Waving a Warning Flag on the Proposed CIT IPO

Recently, I outlined how companies use accounting tricks when acquiring other companies by "priming the pump for future, overstated earnings."

Enough of generic descriptions of accounting games, though. I'll highlight three of the red flags that I look for when reviewing the financials of companies involved in acquisitions, using a real-life example: CIT Group (proposed symbol CIT:NYSE), a subsidiary of Tyco (TYC - commentary - Cramer's Take), coming to you Monday as a very large, very important $5 billion IPO.

Here's what I look for in the financials of companies involved in acquisitions:

Red Flag No. 1: Expense-Packing

In the preacquisition phase, inscrutable acquirers will pack as much expense as possible onto the acquired company's books. This provides a nice lift to earnings immediately after the acquisition. Per the 10-Qs, CIT's income early last year, for the five months immediately before the acquisition by Tyco, was $81 million. For the four months immediately after the acquisition, that number was $252 million.

Red Flag No. 2: Balance Sheet Earnings

This issue is a bit esoteric and hard to explain, but I'll give it a shot: Writedowns taken before an acquisition act as "reserves" and can be turned on, at management's discretion, to pump earnings in future periods. These reserves are typically housed on the balance sheet under "other accrued liabilities and payables."

Look for sizable declines in this category as an indication that the company is producing earnings off the balance sheet. (Adjusting an accrued liability lower equals income.) At CIT, accrued liabilities fell dramatically, per governmental filings, by $713 million for the first 10 months after it was acquired by Tyco (from June 2, 2001, to March 31, 2002).

Assets tend to rise from the dead after a merger, when it's conveniently discovered that those written-down assets aren't worthless after all. Here's the warning flag: Look for increases in other assets on the balance sheet after an acquisition, another sign that a company may be producing earnings via the balance sheet. (Adjusting other assets upward equals income.) At CIT, other assets increased a lot -- by $516 million -- in the first 10 months after it was acquired.

Red Flag No. 3: Change in Business Model

When I review financial statements, I get concerned if sources of income change dramatically. In comparing the cash-flow statements of CIT before and after the acquisition by Tyco, it is apparent that the business changed significantly.

Proceeds from asset and receivable sales increased substantially, as well as purchases of finance receivable portfolios. Both of these items are subject to manipulation when management is in need of earnings.

Here's my concern: To the extent that asset and receivable sales were cherry-picked (meaning that good ones were sold because they'd generate an earnings gain, while bad ones were held because they'd depress earnings), the lease assets remaining in CIT's portfolio might be of poor quality. Of course, that might mean loan-loss reserves are less than adequate.

By the way, when a finance company like CIT sells only its best lease receivables, then you generally see "other income" jump. At CIT, other income went up more than 40% immediately after the acquisition by Tyco.

I'm also concerned about the increase in factoring receivables. Here, commissions that are generated can be impressive, but they come with credit risk. That's not something I can assess, though, without more information.

The CIT IPO

I'm not able to get an inside look at the books of CIT, so all I can do is make inferences from the evidence provided by the financials and disclosures. I realize that the IPO is a critical event for Tyco, which is trapped in the throes of a working capital crisis.

While I don't think CIT's balance sheet warrants the IPO price, maybe the franchise can be successful again, especially if it can regain credibility in the debt market. Maybe that's possible, once it's free from the clutches of the creative team at Tyco.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.