When a Rosy Picture Should Raise a Red Flag
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By GRETCHEN MORGENSON
ith stock prices near their highs and corporate earnings looking
great, investors might think they can take a vacation from the
grunt work of analyzing company financial statements.
Big mistake, says Robert A. Olstein, a 30-year veteran of financial
analysis and the manager of the Olstein Financial Alert mutual fund.
Olstein thinks that investors must be especially vigilant now against
accounting tricks that, while legal, mask a company's real financial
performance.
One reason to be watchful, he said, is that companies may be reaching to
meet analysts' expectations. "A lot of companies are using accounting
shenanigans to project smooth earnings paths that rarely exist," he said.
"Investors need to look behind the numbers."
The Securities and Exchange Commission agrees. One commissioner,
Norman S. Johnson, said in a speech earlier this year that "managed
earnings" are a top enforcement priority. "Barely a week goes by without
an announcement that another large company is restating its past results,"
Johnson said. (Last week it was McKesson HBOC's turn, for the
second time this year.)
Olstein's fund aims to buy companies with solid earnings and bets against
those whose financial performance looks more mythical than real. The
fund is up 30.9 percent this year and an average of 28.324 percent a
year since it opened in 1995.
During three decades on Wall Street, Olstein has identified a number of
red flags in financial statements. "What these alerts help to show is if there
are deviations between the statements as portrayed by the company and
economic reality," he said.
EARNINGS VS. CASH FLOW Olstein first examines what a company
generates in cash flow from its operations. A company with excess cash
flow can raise dividends and survive tough times without being forced to
borrow or sell assets.
To calculate a company's cash flow, start with net income. Add back
what it has taken in depreciation expenses and accounts payable. Then
subtract capital expenditures, inventories and accounts receivable.
Watch out, Olstein said, if net income is much higher than cash flow. The
company may be speeding or slowing its booking of income or costs,
perhaps to meet analysts' earnings forecasts.
Among the companies Olstein is concerned about is Shared Medical
Systems, which supplies information management systems to the health
care industry. In the first quarter of 1999, the company reported net
income of $18 million and cash flow of $10 million.
Why the disparity? Among other things, Olstein found that accounts
receivable were rising almost 50 percent faster than revenues, while
accrued expenses, a reserve set up by the company for future payments,
fell 30 percent in the quarter. The company's chief financial officer was
unavailable for comment last week.
BALANCE-SHEET DISPARITIES Sometimes there is a difference
between earnings reported to shareholders and those reported to the
Internal Revenue Service.
Companies carry two sets of books, one for shareholders and one for
the IRS. Footnotes to financial statements reconcile them by comparing
income taxes currently payable -- the IRS version -- with the taxes a
company has deferred, the results of which shareholders see.
A company reporting higher earnings to shareholders through the use of
deferred taxes should be scrutinized, Olstein says. He estimates that
about one in six companies fall into this category. A notable example was
in 1997, when the Sunbeam Corp. reported earnings of $189 million.
Current taxes on the income were $8.4 million but deferred income taxes
were $66 million.
"This was an alert that the company was reporting materially higher
earnings to shareholders than to the IRS," Olstein said.
Sunbeam later said it had overstated earnings by wide margins, and its
stock plunged.
UNSUSTAINABLE SALES The best revenues are those that continue
year in and year out. Temporary increases are less valuable and should
garner a lower price-to-earnings multiple for a company.
Olstein sees Tricon Global Restaurants, owner of KFC, Taco Bell and
Pizza Hut, as an example of a company booking temporary income. Last
year, it sold restaurant franchises worth $248 million, or 3 percent of
sales. "There's nothing wrong with it," Olstein said. But "it's not ongoing,
so it should carry a lower P/E."
RESERVES TO THE RESCUE? If a company puts aside too much into
reserves that it uses later, that could mask a slowdown in its business,
Olstein said. An example of a company that may use reserves to smooth
out its earnings is Microsoft, he added.
The company recently said that the SEC was investigating the way it
accounts for reserves; industry experts think the commission may be
looking for evidence of so-called cookie-jar accounting, in which
reserves are set aside in case they are needed later to bolster flagging
earnings.
After the announcement, Greg Maffei, Microsoft's chief financial officer,
said, "We are obviously a company that is known for conservatism, and I
would be surprised if someone was to examine our books and suggest
otherwise."
DEFERRED EXPENSES A company's costs should be matched against
the revenues they produce. Companies that defer large amounts of
current expenses to later periods ought to be monitored, Olstein says.
Deferred expenses show up as an asset on the balance sheet and are
amortized over time. The footnote in which management details its
assumptions on how long these assets will have value is an important
piece of the puzzle and should be checked for economic reality.
Olstein pointed to America Online as a company that in its early stages
used accounting methods that proved too optimistic. Its deferred
marketing costs in the mid-1990s were greater than its earnings, he said.
Subscribers, meanwhile, canceled their accounts more quickly than
America Online wrote them off. The company changed its policy in
October 1996 to recognize marketing expenses as they are incurred;
Olstein said he thought the accounting shift contributed to the sharp rise in
its stock.
ACQUIRED PROFITS Under purchase accounting, an acquisition is
included in the buyer's financial statements from the date of the purchase.
To make sure that a company's earnings gains are not solely a result of
acquisitions, investors can examine pro forma earnings -- the net income
of the combined companies if the acquisition had been made at the
beginning of the year.
For example, starting in 1993, HFS, now part of the Cendant Corp.,
reported earnings growth rates of more than 30 percent, owing largely to
acquisitions. The rate at which the company's earnings grew, not
including acquisitions, was an estimated 11 percent, Olstein noted,
according to figures found in the footnotes to the financial statements.
Reality caught up to the perception of Cendant's growth rate in April
1997, and its stock fell by half.
INVENTORY AND RECEIVABLES Slower inventory turnover or
rising accounts receivable can signal a sales slowdown.
To calculate inventory turnover, add together a company's inventory
position at the start and end of a period and divide it in half. Then divide
the company's revenues by the result.
Analysts measure receivables by assessing how many days of sales are
held in the receivables category. First, they figure a company's daily
sales, taking the year's revenue and dividing it by 365. Then they take the
accounts receivable and divide it by the daily sales number.
A company recently experiencing both slower inventory turnover and
rising receivables, Olstein said, is Xerox. He had owned the stock but
became concerned at the end of 1998, when ratios in both inventories
and receivables weakened. Jeffrey J. Simek, a Xerox spokesman, said
those were "just two factors, both inward looking."
"There are a host of other factors we would consider particularly
important," Simek continued.
WATCHING WRITE-OFFS Comparing the reported earnings of a
company with its retained earnings -- what it actually nets each year -- is
a revealing exercise for shareholders in companies that take
reorganization or other charges regularly. Such charges, Olstein said, can
distort earnings.
"If a company's retained earnings before paying dividends are not
growing as much as its reported earnings before write-offs," he said, the
charges may be masking underperformance.
CORE CUTBACKS Some corporate expenses, like those for research
and development at a technology company, are crucial to future growth
and should not be cut, though doing so may make for a better-looking
earnings report.
Olstein cited Eastman Kodak as one such company that has recently cut
important research costs. In the fourth quarter of 1998, it announced a
reduction in R&D costs that contributed 31 percent of its earnings.
Paul Allen, a Kodak spokesman, said the decline was part of the
company's broad effort to cut costs. "We still spend $1 billion on R&D,"
Allen said. "We have determined that combined R&D and sales, general
and administrative costs in the neighborhood of 26 percent of revenues is
a good financially prudent position for us to be in."
Olstein is not so sure.
"Technology companies," he said, "should not derive their growth rate
from cuts in research." |
