Interestingly, difficulties can spread not only geographically, but also along the Time axis, forward as well as backward, New Ec style:
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Spate of Write-Offs, Charges Calls Into Question Lofty 1990s Profits
interactive.wsj.com
By STEVE LIESMAN and JONATHAN WEIL
Staff Reporters of THE WALL STREET JOURNAL
Was the corporate-profits miracle of the late 1990s partially a mirage?
Along with tame inflation and low unemployment, outsize corporate-profit growth stood as one of the pillars of the booming economy and underpinned the stock market's historic bull run. From 1995 through 2000, the Standard and Poor's 500-stock index registered compounded annual growth of 23.3% as earnings grew at a 10% annual rate -- far above the 6.6% pace for the S&P from 1948 through 1994.
In recent months, though, many big companies -- including AT&T Corp., Cisco Systems Inc., Lucent Technologies Inc., Nortel Networks Inc., Walt Disney Co. and Wells Fargo Inc. -- have announced whopping write-offs and charges to earnings. They have slashed the value on their books of everything from investment portfolios and customer loans to inventory and the carrying value of acquisitions.
Since the economy began to slide in the fourth quarter, S&P companies have announced write-offs and other "special" charges of about $50 billion, according to data provided by Multex.com Inc., a financial-research company. That total for the six months ended March 31 is the highest dollar amount by far for any recorded six-month period and the second-highest as a percentage of pretax income since 1992. And the trend is expected to continue as companies release their second-quarter earnings in coming days and weeks.
Igniting a Debate
The sheer size of these write-offs has ignited a debate among economists and Wall Street analysts about whether there is a connection between today's big write-offs and yesterday's massive profits. The question is whether some of the outsize profits rested on shaky business and accounting practices that are now in effect being restated by big charges.
For example, when a company writes off a multimillion-dollar loan that it made to finance sales to a start-up customer, some investors view that as a one-time reduction of the most recent quarter's earnings that can be shrugged off. Others see such a charge as a tacit admission that profits in prior quarters -- when the sales and earnings generated by those loans were recorded -- weren't as large as the books show.
As Wayne Shaw, an accounting professor at Southern Methodist University in Dallas sees it, "What you ought to be thinking when you see a write-down today is that the profits in the past have probably been overstated."
'New Reality of the Time'
That's not to say that companies announcing large charges today were recording past profits in violation of generally accepted accounting principles, or GAAP. And not all of the recent charges reflect management missteps. Some of the biggest write-offs -- such as those related to layoffs and the restructuring of divisions -- appear to stem directly from the sharp economic decline that began in the fourth quarter of 2000, which many executives say couldn't be foreseen. Indeed, write-offs typically accelerate during economic downturns, especially in times of rapid technological advances. "A lot of these write-offs just reflect the new reality of the time," says Neil Soss, an economist at Credit Suisse First Boston.
Still, the idea that prior profits have been overstated helps economists explain what to them was one of the mysteries of the late 1990s. Generally, corporate profits have grown in line with the economy. For the past five years, however, S&P 500 profits have expanded about twice as fast as the economy's total economic output.
The Creation of Confusion
But those S&P profit figures, which are the ones Wall Street mainly cares about, don't include the recent spate of unusual charges. Exclude the write-offs, as many analysts do, and pretax earnings for the current group of S&P 500 companies during the five-year period ended March 31 grew at a compounded annual rate of 9%. Restore the unusual charges as normal expenses, and the rate falls to 7.6%. That's closer to the recent compounded annual growth rate of the economy as a whole over the period -- about 6%, including inflation.
The government's corporate-profits measure, a far broader gauge that accounts for these unusual items and includes both closely held and publicly owned companies, shows much more modest compounded annual earnings growth of just 4.4% over the past five years.
It's easy to see how the spate of charges can create confusion among investors trying to figure out which numbers to follow. If today's charges do, in effect, eliminate past profits, a simple calculation such as a price-to-earnings ratio can become a complex exercise because it's difficult to gauge how much companies really earned.
In response, officials at the Securities and Exchange Commission recently have criticized the growing practice by many companies of issuing news releases that highlight earnings excluding these unusual charges, called "pro forma" earnings, while playing down their GAAP earnings. The commission has opened investigations into a few companies, which it declines to name, over whether their pro forma results have been misleading.
David Kotok, an economist and chief investment officer at Cumberland Advisors Inc., discounts the pro forma results in company news releases along with S&P 500 profit totals. Given all the distortions in individual companies' data from write-offs, "I don't think the small picture is a winning game," he says. Instead, Mr. Kotok relies on the government's statistics for the best assessment of corporate profitability.
In some ways, the willingness of so many other analysts and investors to disregard today's charges is a sign of the times. Wall Street has placed revenue and earnings growth on a pedestal. What has emerged is a culture in which many investors reward companies for big write-offs, viewing the charges as bad news that executives have pushed out of the way to make room for high future growth rates.
Here's a field guide to five types of write-offs currently coloring earnings reports:
Vendor Financing: Profits Go 'Poof'
Extending credit to customers is a practice as old as commerce itself. But analysts say it became far more widespread during the 1990s technology boom. In some cases, companies abandoned prudent risk-management practices and financed purchases by customers with poor credit to meet Wall Street's short-term earnings and revenue demands. In cases where customers have defaulted on those loans and companies have written them off, the question arises: Did the charges negate yesterday's profits?
Gateway Inc. executives became so eager to move computers last year that they decided to provide credit to high-risk customers that Gateway's outside financing company had shunned. The result: Gateway found itself awash in bad loans. To write off the loans, the company in the first quarter took a $100 million "special charge" on top of a $75 million operating loss associated with the consumer loans.
Gateway spokeswoman Donna Kather, confirming the high-risk lending, says Gateway has changed its policy and will refer the high-risk loans "to our lending partners."
In the early 1990s, Qualcomm Corp. thought GlobalStar Telecommunications Ltd. was engaged in a risky but promising endeavor with its effort to erect a world-wide satellite-telephone network. Qualcomm took a stake in the venture, holding as much as 6.5% of the company's equity.
From fiscal years 1995 to 2000, GlobalStar in any given year accounted for 7% to 19% of Qualcomm's annual revenue. Qualcomm, however, received cash for only about half of its GlobalStar sales. Qualcomm financed the rest, according to its SEC filings, and booked the revenue from the loan-generated sales -- about $667 million from 1995 through 2000.
As sales throughout its businesses took off, Qualcomm's stock soared. The San Diego-based telecommunications company's shares rose more than 27-fold in 1999, the best performance by any stock that year. For the fiscal year that ended in September 2000, its profits nearly tripled to $670 million. That capped a remarkable five-year run, during which Qualcomm's net income grew by a compounded annual rate of 67%.
Or did it? GlobalStar failed to attract many customers, and in January it defaulted on its Qualcomm loans. That prompted Qualcomm to take a $595 million write-off for the loans for its fiscal first quarter ended Dec. 31, in effect saying that some or all of the sales made possible by those loans never generated any cash and that the profit associated with those sales existed on paper only.
Qualcomm still beat the analysts' consensus earnings estimate by a penny a share, reporting pro forma earnings of 28 cents a share for its fiscal first quarter ended Dec. 31. How? It excluded the GlobalStar loan losses, among other expenses, from its pro forma results, despite having included the profits generated by those loans in earlier quarters' pro forma results.
Qualcomm's treasurer, Dick Grannis, says the exclusion of the GlobalStar losses from the pro forma figures is sensible because "GlobalStar is not really relevant anymore to our ongoing business. The purpose of pro forma results is to show investors the ongoing recurring operating results of the company." Mr. Grannis adds that the company used generally accepted accounting principles in deciding to record the GlobalStar revenue, and disclosed the loans' risks to investors in its SEC filings.
It's impossible to know precisely how much money Qualcomm has made since the mid-1990s without a formal earnings restatement, which Qualcomm says is unnecessary under GAAP. But since the beginning of 1996, on a pro forma basis excluding unusual charges, Qualcomm reported pretax income of $2.02 billion, according to Multex. Including all unusual charges, its pretax income was $1.44 billion over the same period, making it nearly 30% less profitable.
Lynn Turner, the SEC's chief accountant, says the recent spate of write-offs of vendor-financed receivables raises troubling questions, though he declines to comment on specific companies. "I get very concerned when the accounting rules turn out an answer that just doesn't reflect the economics," Mr. Turner says.
Portfolio Losses: Isn't That Special?
Many companies during the bull market threw gobs of money at start-up firms. When times were good, they booked the resulting paper investment gains as part of their ordinary income. But when those investments headed south, they suddenly found themselves saddled with huge "special" losses.
Wells Fargo, the San Francisco-based financial-services giant, announced on June 6 that it will take $1.05 billion in "special charges" this quarter to account for declines in the value of its portfolio of venture-capital investments. On a pretax basis, Wells Fargo says the charges will total about $1.7 billion.
To put that in perspective, according to estimates by Prudential Securities analyst Michael Mayo, Wells Fargo's pretax earnings for 1999 and 2000 got a combined $1.12 billion boost as a result of increases in the value of its venture-capital portfolio. That accounted for about 9% of the company's pretax income during those two years. However, when the value of those investment holdings was on the rise during 1999 and 2000, the company didn't characterize as "special gains" the resulting noncash, unrealized gains that flowed through its income statement.
"If you take back some of the venture-capital gains from the past two years, then the firm didn't really make their numbers," Mr. Mayo says.
While Wells Fargo doesn't disclose how much of its past earnings were boosted by unrealized venture-capital gains, the company's chief financial officer, Ross Kari, says Mr. Mayo's estimates are "in the ballpark." He notes that Wells Fargo over the past two years had cautioned investors that there could be wide fluctuations in the value of its venture-capital portfolio. As for the company's use of the word "special" to depict the charges, Mr. Kari says: "We tried to use language to indicate that these were certainly not of a recurring nature."
Inventory: One Man's Trash . . .
The debate over whether past profits have been overstated isn't limited to lending practices or investment losses. Some questions also focus on whether earnings were higher because past expenses were understated. One example has been the latest rash of inventory charges in the telecom-equipment industry, where demand has fallen precipitously during the past year, and the glut of equipment has become huge.
Technology bellwether Cisco this spring took a $2.25 billion pretax inventory charge, which the company told investors to exclude from its pro forma earnings. Critics wondered why all of Cisco's write-downs ended up in a single quarter, when the problem appeared to have surfaced as far back as mid-2000.
The company, based in San Jose, Calif., responded that it built up inventories last year to resolve a parts shortage that was hobbling sales, agreeing to buy parts as much as six months in advance. Those parts arrived just as sales unexpectedly slowed, the company said. In addition to what it had in its storehouses, Cisco remained under contract to buy other supplies that had yet to arrive.
Robert Bayless, chief accountant for the SEC's division of corporation finance, says he doesn't understand why investors would accept companies' explanations that inventory charges should be excluded from their pro forma earnings calculations, though he declines to discuss specific companies. "If the way that I was able to generate good sales was by making sure my customer didn't have to wait and also had the full choice of items, then these write-downs are the cost of that policy," he says.
Inventory charges highlight another complication for investors from write-offs: They have the potential to gussy up future earnings. By writing down the value of parts now, companies can sell them at zero or little cost later. Cisco itself acknowledges this dilemma, promising to break out revenue from the written-down inventory in future quarters.
"If I have to take a write-off, I'm going to take a big bath, load the decks, and get rid of everything so that, by definition, future earnings will be higher," SMU's Mr. Shaw says.
Where There Is Goodwill Gone Bad
Questions about charges related to goodwill assets figure prominently in the debate about whether past profits were overstated. Goodwill represents the premium a company pays to acquire another business. According to current GAAP, companies have been able to write down their goodwill assets over periods as long as 40 years. But when the value of that goodwill becomes impaired, companies must write off the impaired amount all at once.
That's what Safeco Corp. did earlier this year. The Seattle financial-services company took a $1.2 billion pretax, goodwill-impairment charge during the first quarter, calling it a "one-time write-off" in its earnings release. Safeco originally planned to take 30 years to write down the goodwill, which resulted from the company's $3.1 billion all-cash acquisition of property-casualty insurer American States Financial Corp. in October 1997. As it turned out, Safeco's amortization period proved to be more than 26 years too long.
To be sure, picking the correct number of years to write down an asset is largely a guessing game because companies can never be sure if an acquisition will be successful. Unexpected events, such as the stock market's recent decline, can drastically reduce the market value of an acquired asset, forcing a write-down. Paul Lowber, vice president and controller for Safeco, says the company simply followed signals put out by the stock market when it wrote off the American States goodwill. Prior to the charge, the market had been valuing Safeco stock at less than its book value, or assets minus liabilities.
Still, accounting specialists say that goodwill charges amount to acknowledgments by companies that they either overpaid for acquisitions or weren't writing them down quickly enough. "Had the goodwill originally been assigned a proper useful life, the annual charges would have been greater and net income would have been correspondingly lower," says Robert Willens, an accounting analyst at Lehman Brothers.
If Safeco had started out using a four-year amortization period, it would have recognized $300 million a year in amortization expenses, instead of $40 million a year. In fact, the $1.2 billion write-off exceeded the $1.06 billion in pretax earnings that Safeco had reported since the acquisition.
Mr. Lowber doesn't dispute that Safeco overpaid for American States, calling the goodwill charge "a bit of a reality check." But he doesn't believe Safeco made a bad acquisition and disagrees with the notion that prior profits were inflated. "I think that what most shareholders are going to be looking at is ... our ongoing earnings capacity," Mr. Lowber says. The charge is "an unusual thing and doesn't happen regularly."
Funny Money: Stock Instead of Cash
There's a flip side to the profits miracle. Many start-up companies during the tech bubble reported famously large losses. Could it be that today's charges suggest those losses actually may have been understated?
Last year, for instance, Amazon.com Inc. recorded $79 million in revenue from dot-com customers that used their own high-priced stock, rather than cash, to pay the Seattle online retailer for various services. Those customers included such dot-com disasters as Internet furniture site Living.com Inc., which shut its doors and filed for Chapter 7 bankruptcy protection in August 2000, six months after Amazon announced the pact.
After the dot-com bubble burst, Amazon last year took charges to write off most of the value of the stock that it was paid, including $14 million for its Living.com holdings. In news releases, Amazon described the losses as noncash items that should be excluded from the company's results. Some investment professionals have accused Amazon of being hypocritical because the company's pro forma results exclude a bevy of noncash expenses but not noncash revenues. For 2000, Amazon reported a net loss of $1.41 billion on revenue of $2.76 billion. But Amazon's "pro forma operating losses" -- the measure by which the company tells investors and analysts it should be judged -- totaled $317 million last year.
"There were good business reasons for those deals at the time," Amazon spokesman Bill Curry says of the stock-based deals. "Did some of them prove to be mistakes? Obviously."
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