Duane Reade's Little Pill

The drugstore chain's stock looks sickly thanks to allegations of aggressive accounting.
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Duane Reade

(DRD) - Get Report

, the drugstore chain, looked like the picture of health in themonths that followed its initial public offering last February, when its sharesmore than doubled. But recently the stock has been looking sickly thanks totwo research reports that allege investors who own Duane Reade are gettinga dose of bad medicine in the form of aggressive accounting.

Reports published by

Avalon Research Group

and the

Center For Financial Research and Analysis

, along with three people who are shortthe stock, question Duane Reade's earnings, which they say may be getting anartificial lift from advanced revenue recognition. They note risinginventories, which is never a good sign for a retailer. And they'reskeptical of the company's knack for meeting analysts' earnings expectationseven as the company has fallen short of sales predictions the past few quarters.Finally, they wonder how the company is able to boost margins, even as itscompetitors are seeing theirs decline.

Duane Reade says the charges have no merit.

Still, by Friday shares had fallen 25% from their high of 45 last seen in September to closeat 33 7/8. The depressed stock price could make the company a takeovertarget, say the short-sellers, some of whom have covered their positions inrecent days.

These critics allege that Duane Reade is recognizing rebates it receivesfrom suppliers before the products are sold. Avalon, an institutionalresearch boutique, offers this example: Duane Reade promises to buy $10million worth of thong sandals from a supplier over one year. The supplier maythen offer Duane Reade a $1 million cash rebate on that business. DuaneReade also receives rebates on advertising when it shares those costs witha supplier.

Usually, companies account for rebates by waiting until products are sold and then reducing the cost of goods on those sales, says Edward Ketz,associate professor of accounting at

Penn State University

. "The keypoint is not to record something until the product is actually sold," hesays.

Recording revenue or expenses at the wrong time can eventually cause a company to restateearnings as was the case with

Pathmark

, which reclassified itsfinancial statements after questions arose about the timing of coupon expenses. Anthony Cuti, Duane Reade's chairman and chief executive, previously served as chief financial officer of

Supermarkets General

(SUGHP:OTC BB), which owns Pathmark.

Cuti, however, says the coupon issue that Pathmark wrestled with is specific to supermarkets. "There's no such issue at Duane Reade." He adds thatPathmark's restatement only shifted earnings from one quarter to anotherand had no impact on the company's overall profits for the year.

The three short-sellers suggest that now he's practicing a similar technique at Duane Reade by booking rebates as receivables from suppliers before the company sells any products. Avalon points out that days outstanding forreceivables increased to 10 in the third quarter ended Sept. 26 fromseven days in the first quarter ended March 28. One short-seller notes that the company's rising receivables could be the result of booking them too early. And, he continues, in its most recent quarter, Duane Reade's operating cash flow ran at a large deficit, but its netincome remained positive. One explanation for such a discrepancy, saysKetz at Penn State, is a company's either slowing the recognition of expensesor speeding up the recognition of revenue.

Cuti, Duane Reade's CEO, says the company only records productrebates after the product is sold. Likewise, he says it only recordsadvertising rebates once those ads have run and the costs have been expensed.

"Our accountants,

Price Waterhouse

, force us to give them writtendocumentation from the vendor for when that money is earned," he says."Management doesn't have a lot of latitude with this."

He says the rise in receivables also includes uncollected amounts frommanufacturers for joint advertising, and that skews the results. He addsthat receivable days outstanding for pharmacy sales alone run about 28days, which is consistent with the industry. (Pharmacy sales, which drugstores typically collect through third-party health providers, are a goodmeasure of receivables, because most other products sold in drugstores arepaid for with cash.)

Another reason for the sharp increase may be the bankruptcy filing of the

Pharmacy Fund

, which had been collecting receivables for Duane Reade.

Meanwhile, Duane Reade, which had experienced losses in recent years, hasreported strong sales and profit growth in recent quarters. For the thirdquarter ended Sept. 26, the company earned $5.7 million, or 31 cents pershare, on sales of $144 million. That compares with a loss of $1.8 million,or 18 cents per share, on sales of $107million the year earlier.

And this fall, the company agreed to buy the 38-unit

Rock Bottom

chain, increasing its presence in New York, where it holdsa 20% market share, according to

Metro Market Studies

, a marketresearch firm.

Along with that rapid growth, however, has come an inventory buildup. Inventories typically grow in line with sales. But days inventory outstanding, which compares inventory with sales, has climbed to 93 days in the thirdquarter, from 72 days in the first quarter ended March 28, according to Avalon.

Cuti says Duane Reade had been building inventory in preparation for theRock Bottom purchase to restock those stores.

Finally, skeptics wonder how Duane Reade is able to meet analysts' earningsestimates even as the company has fallen short of sales projections. Theyask how Duane Reade was able to boost its gross margin over the pastthree quarters, even as pharmacy sales, its lowest-margin products, haveincreased.

Cuti says the company has only missed sales estimates for stores open atleast one year but has met or exceeded predictions for total salesincreases, which includes newer stores. He says Duane Reade is purposelycannibalizing some high-volume stores, which has depressed same-storesales growth.

According to Duane Reade's

Securities and Exchange Commission

filings, gross margins have increased from "the sale of higher marginmerchandise such as cosmetics, vitamins, general merchandise, generic drugsand private label products; and higherpromotional allowances received from vendors."

"In order to compensate for the increase in pharmacy sales, Duane Readewould need about a 400 basis point rise on those higher end products," saysone person who is short the stock. "I find it implausible that they couldbe getting that much better pricing on tissues."

Oddly, questions about Duane Reade's accounting may actually drivethe stock higher in the long run if a consolidator snaps up the company.That seems more likely today with Duane Reade trading at a lower multiple.When

J.C. Penney

(JCP) - Get Report

recently agreed to buy

Genovese Drug Stores

(GDXA)

, it noted that to penetrate the Big Apple it was easier to buy than build.