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Posted 10/3/2002

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The Speculator

Recent articles:
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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.

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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 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.

MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.