Case Harnischfeger Q+A 20240325

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1 Answers CASE = HARNISCHFEGER Version: 3/25/24 Q0. Concisely: • Who is the key FSAV-based decision maker (DM) in the case, and what is his job? (1 pt) Peter Roberts , the research director at Exeter Group, a small Boston-based investment advisory service. Roberts analyzes potential or actual turnaround stocks (FSA), then advises his clients accordingly, based on his view of how much the current stock price incorporates his expert assessment (V) . • What business decision faces the DM that FSAV will help improve the quality of? (1 pt) Roberts has to decide [1] Has Harnischfeger really turned around, or not? (= FSA), and [2] Should he advise his clients to Buy (or maybe Hold, Sell or Do Nothing) with respect to Harnischfeger? (= V) Q1. Concisely: • How did Harnischfeger get into its dismal 1981-84 situation? (1 pt) In 1981-84, Harnischfeger was a 100-year-old, old-line, low-tech, fixed-asset intensive and family- based Midwest firm that made heavy equipment such as construction cranes. Harnischfeger got into its dismal 1981-84 situation because when its revenues plunged during the global recession of 1980-81 (due to customers cutting their CAPEX spending), its cost structure was heavily fixed . Its COGS went down about proportionately, and SGA likely went down less than proportionately. But two key expenses stayed flat and did not go down — Interest Expense and Depreciation . Combined with losses from Harnischfeger’s Credit sub (because the buyers of Harnischfeger’s cranes who had borrowed the money to buy the cranes from Harnischfeger via its credit sub had cash flow problems), the results were massive losses that peaked in 1982 , plus related violations of debt covenants and severe cash flow problems . • Which two key people did CEO Henry Harnischfeger hire to lead the turnaround? (1 pt) 1. Bill Goessel as COO in 1982. 2. Jeff Grade as CFO in 1983. • Out of the following areas of corporate responsibility = Operations, Investing, Financing, and Accounting, which one(s) were each of the two leaders in charge of, and why? (1 pt) Along with Board Chairman and CEO Henry Harnischfeger, Goessel had responsibility for Operations and Investing activities . Goessel has lots of leadership experience in the real side of manufacturing machinery (viz., Operations and Investing), especially by having navigated previous recessions. Grade had responsibility for Financing and Accounting , per the usual job description for CFO. • Ex-ante, were they suitable candidates? If so, why? If not, why not? (1 pt) Goessel = Yes, suitable . Well respected by prominent people in the industry. 54 years old when hired + looked the part with his grey/silver hair. Rightly seen as a wise, experienced and capable leader.

2 Grade = Probably suitable . 39 years old when hired but the case doesn’t say too much more about him . It turns out from outside the case that Goessel hired Grade because he was a talented, if brash and aggressive, financial “ whiz ” with a reputation for bringing in the financing cash + making financial numbers look strong. I’d also bet he was a “smooth talking & persuasive operator” in his demeanor . Q2. How do the Net Income (Loss) and Funds Provided By Operations lines in the Consolidated Statement of Changes in Financial Position on p.14 give the DM a high- level indication that Harnischfeger’s profit of $1.28 per share in 1984 might not be as economically genuine as it seemed? (2 pts) In my “ Motivation + Overview of FSAV ” lecture, I showed a slide of the operating section of Apple’s cash flow statement. I calculated Apple’s net operating accruals = net income – cash from operations; viz, NetOPACC = NI – CFOPS. In my “Analyze Managed Financial Statements” lecture, I also highlighted in red per #4 below that: I did so because comparing NI and CFOPS can give you a top-of-the-ocean sense of whether there are any unusual $ amounts or trends in NI relative to CFOPS due to NetOPACC being managed. One can do this for Harnischfeger by going to p.14 and extracting NI, CFOPS per year x 3 years from Harnischfeger’s Statement of Changes in Financial Position. Then put these $ numbers on a per share basis using the number of shares given in each year, calculated from EPS vs. NI on the Consolidated Statements of Operations [see next page]. Then plot the results per Figure 1 below. Figure 1 shows a huge divergence in 1984 from the “normal” relation between EPS and CF OPSps in 1982 and 1983 . Since NetOPACCps = EPS – CFOPSps, and earnings management will likely show up in NetOPACCps, it is plausible to hypothesize that Harnischfeger managed upwards its EPS in 198 4 … so maybe Harnischfeger’s “ turnaround in 1984 ” is not as genuine as it appears .

3 FIGURE 1 Calculations for CFOPSps and NetOPACCps using EPS and each year’s # shares calculated from EPS vs. NI on Harnischfeger’s P&L on p.12 are: 1982: CFOPSps = $16,270  ( – $76,531  – $7.64) = $1.62 NetOPACCps = – $7.64 – $1.62 = – $9.62 1983: CFOPSps = $37,287  ( – $34,630  – $3.49) = $3.76 NetOPACCps = – $3.49 – $3.76 = – $7.25 1984: CFOPSps = $10,000  ($15,176  $1.28) = $0.82 NetOPACCps = $1.28 – $0.82 = $0.46 Q3. If the DM suspected that Harnischfeger’s $1.28 1984 EPS was “managed upwards”, tell me a simple top-of-the-ocean quantitative question about the $1.28 per share that might have motivated the DM in his FSAV, given what he (and you) does next in the krill in Question 4. (1 pt) SIMPLE ANSWER = By how much in total was 1984 EPS of $1.28 managed upwards? What’s the order of magnitude here -- Are we talking earnings management EM of $0.01, $0.10, $1.00 or $10 per share? MORE COMPLEX ANSWER = The size of EM matters because it affects the extent to which Roberts’ FSA skills enable him to earn “alpha” = a positive risk- adjusted return on Harnischfeger’s stock for his clients . If EM = $0.01 then Harnischfeger’s stock can’t be materially mispriced with respect to EM , even if the marginal investor in Harnischfeger’s stock is unsophisticated and thus EPS CFOPSps 82 83 84 $1.62 -$7.64 $3.76 -$3.49 $1.28 $0.84 KEY QUESTION: Is the $1.28 real or fake? Note: If you didn’t scale the raw $ numbers on p.14 into $ per share, you will still arrive at the same general picture.

4 cannot invert out the EM from 1984 EPS, because EM is so small. Likewise, if EM = $10 then while Harnischfeger’s stock could be greatly mispriced because EM is so large, the fact that EM is so large means that the likelihood that the marginal investor setting Harnischfeger’s stock price realizes that 1984 EPS has been managed upwards by $10 is very high because $10 is too large to have plausibly been caused by a genuine turnaround, even from the perspective of an unsophisticated investor. However, if EM i s “in the middle, size - wise”, then the probability that the marginal investor sees through the EM may also be “in the middle, size - wise”, with the result that the expected amount of mispricing with respect to EM may be “in the middle, size - wise’ . This can be modeled as follows. Let: • p_unsoph = probability that the marginal investor in Harnischfeger is FSAV unsophisticated. • EM = amount of EM per share done by Harnischfeger. • Exp_MISPRICE = expected amount of mispricing in Harnischfeger’s stock due to EM. Then if p_unsoph is decreasing in EM, it is likely that Exp_MISPRICE = EM x p_unsoph will have a maximum value w hen EM and p_unsoph are both “in the middle, size - wise”. For example, if EM ranges between $0 to $100, and p_unsoph = 1 – EM/$100, then Figure 2 shows that Exp_MISPRICE ranges between $0 and $25 and maximizes when p_unsoph = 0.5, EM = $50. FIGURE 2 $- $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 $- $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 Expected_MISPRICE = = EM x p_unsoph = expected $ps mispricing in Harnischfeger’s stock from EM p_unsoph = 1 – EM/$10 = probability that marginal investor in Harnischfeger is FSAV unsophisticated EM = unconditional amount of EM per share done by Harnischfeger p_unsoph Exp_MISPRICE

5 Q4. With a view to Harnischfeger’s EPS of $1.28 in 1984, i dentify up to FIVE “line items or areas ” where Harnischfeger may have managed its financial reporting numbers (such as, but not limited to, net income) in 1984. I recommend that you use the Grid that I’ve provided you in the Excel template on Canvas to structure your work. Write all $ figures in $ millions, so $6,550,000 = $6.6. (10 pts). Note that the template I provide mainly asks you to: • Estimate the effect of each line item or area on Harnisc hfeger’s 1984 net income, components of net income, and cash flows. • Arrive at a view as to whether each effect is likely “one - time” and isolated to 1984, or may plausibly persist beyond 1984. Why does this matter to the DM? I ask you for up to FIVE, but there are arguably EIGHT line items or areas where Harnischfeger may have managed its earnings in 1984 — viz. , “purposefully intervened in its financial reporting process.” Keep in mind, though, that per my in-class general definition of managed financial statements, not all the items may relate to net income per se, and some are debatable. We’ll take the latter into account later by assigning a guesstimated probability for each line item that the impact of the line item is driven by an intent to manage NI and EPS, since that will then enable us to estimate a probability-weighted = expected $ value of how much NI & EPS have been managed. 1a. In 1984, Harnischfeger retroactively changed its depreciation method from accelerated to straight-line for all depreciable assets . The cumulative effect of this change, not including the reduction in the current year's depreciation expense, was a one-time increase in net income in 1984 of +$11.005 million . Until 2005, GAAP said that this kind of retroactive change had to be reported entirely in the net income of the change year — the firm could not restate prior years. However, firms had to provide pro forma indications on their P&L about what EPS would have been in the two years prior 1 (Note 2, p.17). The retroactive change had no effect on Harnischfeger’s cash flows because it was only a change in book depreciation, not in IRS- tax-calculation depreciation. Recall from Intro Financial Accounting that firms have two sets of books: One for reporting under US GAAP, and one for calculating taxes paid to the IRS, and the firm can choose different depreciation for book vs. tax purposes. 1b. Harnischfeger did not report any significant reduction in the depreciation expense in 1984 due to this change. That is, the vast bulk of the effect of the change was from “fixing prior years” , not fixing 1984 per se (Note 2, p.17). 2. Harnischfeger changed its estimated depreciation lives of certain U.S. plants, machinery, and equipment, and the estimated residual values of certain machinery and equipment effective the beginning of fiscal 1984. This increased Harnischfeger’s pretax reported profit in 1984 by +$3.2 million (Note 2, p.17). This change has to be accounted for prospectively only — that is, Harnischfeger was not allowed to collect up the lower depreciation charges that would have arisen had it always had the longer lives and higher estimated residual values that it was now 1 This accounting changed in May 2005 when FASB introduced SFAS 154. This rule required that changes in depreciation method like Harnischfeger’s in 1984 must be accounted for “retrospectively” such that the cumulative effect is taken as an adjustment in the beginning of year retained earnings balance (viz., not as an adjustment of the end of year retained earnings balance via adjusted net income during the change year).

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