Companies call them by all sorts of names: non-comparable, unusual, significant, extraordinary, one-time, non-recurring.
But, to countless investors, the one constant is that these non-recurring charges keep occurring. Despite growing concern about the quality of corporate earnings reports and increased scrutiny by federal regulators, companies are still writing off a host of problems by lumping them into special charges, and encouraging investors to look beyond them.
With the first quarter drawing to a close and investors hungering for improved corporate fundamentals and profit outlooks to sustain the stock market’s rally, look for a renewed focus on earnings quality as companies charge off billions more for impaired goodwill, restructuring costs and other so-called unusual items.
Already, industry heavyweight General Electric Co. has warned of an impending first-quarter write-off of about $1 billion relating to acquisitions as new accounting rules change the way companies treat goodwill–essentially, the difference between what a firm paid for an acquisition and what the hard assets are actually worth on their books.
GE isn’t alone: Hoffman Estates-based retailer Sears, Roebuck and Co. said it will charge off $208 million in the first quarter for impaired goodwill, and late last week, Oak Brook-based McDonald’s Corp. said it would take a charge of $100 million, or 8 cents a share, in the first quarter related to goodwill amortization. Smaller companies are feeling it as well: USFreightways said last week it would take a $70 million first-quarter charge because of the new goodwill rules.
These come on the heels of some stunning one-time charges in 2001–from the $50.6 billion net loss that JDS Uniphase Corp. reported for its most recent fiscal year, mostly due to special charges from acquisitions, to Ford Motor Co.’s revelation in January that it would write off $1 billion because of exposure to price declines in its precious-metals inventory. And of course, there was Enron Corp.’s $1 billion after-tax charge in the third quarter, which proved to be the catalyst for its stunning descent into bankruptcy.
While the biggest charges received the most attention last year, with overall corporate profits in one of the worst slumps since the Depression, the sheer volume of one-time items collectively is staggering–and, some experts argue, misleading.
The Chicago area’s 25 biggest publicly traded companies took nearly $10 billion in one-time, after-tax charges in 2001 or their closest four fiscal quarters–wiping out over a third of what would have been more than $25 billion in after-tax profits.
The overwhelming bulk of those charges came from five big, well-known companies–including Sears, Motorola Inc. and Baxter International Inc.–which together took more than $8 billion in one-time charges, completely wiping out their earnings for the year.
Sears, for example, reported a profit of $1.385 billion, or $4.22 per share–excluding such non-comparable items as “home office and store operations productivity initiatives,” store closings, exiting its cosmetics business and a litigation settlement, which cut net income almost in half, to $735 million, or $2.24 per share.
Motorola, insurance giant CNA Financial Corp. and the area’s biggest company, health-care firm Abbott Laboratories, all reported even bigger one-time costs, for reasons ranging from acquisitions and investment impairments to losses from Enron and the World Trade Center attacks. In Motorola’s case, a string of one-time items turned what would have been a $681 million loss into a mammoth $3.94 billion net loss.
Smaller players also involved
These items weren’t limited to the Chicago area’s biggest players. Fortune Brands Inc. of Lincolnshire took restructuring and goodwill write-down charges of $171.4 million last year, on the heels of $575 million in write-downs the year before. Company officials point out that charges in 2001 were non-cash items and were offset by gains, so that actual net income booked for the year was $10 million higher than reported in pro forma results.
R.R. Donnelley and Sons Co. took restructuring and impairment charges of $102 million in the fourth quarter alone.
Karl Choi, a Merrill Lynch analyst who follows Donnelley, said the restructuring and impairment charges were regrettable but unavoidable.
“You obviously don’t like to see these big charges, but the company is trying to adjust,” Choi said.
“We’re getting kind of numb to it these days,” he said, regarding all the companies issuing the “one-time” items.
A major cause of one-time items in recent years is goodwill. New rules require companies to regularly assess whether the goodwill on their books has substantially declined in value; if it has, they must write it down–leading to some stunning admissions, like that from JDS Uniphase, that they vastly overpaid for acquisitions.
“In the last five years of the 1990s there was a tremendous amount of goodwill on the books. What’s happened in the last year with these write-offs just reflects the unraveling of the bubble,” said David Halford, a senior portfolio manager with Mosaic Funds in Madison, Wis.
But there may be a darker side, with some analysts complaining of a creeping in the 1990s, when companies began writing off expenses that previously would have been lumped into the cost of doing business.
Accounting principles allow for some flexibility in characterizing certain items as special charges. “Unfortunately,” Halford said, “the trend has been more toward expanding the definition of extraordinary items rather than constricting it.”
In Enron’s wake, he predicts a clampdown in the next few years.
Investor scrutiny advised
In the meantime, experts said, investors should carefully examine the cause of one-time charges and assess just how extraordinary they are–if they could be considered the result of the normal course of business–or if they are the result of serious management missteps.
But not every special charge in an earnings report should cause investors alarm, said Scott Sprinzen, managing director for Standard & Poor’s in New York. The rating agency did downgrade Ford’s credit from stable to negative in January when it revealed the metals problem, because it was a surprise, he said.
“It’s hard to give a blanket answer, but they are only significant when they reveal new information to the market,” he said.
Halford assesses the importance of one-time items by looking at a company’s return on equity and capital after the charges and measuring them against industry peers to see if the restructuring worked.
In a nutshell, if a company’s charges strap it with debt that holds return on capital to below industry norms, there’s still a problem, he said.
“If you do these right, you can really clean house,” he said. “But the good analysts will be skeptical.”
