AP analysis: Companies 'adjust' profits more in their favor
Jun 8, 8:44 AM EDT
AP analysis: Companies 'adjust' profits more in their
favor
By BERNARD CONDON AP Business Writer
NEW YORK (AP) -- Those record profits that companies are
reporting may not be all they're cracked up to be.
As the stock market climbs ever higher, professional
investors are warning that companies are presenting misleading versions of
their results that ignore a wide variety of normal costs of running a business
to make it seem like they're doing better than they really are.
What's worse, the financial analysts who are supposed to
fight corporate spin are often playing along. Instead of challenging the
companies, they're largely passing along the rosy numbers in reports
recommending stocks to investors.
"Companies are tilting the results," says fund
manager Tom Brown of Second Curve Capital, "and the analysts are buying
it."
An analysis of results from 500 major companies by The
Associated Press, based on data provided by S&P Capital IQ, a research
firm, found that the gap between the "adjusted" profits that analysts
cite and bottom-line earnings figures that companies are legally obliged to
report, or net income, has widened dramatically over the past five years.
At one of every five companies, these "adjusted"
profits were higher than net income by 50 percent or more. Many more companies
are in that category now than there were five years ago. And some companies
that seem profitable on an adjusted basis are actually losing money.
It wasn't supposed to be this way. After the dot-com
crash of 2000, companies and analysts vowed to clean up their act and avoid
highlighting alternative versions of earnings in a way that could mislead
investors.
But Lynn Turner, chief accountant at the Securities and
Exchange Commission at the time, says companies are still touting
"made-up, phony numbers" as much as they did 15 years ago, perhaps
more, and few experts are calling them out on it.
"The analysts aren't doing enough to get behind the
numbers that management gives them to find out what's really going on,"
Turner says.
Offering an alternative view of profits that leaves out
various costs is not new. It's perfectly legal, and sometimes helpful as a tool
for investors to gain insight into how a business is doing.
But with stocks breaking record after record and the
current bull market entering its seventh year, there's more money riding on the
assumption that the earnings figures being touted by companies and analysts are
based on sound calculations.
"The longer the rally, the bigger the downside
because of all the smoke and mirrors," says money manager John Del
Vecchio, co-author of "What's Behind the Numbers?" a book on how
profit reports can mislead.
In its study, AP compared bottom-line profit figures that
follow rules called generally accepted accounting principles, or GAAP, to the
adjusted profit figures calculated by financial analysts and collected by
S&P Capital IQ. AP looked at companies in the Standard & Poor's 500
index.
Most of the time, the adjustments made companies look
better by leaving out things like costs related to laying off workers, a
decline in the value of patents or other "intangible" assets, the
value of company stock distributed to employees, or losses from a failed
venture. Critics argue that these are regular costs and shouldn't be excluded.
Key findings
- Seventy-two percent of the companies reviewed by AP had
adjusted profits that were higher than net income in the first quarter of this
year. That's about the same as in the comparable period five years earlier, but
the gap between the adjusted and net income figures has widened considerably:
adjusted earnings were typically 16 percent higher than net income in the most
recent period versus 9 percent five years ago.
For a smaller group of the companies reviewed, 21 percent
of the total, adjusted profits soared 50 percent or more over net income. This
was true of just 13 percent of the group in the same period five years ago.
- Quarter after quarter, the differences between the
adjusted and bottom-line figures are adding up. From 2010 through 2014, adjusted
profits for the S&P 500 came in $583 billion higher than net income. It's
as if each company in the S&P 500 got a check in the mail for an extra
eight months of earnings.
Fifteen companies with adjusted profits actually had
bottom-line losses over the five years. Investors have poured money into their
stocks just the same.
- Stocks are getting more expensive, meaning there could
be a greater risk of stocks falling if the earnings figures being used to
justify buying them are questionable. One measure of how richly priced stocks
are suggests trouble. Three years ago, investors paid $13.50 for every dollar
of adjusted profits for companies in the S&P 500 index, according to
S&P Capital IQ. Now, they're paying nearly $18.
In a crackdown after the dot-com crash, regulators
required companies to lay out clearly in their financial reports how they
arrived at alternative versions of their profits. The bottom-line figures have
to be prominently reported, too. But it's not clear the extra details have
helped.
"The data is more confusing than it's been in a long
time, and the reason is all the junk they put in the numbers," says fund
manager Michael Lewitt of the Credit Strategist Group. He says analyst reports
don't help, and finds himself spending too much time sifting through the same
"nonsense" figures he confronted back in the dot-com days.
Michelle Leder, founder of Footnoted.com, which produces
detailed analyses of financial statements, says most investors don't even
bother to sift, preferring instead to seize upon a single number, often the
wrong one.
"People just want to know the number," she
says. "They don't care how the sausage is made."
Frequent adjustments
Boston Scientific, a maker of medical devices like stents
used to prop open arteries, had adjusted profits of $3.6 billion in the five
years through 2014, according to analysts' calculations. But if you include a
write-off for a failed acquisition, various "restructuring" charges
and costs stemming from layoffs and lawsuits, it's a different picture
entirely: $4.9 billion in net losses.
In a brief talk to analysts in April, the chief financial
officer at Boston Scientific used the word "adjusted" in referring to
results 34 times, twice every minute, on average. The word is also littered
throughout the company's presentations and financial reports. In recent years
rivals Medtronic, Stryker and Zimmer have also highlighted their results this
way, says Raj Denhoy, an analyst at Jefferies, an investment bank.
Aluminum giant Alcoa has taken "restructuring"
and related charges in 20 of the past 21 quarters. The company reported net
losses of more than $900 million in the five years through 2014, but analysts
have largely shrugged them off because they're tied to a strategic shift that
involves getting rid of unwanted businesses. Analysts prefer to point to the
$3.1 billion in adjusted profits during that time.
To be fair, analysts see the adjusted figures more as a
tool for helping estimate future profits than as a judgment on the past. They
say many losses and charges are not likely to recur and shouldn't be included
in their calculations.
But in an age of constant change, when some companies
revamp their business repeatedly, many one-time items are starting to seem not
so one-time anymore.
"If you have to reinvent the company every couple of
quarters, then it's not a one-off," says accounting expert Jack Ciesielski,
longtime publisher of The Analyst's Accounting Observer, a newsletter.
What to count
For their part, Boston Scientific and Alcoa say the extra
figures they provide help shed more light on their companies. Boston Scientific
says the numbers allow investors to see the company "through the eyes of
management" because they are the same ones its executives use in making
decisions. Alcoa says its financial results reflect a "significant
transformation" to make it more competitive.
Another number often missing in adjusted profit figures
is the value of stock awarded to employees. This stock-based pay, the argument
goes, requires no exchange of cash, so it doesn't affect a company's earnings
power. Critics say stock distributions are a part of compensation and should be
counted as an expense.
"What if they said they're going to pay for rent by
issuing stock?" asks Brown of Second Curve Capital. "Would you then
(exclude) rent" in calculating earnings?
Salesforce.com, a leader in cloud computing, routinely
excludes the cost of stock compensation from figures it touts to investors, and
analysts largely do the same. Analysts say the company earned $1.2 billion in
adjusted profits in the five years through 2014. Its bottom-line result,
including stock pay and other costs, was a $712 million loss.
Brian Rauscher, chief portfolio strategist at Robert W.
Baird & Co., says stocks can continue to rise based on an inflated account
of company profits for months or even years, but not indefinitely. He says it's
like a bomb no one can see has been placed under the market: You know it's
there, but you're not sure when it will go off.
"We don't know if the fuse is a few inches or a few
miles," he says.
© 2015 The Associated Press. All rights reserved.
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