Since UCP‘s Q4 earnings report and call, the stock has collapsed, dropping from $11.35 to $9.95, or 13%. Other builders’ shares have not performed similarly, leading us to believe that the investor community’s disapproval was specific to UCP and its outlook. As we wrote in our post of March 1, we found much to disapprove as well. This chart compares UCP’s stock price performance over the last 10 days with the iShares U.S. Home Construction ETF (Ticker: ITB):
We were not disapproving enough. There is more to dislike about UCP’s Q4 results than we realized. Today, we elaborate on what we believe to be a slow motion collapse of UCP.
“That’s How It Starts”
In the movie “Training Day,” there is an alley fight scene where rookie cop Jake apprehends two crackheads. Veteran cop Alonzo begins a mock interrogation of the suspects. One of the suspects responds with hostile and vulgar language, to which Alonzo laughs and replies, “That’s how it starts.”
UCP’s conduct over the last several months, perpetrated by Chairman Michael Cortney, CEO Dustin Bogue and CFO James Pirrello, has deteriorated. We have documented the surreptitious removal of the Officer Stock Ownership Guidelines, the Q3 earnings shortfall that was dubiously blamed on the weather, the suspect netting of the Citizens goodwill writedown with the contingent consideration reduction, the undeserved salary increase and Golden Parachute fortification on behalf of Mr. Bogue.
We now add to the list of questionable conduct by Messrs. Cortney, Bogue and Pirrello: grossly inflated earnings presented to the investing public.
That’s how it starts.
On the Q4 Earnings Call, in his scripted remarks, Mr. Bogue said, “For the full year net income was a record $1.15 per share which included $0.31 of net one time benefits. Excluding one-time items Core Earnings would be $0.84 per share.”
Mr. Bogue relied on this $.84 per share number when he said, “Our return on equity improved to 6.5% in 2016 compared to under 3% in the prior year.”
Mr. Pirrello joined the fantasy when he stated, “For the full year, UCP’s net income to public shareholders was $9.2 million or $1.15 per share compared to $0.30 in 2015. This earnings improvement is driving higher returns on equity which steadily trended higher over the past five quarters rising to 6.5% in Q4 2016 compared to 2.7% in the prior year.”
Mr. Pirrello digs himself further into the make-believe hole when he elaborates, “During the quarter we also released our valuation allowance against our deferred tax asset. The impact was a contribution of $5.5 million which provides benefits exclusively to UCP’s Class A shareholders. . . . Excluding these one-time items and the tax benefit, core EPS for the fourth quarter and full year were $0.28 and $0.84 per share and still represent record levels.”
Messrs. Bogue and Pirrello even produce a pretty slide, highlighting their “improvements.” See the Slide here.
Economic Reality – 85% Worse
This is what Messrs. Bogue and Pirrello told the investing public, the builder analysts on Wall Street, UCP’s shareholders and its majority owner PICO Holdings. Let’s check the veracity of these figures.
Here is how UCP arrives at its $.84 “Core Earnings” figure:
Net Income EPS ---------- ------ Reported $9,238 $1.15 Add: Goodwill Writedown $4,223 $0.21 Abandonment/Impairment $3,112 $0.16 Less: Valuation Allowance ($5,482) ($0.68) ---------- ------ $11,091 $0.84 ========== ======
So far so good.
Except there are two problems. One small problem and one big problem. We take the small problem first.
UCP’s “Core Earnings” figure incorporates three adjustments for noncash items. Unfortunately for Messrs. Bogue and Pirrello, there were FOUR noncash items in 2016. And the noncash item these men innocently forgot to adjust had a positive effect on earnings.
Messrs. Bogue and Pirrello do an excellent job of adding back noncash reductions to earnings per the goodwill writedown and the real estate abandonment/impairment charges. They eliminate the effect of the valuation allowance, which sharply increased net earnings.
But alas, these men innocently forgot about the noncash reduction to the contingent consideration, which positively affected consolidated net income by $2.347 million.
To recap: 2016 produced 4 noncash adjustments to earnings, two boosted earnings and two reduced earnings. Messrs. Bogue and Pirrello dutifully reversed the two that punished earnings but innocently forgot to reverse an adjustment that boosted earnings: the contingent consideration.
We find the failure to adjust for the contingent consideration to be especially suspicious given that Messrs. Bogue and Pirrello added back the noncash negative effects of the goodwill writedown. The goodwill writedown and the reduction in contingent consideration are linked. They occurred simultaneously. You could not have one without the other. They go together like divorce and alimony.
(We were going to say, “They go together like poor performance and no bonus” – but at UCP, poor performance is rewarded with a raise, Golden Parachute fortification and a soon-to-arrive bonus. Just ask Messrs. Cortney and Bogue.)
Here is the “Core Earnings” breakdown with the reduction in contingent consideration reversed – a more honest presentation of “Core Earnings”:
Net Income EPS ---------- ----- Reported $9,238 $1.15 Add: Goodwill Writedown $4,223 $0.21 Abandonment/Impairment $3,112 $0.16 Less: Contingent Consideration ($2,347) ($0.12) Valuation Allowance ($5,482) ($0.68) --------- ------ $8,744 $0.72 ========= ======
The contingent consideration reduction was noncash, just like the real estate impairments, the goodwill writedown and the removal of the valuation allowance. Yet Messrs. Bogue and Pirrello conveniently forgot to reverse this noncash item, which would have reduced UCP’s earnings per share figure by $.12 from $.84 to $.72, a reduction of 15%.
Messrs. Bogue and Pirrello trumpet an improved return on equity of 6.5%, based on “Core Earnings.” We suppose these men would label this measure “Core Return on Equity.” That’s pretty funny. Using an average of beginning and ending equity, we calculate UCP’s “Core Return on Equity” as:
$.72/($95 million/8 million shares) = 5.9%
This difference of 0.6% in return on equity is not too bad, given some of the shenanigans we have seen in the PICO/UCP saga. RPN’s Core Return on Equity is only 10% lower than UCP’s figure of 6.5%.
But there is more.
To review, there were four noncash items in 2016. Messrs. Bogue and Pirrello only reversed 3 of them, innocently forgetting to reverse the contingent consideration, which boosted earnings. Messrs. Bogue and Pirrello also innocently forgot to mention another item: a tax payment for $4,830 million. Let’s see its effect on the UCP “Core Earnings” figure:
UCP Core Earnings RPN Cash Earnings ------------------ ----------------- Reported $1.15 $1.15 Add: Goodwill Writedown $0.21 $0.21 Abandonment/Impairment $0.16 $0.16 Less: Contingent Consideration -- ($0.12) Valuation Allowance ($0.68) ($0.68) Cash Tax Payment to PICO -- ($0.59) ----- ------ Total $0.84 $0.13 ===== ======
Messrs. Bogue and Pirrello innocently forgot to tell analysts, shareowners and the investing public that UCP made a tiny little tax payment of $4,830 million to PICO in 2016. Unlike other expenses, which are “shared” 43%/57% with PICO, the tax payment inures 100% to UCP.
In mirror image fashion, Mr. Pirrello says so himself. On the Q4 Earnings Call, he says: “During the quarter we also released our valuation allowance against our deferred tax asset. The impact was a contribution of $5.5 million which provides benefits exclusively to UCP’s Class A shareholders.”
What Mr. Pirrello innocently forgot to tell us was that UCP made a cash tax payment of $4,830 million to PICO, which is borne exclusively by UCP’s Class A shareholders.
As we stated in a post several months ago, UCP’s tax payments to PICO are “off-income statement.” They do not appear on the face of the P&L. Instead, these payments are recorded in the “Financing Activities” section of the Cash Flow Statement, under “Distribution To Noncontrolling Interest.”
Anyone doubt that the $4,830 million was a tax payment? Here is the excerpt from Page 12 of the UCP 2016 10-K: “During the years ended December 31, 2016 and December 31, 2015, UCP, LLC made distributions of $4.8 million and $1.0 million, respectively, to PICO toward its tax liability. . . .”
Sounds like a tax payment to us.
We have a question for Messrs. Bogue and Pirrello: Since when do “Core Earnings” not include tax payments?
This pesky little tax payment reduces UCP’s “Core EPS” by a smidgen: from $.84 cents to $.13 cents, equal to an 85% reduction. Instead of the 6.5% “Core ROE” trumpeted by Messrs. Bogue and Pirrello, RPN’s “Core ROE” for UCP amounts to:
$.13/($95 million/8 million shares) = 1%
Messrs. Bogue and Pirrello boast about their “improved” return on equity of 6.5%, but the true figure is 1%. A slight difference.
Messrs. Bogue’s and Pirrello’s definition of “Core Earnings,” which conveniently ignores tax payments, brings up a host of opportunities. Next time we go out on a date, we will say, “Well baby, we earned $24,000 in 2016, but our ‘Core Earnings’ were $30,000.”
We are going to call Fair Issac and get them to change our FICO score. We will inform them that our creditworthiness shouldn’t be based on after tax income, but on “Core Earnings,” which disregards taxes. We call this “Core FICO.”
Utilization of “Core FICO” may get us that Platinum Card from American Express that we have always wanted.
Call your mortgage broker. Tell them you want a loan for a bigger home. When your broker asks why, say you just realized your “Core Earnings” are 25% more than your tax return indicates.
We could go on forever.
UCP Jumps The Whale
A few months back, we published a post entitled “UCP Jumps The Shark – Dustin Bogue’s Builder Coming Undone.” We had no idea how prescient that piece was: UCP is now jumping larger marine animals.
We have kept a running list of all the improprieties perpetrated by Messrs. Cortney, Bogue and Pirrello. To our constantly growing list, we now add “Dishonest Earnings Presentation.”
Proper conduct seems to be slipping through these men’s hands like water.
This same phenomena occurred at PICO. Certain Directors and Executives became so fearful and desperate that their conduct crashed down through one ethical level after another. Over time, it only got worse; never better. The same thing is happening at UCP.
We are puzzled by the antics of Messrs. Cortney, Bogue and Pirrello. We would think they would want to end the self-humiliation and self-inflicted pain and reach a harmonious solution with the owners of the business.
But alas, these men flounder on. Their list of transgressions against shareowners grows and they face a stare-down with their majority owner. It will likely only get worse from here.
It appears to us the UCP’s own Code of Business Conduct & Ethics warns against the exact conduct now perpetrated by Messrs. Cortney, Bogue and Pirrello. Here is an excerpt:
“When you are faced with a business situation where you must determine the right thing to do, you should ask the following questions:
• Am I following the spirit, as well as the letter, of any law, this Code or other Company policy?
• Would I want my actions reported on 60 Minutes?
• What would my family, friends or neighbors think of my actions?
• Will there be any direct or indirect negative consequences for the Company?”
Messrs. Cortney, Bogue and Pirrello appear to be disregarding their own Code.
The Importance Of Base Case
In his intriguing book, “Thinking Fast and Slow,” Daniel Kahneman invites readers to respect base cases. For example, numerous studies indicate that roughly 50% of marriages end in divorce. Yet soon-to-be-weds always assume their marriage has a 100% probability of ever-lasting blissful success. Mr. Kahneman wisely counsels against scenario analysis that deviates significantly from a base case.
UCP Directors and Executives should look at the PICO base case.
Fourteen months ago, the PICO Board was comprised of 7 corrupt and incompetent Directors. All of them have been removed. In the process, two recently appointed self-interested directors were removed. That is a total of nine Directors removed.
More impressive than the gross number is the success rate: 100%.
Messrs. Cortney, Bogue and Pirrello should also consider the manner in which these 9 Directors were removed. Three (John “The Juicer” Hart, Kenneth “The Slug” Slepicka, and Carlos “The NACD-Decorated Horse Thief” Campbell) were thrown out in complete humiliation. These three men severely damaged their professional reputations and their future earnings power. Two others, Raymond “Delaymond” Marino and Hapless Howie Brownstein, were embarrassingly tossed by their own Board (an action cheered by shareholders). Again, these two men leave with damaged reputations and diminished earnings power.
The only Directors who departed PICO with their reputations and earnings power intact, did so quickly and quietly (Julie Sullivan, Kristina “Malificent” Leslie and Robert Deuster).
We feel Messrs. Cortney, Bogue and Pirrello would do well to objectively analyze the base case before them. Perhaps they will find similarities and can derive a prudent future course of action therefrom.
We started this post with the phrase, “That’s how it starts.”
It remains to be seen how Messrs. Cortney, Bogue and Pirrello choose to finish.