With some companies having done everything they could to disguise their true earnings over the last few years, U.S. corporations might want to highlight their actual results in the fiscal second quarter, and not just because of the recent backlash over accounting gimmicks and pro forma numbers.
After a devastating second quarter last year, earnings, when calculated according to generally accepted accounting principles, are expected to rise 81% in the second quarter of 2002, according to data from Standard & Poor's. In contrast, operating earnings, as measured by Thomson Financial/First Call, are seen rising just 3% from last year.
First Call, of course, compiles its numbers from analysts' estimates, which exclude a number of restructuring charges as well as goodwill amortization and various other costs. S&P's estimates include all charges except those related to discontinued operations, the impact of cumulative accounting changes and extraordinary items, as defined by generally accepted accounting principles.
The focus on pro forma and operating numbers last year, while often obfuscating real earnings, made it harder for firms to beat those results this year. If companies were to report GAAP earnings in the second, third and fourth quarters of this year and contrast them with 2001's profits, the growth rates actually would be much more favorable.
So Many Numbers
Investors are also more likely to go easy on a company that has issued straightforward results -- even if they are disappointing -- in the aftermath of
accounting scandal, some observers believe.
"If people don't see GAAP earnings on the same page as pro forma numbers, they're going to short the stock before they even get to the second page," said David Blitzer, vice president and chief economist at Standard & Poor's.
However, it's worth noting that while GAAP earnings for the
are going to climb to an estimated $8.76 in the second quarter from $4.83 last year, that's still 35% below the level seen in 2000 and, excluding 2001, it's the worst second-quarter performance since 1994. (S&P is introducing a new method for evaluating corporate earnings that will focus on "core" results of companies. Click
here for the press release.)
Also, while GAAP earnings may be better on a percentage basis, operating earnings still look better based on the actual dollar amount. Operating earnings for the S&P 500 are expected to climb to $12.40 in the second quarter, according to First Call.
Among sectors expected to show strong earnings growth in the second quarter are financials, technology, consumer cyclicals and basic materials. Gauging which of those sectors will produce better-quality earnings is hard to tell, but analysts say companies with simple business models, such as consumer staples, should produce relatively clean results.
Conversely, companies that have made numerous acquisitions or have lots of intangible assets on their balance sheets could potentially restate past results or announce large writedowns, according to Barbara Lougee, assistant accounting professor at the University of California, Irvine.
"I think it's time for everyone to come clean, particularly if the CEO is going to be held responsible for the quality of the earnings that are reported," she said.
Highly acquisitive firms like
have come under fire this year for producing earnings that don't reflect the true organic growth of the business.
GE attempted to delineate earnings growth from acquisitions last quarter, and held its first conference call ever in an effort to appear more transparent. Analysts expect more of the same this time around.
The company, and others like it, continue to face criticism for carefully managing their earnings. Aside from these acquisitive firms, Lougee said she would expect to see poor-quality earnings from companies that are close to defaulting on debt covenants. Firms under great pressure to increase earnings from quarter to quarter also are at risk, she said.
Also, any companies that continue to rely on EBITDA, or earnings before interest, taxes, depreciation and amortization, as their main valuation tool, are expected to come under intense scrutiny.
After WorldCom's disclosure last month that it had inflated EBITDA by $3.8 billion over five quarters, investors have been questioning whether EBITDA is really a credible measure of a company's financial position. Media and telecom are the two most prominent groups that rely on this metric.
"It remains to be seen whether companies have enough time to change the way they report their numbers in light of the events in the last few weeks," said Charlie Crane, a money manager at Spears Benzak Salomon & Farrell. "I'm guessing we'll see more disclosure and less emphasis on EBITDA, but we'll still see those numbers."
Joe Cooper, a research manager at First Call, said he already has noticed that companies are becoming more conservative and that analysts are becoming more discriminating in what they will accept as operating earnings.
Still, Lawrence Brown, a professor of accounting at Georgia State University, remains skeptical that anything is fundamentally going to change over the long term.
"I think firms are going to try whatever it is that will boost their stock price or stop it from tanking," he said. "Right now it is in their own best interests to report higher-quality numbers."
Of course, whether that will change when the scrutiny dies down isn't clear.