Quality-of-Earnings Issues Aren't So Simple, Herb

I want to pick a little fight here. Two fights, actually. With my friends and TheStreet.com colleagues Herb Greenberg and Adam Lashinsky.

No, not real fights. I like 'em both way too much to really fight with them. But each has been writing on themes that I think are -- in a term I have licensed from Jim Cramer - just plain Wrong!

These aren't arguments, exactly, but ... let's say ... differences of opinion.

Herb first, Adam later this week.

Herb has recently banging the drum on quality-of-earnings, or QoE, issues. The phrase, and the idea, aren't new, and it's a useful test. But I think Herb has sometimes gone a little overboard here.

In general, QoE refers to how well a company's reported financial results reflect how well a company is doing. Efforts to obfuscate are big QoE sins. If, say, a company stuffs its earnings reports full of one-time, nonrecurring items to hide the fact that its central business has gone to hell, that's a big QoE issue.

(If you're interested in this, you might want to pick up Thornton O'Glove's excellent Quality of Earnings: The Investor's Guide to How Much Money a Company is Really Making. Or, if you're really interested, dig into Bernstein's and Wild's classic, Analysis of Financial Statements, now in its fifth edition. Exhaustive, less readable, invaluable.)

In general, a company ought to face accusations of QoE trickery if its reporting seems to be an effort to shade the truth or conceal an erosion of its main lines of business.

Accordingly, Herb's been watching for companies that have been less-than-forthcoming about their real operating results lately. A good example, where he was bang-on: A month ago, Herb nailed CVS (CVS) for sneaking an extra week of December revenue into its fourth-quarter results, creating a 53-week year, though the depreciation and amortization charges posted against revenue were calculated on an unvarying quarterly basis. In other words, CVS used legal, but nonobvious accounting tricks to make its fourth quarter look better.

The market bit: CVS traded up 10% the day after that funny-money quarterly report. But investors aren't fooled forever. Since that quarterly earnings report, CVS is down 25%.

Great job, Herb.

But as with so many things in the New Economy, divided neatly by the market itself into tech stocks and Everything Else, we have to rethink how the useful notion of QoE questions maps to the reporting of today's cash-flush technology companies.

Are shareholders always being deceived? More importantly, are they being disserved by the actions of high-tech companies that have to report additional revenue? Are these tech outfits deceptively pumping up their earnings with unfair numbers? Real numbers, to be sure, but with the result that things are not exactly as they seem?

Intel (INTC) has been one of Herb's betes noires on the QoE front, both in these pages and on "TheStreet.com" on Fox News Channel, our weekly TV show. His Jan. 18 column pegged Intel for a quarter in which it reported a fat $327 million in profits from its investments in other technology companies.

Wait a minute, Herb. Was Intel really cooking the books, trying to cover up a slide in its real business of making chips?

Well, in Q4 '99, Intel had record revenue of $8.2 billion, up 8% from Q4 '98 and up 12% from the previous quarter. In Q4 '99, Intel rolled out 15 new Pentium III and Xeon CPUs, including the hot 800-MHz (megahertz) chip. All in all, in Q4 '99, Intel achieved record unit shipments of microprocessors, chipsets, motherboards and flash-memory devices. Not shabby.

To be sure, during Q4 '99, Intel also was wrestling with some product shortages and had to deal with difficulties in technology it licensed from Rambus (RMBS), to the detriment of PC makers, some of whom -- Dell (DELL), for example -- pointedly blamed Intel for their own Q4 '99 problems.

No one said Intel was perfect, but no analyst I follow said Intel's shipping problems arose from insufficient capital investment.

If a company has excess cash over operating requirements, what would you, as an investor, have it do? Stash some for future projects, such as building expensive wafer fabs, the building-as-machine structures used to build and test microprocessors and other chips? Or worse, stash some to make succeeding quarters' results look good?

Well, no, because that's against the law. And it fudges operating results.

Pass along that cash to shareholders in the form of dividends? Gasp! The tech business isn't about dividends; that's become an increasingly obsolete notion, associated today with Old Economy companies. Utilities. Banks. Autos. Phone companies. Nobody in tech pays dividends any more.

How about cutting prices so the company doesn't have all that messy cash sloshing around? I won't even deal with that one.

Buy some nice corporate bonds? Ugh.

So what to do?

Come back later today for Part 2 of this inquisition: What Intel, Dell and others have been doing ... and why it's a classic example of doing right by shareholders.

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