A Postmortem on Aurora

Would close scrutiny of Aurora's financials have flagged the problems brewing there? Let's find out.
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Yes, it would have been wonderful to report a week ago on the accounting irregularities at

Aurora Foods

(AOR) - Get Report

which just announced the near-wholesale

firing of its executive team in the wake of said problems.

I didn't own it, I wasn't looking at it and, frankly, I am only peripherally familiar with it. But, I wondered, were the problems detectable from nothing more than a careful examination of the public financial documents? In the continual effort to improve performance by reducing mistakes, what, if anything, could I learn and impart to

TSC

readers?

First, a little history. Aurora has pursued what is essentially a roll-up strategy in the food industry. They are buying up second-tier or simply very niche brands from the megaliths of the food industry, who in classic

Jack Welch

fashion, are shedding tertiary product lines in order to focus on what are presumably their strengths.

On that note, Aurora started in the frozen-food aisle with Van De Kamps frozen seafood and desserts from

Diageo's

(DEO) - Get Report

Pillsbury

, Mrs. Paul's seafood from

Campbell Soup

(CPB) - Get Report

and Aunt Jemima frozen breakfasts and Celeste pizzas from

Quaker Oats

(OAT)

.

More recently, Aurora has attempted to corner the syrup market buy buying Mrs. Butterworth's from

Unilever

(UL) - Get Report

and Log Cabin from

Philip Morris'

(MO) - Get Report

Kraft Foods

. (I guess the

Justice Department

is too busy with

Microsoft

(MSFT) - Get Report

to care). The company also added Duncan Hines from

Procter & Gamble

(PG) - Get Report

and recently bought Lender's Bagels from

Kellogg

(K) - Get Report

.

This is a conceptually interesting strategy: Buy niche brands at bargain prices from disinterested food giants; consolidate and cut expenses; then aggressively market and promote what probably had been ignored brands. And, yes Virginia, there is reasonable money to be made by growing unit volume a few percent a year, grossing it up to the mid-single digits at the operating line and achieving 10% earnings-per-share growth through either debt reduction or share buybacks.

So Aurora did some privately levered deals, consolidated them and went public in June of 1998. The company's public financials -- while confusing because of a variety of one-time charges, transition costs and the vagaries of acquisition -- looked reasonably on track.

Fast forward to last week when the company announced the "resignations" of nearly the entire senior management team, citing accounting differences with the auditors in regard to how promotional expenses paid to retailers were booked.

Details are extremely sketchy and Wall Street is, predictably, ticked off: Two choice quotes in

The Wall Street Journal

were, "They lied to me," and, "It doesn't sound like anyone knows what's going on." (I would add that the latter is a quote we are going to hear repeated

ad nauseam

in the future.)

Despite the fact that the Internet and B2B are going to revolutionize the world, in the jungle in which we presently live, there are still a number of games being played between packaged-goods manufacturers and retailers in an attempt to gain/maintain shelf space and gain/maintain manufacturing volume.

An additional 2%-capacity utilization at the packaged-goods manufacturing plant can vastly leverage the profitability of the manufacturers, hence the temptation to goose sales here and there. Estimates from some industry sources indicate that more than 50% of some retailers' net margins come from promotional dollars delivered from the manufacturer to the retailer either in cash or trade discounts. So these are big issues.

Here's how it's done: The manufacturer can offer "money" to retailers in two basic ways: 1) through lower unit prices if the retailer hits certain volume targets, and 2) through actual cash paid for slotting goods in prime-store real estate or for the retailer to set up special promotions.

What remains both tricky and a very gray area is how to account for this behavior. Some promotional expenses can be legitimately capitalized for short periods, but the rules are not black and white as to how much and what characterizes a true promotion as opposed to the ordinary cost of doing business.

Moreover, a manufacturer can also choose to accrue promotional expenses based on their estimate of the expected sales of the item being promoted. If sales come in below this estimate, at some point there must be a sudden "whoosh" of expenses hitting the P&L to play catch-up. And that appears to be what happened here.

So back to our initial question: Was it possible to see this coming in Aurora's reported financial numbers? Clearly some people saw something, because the stock was already down from 18 to 7 prior to the announcement, an ugly drop even given the sorry state of the packaged-food industry. But even some of Aurora's bankers did not see it coming, as they upped Aurora's credit line late in 1999 for the Lender's acquisition.

After looking at the last year of financial statements, I don't know if an attentive investor could have predicted trouble just from an examination of the numbers. There was some notation that promotional expenses were down year-over-year in the last quarter, but that seemed reasonable in light of a relative dearth of new-product introductions vs. a year ago -- and besides, promotional expenses can be very seasonal.

Another flag was that cash flow from operations was negative for the first nine months of the year vs. positive EPS, but there is inventory build-up for the company's seasonally big fourth quarter, and the numbers can be confusing with a bunch of acquisitions. Prepaid expenses were up and accrued liabilities were down, which can often be curtains drawn to keep expenses off the income statement for as long as possible. But it's tough to say if this was material without comment from management, which is obviously lacking at the moment.

Which brings us to the issue that, as noted here in the past, good securities analysis is not just about sitting in an office and playing with the numbers. It's about getting out and talking to competitors, suppliers and customers to get a feel for the relative strengths and weaknesses of the company's management, products and manufacturing, distribution or selling process.

It's also about focus. I would bet that a dedicated analyst who called a variety of distributors, retailers and competitors to check up on Aurora would have probably elicited a comment from someone to the effect that, "those guys are being very aggressive with promotions" -- which would have been a definite cause for concern.

My conclusions at this point are tentative at best.

  • A wholesale firing of management seems like more than just a few million dollars worth of accounting disagreements here or there. Well educated, seasoned professionals who are determined to "paint" financial statements will often succeed because it is tough to see it unless you are told what to look for.
  • Not all acquisitive companies turn out to be disasters, but often disasters have their roots in acquisitions which were both poorly conceived and overpriced.
  • It also pays to be wary of companies in slower growth industries that are growing much faster than their competitors. The packaged-food industry is unbelievably competitive and is getting squeezed by smarter retailers. So while it does make sense that a management team paying attention to smaller brands that have been ignored by a colossus like Kraft can rejuvenate some growth (the Earthgrains (EGR) spinoff from Anheuser-Busch (BUD) - Get Report is an enormously successful case of this), it's still an uphill battle.

Once again, it comes down to management. Buying the equity seems like an absolute crapshoot right now for those tempted to bottom-fish. If tempted, I would do some serious investigation first. And let me know what you find!

Jeffrey Bronchick is chief investment officer of Reed Conner & Birdwell, a Los Angeles-based money management firm with $1.2 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value fund. At time of publication, RCB held a position in Anheuser-Busch, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at

jbronchick@rcbinvest.com.