The Stirling Homex Case
BA 219 Case 1: Stirling Homex
Group 1:
Alfie Dulatre, Zarah Lacsa, Jay Igpuara, Shaine Lim, Epi Maducdoc, Mico Reyes
I. Point of View:
The group will take the point of view of the top management of Western Union, as a creditor, during the year 1971.
II. Case Context:
Stirling Homex started in 1967 by William Stirling and David Stirling Jr. as a real estate developer who specializes in breakthrough modular housing unit in Avon, New York. Stirling Homex employed various techniques of automobile assembly to mass produce, transport and install large amounts of housing units which significantly revolutionized the housing industry in the United States. This innovation started to become known in the US and started to attract interest from the government and local housing authorities searching to improve the housing condition especially to low income groups.
One of the government agencies which supported Stirling Homex is the US Department of Housing and Urban Development (HUD), a government body in charge with the regulation and improvement of the housing industry represented by Secretary George W. Romney. Stirling Homex’s management is also comprised of some of the former officials of HUD.
Most of the projects of Stirling Homex were under HUD’s turnkey program. In the said program, following the receipt of proposal from a number of applicants, a local housing authority (LHA) will issue a letter designating the applicant as the developer of the said project subject to certain conditions. Once the conditions were met, this is followed by a contract of sale between LHA and the developer countersigned by HUD as evidence of its commitment to finance the project.
Due to its popularity, Stirling Homex was able to attract investors to finance its business. Western Union, represented by Harper Sibley Jr. invested the amount of $16,000 and $25,000 to build housing units and begin its mass production.
These continuous developments resulted to Stirling Homex’s intention to offer its products to a wider market in 1971. Aside from public housing projects and high-rise apartments, Stirling Homex also offered modular units for townhouses, hotels, motels and private residences. The company also ventured into another business when it created the US Shelter Corporation, a financing company, which offers construction and permanent financing assistance. Stirling Homex already signed an agreement with HUD in its next projects.
In summary, it was identified that the primary entities are Stirling Homex, HUD, Western Union and US Shelter Corporation
III. Problem Definition:
With Stirling Homex’s intention to market its products to a broader market, the group implied its intention to expand and thus obtain more financial assistance. Hence,
SHOULD WE LEND TO STIRLING HOMEX?
IV. Framework for Analysis:
To arrive at the decision, the group’s approach in analyzing the case will revolve around the following discussion points:
1. A short summary of the macroeconomic state of the industry during the relevant years
2. Financial Health through analysis of significant financial ratios and a deeper dive of their implications
3. Tackle qualitative indicators based on
a. Capacity
b. Character
c. Capital
d. Collateral
e. Conditions
4. Set up a concise set of criteria to arrive at the decision whether to lend to Stirling Homex or otherwise
V. Analysis
1. Macroeconomic State
US economy in 1950’s was a relatively stale period of time. In 1960 to 1961, the recession began. Shortly after recession, the country experienced the longest uninterrupted period of economic expansion in history. At this time, inflation was relatively stable, corporate profits were at a record high, and the stock market jumped back, but unemployment was still too high. Housing and computer industry became the leading sectors of the economy. Demand for single-family homes in suburbs increased. 1970’s marked the great inflation period. The stock market was a mess and economic growth was weak. This resulted to high inflation, abrupt drop in GDP, and double digit unemployment rate. Central bank raised the interest rates to some 20%, causing calamity to interest-sensitive industries such as housing and cars. With ever-increasing interest rates, many people are priced out of new cars and homes.
With these macroeconomic indicators, as a creditor in the year 1971, Western Union should presumably be cautious and have a relatively stricter criteria in deciding whether to lend to Stirling Homex
2. Financial Ratios. Refer to Table 1.
a. Ratio went down due to increased cost of sales. Refer to Exhibit 1. Cost of Sales percentage went up from 44% to 48%. It serves as an indication that the operational efficiency worsened.
b. In 1970, every dollar of asset earned 8 cents while in 1971, every dollar of asset only earned 5 cents. This is due to higher percentage change in Total Asset than the percentage change in Net Income. Also, as previously mentioned, there was a deterioration in profitability.
c. ROE deteriorated because in 1970, Net Income is 17% of the total Equity while in 1971, it decreased to 9%. The magnitude of change in the Equity increase is greater than the Net Income increase
d. There was a higher percentage change in Current Liabilities than in Current Assets
e. & f. These two ratios showed that the company is mostly financed through debt rather than through equity. 59% of the assets are financed through debt/ borrowings and debt is 1.5 times of equity. For a property company which is capital intensive, the latter is more preferred.
3. Discussion of Relevant Accounts
Receivables
There is no provision for doubtful accounts. Although substantially, all sales are guaranteed by the government, there are customers assigned to US Shelter. These might not be covered by the sovereign guarantee.
Preferred Stock Receivable is included. The amount of 19 million distorts performance indicators concerning current assets. This is not essentially part of the operating cycle of the business.
Assigned receivables to US Shelter understates actual receivables. These are taken out of the Balance Sheet of Stirling Homex.
There is an overstatement of Unbilled Receivables. This will be discussed in the revenue recognition part of the paper.
PPE
$2.2M of PPE are encumbered under the long term payable arrangements. This must be noted in evaluating Total Assets
For 1971, there has been an increase of $4M in PPE. This is just 15% of the total financing for expansion in this year.
Deferred Charges
Another account in the Balance Sheet that moved drastically is the Deferred Charges account. From $944,109, it grew to $2,558,792. A noticeable increase is in the Training and Professional development and in the Research and Development component. Numbers grew from $148,636.00 and $84,496.00 to $491,641.00 and $671,897.00, respectively.
In the Balance Sheet of Stirling Homex, they capitalized Research and Development, as well as the Training and Professional Development. As a general rule, research and development and trainings should be expensed rather than capitalized. The reason behind it is because future economic benefits are uncertain and accountants follow a conservative type of approach. However, if it is pure development cost with certain technological feasibility, it may be capitalized. The company capitalized the cost as an asset and then depreciated or amortized the asset over the expected life. It should have done otherwise, and expensed it outright. Therefore, the two accounts mentioned were erroneously classified overstating the assets and net income and understating the expense to be recognized during the time it was incurred.
US Shelter Corporation
In Notes 1 Principles of Consolidation of Stirling Homex’s 1971 financial statement, it mentioned the existence of the U.S. Shelter Corporation, Stirling Homex’s wholly owned financing subsidiary.
Subsidiary’s Cash - From the financial statement of this U.S. Shelter Corporation, cash amounts only to $5,171 against total asset of $5,056,658. This is just 0.10% of the company’s total asset, a very disturbing number for a financing company.
Unguaranteed Bank Credit - This lack of liquidity of US Shelter was defended in Note 1b of its balance sheet which states “The subsidiary has obtained and unsecured $15 million line of credit from a bank. These funds are being used in financing transactions involving customers of the Company. The company has not guaranteed this line of credit.” This means U.S. Shelter is debt-financed.
Unconsolidated Subsidiary – It is apt that this subsidiary should be consolidated because of its 100% ownership. The intercompany transactions will also be eliminated.
Notes Payable
Cash maintaining requirement of 15% to 20% - Taking a deeper look to Stirling Homex’s debt reputation, Note 11 mentioned 90-day unsecured notes payable to 11 banks. But the last sentence of Note 11 states that “The Company is required to maintain average annual compensating cash balance at each of these banks equal to approximately 15% to 20% of the outstanding indebtedness to such bank.” Taking the numbers in Stirling Homex’s financial statement, cash ($3,196,457) relative to the total notes payable reported ($37,700,000) is only 8.48%. By these numbers alone, it can be said that Stirling Homex is already having difficulty meeting the 15-20% cash maintaining requirements of these creditor banks, not even its financing subsidiary, the U.S. Shelter Corporation, which has cash only 0.14% relative to its total liabilities.
Notes Payable’s term vis-à-vis serving as a source of cash flow for operations and investment.
The term of this unsecured note is 90 days. Compared to Days Receivables of 350 days and 1.02 AR turnover, this note will definitely be difficult to settle.
Operating activities’ requirement is $17M and investing activities’ is $7.6M. Please refer to reconstructed cash flow Exhibit 2. It is obvious that Operating and Investing activities are fully financed with this sole note payable.
Commitments and Contingencies
Lawsuit – In case the company loses its plaintiff case, they would need to pay for compensatory damage of $1,575,000. This is very material and should have been included in the company’s financial statement. This must be reflected as contingent liabilities in the balance sheet.
Upcoming OUCL in Mississippi Plant – Construction of a manufacturing plant in Mississippi is expected to commence in 1971. This must be noted in evaluating Total Liabilities.
Revenue Recognition
According to International Accounting Standards (IAS) 18, Revenue is measured as an exchange for goods or services of a similar nature and value is not regarded as a transaction that generates revenue. Revenue recognition as described in GAAP principle are recognized when they are realised or realisable, and are earned (usually when goods are transferred or services rendered), no matter when cash is received.
The policy Stirling Homex is using to recognize their revenue is aggressive. The contract the company entered is long term in nature but they still recognized revenue even without finishing the projects. They recognized the revenue as soon as they had the contract signed. However, it should be done at the time service is rendered or goods are delivered. They have overstated revenues by around $20 million, which is around 80% of Total Revenues. This materiality is enough to cover up for should-be net losses.
Preferred Stock Offering
There was no cash inflow from the offering of Preferred Stocks. The supposed proceeds were indirectly reflected as a current receivable instead of cash to be used for financing the business. This transaction also bloated current assets and distorted performance indicators.
4. Qualitative Indicators
The violation of IFRS Revenue Recognition, the conflicting interests between HUD and the current members of the board who are ex-HUD officials, and the pending lawsuits, negatively affect the company’s credibility.
5. Criteria
The following table (Table 2) are the criteria, and their respective weights, set by the management in evaluating credit worthiness to ultimately decide whether to lend or not.
VI. Decision:
Again, with Stirling Homex’s intention to market its products to a broader market, the group implied its intention to expand and thus obtain financial assistance. Hence,
SHOULD WE LEND TO STIRLING HOMEX? The answer is NO.
VII. Justification:
Given the criteria set, Stirling Homex scored 57.5 against the passing of 70. Refer to Table 2.
Table 2. Criteria and Stirling Homex’s Scores
The following are the basis of the scores given by the management of Western Union based on the set criteria.
ü Capacity=50
§ Current ratio’s Cost of Sales component went up from 44% to 48%. It serves as an indication that the operational efficiency worsened. ROA and ROE indicated lower profitability and lower asset utilization.
ü Character=60
§ The violation of IFRS Revenue Recognition, the conflicting interests between HUD and the current members of the board who are ex-HUD officials, and the pending lawsuits, negatively affect the company’s credibility.
ü Capital=60
§ Leverage ratios showed that the company is mostly financed through debt instead of the more preferred way which is, equity.
ü Collateral=80
§ There are available assets for collateral. PPE has increased in 1971 from 1970.
ü Condition=30
§ Given the economic conditions, as a creditor in the year 1971, Western Union should presumably be cautious and have a relatively stricter criteria in deciding whether to lend to Stirling Homex.
VIII. Operationalizing Decision:
A formal letter of decline will be sent to the management of Stirling Homex deferring them from their requested financial assistance from Western Union.
Groupmates: Alfie Dulatre, Jay Igpuara, Zarah Lacsa, Shaine Lim, Epi Maducdoc