December 31, 2001
Stock Gurus Disregard Most Big Write-Offs,
But They Often Hold Vital Clues to Outlook
By JONATHAN WEIL and STEVE LIESMAN
Staff Reporters of THE WALL STREET JOURNAL
Conventional wisdom among Wall Street stock analysts holds that investors should ignore large write-offs because they provide little insight about future performance. Now, amid the biggest wave of write-offs in history and mounting bankruptcies, it may be time to revisit that wisdom.
Consider recent events at Bethlehem Steel Corp. In July, it reported a $1.13 billion second-quarter loss, the bulk of it a $1 billion "unusual noncash" charge against earnings to write off the value of a deferred tax asset.
The charge didn't bother Salomon Smith Barney analyst Michelle Galanter Applebaum. It "masked what was essentially an improved quarter," she wrote on July 25, retaining her "buy" recommendation on the stock and predicting it would more than triple.
Three months later, Bethlehem filed for Chapter 11 bankruptcy reorganization.
Far from being something investors could safely ignore, Bethlehem's write-off of deferred tax assets -- mainly deductible losses carried forward from prior years -- held a clue to its future. Such assets can be used to offset future income-tax bills. But, of course, they can be used only by companies that are profitable and paying income taxes. By taking the charge, Bethlehem was signaling that it wasn't likely to use the assets, because it probably wouldn't have taxable profits anytime soon.
Almost any kind of write-off can send a message about the soundness of a business, the competence of its management or its prospects for growth. Although Wall Street stock analysts and financial executives routinely tell investors to disregard these entries, others say they're among the things investors should most closely heed.
"When you see these large write-downs, the antenna should go up immediately, and you should start digging for the underlying business reasons for these losses," says Lynn Turner, an accounting professor at Colorado State University and a former chief accountant for the Securities and Exchange Commission.
The sheer size of recent write-offs has made understanding their nature more urgent. Companies in the Standard & Poor's 500-stock index have reported more than $165 billion of so-called unusual charges so far this year, says research firm Multex.com Inc., more than in the prior five years combined. Meanwhile, Chapter 11 and Chapter 7 bankruptcy filings by publicly traded companies through mid-December hit a record 241, compared with 176 all of last year, according to New Generation Research Inc. in Boston.
Even if bankruptcy seems like a remote prospect, an "unusual" charge against earnings -- often called a "special," "one-time" or "nonrecurring" charge -- can provide an exit signal to investors. While stocks sometimes rally on news of such a charge, as a company announces a bold housecleaning move, the rally often doesn't last. A study by Multex.com and The Wall Street Journal found that companies taking the largest unusual charges as a percentage of sales have substantially poorer stock returns in the three months following the announcement of the charge than companies with minimal or no such charges.
The study, covering the past six years, looked at stocks of all public companies with market capitalizations of $1 billion or more. It divided those that took unusual charges into 10 groups, from the smallest to the largest such charges as a percentage of revenue. Stocks of companies with the largest charges relative to sales had a median decline of 9.4% in the 90 days after the charge was taken. Stocks of companies with the smallest charges relative to sales had a median gain of 1.48%.
World According to GAAP
While it could be argued that the shares might have fared worse without the charges, Marc Gerstein, director of investment research at Multex.com, says the study shows that "if you want to weed out stocks to look at for investment purposes, companies with unusually large write-offs are a good place to start."
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Sometimes the significance of special charges isn't immediately clear. But some investors grow suspicious anyway, on the "cockroach theory": Where there's one problem, there probably are more. "From seemingly minor or immaterial charges, sometimes investors can glean insight into how a company either correctly or incorrectly accounts for its business and whether a company is pushing the envelope," says James Chanos, president of Kynikos Associates, a firm that specializes in short-selling, or betting on stock declines.
Many short-sellers raised their bearish bets on Enron Corp. in mid-October after it took a $1.01 billion charge largely to write down the value of soured investments. Inside the charge was a $35 million write-off of investment losses at a partnership controlled by the company's chief financial officer. Later revelations about that and other partnerships, which weren't consolidated into the Houston-based energy concern's financial statements, led the market to lose faith in the company's finances. Its stock now trades for under a dollar a share as the company seeks to restructure under bankruptcy law. (See full coverage.)
The significance of special charges -- whether they represent old baggage from the past or illuminate the future -- is at the center of a lively debate under way in the accounting world. One side holds that generally accepted accounting principles, or GAAP, provide the best available snapshot of a company's financial position. GAAP, which companies must use in their official financial statements, requires that nearly all charges be treated as ordinary expenses.
Others, including many stock analysts, contend the best view comes from "pro forma" financial results -- calculated "as if" many expenses didn't really exist. The idea is that these expenses aren't relevant to future performance.
Behind Enron's Fall, a Culture of Secrecy Which Cost the Firm Its Investors' Trust (Dec. 5)
Bethlehem Steel Seeks Chapter 11 Shelter, Announces a Plan to Speed Restructuring (Oct. 16)
Companies increasingly highlight the pro forma view in news releases they generally put out before their official filings with regulators. But pro forma calculations adhere to no particular standard. Companies essentially do what they want. Now, accountants and economists say the practice of excluding blemishes is so widespread that companies and analysts often guide investors to dismiss charges that contain prescient warnings -- like the one at Bethlehem Steel.
Ms. Applebaum, the Salomon Smith Barney analyst who played down Bethlehem's big write-off, explains that she has covered other steel companies that returned to profitability shortly after writing off deferred tax assets. She thought Bethlehem would do the same. She notes that GAAP rules on such assets obliged Bethlehem to follow strict criteria in assessing its chances of future profitability -- stricter criteria than stock analysts typically use.
As for Bethlehem, Chief Financial Officer Leonard M. Anthony says the charge the company took was to some extent "predictive of the future."
GAAP also has well-established standards for writing down other kinds of assets. Companies must reduce the value on their books of anything from a customer loan to a manufacturing plant when its worth has diminished. Again, Wall Street stock analysts tend to dismiss the resulting charges as one-time events.
Sometimes that makes sense. During the 1981-82 recession, restructuring was a part of many corporations' strategies. They took charges for streamlining, outsourcing and otherwise shedding costs to position themselves for recovery. Because the resulting earnings volatility made it hard to compare companies' growth rates or price-earnings ratios, and because the charges weren't expected to recur, there was logic to excluding them to come up with "smoothed" earnings trends.
"Investors came to look upon the charges, correctly in many cases, as evidence that those firms had recognized past mistakes and had made tough decisions to become more efficient," said a September 2001 study by the Jerome Levy Economics Institute at Bard College in Annandale-on-Hudson, N.Y.
But the practice soon got out of hand. Some companies became habitual restructurers. The Levy study estimates that "operating earnings" -- another term for pro forma earnings -- at companies in the S&P 500 index have outstripped net income by more than 10% annually on average over the past two decades, and by as much as 20% annually in recent years. One reason: While companies readily exclude all sorts of special losses from their operating earnings, they are far less likely to exclude one-time gains, such as profits from asset sales.
Investors ignore write-offs at their peril, says economist David Levy at the institute. The reason is that when a company writes down an asset, it usually has concluded the asset won't generate as much cash as once assumed. That suggests the company as a whole won't, either. "The write-down of an asset is a recognition ... that the future is not going to be as profitable as expected," Mr. Levy says.
And if the company borrowed to buy the assets it is writing down, it could find itself squeezed by debt, as At Home Corp. was. At the start of 2001, the provider of high-speed Internet access, which did business as Excite At Home, announced a $5.43 billion net loss for the 2000 fourth quarter, on just $169.1 million in revenue. Much of the loss -- $4.63 billion -- reflected write-downs of "goodwill," the intangible asset created when one company pays a premium to buy another.
One such write-down concerned At Home's purchase of Bluemountain.com (free.bluemountain.com), an online greeting-card service. At Home paid $1 billion in stock and cash for the company in late 1999, taking on $350 million of debt to do so. But Bluemountain had little revenue. A year later, At Home took a $684.2 million charge for the goodwill it created by buying Bluemountain at a price far above its net worth.
Rather than its $5.43 billion net loss, At Home highlighted its self-defined "net operating loss" for the 2000 fourth quarter -- a mere $36 million. At Home Chairman George Bell said in a conference call that the charges had "no direct impact" on the company's operating performance.
Most stock analysts following the stock seemed to agree. Bank of America Securities' Douglas Shapiro, in a report following At Home's news release, didn't even mention the gigantic charge or net loss. "With the worst case already largely discounted into the stock, we retain our Buy rating and year-end 2001 $20 price target," Mr. Shapiro wrote on Jan. 26, 2001, when At Home stock stood at $6.47.
At Dain Rauscher Wessels, senior analyst David Lee Smith also ignored the net loss in his commentary after At Home's earnings news release. He retained his buy rating, although he lowered his price target to $15 from $38. The company "has a long-term asset base and is appropriately valued for long-term investors," Mr. Smith wrote when the charge was announced.
But some investors voted with their feet. At Home's stock sank about 32% in the following two weeks. Even though At Home was writing down Bluemountain, it still had to pay for it. Faced with growing cash needs for interest payments and service upgrades, At Home filed for Chapter 11 bankruptcy protection in September. Its stock was last quoted at a penny.
Looking back, Mr. Smith says At Home's huge write-off was a "perfect example" of a charge overlooked by himself and other stock analysts that would have helped predict the company's future performance. "Probably too frequently we have given companies the benefit of the doubt without burrowing in and asking, 'What does it say about the financial condition of the company?' " says Mr. Smith, whose firm is now called RBC Dain Rauscher Inc.
At Bank of America, Mr. Shapiro says he felt At Home's stock price already reflected how little value there was in its media businesses such as Bluemountain and the Excite Web portal. He felt cash flow from At Home's stronger business, a network for cable companies to deliver Internet access, would be sufficient -- and if it wasn't, he figured the cable companies would put up the cash to save At Home. "I was wrong about my assumptions about the fundamentals of At Home's business. But I don't think the implications of the charge itself were that significant," Mr. Shapiro says. At Home says that the actions it took "were in accordance with general accounting principles."
Companies frequently portray charges as part of a broader restructuring effort to restore profitability. But at Lucent Technologies Inc., they signaled a business plan that had failed and a management team that was struggling to find a remedy.
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The telecom-equipment maker told investors in late 2000 it would drive out $1 billion of costs and take other unspecified charges over the coming months. On Jan. 24, 2001, with the stock at about $19, Lucent forecast that the charge would range from $1.2 billion to $1.6 billion. But in April, Lucent announced $2.7 billion in "one-time" charges for the just-ended quarter.
Its news release -- excluding the charges and adjusting for the spin-off of some businesses -- highlighted pro forma results, which showed the loss narrowing to $1.26 billion from $1.31 billion in the immediately preceding quarter. "Lucent delivered much improved performance in the quarter, despite continued softness in several key markets world-wide," said Chairman Henry Schacht.
Results as tabulated according to GAAP pointed to a different trend. Lucent's loss from continuing operations widened to $3.38 billion from $1.58 billion in the preceding quarter.
And the write-offs kept coming. In all, Lucent recorded $11.42 billion of "restructuring and one-time charges" in the fiscal year ended Sept. 30. Its stock, which was in the 80s two years ago and in the high teens when Lucent announced the first one-time charges, closed Friday at $6.18.
Were there clues in Lucent's early charges that might have foretold this future? Lucent's April announcement detailed an amalgam of write-offs and other expenses that showed weakness in many parts of the company's business.
A charge for layoffs, for instance, showed the company had deployed large numbers of employees in key divisions where it no longer expected profits.
A write-off for accounts receivable from a significant customer -- Winstar Communications Inc., which filed for Chapter 11 in April -- showed that some past sales had failed to bring in cash and that future sales growth could be hurt because the customer base had shrunk.
A write-off of goodwill revealed that some acquired assets wouldn't generate the expected profits. Inventory write-downs showed that previous sales projections were too high and future revenue was likely to slip.
"When you're making cuts that deep, it means the company has fundamental problems," says Mr. Turner of Colorado State. That should prompt investors to ask whether "this is the management team that's going to be able to get you back where you need to be," Mr. Turner says, and it also signals "that there's probably more to come." Indeed, had investors focused on explanations of the charges contained on page 16 of the quarterly report Lucent filed with regulators in May, they would have learned that the company anticipated taking additional restructuring charges during the year.
So why the news release's emphasis on the pro forma figure? "We highlighted it because it's the way many of our competitors provide their earnings," says Michelle Davidson, a Lucent spokeswoman, who notes that the GAAP earnings numbers were included in the release.
Asked whether the charges amounted to a warning of a deteriorating financial position, the company declines to comment. Investors, says Ms. Davidson, should focus on Lucent's progress in delivering on its pledges of reduced capital spending and employment and increased working capital. The current management team has "dealt with the tough issues head-on, restructured in a tough market and built a solid track record in creating a plan and delivering on a plan," she says.
Sometimes, even what seems clearly to be a one-time charge can flag fundamental problems. Providian Financial Corp., a San Francisco-based credit-card issuer, reported profits soaring at a 37% compounded annual rate from the end of 1995 through 2000. Its stock more than quadrupled to $57.50.
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But Providian's sales tactics came under attack. In mid-2000, Providian said it planned to settle with state and federal regulators over allegations of consumer fraud. Without admitting wrongdoing, it agreed to soften its practices by, among other things, extending late-payment grace periods and toning down telemarketing scripts. Providian recorded a $272.6 million "one-time" charge for the 2000 second quarter as a result of the settlement. It posted net income of $62.8 million.
Many stock analysts treated the charge as positive news. At CIBC World Markets, analyst Steven Eisman wrote on June 20, 2000, that "for the past year, legal issues concerning the company's sales tactics and back-office processes clouded the stock. By taking a provision for all potential future legal inquiries, we believe the financial risk associated with such legal inquiries is now behind them." Mr. Eisman has since left CIBC and says his new employer doesn't permit him to comment.
In contrast to stock analysts' optimism, bond analyst Kathleen Shanley at Gimme Credit, a New York research firm, saw a red flag. Her concern: "the potential impact of a change in marketing practices on previously sizzling revenue-growth rates."
Although Providian said it had already implemented its sales reforms by the time of the settlement, Ms. Shanley doubted their full impact was reflected in the earnings outlook. Besides worrying that Providian wouldn't have the same marketing tools to deploy in its push for customers, she thought the settlements exposed the degree to which growth had been based on loans to people with shaky credit.
Then, for the first quarter of 2001, Providian reported declining noninterest income and growing credit losses, due to rising bankruptcies and the slowing economy. Alan Elias, vice president of corporate communications, acknowledges that the settlement affected future revenue a little, by applying "some additional pressure in regards to marketing certain membership products.''
Mr. Elias says there was nothing about the settlement that spoke to credit quality, even though Providian eventually had "higher-than-expected loss rates in our low-end portfolio." He adds: "To make a direct correlation that this is what is going to happen two years down the road [as a result of the settlement charge] is preposterous."
In any case, beset by rising consumer defaults and declining revenue, Providian issued a series of further profit warnings. On Oct. 18, it reported a 71% fall in third-quarter earnings, knocking the stock down 58% in a day. The stock closed Friday at $3.55, down 94% for the year.
Write to Jonathan Weil at firstname.lastname@example.org and Steve Liesman at email@example.com