Vendit: <<The Wall Street Journal reported today that AOL could face between $96 million and $243 million in annual charges over a 40-year period if regulators decide Sun's involvement should require AOL to employ the purchase method of accounting, the other method used for acquisitions.>>
The crux of the WSJ article from yesterday was to raise doubts about the possibility of even a 40 year write off (at the upper end of the range cited) almost completely wiping out all earnings for the foreseeable future. However, fortunately for AOL investors, the accounting glitch involving "pooling of interests" associated write-offs, which will apparently be outlawed by 2001 may well be allowed in AOL's case; in other words, it will not be retroactive, permitting AOL to have its cake and eat it too. AOL must also have a lot of supporters/sympathizers in high places.
Here are some 'new' thoughts on "valuation".
interactive.wsj.com
April 1, 1999
Heard on the Street
Analysts Increasingly Look
To Cash Flow Over Earnings
By ELIZABETH MACDONALD
Staff Reporter of THE WALL STREET JOURNAL
When it comes to reported profits, one man's fancy has
become another man's junk.
That is what a number of stock analysts at investment
houses such as Keefe, Bruyette & Woods, J.P. Morgan,
Goldman Sachs and Credit Suisse First Boston say is their
reason for ditching reported earnings in favor of cash flow
in making stock valuations.
Cash-flow valuations were favored by junk-bond kings in
the '80s who wanted to see how much debt companies
could suffer. But today's stock analysts like the method
because they say it ignores accounting tricks and thus
shows the true economic health of companies.
"The reported profits number is now considered an
accounting fiction," says Michael Mayo, a bank analyst at
First Boston. Cash-flow valuations are now in vogue in the
cable, high-tech, Internet, pharmaceutical and
financial-services sectors.
Analysts are also increasingly using cash flow to ward off
potential stock-price volatility that could arise from some
major merger accounting changes.
But as small investors pile into the market through electronic
trading, the move to cash-flow valuations spells more
confusion. That's because no accounting rules exist
governing the proper calculation of cash flow, also known
as EBITDA, or earnings before interest, taxes, depreciation
and amortization.
Some analysts, for example, add back only write-offs for
depreciation and amortization, arguing these charges are for
assets that will increase in value, whereas taxes and interest
are irretrievable costs. In turn, disparate cash-flow results
have sprouted willy-nilly. So far, U.S. accounting regulators
don't plan to issue rules covering cash-flow calculations.
Analysts insist cash flow can help flush out companies' true
growth rates. For example, analysts project Citigroup Inc.
and Wells Fargo & Co. will report above-average future
earnings growth. That's partly due to one-time restructuring
charges stemming from mergers, which could "potentially
inflate the banks' future reported earnings, relative to cash
flow," Mr. Mayo says. Citigroup has reserved about $1.6
billion for these charges; Wells Fargo, nearly $1 billion.
Mr. Mayo warns investors may overlook that the banks
aren't creating as much value as reported profits suggest.
Instead, cash flow would show the banks "might not be
growing as fast because of these upfront earnings hits," he
says.
The companies defend their approach. "It goes without
saying that investors should focus on the fundamental
trends, not one-time charges," responds Bill Pike,
Citigroup's director of investor relations.
At Wells Fargo, Vice Chairman and Chief Financial Officer
Rod Jacobs says, "I don't think it's legitimate to say these
charges distort future earnings."
Analysts say that when cash flow is lower than reported
earnings, that's a sign profits are coming from items other
than cash -- including possible accounting tricks.
For example, before it restated its 1997 numbers due to
alleged accounting irregularities, Sunbeam Corp. reported
$109 million in net profits for 1997, (the company also
restated 1996 and first-quarter 1998 earnings). But Sunbeam
also reported $8 million in net outflows of cash for the year.
Thus reported earnings may have come instead from
possible accounting manipulations, accounting experts say.
Sunbeam declined to comment.
About 72% of 178 brokerage-firm reports from firms like
Merrill Lynch and Citigroup's Salomon Smith Barney now
publish a cash-flow earnings multiple, according to a study
by Rick Escherich, a managing director in J.P. Morgan's
M&A group. "Fifteen years ago, there was very little
emphasis on cash flow," he says.
Mr. Escherich also found 55 large companies reported a
cash-earnings number in the first seven months of 1998, up
60% from a similar period in 1997.
Cash-flow valuations are also taking off to ward off
stock-price volatility from the restriction of pooling of
interests, which lets merging concerns avoid future earnings
charges for goodwill, the premium paid over acquired net
assets. In 1998, companies issued almost $1 trillion in stock
to purchase companies, mostly in pooling deals.
If these bookkeeping changes are adopted as expected in
2001, that will spell higher goodwill charges to reported
profits (and a likely increase in merger activity before that
deadline). "If the market multiple doesn't adjust, which it
probably won't, then stock prices are going to be lower,
too, due to these increased earnings charges," says Robert
Willens, a managing director at Lehman Brothers.
And because of these changes, "investors will likely become
more confused about net-earnings results, and such
confusion spells discounted stock prices and valuations,"
says Hal Schroeder, a senior equity analyst at Keefe,
Bruyette & Woods. To protect against that, there will be an
"accelerated shift toward cash-flow-based multiples in
valuing equities," predicts Mr. Escherich.
Wells Fargo's April 1996 purchase of First Interstate
Bancorp suggests the market adjusts for sizable goodwill
charges. Despite $7.23 billion of goodwill charges in the
deal, Wells Fargo's price/earnings ratio jumped to 14.07 in
September 1996, up from 11.00 in October 1995, right
before the deal was announced. But its cash multiple
remained flat, and didn't vary from the average cash multiple
for three other banks. The market thus saw through the
dilution and preserved Wells Fargo's share price, Mr.
Escherich says.
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