Why Company Write-Offs Should Be a Warning Bell

“We’ve bitten the bullet and put our problems behind us. Now we look forward to a bright future.” That’s the way most corporate managements announce huge write-offs to take care of massive restructuring, layoffs or real estate losses.

Most Wall Street equity analysts and many investors agree, at least initially; most stocks rally on the announcement of big write-offs. And investors have had plenty of huge write-offs to cheer lately, as banks, troubled insurers and other financial institutions write off bad loans, and as other companies, such as Pepsico., Weyerhaeuser Co., Xerox Corp. and British Petroleum have joined the parade.

Why such jubilation over recent write-offs? First, many analysts and investors reason that earnings were so depressed anyway that corporate America decided to get all the bad news out of the way and consequently wrote off everything in sight. With everything including the kitchen sink thrown in, many believe, write-offs are a thing of the past. Second, 1992 earnings will look so strong compared to write-off depressed 1991 results that stocks have no where to go but up. Third, the corporate restructuring that most of these write-offs paid for have made many companies so lean and efficient that 1992 sales gains, spurred by the expected economic recovery, will spawn huge profit increases, they believe.

Although I certainly agree with this last point, I don’t agree that write-offs are over for the foreseeable future. The problem with this view is that it fails to acknowledge the fact that write-offs beget more write-offs.

Despite corporate management’s beliefs and Wall Street’s hopes, they never seem to get all of the cancer removed on the first trip to the operating room. Managements are often slow to act on problems that require write-offs, and even when they do act, don’t grasp or don’t want to grasp the full extent of the difficulties.

For instance, McDonnell Douglas Corp.’s management assured security analysts early this year that their earlier write-offs on military and civilian businesses were over, but then took additional charges in the second quarter. Eastman Kodak Co. had massive restructuring charges in 1989, 1990 and 1991, despite hopes that each one would be the last. Sears, Roebuck & Co. suffered restructuring charges in 1988 and 1990 that were aimed at reviving its stores and catalogue business, but now is dismantling the company, selling off its profitable financial services.

Several years ago, BankAmerica Corp. took write-offs for bad loans with such repetition that the announcements became monotonous. Yet the then-CEO, at board meeting after board meeting, assured directors that the most recent write-off would absolutely, positively be the last. Eventually, his credibility disappeared and so did his job.

The urge to rejoice over write-offs, then, should be muted by the fact that the first is seldom the last. But there’s another reason to restrain jubilation. A write-off today means that earnings reported in the past were overstated. Corporations, however, never go back and restate earlier earnings. They don’t, in effect spread current write-offs over the previous years to which they apply and during which earnings were overstated. Instead, managements dump all the bad news into the current quarter, and in effect, treat write-offs as reductions in stockholder equity, not as corrections to overstated past earnings.

This may be proper accounting, but it can seriously mislead stockholders and analysts. Future earnings estimates, and from them, stock prices, are to no small extent based on past earnings trends. Consequently, the failure to correct past earnings for write-offs can seriously distort the outlook for stock prices.

Of course, write-offs because of, say, layoffs, do portend lower costs and hence higher earnings in the years ahead. In that sense, the trend in past earnings, even if reduced to correct for charge-offs, may be less relevant for further earnings and stock prices than if the write-offs had not occurred. Nevertheless, past corrected earnings are indeed relevant unless the write-offs in question are the last ones, which is seldom the case.

There is no easy way to correct past reported earnings for write-offs, and attempts at precise accounting would be a nightmare--no wonder no one does it!

It seems reasonable to assume, however, that the problems that required those write-offs occurred over about a three-year span. Consequently, to get at least a rough idea of what corrected earnings should look like, we have spread write-offs equally over the year in which they were taken and the two previous years, with one-third assigned to each year.

Also, since write-offs are stated in pretax terms, we have applied the corrections to pretax earnings. In effect, this assumes that the tax rate in a particular year would not have changed had the correction actually been made. Let’s see how this works with an example:

International Business Machines Corp. has had huge restructuring charges in recent years as it attempted to adapt to a rapidly changing and hostile computer market.

In 1988, the firm took $870 million in write-offs, $2.3 billion in 1989 and another $3.4 billion in 1991. Spreading each of these pre-1992 write-offs over three years reveals a much different and more useful trend for corrected earnings. While IBM’s reported earnings rose through 1990, the corrected series peaked in 1988 and has fallen since, foreshadowing big trouble ahead.

It’s fair to argue, of course, that corrections in IBM’s 1989 and 1990 earnings for write-offs taken in 1991 can’t be made until they are announced, and therefore that investors could not construct the declining earnings pattern until it was too late to take advantage of it. But this is not true.

As noted earlier, write-offs tend to beget write-offs, and IBM is a perfect case in point; the company recently announced another write-off of $2.1 billion pretax, which will cut $3.70 a share from third quarter after-tax earnings.

Write-offs do indicate that corporate managements are taking necessary actions, whether voluntarily or involuntarily, and that in itself is a healthy sign. But before you join company managements and most Wall Street analysts in first cheering and then rushing to buy these stocks:

* Be sure that the write-off will reduce future costs and increase future earnings significantly and is not simply a belated recognition of past problems.

* Don’t jump in and buy on the first write-off--bear in mind that the first big write-off often isn’t the last, and sometimes a change in management is necessary before the process is completed.

* Remember that previously reported earnings may be overstated. Correcting them for write-offs can reveal trouble ahead.