Corporate earnings are finally on the rebound, and investors are celebrating. But here's a sobering trend: Companies continue to announce earnings write-offs, often viewed as an admission that past results were overblown, at a rate that's far above the norm for previous economic recoveries. In fact, the current wave of write-offs -- the largest in history, at $400 billion in 2001 and 2002 -- has helped create "the worst quality of earnings in more than a decade," says David Bianco, an accounting analyst at UBS (UBS) The trend is likely to continue. Although UBS expects the dollar volume of write-offs to decline this year as the economy brightens, "on average, the frequency and amount of one-time charges has been increasing," Bianco says. In short, write-offs, which used to be infrequent, are now far too common. As a result, you can't analyze a company's income statements without parsing these special charges for restructuring operations and marking down the value of assets on the books. That's why this installment of The Fine Print, an occasional series examining financial statements and other corporate disclosures, is devoted to showing you how to find these charges and weigh their impact on the bottom line.
Recurring write-offs can make it hard to decipher a company's true performance. Consider International Paper (IP) The Stamford (Conn.) company has taken a charge against earnings in each of the past six years. And the tab -- $5 billion pretax -- keeps rising, according to Carol Levenson, director of research at independent bond researcher Gimme Credit. This year, the paper giant announced an additional $100 million in restructuring charges, with more likely to come, Levenson predicts. The write-offs, she says in a recent report, make it "nearly impossible to get a handle on International Paper's normalized earnings." That, of course, makes it difficult to value the stock. A spokesperson for the company responds that the restructuring has improved "our core business and made us a stronger company."
The first place to look for write-offs is the income statement. There, companies often voluntarily segregate charges from other expenses. Why? To encourage investors to look upon them as different than routine operating expenses such as "selling, general, and administrative" costs and treat them as a one-time problem.
That's how telecommunications-equipment maker Avaya (AV) presents charges in the 2002 income statement found in its amended 10-K. Since it was spun off from Lucent (LU) Technologies in 2000, the Basking Ridge (N.J.) company has disclosed three types of charges on its income statement. By far the biggest: "business restructuring charges and related expenses."
For more information, flip to the footnotes. There, Avaya itemizes these charges in a table. The totals: $684 million in fiscal 2000, $872 million in 2001, and $229 million in 2002.
Not surprisingly, Avaya has earmarked most of the money for layoffs and lease terminations. Of 2002's $229 million charge, for example, the company allocated $116 million for layoffs and $84 million for leases it no longer needs (table). Avaya also reduced the value of assets on its balance sheet by $7 million. Why? Current values are now below those on the books.
Although charges for such "asset impairments" -- the term in the financial reports -- require no cash outlays, they are troubling, since they're an acknowledgment that the asset won't generate as much future profit as expected, says Charles Mulford, an accounting professor at Georgia Institute of Technology. In 2000 and 2001, Avaya took asset-impairment charges of $95 million, according to the expanded version of the table in the footnotes.
TOO FUZZY. In 2002, Avaya benefited from a $20 million reversal. When companies -- either intentionally or accidentally -- set aside more than is necessary to complete restructuring programs, they are required to "reverse" the excess by releasing it into earnings. The bulk of the $20 million reversal -- $13 million -- resulted from "fewer employee separations than originally anticipated," Avaya explains.
Although generally small, reversals can make a difference. In the fourth quarter of 2001, a $35 million reversal added an estimated 7 cents to Avaya's earnings-per-share. In the second quarter of 2003, the company reversed $17 million, adding 4 cents to the bottom line. Since profits from reversals have nothing to do with a company's operations, Mulford advises investors to ignore them.
The table also discloses how much progress Avaya has made in completing its restructuring plans. This is important because the Securities & Exchange Commission encourages companies to finish restructurings within a year of their announcement, says Dennis Beresford, accounting professor at the University of Georgia. Because charges are estimates, one way to improve their accuracy -- and cut down on reversals -- is for companies to calculate the cost of maneuvers such as plant closings just before they occur, says Beresford.
SMART FORMULA. Some of Avaya's restructuring reserves have been outstanding for longer than a year. For instance, at the end of fiscal 2002, the table lists a $170 million balance -- hence, a $170 million "business restructuring reserve" on the liability side of the balance sheet. As of june, the balance was down to $81 million. A company spokesperson says although the company implemented its plans within a year, some obligations have taken longer to pay down.
To make sure you haven't missed anything, scan the footnotes beyond the table. In 2002, Avaya reveals a $17 million charge for soured investments in other communications companies. That's deducted from "other income" on the income statement.
To assess the impact of write-offs on the bottom line, you should treat recurring charges as a normal cost of doing business, just as you would salaries or overhead. UBS' Bianco calculates the average annual cost of write-offs over several years -- 10, if possible. Then, he subtracts that average from the bottom line, ignoring the actual charges. The result: a version of the bottom line that takes write-offs into account without the boom-and-bust volatility you would get by looking at the printed numbers. In an era in which "special" charges are, unfortunately, anything but special, it pays to do the math. By Anne Tergesen