2001-Two Profit Calculation For S&P 500

Will the real earnings decline please stand up?

In a sign of how confusing earnings calculations have become, two well-known financial-services companies are reporting widely different second-quarter corporate-profit declines for the Standard & Poor's 500-stock index of large companies.

S&P, the unit of McGraw-Hill Cos. that compiles the index, says that so-called operating earnings have fallen 32.9%, to $9.99 a share, compared with one year ago. But Thomson Financial/First Call puts the decline at just 17%, to $11.81 share. Both figures are preliminary as both First Call and S&P continue to adjust them throughout this quarter.

Companies Pollute Earnings Reports, Leaving P/E Ratios Hard to Calculate (Aug. 21)

The gap is the widest it has been in at least the past 10 years. A small part of the disparity results from the use by each service of a slightly different set of companies in the second quarter this year and last, which, among other things, resulted in differing baseline numbers. But the biggest part of the gap reflects a growing disagreement between First Call and S&P over the expenses companies should be allowed to exclude and have treated as "special items" in their so-called operating-earnings figure.

Over the past several quarters, S&P has taken a tougher line than First Call, refusing to exclude expenses that it considers part of normal operations. But First Call says it follows the lead of Wall Street analysts, backing out the same expenses they do.

For example, First Call puts the earnings for Loews Corp. at $1.14 a share, excluding most of the losses that the company and analysts treated as "one time." S&P treated those expenses as ordinary costs of business and recorded a loss for Loews in the second quarter of $7.18 a share.

For investors, the disparity adds to the growing problems of how to gauge the market's value at a time when more and more companies are presenting glossy earnings that exclude expenses that they call special, unusual or one-time. These include charges for restructuring and layoffs, and write-downs in asset values.

The gap is significant because "investors need to assess what they are benchmarking against and need to gauge how their portfolio is performing," said Karina Mayer, managing director at International Strategy & Investment Group Inc., a New York economic-research firm.

Operating earnings differ from operating income and net income, which have strict definitions under generally accepted accounting principles. Virtually all of the expenses that companies call "special" are treated as regular charges under GAAP and can't be excluded. Despite its fuzziness, operating earnings is the profitability figure most widely watched by Wall Street analysts and many investors. When a company announces earnings that meet or beat "the Street" -- a significant factor that often moves a stock -- it does so based on the difference between estimated and reported operating earnings.

But the gap between operating earnings and earnings calculated according to GAAP standards has widened in the past several years as companies have taken to excluding a broad array of ordinary expenses in their earnings releases in an apparent attempt to meet Wall Street expectations.

And now, the gap between the two different operating-earnings figures is growing as well, creating confusion over the market's value. Based on the previous four quarters' operating-earnings estimates, S&P figures yield a price-to-earnings ratio of 24.2 for the S&P 500. The First Call numbers yield a P/E of 22.2. Based on earnings as reported under GAAP, excluding a very limited range of expenses known as "extraordinary items," the S&P 500 finished Wednesday with a P/E ratio of 36.8, the highest ever recorded for the index, according to a Wall Street Journal analysis.

In the staid world of data gathering, the gap has led to some strong words from both sides over how they calculate their figures. In an interview, Chuck Hill, director of research at First Call, accused S&P of acting like a self-appointed "earnings pope," including expenses in its operating earnings that most analysts believe should be excluded.

Howard Silverblatt, editor of quantitative services at S&P, responded: "We have no problem with being the pope. It is our index, and it is our name that we are dealing with." He said the company was actually reviewing its standards and would likely grow more conservative in choosing to accept "special items."

New York investment banker Gary Lutin said the gap shows the dangers of using operating figures in any situation, because there is no standard.

"It could just be a question of what color fairy dust you prefer," he said. "The issue is really whether you should do anything that strays away from reality-based numbers."

1997-Coca Cola's Advanced Accounting Theory

You remember the old election-night parley. The anxious party boss demands, "How many votes did we get in the fourth ward?" Comes the crony’s reassuring reply: "How many votes do we need?"
Such sweet corruption has largely faded from politics but not from corporate America. Substitute, "profits" for "votes," and you could be a chief financial officer assuring his boss he will bet him the bottom line he needs.

Unlike stealing the vote, managing the numbers is merely a theft against perceptions, for it masks the reality of shifting trends with the illusion of smoothness. There is one other difference. Politicians practice their art under cover; earnings managers do their doctoring in daylight.

Witness Coca-Cola Co., which all but promises Wall Street that earnings per share will grow 18% to 20% a year and-one way or another-delivers. So much faith does the Street put in Coca-Cola’s magic that Roy Burry, a veteran analyst at Oppenheimer, recently wrote that Coke has "absolute control over near-term results," referring to its profits through the end of 1998. The drinks have yet to be pursed; the economic and climatic conditions that will affect results cannot be known, but the numbers would seem to be in the bag.

Coca-Cola is as good a company as it exists, and one with no seeming need to manage results. It has 48% of the world soft-drink market, and it is still adding share. Give the folks in Atlanta time, and even water may come in contour bottles.

But its growth does not come evenly, nor is there any reason to expect that it should. One year, Mexico is depressed; the next, Coca-Cola nabs the dominant bottler (and long-time Pepsi franchisee) in Venezuela. But Coca-Cola, like some others, has struck an implicit bargain with Wall Street: It pretends that its profit growth is smooth, and the Street pretends not to notice that it isn’t.

In the first quarter of 1997, Coca-Cola earned 40 cents a share, putting it on target to increase its full-year net by its customary 18%. However, the quarter concluded an eight-cent gain from selling its stake in Coca-Cola & Schweppes Beverages, one of its biggest nonanchor bottlers.

Coca-Cola, which booked similar gains on bottlers last year, is adamant that Wall Street treat such profits as part of its normal earnings stream. It made a point of discussing its investments in its annual and first-quarter reports. Gains from sales, it said, "are an integral part of the soft-drink business."
But are they? Coca-Cola, to its credit, long ago realized that selling concentrate is a far better business that bottling soda. The latter requires lots of capital, while Coca-Cola’s business enjoys high margins, heady growth and vast potential. That’s why its stock trades at 42 times earnings.

Coca-Cola periodically invests in weaker bottlers, shores them up and sells out at a profit-and such sales will undoubtedly recur. Nancy Ford, manager of investor relations, rejects the notion that Coca-Cola does so to manage its numbers. As she notes, the strategic impact of its investments is crucial. "Our bottlers are absolutely critical to our success," she says, meaning critical to the strong distribution that allows it to streamroll the competition.

But not even Coca-Cola can sell the same bottler twice, and it is dubious that such profits from disinvesting will rise at the same rate as soda sales in Beijing. "That doesn’t get valued like selling a case of Coke," says Pat McConnell, accounting analyst at Bear Stearns. "In a sense, it’s a discontinued operation."

The profits are real, but to treat the appreciation on long-held assets as occurring in a single year is an accounting fiction. Coke analysts mostly look the other way, but uneasily.

"It’s controversial," says Salomon Brothers analyst Jennifer Solomon, who includes the gain. "It’s an issue we have been struggling with." Mr. Burry, more bluntly, says, "Of course [the gain] is nonrecurring." But if Coca-Cola can deliver such feats each year, his report suggest, who cares? Last year, Coca-Cola earned $1.40 a share, up and impeccably on-target 19%. But that included large extraordinary and nonoperating items, which contributed roughly 11 cents.

In Coca-Cola’s view, the unusual items merely replaced normal profits that were "lost" when it decided to curtain concentrate shipments to certain bottlers. "They encouraged analysts to think of the unusual gains as income that replaced concentrate income it otherwise would have recognized," says Marc Cohen of Goldman Sachs.

But the curtailment cleared the decks for Coca-Cola to sell more concentrate-and book it-in future quarters. Knocking out the nonoperating items, Mr. Cohen derives a figure for Coca-Cola’s "underlying profits," which advanced in1996 by only 11%. In effect, Coca-Cola masked a (for it) sorely disappointing year.

This year is stronger, but a good case can be made that Coca-Cola’s continuing profits are growing at a midteens rate, not higher. Probably, the strong dollar is catching up with it; perhaps there are other trends bubbling in the business that smoothing the bottom line obscures.

The difference of a few percentage points a year is small, but investors in high-multiple stocks must telescope projected earnings far, far into the future, magnifying the effect of even small differentials. They may be surprised to discover that Coca-Cola has been marketing its stock as aggressively as its drink.

2001-Don't one-time events happen just once?

Don't one-time events happen just once?

Not at Proctor & Gamble . The maker of Tide detergent and other household staples has booked restructuring charges with tidal regularity -- in each of the past seven quarters.

And that, critics note, has led to a cleansing of the earnings figure that Wall Street analysts use to calculate the company's growth rate and stock-market value, making this much more than an academic accounting question. P&G's growth rate is a particularly prickly issue because the company faces a mature U.S. market for its products and is trying to prove it can still expand sales by operating more efficiently, producing innovative products and out-marketing the competition.

The tally of the charges since 1999: $1.3 billion. And more of these nonrecurring events are expected to recur. P&G says it plans to take such quarterly charges for the next three years. It expects to wrap up restructuring efforts by June 2004, at which time the charges are likely to total $3.9 billion to $4.3 billion.

P&G says its accounting is entirely appropriate, because restructuring isn't business as usual. The charges stem from an overhaul of the company's operations that was begun in June 1999, and the new ones will be the result of a big expansion of that restructuring effort, announced two weeks ago. The company notes that Securities and Exchange Commission rules preclude it from taking a mammoth charge upfront to cover all anticipated costs, and that it instead is required to book the charges as the costs are actually incurred.

Critics, however, say the treatment ignores the fact that closing factories and cutting jobs are part of running a big company in tough markets. "They've got to do them to do business," says Jack Ciesielski, an independent accounting expert in Baltimore, who publishes the Analyst's Accounting Observer, a newsletter. "It's a cost of doing business."

Adds J. Douglas Hanna, a professor at the University of Chicago: "It's just not safe to ignore these charges." Mr. Hanna, who studies what he calls "the infamous recurring nonrecurring charge," says more companies are booking charges. According to his research, more than a quarter of all companies filing with the SEC take a charge each year, up from 1% in 1970.

There are some companies that have bucked the trend, including International Business Machines-IBM . Since 1996, it has included restructuring costs as part of operating expenses. An IBM spokesman says, "It's a cost of doing business."

But even as P&G excludes the restructuring charges from what it calls its "core net earnings," it includes gains from selling brands, sales that some analysts and investors believe should be treated as one-time events. Sales of smaller brands have helped P&G post gains in its core net earnings over the past three quarters; excluding those gains, operating income dropped in those periods.

The company, based in Cincinnati, says it includes gains from selling business units because shedding brands is part of a continuing strategy to narrow its focus. For investors who prefer not to include such gains, the company notes that it breaks out the components so investors can do their own math.

Depending on investors' views of the charges and gains, P&G earnings are either rising or falling. Ignore the charges and gains, and operating earnings have declined in the past four quarters. Include the charges and gains: Net income rose in the past three quarters but fell in the quarter preceding those three.

Consider the most recent quarter, the three months ended Dec. 31. P&G reported net income of $1.19 billion for the fiscal second quarter, a 6% increase from $1.126 billion in the year-earlier quarter. The most-recent quarter included a restructuring charge of $120 million and a gain of about $141 million from the sale of brands (primarily its Clearasil skin-care products). Excluding the charge and including the gain, "core net earnings" were $1.314 billion, up 4% from $1.263 billion the year earlier and beat Wall Street estimates by a penny a share.

If you back out the gain, as does Tim Drake, a senior equity analyst at Banc One Investment Advisors, in Columbus, Ohio, P&G's core earnings actually dropped 7%, to $1.16 billion.

"Their business isn't manufacturing brands and companies to sell. Their business is manufacturing products to sell," Mr. Drake says. "My projections for this year and next year are well below what anybody's talking about on Wall Street." The funds he advises continue to hold about $449 million of P&G stock, though, because the company has strong brands.

P&G shares have traded down so far this year, along with those of the company's peers. The stock is off 22% since year end, and at 4 p.m. Tuesday in New York Stock Exchange composite trading, it fell 50 cents to $61.10.

Some analysts have expressed doubts about P&G's ability to meet its growth objectives in recent months. While P&G says its double-digit earnings-growth target may be hard to hit next fiscal year because of disruption from the restructuring, it is sticking with this as a goal. The restructuring is to help the company gain ground on rivals with lower operating costs.

P&G says the overhaul will take through June 2004 because the company, with $40 billion in annual sales, is so big and the program so extensive. P&G is putting thousands of managers in new jobs in an effort to work globally, instead of regionally. In revamping the plan two weeks ago, the company said it would have three global business units, down from the seven planned in 1999, and would cut 24,600 jobs, instead of 15,000. As a result, it will spend twice as much as originally planned, necessitating as much as $4.3 billion in charges.

Most Wall Street analysts accept P&G's view of how its earnings should be analyzed. The 14 Wall Street analysts who follow the company and submit per-share earnings estimates to Thomson Financial/First Call exclude the restructuring charges and include the gains. "It's considered part of normal operating procedure," says Heather Murren, a Merrill Lynch analyst. A big purpose of analysts' estimates is to allow comparisons of a company's results over the years. In order to do that, "to be consistent you've got to exclude [charges] now," she says.

But that doesn't mean they're all thrilled with the situation. "The reality," says William Steele, a Banc of America Securities analyst who is among the Thomson Financial/First Call filers and who rates P&G a "buy," is that P&G shares are "being judged on consensus estimates which are probably not that accurate, or not totally representative of the ongoing operating strength of the company."

Given that P&G has laid out a schedule for coming charges, "you can chastise the company for the way it puts a [news] release out, but it is still the analysts' job to put some thought into this issue and decide what should or shouldn't be included," says Chuck Hill, director of research at Thomson Financial/First Call.

Corporate Governance in India

It was heartening to see in a recent edition of the  Economic Times that the Securities and Exchange Board of India (SEBI) would likely discuss an overhaul of its corporate governance code at a board meeting the next day.
Although it is too early to know whether the SEBI board ultimately discussed the code at the meeting, it is clear based on SEBI’s Consultative Paper on Review of Corporate Governance Norms in India that there is a discernible shift towards empowering shareholders to take management to task on corporate affairs.
This is consistent with what is happening throughout Asia. As documented in our 2010 report Shareholder Rights in Asia, we too have noticed the trend of growing shareholder activism. Unlike in the past, when the response was to sell shares in companies that exhibited poor corporate governance behavior, shareholders are now more willing to engage with the company boards and managers to safeguard their investments.
But what are these rights?
The Principles of Corporate Governance published by the Organization for Economic Co-operation and Development (OECD) in 2004, defines shareholders as having the basic rights to:

• secure methods of ownership registration and transfer of shares
• obtain relevant and material information on the company on a timely and regular basis
• participate and vote in general shareholder meetings
• elect and remove members of the board
• share in the profits of the company

In addition to incorporating the above, SEBI’s consultative paper engenders greater shareholder activism, including mandating e-voting for all resolutions of a listed company to promote greater participation; having stricter rules on related-party transactions; strengthening private-sector enforcements through improved investor education and better participation at general meetings; and regulatory support for class actions suits.
Additionally, due to the importance that institutional investors play in engaging with public companies, the recommendations now require these organizations to exercise greater fiduciary responsibility and stewardship on their investments. These include:

• having a clear policy on voting and its rationale
• dealing with conflicts of interest
• having a policy on monitoring investee companies
• cooperating with other investors to engage with the company where appropriate
• knowing when to have an active intervention on company matters
• addressing disclosure concerns by regular reporting on engagement with companies

In India, the need for good corporate governance is not a new concept. In fact, 10 years ago at the Global Corporate Governance Forum in Paris, G. N. Bajpai, then-chairman of SEBI, stated in his address that corporate governance is the conduct by companies (as the main economic agent of the country) to “produce synergies for all other agents in the economy.”
His view extends the concept that running a corporation well is crucial for the economic prosperity of the country, such that both “the state and market have to co-exist and complement each other’s effort.” Where failures in corporate governance occur (particularly by the larger firms), there will be economic repercussions for the entire country. And when this impacts the lives of people in the country, state intervention becomes necessary. In Bajpai’s view, running a company well is not only good for its owners, but also for the country. And the foundation of good corporate governance “must be an unwavering commitment to integrity” and “an undying commitment to serve the investor.”
With these changes coming, it looks like India is forging ahead in its quest to improve the governance practices of public companies and, if done correctly, could lead to what Bajpai calls the “triumvirate of Indian values”: satyam (ethical business practices), shivam (serving society), and sundaram (morality in behavior).
Let’s all stand up and applaud the impending rise of minority shareholders in India!

2001- No Expenses Stemming From The Attacks On The World Trade Center And The Pentagon Will Be Classified As Extraordinary.

In an abrupt reversal, accounting rule makers have decided that no expenses stemming from the attacks on the World Trade Center and the Pentagon will be classified as extraordinary.

But the new rule, expected to be issued today, will encourage companies to tell investors just how badly the company was hurt by the attack and by the resulting business changes. Companies that wish to do so will also be able to leave out such losses when calculating the pro-forma earnings that they emphasize in their own earnings forecasts and in their news releases.

Before the reversal, the Emerging Issues Task Force of the Financial Accounting Standards Board had tentatively decided on a policy that would allow companies considerable latitude to classify losses as extraordinary and thus more likely to be ignored by investors.

But a meeting on Friday, at which members of the task force were expected to adopt the earlier decision, turned into an extended debate, said Timothy S. Lucas, the research director of the accounting board and the nonvoting chairman of the task force.

The task force, which has 12 voting members -- 9 from accounting firms and 3 from major companies -- had several 6-to-6 tie votes during the day before it finally reached the decision that no expenses could be listed as extraordinary.

''The E.I.T.F. believes that the events were so extraordinary that they were pervasive,'' said David Zion, an accounting analyst for Bear Stearns. ''Nearly every company has some financial impact.'' Trying to draw a line between those that could be labeled extraordinary and those that could not would be impractical and not very helpful to investors, he said.

Mr. Lucas pointed out that even with the airlines, which clearly were harmed, it would be hard to separate the losses that could be attributed to the attacks. The preliminary decision had been to treat the loss of aircraft, and damages paid to victims, as extraordinary.

But, Mr. Lucas noted, ''revenues they are not earning'' are very important to the airlines, both during the period when all flights were grounded and since then as a result of the decline in passenger traffic. Yet there is no way to classify as extraordinary the decline in revenue, he said.

Book By-Jason Zweig -Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich

 

What happens inside our brains when we think about money? Quite a lot, actually, and some of it isn't good for our financial health. In Your Money and Your Brain, Jason Zweig explains why smart people make stupid financial decisions -- and what they can do to avoid these mistakes. Zweig, a veteran financial journalist, draws on the latest research in neuroeconomics, a fascinating new discipline that combines psychology, neuroscience, and economics to better understand financial decision making. He shows why we often misunderstand risk and why we tend to be overconfident about our investment decisions. Your Money and Your Brain offers some radical new insights into investing and shows investors how to take control of the battlefield between reason and emotion.
Your Money and Your Brain is as entertaining as it is enlightening. In the course of his research, Zweig visited leading neuroscience laboratories and subjected himself to numerous experiments. He blends anecdotes from these experiences with stories about investing mistakes, including confessions of stupidity from some highly successful people. Then he draws lessons and offers original practical steps that investors can take to make wiser decisions.
Anyone who has ever looked back on a financial decision and said, "How could I have been so stupid?" will benefit from reading this book.

Is Your Growth Strategy Flying Blind?

In early 2007, U.S. senators asked then–Lieutenant General David Petraeus how much sectarian violence might erupt if U.S. forces withdrew from Iraq. He admitted being uncertain: “It’s hard from this distance,” he said, to understand “the real granularity of what’s going on.”
The Senate questioners sought the big picture—something CEOs are continually told it’s their job to provide. Yet for that big picture to be meaningful, Petraeus needed “granularity”—which few chief executives have the time to pursue.

For most of the past century, CEOs have coped with this tension fairly elegantly by organizing their companies into business units and geographic regions and then holding those entities accountable for performance. Over the past two decades, however, advances in information technology have made it feasible both to target ever-finer-grained market segments and to measure the sources of growth—market momentum, mergers and acquisitions, and market share gains—in an increasingly detailed way. So far, few organizations have figured out how to turn the oceans of data available to them into islands of insight about their best opportunities for growth. Even fewer have attempted to structure and manage themselves with sufficient granularity to match the texture of the markets in which they play.

Therein lies largely untapped potential for companies to accelerate their growth and separate from the competition. By looking microscopically at their markets and their current performance relative to rivals’, companies can develop far better growth strategies. In most cases, the new strategic direction will highlight a need for significant changes in how the company allocates resources, deploys people, and reviews results. This additional granularity becomes especially important during economic downturns because it enables much more nuanced strategies, both in terms of cutting costs and of going on the offensive.

This article describes how the world has become more granular—through, for instance, the global expansion of markets and the impact of advanced information technologies—and the challenge that presents for companies as they try new ways of understanding their growth potential and then wrestle with the organizational implications of their enhanced understanding. It is meant to be a practical road map that builds on our recent book, The Granularity Of Growth, with new analyses and descriptions of several companies’ experiences adopting more granular approaches to growth. It is increasingly clear to us that granularity and economies of scale can—indeed must—coexist, and that mastering this balancing act will confer competitive advantage through the downturn and once the economy begins to recover.

Growth Is Granular, but Most Companies Aren’t
During the early twentieth century, a new organizational form emerged in the United States: the multidivisional company, in which business units corresponded to key product lines and shared a central set of resources. DuPont was an early pioneer, and Alfred Sloan took the form to fruition during the 1920s, when he reorganized a hodgepodge of companies and brands into the General Motors Corporation. By adopting this new structure, DuPont, GM, and many others honed their precision in making decisions, measuring performance, managing their workers, and organizing themselves.

Our research suggests that firms today can benefit from an even more granular approach than Sloan could have imagined possible. A snapshot of one large European manufacturer of personal-care products illustrates how. The company has three lines of business and appears at first glance to labor in a number of low-growth markets (growth forecasts for the three divisions range from 1.6% to 7.5%). But a deeper look reveals a prodigious spread in anticipated growth rates among countries and product lines within each division. What’s more, some of the most promising segments in the company happen to reside in the division with the lowest overall growth forecast.

A large European multinational manufacturer of personal-care products has three divisions: hair care, personal hygiene, and organics (a three-year-old group that develops natural and organic alternatives to traditional offerings). Successively finer levels of disaggregation yield increasingly useful insights about revenue growth forecasts.

This is not an isolated phenomenon. We reviewed growth patterns of global firms from 1999 to 2006 and found that the correlation between overall growth rates and sector growth rates increased dramatically for companies that had taken a granular approach to management and analyzed smaller slices. In other words, companies can get a much more accurate picture of their growth prospects by digging deeply into micromarkets (typically ranging from $50 million to $200 million in value) than by looking at the divisions commonly used for measuring, organizing, and managing.