The 5 biggest lies (so far) this earnings season -- Jubak's Journal

Indicators I follow suggest the stock market’s upturn may be a real rally. What would really help the market is for companies to stop trying to make bad news look good. Here are five of the worst obfuscations I’ve seen so far.

There are lots of ways to measure the staying power of this most recent market rally, and the measures I watch -- including my own -- seem to say “Maybe.”

Dan Sullivan, editor of The Chartist newsletter, is checking to see if trading volume expands or contracts as stock prices move up. He was encouraged in the early stages because volume was increasing, showing that more investors were moving into the market even as prices climbed. But he has grown worried in recent days: Volume started to drop off as the Dow Jones Industrial Average ($INDU) and the Standard & Poor’s 500 index ($INX) rose to within 5% of their August highs -- and the level at which the last rally failed.

According to my read of Sullivan’s technical data, this rally is right on the cusp. It could still go either way, although Wednesday’s action on the Nasdaq and the Dow was promising to those looking for the rally to continue. The Dow rallied at the end of the day to finish in the black. Perhaps more important, the Nasdaq Composite index ($COMPX) managed not just to hold its ground but actually to close above the technically important 1,300 level.

Charles Hill, research director of earnings tracking service First Call, is weighing the number of positive surprises so far this quarter against the historical record. Actual earnings always beat estimates, he reports, so the real issue is whether or not actual earnings are beating estimates this quarter by more or less than usual. With 42% of the S&P 500 reporting to date, actual earnings are running about 3.5% above estimates. That’s above the 2.8% average rate for the last eight years. But take away Microsoft’s (MSFT, news, msgs) big surprise, and the rate this quarter looks like it will roughly match the historical average. (Microsoft is the publisher of MSN Money.)

Looking ahead, the ratio of negative to positive preannouncements for the fourth quarter stands at 1.8-to-1. That’s substantially better than the 2.3-1 negative-to-positive ratio for the third quarter at an equivalent time, but it’s worse than the 1.6-1 and the 0.9-1 ratios of the first and second quarters of 2002, respectively.

Earnings may be getting better, I conclude, but they’re not getting better at so strong a rate that fundamentals couldn’t slip back into negative territory.

After all, lying CEOs and CFOs, biased Wall Street analysts, deliberately confusing financial statements and in some cases actually fraudulent reports inflated the bubble of the late 1990s and formed the foundation of this bear market. Some part of the money now out of the stock market has been pulled out of stocks in disgust and distrust. And this cash isn’t coming back until investors feel the financial markets are reasonably trustworthy.

A lot of lip service has been paid to the idea of full disclosure, clarity in financial reporting and the need to rebuild investor confidence in CEOs and Wall Street analysts. So, roughly halfway through third quarter 2002 earnings season, what does the scorecard read?

The results are a mixed bag, a disappointingly mixed bag, and we’ll look at five of the worst reports.

Some companies get it. For example, I’d give IBM (IBM) major points for improving visibility in its reporting of the operating units that produce the company’s revenue. It’s easy this quarter to tell that hardware and software make up 15% and 16% of revenue, respectively, and that revenue in each business fell 1% and 3% for the quarter. It’s even easy to understand how the service business now dominates the company -- accounting for 45% of revenue against the 15% and 16% for hardware and software.

(IBM still has a big gap to bridge in its pension accounting, however. It’s reducing its assumed return on its pension fund from 10%, but it’s still an aggressive 8% or 8.5%. And I wish IBM had been clearer about how much of its free cash flow it will need to shore up the fund. Through three quarters, IBM has generated $1.4 billion in free cash flow, but Big Blue now estimates it will have to contribute all of that and more -- $1.5 billion -- to its pension fund. But that kind of brutal honesty is a lot to expect from company management, and, hey, that’s what Wall Street analysts are for, isn’t it?)

But for other companies, this quarter has been business as usual: earnings reports with the same old misleading one-time charges or gains that offer a glossy sheen to ugly operating results – and perhaps bottom lines puffed up by accounting tricks. And new companies have stepped forward with their own accounting shenanigans to replace those practiced by Tyco International (TYC), Qwest Communications (Q), WorldCom (WCOEQ), and others now facing investigation in one venue or another.

I’m a firm believer that sunshine is the best disinfectant; so here’s my effort to give the five biggest lies of this earnings season (it is only half over, remember) their day in the sun.

It’s so simple and so misleading that it’s stunning. “Ford Exceeds Estimates for Third Quarter, Reports Operating Profit,” reads the headline of the company’s Oct. 16 quarterly earnings release.

Gee, anybody would think that Ford (F) actually made money while making cars in the quarter. Nothing, of course, could be further from the truth. The automotive unit showed an operating loss of $243 million for the quarter, more than the $220 million operating profit that Ford trumpeted in its release. Most of that operating profit actually came from renting cars (Ford owns Hertz Rent-a-Car) and making loans to customers who bought new cars.

Why is that so important? Because the impression that Ford generated an operating profit from auto operations will hinder many investors from understanding exactly how dire the situation is at Ford. Take away all the rhetoric about operating profit and focus just on cash flow (not highlighted in the press release for reasons that will become clear). Take away the one-time contributions to cash flow from a non-recurring $1.8 billion tax refund (thanks to the post-Sept. 11 changes in tax treatment of depreciation and losses from previous years) and the $600 million that Ford drew down from a trust set up to pre-fund retiree healthcare liabilities, and Ford showed true free cash flow of a negative $1.3 billion in the quarter. (This trust is now down to $900 million from almost $4 billion at the end of 2000.) Free cash flow could be negative by another $2 billion or more in 2003.

And that, rather than “operating profits” is the news for investors in Ford’s third quarter.

When Motorola (MOT) announced on Oct. 15 that it would take a net $30 million pre-tax special charge for the third quarter, it kept alive one of the longest running strings in current accounting. For 16 quarters in a row, Motorola has taken a special charge for one thing or another that had the effect of removing what I’d call legitimate ongoing costs of doing business from its bottom line. In other words, for 16 straight reporting periods, this company has found itself surprised by special, one-time expenses that shouldn’t be considered, says the company, as part of its normal cost of doing business.

And the record isn’t going to end with this quarter. In the fourth quarter, the company will take at least $200 million in special charges. That will be the last of the $3.5 billion pretax special charge the company announced on June 27 for 2002. That announcement then struck me as the height of double-standard accounting: the company announced that it would take a charge of $3.5 billion for severance and write-downs of its semiconductor plants, while at the same time affirming that it would match its earnings guidance for the year.

You can find the same spirit of “It’s not a cost if I say it’s a special charge” in the company’s guidance for the fourth quarter of 2002. Earnings will be 4 cents a share following GAAP (generally accepted accounting principles) standards that include the $200 million special charge. But investors can’t be sure that the company won’t have to take a bigger charge than the $200 million already announced. On that I have to beg to differ -- on the record, I think investors already know what to expect in the fourth quarter.

Best damaging lack of disclosure in a supporting role: tie between Lincoln Financial and Nationwide Financial Services

I admit I’m guessing on this one -- but that’s the point. Some insurance companies have built up potentially huge liabilities from insuring the returns on guaranteed variable annuities. And extremely limited disclosure makes it impossible to tell which companies are on the hook and for how much.

Here’s the problem: When insurance companies sold annuities that included a guaranteed minimum payout when the investor died, or a guaranteed minimum return no matter what the stock market did, the insurance companies weren’t anticipating a two-and-a-half-year-long bear market. Now they’re on the hook for those guarantees, and, guess what, nobody in the industry is disclosing enough information for investors to tell what the potential damage might be.

And damage there certainly is. CIGNA (CI) announced in September that it will take a $720 million charge related to guaranteed minimum death benefits on annuities.

Some companies are providing partial disclosure. Lincoln Financial (LNC) told the Securities and Exchange Commission that its total exposure to such guarantees was $3 billion as of June 30, and that it set up reserves of $27 million against that liability.

But that level of information isn’t enough. Investors need to know more about the ages of annuity holders (the older the holder, the greater the likelihood that the insurance company will have to pay off big on its guarantee) and how far under water the median account might be. Prudential Securities analysts John Hall and Roger Smith have used available information to rank insurance companies by the degree of their exposure. Lincoln National and Nationwide Financial (NFS) are at the top of their list. The analysts figure that these two companies face potential negative impacts equal to 6% and 3% of their GAAP book value, respectively. It sure would be great to know if Hall and Smith are right.

Can companies be expected to tell the truth if Wall Street analysts let them get away with lies?

Case in point: The Citigroup (C) Oct. 15 earnings report. The company’s press release trumpeted 74 cents a share in what the company called “core earnings.” That beat the Wall Street consensus estimate of 73 cents by the now classic penny a share and helped fuel a strong rally in financial stocks in the following days.

Except that there wasn’t anything core about that 74 cents in earnings . . . About 6 cents a share came from the company’s sale of its headquarters building at 399 Park Ave. for $323 million. Unless Citigroup has more headquarters to dispose of, it’s hard to see how this is anything but a special one-time gain. And we all know how we’re supposed to account for special charges and gains, don’t we? Altogether now: They don’t count toward GAAP earnings.

So instead of beating by a penny, Citigroup actually missed Wall Street estimates. Some analysts have picked up on the non-core nature of Citigroup’s core earnings -- Prudential Securities bank analyst Mike Mayo is one -- but as far as the Wall Street analyst consensus goes, Citigroup delivered a positive surprise this quarter.

Best accounting performance in a comic role: Duke Energy There’s always one company that bucks the crowd. Most companies use accounting tricks to inflate earnings, but a few go to the opposite extreme.

Not so long ago it was Microsoft, the parent of this Web site, that had to reach a settlement with the SEC over charges that it had used reserves to improperly reduce reported earnings per share.

This quarter it’s Duke Energy (DUK) and, specifically, its regulated utility arm, Duke Power, that’s been caught stuffing cookies back into the cookie jar.

Acting on orders of utility regulators in the Carolinas, outside auditor Grant Thornton found that Duke Power had failed to report $124 million in pretax income from 1998 through 2000 so that the utility wouldn’t show profits above those allowed by the utility commissioners. Duke Power has agreed to pay $25 million to its customers. Those customers would have paid lower prices if Duke had reported its profits accurately and the commissioners had reduced electricity rates.

One of the more interesting internal Duke memos unearthed by Grant Thornton read, “For the last two quarters in 1998, Duke Power has been earning a higher rate of return than allowed by the current rate structure. We have come up with the following strategies to reduce Duke Power's current rate of return.”

Those are my top five lies -- but I’m sure I’ve missed some, and perhaps I’ve overlooked a personal favorite or two of yours.

No problem. As I said we’re only about halfway through the earnings season. Send me your own favorites -- and I’ll put up another list in early November when the earnings season is over.

I think that there are big problems at the insurers and banks that we don't have any idea about yet. They may bring down the whole financial house of cards -- sooner rather than later.

Richard W.

I think that there are big problems at the insurers and banks that we don't have any idea about yet. They may bring down the whole financial house of cards -- sooner rather than later.

I'm wondering when people are going to realize that their annuities and life insurance policies aren't FDIC insured and that the information they're getting doesn't tell them how the insurance company invests their money.

Next bubble? Logically, should they have the same problem paying for the boomers when they retire as Social Security will? People are going to start collecting their savings.

Yeah, they are "guaranteed" by the issuer -- but that isn't even the real problem. I'll bet that most people have no idea that money market funds are investments and not covered by even any guarantees let alone insured savings. Just heard this week that one of Mellon Banks money market funds took a hit to its NAV and the bank put in the difference to make shareholders whole again so as not to cause a panic, but you can't count on them to do that. I'm in the process of moving all my money market funds into a treasury fund as we speak.

Richard W.

I'm in the process of moving all my money market funds into a treasury fund as we speak.

I had a small annuity with an insurance company and fortunately met all of those conditions to switch it to a bank a few years ago...age, years retired, years I had it. (Anyone who might be eligible has to research it...the rules change). So, now it's in a tax deferred, no fee, FDIC insured account, in a ladder of CDs.

As far as those money funds...what a ripoff. A friend transferred into a money fund that actually managed to lose money with all of their non-money market investments! Plus, there are fees. A little research, and it's possible to find a money market account that has a pretty good interest rate by dealing directly with the bank.

They're soooo sneaky with our money!

All insurer are at risk because of the nature of their crosswired financial dealing in areas that we can only guess at. Cigna is now halted on the NYSE. Go here to see who the largest bagholders of Cigna's decline are. JPM tops the list, like that is a surprise.

Yahoo Finance

Richard W.

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