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Jubak's Journal
Recent articles:
• Lies, damned lies and earnings reports, 4/25/2003
• Can earnings disappointment ever be good? Yes, 4/18/2003
• Tales from the 2 economies, 4/17/2003
More...
| | Jubak's Journal
Tear up the earnings rule book
Forget apples to apples. Earnings reports now compare mangos to mandarins, making this quarter's numbers more confusing for investors than ever. Let's look at Nortel and Qualcomm to see why.
By Jim Jubak
No matter how good the intention, reform never works quite the way it was intended. The short-term result of almost any change is chaos. And in the case of efforts to reform the way companies report quarterly earnings, chaos has certainly been the short-term result.
But the long-term picture isnt much more comforting. The reform efforts have cast doubt on the historical relationships between earnings and stock prices. And that has seriously weakened earnings per share as a tool for valuing stocks.
This quarter, reforms intended to make companies use stricter rules in reporting earnings have, in the short run, made reported earnings even harder for investors to understand. Caught in midstream while the new rules are being put in place, Wall Street analysts are producing earnings projections without a consensus about which earnings numbers they should be watching.
A sea of earnings confusion
Add that to the earnings quality problems I detailed in my last column and I think investors this quarter are looking at one of the most confusing and least useful sets of quarterly earnings reports delivered since the Securities and Exchange Commission opened shop.
But the problems dont end there. Even if Wall Street and investors make a successful shift from pro forma to GAAP numbers, the change itself will make the historical earnings record difficult to use to value stocks. Whats the point of knowing that General Electric (GE, news, msgs) has traded at a price-to-earnings multiple between 40 and 14 over the last 10 years when the way earnings per share will be calculated in the future has an undefined relationship to the way earnings were calculated in the past. Certainly investors can say that a multiple of 40 on future earnings calculated using a different methodology is expensive and a multiple of 14 is cheap. Historical price-to-earnings ratios become useless for valuing stocks.
Let me start by explaining the short-term chaos and gradually work toward the long-term problems.
For the short-term end of the problem, take the case of Nortel Networks (NT, news, msgs). The deeply troubled telecommunications equipment maker delivered some good news when it reported earnings for the first quarter of 2003 on April 24.
Nortel said it earned a penny a share, the first time in 13 quarters that Nortel had reported a profit. And these results, the company proudly said, were based on the stricter GAAP (generally accepted accounting principles) rules rather than on the loose pro forma standards that give companies more wriggle room in calculating their bottom line.
So great news, no? Especially when the 24-analyst consensus reported by Zacks Investment Research projected that the company would lose 3 cents a share this quarter. Nortel had reached profitability a quarter before its own predictions.
Maybe.
Nortels report sent Wall Street analysts running to their calculators not to see if the stock of the now-profitable company was a buy, but to see how the GAAP standards the company had used to calculate its earnings actually compared to the pro forma standards Wall Street had used to prepare its estimates.
No agreement on methodology
After much head-scratching, Reuters Research, the parent of earnings and estimate compiler Multex, concluded that the real comparable earnings per share numbers for Nortel Networks came to a loss of a penny a share after the number-crunchers shuffled some gains and losses around. Not the one penny a share profit reported by the company under GAAP rules, as the company interpreted them. And not the 3 cents a share loss under the pro forma accounting standards that Wall Street accountants had used to come up with their original projections. But instead yet another earnings number calculated using some other methodology.
Confused?
Welcome to the club. To be sure, it has always been tough to know if Wall Street analysts and company accountants used the same rules in calculating earnings numbers. And it has always been wise to take the numbers apart before accepting the headline judgment that Intel (INTC, news, msgs) beat estimates by 2 cents a share (apples to apples, it looks more like a penny surprise) or that Microsoft (MSFT, news, msgs) beat by 3 cents (the company, counting differently than the analysts, says 2 cents). (Microsoft, by the way, is the parent of this Web site.)
But the confusion has hit new heights this quarter. There seems to very little agreement between companies and analysts, or even among members of those groups, on how earnings should be calculated.
Part of the blame, ironically enough, falls on efforts to tighten accounting standards that are now being put in place. According to a new SEC rule, called Regulation G, that took effect last month, companies are supposed to make sure they calculate earnings using GAAP rules and give those figures top billing in their earnings reports. Companies can still report whatever pro forma numbers they choose, but they cant promote those figures at the expense of the GAAP numbers. And they have to explain how to reconcile any pro forma numbers with the GAAP figures.
So far this earnings season, about 70% of the companies reporting have used GAAP earnings, according to First Call.
The problem, however, is that Wall Street analysts have lagged behind corporate CFOs in converting their earnings estimates to GAAP. Analyst estimates for the first quarter now being reported include figures based on GAAP earnings, on operating earnings, on traditional pro forma measures, and on who knows what else. All those figures, despite being calculated using incompatible methods, are simply averaged into the consensus Wall Street expectation.
The difference is significant. If you use 2002 GAAP earnings to calculate the markets price-to-earnings ratio, the Standard & Poors 500 trades at 32 times earnings. According to First Call, if you use operating earnings, a loose figure that includes many different kinds of earnings methods, the price-to-earnings ratio drops to 19 times earnings.
The Qualcomm quandary
Heres how the confusion and the price-to-earnings difference plays out at a single company, Qualcomm (QCOM, news, msgs). According to Zacks Investment Research, Qualcomm beat the Wall Street consensus estimate of 35 cents a share for the March quarter when it reported earnings on April 23 of 38 cents. Thats a 9% positive surprise.
Of course, that consensus was based on pro forma earnings. Qualcomm led its earnings press release with its GAAP earnings of 13 cents a share.
For fiscal 2003, which ends in September 2003, UBS Warburg projects Qualcomm will earn $1.31 a share pro forma or 95 cents GAAP. So right now Qualcomm trades at either 24 times projected fiscal 2003 earnings per share or 33 times projected GAAP earnings per share. Thats a 38% spread between the high and low multiples.
Its tempting to say Go with the GAAP number and the GAAP multiple because its more accurate, but that runs into immediate problems. Investors have no idea of the multiple Qualcomms GAAP earnings have commanded in the past -- since the stock traded on pro forma earnings and multiples of those numbers. So we have no way of knowing if a projected multiple of 33 times GAAP earnings for Qualcomm is historically cheap or expensive.
On the other hand, it seems dangerous to go with pro forma numbers. Perhaps all of Qualcomms past price-to-earnings multiples were inflated because the pro forma numbers made the company look more profitable than it is by GAAP standards. In the aggregate, say some market historians, that kind of accounting inflation played a major role in creating the stock market bubble that burst in 2000. Paying pro forma multiples when their history has been distorted by that kind of bubble seems dangerous.
That leaves investors in a quandary. On the one hand, these numbers continue to be the measures of short-term success or failure most commonly reported and closely followed by analysts and investors. In the short-term, the earnings game continues as usual: as long as the stock beats or misses some Wall Street consensus, it will soar or dip. As flawed as these numbers are, they continue to have the power to move stocks in the short-term.
Yet were in a period where disagreements about how earnings should be measured are extreme. And that disagreement does make it difficult for investors to use earnings numbers to judge the trend in a companys business without first tearing apart the reported numbers, the analyst consensus, and historical reported earnings to understand the methods used to arrive at those numbers and to recalculate the results into a seamless record that can be used to judge and value stocks. I doubt that most individual investors can or will go through that exercise. One of the reasons that earnings numbers were such a popular tool for valuing stocks was because the methodology involved was relatively simple. Thats no longer the case if all earnings numbers require diligent mathematical massaging before theyre ready for use.
The search for 'core earnings'
Some analysts on Wall Street have responded to this challenge by searching for better methods for calculating earnings and earnings trends. One of the most promising of these is something called core earnings. In applying this concept, an analyst or investor tries to separate the earnings growth thats a result of core activities of the company from one-time gains from extraordinary events or gains or losses from businesses that seem peripheral to the core.
So for example, in looking at student loan provider SLM Corp. (SLM, news, msgs), Smith Barney uses a definition of earnings that seeks to exclude gains from turning loans into securities and then selling them, from any trading income, and from any sales of loans, and equally to exclude any charges from acquisitions. The result, Smith Barneys analyst concludes, is a number that is the best measure of the companys economic earnings power.
Core earning analysis is a very useful approach, in my opinion, especially at a time when so many manufacturing and retailing companies are announcing earnings that are pumped up by gains from financing activities that are unrelated the companys core business. But the method is irretrievably subjective -- one analysts core is anothers periphery -- and so labor-intensive that its not a viable replacement as a valuation tool for most investors who have relied on earnings per share and historical multiples.
In my opinion, finding methods that will replace those tools for most investors will require leaving earnings numbers and price-to-earnings ratios completely behind and looking at measures such as price-to-sales and growth in cash flow per share where the record of historical valuation hasnt been disrupted by radical changes in how the numbers have been calculated.
In the next month Ill be looking at some work on relative price-to-sales ratios that might fill the bill for more value-oriented investors. And Ill try to take some of the mystery out of valuing a stock on cash flow for growth investors that are looking for an alternative -- or perhaps just a backup -- to traditional earnings-based valuation tools.
New developments on past columns
5 stocks poised to lead the market back
Theres a debate on Wall Street about Sysco (SYY, news, msgs) after its April 28 earnings report. The naysayers point out, rightly, that organic sales growth -- thats sales growth before acquisitions -- was flat in the first quarter from the December period. Cash-flow trends are modestly downward: Thanks to rising accounts receivables, cash flow from operations grew by just 8%. And finally, the company missed Wall Street consensus projections of 27 cents a share by a penny. On the other hand, those who like the stock say, overall sales grew by 14% in a very tough quarter, what with the war with Iraq, bad weather, high fuel costs, and the turmoil from the accounting scandal at Royal Ahold (AHO, news, msgs). Free cash flow actually picked up and the increase in receivables is a result of Sysco's effort to improve margins with a major customer. And finally, supporters of the stock say, whats the matter with 13% earnings growth in a bad quarter? How many companies are hitting that number quarter in and quarter out in this economy? And there, I think, youve got the crux of the case both for and against this stock. If you think the economy is about to stage a sharp second-half recovery in 2003, then Syscos solid 12% to 13% growth quarter in and quarter out isnt especially attractive since lots of companies will post far bigger earnings increases as business picks up. In that case, Sysco is probably stuck in its current range of $26 to $32 for the next six months. If, on the other hand, you believe that any second-half recovery will be modest at best, then Syscos earnings growth is far more impressive and far more valuable. In that case, the stock could hit $35 by October. I belong to the second of these camps and believe the stock is a great hedge on a less-than-robust recovery with downside thats limited by its solid growth rate. As of April 29, Im raising but stretching out my target price to $35 by October. (Full disclosure: I own shares of Sysco.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Microsoft and Sysco. He does not own short positions in any stock mentioned in this column.
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