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Posted
10/3/2002 |
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The Speculator
The earnings gimmicks roll on
With mistrust growing,
you'd think companies would place a premium on straightforward,
transparent bookkeeping. Think again. It still takes a lot of work
to slice earnings to the core.
By
Victor
Niederhoffer and Laurel Kenner
This absurdity destroys the credit of the
story.
-- Du Mont, Voy. Levant (1696)
If
investors agree on one thing nowadays, it's that we need
transparent, nondistorted financial statements to restore trust in
Corporate America.
You'd think
that every executive of a major company would lean over backward to
avoid being perceived as managing earnings, for the good of the
business world as well as their own stockholders.
The time
when a company could expect applause for pulling a rabbit out of the
hat to meet earnings forecasts -- say, by selling one of the
businesses it had acquired over the years -- would seem to be over.
But apparently, some companies don’t feel this way.
General Electric (GE,
news,
msgs),
for example, announced Sept. 25 that it expected to meet
third-quarter earnings projections. Wonderful, the market said. GE
shares rose 4.3%. The next day, it came out at a news conference
that the forecast would be met by selling a business unit, Global
eXchange Services. Disappointed investors sent GE down 2.3%. By
Friday, when they figured out that GE had loaned the purchase money
to the buyer and had even taken back a 10% interest, they were more
than ready to laugh GE out of town. The 9% loss over those two
sessions took some $25 billion off the market capitalization of the
world’s most valuable company.
GE may have a great reason
for the sale, but, as the company has repeatedly told The
Speculators to refrain from contacting it, we can’t report any
explanation at all. What’s clear is that GE’s decision cost its
shareholders dearly at a time when the need to be beyond reproach is
more than evident.
It's an old
trick
Such a reaction wasn’t exactly unprecedented. In
February, IBM (IBM,
news,
msgs)
took a 5% hit after The New York Times reported that the company
used the sale of a unit to lower fourth-quarter operating expenses,
instead of reporting the sale as a one-time gain. The demise of
Enron (ENRNQ,
news,
msgs),
WorldCom (WCOEQ,
news,
msgs)
and Arthur Andersen over the past several months after the
disclosure of earnings misstatements and cover-ups has made
investors skeptical even of squeaky-clean companies with cash from
operations soaring to the moon and no nonrecurring items of any
kind.
Yet GE’s skill in managing earnings to meet analyst
expectations has been known for years -- and until recently,
renowned. Carol Loomis, writing in Fortune in August 1999, observed
that after The Wall Street Journal published a front-page story in
1994 detailing the many ways that Jack Welch and his team “smoothed”
GE’s net income, American International Group (AIG,
news,
msgs)
and Cigna (CI,
news,
msgs)
called to say, “Well, this is what companies do. Why is this a
front-page story?” (We suspect that many other companies read the
article to see how it was done.)
Former SEC chief Arthur
Levitt declared war on managed earnings back in September 1998. In a
dinner speech at New York University, the audience put down their
forks and started taking notes when Levitt said many executives and
auditors were playing “a game of nods and winks” to meet or beat
earnings projections in order to pump up market capitalization and
increase the value of management’s stock options. Levitt asked
Corporate America and Wall Street to stop using accounting gimmicks:
no more big write-offs for restructuring charges, future operating
expenses or “in-process research” to make future earnings look
better, no more stashing profits in ‘cookie jar reserves” to bring
out later, no more booking sales before delivery takes place, no
more quibbling over how big a lie has to be before it’s “material”
under Generally Accepted Accounting Principles.
The
“better-than-expected earnings” game has been a longtime favorite
for corporations and their Wall Street cheering section. Come
recession, come boom, come 100-year interest-rate events, come
terrorist attack, some 60% of the S&P 500 ($INX)
has consistently “beat” analysts’ forecasts. Here is the
distribution percentage of positive surprises for S&P 500
companies, collected two months after the quarter has ended:
| S&P 500 positive
surprises |
| Quarter |
|
% of companies that 'beat'
expectations |
| Q2 2002 |
|
60.1% |
| Q1 2002 |
|
62.1% |
| Q4 2001 |
|
55.3% |
| Q3 2001 |
|
51.2%* |
| Q2 2001 |
|
55.2% |
| Q1 2001 |
|
54.4% |
| Q4 2000 |
|
51.0% |
| Q3 2000 |
|
58.2% |
| Q2 2000 |
|
63.7% |
| Q1 2000 |
|
70.7% | | *This 51.2% had positive surprises even though the
country was shut down for a fortnight.
The question is
not whether they nudge and wink, but how high they’ll take you
before they drop the ball.
Credibility at the core
We wonder how
many other companies have a choice now of deciding whether to meet
earnings expectations by selling a company or asset they acquired
long ago. Let us hope they learn from GE’s experience. Otherwise,
there may come a time when credibility is on the line. If their
response meets the new standards of evaluation, success is assured.
If not, investors will be disinclined to accept at face value any
official statements at all.
Similar turning points can be
observed in politics. If the gap between word and fact becomes so
noticeable that even supporters cannot countenance it, an office
holder will soon find his power on the downtrend. In sports, the
scandal at the Winter Olympics in Salt Lake City indirectly enabled
American figure skater Sarah Hughes to finally gain her
well-deserved recognition. According to sportswriter Rick Reilly,
Hughes had been the best for some time. But only after the public
humiliated the judges in the pairs skating competition were the
Olympic figure skating judges able to do the right thing and give
the nod to Hughes.
Standard & Poor’s, the securities
rating firm, has introduced a method of calculating earnings that is
designed to reduce earnings distortions. The new measure, called
“core earnings,” adjusts net income to include:
- expenses from stock-option grants
- restructuring charges from ongoing operations
- write-downs of depreciable or amortizable operating assets
- pension costs
- R&D expense assumed through acquisitions.
The
measure excludes:
- gains or losses from asset sales
- pension gains
- unrealized gains or losses from hedging activities.
In
some cases, the change would be quite material. GE, for example,
reported net income of $1.42 a share in 2001. If the company had
excluded gains from pension investments, however, earnings would
have been $1.11, according to S&P.
Cisco
Systems (CSCO,
news,
msgs)
reported net income of 14 cents a share in fiscal 2001. If Cisco had
included stock-option expenses, that would have been a 35
cents-a-share loss, S&P said.
It might be good for
executives as well as investors to pay particular heed to these
items when it comes to figuring out how to meet earnings targets.
Unfortunately, merely vowing to change won’t work when
credibility has been damaged too badly. More than 50 companies have
pledged since mid-July to treat options as an expense, responding to
calls for greater transparency in reporting operating costs. We
compared the performance of these “transparent” companies with that
of the S&P 500 and found that they actually lagged the index by
3 percentage points. The 52 companies that took the pledge lost
9.6%, on average, versus a 6.4% loss for the S&P 500.
The buyback signal
One way
that a company can overcome disbelief is to show feeling not with
words but with cash. The corporate analog of this is to buy back
shares. This action signals that the company believes that the
quality of its finance and business is sufficient to make their
stock valuable. Numerous academic studies have confirmed the
superior performance of companies that buy back their own shares. We
reported them in our articles of April 18 and April 25. We also
noted that The Buyback Letter had one of the best newsletter ratings
from Hulbert Digest.
We verified this ourselves by compiling
a list of every company in the S&P 500 that had announced a
buyback since the beginning of 2000 and tracking its performance
over a full year. The close on the day after the announcement was
the buy date. The results, published in our April 18 column, showed
that 224 companies outperformed the S&P 500 by an average of 30
percentage points a year, a one-in-100 million shot by chance alone.
Note that when a company announces it is buying back its
stock, it often does not follow through right away. Many people tend
to be skeptical of buyback announcements because of this potential.
We do not agree with this skepticism. A company’s buyback
announcement signals that management believes the stock is
undervalued. If the stock immediately goes up based on this signal,
so much the better. The signal was enough to do the job. We have
found no evidence that companies that do implement buybacks (which
can be monitored by noting the number of shares outstanding in the
corporation’s consecutive quarterly reports) perform better than
those that do not.
We have been running a tally of S&P
500 companies that announced buybacks in 2002. Since our last update
on Aug. 29, we have added the following 15 companies to the list:
| Companies with
buybacks |
| Company |
Date of buyback announcement |
| John Hancock Financial (JHF) |
8/21/2002 |
| Principal Financial Group (PFG) |
8/29/2002 |
| Yahoo (YHOO) |
8/29/2002 |
| Exelon (EXC) |
9/3/2002 |
| TMP Worldwide (TMPW) |
9/3/2002 |
| Albertson’s (ABS) |
9/6/2002 |
| Baker Hughes (BHI) |
9/10/2002 |
| Thermo Electron (TMO) |
9/12/2002 |
| Colgate-Palmolive (CL) |
9/13/2002 |
| Darden Restaurants (DRI) |
9/18/2002 |
| Biomet (BMET) |
9/23/2002 |
| Paccar (PCAR) |
9/24/2002 |
| Wells Fargo (WFC) |
9/24/2002 |
| Marathon Oil (MRO) |
9/25/2002 |
| Travelers Property Casualty (TAP.B) |
9/25/2002 | |
So
far, the average performance for the entire group of 77 companies
that announced buybacks in 2002 is -8%. This is 6 percentage points
better than the comparable performance of the S&P during the
period. We will make the full list available to those who write us
at request@dailyspeculations.com
with suggestions, comments or critiques of our columns.
Final note: We thank Gitanshu Buch and Shi Zhang for
contributing to this article.
At the time of publication,
neither Victor Niederhoffer nor Laurel Kenner owned or controlled
any of the securities mentioned in this
article.
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