great article on "earnings"...must read.
MARKET WATCH
January 21, 2001
If Earnings Depend on Investing, Watch Out
By GRETCHEN MORGENSON
Until 10 days ago, Yahoo had been in a class almost by itself
a high-profile Internet concern that had figured out how to turn
a profit for its shareholders. But on Jan. 10, after the market
had closed, it reported that even though revenue rose 53 percent,
to $311 million, in the fourth quarter of 2000 it would incur a
net loss of almost $100 million for the period. By contrast,
Yahoo earned $38 million in the fourth quarter of 1999.
With the new economy slumping even more than the old one, Yahoo
is facing, as it acknowledged, a tough year. But troubles in its
core operations were not at the root of its fourth-quarter loss.
The chief culprit was a $163 million write-down on the value of
investments it had made in other companies.
As Yahoo goes, so go Apple Computer and Gateway, as well as
older-economy companies like J. P. Morgan Chase and Nordstrom.
And the list goes on. Halfway into the earnings announcement season,
it is clear that the rapid slowdown in the economy is wreaking
havoc on companies' results.
But something else is putting pressure on corporate earnings today
and to a degree never before seen that has little to do with the
economy and even less to do with corporate operations. Yes, the
economy is slowing, but that alone is not responsible for the
double-digit declines in net income that so many companies are
reporting. Also at work is the declining stock market that across
industries is having a decidedly dampening effect on companies' earnings.
That the fortunes of the stock market can have an impact on corporate
earnings is a relatively new phenomenon and a direct result of the
decade-long bull market in stocks.
As Yahoo shows. Like many other technology companies, it spent
hundreds of millions of dollars in recent years investing in smaller
concerns that it hoped would expand its reach, round out its business
and increase its earnings. For a while, that strategy paid off, revving
up its financial performance. The strategy also worked at companies
like Gateway, Intel and Microsoft.
Now, however, with the market for Internet stocks in the cellar, these
investments are no longer producing gains; in many cases, like Yahoo's,
they are damaging companies' results.
But corporate investment was just one of the earnings-enhancement strategies
tried by companies. Drawing from a well of creativity, they turned the
market's climb to their advantage by offering millions of stock options
as a substitute for paying higher wages. They also sold put options in
their own stock to generate income, and they recorded gains that resulted
from the rising value of assets held in the pension plans of their employees.
In every case, reported earnings looked better than they would have if
they had been based only on company operations. And each one worked
only when stock prices were rising.
"The rising stock market was a great boon to reported corporate earnings,
and all of these things were buried so you had to look awfully hard to find
them," said H. Bradlee Perry, former chairman of David L. Babson & Company,
a money management firm, who has been an investment professional since 1952.
"In past bull markets, these sources of earnings enhancement really were not
available. So all these things sort of snuck up on people."
Now, however, stock prices are no longer galloping. And as many veteran money
managers point out, shareholders are suddenly learning just how much of their
companies' high-powered financial performance came from the bull market. At
the same time, they are getting a whiff of how much their companies' earnings
may be hurt in coming months if stock prices continue to stagnate.
"What every one of those things did was overstate earnings," said
William Fleckenstein, president of Fleckenstein Capital, a money
management firm in Seattle. "Even without economic weakness, the
earnings are going down. What's going to be shocking is how fast
and how sharply the earnings collapse."
Contributing to the earnings shortfalls, of course, is the first
significantly slowing economy in almost a decade. As the speed of
that slowdown sinks in, Wall Street economists have been steadily
paring back their forecasts for earnings this year at hundreds
of American corporations.
But there is another reason that this earnings season will look grim.
With managers less able to pad results with stock-market related gains,
earnings will suffer by comparison to last year, when rising stock
prices were contributing handsomely to profits.
With investors tripping over themselves to get into the stock market
in recent years, it is not surprising that corporate executives felt
the urge to join the crowd. Intel was perhaps the biggest and most
aggressive corporate investor. In its third quarter, which ended last
September, Intel's portfolio was valued at $5.86 billion and produced
investment and other income of $966 million.
How quickly those profits can evaporate. When Intel announced its
fourth-quarter earnings on Tuesday, it said that the value of its
portfolio had fallen to $3.7 billion and that it had produced $800
million in gains and interest income. More ominous, Intel said it
expected gains and interest income to fall to $180 million in the
first quarter of 2001, adding that it forecast "no net gains from
the sale of equity investments" in the coming quarter.
Aside from making investments to propel earnings, many technology
companies made a habit of lending to smaller companies, their customers,
that needed money to buy equipment. Nowhere was this practice, known as
vendor financing, more prevalent than in the telecommunications industry.
Companies like Lucent Technologies, Nortel Networks and Qualcomm lent
billions to their customers.
All went well until the stock market swooned last year and the corporate
bond market froze leaving many of the fledgling companies that had
received the financing unable to raise the additional cash they needed
to keep their businesses operating. Now, with many of these companies
experiencing severe financial difficulties, the companies that made
the loans are being forced to write them off as bad debt.
Consider the news last week from Globalstar, a company founded
by Loral Space and Communications and Qualcomm to design and operate
a satellite-based wireless telecommunications system. Globalstar,
which has yet to make a profit, announced on Tuesday that it was
suspending indefinitely the principal and interest payments on all
of its debt, including its credit line and vendor financing agreements.
According to the company's regulatory filing for the third quarter,
its loans from vendors totaled $765 million. Some $528 million,
or 69 percent, was owed to Qualcomm. Globalstar also had a $250 million
credit line with a bank that was guaranteed by other companies,
including Qualcomm to the tune of $22 million.
When Globalstar made its announcement, Qualcomm played it down, saying
it would result in only a "small negative impact" to operating earnings
in its quarter ended on Dec. 31. Qualcomm's stock barely budged, falling
just 1 percent that day, even though the company owns 9.5 percent of
Globalstar. Shares of Globalstar fell 48 percent.
Cecilia Wagner Ricci, professor of finance at Montclair State University
in Upper Montclair, N.J., has studied vendor financing among
telecommunications companies. "There are several problems for
companies doing a lot of vendor financing," she said. "First,
they are going to see increasing bad debt among their customers.
At the same time, the companies they sell to are going to be spending
less, because they will not have the money. I think the effect on
earnings is going to be absolutely terrible."
Making matters worse, Ms. Ricci said, many companies do not divulge
how much they have lent to customers, leaving investors in the dark
as to the depth of the potential problems caused by the practice. For
example, while Lucent has stated how much credit it has extended to
customers, some $8 billion, Cisco Systems has not. A Cisco spokeswoman
said its vendor financing is very conservative.
Rising stock prices have also plumped up corporate earnings through
gains in assets held in employee pension funds. Accounting rules
allow companies whose pension assets exceed their liabilities to
feed the investment gains into their profits. The practice is commonplace.
Although those gains certainly reflect the able administration of pension
fund assets, the profits are less reliable than income from continuing
operations. With stock markets at record volatility, those profits
could quickly become losses.
Thanks to the roaring stock market, pension gains became a significant
contributor to profits at some companies. Northrop Grumman is a
prime example. Roughly half of its earnings last year were a result
of a strong stock market- the company has 62 percent of its
pension assets invested in stocks.
But last month, the company warned investors that diminished
pension gains could slice $50 million, or 7.6 percent, from
earnings expected by analysts in 2001.
If taking pension gains to enhance earnings became popular in corporate
America, so did using stock options as a form of employee compensation.
In corporate accounts, options are "free," not deducted as an expense.
By cutting the wage costs of a company, options make earnings look
better than they would if it had to pay cash to employees.
But stock options work as a form of pay only when a company's shares
are rising. Now that many stocks have been crushed, many employee options
are under water below the strike price that makes them valuable and some workers
are beginning to demand fewer options and more cash. So corporate
expenses will rise, and earnings will diminish.
Microsoft was one of the largest beneficiaries of the use of stock
options in recent years. In 1999, according to Pat McConnell, an
analyst at Bear, Stearns, if Microsoft had taken the $1.13 billion
worth of stock options it dispensed as a business expense, the
company's earnings would have come in 8 percent lower.
With the company's stock trading at about half its peak value last
year, roughly 40 percent of the options that Microsoft has granted
and remain outstanding are under water, based upon their weighted
average prices. Not surprisingly, Microsoft executives recently
warned that they might incur higher wage costs in coming years.
There was another type of option that helped companies bolster
results: put options on their own stocks that they sold to private
investors. Through such deals, companies like Dell Computer,
Microsoft and Intel were essentially betting that their stock prices
would not fall below a certain level within a specified time. The
investors who bought the options from these concerns, for example,
paid for the right to sell the shares back to the issuer at the
specified price.
As these companies' share prices raced higher in the 1990's,
sales of put options generated cash and never required the
exchange of a single share of stock. Now, however, many stocks
are below the so-called strike price of the put options, meaning
that Dell and other companies may have to pay to buy back the
shares covered by the puts at a higher-than- market price. In
some cases, these purchases will require hard-earned cash that
could otherwise be put back into the company's operations.
Consider the obligations that Dell faces because of its put
option sales last year. Dell pocketed $59 million in proceeds
from option sales. But if the company's stock remains at its
current depressed price of $25.63 until its put options expire
by September of this year, the company will have to pay $1.06
billion if the options are exercised at the average price of
the range noted in the company's filings. That figure is 64
percent of Dell's net income last year.
Baruch Lev, an accounting professor at New York University's
Stern School of Business, said: "I really don't understand why
would they speculate in the stock market. What you want to do is
have built-in stabilizers if the market goes down that would
protect you automatically, not make it worse."
Mr. Lev said there was another bull-market practice that is
no longer effective but that may leave companies struggling
for future earnings growth: corporations' use of their own
high- priced stock to make expensive acquisitions.
Between May 1999 and June 2000, Cisco Systems used its shares
to make acquisitions totaling $15 billion. The purchases, a
way for Cisco to get technologies needed to round out its
business, had the additional impact of increasing sales and,
it is hoped, future earnings.
But with Cisco's stock down 51 percent from its peak last March,
this currency is no longer as valuable. "Where is the future
growth coming from now that they don't have this currency
anymore?" Mr. Lev asked. If the company has to pay cash for
its purchases, earnings will suffer. And if Cisco chooses to
generate earnings growth from internal research, that will
be more costly as well.
Without all of these financial devices, many companies may have
a lot of explaining to do as they announce earnings this year.
"People thought the party was going to go on forever, and
now it's over and they don't know what they're going to do,"
said Ms. Ricci, the professor. "Remember in high school when
you went to a dance and they kept the lights down really low
and when they turned the lights on at the end of the night, nobody
looked as good as when the lights were low? This is what it reminds
me of. Because the lights are definitely on." |
