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Bleeding Reserves To Artificially Boost EPS: Sell Principal Financial Group, Inc. (PFG)

Tuesday, March 8th, 2011

Principal Financial Group, Inc. (PFG) reported accounting earnings in 2010 that are misleading compared to the true economic earnings of the business. PFG’s 2010 reported earnings are artificially boosted by a reduced loan loss expense, which is funded by a draw down of the company’s loss reserves. This drawdown in reserves, equal to $42mm, fuels the majority of the $76mm increase in reported earnings for 2010. A drawdown of reserves means that the actual loan losses exceed the loss provision reported on the income statement. This results in accounting earnings looking better while cash flows look worse. To get to the true economic earnings, one has to back out the false $42 million boost from drawing down loan loss reserves. In addition to a few other smaller adjustments, we back out the benefits of a 300%+ increase in deferred tax liabilities to arrive at economic earnings of -$1,576mm for 2010, a $202mm decrease versus the prior year. We consider PFG’s accounting earnings misleading because they are reported at $666mm for 2010, showing a $77mm rise versus 2009. In sum, PFG’s accounting earnings are positive and rising while economic earnings are negative and declining – fitting our definition of “misleading earnings”.

Notably, this year’s large drawdown results in PFG’s loan loss reserves being $1mm less than what they were at the end of 2001. We find this fact alarming given the increase in PFG’s investment portfolio over the same time and the still uncertain economic outlook for commercial and residential real estate.

We are also alarmed by the nosebleed valuation currently awarded PFG’s stock. At $32.68, the market price of PFG’s stock implies the company will grow its profits at 15% compounded annually for over 15 years. Note that the company’s highest annual growth in the past 10 years is 11%. The belief that the company will be able to maintain 15 years of growth at a rate that is 50% greater than it’s best rate in 10 years is hard to share. Expectations in this stock price are high to say the least.

Looking beyond the reported accounting results reveals that PFG is not quite as profitable a company as it seems, and its valuation has out-grown its profits by a wide margin – the required combination of factors for making March’s list of most dan­ger­ous stocks.

Our report on PFG, available here, has detailed appendices for you to see how we perform all calculations, including NOPAT, NOPAT margin, invested capital, economic earnings and discounted cash flows.

Over­all, the risk/reward of invest­ing in PFG’s stock looks “very dan­ger­ous” to me. There is lots of down­side risk given the mis­lead­ing earn­ings while there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price.

In a business where investors make money by buying stocks with low expectations relative to their future potential, PFG fits the pro­file of a great stock to short or sell.

Our report on PFG, available here, has detailed appendices for you to see how we perform all calculations, including NOPAT, NOPAT margin, invested capital, economic earnings and discounted cash flows.

Our analysis of PFG’s reerves is possible only by scouring the financial footnotes in the company’s 10-k filings from 2001 to 2010. No where on the income statement, balance sheet of cash flow statement is the any mention of reserves or valuation allowances. Not until page 111 of the 2010 10-K does one see details on how the companies loan loss reserves, aka valuation allowances change.

For more details on how accounting earnings are misleading, seeWhat You Don’t Know About a Company’s Earnings Can Cost You“.

Note: Stock pick of the week is updated every Tuesday.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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