Tuesday, September 18, 2012

Lesson 16: Manipulating Income with Tax Credits, KKD Krispy Kreme Donuts

Here is a very interesting case study on KKD Krispy Kreme Donuts. We be using KKD's 10-K from Edgar. If you have a look at KKD's net income on page on page 33, you see an enormous jump in 2012 from prior years, from $7.5M to $166M. In the shareholder equity section, you also find an enormous jump from $170M to $335M. I wanted to see how this was possible. Revenues did not dramatically increase. Cash flows did not dramatically increase. My guess was that it was the re-evaluation of some asset that it had, and that the jump in income was probably a non-cash accounting change.

I finally found it on page
46 in the Provision for Income Taxes section. This is very interesting because I imagine that a lot of companies probably do this. KKD is probably doing this on a much larger scale though.

When a company makes money, they pay taxes. When a company makes $100 dollars in year 1, and loses $100 dollars in year 2, they don't end up with 0. They pay 35 dollars in tax in year 1 (assuming 35% tax rate), and they end up with -$35 dollars in year 2. Effectively, you've paid taxes on money that you didn't really make. Now, Uncle Sam isn't nice enough to hand you back the $35 dollars that you paid in year 1. However, what he'll do is spare you from paying the next $35 dollars worth of taxes.

In year 3, lets say you make $10 dollars. You would normally get taxed $3.50 at the 35% tax rate. However, you are given a $35 dollar credit against future taxes that you have to pay. So in year 3, you end up paying  $0 taxes, and your $35 dollar credit gets reduced to $31.50.

Now, this 35 dollar credit is worth something. If your losses are temporary and you expect to make more money in the future, you can take full advantage of the credit. If you make $100 in year 2, you would be to fully use the tax credit. Any less and you'll save the rest for later.

However, if your company is doing poorly and there's a good chance you might go bankrupt and have to shut down, you may never get to utilize the credit. In that case, you would create a reserve against the tax credit, which is like writing down an asset. If you're going bankrupt tomorrow and shutting down, your $35 credit is as good as $0.

KKD has amassed a huge amount of losses from 2004 to 2009. They've accumulated $139M worth of credits and has created a valuation allowance because they did not think they would ever be profitable again to be able to utilize it.

Now, they've reversed all of it at once and added the amount into income. What this means is that by showing a larger net income today, you end up with smaller net incomes in later years. Considering they've been showing free cash flow in the $10M to $15M area the past couple of years, I'm not too enthusiastic about them releasing the whole valuation allowance. It would take KKD years to realize this credit. I would have been much happier to see a more conservative middle ground.

As of right now, Google Finance shows a Return on Equity on KKD of around 100%, which is enormous. This is due to the inherent flaws of the ROE ratio, which is why it is necessary to always dig deeper. By removing the tax credit from their assets, I would use a shareholder equity of around ~110M (by subtracting the $139M credit from shareholder equity of $249M). I would subract $139M from net income to get $27M to remove the effects of the allowance reversal.

This leaves me with an ROE of 27 / 110 = 24.5%, which makes far more sense than the 100% that google finance currently shows.

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