APRIL FOOLS!
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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