Four Ways Investors Are Tricked
The beginning of the year is a good time to get reacquainted with the chicanery that goes on with financial statements. Pro forma numbers, investment gains, and my personal favorite, onetime charges, are as prevalent as ever -- especially among the biggest names in tech.
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By Todd N. Lebor (TMF TeeTime)
February 1, 2001
Last week in this column, TMF Tonto took a second look at Ariba's (Nasdaq: ARBA) revenue recognition change. Even though it was sparked by a change in Ariba's fee structure, not as an attempt to mislead investors, it reminded me of the ways financial statements can pull the wool over an unsuspecting investor's eyes, and of the lessons that can be learned from evaluating various companies' accounting practices. Below, I've laid out four such lessons.
Ariba's change is perhaps the most dangerous because many investors would never look deep enough to discover the change and management did not explain it well. In reading the press release, a trusting individual investor would never be the wiser because the change does not constitute a "change in accounting policy" as determined by Generally Accepted Accounting Principals (GAAP). Therefore, the income statement does not provide a line item detailing this new way of billing customers.
Lesson: Reading the quarterly earning releases is not enough. (In Ariba's case, listening in on the conference call was instrumental to discovering this new policy.) If you still don't understand what's happened or feel uneasy, avoid the company.
Pro forma numbers
Pro forma numbers are a necessary evil. (Pro forma refers to financial statements that are adjusted to reflect a projected or recently completed transaction.) They are usually not an attempt to mislead investors but just the same, they can be used to show a company in its best light.
Take the recent Qualcomm (Nasdaq: QCOM) earnings release. Net income has more figures excluded from it than included. A footnote regarding the fiscal first-quarter numbers reads, "Pro forma results exclude asset impairment and other charges related to the Globalstar (Nasdaq: GSTRF) business, amortization of goodwill and other acquisition-related intangible assets, employer payroll taxes on employee non-qualified stock option exercises, charges related to an arbitration decision against the company, unrealized changes in market values of derivative instruments, unrealized other than temporary impairment of marketable securities, and the cumulative effect of an accounting change." But here's the kicker: After all that excluding, Qualcomm left in investment gains.
How is that all those "one-time" charges should be excluded from pro forma net income when onetime investment gains are included?
Now, don't get me wrong. I understand the need to separate out some of the onetime charges and losses. Pro forma numbers do serve a purpose. In defense of Qualcomm, if an investor were to merely look at the GAAP financials, they would see a decline of $436.1 million ($1,120.1 minus $684.0) in revenues from Q1 2000 to Q1 2001. But by reporting pro forma numbers, Qualcomm is providing an apples-to-apples comparison that reveals an $80 million revenue decline instead. Pro forma numbers are also handy when a company has sold or acquired businesses recently, as is the case with Qualcomm. It sold several major business units over the last few years, rendering the GAAP financials useless in evaluating the growth of its remaining businesses.
But let's be consistent. All onetime effects should be excluded, not just the ones management deems necessary. This is the inherent danger in pro forma numbers. They are not GAAP and are therefore subjective. Investors really need to be on their toes to avoid being sucked into pro forma fantasy-land.
Lesson: Read the footnotes and question any pro forma numbers. Be sure to understand exactly what is and isn't included in the pro forma numbers.
Onetime charges
Spring cleaning may be a better term to describe onetime charges, also referred to as "taking a bath." Companies have been using onetime charges to bury unfavorable expenses for years. Two of the biggest numbers I've ever seen came from Motorola (NYSE: MOT) and Lucent (NYSE: LU). In 1998, Motorola took a $1.95 billion charge and announced 15,000 layoffs that eventually turned into a more than $2 billion hit and 24,000 displaced workers. Just last week, Lucent stated it was taking a $1.2 billion to $1.6 billion charge "to reduce the number of jobs in the business, eliminate some product lines as a result of our portfolio review, and make the associated asset write-downs and facility consolidations." To top it all off, 10,000 heads will roll as a result.
Once again, I must caution that write-downs and charges are necessary and even good sometimes. We wouldn't want companies to hide their troubles and risk financial collapse when the you-know-what hits the fan. Chronic chargers are really the concern here. Companies that use charges regularly to clear out the skeletons and hide management's missteps should be avoided. Often, expenses that would otherwise flow through the income statement lowering unadjusted net income are buried in these onetime charges.
Lesson: Charges can be a red flag for mismanaged companies. Spend some time looking for a pattern of chronic onetime charges.
Investment gains
This is probably the most written about and at the same time, most brushed-off earnings distorter around. In fact, it has become so commonplace with blue-chip tech companies like Microsoft (Nasdaq: MSFT), Intel (Nasdaq: INTC), and Cisco (Nasdaq: CSCO) that we have become numb to billion-dollar quarterly investment income. The danger is that these cash-rich companies lull us into complacency with their investment income and we lose focus on the underlying businesses. Even worse is the danger that management will lose sight of its fundamental job and become fixated on investment income to meet earnings goals.
Below is a chart showing investment and interest income and gains for the three behemoths mentioned above. Of note is Microsoft's cash and investment arsenal ($45.2 billion), which would rank it as the sixth-largest mutual fund if it were an investment company! Also noteworthy is that Intel's calendar 2000 investment income of $4.7 billion was larger than all of AMD's (NYSE: AMD) 2000 revenues of $4.6 billion! The figures below are in millions of dollars.
1999
Q1 Q2 Q3 Q4 YR
CSCO $91 93 102 151 437
INTC 347 290 316 508 1,461
MSFT 720 485 531 760 2,496
2000
Q1 Q2 Q3 Q4 YR
CSCO $314 541 420 NA 1,275
INTC 640 2,341 966 799 4,746
MSFT 885 1,127 1,075 723 3,810
Source: Company Financials
Investment gains may have become recurring revenue streams at these companies, but they are not predictable. If they were, I'd be entrusting my money to Bill Gates as an investment manager rather than as a software architect. Besides the enormity of these numbers, note the increasing trend over the past two years.
Lesson: Don't just look at the bottom line (i.e., net income) for financial health. Dig a little deeper and review the segmented revenue and growth rates.
Here's a bonus for those of you who actually got this far. Watch out for income from overfunded pension funds. Companies with pension liabilities that are less than pension assets can use this overfunded amount to make up for revenue shortfalls. The more sinister CFOs may try to sneak positive income under your nose while claiming that legally required contributions are not part of ongoing operations.
It's you against the bean counters. Arm yourself.
Fool on.
Todd N. Lebor is a co-manager for the Rule Maker Portfolio and lives in Alexandria, Virginia. At the time of publication, the writer owned shares of CSCO, INTC, LU, and MSFT. Todd's other holdings can be found in his personal profile. The Motley Fool is investors writing for investors. |
