Earlier this week the SEC fined Weatherford International (NYSE:WFT) $140 million for accounting fraud. From 2007 to 2012 the company overstated profits by $900 million. Weatherford grew its operations aggressively through acquisitions and pitched its "entrepreneurial culture" to investors. It also talked up its tax avoidance strategy that would be potentially give the company a competitive advantage over its domestic peers. Weatherford's tax avoidance strategies allowed the company to reduce its effective tax rate ("ETR") from 36.3% in 2001 to 25.9% by end of 2006.
However, its internal controls did not catch up with the company's explosive growth. Most of the fraud allegations involve former employees from the tax department -- James Hudgins and Darryl Kitay. I found the fraud allegations shocking due to the size of the profit overstatement and the sheer brazenness of it. I was even more shocked by details of the SEC investigation. I paraphrased below the four most shocking revelations from the SEC probe.
WFT Fabricated Earnings To Align With Analysts' Expectations
- For FY2007 to FY2010, Hudgins and Kitay engaged in fraudulent practices relating to income tax accounting that violated GAAP and made Weatherford's financial statements false and misleading.
- Weatherford repeatedly and publicly disclosed ETR estimates and recorded tax expense that Hudgins and Kitay knew, or were reckless in not knowing, were fabricated.
- They "plugged" consolidated tax provisions to arrive at lower estimated ETR and tax expense amounts. The plugged adjustments ranged from $286 million to $439 million per year and were taxed at 35%, falsely lowering the company's income taxes by $100 million to $154 million per year.
- The adjustments were made to allow Weatherford's earnings to align with analysts' expectations and the company's projections.
The details of the SEC probe illustrate the fraud happened repeatedly and was clearly designed show bogus earnings. The fraud helped boost the share price. Those shares might have been used to make acquisitions and put the company in an advantageous position vis-a-vis competitors.
The SEC will not require the company to claw back incentive compensation paid to the CEO and CFO. However, I believe such clawbacks are warranted. The accounting fraud boosted earnings and likely the share price, which inured to the benefit of management. In my opinion, management should have known, or was reckless in not knowing, earnings were being boosted by fraudulent tax adjustments.
A commenter from my previous article suggested the company could be a target of class action lawsuits:
Commenter 1: Here come the class action lawsuits. How will they affect free cash flow?
I tend to agree. If tax fraud previously inflated earnings and the share price, investors who purchased WFT at inflated levels might potentially sue the company. Weatherford has only $452 million in cash after burning through $400 million in the first half of the year. A class action lawsuit could drive up Weatherford's legal fees when it can least afford it. A sizable pay out could sink the company.
Cut In 2007 ETR From 29% to 20% Helped WFT Meet Earnings
- Hudgins and Kitay [i] plugged the 2007 year-end tax provision by $439.7 million and [ii] taxed it at 35%, allowing the company to reduce tax expense by $153.9 million for the year. This also lowered ETR in line with previous estimates publicly disclosed during quarterly calls with analysts.
- The adjustment moved ETR from 29% to 20% over the span of one year.
- In an internal email expressing disappointment with operational results Weatherford's CEO stated: "In spite of our ability to meet Wall Street's 2007 earnings expectation, the reality is that our operations delivered $130 million less than the EBIT target set ... a lower than expected tax rate (20% vs. 29%) allow[ed] us to make our Wall Street numbers for the year."
The fact that Weatherford's ETR fell from 29% to 20% in one year should have raised red flags from management. The fact that the company's ability to meet Wall Street expectations was driven by a lower ETR should have raised red flags from investors and analysts. It gives the impression that management looked the other way as the fraud was occurring.
Accounting Fraud Led To A $461MM Phantom Income Tax Receivable
The plugged adjustments and accounting fraud perpetrated by Hudgins and Kitay created a phantom income tax receivable of $461 million.
A $461 million receivable implied that Weatherford was overpaying for taxes and the government owed it money. The fact that it had such a large receivable while at the same time reducing its ETR should have drawn the attention of management and Wall Street analysts.
WFT Applied "Pepto Bismol" To Reduce Its 2010 Tax Liability
- While performing the audit of Weatherford's 2010 tax provision Ernst & Young ("E&Y") uncovered accounting errors that increased Weatherford's tax liability; they included a spreadsheet computation error related to a Slovakia-based subsidiary that increased Weatherford's tax expense and liability by $13.4 million.
- Hudgins instructed the tax department to work around the clock to hunt for additional credits to reduce the tax liability and offset the unexpected Slovakia tax charge.
- On January 20, 2011, Hudgins informed E&Y that he found "Pepto Bismol" to offset the unexpected Slovakia tax charge. On January 21, 2011, Kitay sent E&Y an email with a list of newly recorded offsetting tax benefits, which E&Y understood to be Hudgins' "Pepto Bismol." Among the items, many of which were later deemed unsupportable, was a tax benefit of $14.4 million in Russian intercompany expenses.
- Emails exchanged between Hudgins and Kitay during this period make clear that Hudgins knew a portion ($8.2 million) of Russian intercompany expenses were not deductible.
Weatherford's tax department during this period was practically incorrigible. Who is to say this behavior is not endemic of a wider cultural problem at the company? The same management team that ran the company back then is still around.
Weatherford has over $4 billion in reported GAAP equity. That sizable equity position allowed it to raise over $3 billion in capital in the first half of 2016. The fresh capital helped the company meet near term principal payments and buy it time to rightsize its money-losing operations.
However, I am on record that based on liquidation value the company is insolvent by over $3 billion; I estimate its goodwill, PP&E and inventory are $7 billion less than their carrying value. Weatherford performs a goodwill impairment test in the third quarter. If the company incurs sizable impairments for goodwill or other assets will investors "Pepto Bismol" the stock?
Despite $3 billion in fresh capital Weatherford is still bleeding cash and cannot cover its quarterly interest expense. Sans new money it could become the oil industry's Bernie Madoff. Avoid WFT.
Disclosure: I am/we are short WFT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.