The Earnings Confidence Problem - Part = I

25-Jun-02 14:18 = ET

[BRIEFING.COM - Robert V. Green] In the midst of the more = scandalous market problems, the earnings confidence problem = is not=20 receiving the attention it should. Here is more on the = topic.

The Market Problems

The current market suffers from the following ailments: =

Distrust of management - from excessive comp to = outright=20 fraud. Tyco is the best example.=20
Distrust of accounting - Andersen=20
Distrust of analysts - Blodgett

These three problems get all the press and attention. =

But a deeper problem is afflicting the buy side - a = growing=20 concern about the validity of earnings reporting.

The Earnings Problem

Accounting rules have always been flexible enough to = allow most=20 companies a far amount of flexibility both in revenue = recognition=20 and expense recognition. Even when earnings reporting was = somewhat=20 standardized, some companies were criticized for how they = recognized=20 revenue and expense.

But in the last five years, the types of earnings = that=20 companies have driven Wall Street to focus upon have become=20 questionable.

There are four different basic types of earnings = today:

GAAP earnings: Generally Accepted Accounting = Principles - A=20 standards board that publishes rules on how expenses = should be=20 booked. Generally, all types of expenses are deducted.=20
As reported: Earnings excluding extraordinary items = (as=20 defined by GAAP), changes in accounting charges, charges = related=20 to discontinued operations (plant closings, etc.)=20
Operating earnings: As reported earnings but excluding = "one-time" charges which do not fit the GAAP definition of = "extraordinary"=20
Proforma earnings: Loosely defined "as if" analysis.=20 Originally designed to provide comparison data for=20 mergers.

GAAP accounting principles are guidelines for = accountants,=20 not investors. The GAAP standards are guidelines for how a = company=20 should keep its books, not how the company should report = earnings.=20

For example, a basic principle behind GAAP is that = revenue must=20 be booked over the time period for which services and = product are=20 delivered. If a two year $200,000 contract is pre-paid in = cash, up=20 front, the entire $200,000 cannot be booked in the quarter = in which=20 the contract is signed. However, the revenue does not have = to be=20 booked as $25,000 per quarter for two years. A fair amount = of=20 flexibility, sometimes negotiated by auditors, is possible = for how=20 much of a contract can be booked in each quarter.

GAAP covers expenses as well as revenues, of course.

As reported earnings are the historical standard = for=20 earnings. Until the mid-eighties, in fact, there was little = debate=20 over how earnings should be reported as everyone used "as = reported"=20 earnings as a standard. For the most part, there was no = difference=20 between "as reported" earnings and any other methodology = because=20 one-time charges were not as common. Furthermore, companies = did not=20 actively seek, as they do today, to have certain expenses = classified=20 as "one-time."

Operating earnings are designed to allow = comparisons=20 between quarters and years for a company. One time charges = in any=20 quarter are excluded because these would distort the = comparison.=20 Operating earnings became important when it became clear = that Wall=20 Street would completely ignore any "one-time" charges, and = focus=20 solely on earnings growth. This provided a strong incentive = for=20 companies to classify large expenses as one-time charges. =

An example of one company's aggressive attempt to get = charges=20 classified as one-time was Excite's 1997 $40 million = marketing deal=20 with Netscape. Now long forgotten, Excite paid Netscape = up-front for=20 a four-year deal to be the principal search engine at the = Netscape=20 web site. Excite tried to classify the entire $40 million = payment as=20 a one-time charge in a single quarter. By doing so, Excite = was=20 almost profitable. At Briefing we highlighted this event as = an=20 indicator of the times. The SEC later forced Excite to = restate the=20 payment as a four-year expense. But many, many companies = were=20 successful in getting major expense outlays classified as = "one-time"=20 which improved income statements.

The focus on operating expenses led to the development of = the=20 "EBITDA" concept, which is "Earnings Before Interest, Taxes, = Depreciation, and Amortization." The EBITDA concept, which = has to be=20 calculated from the line items shown on an operating = earnings=20 report, was designed to show the basic business model of the = company, without regard to cost-of-capital. If capital were = free,=20 then EBITDA would be earnings.

The focus on EBITDA has fallen from favor in recent times = for one=20 single reason: Interest. The interest payments on = bonds,=20 which are excluded from EBITDA calculations, has ruined many = debt-ridden.

Only through focusing on EBITDA projections could a = company like=20 Exodus Communications raise so much debt that their interest = payments exceeded their gross margin. That won't happen = again for=20 decades.

Pro-forma earnings are very hard to define today. = The=20 original purpose of pro-forma earnings calculations was to = show the=20 effects of a merger in a format that allowed a single income = statement to combine only the operating models of each = company, and=20 exclude the actual costs of making the merger.

Under the pro-forma for merger guidelines, pro-forma = calculations=20 could only be used for one year, after which the company = should=20 start reporting as-reported earnings for the combined = entities.

However, companies soon learned that as long as they made = a new=20 merger each year, they could continue reporting pro-forma = earnings=20 indefinitely. This "flexibility" in how earnings could be = reported=20 led to "pro-forma" meanings that were never intended, = including=20 stock option compensation expenses and R&D "in-progress" = write-offs.

The Erosion of Earnings Confidence

The now long-departed CFO of Amazon.com, Joy Covey, was = the=20 unsung hero of bringing pro-forma earnings to the popularity = they=20 enjoyed. She did so by diverting attention away from = standardized=20 earnings reports.

Ms. Covey invented the concept of "EBITMA" which was = defined=20 "EBITDA plus marketing." She was successful in convincing = Wall=20 Street that marketing costs were equivalent to capital=20 investment, a concept which looks ridiculous in = retrospect. But=20 in the early days of the internet, marketing and brand = development=20 was equated with capturing "territory" which, presumably, = everyone=20 thought could never be lost. (Tell that to investors in = Excite.)=20

Nevertheless, Joy Covey was successful in convincing = investors,=20 particularly convertible bond investors, to focus on the = EBITMA=20 concept. It was a crucial element in selling the $2 billion = in=20 Amazon.com bonds that built the company. After all, if you = ignore=20 the interest payments on the bond, and you consider spending = the=20 bond principal on marketing as "not an expense," Amazon's = income=20 statement would look great!.

The problem, of course, is that bond holders don't care = about=20 earnings statements. They just care about the payments. The = jury is=20 still out on whether Amazon.com will eventually be able to = pay the=20 principal on their bonds. (See the Stock Brief of: 14-May-01=20 Amazon.com's Bond Problem.

After Joy Covey established the principle of EBITMA, = internet=20 companies began using all types of non-earnings related = statistics=20 to show growth. Page views, registered users, unique monthly = visitors are just some of the meaningless examples that = became=20 popular. (Surely you remember.)

When "non-revenue statistics" becoming drivers of stock = prices,=20 (around 1998) pro-forma earnings increased in popularity. = After all,=20 a pro-forma income statement that showed some kind of=20 earnings progress looked a lot more "real" than the = phony=20 statistics being coughed up by internet companies.

But when the bubble collapsed, everyone began = questioning=20 earnings quality. It didn't happen overnight, and it didn't = happen=20 all at once. But as a long, slow evolutionary force, = earnings=20 confidence has eroded, and is still present today.

The Aftermath

The evolution of earnings focus over the past 10 years = has led us=20 to today's situation: a basic lack of confidence in many = companies=20 income statements.

Amazon.com still reports earnings on a pro-forma basis. = In their=20 Q1 income statement, you can take your choice of earnings: =

Pro-forma: $25 million profit=20
Operating: $2 million profit=20
Net (as-reported): $(23) million loss

The earnings format you choose is not relevant, = frankly.=20 It is far more important to the stock value what format = the guy=20 next to you chooses.

After all, value to you is primarily determined by = what=20 someone else will pay, not by what you pay.

Even GE

Even solid companies like General Electric have come = under=20 scrutiny because of the extremely complex financial = situations.=20 Unraveling a GE earnings report has now become a major task. = Where=20 GE only had to beat earnings estimates by $0.01 each quarter = to=20 count on an ever increasing stock price, today that is not=20 enough.

GE stock is down 50% in the last two years despite = having only=20 missed one earnings estimate in the last four years and = having=20 continual year-over-year growth in earnings averaging 15%. =

This bears repeating: GE, as representative a stock as = you can=20 get of the overall economy, is down 50% since September = 2000. During=20 that time period, they have grown earnings at over 11% = (year-to-year=20 basis) and beat or met earnings estimates every quarter = except one.=20 The one shortfall was October 2001, the quarter of the = Attack on=20 America and GE was only one penny short.

Why can't GE get any respect? The only definable = long-term=20 culprit is a decline in confidence in GE's earnings numbers. = During=20 the same eight quarter time-period, GE revenue growth rate = has been=20 consistently falling. From a growth rate of 24% and 20% in = 00Q1 and=20 00Q2, growth has steadily fallen, and even was negative for = most of=20 2001.

Flat or declining revenue combined with continuing = increasing=20 earnings leads to only one conclusion: you can't keep = this up=20 forever. Eventually, GE will be unable to book the = earnings=20 number higher than previous years. When (if), that happens, = GE stock=20 will be further devastated. Until then, the slow erosion of=20 confidence causes the stock price to decline.

GE is just one good example of how confidence in earnings = numbers=20 has been eroding over time since the bubble collapse. Until = greater=20 confidence in earnings numbers is established, you can = expect=20 further difficulties in the market overall.

Standard & Poors is now pushing for a standardized=20 calculation for earnings reporting, called Core Earnings. We = will=20 have more on this concept in Part II of this story, to = appear later=20 this week.

Comments may be emailed to the author, Robert V. Green, = at rvgreen@briefing.com =