What we are missing...
KRISPY KREME BITES
By CHRISTOPHER BYRON
Krispy Kreme is using something called Special Purpose Entities to make business look better than it is.
- NY Post: Jennifer Weisbord
February 11, 2002 -- IT'S been great to watch the gang from Enron Corp. weasel around in front of the cameras regarding who said what to whom as they looted and robbed the Houston-based energy giant. But if you want to know where some smart folks on Wall Street think the whole subject of fishy accounting is headed next, then look no further than a harmless-sounding financial concept that's been repeated a lot in the Enron scandal lately: so-called "Special Purpose Entities."
I talked to a hedge fund manager in Boston the other day who said he's now spending all day and night tracking down companies with Special Purpose Entities in their financial filings, and then shorting their stocks with no further questions asked.
"These things are radioactive," says my source. "In the current climate on Wall Street, they're just deadly." That's because Special Purpose Entities can be used to distort and prettify the true picture of a company's financial health, seducing investors into acquiring shares that turn out to be cream-curdling horrors once the rouge and lipstick is removed.
A special purpose entity - known among the cognoscenti as an "SPE" - is the financial equivalent of a magic wand. With the single stroke of an SPE you can make an entire mountain of debt disappear from a company's balance sheet.
Oh, the debt is there, all right - or at least let us say, the obligation represented by the debt is still there. The only thing that actually changes is that the auditors can no longer see it. The debt simply gets moved into that make-believe land known as Off The Balance Sheet.
We'll look at a recent use of this prestidigitation in a minute - a conjurer's trick by which the Krispy Kreme doughnut company is using a Special Purpose Entity and something known as a "synthetic lease" to make an entire doughnut factory disappear. But first some background on what SPEs really are, and just how widespread their use has become.
Special Purpose Entities are accounting gimmicks set up to help a company switch its money from one pocket to the other. There are supposedly lots of good, sound, legitimate reasons why a company might want to do this, but the explanations are so complicated I can't follow them. In many cases, the whole rigmarole boils down to legalized self-dealing, which is what the crew at Enron tried to pull off. In other cases, a company just seems to want to pump itself up and pretend to be bigger than it really is - like the guy who stuffs a wad of socks in his jeans before walking into the bar.
There are currently over a thousand SPEs mentioned in the financial filings of publicly traded companies, and untold thousands more that have been set up on the sly in offshore tax-haven hideouts like the Cayman Islands, where the Enron gang stashed their loot.
SPEs are normally set up as partnerships, with a "general partner" who calls the shots, and a group of limited partners who put up the money. The assets or liabilities that get shuffled in and out of the SPE can be anything from office buildings to software licenses, property mortgages, financial derivatives, high-tech equipment, and even fleets of automobiles. In all cases the idea is to tart up the company's financials by making the business look healthier than it really is - without actually coming right out and lying.
Let's imagine an office building that has an appraised market value of $35 million. Let's further imagine that the building is rented out to a single corporate tenant for $3.5 million annually. How does the tenant cut its rental load? Easy, just wheel in an SPE and a "synthetic lease." First step is to find a bank that will play ball. The bank creates an SPE partnership, then sells a 3 percent stake in the partnership - worth $1 million - to some of the bank's favored fat cat private banking clients. Next, the bank loans $34 million of its own funds to the partnership. The loan represents the other 97 percent of the partnership's capital. After that, the partnership takes the entire $35 million wad of cash and buys the office building from its owner. Then the partnership turns around and begins charging the building's tenant what amounts to an occupancy fee. The fee is equal to just a fraction of a percentage point over the cost of the money that the bank itself has lent to the partnership. The net effect is often to cut the tenant's occupancy cost on the building in half, thereby making the company's profit margin improve.
But there's a catch. To get this juicy deal, the tenant has to agree that at the end of some set period of time - five years, let us say - it will buy back the building from the partnership for the full $35 million. This pledge is a real obligation that will one day place a burden on the entire corporation. But because that burden lies off in the future, it doesn't get recorded on the balance sheet. So far as the auditors are concerned, it simply doesn't exist.
A fine example of this sort of thing lies buried in the footnotes of a recent financial filing by the Krispy Kreme doughnut folks. Since April of 2000, when Krispy Kreme went public in a Deutsche Banc Alex. Brown IPO at $21 per share, the stock has soared nearly 400 percent in the belief that the American appetite for junk food is insatiable. But the stock has lately begun to weaken as sales growth from existing stores has slowed, meaning that future growth in the business will come largely from simply opening more and more new stores - a gimmick that will eventually run out of steam.
So insiders have begun bailing out of the stock in droves - a clear sign of problems in the business. Since last autumn, the company's insiders look to have been making nearly as much money by selling their own shares of Krispy Kreme stock as the company has been collecting in revenues by selling actual doughnuts. What's more, even franchisees have begun selling their operations back to the company, recalling the same sort of behavior that spread through the Boston Chicken chain as that business began to run into trouble.
With the company's margins being squeezed, the last thing any man- agement wants to do is add yet more overhead to the operation. But what do you do if you're in the doughnut business and you've now got so many stores up and running that you've simply got to add more doughnut making capacity? Can you get yourself a doughnut factory for free - or at least let us say, make the cost invisible for the time being?
That's where a SPE and a "synthetic lease" comes in handy. Back in March the company thus announced that it plans to spend $30 million to build some 164,000 square feet of additional doughnut manufacturing capacity for the business, at a location in Illinois. The facility will increase the square footage of the company's properties by more than 50 percent, but you won't find the cost of the project - or the asset that results from it - turning up anywhere on the balance sheet: no increase in debt, and no increase in assets either. For all practical purposes, it'll simply be the Factory That Isn't There, financed off the balance sheet by, as the footnote puts it, a "synthetic lease arrangement with a bank."
Now I am sure the Krispy Kreme folks have plenty of good, sensible-sounding reasons why all this makes great business sense. But I'm one of those old fashioned guys who doesn't want to buy a company in which a third of all its property and equipment turn out to require a lot of "explaining" about how come you can't see it stated on the balance sheet. In the current climate of Enronitis, lots of investors are starting to think the same way - and that's why these SPE things are becoming the new toxic waste of Wall Street.
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