JDA Software Group Inc (JDAS) is one of November’s Most Dan­ger­ous Stocks, small cap special. And like all of our Most Dan­ger­ous Stocks the company has (1) mis­lead­ing earn­ings = account­ing prof­its are pos­i­tive and ris­ing while true, eco­nomic prof­its are neg­a­tive and falling and (2) high val­u­a­tion = very high expec­ta­tions embed­ded in the cur­rent valuation. JDAS gets our “Very Dangerous” rating.

Below are the specific Red Flags my research reveals:

  1. Mis­lead­ing earn­ings: JDAS reported a $14.6mm increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $12.9mm (a dif­fer­ence of $27.5mm or 155% of reported net income).
  2. Very dan­ger­ous val­u­a­tion: stock price of $27 implies JDAS must grow its NOPAT at over 20% com­pounded annu­ally for 10 years. A 10-year growth appre­ci­a­tion period with a 20%+ com­pound­ing growth rate sets expectations for future cash flow performance quite high.
  3. JDAS competes with industry giants Oracle (ORCL) and SAP (SAP), whose businesses are growing stronger while JDAS appears to be weakening. I doubt a comeback is in the cards for JDAS.
  4. Free Cash Flow was -$203mm or -15% of the company’s enterprise value last year.
  5. Asset write-offs of $21mm or 3% of net assets – this means that management has written off at least $0.03 of assets for every $1 on the current balance sheet. Writing off assets is the opposite of creating shareholder value as it reflects management’s inability to derive any profits for the investments it makes with shareholder funds.
  6. Off-balance sheet debt of $40mm or 6% of net assets.
  7. Outstanding stock option liability of $13mm or 1% of current market value.

Over­all, the risk/reward of invest­ing in JDAS’s stock looks “Very Dan­ger­ous” to me. There is lots of down­side risk given the mis­lead­ing earn­ings and red flags while there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price.

Our report on JDAS has detailed appendices for you to see how we perform all calculations. The primary cause of the dif­fer­ence between eco­nomic ver­sus account­ing earn­ings is that JDAS’s NOPAT rose much slower than its invested cap­i­tal. See Appen­dix 4 to learn how JDAS’s NOPAT rose more slowly than Net Income. See Appen­dix 5 for details on JDAS’s invested cap­i­tal and how off-balance sheet debt and asset write-offs are added back to provide a more accurate reflection of the capital invested in the business. Appen­dix 7 (in the return on invested cap­i­tal sec­tion) shows how a slight rise in NOPAT mar­gin paired with a big decrease in invested cap­i­tal turns result in a decrease in return on invested capital (from 6.9% to 4.7%) and eco­nomic earnings.

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

See my blog for all of my stock picks and pans. Samples of some recent picks: Buy MSFT and buy IBM. Short CBG and short VMC.

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