By John Del Vecchio, Editor, Hidden Profits
Last week, National Beverage (Nasdaq: FIZZ) shocked the market by announcing it received a Securities and Exchange Commission (SEC) inquiry into a couple of “unique” financial metrics the company uses to measure sales performance.
National Beverage produces LaCroix seltzer water, the favored drink of Millennials and “influencers” the world over. The stock has been on fire as fizzy water gains share on traditional soda companies.
When the government asks for information, I find it wise to give it to them.
National Beverage refused, and the stock price sprung a leak.
This isn’t some random government meddling. The company’s actions raise serious concern.
On the surface, it’s a blazing hot market – which means any sign that growth may be slowing or unable to meet future expectations could send the stock into a tailspin.
Trust me, I know of which I speak.
I’ve spent the last 20 years focused on financial statement analysis and catching aggressive management teams with their hands in the cookie jar. The No. 1 red flag is when management messes around with revenue recognition.
Well, a modern company’s entire financial model flows from revenue on down. Revenue impacts profit margins, cash flow, and the strength of the balance sheet. When business is doing well and customers are eager for more product, there’s no incentive on the part of management to plays games with the top line.
Why mess with success?
That mostly happens when there’s a bump in the road and management isn’t open and honest about it.
That’s when they make stuff up.
And, to be clear, LaCroix’s metrics are made up. The company uses a figure called “velocity per outlet” and another one called “velocity per capita” to measure sales performance.
No one outside of the company knows what to do with those metrics.
That’s a problem, and it’s nothing new.
It probably won’t surprise you that companies do it all the time. The sweet spot for sour numbers is in the reporting of non-GAAP financial performance. GAAP is the acronym for “Generally Accepted Accounting Principles – you know, the legitimate stuff.
When it comes to non-GAAP figures, there’s a lot of leeway for management to create new metrics and, in doing so, report earnings in a sparkling light.
Warren Buffett calls these metrics “earnings before the bad stuff.”
FIZZ’s numbers might not be fraudulent. But management touted them enough to pique the curiosity of the SEC. When asked about what these velocity metrics measure, the company refused to answer and called them “secretive.”
Um, OK. We’re free to call them “bullshit.”
While “velocity per outlet” may look great on paper, using it in the first place is a solid red flag.
The stock has now recovered most of its losses. But that doesn’t mean the concerns have gone flat. In the end maybe, it’s nothing.
There’s a primary rule you should follow when it comes to stocks you own. It’s especially true for high-growth companies, where expectations might be in nosebleed territory.
Here it is…
Every company is guilty until proven innocent.
That might sound cynical. But that’s two decades of looking at these kinds of numbers talking.
Management must show you – not just tell you – with its financial disclosures that everything is fine. It must demonstrate there’s no reason to be concerned, that it’s presented a true financial performance and it’s sustainable.
This requires looking beyond the press release and digging deep.
One of the best things you can do for yourself each quarter is to analyze your portfolio’s quality of revenue recognition and look for red flags.
It’s the sort of work I do each month with my Hidden Profits recommendations. We’ve closed seven positions so far, with six winners averaging 35.35%. Our top winner’s at 56.16%.
Good luck out there,
As originally appeared in The Rich Investor.