Accounting Is Fishy at the Zumiez (ZUMZ) Surf Shop

We closed this position on August 18, 2011. A copy of the associated Position Update report is here.

2010 earnings for the retail apparel sector have been quite strong, especially compared to 2009. However, looking behind the window dressing of reported earnings, we find that not all earnings are made the same.

Zumiez Inc. (ZUMZ), retailer of cool, new action apparel turned to an old accounting trick to boost its 2010 earnings by 13%. Digging through the footnotes of its 10K filing, we found that ZUMZ increased the useful life estimate of its leasehold improvements. This change in accounting estimate reduces the company’s depreciation expense by $2.7mm after-tax and increases GAAP earnings by 13%. Without this change in accounting estimates, ZUMZ would have earned $0.70 per share in 2010, not $0.79.

Investors should beware of stocks whose earnings are boosted by changes in accounting assumptions because these changes are rarely representative of changes in the underlying economics of businesses, except maybe as a counter-indicator. In other words, companies are less likely to exploit accounting rules to boost earnings when their actual cash flows are looking good. Common sense suggests that there are few good reasons for a company to spend money to pay accountants to perform a review of the useful lives of assets when resources could be focused on efforts that actually improve the economics of the business.

Moreover, changes in estimated useful lives of assets are quite rare for publicly-traded companies; increases in these estimates are the most rare. ZUMZ is scratching the bottom of the accounting-trick barrel.

ZUMZ is the only retail company, and 1 of only 9 in the 3000+ companies we cover, to increase the estimated useful life of any of its assets according to all 10-Ks filed since January 2010. Note that in the 7,183 10-K filings we have analyzed for changes in useful life estimates (among many other Red Flags), we found 11 companies who decreased their useful-life estimate and lowered their earnings. Usually, such decreases are associated with restructuring and asset impairments, which are often reported on the income statements and not buried in the footnotes.

A couple other companies that have used the same trick as ZUMZ are tw telecom (TWTC), formerly known as Time Warner Telecom, and Pride International (PDE).

Increasing useful-life estimates is not the only accounting trick in ZUMZ’s bag. Further analysis of the financial footnotes reveals that the company carries over $310mm (nearly 50% of its market cap and over 120% of reported net assets) in off-balance sheet debt. This large, hidden liability means the valuation of the stock is much higher and riskier than it appears.

Analyzing the valuation of the stock only gives us more conviction that investors should avoid exposure to ZUMZ. The current market valuation of the stock implies that ZUMZ will grow profits at over 9% compounded annually for 20 years. More specifically, our model shows that ZUMZ will have to grow revenues at 10% compounded annually while also improving its return on invested capital (ROIC) from 7% today to over 10% in 20 years. Those are some high expectations compared to what ZUMZ (or most any publicly-traded company in the history of the world) has done historically.

The combination of fishy accounting and dangerous valuation means ZUMZ gets our “dangerous” rating. We recommend investors sell or short the stock. Looking beyond the reported accounting results reveals that ZUMZ is not quite as profitable a company as it seems, and its valuation has out-grown its true economic earnings by a wide margin. For more details, see our report on ZUMZ.

In a business where investors make money by buying stocks with low expectations relative to their future potential, ZUMZ fits the pro­file of a great stock to short or sell.

Note: Stock pick of the week is updated every Tuesday.

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