Financial Fine Print Uncovering a Company’s True Value phần 4 pot

And unlike other numbers that require investors to digthrough the fine print, companies often tout these “special” chargeswhen they first report their quarterly results.. In their quarte

important, though it will not provide details on when ment is being overly aggressive with their accounting

manage-“If you’re going to do research, you have to dig in,” says DaveHalford, of Madison Investment Advisors and the Mosaic FundGroup “There’s no easy way to do this.”

Colette Neuville can certainly attest to that

EACH QUARTER,COMPANIESannounce billions and billions ofdollars in charges that investors are told to ignore becausethey’re described as one time, or nonrecurring, or unusual, or someother word meant to conjure up a unique set of circumstances thatcan only take place when Jupiter aligns with Mars Even when thenext quarter or next year rolls around and the same companyannounces another set of suspiciously similar charges, few people—analysts, financial journalists, and especially individual investors—stop to question whether it’s really appropriate to treat theseexpenses as one-time events

The charges themselves have a broad range of thing from asset markdowns to merger-related expenses to restruc-turing charges And unlike other numbers that require investors to digthrough the fine print, companies often tout these “special” chargeswhen they first report their quarterly results The idea behind this is

names—every-for investors to think about the company’s earnings as if these pesky

CHAPTER 4

Charge It!

In their quarterly earnings releases, companies typically describethis as pro forma earnings or operating earnings, names that have

no specific meaning and that give companies lots of flexibility topresent their earnings in the best possible light.*While operatingearnings often can be a more useful tool than net income in eval-uating a company’s future performance, the lack of rules hasprompted many companies to take an overly broad approachwhen it comes to counting routine expenses as “special” items

“There’s 10 different ways to define operating earnings It’s alittle like a recipe,” says Bruce Gulliver, chief investment officer forJefferson Research, a boutique research firm in Portland, Oregon.For the most part, stock analysts have played along by excludingthese one-time charges from their quarterly earnings estimates,such as those provided to Thomson/First Call, which are widelyavailable online Business journalists have also played a role byreporting on whether a company missed or met its earnings esti-mates, often without fully explaining the types of expenses thathave been excluded

But we investors also bear some responsibility by focusing toomuch of our attention on whatever “headline number” the companyfeeds us in its quarterly earnings release, without bothering to checkthat number against those disclosed in the company’s 10-Q and10-K filings By deducting all sorts of expenses, many companieshave been able to report pro forma results in their earnings releasesthat are substantially better than those reported to the Securities

* It’s pretty easy for investors to confuse operating earnings with operating income, but the terms don’t mean the same thing Operating earnings is a pro forma number that subtracts some costs and expenses from net income but doesn’t exclude others What’s included and excluded can change from quarter to quarter

or year to year, which is why this “number” is talked about only in quarterly press releases and never in the company’s SEC filings.

and Exchange Commission (SEC) several weeks later, when few of

us are still paying attention

A new SEC rule—Regulation G—which went into effect inMarch 2003, makes it a lot easier for investors to see the differencebetween the two numbers Under this new rule, companies thatreport pro forma earnings to investors are also required to explainhow (and why) the number differs from net income as defined bygenerally accepted accounting principles (GAAP) Even before thenew rule went into effect, many companies began touting theirGAAP results in press releases, in an effort to reassure investorswho had grown wary of pro forma results Of course, it’s important

to remember that GAAP still gives companies a great deal of way because under the accounting rules, companies need to makeall sorts of choices that can have a huge impact on the bottom line.(For more on this, see Chapter 2.) As a result, even companies thattout GAAP numbers in their earnings reports may still be makingaggressive accounting assumptions—information that’s really dis-cernable only by reading footnotes in the 10-Qs and 10-Ks

lee-When it comes to quarterly earnings releases, most companies try

to focus investor attention on the good news, such as their pro formaearnings, before segueing into GAAP net income, which is almostalways lower The truth—or at least the most interesting number—usually lies somewhere between the two, which is why it’s important

to pay close attention to the special charges Compare both thepro forma and GAAP results side by side—something that’s mucheasier thanks to the SEC’s new Regulation G If there’s a big dif-ference between the two numbers, it pays to dig a bit deeper andpoke through the footnotes for more details on these charges

SE A R C H TI P

New rules were needed because during the late 1990s, proforma reporting had become endemic The problem was so pro-nounced that in December 2001, the SEC even issued a highlyunusual warning to investors to treat pro forma earnings with sus-picion because they “might create a confusing or misleadingimpression.”1 In 1992, only 31 companies in the Standard andPoor’s (S&P) 500 reported a one-time charge By 1999, more thanhalf had taken at least one special charge By the end of 2002, only

58 companies in the S&P 500 index did not announce any special

charges, according to Thomson Financial/Baseline This growinguse of pro forma numbers was occurring despite the SEC’sDecember 2001 warning and at a time when accounting scandalshad jangled many investors’ nerves

One of the biggest critics of this trend has been Warren Buffett

In his 2002 letter to shareholders, Buffett snidely noted thatBerkshire Hathaway would “make a little history” by reporting proforma results that were lower than the company’s GAAP results—something he said no other company he knew of had done

“If you’ve been a reader of financial reports in recent years,you’ve seen a flood of ‘pro forma’ earnings statements—tabula-tions in which managers invariably show ‘earnings’ far in excess ofthose allowed by their auditors,” Buffett wrote to shareholders “Inthese presentations, the CEO [chief executive officer] tells his owners

‘don’t count this, don’t count that—just count what makes ings fat.’ Often, a forget-all-this-bad-stuff message is delivered yearafter year without management so much as blushing.”2

earn-Not too long ago, the only time that companies really talkedabout pro forma results was when they had merged with anothercompany and wanted to provide investors with some basis of com-parison But sometime in the late 1990s, a few Internet companies

On January 24, 2001, Qwest Communications released what it called

“record revenue and earnings,” noting at the top of its earnings releasethat this marked the 15th consecutive quarter that the company hadeither met or exceeded analysts’ earnings expectations Net income,the company said, was up 44 percent for the fourth quarter to $270million and 54 percent for the year to $995 million—impressivenumbers to be sure These same figures were repeated over andover again that day and the next in various media reports aboutQwest’s results (For more on Qwest, see Appendix B.) Reporters atthe two Denver newspapers, where Qwest was based, described

the results as outstanding Even The Wall Street Journal’s story on

Qwest the next day noted how well the company was doing whencompared with more traditional competitors like AT&T, Sprint, andWorldCom, companies that the article noted were struggling at thehands of more nimble competitors like Qwest.*

Investors snapped up Qwest’s shares on January 25, sendingthe stock up by $2.44 in very heavy trading to close at $47.06 Theproblem, however, was that net income as reported by Qwest wasn’tactually net income, a term that has a specific meaning under GAAPrules, though investors would have had to have carefully read therelease to figure this out Using the GAAP definition, Qwest’s resultsweren’t quite as spectacular as had been reported and, had they beenmade available to investors that day, would have painted a sharply dif-ferent picture of the company Nearly two months later, in Qwest’s10-K filing, the company reported a net loss of $116 million (vs the

$270 million in pro forma net income) for the quarter and an $81million net loss for the year (a far cry from the $995 million in proforma income) Yet, in the days after Qwest filed its 10-K not a singlenewspaper noted the discrepancy between the two sets of numbers

* “Qwest Net Soared, Up 44% on Strong Sales of Services,” The Wall Street Journal, January 25, 2001, p B6.

IN FO C U S

began deducting various expenses that they considered to beextraordinary—Amazon.com regularly deducted its marketingexpenses, for example, descrbing them as unusual expenses—enabling many companies to report substantially better pro formaresults than they otherwise would have had they used GAAP rules.

As more and more companies began to realize that investors didn’tseem to mind the pro forma results—remember, ignorance wasbliss—and were even rewarding companies based on these rosierresults, many more decided that it made sense for them to reportresults in this way too

Given investors’ reactions to rosier pro forma results, somecompanies began excluding special charges quarter after quarter,assuming—correctly, it turns out—that few people would notice apattern Even when the charges were huge or were taken repeatedlyand for the same or similar-sounding reasons, few people seemed toask questions

For example, Cendant Corp., a New Jersey–based consumerservices company whose brands include Avis, Days Inn, and JacksonHewitt tax preparation services, took 20 special charges—one foreach quarter—between January 1998 and December 2002, accord-ing to Reuters Information Network That was more than anyother company during that period and seems more than a bitbrazen, given Cendant’s history of aggressive accounting During

Look carefully at companies that report big differences betweentheir pro forma earnings and net income Ask yourself what thereason is for the gap and try to determine what expenses arebeing excluded

RE D FL A G

that time, these “special” charges added up to nearly $5 billion,according to Reuters Other companies that have consistentlytaken one-time charges according to Reuters include CardinalHealth, HCA, Kroger, Motorola, and Yahoo! (See Exhibit 4.1.)

Why would any company want to repeatedly announce bigcharges? Because as long as everyone was happily ignoring thesecharges, it was easy for companies to brush away all sorts of baddecision making Not only were these charges able to help thecompanies exceed earnings expectations and enhance importantvaluation ratios, such as their price to earnings ratio (P/E) for thecurrent quarter or period, but they also laid the groundwork thatwould enable companies to make future earnings look better aswell Individual investors, however, don’t fare as well because thevarious charges make it much more difficult for us to figure outwhat’s really going on

“The economy was deteriorating and companies didn’t want toreport poor earnings,” says Mitch Zacks, president of Zacks Invest-ment Research, which, like Reuters, began tracking these specialcharges at the request of large institutional investors who havebegun to pay a lot more attention “Big institutional investorsknew what was going on, how Motorola and the other companieswere constantly able to beat their earnings expectations But smallinvestors really got burned by this because they didn’t come to thetable with this history.”

Be wary of companies that seem to take “special” charges quarterafter quarter or year after year

RE D FL A G

Something Special’s in the Air

The listed companies repeatedly took “special” charges or gains during the 20 consecutive quarters between 1998 and 2002.Investors and most Wall Street analysts have long ignored such

“special” situations when calculating earnings because the itemswere considered to be nonrecurring But some companies seem

to take nonrecurring charges (or gains) pretty regularly, includingthe six companies at the top of this list, which had a “special”charge or income every single quarter over the five-year period

Source: Reuters Information Network.

Sun Microsystems 17

Consumer products giant Procter & Gamble (P&G), forexample, launched a large restructuring plan in July 1999 and pro-ceeded to take restructuring charges, which the companydescribed to investors as “one-time” items, through June 2003.Over those four years, the company took an estimated $3.6 billion

in restructuring charges, or about $900 million each year, creating

a significant gap between net income and the “core earnings” thatP&G, analysts, and the media tended to focus on In December

2002 P&G said that it would stop reporting two sets of numbers atthe start of its fiscal year in July 2003.3

Not only do big charges make future earnings look betterbecause most investors simply focus on the absolute change betweenthe two numbers, but companies sometimes wind up reversing apart of that charge at some point in the future, which also boostsearnings One simple way to think about this is how you feel afterfinding a $20 bill that you thought you had lost stuffed deep in apocket somewhere You feel richer, even if you’re not When acompany takes a big charge, the money is gone, until the chieffinancial officer (CFO) finds it again and turns it into earnings.Companies practically never tout these reversals—after all, it isfound money—though the details usually can be found in thecompany’s footnote on restructuring

In a 1998 speech at New York University called “The NumbersGame,” former SEC chairman Arthur Levitt warned that the SEChad begun to notice a pattern of companies taking large restruc-turing charges, only to reverse a portion of these charges later on,creating earnings In the speech, Levitt warned investors to payattention to large restructuring charges But few investors, includ-ing many large institutional players, heeded his call “Why arecompanies tempted to overstate these charges? When earnings

take a major hit, the theory goes, Wall Street will look beyond aone-time loss and focus only on future earnings And if thesecharges are conservatively estimated with a little extra cushioning,that so-called conservative estimate is miraculously reborn asincome when estimates change or future earnings fall short.”4Recently the SEC has begun to focus a lot more attention oncompanies that take big charges, particularly those that have done

so repeatedly In a November 2002 speech to members ofFinancial Executives International, a group largely comprised ofCFOs, SEC commissioner Cynthia A Glassman compared thispractice to a football team constantly coming up with new andever-more creative reasons on why they lost an important game

“The clever ones always take different one-time charges,” Glassmantold the group.5

In March 2003, as part of the new rules required by Oxley—federal legislation passed in July 2002 that was designed toreign in corporate fraud—the SEC introduced a rule that isalready putting the corporate creativity Glassman described to thetest Under the new rule, companies can no longer take a one-timecharge when there’s a reasonable likelihood that they will need totake a similar charge within the next two years or if they have done

Sarbanes-so within the previous two years The rule was established to vent some of the abuses that took place at both Tyco andWorldCom, companies known as serial acquirers because much oftheir business strategy was based on buying other companies.Immediately following the acquisitions, Tyco and WorldComwould take large restructuring write-offs—charges that sometimeseven exceeded the purchase price of the companies acquired.Then the process would be repeated after the next acquisition,with investors once again told to ignore the charges