Hard-to-Decipher Results

Invite Investors' Wrath

By JESSE EISINGER

Staff Reporter of THE WALL STREET JOURNAL

So far, Europe hasn't produced its own Enron Corp.

But the Old World has its share of "black boxes": companies whose financial statements are hard to penetrate, that have items off the balance sheet or that use unorthodox accounting methods.

Investors have been flushing out any company in their portfolios that fits that description. British airplane-engine maker Rolls Royce PLC, telecom operator Cable & Wireless PLC and Swedish insurer Skandia Forsakrings AB have all been roiled in the past several weeks by accounting worries.

"There is a big change going on," says Benoit Flamant, chief executive of IT Asset Management, a Paris fund management firm. "Markets and investors will punish companies going forward that are not transparent. Investors will give a premium to companies with clear reporting."

In the post-Enron environment, investors are punishing some already. Take France Telecom SA, whose shares have plunged 42% over the past three months, much steeper than the drop by the overall market or by other telecom companies. A takeover spree of a few years ago has left questions about the exact size of the company's off-balance-sheet liabilities. The dispute is raging right now.

France Telecom isn't alone with such debt questions, but it's one of the most visible examples. Likewise, Siemens AG isn't the only big company to shift expenses and other items between its many divisions for reasons that aren't clearly explained, but it outshines many at the practice. Other companies that have drawn scrutiny for excelling at accounting that investors are now frowning on: Aegon, for taking the bumps out of its results; Alstom SA, for its enormous off-balance-sheet liabilities; and BAE Systems, for taking so many charges.

Here's a guide to prying open and letting some light into some of Europe's black boxes.

The Serial One-Time Charger

Investors who like the stock of BAE Systems, the giant British defense contractor, must be fans of what some London analysts joke is the "EBBS" valuation technique: Earnings Before Bad Stuff.

This usually goes by the more common phrase "operating profit." Many investors and analysts simply concentrate on income from operations and disregard what the company calls "extraordinary" or "one-time" items.

The reason is simple for BAE. Profit before interest, goodwill amortization and exceptional items was 1.3 billion pounds ($1.83 billion or 2.1 billion euros) in 2001, compared with 950 million pounds a year earlier. But after all was said and done, BAE had a net loss of 134 million pounds compared with a net loss of 25 million pounds a year earlier. Part of the reason was that in 2001 the company recorded 518 million pounds of "exceptional" items, compared with 307 million pounds the year earlier.

This set of circumstances wasn't unusual for BAE. In each of the last 10 years, BAE has taken some sort of one-time charge, according to Goldman Sachs. In eight of those years, the losses from the charges outstripped exceptional gains.

It's gotten to the point that in an unusual move, some analysts forecast "extraordinary" charges in their financial models on BAE. BAE is a "perennial exponent of EBBS, and it's a dangerous habit to get into and a difficult habit to kick," says Sash Tusa, an analyst for Goldman Sachs.

BAE failed to comment in response to several phone calls to the company's finance director and the company's spokesman as well as several e-mails to the spokesman. Many companies take frequent charges, arguing that stripping away one-time items enables investors to better see underlying operations.

In the defense industry, companies sign long-term contracts. Common practice is to book revenue not when the cash from customers comes in but in increments based on what percentage of the contract is completed. This gives management leeway to report revenue, since no company in the industry reveals exactly how its projects are going. The outside world just sees that the company is booking revenue. Since the industry is plagued with overcapacity and has been contracting since the 1980s, the pressure onprofits is particularly acute.

Some investors say cash flow -- which records what cash came in and what went out in a given period -- gives a truer picture of a company's performance. For BAE, it's anemic. Cash flow from operations after interest and taxes fell to 486 million pounds in 2001 compared with more than 1.7 billion pounds a year earlier. After capital expenditures and dividends, BAE had a cash outflow. In other words, to pay its dividend the company had to raise money through selling assets or equity or raising debt.

That's not good.

-- Jesse Eisinger

The Unbalanced Balance Sheet

Dogged by concerns about its financial disclosure, French engineering company Alstom Thursday named Philippe Jaffre, the former chief executive of oil company Elf-Aquitaine, to oversee all aspects of its finances and act as a special consultant to Alstom's chairman, Pierre Bilger. Alstom also said it would replace its chief financial officer, Francois Newey, by the summer. The new CFO will report to Mr. Jaffre, who is credited with cleaning up Elf in the 1990s after years of corruption and mismanagement.

The moves are part of a campaign by Alstom's management to regain investor confidence, which was badly dented last fall by revelations about the company's accounting practices. Mostly known as the maker of the famous high-speed TGV trains as well as ships and power plants, Alstom is a champion of off-balance-sheet liabilities.

At the bottom of its financial statements, Alstom lists an obscure line item called "commitments and contingencies." At the end of September, the figure next to that line item was 12.8 billion euros ($11.13 billion), not small change for a company with a stock market capitalization of around three billion euros.

"Talk about a black hole," says Jay Huck, a London analyst with the Center for Financial Research and Analysis, a boutique research firm that combs through companies' financial statements for institutional investors.

Until recently, Mr. Huck and other investors had no way of knowing what the 12.8 billion euros represented because Alstom neither highlighted nor explained it. Then came the Chapter 11 bankruptcy-court filing in late September of Renaissance Cruises, a Florida cruise line that operated eight cruise ships built by Alstom's French shipyards. After initially saying its exposure to Renaissance was minimal, Alstom said on Oct. 1 that it could lose as much as 684 million euros as a result of the bankruptcy.

What Alstom had neglected to disclose is that among the commitments and contingencies were written guarantees it had given to banks that had lent money to cruise lines so that they could buy ships from Alstom. This is known as vendor financing. When Renaissance defaulted on those loans, they became Alstom's responsibility.

Suddenly, shareholders became nervous that Alstom might be liable for other guarantees. They were right. When the company released its fiscal first-half results in November, Alstom for the first time provided a breakdown of the 12.8 billion euros -- in footnotes. Turns out that roughly two billion euros are vendor-financing liabilities, including 1.3 billion euros to the cruise industry.

Alstom now promises to put an end to its vendor financing practices. Nonetheless, it continues not to classify these liabilities as debt, which many analysts say would more accurately reflect what they are, since Alstom is the ultimate guarantor of these loans.

In its first-half results, Alstom disclosed net debt of two billion euros. Adding in the vendor-financing liabilities would have doubled the company's net debt to four billion euros, one billion euros more than the company's market capitalization.

The rest of the commitments and contingencies -- 10.8 billion euros -- are guarantees given to customers that awarded Alstom a long-term, big-ticket contract, such as the construction of a power plant or the maintenance of trains. Alstom gives these customers guarantees that the company will make good on the terms of the contract, says Mr. Newey, the current CFO. The practice is routine in the engineering industry, he says.

"That the figure is high is actually a sign that our business is healthy," Mr. Newey says. "It means we're getting a lot of contracts." When an unhappy customer moves to claim the guarantee -- a rare occurrence, Mr. Newey says -- Alstom immediately moves the liability onto its balance sheet.

In the case of Renaissance Cruises, Alstom didn't reclassify the liability as debt. Instead it took a charge of 110 million euros. The company says that's the most it can lose because it has repossessed the eight ships and thinks it can resell them to another cruise customer, albeit at a discount to their catalog price.

CFRA's Mr. Huck is unconvinced. He says 12.8 billion euros "is a huge number, no matter how you slice it. It's one of the biggest off-balance-sheet liabilities in Europe, period." The company's stock has been particularly hard hit, down more than 60% since September.

Mr. Newey concedes that he has had trouble convincing analysts that these liabilities carry little risk. "There's confusion in the market about the strength of our balance sheet and our level of debt," he says.

-- John Carreyrou

The Earnings Smoother

Income at Aegon, as at all insurers, fluctuates depending on when it sells investments and how much it makes on them. But the company doesn't like that fluctuation. So instead, the huge Dutch insurer estimates its net income.

Through the first nine months of 2001, Aegon had accumulated 4.5 billion euros in gains from selling equities and real estate. The company hadn't booked those gains immediately on its income statement when it sold the investments, however. Instead Aegon put the gains into its "revaluation reserve," which is the repository on its balance sheet for the amount by which its stock and real estate investments have appreciated. In each quarter, Aegon draws a bit of the reserve through its profit and loss statement. The result is that the Dutch company reports smoother earnings than it otherwise would.

Some people say the technique obscures how the company is actually doing. "It doesn't reflect the economic reality," says Roger Doig, an analyst for J.P. Morgan. "In a bull market, they understate earnings and in a bear market, like we have now, earnings are overstated."

Aegon declines to comment but is aware there is concern. In a December speech, Chief Executive Kees Storm said the company's system was "not widely followed" and that Aegon had "faced criticism." But he argued that reflecting the rise and fall of equity and real estate investments gives a "very volatile picture that doesn't give the reader [of the income statement] a real insight into the quality of the assets, results and financial soundness of the company." Mr. Storm also said that its method prevents the company from selling an investment simply to be able to book the gain to boost short-term results.

Many companies try to manage their results so that they come out smoothly, but Aegon's accounting technique is rare among major insurers.

How does Aegon know how much to draw down? The insurer explains the hows and whys of its technique in a seven-page document on its Web site.

Here's a summary:

Aegon estimates what the total return on its equity and real-estate portfolio would be by taking an average of returns from the last 30 years. Then it multiplies that figure by the average value of its investments over the last seven years, adjusted for big investment purchases and sales. Aegon says in its booklet that the 30-year and seven-year periods "were selected as reasonable after a thorough analysis."

Then the insurance company calculates the difference between the hypothetical total return and the direct return from dividends from stock holdings and rent from real estate. Aegon calls the difference "indirect income" and releases that difference into the income statement.

This can be a very large number. In the first nine months of 2001, indirect income was high because direct returns lagged behind the hypothetical returns, as they often do. The amount released into the profitand loss statement was 541 million euros, which was more than half the company's reported net income in the period. That compares with indirect income of 424 million euros in the first nine months of 2000.

Aegon doesn't disclose indirect income on its income statement. But it has a separate "quarterly statistics" page on its Web site that contains the number.

Compared with the way many other insurance companies report these gains, Aegon has been understating its profitability. In 2000, Aegon reported net income of just over two billion euros. If it booked the gains right away in accordance with U.S. accounting principles, Aegon would have earned 2.6 billion euros. For 2001, however, Aegon's net income will probably be higher by its count than it otherwise would be because of the weaker stock market.

"People have historically valued Aegon higher than its peers because it's boring and predictable," says Lewis Phillips, a London analyst for Fox-Pitt, Kelton, a financial-services boutique research firm. "They tell you what they are going to do and then they do a bit better."

Aegon has used this unusual technique since 1995. The Dutch finance ministry says Aegon's accounting method lacks transparency and the government is in the process of introducing legislation to ban its use. "It is not transparent to spread capital gains over 30 years as it does not reflect the financial reality," a ministry spokesman says.

-- Jesse Eisinger

The Complicated Deal Maker

France Telecom racked up a pile of off-balance-sheet liabilities during an acquisition spree in 1999 and 2000. Exactly how big a pile, however, isn't clear, some investors say. In an early February research report, Credit Suisse First Boston said the company's level of contingent liabilities "do not seem to be adequately disclosed."

Even excluding off-balance-sheet debt, France Telecom's debt is more than 180% of its market capitalization, highest of any European telecom operator. Those figures are based on net debt on June 30, 2001, of 64.9 billion euros, the last time the company made a debt disclosure.

France Telecom says it can afford its debt because of the company's healthy revenue and broad European presence. It says all of its potential liabilities have been filed with the U.S. Securities and Exchange Commission. "The off-balance-sheet commitments of France Telecom are totally clear," says Bruno Janet, a France Telecom spokesman. He says the company discloses them in filings with the SEC and on its Web site.

The most significant contingent liability France Telecom has disclosed is a put option that Mobilcom AG chief executive Gerhard Schmid holds as a result of France Telecom's acquisition of a 28.5% stake in the German company he founded. Under the March 2000 deal, Mr. Schmid under certain conditions can force France Telecom to buy a 33% stake in Mobilcom from him at a price determined by a panel of investment banks. Should that happen, German takeover law could force the French company to offer the same terms to all other shareholders. It's not clear exactly how much money France Telecom could be on the hook for, since estimates about what Mobilcom could fetch in such a sale vary so widely.

At the moment, Mr. Schmid and France Telecom are fighting bitterly over the terms of their agreement, further clouding France Telecom's potential exposure. People familiar with the French carrier's thinking have argued that the such disagreement in interpretation means the accord is no longer valid and the issue could land in the courts.

Meantime, France Telecom could be forced to pay as much as two billion euros to Equant NV shareholders in June 2004, depending on how Equant's shares trade. That agreement was struck when France Telecom agreed to take a majority stake in Equant in November 2000 and merged it with its Global One unit, which caters to multinational business customers. If the average price of Equant stock falls below 60 euros over a certain period, the payment kicks in.

Another off-balance-sheet liability is $1.1 billion of put options related to France Telecom's investment in NTL. The carrier first took a stake in the U.K. cable operator in July 1999. In this case, the terms of agreement have been a moving target. According to a February 2002 France Telecom filing with the SEC, the company's option agreement related to NTL was amended in March 2000, September 2001 and December 2001.

"As an investor, from my point of view, do I have all of the information to judge the level of risk with NTL and Mobilcom? The answer is 'No,'" says Mr. Flamant of IT Asset Management. "Nobody really knows what is in the shareholder agreements."

A French minority shareholder activist organization, ADAM, this week called for the publication of the shareholder agreement between Mobilcom and France Telecom, and any accords between the French carrier and its publicly traded wireless affiliate Orange, citing lack of visibility on each party's liabilities.

France Telecom says it has provided all of the key details and says it is standard business practice that the texts of such accords aren't disclosed. "The shareholder agreements are not public documents," Mr. Janet says. "But the most important points they contain are public."

It's just a question of when. In a November 2001 filing with the SEC, France Telecom discussed for the first time a November 2000 put agreement it signed with Germany's E.On. The option would have allowed E.On to sell its shares in France Telecom's Orange wireless affiliate to France Telecom and Orange for over &900 million in February 2002. This option came out of France Telecom's purchase of E.On's stake in Orange's Swiss unit. France Telecom hadn't previously disclosed the option, though E.On posted it on its Web site.

"We realized that we needed to communicate it, and we corrected that," Mr. Janet says. In January France Telecom said it renegotiated the E.On agreement.

-- Kevin J. Delaney

The Inscrutable Giant

It's not just that Siemens AG's accounts are complex -- and with 16 individual operating businesses ranging from medical equipment to mobile phones to streetcars, they definitely are.

What makes Siemens accounts especially difficult to understand, some analysts and investors say: The company shifts around charges, expenses and other bad items between divisions and the parent company in ways that make it hard to evaluate how any given business is doing, let alone the whole company.

"It's like a bus with 16 passengers on it," says Luc Mouzon, analyst at BNP Paribas in Paris. "The problem is figuring out who is driving the bus at any given moment. It's always extremely difficult to get a clear overview of the company."

One of the German conglomerate's most puzzling accounting categories is called "corporate eliminations." These are a pile of costs absorbed by the parent company, many of which come from the 16 operating businesses. Siemens provides some details of these costs, which its management board says "are not indicative of the segments' performance," in footnotes of a 200-page SEC filing.

A Siemens spokesman says "this level of transparency is appropriate for a company of our size."

These expenses add up. In 2001, the company's corporate eliminations totaled 320 million euros. The year before the figure was 1.27 billion euros.

Siemens doesn't always offer the source of the expenses in its filings. For instance, in footnote 29, page F-49 of a Siemens SEC filings for 2001, the company says that eliminations included 78 million euros in expenses from "litigation issues."

For a company with 2001 net income of 2.1 billion euros and 2000 net income of 8.86 billion euros, the eliminations can be substantial, says Mr. Mouzon. What's more, the large swings in these costs from one year to the next make it difficult to forecast earnings, analysts say. "They get away with a lot of things," says Lehman analyst Chris Heminway. While Siemens uses acceptable accounting techniques, it has a knack for "making things look better than the reality," he says.

Another example of shifting bad things around: For 2000 Siemens reported 450 million euros of losses due to the cancellation of two Mexican power projects. But instead of accounting for the losses at the divisional level, Siemens put the loss on the corporate line as a one-time cost. As a result of this and another 60 million euro charge also absorbed at the corporate level, the power division's results showed a profit of 58 million euros instead of loss of 450 million euros.

A Siemens spokesman says the company was justified in taking the charge out of the divisional accounts because Siemens' management board assumed responsibility for the projects. "The allocation of this charge as a 'special item' was clearly not done to improve divisional results," a spokesman says, adding that the SEC approved the company's treatment of the charge. The company's accounting and disclosure on the matter was "extremely transparent," the spokesman says.

In another instance, faced with a slump last April, Siemens transferred 15% of its remaining stake in semiconductor maker Infineon to the company pension fund, booking a capital gain of about 3.46 billion euros. In effect, Siemens sold the stake to its own pension fund and recorded a gain on the sale to itself, boosting its earnings.

Other companies also shift pension fund assets around. A Siemens spokesman says it made the transfer as part of its longer-term strategy to get out entirely from Infineon and also because it needed to shore up its pension fund following a major acquisition.

-- Matthew Karnitschnig