The diminished quality of financial reporting and some creative accounting practices are making some companies look better than they are.
Earnings reports have been coming up rosier than ever for the first quarter of 2000, up about 20 percent from the corresponding period last year. As a result, many market strategists think stocks soon will resume a steady upward climb.
But there is growing concern among some accounting professionals that many companies are relying on financial alchemy to burnish their results.
More companies are investing in other companies' stocks, for example, bolstering their own earnings when they sell shares at a profit. Experts say such gains _ like those recorded for the rising value of a company's pension funds, or those helped by adjusting assumptions about the depreciation of assets _ can obscure the results from a company's operations.
Yet with many stocks trading at sky-high multiples of their earnings, at least on a historical basis, assaying a company's true financial position has never been a more important exercise for shareholders.
Lynn Turner, chief accountant at the Securities and Exchange Commission, is concerned about the diminished quality of financial reporting. As such, he finds himself on something of a crusade.
"I've been reminding financial professionals to tell the truth, the whole truth and nothing but the truth," Turner said. "And I tell investors they should be forewarned to read each public filing and not rely on any particular document when making financial decisions."
Turner knows this is an uphill battle, at least where the average investor is concerned. Poring over SEC filings is rarely anybody's idea of fun.
Unless, that is, the person doing the examining is Robert Olstein, a veteran accounting expert and manager of the Olstein Financial Alert mutual fund. Olstein, whose fund buys shares of companies with solid earnings and occasionally bets against those whose numbers are dolled up to look better than they are, likes nothing more than to dissect company financial statements.
The work has paid off.
Although the broad market averages have been down for the year, Olstein's fund has turned in a gain of 5.67 percent. It has gone up 25.7 percent a year, on average, since it started in 1995.
"We believe the best long-term investing performance is associated with making the fewest errors," Olstein said. "So we are always looking around and between the numbers to see what a company's real or repetitive earnings are."
After parsing the recent crop of annual and quarterly reports, Olstein has identified popular accounting practices _ all perfectly legal _ that help companies give their results a glossier look than they would have based on operations alone.
"Investors have to be on the lookout for anything that masks a company's true position," he said.
Here is a tour of some of the bumpier parts of the earnings topography, with Olstein as the guide.
More and more companies that report impressive earnings today do so with a little help from the bull market, Olstein said. Gains from the sale of securities have become a bigger piece of the earnings pie.
For example, in its most recent quarter, Bank of America reported gains on equity investments of 8 cents a share, or 6 percent of its earnings of $1.33 a share.
Although Bank of America can take pride in its investing prowess, such gains may not continue forever. So Olstein thinks investors should consider these types of gains as icing on the cake rather than the cake itself. (His fund does not hold a short interest in Bank of America, or any of the other stocks mentioned in this report.)
A company with securities gains of a different sort is American Express. In January, the company reported a $154-million pretax gain on its sales of credit card receivables during 1999. It did not attribute any earnings to the sales, saying it invested the gains in marketing and promotion programs to increase card use and the number of cards in force.
But Olstein reckons that American Express' earnings would have fallen had it not been able to cover those marketing costs with the proceeds of the securities sales. Indeed, he says, the sales of receivables accounted for about 22 cents a share in earnings, or almost 4 percent of the company's net income for the year.
Further, because these gains were one-time in nature, he said, they should not have been used to offset a continuing business expense such as marketing costs.
The company said it chose to increase its spending on marketing only because of the windfall it received from the securities sale. But Olstein contends that offsetting securities gains with marketing costs is "comparing apples to oranges."
Another effect of the long bull market is the rocketing value of many companies' pension fund assets. Under accounting rules, to the degree that investment growth makes a pension fund's assets exceed its liabilities _ what it is obligated to pay pensioners _ the gains can feed directly into the profits of a company.
Although such profits are wonderful things, Olstein said, they cannot be viewed as favorably by shareholders as income generated from a company's business operations. In other words, the income from pension gains should not be assigned the same multiple as, say, the income from a company's sales of jet propellers or beach balls.
Pension gains can account for quite a bit of a company's net income. General Electric, for example, had total pension gains last year of $1.38-billion, up almost 40 percent from 1998. That amounted to 9 percent of GE's pretax operating income.
Without its pension fund's growth, GE's earnings per share for the year would have been 7.6 percent lower, the company confirms.
Reaching for revenue
Because Internet companies are judged on their revenue growth, that is where investors in such companies should look for oddities, Olstein said.
Consider events last year at that Webvan Group, an Internet grocer based in Foster City, Calif., that went public in November. On Jan. 27, the company said its revenues for the fourth quarter were $9.1-million, up 136 percent from the previous quarter. Gross profit was $1.7-million, up smartly from the $350,000 the company recorded in the quarter before.
According to Webvan's earnings release, some 8.3 percent of the quarter's revenues, $750,000 worth, came from purchases by the company's executives and affiliated companies of goods that were then donated to charity.
While those sales may seem small _ and the purchases certainly showed a generous spirit _ they allowed Webvan to report gross profit that was more than five times the level in the previous quarter. Without the sales, the company's gross profit would have been up a bit less than three times _ not bad, of course, but not nearly as impressive.
Webvan confirmed that the donations were booked as revenues but said that they were part of a corporate giving program started to help local food banks.
When Webvan disclosed the $750,000 in purchases, the company's stock was trading at $15.9375; it closed at $6.1875 UPDATE Friday. Most of the fall was owed to investors' general aversion recently to e-commerce companies' shares. But any investor perplexed enough by this odd transaction to sell saved himself quite a bit of portfolio damage.
Olstein advises that investors beware of companies that overestimate how much their assets, or the equipment they lease to customers, will be worth down the road. Optimistic assumptions allow a company to reduce the amount of depreciation it reports on its income statement each year.
That, in turn, makes earnings look better _ and sets up investors for earnings-damaging writedowns in the future.
One company that may be doing this, Olstein said, is IBM. In its financial report for 1999, the company said the salvage value of equipment it leases, $737-million last year, was rising as a percent of the money owed on the leases (in accounting jargon, the net investment). Last year, the salvage value was 5.2 percent of the net investment, up from 4.8 percent in 1998 and 4.1 percent in 1997.
IBM said the increase reflected the leasing of more advanced products that would retain more value when the leases end.
But Olstein said that given the speed with which technology becomes obsolete, it seemed at best a guess on IBM's part that the salvage value of its equipment would be higher in years hence.
Competition is getting so tough among companies selling telecommunications equipment and other technology that many of them are pulling out all the stops to make a sale. An increasingly popular approach is to finance their corporate customers' purchases of equipment over a period of years.
Cisco Systems, Lucent Technologies, IBM and Hewlett-Packard are some of the companies doing this. Many of those buying the gear are small start-ups that lack the cash to buy the equipment outright. The problem, of course, is that such buyers may never have the cash.
Cisco, which said in its latest quarterly report that its financings were rising, acknowledged the danger. "Although we have programs in place to monitor and mitigate the associated risk," the report said, "there can be no assurance that such programs will alleviate all of our credit risk."
The difficulty for investors in all this, Olstein said, is that some companies, Cisco included, do not specify what portion of their sales are financed. How companies account for these sales often is not clear, either.
A company that provides the clearest disclosure of its financed sales is Lucent, which had sales of $38-billion last year. In its most recent quarterly filing, the company said it had extended credit of about $8.4-billion to customers. Lucent has sold some of its receivables and hopes to sell more, reducing some of the risk.
"It's important that people understand how material it is to the bottom line," Olstein said. "It's fraught with risk. Investors need to know the dollar amount, quarter by quarter."
Or they can just wait to be taken by surprise.