Tuesday, December 13, 2005

Earnings Breakage?


Gross profit dollars increased 16% to $1.8 billion, fueled by revenue growth and a 120-basis-point improvement in the gross profit rate. The improvement included a 30-basis-point benefit (or $0.04 per diluted share) related to the initial recognition of gift card breakage (gift cards sold but not expected to be redeemed). The gift card breakage was recognized in revenue [emphasis added].


Thus reads today’s earnings press release from Best Buy, which—surprise, surprise—matched the Street’s 28c a share earnings expectation to the penny.

Followers of the retail sector—and anybody who’s ever received a gift card themselves—know that a certain percentage of those cards are never redeemed. They get lost or forgotten—or they’re from stores you never get around to visiting.

But without this up-front inclusion of assumed income from credit card “breakage” it looks like Best Buy would not have been close to the $0.28 a share earnings expected by Wall Street’s Finest.

Sounds more like earnings breakage to me.


Jeff Matthews
I Am Not Making This Up


© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

18 comments:

cdub said...

not that it matters, but consensus was $0.30. so they missed by $0.02, vene with the "breakage."

Jeff Matthews said...

I think there was a 2c non-recurring impact from the hurricanes in the 28c.

But they also gained 3c from a lower tax rate.

So they missed by 7c. And this conference call is bizarre. Almost as much spin as the old Tyco calls!

cdub said...

Bizarre indeed. Bit surprising more people aren't exiting CC ahead of next week's call.

Jeff Matthews said...

Not sure I'd go there.

I have been a non-fan of CC for a long time, and have said some harsh things in previous posts.

But I hear not-so-bad things about CC's business out there. You'd think what's bad for BBY is worse for CC...but that may not be the case.

I have no bet on CC either way, but it sounds like they have been recovering some lost share.

Any informed Circuit-Citiers out there willing to offer some first-hand observations are welcome.

r-toc said...

Management was upfront about the fact that the breakage is how they met consensus on the call.

However, I agree that there was a pretty good dose of "trust management" as they further evaluate the investments they've made.

I think the comments BBY made today were driven more by internal performance then external market movements. Revenue was good, so I wouldn't anticipate a similar quarter for CC.

Its_strange said...

Think we will see gift cards to whoever up for bid on Ebay ? Think auctions of unwanted gifts threaten clearence sales ?

Jamie Sidey said...

I'm not sure about the CC stores, but I have been involved in a number of consumer electronics usability studies, and CC's web site is consistantly near the top of the lists. Very easy to use, very accessible, clean & attractive layout, relevant product information prominently displayed... my guess is their web site is doing pretty well. Anyone know if they break out online v offline sales?

justanotherhedgie said...

...ditto the comment about CC's website. the wife works in marketing and does a lot with Internet advertising/sales. she's been telling me the same for the past couple of months.

other good sources in the electronics retail supply-chain have indicated CC has clearly been outperforming BBY (& WMT) this Q on the execution front. from my vantage point, mgmt is doing a better job merchandising & focusing store space & sales on key items...namely, LCD TV's & consumer electronic peripherals.

full disclosure (long CC...but have trimmed in half)

The Irrational Investor said...

After all these years, it seems suprising that management could try to pull something so obvious as early revenue recognition.

They have to make this up in coming quarters, so their job has gotten harder. They could have left it alone, and future expectations might be makeable. Lemme guess, this is an all guy management, right?

the management said...

What is the balance sheet implication of this treatment of gift card liabilities and is it prudent?

Its_strange said...

why give gift cards and not cash ? Seems so silly . I guess they will become a success .

rkb said...

Isn't it true that the revenue from "breakage" should not be recognized at the time of the gift card sale, but rather at a reasonable point after the sale? It is ok to be recognized as revenue at some point, just not up-front. Pretty coincidental amounts though (just enough to match the earnings expectations).

cdub said...

My understanding: Revenue from breakage doesn't result in a future liability (ie, delivery of goods/services) because the cards will never be used - thus it can be recognized immediately. Revenue from gift cards that will be used, however, shouldn't be recognized until the good/service is delivered.

Jeff Matthews said...

The important point is this: BBY had never mentioned "breakage" at all.

If they had recognized it consistently every quarter based on lots of historic data, no big deal.

After all, companies make estimates all the time about return rates, inventory shrink, customer payments.

But now, suddenly, they're booking it into earnings, and it added 4c a share. That plus 3c from a lower tax rate are the only thing that stood in the way of a 21c number versus the Street's 28c.

That's called 'earnings management.'

It will be very interesting to see how CC's numbers compare, and whether they book "breakage" to make the number.

DaleW said...

If they had recognized it consistently every quarter based on lots of historic data, no big deal.

That's just the thing -- companies selling gift cards don't have tons of historical data. Many retailers have been taking adjustments in the last year for over-accruals. So fine, they took a credit this quarter -- that just means earnings have been under-stated in the past because they have been over-accruing for usage.

Also, isn't breakage part of the business model of gift cards? It's just like warranties -- breakage is akin to underwriting profit. If you assume away their profit centers, then yes, earnings will be lower.

Jamie Sidey said...

A note on unused gift cards:
If the gift cards are not used, the company does not get to keep the money... instead, after a period of time, the money goes to the state and is held in escrow for the gift card recipient... not sure how long, but eventually I believe the money goes to the state. This is why you'll see some gift card companies start charging a monthly maintenance fee on the card after 12-28 months. This way they get to keep much of the gift card money if it isn't used.

aralls said...

Escheat laws are determined at the state level, so each state will be different. You can read more here:

http://tinyurl.com/cfaau

and here:

http://tinyurl.com/7uahd

AllenCap said...

Wow.....That's aggressive accounting 101.

I concur with the comments about CC's website. It is really nice and easy to use. I only research purchases there though after getting burned in the audio department about 5 years ago. They will be having a winter carnival in hell before i shop there again.

Long story short, the amount of ineptitude and general ill will i was shown on a big ticket purchase was enough for me to never return. If someone ever made the mistake to give me a gift card from there for christmas (which i doubt since i will happily slam them whenever the opportunity presents itself) i would auction it on ebay rather than redeem it.

Apparently though i am alone. Domestic same store sales were up 13%. Good for them. Maybe it has something to do with being able to pick up items in store, while purchasing on the site.