HealthSouth's Slide Had Early Warnings

Berkshire Hathaway's (BRKA - commentary - Cramer's Take) Charlie Munger likes to tell people that all he wants to know is where he's going to die. That way, he'll never go there and thus will live forever.

I think of Munger's line whenever I look at a company that caused investors to lose billions. The reason I like to do these financial autopsies is to see if there were any red flags that would have warned me to stay away. I find this postmortem examination improves my analytical skills, thereby increasing my chances for finding the best opportunities on Wall Street and avoiding the investment dreck.

Today's patient is HealthSouth (HLSH - commentary - Cramer's Take). The Birmingham, Ala.-based firm operates a network of nearly 1,700 health care facilities in the U.S., as well as in the U.K., Australia, Puerto Rico, Canada and Saudi Arabia. For a time, HealthSouth was one of the great growth stocks. In 1993, for example, its shares traded at $3.50. By early 1998 the stock reached almost $31, resulting in a peak market value of $13.4 billion.

However, it now appears that HealthSouth cooked its books. In fact, according to some press reports, HealthSouth made up its earnings from its earliest days as a publicly traded company. So far, nearly a dozen executives -- including every CFO -- have confessed to participating in what may be a multibillion-dollar accounting scam. Federal authorities say Richard Scrushy, HealthSouth's founder and ex-CEO, orchestrated the alleged fraud. The company's stock, which had traded as high as $15 in early 2002, now fetches 29 cents on the pink sheets.

Follow the Money

Could you have known that HealthSouth was probably breaking the law? No, of course not. However, as we're about to learn, on the basis of financial statements filed with the Securities and Exchange Commission, it's clear the company had so-so earnings quality for the last several years. And that was all you needed to know to stay away. (To avoid any ex-postfacto bias, all stock prices are 30 days after the company filed with the SEC.)

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].