Hiding Bad Numbers Behind the Disaster

Sept. 11 deserves the blame for a lot of things -- but not everything.

As corporate America nears the end of the third quarter and profit warnings start rolling in, a large number of companies are citing the tragic attack on the World Trade Center and the Pentagon as the reason for ratcheting down earnings expectations. But look more closely. While it's valid in many cases, some of those companies may be using the terrorist attacks as a smoke screen for previously existing fundamental problems.

To help dissipate that smoke screen, the Financial Accounting Standards Board, or FASB, recently reversed an earlier decision to allow companies to regard costs related to the disaster as extraordinary and include them as a separate item on their financial statements. Instead, companies must account for these expenses as routine costs. In effect, this decision prevents companies from showing how much the disaster affected their earnings on their income statements.

But the FASB can't control what firms tell the public in earnings announcements. While the board's decision prohibits companies from breaking out the cost of the attacks as a separate line entry called an "extraordinary item," companies face little or no regulation in what they can say in the body of a press release. Many will presumably adopt pro forma treatments that purport to isolate earnings before the effect of the terrorist attacks, and therein lies the possibility for doctored numbers.

"Some companies will try to use the attacks as an explanation for bad performance," said Dan Kasper, analyst at LECG, an economic consulting firm. "Look at each case on its own merits."

The Obvious

Take the most obvious example: the airline industry. Certainly, an unprecedented grounding of aircraft immediately following the attacks, increased security requirements and skittish air travelers -- all the result of the terrorist activity -- will hammer airline companies' bottom lines.

But many carriers were struggling before the attacks because of decreased business travel, an overcrowded sector and poor business models. Some companies teetered on the brink of bankruptcy. Just before the attacks, Midway filed for Chapter 11, which gives companies a chance to restructure. On Sept. 12, the airline company suspended all flights.

Indeed, the $15 billion in federal aid to the airline industry might push companies back from the brink. The federal government intended the $5 billion cash part of the package to compensate the airlines for losses during the month of September, said Scott Gibson, analyst at Simat Helliesen & Eicher, a financial and aviation consulting company. "It didn't make them healthy."

A second part of the federal aid package, the $10 billion in loan guarantees, is being hotly debated in Congress. Some airlines were in such jeopardy on Sept. 10 that they didn't have access to capital markets. "The loan guarantees shouldn't give these companies access now," said Gibson.

Even though it is too early to tell if the federal bailout changed the long-term survival odds of some airlines, the recent crisis has called the industry's financial model into question. "The airline business is highly leveraged," says Kasper. "It has a high debt-to-equity ratio. That tends to increase vulnerability under highly adverse circumstances. It doesn't call into question the health of the industry. But it does call into question whether this is a sustainable financial structure."

Kasper says airlines have never been a good long-term investment, "with one exception: Southwest(LUV)." The no-frills carrier uses short jaunts across the country to avoid congestive airports, and nearly always fills its planes.

The Obscure

Now let's take two less obvious examples.

A week after the terrorist attacks, Kodak (EK) lowered its third-quarter earnings to 65 cents per share, compared with an earlier guidance range of 90 cents to $1.20 per share. The company attributed the reduction to a slowing economy and negative effects from the terrorist attacks.

Less leisure travel from scared consumers does result in less picture-taking. But Kodak struggles with other problems. Its health imaging business is faltering. The increasing number of group-purchasing organizations, which act as buyers for multiple hospitals, has decreased prices for medical images and, as a result, Kodak's revenue. During its second quarter this year, Kodak earned $1.12 per share, compared with $1.65 per share a year earlier, according to Thomson Financial/First Call.

In addition, the conventional photography company is struggling to make a transition into the digital age. "If people weren't so worried about digital cameras reducing the demand for film, this company would be trading at a higher price," says Peter Ausnit, an analyst at Deutsche Banc Alex. Brown. "Within the next several years, the use of film will decline."

Elsewhere, Impath (IMPH), a provider of cancer diagnostic information, ratcheted down its third-quarter earnings, projecting 23 cents to 24 cents, which falls short of the 27 cents analysts predicted. Like Kodak, Impath cited the terrorist attacks as a cause.

The Manhattan-based company did have difficulty receiving tissue samples because of the ban on air travel immediately following the attacks. A couple of days' lost work represents 3% to 5% of revenue per quarter, points out Ruby Holder, analyst at ABN Amro.

But Joel Ray, analyst at First Union Securities, recently downgraded Impath's stock because the company is having difficulty collecting money from clients. Impath recently appointed a new executive to focus on accounts receivable, and the company has made some improvement in this area, says Ray.

The decline in days sales outstanding, or DSO, for the company's 2001 second quarter did decrease to 118 days from 123 days in the previous quarter, according to a statement issued by Impath's COO, Richard Adelson.

"If the company continues to make progress on its DSO, it will have a positive stock," says Ray. "If it can't, it won't."

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