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A Penny Less ~ A Penny More
(Nov 9, 2001)
by James J. Puplava / Financial Sense Online
The stage is set, the props are in place and the actors have entered stage left. The play is about to begin. Welcome to "The Earnings Game," a quarterly entertainment that is accompanied by much aplomb and repeat performances. The actors are always the same. They are Wall Street, major corporations, and the media. The play is presented for the benefit of the sophisticated as well as the uninformed. It is a melodrama that is repeated each quarter with regularity and predictability. The plot never changes. The players never change. The curtain always falls at the same predictable finale. Companies beat estimates, analysts look good and the media has something to talk about. Investors enjoy the ride and momentary thrill as stocks rise and fall on earnings reports that meet or beat estimates by a penny less or a penny more a share.
For those who know the plot of "The Earnings Game", it has the same beginning, the same format, and the same outcome each quarterly showing. Companies beat analysts' estimates, the media gives them a standing ovation, and investors show their appreciation by bidding up the price of the shares. This three-act performance is repeated each quarter to an audience of well-informed sophisticates and the uncultivated masses.
The performance has a certain protocol. Professional actors must play according to certain rules of engagement. The investor audience watches three major scenes: the opening act, intermission, and the final conclusion. However, the play is much more complex than what is depicted on stage. There is the pristine version visible on stage and a more subtle plot only understood by proficient viewers. Both versions are contained within the same plot and involve the same outcome. The plot focuses on one outcome and one number which is called earnings. Earnings can mean many things and for variety, it often does. Earnings can mean net income, pro forma income, cash flow, or whatever the players want it to be. The dialogue and the lines are often changed to get the audience to respond. For those not familiar with this play, its sequence and plot are described below.
Act I RULES OF ENGAGEMENT
"The Earnings Game" is much more complex than what appears on stage. However, there is a general plotline that is performed sequentially, and if understood, will give the viewer a better understanding of the game. There are three rules to this game that are critical to understanding how it is played and won. The first rule involves company earnings. It has three parts as follows:
* Deliver a track record
of consistent earnings growth.
* Manage earnings expectations carefully.
* Slightly beat earnings estimates.
Rule #1 Deliver A Track Record of Consistent Earnings Growth
Investors in the audience are encouraged to applaud by bidding up the share price of companies that deliver earnings that meet expectations. The audience hates to be disappointed, so the main actors have learned to deliver their lines in such a way that generally guarantee audience approval. The widely accepted doctrine is, "Good companies always deliver consistent earnings growth." This is because any well-run company has planning and control systems that help management to set earnings targets, track their progress, and make in-course adjustments to meet expectations of the investment crowd.
If delivered well, the managers of the companies are rewarded by rising share price that make them wealthier through exercisable stock options. Since most businesses involve a certain degree of uncertainty, management's job is to remove as much uncertainty as possible. The key rule is to deliver earnings that always go up and do whatever it takes to make that happen. A consistent trend of quarterly earnings growth sends a strong signal to the stock market. It is rewarded by analyst's upgrades and recommendations and a rising stock price. Good examples of delivering this kind of performance are companies such as GE, Microsoft, IBM, and Cisco.
The problem for managers is that the vagaries of business make it difficult to deliver continuous growth in quarterly earnings. Product introductions can be delayed, there can be production bottlenecks, customers can delay orders, competitors can introduce better products, or new entrants into the market can shrink margins. This makes it necessary to employ a tactic known as managing earnings expectations. Analysts always want to look like smart people, so they spend a great deal of time estimating company earnings for the next quarter. Stock prices rise and fall on companies meeting or beating their numbers. This is no easy task considering today's complex business world which is global in its scope. Consider a company like Coca-Cola which sells its product in over 140 different countries. They have multiple product lines and record their sales in different currencies. The stock market places major emphasis on these numbers. This is even more remarkable by the fact that these quarterly earnings reports aren't audited, and in many cases, are often restated later.
Estimates have become the center of attention by the media and investors and garner much publicity when they are made or changed. Analysts and company managers have learned to choreograph this process down to a refined poetic tango. The managers provide the guidance to the analysts who make up the numbers. It has become a dysfunctional web made up of complex relationships strewn with conflicts and irregularities. It has become management's job to provide guidance in the numbers that enable them to meet or beat expectations. In effect, they set the standard or benchmark by which they will be measured. It would be similar to a pole-vaulter setting the height of the bar. Companies willingly provide the guidance because Wall Street analysts ask them for it. Both sides benefit from the relationship. The companies benefit by setting targets that they can easily beat. The analysts benefit by looking smart, coming up with numbers that make them look psychic. They set the mood of the stage as they shroud their numbers like the Oracle of Delphi. It is similar to students being given the answers to an exam before the test is given.
The result is that Wall Street can keep selling stock because they have a story to sell even when there is no story. The brokerage houses, which employ the analysts, like it because it generates lots of trading volume, which in turn, translates into higher commissions. Management is fond of the practice because beating expectations generally leads to higher stock prices. Higher stock prices translate into more valuable stock options. Investors buy into it because it means rising share price and an increase in their net worth.
Rule #2 Manage Earnings Expectations Carefully
This process has many variations with highly skilled players able to consistently beat expectations. In order to do that, managers guide analysts expectations forward, but hold back a few pennies of earnings in reserve. This enables them not only to beat expectations, but to do so with much higher numbers. This is the sort of thing that can make a stock price take off like a NASA space launch. The strategy not only makes management and analysts happy, but it also gives the media something to talk about. It helps to bolster ratings, attract new viewers and keep advertising dollars flowing in. Investors, knowledgeable and otherwise, are also happy with this game. If they own the stock, they also participate with management by profiting from the stock's rise in price. And like analysts, they too can look smart by owning the shares. They can claim bragging rights at the golf course, yacht club, the water cooler, or the Friday night pub.
A more advanced version of the game is observed before earnings numbers are released. Analysts call on companies to get a better fix on the soon-to-be-released earnings results. These numbers are the called the "whisper numbers." They give Wall Street an advance look at the real numbers which allow firms and their favored clients time to buy or sell stocks on advanced notice. This abuse was recently brought to an end under SEC Chairman Arthur Levitt. The misappropriation prompted the SEC to implement its Regulation Fair Disclosure (Reg FD) last October. The new rule requires companies to disclose the same information to investors. They can no longer reveal privileged information to Wall Street. The result has been that Wall Street and Main Street get the same information at the same time. The new regulations helped to level the playing field. Management and analysts protested and were dragged kicking and screaming, but the new regulation has resulted in more accurate forecasts. It has also forced analysts to focus more on fundamentals than forecasts. PricewaterehouseCoopers recently conducted a survey of top executives of large multinational corporations concerning the analysts that follow their business and the impact of Regulation FD changes. Executives see analysts as helpful, but the best analysts are independent and better at understanding corporate strategy, forecasting performance, and the likely market impact on earnings.
This second rule of The Earnings Game is to do what it takes to meet or beat expectations. Top managers always set goals and articulate those goals to the organizations that they manage. That can be a positive thing. Setting goals and meeting objectives is a sign of leadership. However, there is a negative side to this as well. Sometimes decisions are made by management that are designed to deliver short-term results at the expense of the longer-term health of the company. Some examples are cutting costs needlessly by reducing spending on research and development, delaying maintenance on plant and equipment, or postponing needed purchases. These kinds of decisions are designed to bolster earnings in the short-run.
Every firm has to make judgment calls regarding accounting decisions. Accounting for earnings and expenses via the accrual system is an imperfect system, but it is the best one we have for measuring revenues and expenses. It allows management a certain leeway for making business decisions. Inherently, there is always the possibility for abuse. Companies have become experts at managing their earnings. They have honed and refined the practice to perfection. Companies that are in very cyclical businesses like manufacturing or technology manage to report earnings that go up just about every quarter in a predictable fashion. The analysts and the pros know the game that is being played. Strangely, it has little effect on the market. The SEC has begun to take tougher measures by issuing new standards that set stricter guidelines on managing earnings. One such guideline was the SEC Bulletin No. 99 regarding the materiality loopholes. Materiality in reporting was based on rules of thumb, a percentage threshold number that essentially gave managers a great deal of discretion in reporting their earnings. The new bulletin sets additional criteria that make it more difficult to misstate or mask a change in earnings. The rule attempts to ensure that management meets the spirit of the law.
Rule #3 Slightly Beat Earnings Estimates
The third rule in this game is the reward and punish rule. Analysts and the market reward or chastise those companies that fail to play the game and deliver results that are expected. Numerous studies have documented the market's negative reaction to a negative earnings surprise. Just look at the charts of the fallen angels in the tech field who could no longer manage their earnings. Cisco is a prime example. At one time, its market value approached $600 billion. Today at $140 billion, it is a shadow of its former self. No longer able to deliver what the market wants, it has paid the ultimate price in loss in share price and market cap.
Price charts of Cisco, JDS Uniphase, Oracle, and Sun Micro Systems have given efficient market professors something to contemplate. In ivory towers, they raise the question, "Are the markets efficient or are they totally irrational?" At the height of its stock market value in 2000, Cisco had a market cap of close to $600 billion. Sales for the previous year were $12.2 billion and net income was only $2 billion. The company had $12.2 billion in sales and $2 billion in profits and was valued at over half a trillion dollars. That isn't rational. It is insanity. It is one reason why the markets reacted with such vengeance and swiftness.
Management's inability to come up with a few extra pennies for a rainy day suggests that earnings surprises were just that, a surprise. The downward earnings report was not only a surprise to analysts and investors, but also a surprise to management as well. The market interprets this to mean deeper problems are ahead and that management has failed to disclose, or worse, is unable to control. Analysts and the market then shift their attention from one of enthusiasm to one of concern. Bad news usually comes in spades, so everyone becomes suspect of future earnings. The stock is taken out to the woodshed and trashed, sometimes irrationally so. However, there is good evidence that justice has been administered. Eventually the piper must be paid for the fancy footwork that created the artificial earnings. Sometimes you can play the game for quarters or even years. The noose is now being tightened by a stricter stance taken by the SEC. Unfortunately, regulators are a bit late. Where were they during the boom years of 1995-99?
Act II THE PRESS CONFERENCE
It is unfortunate, but the game continues to be played. The numbers continue to be managed, analysts continue to project earnings, and media continues to focus on the numbers in whatever form they are given. There is much to this game that is still hidden and not disclosed. The president of the company may be the front man who holds the press conference and has to face shareholders, but it is the CFO (Chief Financial Officer) who knows the real numbers. The CFO is the company's chief bean counter. He crunches the numbers that go into the quarterly reports. What goes on at press conferences is similar to what goes on in Washington. What you hear is more spin than fact, especially if things aren't going well.
What passes for earnings today is all relative. Earnings can be pretty much anything a company wants them to be. They can be real earnings, pro forma earnings, economic earnings, cash earnings, hypothetical earnings or earnings for the future. The SEC dictates what companies are required to report in their 10-K report to the SEC. As far as what is reported in press conferences, well, it's an open game with very few rules. In 1995 Congress passed the Private Securities Litigation Reform Act which has a clause within it called "The Safe Harbor Provision." It was designed to protect companies from frivolous lawsuits. Companies have learned to abuse it. In effect, a company exec can say anything about the company's future prospects as long as they add that the statements are" forward looking". This interpretation can mean anything. It's like giving CFOs a free pass. Hewlett Packard, Lucent, Cisco, and Procter & Gamble have used forward statements to help mitigate bad news.
Too many times what companies report as earnings are open to interpretation. Once again, what goes to the SEC and what is released in company press releases are two entirely different sets of numbers. The SEC numbers are required to be reported in the 10-K. They have to conform to GAAP (generally accepted accounting principles). What you hear reported may or may not be the same numbers. It happens every quarter. Wall Street takes out its crystal ball and makes bold predictions, and then everyone holds their breath in a wait-and-see mode on whether companies meet, beat or fall short of expectations. It's a great game that generates lots of turnover. It means more transactions and revenues for brokerage firms.
The great part from a company perspective is that it is done in full view of everyone. A favorite term used by companies is "pro forma" earnings, which translated means a changing series of accounting techniques designed to make the company look better. The caveat emptor (buyer beware) for investors is that this is all perfectly legal. The pro forma numbers leave out acquisition charges related to overpayment for acquiring other companies, payroll expense associated with the exercise of stock options, stock option expense, and sometimes the "big bath charge." The big bath charge is so big it is usually ignored. The plain facts are listed only in the official numbers filed with the SEC. Even then you may still need the talents of a skilled number-cruncher to reconstruct the financial statements. The report includes the income statement and the balance sheet. In this new world of pro formas and hypotheticals, the real answer often lies in those famous words of an X-President, "It depends on what your definition of 'is' is."
Predictability Overrules Accountability
The problem for investors and regulators is that the basic objectives of accounting have changed over the last decade to the detriment of shareholders who are the real owners of a company. The principle of stewardship dominated accounting principles for decades. It meant that managers were stewards, entrusted with the care and responsibility of safeguarding assets, increasing the wealth of shareholder/owners of the business, and rightfully honoring commitments to the firms creditors. Even though today's managers are entrusted with stewardship, they often act in their own self interest. This tendency gives rise to conflicts of interest between managers of the enterprise and its shareholder/owners. It has been unfortunate that this principle has been overshadowed by a greater emphasis on predictability in determining manager compensation.
Because there is so much emphasis on predictability, the emphasis in accounting has shifted. The need for information relating to the magnitude, timing, and the uncertainty of risk in determining a company's intrinsic value by the accounting profession has changed with the times. The conceptual framework of the accounting rules board the FASB has changed. Providing information to an information-demanding financial system requires new methods of reporting. The standard has moved away from measuring the effects of transactions on financial statements to reporting key information in the footnotes accompanying financial statements. The shift from measurement to disclosure has made accounting statements more complex and analytical skills more necessary. Sadly, these skills are absent everywhere you look -- from Wall Street, to Main Street, to network news.
The main victims of the earnings game are the shareholders. Because the emphasis has changed from the principle of stewardship to predictability, it has facilitated and enhanced the playing of the game. It has rewarded managers all too often to the detriment of the shareholders. It has led to the abusive and dilutive effects of stock options and excessive compensation of corporate officers. In 1999 Bloomberg published an article titled, "The New Math of CEO Pay." The article highlighted the fleecing of shareholders by chief executives and their compensation structure. The article was written at the height of the stock market bubble. Even though pay scales were out of whack, nobody seemed to mind because the rising tide of stock prices was benefiting most shareholders. But as Bloomberg pointed out, not all shareholders were equally blessed.
For example, in April 1998 a hotel franchise and direct marketing company revealed massive accounting fraud by employees. The fraud included booking $500 million in fake revenue at CUC International which had merged with HFS to form Cendant. The company shares fell 44 percent that year and the impact has brought a class action suit against them. Even their auditor, Ernst & Young, was slapped with a $335 million dollar bill to settle claims against them because of false financial statements. But the company's CEO, Henry Silverman, received a re-pricing of his stock options worth an estimated $50 million to the new CEO. Options were originally used to tie CEO pay to company performance. That was the original intent, but it no longer is a general guideline. Boards can now use the re-pricing of options to line management's pockets despite lack of operating performance. In 1998, 54% of the average CEO's compensation came from options in a survey done by Bloomberg of 86 large companies.
In that same year, Michael Eisner received $598 million in pay despite Disney's 10 percent stock loss. Eisner's pay that year amounted to a third of the company's net income of $1.85 billion. Disney's earnings have been in decline since 1997. In 1999, the board of directors of Oracle awarded their chief executive, Larry Ellison, one of America's richest people, the right to buy 40 million Oracle shares at an adjusted split price at the time of $6.88 a share. The award was so large that Ellison waived his salary and bonus for the year. At the time of their award, the option grant would be worth $438 million if the stock grew by 10% a year over the next decade. There are so many examples that it would take volumes to document them all. These examples are from all types of companies like American General, IBM, Pfizer, E*Trade Group, Microsoft and Cisco. Numerous examples exist of companies bailing out their CEOs when their stocks tank, making their options worthless. The board simply re-prices the options at a lower exercise price.
Options have become the new CEO entitlement. Companies are generous with their use because they are free. Granting options in lieu of pay allows a company to lower their payroll expense. Companies can grant them in place of higher pay because they don't have to account for them as an expense. This serves to understate earnings by underreporting payroll expense. Their true costs are buried deep within the footnotes of the annual report. They are also a source of dilution in earnings later on when they are exercised. CEO's and employees and have grown to love them during the boom years of the stock market. What happens to payroll expense now that the stock market is no longer booming may go towards more pay raises demanded by employees. Suffice to say that within this new world of investing with pro forma earnings, stock options, the "big bath charge", restructuring and other related earnings obfuscation, the real earnings will have to be dissected from the footnotes and then reconstructed onto the financial statements. This will not only take the analytical abilities of Sherlock Homes but also the patience of Job.
There has been a real battle within the financial community that has been fought hard by company management. So far the companies are winning. Washington and the accounting profession have given in, and I believe, to the detriment of the shareholders. The fact remains that stock options are dilutive and that executive pay can sometimes be out of line with corporate performance. The facility with which options can be granted makes it easy to abuse the privilege of their issuance. Unfortunately, today there isn't any watchdog to protect the stockholders who still remain the real owners of the business. Analysts are mum on the subject and so are the accountants. They don't want to upset their relationships with these companies for investment banking needs, consulting contracts, and company audits. That leaves the SEC which has been moving in the right direction, but has a long way to go in correcting the abuse.
A Living Example of Successful Stewardship
A good manager should not be denied the fruits of his labor. But that compensation should in no way be at the expense of the shareholders. It should also be proportional to the CEO's contribution. Paying an executive one-third of a company's net income is out of line. It robs the shareholders of what is rightfully theirs. A good example that should be emulated by responsible CEOs and their board of directors is the practice of Berkshire Hathaway and its CEO, Warren Buffett. Buffett usually pays cash for businesses that he buys for Berkshire's portfolio. Buffett is aware of the dilution to shareholder value when companies are taken over by the issuance of stock. Because Buffett is a major shareholder of Berkshire, he adheres to the stewardship principle of accounting, mindful that he is a caretaker of shareholder value. Buffett's longstanding track record is that he has grown the book value of Berkshire Hathaway by over 20% a year since taking over Berkshire in 1965. His track record has been unmatched by any other CEO or investment manager in the last century. The key to his success is that Buffett bought companies at prices that made mathematical and economic sense to Berkshire's bottom line. Buffett is cognizant of buying companies with stock and the dilutive effect that it has on book value. He also understands and has become the master of investing only when the right combination of price and value exists.
Leading with Misleading News
Principles espoused by investment leaders like Warren Buffett encourage me to rally against today's deceptive practice of the earnings game. Even after stricter SEC monitoring, Congressional laws, and GASB and FASB tightening the reins, investors are still misled by false earnings reports. Corporate press releases and financial coverage by the media lead us to believe that things aren't as bad as originally thought as a result of the events of 9-11. Daily press briefings contain numerous stories of companies meeting or beating analysts estimates. Headlines portray an economic picture that is improving. Wall Street analysts and media anchors are telling investors, "Now is the time to buy because the market is close to a bottom." In my opinion, Wall Street is trying to reactivate "the buy on the dip" philosophy that worked so well over the last decade. The following headlines are just a sample of the headlines appearing on a daily basis during this third quarter reporting season.
What do you read in the above headlines? Pretty inviting, wouldn't you say? Like you, investors have been given the impression that things are going well or at least to quote a cliché, "better-than-expected". An examination of the actual results portrays a different picture. A more accurate portrayal of what was really happening might read much differently. I've taken the liberty of restating these headlines based on the real numbers. Mine would read more like this:
The Truth of This Recession is ...
Headlines like mine would give investors a better read on what is turning out to be one of the principal causes of the current economic downturn -- a recession in corporate profits. Wall Street has managed to create the perception that corporate profits were rising at double-digit rates of close to 20% a year. These profit figures were inconsistent with the profit numbers shown in the NIPA numbers. The Commerce Department's Survey of Current Business indicates that profits peaked in 1997. Even then, those profits were highly inflated by the contribution to earnings coming from capital gains.
Seventy Years of Earnings
The Commerce Department numbers indicate there never was a profit miracle or a new paradigm economy. What they show is something Warren Buffett spoke about in his November 22, 1999 Fortune Magazine article. He said you can't have a subsection of the aggregate growing at a faster rate than the entire economy. In this case, the aggregate is GDP and the subsection is corporate profits. Buffett argues that profits over the last decade were sub-par and were temporarily boosted by debt refinancing, tax law changes reduced depreciation charges, and the change in tax rates. These were one-time events unlikely to happen again.
Since the mid-90's, profits have been boosted by creative accounting. Only recently has this begun to surface in earnings reports. The temporary measures that artificially-boosted profits are now starting to come home to roost. The share buybacks, the inflated price of mergers, debt financing, and option issuance are now starting to take their toll on company profits. The accounting profession faces a tough task in curbing the growing incidence of misleading corporate reports. Financial reporting is a quagmire. Companies report one number to the SEC and another to investors in their press releases.
Investors may find better information by going to the SEC reports located at www.sec.gov or www.edgar-online.com Even while you can access these reports, you may have difficulties. You will at least be able to get the real numbers instead of the balderdash reported in company press releases. But prepare to use your magnifying glasses. You'll need them for the footnotes. The real numbers lie buried in the fine print. At least you'll be looking at numbers prepared according to GAAP (generally accepted accounting principles) instead of CRAP (cloudy reporting accounting principles). The numbers that corporations, Wall Street, and the media focus on are generally pro forma numbers. Today, the term "pro forma" is vague in its meaning. As a general rule, it is safe to say the company is using and making up its own rules as it goes along with a caveat that those numbers will have explanatory notes attached in the fine print of the footnotes. The company hopes that nobody reads them. Therein lies the problem. The fine art of accounting analysis is quickly disappearing in today's momentum-crazed market. Technical analysis and momentum-based trading have overridden the need for fundamental and accounting analysis. Many of today's accountants and analysts are experts at preparing financial statements, but few know how to analyze them.
Act III THE CLASSROOM
For these reasons, an understanding of a few basics are in order. Every financial report starts out with an income statement. The income statement measures a company's financial performance between balance sheet dates. It tells the reader or investor about the operating activities of a company. A general format is followed that can give the investor greater understanding as to how well management is doing in operating the business. That format is as follows:
|Cost of Goods Sold (COGS)||x,xxx|
|Selling & Administrative||x,xxx|
|Research & Development||xxx|
|Earnings From Operations||$x,xxx|
This format tells the investor what the company actually made running the business. It lets investors know what the company is making or losing from the principle business it is involved in. It is useful for year-over-year comparisons. It tells you how well management is doing in running the business. What follows below these numbers has to do with other activities such as interest expense, other charges, and other outside income from sources outside the regular business. If the company is going to take a major write-off, it is shown here. This is where the "BIG BATH" charges usually show up. The format continues from above.
|Other Income (Charges)||xxx|
|Earnings Before Taxes||x,xxx|
|Provision for Taxes||xxx|
The net income figure reported at the very bottom of the income statement is the Real McCoy. That is actually what the company made and you the shareholder have a claim on. The pro forma numbers so often quoted in the press can be anything between earnings from operations and net income. Pro forma numbers AREN'T the bottom line. Just remember this when you hear those stories of how a company beat estimates. Part of the real story is in the NET INCOME figures and the rest of the story is buried in the footnotes.
To decipher whether earnings are being "managed", a whole set of guidelines need to be understood. Areas that offer opportunities for earnings management are revenue recognition, inventory evaluation, estimates for bad debt expense, deferred taxes, one-time charges (my personal favorite abuse), and asset impairment. The principal abuse starts at the top with the first number on the income statement which is sales. This will involve income-shifting techniques of managing income by shifting income from one period to another. This is accomplished by accelerating or delaying revenues and expenses. Examples would include:
The most common practice of management is to move expenses below the line or below operating income. This reclassifies operating expenses in a category referred to as unusual or nonrecurring items that are usually ignored by analysts and investors. This earnings management serves to distort financial statements and management yardsticks. They make things look better than they really are. Investors should check the following before concluding that earnings are being managed.
* Reported earnings higher than operating cash flows.
* Reported earnings consistently higher than taxable income.
* Qualified audit report.
* Use of a smaller, Non-Big Five accounting firm for audits
* Unexplained or frequent changes in accounting policies.
* Sudden increase in inventories in comparison to sales.
* Circumvention of accounting rules such as operating leases.
* Frequent one-time charges and big baths.
Make Financial Statements Your Passion
To verify whether management is manipulating earnings can be further analyzed through various ratios measures. Investors will find it helpful to look at comparative financial statements, index-number trend analysis, and common-size financial statements. What you are trying to understand is this, "What you hear is what you get." It is your money and you can't rely on Wall Street sell-side analysts who are subject to conflicts of interest. Have you ever heard of a sell recommendation coming from an analyst? You can't depend on the networks either. They are also subject to conflicts of interest with their financial advertisers. Many times reporters are too lazy to check the facts or seem to be running deaf, dumb and blind. In many ways, they don't do a good job at getting at the facts or asking the right questions. Going to a book store and getting a primer on financial statements will give you a heads up over other investors and the financial media. It will at least teach you important facts about financial statements and questions you should be asking. The financial sections of major book stores are full of books on financial statements. Find the one that you are comfortable with and buy it. Starting reading and apply this knowledge to the companies you own and or considering buying.
The Importance of Book Value
I have a few final thoughts on financial statements. Looking at what happens to book value per share is a helpful measure. Book value is your bank account at the company. It tells you how much you have earned and have on deposit with the company. When companies take huge write downs or big bath charges, they show up in a reduction in shareholder equity and book value per share. Over the last decade, companies went on a buying binge, issuing stock to buy companies in order to bolster sales growth or buy earnings. In many instances, they overpaid for the companies they bought. This has resulted in a dilution of shareholder value and the impairment of assets on the balance sheet. A recent example of what can happen to shareholder equity is taken from the financial statements of JDS Uniphase.
|Balance Sheet||1998||1999||2000||1Q 2001|
(All in Millions)
|Number of Shares||643.69||935.93||1,318.2||1,323|
|Book Value per Share||$5.62||$26.47||$8.12||**$7.20|
|* reduced by accumulated deficit of $57,224 billion ** estimate based on recent SEC filings Source: Edgar Online|
As the brief financials above illustrate, JDS Uniphase's assets and shareholder equity grew over the last four years as the company grew through acquisitions. It did this by issuing new stock to make its purchases. The amount of shares increased from 306 million shares outstanding in 1997 to 1,323 billion as of 9/30/01. In the process of issuing new shares to make acquisitions, shareholder equity and book value increased from $.71 in 1997 to their peak in 1999 at $26.47. Capital surplus through the issuance of new shares grew from $307 million in 1997 to $68,047 billion in 2000. Since the second quarter of 2000, losses and write downs have reduced both shareholder equity and the book value of each share. The capital surplus of $68,047 billion has been reduced by impairment of assets, losses and writes downs that resulted in an accumulated deficit of $57,224 billion. This reduced shareholder equity and reduced book value per share by 73%. Analysts and investors may dismiss such losses, but they do have a way of catching up as the following graph illustrates. From its peak back in March of 2000 at over $150 a share, the company stock has fallen by 94% to today's current price of $9.17 a share.
So, Who Benefits From "Goodwill"?
Traditionally, goodwill has been written-off against earnings over time. That has changed over the last few years as companies have taken huge write downs due to issuing new stock to pay over-inflated prices for takeovers. In an effort to hide the numbers from shareholders and analysts, the companies have turned towards pro forma numbers which exclude these gigantic write-offs. The result has been the kind of numbers you see above. In the case of JDS Uniphase's acquisition of SDL Inc., a laser manufacturer, the acquisition created goodwill on the balance sheet of $37.4 billion. That goodwill, along with other goodwill of $6.1 billion made in other acquisitions, has finally been cleared from the balance sheet. In its most recent 10-K filing with the SEC, the company admits that its acquisition strategy has been expensive. The company paid executives of SDL $300.9 million to amend their change in control agreements.
Goodwill has traditionally stood for the value of franchises and brand names. The value of a business product or brand image is worth something. A good example is the brand recognition of Coca-Cola which is ubiquitous. The value of the Coke franchise means something to shareholders. It has taken a century to build. In my opinion, the stock market bubble of the 90's disparaged the meaning of goodwill as it began to represent fluff. It represented overpayment for the inflated stock prices of companies. Many of whom had very little in the way of assets, sales or profits. It was both a bi-product and casualty of the era. Companies still pay for it when they acquire another company. It is carried as an asset on the balance sheet. It does signify something to you as a shareholder because you're paying for it. Let's hope what you pay for and what you get actually have some value. If it doesn't, the above example of JDS' financial statements and accompanying chart can be the result. It is one more reason why investors need to understand financial statements.
Who Are We To Believe?
If this all seems overwhelming, it is. Even professionals in the business can't agree on what constitutes legitimate earnings. The accounting for financial statements has become more complex and strewn with potholes. Recently, the Wall Street Journal documented how confusing earnings calculations have become by comparing the differences in second quarter earnings for the S&P 500 companies. The S&P, a unit of McGraw-Hill, which compiles the index, said that second quarter earnings for the S&P 500 companies fell 32.9% to $9.99 a share. Thomson Financial/ First Call put the second quarter decline at $11.81 a share or a decline of only 17%. The difference between the two organizations reflects a growing gap over the expenses companies should be allowed to exclude or treated differently in their so-called operating-earnings figure. S&P is taking a tougher stance against companies by refusing to exclude expenses it considers to be part of the normal operations of the company. First Call, on the other hand, follows the lead of analysts, who back out many of those expenses to make earnings appear bigger.
It depends on what your definition of 'is' is ...
The debate is important if investors want to avoid what I've illustrated above with JDS Uniphase. The phrases, operating earnings and operating income, differ from net income and carry strict definitions under GAAP. Just about all of the expenses which companies call "special", and are excluded by most analysts, are treated as regular expenses under GAAP. GAAP requires that these expenses can't be excluded. They aren't excluded in 10-K filings with the SEC. However, on Wall Street, we are dealing with fuzzy math. Despite the questionable practice, Wall Street and investors follow operating earnings. When you hear that a company either meets or beats estimates, it is usually the operating numbers that they're talking about. The problem, as the chart below indicates, is the gap between what is being reported and what is required under GAAP keeps widening.
So what is an investor really paying for a stock? The answer of course "depends" on what you are counting as earnings. In this new era of investing and make believe, that number can be almost anything you want it to be.
This is the dilemma the investor now faces when making an investment decision. What do you base your decision on -- make believe numbers or the real thing? The question that should now be posed by analysts and investors goes back to an old commercial, "Where's the beef?" Just as accounting numbers are strewn with potholes, the investment business is strewn with conflicts of interest, lots of them. It is not unusual today to hear the sell side of the firm projecting higher targets for the major stock indexes, while the other side of the firm is downgrading the very same companies that make up the S&P 500 or the Dow. Most sell-side analysts spend most of their time flying around the country, drumming up business, and supporting the investment banking division. When do you ever hear sell recommendations? On Wall Street, the sun always shines. There are never any clouds. There is no such thing as winter. The constant mantra is buy, buy, and buy.
The sad truth in all of this is that close to $6 trillion in investor wealth has now disappeared. This compares to the losses of close to $1 trillion in the crash of 1987. As of this writing, the Dow is down 18% from its peak back in January of 2000. The S&P 500 is down 27% from its top of 1527 in March of 2000. The Nasdaq is where most of the losses have occurred. From its zenith reached in March of last year, the Nasdaq has lost over 64%. The biggest reason for this collapse has been the inflated valuations given to companies based on accounting smoke and mirrors. Corporations and Wall Street have learned well from Washington. They know how to play the numbers game. They honed it, refined it, and have become masters of the game. There is very little oversight. What little there is can be influenced or bamboozled.
So the next time you are ready to buy a stock based on the company beating expectations, have as second look. Look at net income or the bottom line. These are the real numbers according to GAAP. Forget the pennies. ~ JP
by James J. Puplava
November 9, 2001
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