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Why Hailing a 'Taxi' Can Be Dangerous on Wall Street

Leave it to the 10-Q to tell the real story of a company's earnings. Consider New York-based Medallion Financial (TAXI - Get Report), which finances the purchase of taxi medallions by taxi drivers and also runs a business that places advertising on the rooftops of taxicabs (which explains the stock symbol!). Even before the company reported earnings recently, some short-sellers had been predicting (to me, at least) that the company was likely to miss earnings estimates of 33 cents per share.

It did (the actual number was 30 cents) but the surprise wasn't with the bottom line: It was the top line. Interest income (the equivalent of revenue at a finance company) rose 47% year over year and 33% from the prior quarter.

How'd they do that? That's what short-sellers wanted to know, especially because the loan balance was up only 5.5%, and interest rates, while up, weren't up that much. "That's a big discrepancy," says one short. And neither the earnings press release nor the company's post-earnings conference did much to explain the gap. In fact, during the conference call, execs pretty much attributed the increase to income from interest on bad loans that finally were being paid.

The shorts, however, didn't buy it. That was just too big of a leap to come from bad-loan interest.

That's where the 10-Q comes in. Medallion filed its "Q" three days after reporting earnings, and the first thing the shorts noticed, in the "Management's Discussion and Analysis" section, was the mention of something not in earlier financial statements: "Investment income," the company wrote, "contains a component, which is derived from a new loan product collateralized by taxi medallions. In consideration for modifications from the Company's normal taxi lending terms, the Company offers loans at higher loan-to-value ratios and will be entitled to earn additional interest income based upon any increase in the value of the collateral."

Put another way -- in English!: The company booked interest income when the value of the collateral of these newfangled loans rose, but the only way that income can be converted to cash is when the medallion is sold at some point in the future.

In other words, it's noncash income. (Otherwise known as nonincome income.) That was verified by the statement of cash flows from operations, where an analysis showed $2.2 million in something called an "accrued interest receivable." That's where the company accounts for income that has been recognized, but that it hasn't yet received. And in the case of Medallion, it was 10 times higher than the same account a year earlier (which helps explain the out-of-whack income).

Like any receivable, the higher they are or the more they jump, the bigger the red flag. This type of receivable, argues one short, is even worse than high receivable days outstanding found at nonfinance companies, "because DSOs [days sales outstanding] are often a matter of timing and you know you'll eventually get the money. With this, you don't know if they will ever see the money they're booking as income. What if medallion values rise and then in two months fall? Then you'll have to reverse the income," and that could lead to a charge.

Which is why the shorts consider income from the newfangled loan, and other accrued interest receivables, low-quality income. It's also why they don't believe it should be included as part of earnings calculations. But it's also easy to see why the company included it without mentioning what it was: Strip it out and suddenly, instead of missing earnings by just 3 cents, the company would've missed by 14 cents. That's not good for a finance company, especially one that counts around 70% of its outstanding loans as fixed, while an almost equal amount of its own borrowings are adjustable.

Not a pretty picture, especially when interest rates rise.

Medallion's CFO didn't return my call.
Herb Greenberg writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, though he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback at . Greenberg also writes a monthly column for Fortune.

Mark Martinez assisted with the reporting of this column.

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