New York – Good times can hide a multitude of sins.
Double-digit earnings growth over the past 14 quarters has prompted some investors to ignore the main lesson of the go- go years, which is that the nitty- gritty details of corporate finance are still the main story.
Richard Bernstein, Merrill Lynch’s U.S. strategist, has said investors remain “too sanguine on issues of corporate governance and financial reporting.” David Bianco, head U.S. equity strategist at UBS, estimates that what he calls “accounting quality adjustments” will take $10 a share off the 2006 earnings per share of the Standard & Poor’s 500.
“People often talk about how earnings quality has improved a whole lot,” Bianco said. “And it has improved from 2001 and 2002, but that’s not saying much.”
Bianco focuses on three main areas of what he calls “earnings quality”: one-time charges, employee stock options and pension assumptions.
Let’s consider them one by one:
One-time charges. At some companies, one-time charges have become a way of life.
Consider Eastman Kodak Co., which has taken one-time charges for each of the past 14 quarters. By treating the charges as extraordinary events, the company can say its earnings would be ever-so-much stronger without them. But, considering that the charges seem unrelenting, that argument looks wobbly.
Pension accounting. Under current pension accounting rules, a company can legally book a pension credit, even if its pension fund is losing money.
How does this accounting magic work? Under a process called “smoothing,” the company can set an assumed return for its pension fund. Across the S&P 500, that assumed return is 8.22 percent, according to Howard Silverblatt, editor of quantitative services at S&P.
That would be a stellar return in today’s market, especially because pension funds are almost always diversified. With interest rates near historic lows and equity returns anemic at best, it’s the rare fund manager who is getting the assumed return.
But, thanks to smoothing, a company doesn’t actually have to see that return to act as if it did. It can add its expected return right into its net earnings, even if the actual return differs greatly.
Look for pension information in the annual report. Read the footnotes, which will tell you what the fund’s actual return is.
Stock options. “Most companies will be required to expense employee stock options beginning in 2006, but earnings guidance and analyst estimates for many companies have yet to reflect this cost,” said David Zion, accounting analyst at Credit Suisse First Boston, in an October research note.
The bigger question: How much will all this cost you? Since very little has been done to make corporate communications more transparent to investors, investors “should be demanding higher risk premia to compensate them for that opaqueness,” Bernstein wrote in an October note. “If the profits cycle continues to decelerate and investors do not perform more and better due diligence, then the insightful short-seller may soon gain the upper hand.”
