Real profits? Searching for the whole truth
nationalpost.com
David Thomas, Investing Editor
Financial Post
A bear market and the collapse of Enron Corp. have given regulators an added push to clean up creative accounting in corporate earnings. How bad did things get? So bad the profit boom of the late '90s may well have been a mirage. Today, the Financial Post begins a week-long report on how we got into this mess and how to fix it.
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It's not just the crooks at Enron Corp. that have been misleading their investors by dressing up earnings statements with mojo accounting; it's an epidemic.
More and more companies have been pulling essential costs of doing business out of their earnings numbers and burying them under various "extraordinary" categories in their reports. Presto, the result is a new bottom line with improved profits and a record of investor-friendly growth that lends support to the firm's stock.
The Enron link shouldn't be overplayed since its rogue managers used earnings tricks to disguise an outright fraud while most practitioners of so-called "pro forma" reporting have been engaged in the perfectly legal practice of earnings management. But while the practice may be legal and there may not be a deliberate attempt to deceive investors, the sad truth is that earnings just aren't what they used to be.
"For the average shareholder, [pro forma] numbers can represent a welter of confusing and potentially conflicting signals about how their investments are performing," offers Robert Reid, the head of Independent Equity Research in Toronto.
That's a balanced view from a veteran stock analyst. Investors who have had their pockets picked during the tech bubble are likely to be less polite. Recent estimates have pegged the combined losses of the top 100 Nasdaq firms in the first three quarters of last year at US$82-billion. This while the same firms reported profit of US$20-billion. Now that's earnings abuse.
"Charles Ponzi would have undoubtedly have approved," Bill Gross, managing director of Pacific Investment Management Co. (PIMCO), the biggest bond player in the world, quipped wryly to clients last week.
We didn't need Enron's spectacular US$60-billion flameout in Houston to learn we had a problem; the issue was already shaping up as a regulatory priority. Enron simply turned up the heat so we can get things cleaned up faster.
In a week-long Earnings Abuse series starting today, the Financial Post reports on how we got into this mess and what needs to be done to clean it up. At the centre of the report -- today through Friday -- investing writer Steve Maich delves into the filings of four of Canada's leading blue chips. We picked the firms not because they are the most flagrant earnings abusers but because each allows us to draw attention to a different kind practice that has left investors with either a misleading or incomplete picture of performance. We also picked them because each is a stock that most Canadian investors are likely to hold.
By its very nature, quarterly disclosure should clear things up but Maich discovered investors are often given conflicting messages in earnings statements. Different sets of numbers, it seems, tell different stories.
In the case of Nortel Networks Corp., we know a collapse in sales and even larger plunge in profits accompanied the meltdown in the shares of Canada's one-time market gorilla from more than $120 to yesterday's close of $6.97 -- its lowest in more than six years.
What is less well known is that the warning signs were there in Nortel's earnings reports years earlier and a savvy investor prepared to dig a bit could have found sound, fundamental reasons to get off the train before the tech wreck.
In the late 1990s, Nortel was cash-flow negative and bleeding red ink on its bottom line. By 2000, the difference between its net income loss and pro forma profit was a staggering $5.4-billion. As Mr. Maich reports, Nortel guided investors to watch its multi-billion-dollar pro-forma profit and dismissed the gap between the two sets of numbers as hiccups caused by acquisitions.
It may be necessary for a company to guide investors past its net income numbers on any given quarter or year if major one-time costs distort the underlying fundamentals. But in Nortel's case, the net income loss turned out to be much closer to the real picture.
Anthony Scilipoti, an analyst with Veritas Investment Research in Toronto, says Nortel's pro forma reporting masked the fact that the telecommunications equipment maker's core business was racking up huge losses.
Veritas is a respected independent research business that specializes in sniffing out accounting red flags. We enlisted Mr. Scilipoti's support throughout our series, along with that of Mr. Reid. His firm, Independent Equity Research, is not affiliated with a brokerage or investment bank and markets its services to the investment industry and publishes some of its work under the eResearch banner.
So how did we get into this mess? There is always a period of reckoning in a bear market, as participants wrestle with the questions of what went wrong during the previous bull and who's to blame.
When any bull market tide retreats, it tends to leave a lot of garbage on the beach and the trumped-up earnings report looks to be the one thing market beachcombers are picking over most.
Firms have always had a measure of core or operating earnings they could report, which may often differ dramatically from their net-income bottom line. The biggies include discontinued operations and genuine extraordinary writedowns, including acquisitions and the sale of real estate.
Those are defined by Canadian and U.S. generally accepted accounting principles (GAAP). But GAAP has an elastic definition of operating earnings and, as a result, firms have been customizing their own reports for years.
In the late 1990s, things got out of control. Firms found ways to inflate revenue, booking swapped ads as real sales or recording an online purchase as a full sale even if the online firm is only entitled to a small transaction fee.
On the profit side, earnings were boosted by investment gains and grossly distorted when firms capitalized on big tax savings on stock options, but then didn't account for the cost of options compensation in their pro-forma earnings.
Looking back, the whole profit boom of the '90s looks as though it might have been a mirage, mourns Robert Barbera, chief economist at the brokerage Hoenig & Co. He estimated recently most of the 26% growth in operating earnings for firms on the Standard & Poor's 500 composite index between 1997 and 2000 was directly due to accounting hocus pocus.
"I don't believe that the earnings growth in the late 1990s was there."
Somewhere along the way, the art of earnings reporting changed from earnings per share (EPS) to everything before bad stuff (EBBS). Now we're coming full circle and investors want to see real earnings again -- or else.
Real EPS, according to Marc Gabelli, a prominent U.S. fund manager, can act as a pointer to the "estimated probability of survival."
TOMORROW: How BCE Inc.'s "cash baseline earnings" mask bad news on the bottom line.; dthomas@nationalpost.com
OTHER STORIES IN THIS SERIES
» Real profits? Searching for the whole truth (March 26, 2002)
A bear market and the collapse of Enron Corp. have given regulators an added push to clean up creative accounting in corporate earnings. How bad did things get? So bad the profit boom of the late '90s may well have been a mirage. Today, the Financial Post begins a week-long report on how we got into this mess and how to fix it.
» Pro forma numbers masked Nortel's woes (March 26, 2002)
When Nortel Networks Corp.'s stock crested above the $120 level the market was blasted with hype about the company's enormous potential. When its "can't miss" business model fell short of the target, investors were left wondering how it all went so wrong.
» How many ways are there to say the word earnings? (March 26, 2002)
If you haven't read a financial statement since before 1990, you're in for a rude surprise. They're often written in a new language these days. |
