Earnings 'Noise' Lowers Boom on Conseco

The grisly saga of Conseco (CNC Quote - Cramer on CNC - Stock Picks) just got a lot bloodier.

Reflecting wider-than-expected bad loans and steep losses in its bond portfolio, the stricken insurer and lender said Tuesday that it expected to take third-quarter charges estimated at $475 million after taxes. This brings total charges over the six quarters ending in 2001's third quarter to a whopping $2 billion, which is 14 times the company's 2000 operating earnings.

Particularly concerning, Carmel, Ind.-based Conseco also said Tuesday that cash flows from some of its loans would be much less than it originally thought. This could hamper the company's efforts to raise cash to repay its hefty debt in 2002. Perhaps reflecting jitters among Conseco's bank creditors, a sizable chunk of the company's bank debt traded this week at a sharp discount to its par value.

The Tuesday warning, which took the form of a memo from CEO Gary Wendt, left a lot to be desired in terms of the information it provided investors. Wendt didn't provide a third-quarter earnings projection and offered no guidance on closely watched numbers like companywide operating cash flow, past-due loans, mobile-home repossessions and defaults. Conspicuously, the writedowns didn't include any adjustment to the value of Conseco's $8 billion of intangible assets, which appear substantially overvalued on the company's balance sheet. Conseco didn't return calls seeking comment.

Some $225 million of the charge stems from deterioration in the credit quality of portions of Conseco's $44 billion loan portfolio. The $225 million writedown is to bondlike instruments called I/O securities, which represent the company's exposure to its own loans. The adjustment essentially says loan losses are worse than the company expected. The I/O securities have been written down several times over the past few quarters.

Conseco said it expects to make $10 million in cash from the I/O securities in 2002. That's a bombshell: The company had expected to generate $120 million of cash from these instruments. The expected failure to produce that sum therefore calls into question lending arm Conseco Finance's target of generating $335 million of cash in 2002.

Christmas in July

The banks may have seen these problems coming. This week, a $50 million slice of bank debt due in 2003 traded at around 81 cents in the dollar, according to market sources. After a restructuring last year, Conseco's bank debt was thought to be safer than its bond debt. But this trade suggests worries are swirling around these loans, too.

Wendt said in the Tuesday memo that "none of these special charges causes us to violate any of our debt covenants." However, the company could be getting close to breaking some provisions in its debt covenants. In an agreement with Lehman Brothers (LEH Quote - Cramer on LEH - Stock Picks), Conseco Finance's tangible net worth has to be at least $1.95 billion. It was $2.2 billion at the end of June. Will these write-offs, and others that could come by the end of the year, take it below $1.95 billion?

The other charges were: $125 million on its bond portfolio; $40 million to get out of major medical insurance; $45 million to mark down the value of its investment in TeleCorp; and a $40 million addition to the reserve the company has taken for loans made to directors and officers.

Of course, some of these are extraordinary items. The bond portfolio, insurance and Telecorp markdowns could all be classified as such. But the I/O adjustments and the increase to the loan reserve clearly belong in operating numbers, regardless of what this management says.

As usual, Wendt has tried to blame most of the company's problems on the previous management. But this memo nowhere mentions the fact that mobile-home loans made under Wendt's tenure are going bad much faster than they did on the vast majority of loans written by Hilbert and his minions.

At this rate, we'll need Stephen King to draw up a suitably gory ending to this saga. Soon.