Tough Times, Twisted Talk From TRW

When times get tough, accounting by major corporations gets tougher. Many companies are clearing the decks in the current environment by blaming their shortcomings and missteps on the Sept. 11 disaster.

However, many others have chosen to stumble forward, trying to make their quarterly numbers through misleading accounting. More than ever, it's during tough times that investors need straight talk from companies -- both in the presentation of meaningful, honest numbers and in comments from management about the challenges they face.

To illustrate just how silly quarterly earnings announcements have become for some companies, I'm going to pick on TRW (TRW), one of my Top 10 Turnaround Candidates and a company I'm long (though it's a small position). By the way, TRW is a company with a rich reservoir of assets, with market-leading positions in many areas of defense, technology and automotive parts (air bags).

Here are a few simple rules to follow when reviewing quarterly earnings reports, applied to TRW's recent earnings release:

1. Don't accept earnings at face value. You'd think that most investors already know this rule. But if that were true, then companies like TRW wouldn't attempt to foist dubious earnings numbers on the public. In the TRW press release, management discusses pension income in a section titled "Non-Operational Items," then proceeds to include pension income in net income!

   Pension income makes up about half of TRW's quarterly net earnings of 59 cents a share. It's always cause for concern when a company generates half of its income from a source so wholly unconnected to operations.

2. Don't accept charges at face value. Companies levy too many charges that should be included in earnings calculations. For TRW, about $105 million was included in a charge for "pending and threatened litigation" and $22 million "for unrealized losses on foreign currency hedges."

   I'd like to see both of these charges included in income calculations, especially the foreign-currency hedge expense. The purpose of hedging is to smooth out volatility in the results of foreign operations. By definition, this is an operational expense.

   Also, if litigation and currency hedging are excluded from net income because they are nonoperational, then pension income should be excluded as well.

3. Don't accept cash flow at face value. TRW prominently boasts that it "generated $200 million of cash flow" in its press release. However, I focus mainly on free cash flow, meaning cash generated that is free to be used for any purpose. TRW has not disclosed the amount of free cash flow in its most recent quarter. Given that, my calculations suggest that free cash flow generated from operations was negative -- more than $100 million negative, not $200 million positive.

   This discrepancy occurs because TRW uses a generic definition of cash flow, so it includes, for example, its sale of RF Micro (RFMD) stock (at a pretax gain of $169 million). I'm solely concerned about cash flow from operations.

   Logically, can investors be impressed with a company that generates cash flow from asset sales? A company with $1 billion in assets could, for example, generate $250 million in cash flow each quarter by selling one-fourth of its assets, but is this a company you want to own a year from now?

4. Don't accept company comments at face value. In quarterly earnings releases, always compare company comments with reality. In the TRW release, management claims that the company "met its earnings-per-share commitment" and "generated $200 million of cash flow." But as we know, from the details above, earnings are heavily buttressed by pension income and positive cash flow is a result of asset sales. That's hardly the stuff that builds investor confidence in the trustworthiness of management.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, Alsin and/or ACM was long TRW, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail].