WorldCom's Peak Was Less Than Lofty

As readers of my column know, the income statement in every annual report, 10-K and 10-Q has four major limitations:

It omits investment in fixed capital

It omits investment in working capital

Intangible growth-producing initiatives like R&D and advertising are immediately expensed

Stockholders' equity is free.

As a result, a firm can appear profitable in the traditional word and yet not be able to self-fund and/or create value. For the growth investor, these poor earnings-quality companies make for the riskiest investments, because in addition to the Swiss cheese profits and losses, you're probably paying a big multiple of sales, earnings, dividends and book value (corporate net worth.) Then, if bad news strikes (and it will, if you own a company long enough), the resulting multiple compression can sear a hole in your brokerage account that may take years to mend.

To illustrate my point, let's look at WorldCom's (MCWEQ - commentary - Cramer's Take) earnings quality between 1997 and 2001 (the company is now called MCI). The phone company that Bernie Ebbers built is making news again, this time over what the Wall Street Journal has described as a "massive and systematic fraud." What follows are two charts exclusive to RealMoney.com -- you've never seen this type of dual income statement analysis anywhere before.

Source: SEC; EarningsPower.com; BigCharts.com

As we see in Exhibit 1, "Quality of Profits," WorldCom was profitable on an accrual basis in four out of five years ending in 2001. The only year it lost money was in 1998. But in 1999 and 2000, earnings as calculated under generally accepted accounting principles, or GAAP, were up over the prior year. Ostensibly, this is a bullish signal.

Meanwhile, on a defensive basis, WorldCom made money in only two out of five years. As I've explained before, the defensive income statement expenses investment in fixed and working capital in the year incurred, because they are uses of cash and you never know if the outlays will create long-term value.

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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].