Our moms always told us not to say anything if we couldn’t say something nice. It turns out that somebody was listening.
Earnings releases from publicly owned companies routinely post the results sunny-side up.
Did the company lose money again? Then company executives want to lead with that big jump in revenues.
Were earnings wiped out by the cost of closing that plant? Then back out the cost and focus on the positive adjusted results.
Are profits still years away? Then shift attention to the cash coming in, even if none of it is left for the shareholders.
The spin that companies put on their earnings releases has created a struggle for investors who focus on the bottom line. Earnings reports are full of adjusted numbers that don’t meet the rigors of an income statement in an annual report. But as long as the numbers are accurate, it’s OK with the feds.
“Generally speaking, we don’t regulate press releases,” said John Heine, a spokesman for the Securities and Exchange Commission in Washington.
In their defense, managements say they’re actually focusing on the numbers that show how the core business is doing. But analysts and others say the scrubbing is sometimes spotty.
Analysts agree, however, that they’re looking less these days at companies’ bottom lines, or net income. They’re skeptical of all the hidden twists and turns managements can take to get there.
“Net income can be an accounting fiction,” said Jeff Potterman, a chartered financial analyst at George K. Baum & Co. in Kansas City.
More and more their holy grail is something called EBITDA (pronounced ee-BIT-dah). It’s been around for decades but its role on Wall Street is expanding.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. The number is bigger than net income because it doesn’t include all those costs for interest, taxes, depreciation and amortization.
For most companies, EBITDA also is a close proxy for the company’s cash flow. And cash flow is one measure that analysts use increasingly to put a value on companies and stock in those companies.
Earnings releases are getting more attention from investors as individuals do more of their own research. Once available only through the filter of the media, earnings announcements show up immediately on Internet sites, open to all.
Releases also have become the financial equivalent of a good-news, bad-news joke. Start with the positive and leave investors to hunt out the painful punch line.
One of the most common twists is to sidestep a big, one-time loss to the company.
The idea is that this big loss was caused by something that doesn’t happen every year. So the company reports the loss but focuses on how high profit would have been without the unfortunate, one-time event.
It’s a fair claim, say analysts who routinely accept such adjusted numbers. But they say that doesn’t mean investors should ignore the loss.
If the company takes a loss because it has to close a plant that still has significant value, it is fair for investors to question management’s decision to build or acquire the plant.
“Every one-time charge indicates that somebody made a mistake,” Potterman said. “And you need to understand why it’s important to the company and its future.”
The issue becomes more important if management seems to produce a steady stream of mistake-driven one-time charges.
L.E. Krueger, an associate accounting professor at the University of Missouri-Kansas City, said Eastman Kodak Co. has gotten a reputation for repeatedly restructuring and charging off restructuring costs.
Such adjustments can be enormous.
Waddell & Reed Financial Inc. had two big one-time losses during its fourth quarter of 1999. The losses cut Waddell & Reed’s net income to only $12.3 million, or 42 percent less than a year earlier.
But the earnings release from the Overland Park, Kan., financial services company focused on “adjusted net income” that excluded the two big losses. An investor reading the announcement was treated to a “40.8 percent increase in adjusted net income per share.”
Moreover, the bottom line reported in the financial table in the release was the adjusted net income without the one-time losses. A footnote sent investors farther down the page to the rest of the story.
To its credit, Waddell & Reed made similar adjustments a year ago that weren’t in its favor. Those adjustments increased profits in 1997, making growth in its 1998 earnings seem smaller.
The adjustments are an effort to keep the comparisons consistent, said Ty Towery, who heads investor relations at Waddell & Reed.
“From the . . . investor to the analyst community, they’re wanting to know what the fundamental business is doing,” Towery said.
The problem is that earnings releases don’t always take out all items extraneous to the company’s field of endeavor.
One of the examples Krueger uses with students is America Online Inc. On Wall Street, AOL often is hailed as one company that actually profits on the Internet.
But Krueger pointed out that gains on investments accounted for more than 70 percent of the profit America Online earned in its fiscal year that ended June 30, 1999. Much less came from subscribers.
American Century Investments employs 15 people just to clean the earnings releases from companies before the fund managers make their picks.
They look at the adjustments management makes and look for ones management doesn’t make.
“That’s one of the main things we do with our system,” said Paul Watkins, manager of research at American Century. “We don’t want any one-time items that skew the numbers.”
For example, Watkins said he recently backed out some of the profits Microsoft Corp. reported. The company had beaten Wall Street’s earnings expectations but a sizable amount of that excess came from investment gains, he said.
Sometimes cleaning up the numbers might mean undoing some of management’s adjustments.
“The question an investor should always ask . . . is are these genuinely one-time events or are they a continuing part of this business?” Potterman said.
There’s an old joke on Wall Street that companies that focus on EBITDA are the ones without net income. But there’s more to the oddly named number than humor.
“EBITDA is a good number to look at any time,” said Watkins of American Century. “It takes a lot of the accounting issues out of the picture and focuses on the cash flow.”
Potterman said EBITDA is a particularly useful measure for investors in an industry that is spending heavily to expand, such as the cable television and cellular phone industries when they were building their networks.
“If you were waiting for a cellular company to become profitable, you missed the boat” to buy stock, Potterman said.
The task for investors is to take apart companies’ earnings releases, instead of taking them at face value.
Figure out the adjustments management made and look for others they perhaps should have made.
You might encounter some free-handed spin. Financial statements in annual reports must follow strict presentation rules.
But management is free to make its own adjustments on earnings releases. There are no guidelines for “all these other back-of-the-envelope calculations,” Krueger said.
