The Significance of Accruals and the MSOs

Summary

  • Due to adjustments in fair value of inventory and biological assets, I am wary of potential earnings management/manipulation.
  • Using traditional methods to measure cash flow and balance sheet accruals, during Q2’20 Trulieve measured with the highest earnings quality, but otherwise reported the worst earnings quality in FY’19.
  • Curaleaf reported the lowest earnings quality relative to the peers for Q2’20.
  • However, at face value, I would not qualify these results as grounds for better (or worse) cannabis operators; just something to be mindful of going forward.

Background

In 1996, Richard Sloan from the University of Michigan published a paper titled Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings? He found that companies with a larger cash component of earnings led to significant excess risk-adjusted returns. Noted in the graphic below, between 1962 and 1991, only two years did a long-short portfolio based on accruals lead to negative returns.

Accruals as an independent factor has been arbitraged away since 1991 and no longer generates alpha on its own, but is still helpful when evaluating the quality of a company’s earnings.

This has been in the back of my mind ever since I looked at Trulieve and noticed the large portion of accruals during 2019. From A Deep Dive into Trulieve (Part 1):

Lower accrued profits = higher earnings quality

This spread should be acknowledged because the income statement for cannabis companies is heavily skewed by fair value adjustments on inventory sold and growth of biological assets. In 2019, Trulieve collected $252.8M in sales, but its net income was adjusted higher by an additional $199.3M due to non-cash fair value adjustments.

Meanwhile, looking at Trulieve’s FY’19 Statement of Cash Flows, it generated $23.5M in cash from operating its business, reinvested $74.1M to grow future operations, and raised $117.9M of capital through equity/debt. The total increase of cash acquired amounted to $67.4M, which reconciles against the net change of their cash balance between 2018 and 2019.

That said, I wanted to compare accruals among the MSOs.

Sloan Ratio

Indicated above, the Sloan Ratio = (Net Income – CFO – CFI) / Total Assets, essentially measures the amount of non-cash earnings (accruals) scaled by total assets. For my analysis, I used average total assets for each quarter.

Comparing the “Big 4” MSOs, Trulieve saw the largest variance, falling from 29.8% in Q2’19 to -4.9% in Q2’20. This indicates that its non-cash component of earnings scaled by average total assets is the smallest (best) among the peers. Meanwhile. Curaleaf ranks with the worst ratio, as 3.5% of its average total assets in Q2’20 were attributable to the non-cash component of earnings.

An alternative approach commonly used by practitioners includes scaling the cash flow accruals by average net operating assets (NOA). Though, the results are mostly the same.

Balance Sheet Accruals

Alternatively, accruals can be measured through the balance sheet, which account for M&A activities. Hirshleifer et al. 2004 found that companies with bloated balance sheets are generally overvalued by investors, leading to poor forward risk-adjusted returns. Prime examples of this relate to the LPs which have gone through a number of write-downs and impairments over the past year. Hirshleifer et al. 2004 measured balance sheet accruals as (Ending NOA – Beginning NOA) / Total Assets, where NOA = Operating Assets – Operating Liabilities.

On a quarterly basis, Trulieve ended Q2’20 with the most favorable balance sheet accruals ratio (-3.3%), vs Curaleaf and Green Thumb which ended the quarter with less favorable ratios (6.4% and 3.1%, respectively).

Similarly, balance sheet accruals are emphasized when scaled by average NOA instead of average total assets.

As always, feel free to DM me on Twitter @PVofFCF or email me at graham@pvoffcf.com if you have any questions.