Abelson writes well.
Of course, just his opinion (bearish) but the writing sure is witty.
"..We sympathize with the aggrieved corporate brass who spent years getting
advanced degrees in financial engineering and see it all going to waste..."
ragingbull.lycos.com
Strength in Numbers - Abelson
Some comments on S&P's outrageous notion that corporate earnings should
be clear, consistent and accurate. The high cost of options.
Listen to the coyotes howl!
No, they're not upset by the disclosure the White House had a tip more than a
month before Sept. 11 that bin Laden & gang might try hijacking some U.S.
planes and, on the advice of "intelligence" (?), chose not to share the warning
with us humble folk. After all, as both the CIA and FBI in rare agreement
noted, the tipster didn't supply the flight times or even the names of the
airlines.
And, no, they're not howling about Jimmy Carter's junket to Castroland
where he lectured the natives (boy, we do remember those homilies about
moral malaise Jimmy used to regale us with). After all, the Cubans have
survived listening to Fidel rant on for 40 years, so they're impervious to a gust
of hot-air hectoring from old Jimmy.
Nor was the wailing provoked by the latest revelations that energy traders
swapped mythical orders with each other. After all, nobody else wanted to
trade with them and they were bored out of their minds (in the case of energy
traders that doesn't take too much boring).
Not to keep you in suspense: The thing that got the coyotes' hackles up is the
idea that earnings are what a company actually earned, not what a company
could have, should have, would have earned if it weren't for a few odds and
ends, like having to pay people a salary or send along a bundle every month
to Ming the Merciless, a.k.a your banker, for interest and paydown on the
dough he lent you.
More specifically, what has them in such a state of agitation is the decision,
announced last week, by venerable Standard & Poor's to introduce a new
system for gauging corporate earnings. We don't blame the captains of
industry and the revered analysts of Wall Street who rushed to take up the
cudgels against the outrageous notion of trying to present earnings as they
truly are.
What could be more subversive of a noble tradition of gussying up profits so
that your stock takes off and everyone is happy -- your shareholders, your
faithful analytical followers and, not least, your loved ones, who can count on
the skyrocketing value of your options to provide sustenance (caviar and foie
gras), shelter (manses in Greenwich and monster bungalows in the Hamptons)
and educational expeditions to exotic places (Saks, Bloomingdale's,
Neiman-Marcus)?
A sly lot, alert to which way the wind is blowing, the critics aren't coming right
out and damning S&P for sticking its nose in their business. Instead, they
gently bemoan the possible harm to investors. S&P's new way of describing
what earnings are, they murmur sorrowfully, will only "confuse" the poor
souls.
And the critics are right. Investors are going to be terribly confused when they
look back at the dehydrated versions of past years' reported results and
wonder where all the earnings went.
We sympathize with the aggrieved corporate brass who spent years getting
advanced degrees in financial engineering and see it all going to waste. And
we sympathize as well with their camp followers on the Street who swallowed
whole those sugarplum earnings confected by their corporate clients and now
are faced with the formidable task of finding nice things to say about
uncooked fare.
Amid the grumblings, lamentations and cries of "confusion," David Blitzer,
S&P's chief investment strategist and the main man in the noble
truth-in-earnings undertaking, seemed remarkably serene when we chatted
with him briefly last week. A thoughtful type, he evinced neither a trace of
surprise at, nor so much as a hint he was perturbed by, the instant carping that
accompanied release of the new earnings treatment. He and his diligent crew
merit three cheers -- heck, make that four -- for striving to restore sense and
integrity to a vital investment measure that has been deliberately and
maliciously robbed of both.
Does this mean that S&P's new formula for describing profits is perfect? Of
course not. But is it a major step forward toward a reasonable, consistent and
disinterested definition of earnings? Absolutely.
For good and sufficient reasons, which it sketches out in the preamble to its
discussion of the new approach, S&P found each of the alternatives --
reported earnings, operating earnings and pro forma earnings -- wanting. So it
came up with "core earnings," which are, in S&P's words, "after-tax earnings
generated from a corporation's primary business or businesses."
The guiding principle in the new formulation is to encompass all revenues and
costs of ongoing operations and exclude pretty much anything that isn't part
and parcel of the basic business. Not included in core earnings, for example,
are goodwill "impairment" charges (triggered when market value of the item
drops below book value); gains and losses from asset sales; pension gains;
unrealized gains and losses from hedging activities; merger and acquisition
expenses and litigation or insurance windfalls.
Included in core earnings are not only the usual R&D expenses but the cost of
purchasing research and development as well, thus removing a dodge notably
popular among tech companies; restructuring charges from ongoing
operations (under the old regimen restructuring charges were a neat catch-all
routinely used for a variety of purposes, all of them nefarious); write-downs of
depreciable or amortizable operating assets; pension costs and, lest we forget,
employee stock-option-grant expenses. This last, need we say, is a
particularly sore point for Corporate America, especially that chunk of it that
occupies Silicon Valley.
And no wonder. By S&P's reckoning, options expense could cut earnings by
as much as 10%, and, if anything, that probably errs on the side of
conservatism. Of the 500 corporate worthies that make up the S&P index,
only two (Boeing and Winn-Dixie) include the cost of stock options in figuring
net income. Why do we have a nagging feeling that not all the other 498
companies that neglect to do so are motivated by a concern that their
shareholders might suffer information overload?
The logic of S&P's inclusion of option expense in toting up earnings seems
irrefutable: stock options are granted to employees as part of their
compensation package. Ergo, they should be counted among compensation
expenses. Logic, schmogic, just listen to those coyotes howl!
And our heart goes out to the poor creatures. The pain will be palpable. S&P
reckons, for example, that counting options expense would render quite
palpable damage to our old friend Cisco's bottom line: instead of the 14
cents-a-share loss reported for the fiscal year ended July '01, the loss
balloons to 35 cents a share.
David Levy, who with his father, S. Jay Levy, authors The Levy Forecast and
Macroeconomic Profits Analysis (try saying that out loud in a hurry), a
first-rate monthly diagnosis and prognosis of the economy, is one of the select
group S&P tapped to help shape up its core earnings concept. By David's
estimate, reported operating earnings in recent years have been exaggerated
by at least 20% and possibly a heap more. So ask not why we needed a new
way to measure earnings; ask rather, why it was so long in coming.
Under the old definition of earnings, the S&P 500 sports a P/E of 22. Under
the new, that rachets up to around 30. As David Blitzer observes, the average
price/earnings ratio over the past half-century is roughly 16, so today's market
is not only overvalued but extremely overvalued.
It's not exactly a stretch, obviously, to suspect that as S&P puts its
core-earnings approach into effect and, in the fullness of time, as it or some
near-facsimile gains currency and the overvaluation of the market becomes
inescapably evident, stock prices will suffer, perhaps severely. But whatever
the short-term pain, over the long haul anything that makes corporate
reporting clearer, more consistent and more true has got to be an enormous
plus, for the market, for investors, and mostly certainly for corporations, not
to mention our collective economic health and well-being.
There's simply no substitute for honest numbers.
Standard & Poor's conclusion that it isn't kosher to include pension gains in
corporate earnings could take a whack out of some prominent blue-chip
bottom lines. By way of example, S&P cited General Electric. Ex the
contribution from its overfunded pension plan, GE's per-share net last year
would have been $1.11, rather than the $1.41 the company reported (GE
sniffs that S&P overstated how much pension income chipped in to total
profits).
The gross numbers, as Barton Biggs pointed out in a recent commentary for
Morgan Stanley, are formidable. At the end of 2001, GE's pension plan had
$45.8 billion worth of assets and was an astounding 45% overfunded. And,
even though, reflecting the bum stock market, the value of the fund declined
last year, no less than $2.1 million of the company's $13.7 billion in reported
earnings came courtesy of its still-fat pension fund.
While Barton cautions that GE's pension fund contribution to the company's
earnings may fade in the years to come, should the market's performance
prove relatively subdued, if S&P has its way it'll vanish entirely.
Barton wasn't picking on GE. Rather, his remarks were part of a somewhat
mournful discourse on how "bad things happen in a leveraged, equity-soaked
financial system as stocks drift down," as stocks have for the past two years
and counting. And prominent among the institutions bad things are happening
to pension funds.
The percentage of pension fund portfolios in equities is a towering 75%; that's
one problem. Another is that they've been counting on returns of
9.25%-9.5%, which, as Barton notes, may well prove at least a couple of
notches higher than they're likely to enjoy.
He cites Milliman, a Seattle actuarial firm, as calculating that the 50 biggest
U.S. pension funds took a hit to the aggregate value of their portfolios last
year of $36 billion. Thanks to their generous assumptions of how much their
investments should return, however, the fabulous 50 were able to use a
"hypothetical" pension fund gain of $55 billion in reporting to shareholders,
and include $9 billion of pension fund earnings (or something) in their net
income.
As Barton observes, the spread between reality and accounting was a cool
$92 billion and it wasn't tilted in favor of reality. In the bubble years, of
course, the tilt was positive; but those years are gone, maybe never to return.
Fair to a fault, Barton adds pension funds have no alternative to basing their
accounting on long-term assumptions. Still, as indicated, those assumptions
may be entirely too cheerful and, in any case, the contrast between the real
and the hypothetical strikes us as a great argument in favor of excluding
pension-fund "earnings" from corporate net income.
Especially in light of what's happening to those monster surpluses that pension
plans enjoyed through the roaring 'Nineties. At the end of '99, a mere 15% of
the big pension plans were underfunded; currently, about half of them are and,
absent another bull market, that proportion will inexorably grow. As it is, the
surplus in the top 50 plans in the two years ended 2001 shrunk an incredible
90%.
While none of those plans are deemed by Milliman in danger of running short
of cash, it's not inconceivable, as Barton says, that companies may have to
start coughing up dough to meet their obligations to their retirees. By way of
illustration, he relates that GM at the end of last year had pension-fund
obligations of $93 billion, against assets in its plans of $76 billion.
In the 'Nineties, as stock prices went racing to the moon and assumptions on
how much portfolios would return over the long term went along for the ride,
pension funds changed, as Barton puts it, "from cost center to important profit
center" for any number of companies. The trip back, to cost center from profit
center, no surprise, is proving not nearly as much fun.
P.S. Barton reports that public pension funds are also hurting: their assets
plummeted $370 billion in the past two years. Liabilities are mounting by
about 7% a year and state and local governments have no choice but to make
up the shortfalls. That translates into possibly higher taxes and probably
reduced services.
As he comments: "There will be a lot of dry municipal swimming pools this
summer." And not because of the drought. |
