capital expenditure on new long term assets, changes to debt financing and dividend payments.)

All companies make have adjustments on their cash flow statements, sometimes big, sometimes small. As a general rule, the bigger the adjustments the more wary you should be.

All companies make have adjustments on their cash flow statements, sometimes big, sometimes small. As a general rule, the bigger the adjustments the more wary you should be.

But more than that is the sheer number of individual adjustments. The quantity of line items that need to be disclosed. In the case of GTAT there are so many that the size of the text has to be tiny to make it all fit on one page.

In all I counted 12 adjustments larger than US$10 million, out of a total of 24 items in total. Just one of these alone was a deduction of US$91 million, which is huge in relation to a reported loss of US$83 million. This sets alarm bells ringing.

Then there are the debts. Interest expenses shot up from US$13 million in 2012 (a profitable year) to US$32 million in 2013 (a loss making year, even before interest expense). Another worrying sign of a company approaching the point of no return.

Also the amount of debt issued as convertible bonds had shot up by US$127 million during 2013, essentially replacing a bank loan facility.

Convertible bonds are a type of bond that can be converted into shares in the company if the share price rises by a certain amount. In theory they provide the higher safety of a bond combined with the potential capital gains of a share.

Convertibles are supposed to be safer because in a bankruptcy and liquidation of the company the bond holders are paid before the shareholders.

But in practice convertible bonds are very often issued by shaky companies who want to keep their interest costs down by offering the convertibility feature on the debt.

And they’re bad news for existing shareholders since if the bondholders convert into new shares then the existing shares are “diluted”. Assets and future earnings would be divided across more shares, make each pre-existing one worth less.

Then there were some strange goings on with capital management. In 2012 the company bought back US$75 million of shares. A buyback is when a company buys shares in the market using company cash and then cancels the shares. It usually drives up the share price, since ownership of company assets and earnings is divided across fewer remaining shares.

But then having bought and cancelled all those shares, in 2013, the following year, the company issued US$83 million of new shares. At best this is very short term thinking. And it’s expensive paying fees to investment banks to buy back and then re-issue all those shares, so it’s a waste of company funds.

But it’s possible that there were other motives here. After all, company managers own stock options. Buybacks drive up share prices and make options more valuable. Did somebody inside the company profit from this? Maybe.

Companies with shaky finances and poor earnings often report what are called “non-GAAP earnings”.

The final thing to highlight are the “non-GAAP profit adjustments”. Companies with shaky finances and poor earnings often report what are called “non-GAAP earnings”.

GAAP (pronounced “gap”) refers to Generally Accepted Accounting Principles, which are the strict accounting rules that apply to all companies.

Non-GAAP earnings show profits how they would have been if the company could make up the accounting rules for itself. Often they are also known as “pro-forma” earnings.

So, as with cash flow statements, the more adjustments there are to non-GAAP earnings, and the bigger they are, the more cautious any prospective investor should be.

In the case of GTAT they have been huge. Net income (profit or loss after tax) for first half 2014 is transformed from a loss of US$86 million to a much more palatable US$22 million loss. That’s a huge difference of US$64 million added back to profits by the company.

The biggest item added back US$45 million of “Sapphire production ramp-up costs”. In other words, the company had some huge costs (12% of total expenses for the year) that they somehow think don’t count. Hmm. Does that sound reasonable to you? Obviously not.

Also there is US$9 million of “share based compensation expense”. In other words the company is saying: “We paid people in shares, instead of cash, therefore that doesn’t count. Never mind that it will dilute the ownership of other shareholders.” Oh dear.

Actually this last one is a favourite of young technology companies and others short of cash to pay people. For years the corporate lobbyists fought to stop pay in the form of shares or options being shown as costs. Fortunately the setters of accounting standards eventually saw sense, and insisted they were properly charged. It seems some people are still in denial. In total there are 11 adjustments to get to the non-GAAP illusionary figure.

These are just some of the highlights that I picked up in a very quick read of the company literature. There are plenty areas of concern that would have deterred an experienced investor from investing in this stock. And I’m sure I could find more problems with more time.

But there are some clear lessons to learn from all this.

  1. Beware of complicated companies that do things that you don’t understand. If you can’t even understand what they’re selling, then stay away.
  2. If you invest in single stocks, make sure you’ve studied the financial accounts and company reports in detail. Financial condition matters. If you don’t have the necessary skills to do this kind of detailed analysis then stick to big established companies or index funds (preferably bought when they are cheap).
  3. The more that something is hyped by the mainstream media and financial industry, the more suspicious you should be. Many are the portfolios that have been sacrificed on the altar of overpaying for growth. Never invest in a company just because it has a big brand, or its main customer is a big brand like Apple.

Stay tuned OfWealthers,

Rob Marstrand
robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.