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Pricey Stocks Risk a Fall Into the GAAP

The difference between pro forma and reported earnings keeps widening. The bottom-line wake-up call.

The gulf between what corporate America would like people to think it earns and what it has actually been earning, according to the rules of accounting, has never been so wide. Perhaps that's because if investors started looking at actual bottom lines, rather than their jazzed-up ones, stocks might be significantly lower.

In the past year, many companies have taken to writing off huge losses and then asking investors to ignore them as one-time events. To take a recent example, when optical-equipment maker

JDS Uniphase

(JDSU)

reported results for the calendar fourth quarter last week, it said it had lost 19 cents a share on a pro forma, or operating, basis. But according to generally accepted accounting principles, or GAAP, the company lost $1.60 per share.

Here's why: The company asked that investors ignore a $1.3 billion writedown in goodwill -- due, in part, for having paid too much for other companies in the past -- as well as $73 million for shutting down plants and laying off workers and $80 million for excess inventory. These were nonrecurring items, said the company, conveniently ignoring the fact that just six months ago it took write-offs for the very same things.

"Operating earnings have taken on their own definition," complains Howard Silverblatt of Standard & Poor's quantitative research group.

Rationalizing

The point of using pro forma earnings in the first place is that some losses and gains really are extraordinary, and therefore don't reflect what's going on at a business. The costs of repairing a warehouse that has been gutted by fire, for example, would get taken out of your pro forma earnings even though they would fall to the bottom line on GAAP. Unfortunately, many companies appear to have become freer with what they consider pro forma.

Standard & Poor's has taken issue with the way earnings are reported by Thomson Financial/First Call, Wall Street's unofficial arbiter on how company results are quantified. First Call reproduces company results as analysts see them -- if the majority of the analysts agree that a certain loss should not be included in a company's pro forma numbers, it is not. Standard & Poor's, in its analysis, has over the past year often found that certain write-offs do not match its definition of one-time charges. The results aren't all in yet, but for 2001 it looks as if companies in the benchmark

S&P 500

will have earned 88% of what they earned according to First Call as tallied by Standard & Poor's.

The S&P 500's Yawning GAAP
GAAP earnings as a percentage of earnings as reported by First Call

Sources: Standard & Poor's, Thomson Financial/First Call

"We'll continue to use the numbers the majority of analysts are using," says First Call research manager Joe Cooper. "If there are flagrant things that are being committed, we'll police those."

Standard & Poor's, while more conservative than First Call, still allows for what it sees as legitimate write-offs. Its methods differ from GAAP, which is all about the absolute bottom line. When we look at company earnings on a GAAP basis, the true depth of U.S. companies' sordid affair with pro forma accounting reveals itself.

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Murder by Numbers

Current estimates suggest that S&P 500 companies will have earned about $410 billion in 2001 on a First Call basis. On a GAAP basis, however, they earned just 58% of that, or about $240 billion. A $170 billion difference.

The discrepancy between pro forma and GAAP earnings has never been so great. Companies might reasonably be expected to run into more extraordinary losses during recession years, but in 1991 -- the trough year of the last recession, GAAP earnings came in at 82% of the First Call numbers. And in 1982, when the country got hit by the worst economic downturn since the Great Depression, GAAP earnings for the S&P 500 came in basically in line with the First Call results. Apparently, there was a time not so long ago when there wasn't all that much difference between GAAP and pro forma earnings.

GAAPing Higher
The S&P 500's trailing P/E, using GAAP Earnings

Source: Standard & Poor's

"When a company used to take a write-off, it was because of some surprising development, some God-created event that crippled the company," says Stanley Nabi, managing director of Credit Suisse Asset Management. Gradually any event that has taken a sizable chunk out of the bottom line has come to be seen as nonrecurring, thinks Nabi.

Producing more than you can sell and being stuck with excess inventory, for instance -- a mistake that business people have made since, oh, at least the founding of Mesopotamia -- is now regularly taken as a one-time event. Figuring out that you paid too much for something is a one-time event. Costs associated with laying people off are now one-time events.

Bausch & Lomb

(BOL)

last week excluded $4.6 million from its pro forma fourth-quarter numbers -- money spent in hiring a new CEO.

Moral Hazard?

It's not a bad gig, at least on the surface. We might even briefly fantasize that we could do it ourselves -- that our small injustices and acts of cowardice might turn suddenly invisible, making us seem nobler than we really are. But on reflection we know that if our mistakes were clouded over, we would never learn from them and as a result would be doomed to repeat them over and over again.

And this is the risk for companies. All of their mistakes are getting treated as one-time events, which basically makes it OK to commit the same mistakes over and over again. In fact, in some cases you might even say they're being rewarded for taking on too much inventory, for laying people off, for making acquisitions at too high a price. Meanwhile, most of Wall Street puts on the blinders.

"Never underestimate Wall Street's ability to find a way to get you to invest," says Jeff Saut, chief investment strategist for Raymond James. "Nobody pays much attention to GAAP earnings because it's in nobody's best interest to do that." On a

price-to-earnings basis, moreover, the S&P looks exceedingly expensive when you use GAAP. It currently trades at 43 times 2001 earnings. That's about three times the low it hit in the last recession.

But even more than a valuation problem, the huge difference between S&P 500 companies' earnings on a GAAP basis and on a pro forma basis poses a tremendous event risk for investors. In the post-

Enron

world, these specious pro forma results aren't going to fly. Securities regulators are out for blood in this game. And they have $170 billion to play with.