AIG: A Complex Industry,

A Very Complex Company

By CHRISTOPHER OSTER and KEN BROWN

Staff Reporters of THE WALL STREET JOURNAL

Lanny Thorndike, manager of the Century Shares Trust mutual fund, knows as much about insurance company American International Group Inc. as almost any other investor. He keeps a 3-foot-wide color-coded map showing 250 of AIG's subsidiaries and where they fit into the parent company. It's the only such map the fund manager has. "It's the only one we've needed it for," says Mr. Thorndike, who says AIG is one of his fund's largest holdings.

But Mr. Thorndike admits he doesn't know everything about AIG. "It's the only company we feel we have not developed the type of subsidiary knowledge we want," says Mr. Thorndike, whose firm specializes in financial-service stocks. Mr. Thorndike says his research on AIG includes talking to rivals and insurance brokers who sell AIG products. "You have to talk to that many more people just to get a sense of understanding" even a small piece of it.

New York-based AIG falls into the realm of black-box companies both because of its sheer size and because it is in the insurance industry, which itself is rife with black-box issues. "To some extent, every insurance company is suspect," says David Schiff says, editor of Schiff's Insurance Observer, a newsletter, noting that insurers have leeway in the way they reserve for claims.

Many Accounting Practices Are Hard to Penetrate

Insurance companies take in premiums and set aside some of that money as reserves for future losses. Insurers have discretion about how much to set aside, which means they can build bigger reserves during the good times and put aside slimmer ones when times get rough. A big reason for the discretion is that setting up reserves involves a large number of assumptions about claims that in some cases, as with workers' compensation and medical-malpractice insurance, won't be paid for years.

Mr. Thorndike believes that AIG could be in the camp that maintains better-than-adequate reserves in the good times, a tactic that helps smooth out earnings in what is normally a cyclical business. Aside from the quarter including claims from the Sept. 11 terrorist attacks, AIG hasn't had an earnings disappointment of any real note for at least 15 years. "It's part of the mystery of AIG, they just make their number," says David Bugajski, a senior analyst at Fred Alger Management, a big AIG shareholder.

For its part, an AIG spokesman says, "Our reserve development is fully disclosed in our regulatory filings," declining to elaborate. He adds: "AIG's strong performance year after year speaks for itself."

Insurance companies' financial statements are complicated enough -- then add AIG's hundreds of subsidiaries to the mix. "Who the hell knows what each one does? In trying to analyze their numbers, it's not obfuscation, it's sheer complexity," Mr. Schiff says. "So many businesses -- and businesses that involve estimates that can be proven wrong even if they're made with the best of intentions. It's hard to understand these things."

What investors understand, however, is that AIG delivers double-digit earnings growth year in and year out, which is why AIG stock is richly valued, particularly compared with other insurers. The company, with its $207 billion in market capitalization, boasts a price-to-earnings trading multiple of 22.7 based on estimates of its earnings for this year, highest of any property-casualty insurance carrier and well above the industry average of 13.4.

Insurance reserves are watched by state insurance regulators and ratings agencies, but as a sign of how malleable they can be, consider the experience of Reliance Group Holdings Inc., the insurance holding company long controlled by financier Saul Steinberg. Hit in 2000 by ratings-agency downgrades and deteriorating underwriting results, Reliance boosted its reserves by more than $1 billion in roughly 12 months, adding to the $3 billion it already had set aside. Even that, however, wasn't enough, and regulators announced in October that it would liquidate Reliance's insurance operations.

Of course, no one is comparing Reliance with AIG, whose chairman, Maurice R. "Hank" Greenberg, has been at the helm since 1967 and is famous for his strong oversight of the company and knowledge of insurance. "Their reserves are always top level, even using our stringent requirements," says Peter Dickey, a managing senior financial analyst who follows AIG's property-casualty operations for ratings agency A.M. Best Co.

Coca-Cola: The Real Thing

Can Be Hard to Measure

By BETSY MCKAY

Staff Reporter of THE WALL STREET JOURNAL

Soft drinks would seem like a straightforward business. But at Coca-Cola Co., critics say it can be hard to figure out the real thing.

Analysts and accountants say the company has muddied the waters since the mid-1980s, when it started spinning off capital-intensive bottling operations into publicly traded entities in which it retained stakes of just less than 50%. The move allowed Coke to wipe capital-intensive assets and billions of dollars in debt off its books. But it also saddled its bottlers with huge debts. "It was a contrivance," contends Albert Meyer, an analyst with Dallas-based investment research firm Tice & Associates, and a frequent critic of Coke's accounting practices.

Mr. Meyer and others concede that the Atlanta beverage powerhouse is no Enron. It makes a lot of money on its basic brands by selling concentrate to the bottlers, and the bottlers are publicly traded, so it isn't as if the debt is hidden in a private partnership. "If you want to do a lot of work, you can figure out what is going on," Mr. Meyer says.

Many Accounting Practices Are Hard to Penetrate

Mr. Meyer and others have historically argued that Coke used its bottlers, franchisees that make and distribute the soda pop, as tools to boost its profits -- an argument buttressed by Coke's hefty ownership stake and board seats on many of these entities. Coke would increase the price of the concentrate sold to bottlers every year, raking in big profits, even if the bottlers were having a bad year and unable to raise soft-drink prices. The bottlers would get some compensation from Coke in the form of marketing support, but this funding often didn't make up for the concentrate price increase.

In the past couple of years, this formula has been a source of friction as bottlers -- and investors in these bottling companies -- complained about Coke's unfair advantage. Late last year, Coke said it would rejigger the formula of concentrate prices and marketing support with its biggest bottler, Atlanta-based Coca-Cola Enterprises Inc. Coke will now take into account the bottler's ability to raise soft-drink prices when it raises concentrate prices. It has also agreed to increase CCE's marketing allowance, injecting $160 million more than originally planned this year and next, according to analysts.

Still, William Pecoriello, an analyst with Morgan Stanley, estimates that Coke's return on invested capital is 26%, while its big publicly traded bottlers around the world post an average return of only 5%. Rating agencies such as Standard & Poor's Ratings Group reconsolidate key bottlers, such as Coca-Cola Enterprises, into Coke's balance sheet when analyzing the company.

At the end of the third quarter, CCE reported about $11.2 billion in long-term debt while Coke's long-term debt was a meager $1.4 billion. In 2000, the bottler had net income of $233 million, or 54 cents a share, on revenue of $14.8 billion.

It doesn't help investors that Coke and CCE record some of the support payments in conflicting ways, Mr. Meyer notes. Coke defers recognition of some of its infrastructure support payments made to CCE, with the idea that they are for equipment to be amortized, he says. At the same time, CCE takes immediate credit for those same payments against its operating expenses. In 2000, Coke gave $989 million in total support payments to CCE, including $223 million in infrastructure support. "It's treated as an asset by one company and an immediate credit by another," Mr. Meyer says.

Coke makes up for the deferred expenses by adjusting the amount of equity income earned from its bottlers. A Coke spokesman says, "In accordance with U.S. GAAP, our accounting policy is to record an expense to match the period in which we obtain benefits." The spokesman added that in recording income from bottling investments, "we eliminate the financial effect of different accounting methods." A CCE spokeswoman declined to comment ahead of the company's earnings release, due today.

Coke has been one of the most outspoken opponents of an FASB draft rule for consolidating related entities that are less than 50%-owned. In a 1999 letter, Gary Fayard, who is now Coke's chief financial officer, wrote that the draft rule "will result in numerous disagreements among corporations, their auditors, the public and the Securities and Exchange Commission on how to interpret these highly subjective guidelines and presumptions as to when control of another entity exists."

General Electric: Some Seek

More Light on the Finances

By RACHEL EMMA SILVERMAN and KEN BROWN

Staff Reporters of THE WALL STREET JOURNAL

To some critics, General Electric Co. could bring a little more light to its own finances.

Shining one of its famous light bulbs onto its financial statements would help explain one of the great mysteries of the stock market -- how GE has managed to produce steady earnings growth for better than two decades even though many of its businesses are cyclical in nature.

Some observers say GE has built that enviable track record and earned a premium valuation in the stock market in the process by "managing earnings." That is the practice of offsetting gains from large asset sales with carefully timed "one-time" restructuring charges in certain businesses, for plant closures or layoffs, for example. That way, quarterly earnings appear smooth, rather than jagged. How the biggest company in terms of stock-market valuation achieves this is, at times, one of the biggest black-box mysteries around.

Many Accounting Practices Are Hard to Penetrate

For its part, GE maintains that it doesn't manage earnings. "Our focus is on managing businesses, not on 'managing earnings,' " says a GE spokesman.

Still, there are two phrases that appear with frequency in analysts' earnings reports about GE: "in line with expectations" and "offset by." And so it was last week when the company announced its fourth-quarter earnings. Despite the lousy economic environment, the company's net income rose 9.7%, right "in line with expectations," with strong performance in its power-unit business helping to "offset" weakness in other areas such as aircraft engines. Until the third quarter of last year, which was hurt by the Sept. 11 attacks, GE had met or beat analysts' expectations for 29 consecutive quarters.

All Under One Roof

But ask an analyst or professional investor how GE hits those numbers and some will smile and shrug, admitting that they don't really know. Most will attribute it to GE's diversity and scale, which hedges it against downturns in individual units. Many will also point to GE Capital Services, the company's huge financial-services arm, accounting for roughly 40% of the company's earnings, as the source of the mystery.

Sure enough, GE Capital, which does everything from issuing credit cards to airplane leasing to mortgage lending, posted a big one-time gain in the past quarter, which came stunningly close to the charge it took in the same period. GE's one-time gain was $642 million from a strategic partnership in a satellite business, which was more than offset by a $656 million charge incurred after exiting from "certain unprofitable insurance and financing" product lines, disposing "several nonstrategic investments and other assets," and "restructuring various global operations," according to its fourth-quarter earnings release. No detail was given in the release on what those global restructurings entailed, although GE did disclose its $84 million in losses in Enron Corp. bonds.

GE officials dispute contentions that the company doesn't tell investors enough. "We disclose more than is required," the spokesman says, adding that the company discusses GE Capital "in substantial detail numerous times in a given year with the financial community."

Investors and analysts say it's tough to get a grasp on GE Capital's earnings because of its size and complexity. GE Capital has 25 businesses, ranging from airplane leasing to mortgage lending, but it consolidates those businesses into six segments on its financial statement. "Disclosure is always a concern," says Joe Williams, senior portfolio manager of the Commerce Trust Company's Commerce Growth Fund and a GE shareholder. "They have so many different parts to it. Whether or not you're getting the full disclosure on it -- I'm sure you're not. It's so complicated. You're not quite sure where your risks are."

"It's a challenge to find out what's going on" in each individual GE Capital business, agrees William Fiala, an analyst with Edward Jones. "You don't know everything. You never will, even in the ideal disclosure situation." Still, he believes "GE does a good job telling the big-picture story."

One reason GE doesn't disclose more is its huge size. Companies are required to tell the public "material information," but "what's frustrating about 'materiality' is that there is no clear definition," says Paul R. Brown, chairman of the accounting department, New York University's Stern School of Business. "Policy makers have literally avoided defining materiality." With GE, he says, "it's extremely frustrating, because we know, given the size of GE, there are probably some interesting disclosures that would say something about their business model, good or bad, that we're not getting." GE officials respond: "Material information is what we believe will be important to a prudent investor. There is judgment involved."

Supplement

GE Capital has 25 businesses, ranging from airplane leasing to mortgage lending, but it consolidates those businesses into six segments on its financial statement.

Six categories...

GE Capital Services' profit for three months ended Dec. 31, 2001, in millions

Specialized Financing $126

Middle Market Financing 400

Consumer Services 587

Equipment Management 771 (1)

Specialty Insurance 94

Other -572 (2)

Total GECS 1,407

(1) Includes $642 million gain on formation of Astra/SES partnership

(2) Includes the after-tax costs of $656 million

For 25 businesses

MIDMARKET FINANCING

* Commercial Equipment Financing

* Commercial Finance

* European Equipment Finance

* Health-care Finance

* Vendor Financial Services

SPECIALIZED FINANCING

* Equity

* Real Estate

* Structured Finance Group

SPECIALTY INSURANCE

* Employers Reinsurance Corporation

* Mortgage Insurance

* Financial Guaranty Insurance

EQUIPMENT MGMT.

* Aviation Services

* European Equipment Management

* Fleet Services

* GESeaCo

* Modular Space

* Penske Truck Leasing

* Rail Services

* Technology Services

* Trailer Leasing

SPECIALIZED SERVICES

* Capital Markets

* Global Process Solutions

CONSUMER SERVICES

* Card Services

* Financial Assurance

* Global Consumer Finance

Source: the company

IBM: Unexplained Expenses

Can Mean Other Opinions

By WILLIAM M. BULKELEY

Staff Reporter of THE WALL STREET JOURNAL

Last week when International Business Machines Corp. reported that net income fell 4.9% in 2001 -- its first downturn in eight years -- the focus was on falling sales of personal computers and semiconductors and weak growth of services.

But deep in its financial results was another reason. An unexplained category of expenses called "other income" had gone from a positive $617 million in 2000 to a negative $95 million in 2001. Without that $712 million swing IBM's pretax income would have edged upward.

Such accounting moves -- given little elaboration by IBM officials -- help to explain why the company draws criticism from investors who pore over its financial statements long after the quarterly news headlines appear.

In this case, the $617 million gain in 2000 came mostly from the sales of company investments in Web-related enterprises made during the Internet bubble period. In 2001, IBM wrote down hundreds of millions of dollars in such investments, with little more than an occasional aside about the moves mentioned during conference calls with analysts. In both years, the adjustments had little to do with the performance of IBM's operations but made a significant impact on per-share earnings.

James Grant, editor of Grant's Interest Rate Observer and a longtime IBM skeptic, says IBM's steady earnings growth prior to last year "was the result of ingenuity in the financial department. It isn't illegal or fattening, but it's not generated by operating results."

In past years IBM's results have been bolstered by big investment gains in its giant employee pension fund, huge stock buybacks, which reduce shares outstanding and thereby bolstered per-share earnings, and by steady reductions in its world-wide tax rates.

Nobody sees an Enron situation in IBM. There is little doubt that the bulk of its revenue and earnings result from profitably selling computers, software and services to some of the world's biggest companies. John Joyce, IBM's chief financial officer, says, "We pride ourselves on being one of the most conservative companies regarding our accounting policies." Noting that IBM doesn't have any off-balance sheet financing, he added that "cash becomes the great equalizer in financial analysis, and we have grown cash flow significantly since 1998."

Indeed to its fans, part of IBM's appeal is its ability to deliver expected per-share earnings numbers, even when sales falter. Jay P. Stevens of Buckingham Research says that because IBM gets a lot of its revenue from long-term contracts, each year "they know what they have to do. They can be conservative or aggressive," and speed or slow operations and accounting in various places around the world to deliver predictable earnings.

Critics say the ability to precisely control reported earnings obscures IBM's true performance. "I care how realistically financial statements reflect the economic realities of the basic business," says Robert Olstein, manager of the $1 billion Olstein Financial Alert Fund. "The long-term growth rate that people are building into the [stock price] is too high if you strip out nonrecurring factors."

Critics complain that they can't calculate the impact of IBM's gains from its overfunded pension plan. That plan added $530 million to IBM's pretax income in 2000, 80% more than the previous year. Fueling the rise, IBM had raised its expected return rate on the fund's investments to 10% from 9.5% for 2000, a move that boosted 2000 pretax income by an extra $195 million. An IBM official says that the increase reflected IBM's experience with the long-term growth of its fund.

IBM includes the impact of the pension fund as part of its expense line for "sales, general and administrative." For 2001, Mr. Joyce indicated to analysts that the fund contributed even more to earnings, although IBM won't break out the number until it files its 10-K report with the Securities and Exchange Commission in March.

Meanwhile, investors complain that preliminary results fail to reveal various other elements that in the past have been a factor in earnings. For example, IBM includes income from royalties and licensing as part of its SG&A line, helping hold down the expense line.

Once a year it discloses the amount of that income -- in 2000, it was $1.7 billion, up from $1.5 billion the year before. Mr. Joyce told analysts the amount dropped last year.

Williams: Enron's Game

But Played With Caution

By CHIP CUMMINS

Staff Reporter of THE WALL STREET JOURNAL

Amid sky-high energy prices last January, Williams Cos. made an unusual boast for an energy company.

Instead of relying on cyclical oil and natural-gas prices, the 94-year-old pipeline company told analysts it had figured out a way to make at least $500 million a year in profit "under most market conditions" as it bought and sold commodities on its trading floor. It did that and more over the course of the year, accumulating pretax operating profit from trading of $1.14 billion in just the first nine months of 2001.

Williams already had followed Enron, Dynegy Inc. and others into the explosive business of energy trading, transforming itself by the middle of last year into an energy conglomerate with oil and natural-gas fields, pipelines and power plants and a trading floor that was bringing in an increasingly hefty portion of profits. Williams's trading profits for those first nine months contributed more than half of the Tulsa, Okla., company's overall pretax operating profit.

Many Accounting Practices Are Hard to Penetrate

As Wall Street started asking more questions last year about how energy companies were accounting for their trading-floor gains, Williams's then-chief executive, Keith E. Bailey, moved to distance his company from Enron and its opaque accounting, its related-party transactions and what Mr. Bailey described as Enron's aggressive appetite for risk. "If you think of a spectrum of businesses that operate across a risk continuum, I would sort of view Williams as one bookend and Enron being another," he said in an interview in July.

Wall Street has generally agreed. While Williams's stock price is down about 40% over the past year amid the whole Enron meltdown, it has held up better than many of its peers. But one fundamental question continues to dog Williams: A large chunk of Williams's earnings still comes from unrealized, noncash gains. Therein lies this company's black box.

At issue is a technique called mark-to-market accounting, under which energy traders have wide latitude to include in current earnings the profits they expect to get in the future from energy-related contracts andother derivative instruments. Each quarter, Williams and others "mark to market" their energy contracts outstanding, valuing them according to current market prices. If prices increase, companies can record gains in their contracts' values and book those gains as earnings for the quarter.

But many of these contracts, especially in Williams's case, stretch out as long as 20 years, when reliable market prices don't yet exist. For instance, Williams early last year signed a contract to sell electricity to three Georgia power cooperatives over the next 15 years.

In these cases, accounting rules allow companies to use their own mathematical models to come up with a contract's "fair value." Critics maintain companies have too much discretion to assign value, but the Financial Accounting Standards Board says there are so many different types of energy contracts out there that it would be impossible to apply a cookie-cutter approach.

Williams's unrealized, noncash earnings for the first nine months of last year were $1.1 billion, according to a presentation by the company late last year. That is about half of the company's total pretax profit in the period.

That makes it hard for investors to value Williams, according to Jeff A. Dietert, an analyst at Simmons & Co., an investment firm in Houston. Based on Williams's earnings projections for this year, the stock "looks cheap," he says. "On the other hand, it's hard to say how much of that is mark-to-market" gains that could ultimately prove too optimistic.

Mr. Dietert says he "trusts" Williams's management, which he calls "arguably the most proactive in providing incremental disclosure" of its trading-floor accounting methods. Still, the latitude energy companies have to value their contracts and book noncash earnings make it almost impossible to compare the performances of energy-trading companies.

Williams, like its rivals, doesn't disclose the models it uses to value its contracts, but it says that most of its noncash gains will be fully realized within five years and are booked only after committed buyers and sellers of energy contracts are matched up, effectively locking in profits.

And, Williams notes, the company doesn't have a choice about using mark-to-market accounting. "We realize the need for further disclosure," says Andrew D. Sunderman, vice president for finance and accounting. "Williams has always been upfront. Our model is very different than Enron's."