CORPORATE EARNINGS: TRUTH, PLEASE
It's amazing how fast investment psychology can change. Before July, when the bull market stopped in its tracks, Wall Street's mantra was steady "growth of earnings per share." Nothing seemed to matter but those rising quarterly earnings figures. After all, they enriched 401(k)s, fattened options, and created wealth for millions. Twelve hundred Dow points later, and lower, a new realism about the "quality" of those earnings is taking hold. For good reason. Fundamentals matter more when a rising tide isn't floating every company's earnings. They become critical when a profits recession begins to set in, as appears likely.
But investors looking for numbers that show the real picture may be searching in vain. Many corporate managers are stretching accounting rules like taffy to keep the bottom line moving up. Accountants are increasingly reluctant to blow the whistle for fear of jeopardizing remunerative consulting work. And analysts have morphed into cheerleaders and investment banking rainmakers. Truthsayers can get sacked. Just when investors need trusted information, the usual sources have turned fishy. What's going on?
While most attention is focused on accounting disasters that decked Sunbeam, Cendant, and Waste Management, the more widespread problem is the exaggerated use of ordinary practices. A favorite tactic: avoiding goodwill charges in mergers. Take in-process research and development write-offs, popular among high-tech companies that merge. In its $37 billion purchase of MCI Communications Corp., WorldCom Inc. has announced plans to write off some $6 billion to $7 billion of in-process MCI R&D that may have commercial application down the road. Or not. Who knows, really? Yet the accounting maneuver lets WorldCom avoid huge charGes for goodwill in the merger that could have reduced earniNgs by $100 million a year (page 134).
Taking "extraordinary" write-offs again and again is another tactic favored by managers. Since 1991, Eastman Kodak Co. has taken six extraordinary one-time-event write-offs totaling $4.5 billion, equal to all the company's profits for the past 9 years. True, the write-offs stemmed from a drastic restructuring of Kodak. Yet can a company have "extraordinary" one-time events for six out of the last seven years?
Then there is pooling-of-interest accounting, another merger technique. Pooling lets companies avoid goodwill charges by combining their assets at book value. Pooling boosted earnings by $3 billion to $4 billion when USA Waste Services Inc. and Waste Management Inc. combined in a $16 billion deal.
All this is perfectly legal, but many of the accountants and analysts that investors expect to referee the game and protect them increasingly are playing for the other side. Many accountants are under pressure to go easy because their firms want to sell consulting services to the companies they are auditing. A number end up working for the companies they audit. Many analysts succumb to the pressure from the investment banking side of their businesses to pump initial public offerings and support corporate clients.
What is to be done? Investors can look to the growing number of new sources of company data on the Internet. At the least, they should temper the idea of Wall Street analysts as fair-minded observers. Accounting firms should separate their businesses cleanly or face shareholder lawsuits. And corporate CEOs should realize that the economic and financial world has changed in the past few months. Quality is valued when quantity can't be delivered. Let's get back to basics.