What the Earnings Reports Don't Tell You
Here's how to find the real story behind the numbers
Business Week: October 16, 2000
BusinessWeek Investor: Stocks
The curtain is rising on the third-quarter-earnings drama, and the setting is ominous: slower economic growth, higher oil prices, and a weak and stumbling euro. U.S. corporations will be hard-pressed to deliver crowd-pleasing profits in this scenario, and so now more than ever companies are likely to resort to various accounting games--all perfectly legal--to puff up their profits and win over the audience.
Over the past few years, investment managers and accounting professionals have complained increasingly about the ploys that companies sometimes use to boost their profits: making selective disclosures in earnings releases, paying expenses with stock options, or bolstering the bottom line by taking investment profits when operating profits fall short. ``We'll see companies playing the same games as before, only more so,'' predicts Fred Hickey, editor of The High-Tech Strategist, a newsletter in Nashua, N.H.
Your best defense as an investor? Be extremely skeptical of the earnings announcements that companies make during the next few weeks. ``News that a company beat its earnings estimates can't be taken as fact,'' warns Hickey. ``What really matters,'' adds Charles David Scavone, a senior portfolio manager for AIM mutual funds, ``is the quality of earnings, not the quantity.''
Don't think that third-tier outfits are the only companies resorting to aggressive accounting strategies. Hewlett-Packard (HWP), for instance, handily beat consensus estimates when it reported its fiscal third-quarter earnings in an Aug. 16 press release, and CEO Carly Fiorini termed the results ``superb.'' The company's stock price immediately jumped 10%. But the next day, HP shares gave back those gains amid concerns that the company had boosted profits with one-time gains and favorable currency and tax rates.
Fortunately, knowledge is power. The more you know about profit gimmicks, the better you'll be able to diagnose a company's financial health. Another plus: Comparing different companies will be easier when you know which ones are spin doctors and which play it straight. Here are some things to look out for.
-- What you see is not what you get. Companies sometimes tweak their earnings press releases to make profits look better than they are. For instance, companies increasingly highlight an earnings number that doesn't reflect all of their expenses. The real numbers--the ones calculated using generally accepted accounting principles (GAAP) that have to be reported to the Security & Exchange Commission--are usually listed at the end of the release and with little explanation or guidance. Companies defend the practice on the grounds that they're just pointing out what they feel is important in their results.
To spot these faux earnings, look for what are called pro forma results. Traditionally, companies use pro forma numbers only for an extraordinary event, like a merger or corporate restructuring, to show what earnings might have been had the event not occurred. But increasingly, technology companies are using pro forma earnings numbers that exclude certain items even when they aren't undergoing a transformation. ``Pro forma numbers have their place, but some companies are taking advantage to make their earnings look better,'' says Charles Hill, director of research at First Call, which compiles and analyzes earnings and forecasts.
Hill says the practice began about two years ago when Yahoo! Inc. and other dot-coms began to exclude an expense called ``goodwill'' in pro forma earnings, and dubbed the reformulated number ``cash earnings per share.'' Goodwill is an accounting term for the premium that an acquiror pays for another company that exceeds the fair market value of the acquired company's assets. Accounting rules require that goodwill be expensed, or amortized, over the lifetime of the acquired assets, up to 40 years. But because technology becomes obsolete so quickly, tech assets are usually amortized over a period of three to five years, which can result in hefty goodwill charges. Hill points out, for instance, that in Lycos' (LCOS) July quarter, it reported pro forma per-share earnings of 12 cents, which excluded goodwill. If you add back the goodwill, the company had a loss of 36 cents.
Hill says he counted more than 100 companies that excluded goodwill in the second-quarter earnings press releases. Indeed, the practice has become so widespread that the Financial Accounting Standards Board has proposed a rule that would require companies to report two earnings figures--one that includes the amortization of goodwill and one that doesn't.
That won't solve all the problems with pro forma earnings. Hill says about 100 additional companies ignore costs other than goodwill from their pro forma earnings. Most commonly, companies exclude the payroll taxes they owe when employees exercise stock options. For instance, in its second-quarter release, Qualcomm (QCOM) did not count as an expense the $12 million in payroll taxes it paid on exercised stock options. Another cost that companies ignore in pro formas are marketing expenses that are paid for with stock options or warrants.
To learn what the pro formas don't reveal, go directly to the GAAP numbers at the end of the earnings press release. You'll also want to check the Form 10-Qs that companies must file at the SEC within 45 days after the quarter's end. They're available--along with annual reports, proxies, and registration statements--at the EDGAR section of the SEC's Web site (www.sec.gov), or at Freedgar.com, whose more user-friendly software makes it easier to access the SEC database.
-- Earnings don't matter. Another way that companies obscure actual earnings is to shift investor attention to EBITDA, or earnings before interest, taxes, depreciation, and amortization. For instance, in Exodus Communications' (EXDS) first-quarter earnings release, issued in April, CEO Ellen M. Hancock termed the results ``a milestone'' because the company had for the first time ``achieved EBITDA profitability.'' However, Exodus, which manages Web sites for businesses, lost 32 cents a share that quarter.
EBITDA can be a legitimate measure of financial health for a company with long-lived assets, one that doesn't need to make much capital investment to keep the business going. The problem with many companies using EBITDA, says Pamela Stumpp, a senior vice-president at Moody's Investors Service, is that they generally must spend amounts equal to their depreciation to keep their equipment up-to-date.
-- The options game. Stock options have become a regular part of employees' compensation at many technology companies. But guess what. Current accounting rules don't require companies to list stock-options grants as an expense in calculating earnings.
To determine the impact of options on a company's bottom line, you must look in the annual report for a footnote titled ``diluted earnings per share.'' Although this footnote is rarely included in quarterly reports (Microsoft does so), thumbing through the footnotes in the last annual report will at least give you an idea of the impact of this maneuver in the previous year. Unfortunately, there is no way for investors to figure out the quarterly impact of such grants, says Pat McConnell, the chief accounting analyst at Bear Stearns. She argues that accounting rules should require companies to provide quarterly updates on stock options.
The hit to earnings can be substantial. Last year, Yahoo reported earnings of 10 cents a share. If the company had been forced to adjust its earnings for stock-options grants, Yahoo's (YHOO) profit would have turned into a 50 cents-a-share loss, McConnell notes. Similarly, Autodesk's 16 cents-a-share profit in 1999 would have instead been a 74 cents loss, she says. In a study of how stock-options grants affect the companies in the index whose 1999 earnings would have fallen by 50% or more if stock-options grants were factored in. Technology and telecommunications companies were most likely to be impacted by stock-options grants, but they weren't the only ones. Gas- and oil-drillers, and some financial services anc healthcare companies also took big hits to earnings when stock-options grants were added to the equation, McConnell found.
Among the industry groups in the S&P 500 that were most affected, McConnell found that 1999 earnings at computer networking companies would have been 24% lower and 19% lower at telecommunications equipment makers. Because options are becoming such a popular way to pay employees, McConnell believes the impact of stock options grants on corporate America's bottom line will be even greater in the future.
-- Boosting earnings with investment gains. Many big technology companies such as Intel (INTC) and Microsoft (MSFT) make venture-capital investments as part of their research-and-development efforts. If these venture-stage investments go public, the big companies can reap a bonanza: They suddenly have stock that can be sold at a profit when needed. ``These investment gains are like a cookie jar,'' says David W. Tice, who runs the Prudent Bear Fund. ``Companies can reach into it to make sure they make their earnings.''
Indeed, these gains often give a big boost to a company's bottom line. For instance, when Microsoft reported its fiscal fourth-quarter earnings in July, it earned 44 cents a share and, as usual, beat Wall Street's expectations. But its reported earnings included a one-time investment gain of $1.1 billion, or 20 cents per share. Intel is another tech giant that has relied on big investment gains. For instance, the chipmaker earned 50 cents a share in its June quarter, but 21 cents of that came from $1.5 billion in investment portfolio profits.
Big tech, telecom, and financial-services companies are most likely to have sizable investment portfolio gains. To find out what a company earned from investments, look at the ``other income'' figure on the profit-and-loss statement.
As the earnings season plays out, remember that the numbers the companies trumpet may not be the ones you really need to know. The critical numbers are there--you just have to dig them out.
By SUSAN SCHERREIK
Copyright 2000 by The McGraw-Hill Companies, Inc. All rights reserved. Any use is subject to (1) terms and conditions of this service and (2) rules stated under ``Read This First'' in the ``About Business Week'' area.
10/5/00 6:53 PM |
