Taking a Harder Look at Earnings ‘Quality’
A world where corporate earnings forever surpassed expectations would be a bit like writer Garrison Keillor’s mythical Lake Woebegon, where somehow all the children are above average.
Yet Wall Street these days seems to demand just such an unending string of pleasant surprises. In a stock market that some consider “priced for perfection,” tiny profit stumbles get punished with big declines in share prices.
“The unrealistic valuations [on stocks] are putting tremendous pressure on management to create earnings,” said Robert Olstein, who manages the Olstein Financial Alert stock mutual fund in Purchase, N.Y.
That’s why when a problem like the Asian financial crisis starts crimping results, companies may have to use all their wiles to keep their quarterly profit numbers on target.
Sometimes they do it with one-time gains on sales of securities or assets, sometimes with one-time cost cuts, sometimes by pushing merchandise out the door at the end of the quarter to boost sales figures.
Although one-time measures undeniably can help a company hit its all-important quarterly profit-per-share bogey, such earnings are generally considered to be of lower quality than those achieved in the normal course of business.
And at least in theory, lower-quality earnings ought not to support the same stock price level that would be supported by earnings gains generated by a company’s core business.
What’s disturbing to some analysts is that companies seem to have reached deeper into their bags of tricks in the earnings-reporting season now coming to a close, as it has gotten harder for them to beat Wall Street’s expectations.
Asia may be just one negative factor. Many companies also are facing rising labor costs, and nearly all industries face increasing competition, limiting pricing power.
“More and more companies are just barely making their estimates,” said Ben Zacks of Chicago-based Zacks Investment Research, which compiles industry analysts’ earnings estimates. “This quarter signals the transition from almost five straight years of exceeding estimates.”
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With fourth-quarter 1997 reports in hand from about 90% of the Standard & Poor’s 500 companies, earnings are topping estimates in only 50% of the cases, down from 54% in the third quarter and 59% in the second quarter, according to First Call Corp., another tracking firm.
What’s more, companies may in many cases be exceeding estimates that were sharply reduced in the first place, as Wall Street has lowered its sights over the last two months.
“Life is not a series of linear events, so the fact that so many companies always come in within a penny or two [of estimates] should make you suspicious,” said James Chanos, one of Wall Street’s best-known short-sellers. (Short-sellers try to profit by borrowing and selling stocks they believe are poised to decline.)
Although analysts have become more focused recently on earnings quality, Chanos argues that the problem has for some time been worse than Wall Street wants to admit.
For example, Chanos argues that the use of stock options in lieu of salary--ever more popular in this historic bull market--masks the true cost of compensation.
He pointed to a little-noticed chart in a third-quarter earnings report that Microsoft Corp. filed with the Securities and Exchange Commission.
The chart, labeled “Alternative Presentation of Accounting for Stock Options,” indicates that if the cost of the options were folded into operating expenses--as ordinary salary would be--Microsoft, instead of reporting a $663-million quarterly profit, would have shown a $60-million loss.
Another widely accepted corporate practice results in the paradox that Chanos calls “the annual one-time restructuring charge.”
Companies such as Sunbeam Corp. and Whirlpool Corp. treat restructuring charges--costs associated with closing factories and laying off workers--as nonrecurring events to be considered separately from operating earnings.
“But how ‘one-time’ are they if they occur every year?” Chanos asked. If opening and closing factories and hiring and firing employees are integral to a manufacturer’s business, shouldn’t they be treated that way in its earnings reports?
Money manager Olstein, who used to publish a newsletter called Quality of Earnings Report, constantly tells investors to focus on cash flow or earnings from operations and to pay less attention to the net earnings-per-share number.
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But in a sense, it helps him when people ignore his advice.
Olstein said he often finds bargains for his fund by snapping up stocks that have been pummeled for missing their earnings number by a penny or two.
By the same token, Olstein shuns companies that bolster their current earnings statements at the expense of future profits. A classic example of such shortsightedness may be a company’s decision to cut back on strategic expenses such as advertising or research and development, he said.
Chief executives nearing retirement have been known to cut research-and-development outlays, hoping to boost their final pay packages with timely profits while pushing the consequences into the laps of their successors, said Lawrence Revsine, finance professor at Northwestern University’s J.L. Kellogg Graduate School of Management.
Of course, some companies, particularly blue-chip multinationals, have enough financial flexibility given their far-flung operations that they can easily smooth out a rough patch in quarterly earnings, keeping growth steady.
The question for investors is when such smoothing becomes excessive.
For example, Citicorp’s fourth-quarter pretax earnings of $1.67 billion included $733 million of venture-capital gains and sales of securities and other assets that banking analyst George Salem of Gerard Klauer Mattison considers discretionary.
The gains offset Asian-related trading losses and helped Citicorp match Wall Street’s earnings expectations.
“When discretionary income gets to be that high,” Salem said, “it’s not the icing on the cake anymore, it’s the cake.”
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If there’s no way to escape a profit shortfall, sometimes a company can still hit the mark by simply getting Wall Street analysts to set a lower target.
Take Coca-Cola Co. It’s a fabulous company by any standard, but for a growth stock trading at upward of 40 times earnings, its fourth-quarter profits were up a relatively paltry 7.2% from a year earlier.
Not to worry. Coke had prepared analysts a month before the announcement, warning that falling currency values in Asia would restrain profits. When the earnings number arrived Jan. 28, it was right in line with revised estimates, and the stock price kept rising without a ripple. Shares are up about 10% since the announcement.
Coca-Cola’s ownership stake in bottling companies around the world can often be counted on to add some fizz to earnings, but a fourth-quarter falloff in bottling results actually trimmed profit growth by about 5 percentage points. Again because of early warnings, the blip was largely ignored.
Jennifer Solomon of Salomon Smith Barney is one of the few beverage analysts who isn’t currently enthusiastic about Coke, giving the stock only a “neutral” rating. She sees no reason to overlook the bottling results now “just because the trend went against them this time.”
She added: “With Coke, since most of Wall Street is so uniformly in love with the company, they’re always going to try to put it in a good light.” (For another view on Coke, see Street Strategies, D6)
Revsine, the finance professor, said investors should watch cash flow, read footnotes to financial statements and constantly remind themselves that relying solely on earnings per share is a shortcut, and “shortcuts can get you burned.”
That may not be a worry for now, in this still-raging bull market--but it will be when euphoria eventually gives way to tougher scrutiny of what underlies stock values.
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Beating the Street
Corporate earnings overall continued to rise in the fourth quarter, with an average gain of between 10% and 11% over the fourth quarter of 1996. But the number of major U.S. companies beating Wall Street’s estimates continued to slide--even though many of those estimates were reduced. Percentage of Standard & Poor’s 500 companies beating average estimates, by quarter:
1997
Q1: 64%
Q2: 59%
Q3: 54%
Q4: 50%
Source: First Call Corp.
