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 the months that followed its initial public offering last February, when its shares more than doubled. But recently the stock has been looking sickly thanks to two research reports that allege investors who own Duane Reade are getting a 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 short the stock, question Duane Reade's earnings, which they say may be getting an artificial lift from advanced revenue recognition. They note rising inventories, which is never a good sign for a retailer. And they're skeptical of the company's knack for meeting analysts' earnings expectations even 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 its competitors 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 close at 33 7/8. The depressed stock price could make the company a takeover target, say the short-sellers, some of whom have covered their positions in recent days.

These critics allege that Duane Reade is recognizing rebates it receives from suppliers before the products are sold. Avalon, an institutional research boutique, offers this example: Duane Reade promises to buy $10 million worth of thong sandals from a supplier over one year. The supplier may then offer Duane Reade a $1 million cash rebate on that business. Duane Reade also receives rebates on advertising when it shares those costs with a 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 key point is not to record something until the product is actually sold," he says.

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


, which reclassified its financial 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 that Pathmark's restatement only shifted earnings from one quarter to another and 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 for receivables increased to 10 in the third quarter ended Sept. 26 from seven 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 net income remained positive. One explanation for such a discrepancy, says Ketz at Penn State, is a company's either slowing the recognition of expenses or speeding up the recognition of revenue.

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

"Our accountants,

Price Waterhouse

, force us to give them written documentation 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 from manufacturers for joint advertising, and that skews the results. He adds that receivable days outstanding for pharmacy sales alone run about 28 days, which is consistent with the industry. (Pharmacy sales, which drugstores typically collect through third-party health providers, are a good measure of receivables, because most other products sold in drugstores are paid 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, has reported strong sales and profit growth in recent quarters. For the third quarter ended Sept. 26, the company earned $5.7 million, or 31 cents per share, on sales of $144 million. That compares with a loss of $1.8 million, or 18 cents per share, on sales of $107 million 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 holds a 20% market share, according to

Metro Market Studies

, a market research 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 third quarter, from 72 days in the first quarter ended March 28, according to Avalon.

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

Finally, skeptics wonder how Duane Reade is able to meet analysts' earnings estimates even as the company has fallen short of sales projections. They ask how Duane Reade was able to boost its gross margin over the past three quarters, even as pharmacy sales, its lowest-margin products, have increased.

Cuti says the company has only missed sales estimates for stores open at least one year but has met or exceeded predictions for total sales increases, which includes newer stores. He says Duane Reade is purposely cannibalizing some high-volume stores, which has depressed same-store sales growth.

According to Duane Reade's

Securities and Exchange Commission

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

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

Oddly, questions about Duane Reade's accounting may actually drive the 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


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