There's a bull market in outrage in most corners of Wall Street these days, but curiously not where holders of Anadarko Petroleum ( APC) linger.

Shares of the nation's biggest independent oil exploration company have risen 3.8% in the past two weeks since embarrassed executives announced that an accounting error would force them to take a $1.7 billion charge against third-quarter earnings.

Bulls interpret investors' indifference as a positive, but that compounds the mistake. The dispassion instead is symptomatic of a mutant form of Enronitis in which shareholders become so saturated with poisonous news they don't feel the immediate impact from one more toxic drop. The classic example occurred in August 2001, when already-battered owners of Enron shares failed to understand that Jeff Skilling's sudden departure as president signaled a much larger problem.

In the case of Anadarko, the postblunder bounce was largely a function of a surge among all energy stocks now that President Bush is rattling sabers at Iraq. Frisky peers such as Devon Energy ( DVN) and Patterson-UTI Energy ( PTEN) are up 13% and 7.5%, respectively.

What does the mistake mean? Donn Vickrey, executive vice president of research at the stock-research firm Camelback Research Alliance in Arizona, considers it emblematic of deeper earnings quality issues at the firm. In a prior era, few of these would have caused concern. But these days it pays to understand all nuances of corporate reports, especially when the subject is both an industry leader and a cross-town rival of a once-admired corporate crook such as Enron.

For the rest of this year, I'm planning to regularly feature Vickrey's earnings-quality analysis in an effort to bring a wider range of accounting concepts to the foreground. Prior to joining Camelback to work on behalf of clients such as Thomson Financial and Credit Suisse First Boston, Vickrey was an accounting professor at the University of San Diego.

In a review of Anadarko's fiscal third-quarter earnings report, issued last week, Vickrey noted:

  • The company is suffering from a significant decline in free cash flow compared with prior quarters.

  • It shows a decline in the quality of receivables, yet has eliminated its usual reserve for "doubtful accounts."

  • It uses the most lenient methods of accounting for oil and gas properties, leading to higher reported income in relation to more conservative methods used by many of its competitors.

  • It has extended a $1 billion stock repurchase program despite an announcement that it deeply cut its exploration and development budget for 2002 -- implying that its best use of capital is to return it to shareholders and reduce investments in future revenue streams.

  • It significantly increased its use of derivatives starting in 2000 and continuing into 2001.

    Anadarko declined several requests for response to these issues. Before I explain them further, you may need a crash course in accounting.

    Accounting 101

    Federal securities law requires most U.S. public companies to publish three documents every three months to help investors understand the company's operating performance: An income statement, on which expenses are deducted from revenue to yield a net income figure; the balance sheet, which offers a snapshot of the company's assets, liabilities and shareholders' equity; and the cash-flow statement, which offers a snapshot of how much cash is generated during the quarter from normal operations, investing and financing.

    Camelback computers crunch data on 3,000 of the largest U.S. stocks each week and rank each one from -4 to +4 on earnings quality. Analysts then dig deeper by hand and study the most interesting results for institutional clients. Anadarko rated a -4 last week, which means it is expected to underperform its peers over the next 12 to 36 months. Here's a closer look.

    Income Statement

    Nothing too bad for Anadarko here, except that it was a lousy quarter for business due to plummeting prices for crude oil and natural gas. While annual revenue increased 52% with the acquisition of RME Holding Co. (formerly Union Pacific Resources Group), fourth-quarter revenue dropped sharply with the decline in oil and gas prices.

    Selling, general and administrative expenses grew slightly faster than revenue during 2001, reflecting an increase in the fixed-cost portion of Anadarko's cost structure resulting from the RME acquisition. Operating and net income for the year also decreased significantly due to the correction of the $1.7 billion accounting error that resulted in an overstatement of property, plant and equipment. While the error does not impact the company's cash flow, it raises serious questions about the company's internal control. Why wasn't this caught earlier?

    Cash Flow Statement

    The primary cause of the sharp decline in free cash flow was the plummeting price of both crude oil and natural gas, which ultimately affects all significant sources of Anadarko revenue. In response to this development, Anadarko announced that it would slash its exploration and development budget for 2002.

    (On Sunday, Bloomberg reported that Anadarko is using 40 drilling rigs now, down from 94 in July. "You can't spend beyond cash flow," Anadarko Chief Executive John Seitz said at a UBS Warburg energy conference in New York last week, according to Bloomberg.)

    Quality of Receivables

    Vickrey notes that accounts-receivable collections slowed substantially through the first three quarters of 2001. He also observed that while revenue declined significantly during the first nine months of the year, accounts receivable declined only modestly. And despite the slowdown in collections -- days sales outstanding ballooned from 50.7 in the second quarter to 63.5 in the third -- Anadarko appears to have discontinued the accrual of expected credit losses, because the income statement no longer contains a provision for doubtful accounts as it had in previous quarters, according to Vickrey's analysis. It's uncommon not to reserve funds for this purpose, and to use them as a short-term means of boosting net income.

    Long-Term Assets

    There are two methods of accounting for oil and gas properties: In "full-cost accounting," the more aggressive route, costs of buying and developing a property are capitalized and amortized over time even if it's later discovered that it does not contain oil. In "successful-efforts accounting," a more conservative route, companies capitalize the cost only of properties that turn out to produce oil. In the event of a dry hole, a company using "successful efforts" would expense the cost immediately, resulting in a hit to earnings.

    Both are legal and acceptable, but most large integrated oil companies use the more conservative method, while much smaller companies typically use the latter. Anadarko started small, with a single pipeline, and has stuck with the more aggressive accounting method even as it has become a very large player. The main thing to keep in mind is that the use of the full-cost method has the effect of increasing reported earnings over the more conservative successful-efforts method.

    Additionally, the third-quarter report shows that Anadarko capitalized interest associated with significant investments in unevaluated properties. Vickrey says that capitalization of interest on unevaluated properties has the effect of decreasing reported expenses while increasing reported income (and assets).

    Capitalized interest increased from $51 million in the first nine months of 2000 to $157 million during the same period in 2001. Without the increase in capitalized interest, Anadarko's 2001 net loss would have been significantly larger. Again, it's not illegal, but it has the effect of making income look rosier than it might otherwise be.

    In addition to boosting reported income, Vickrey says, use of the more lenient methods of accounting for oil and gas properties also tends to smooth out a company's reported earnings stream -- making it more difficult to assess the success (in dollar terms) of the company's exploration and development efforts from year to year. Smoothing the income stream also gives the appearance that the company's performance is less volatile and more predictable than it really is.

    Liabilities

    Anadarko significantly increased its use of derivatives beginning in 2000 and continued in 2001. Based on the disclosures provided by the company, it does not appear that unrealized gains or losses from the use of derivative instruments are material, Vickrey said.

    But since the amount of disclosure is limited, it's hard to determine the impact of future derivatives gains and losses, not to mention the impact of gains and losses on 2000 and 2001 net income. The trouble with derivatives is that they are so complex that the limited amount of disclosure provided is generally not sufficient to gauge the company's true liability. Other than assessing the reasonableness of stated assumptions, you just have to take the company's word for whether they're working and don't represent a substantial hidden liability.

    More Warning Signs

    The company continues to buy back shares under a $1 billion repurchase plan initiated last year. Vickrey says the company continuing buyback of shares shares -- as it simultaneously slashes its exploration and production budget -- does not bode well for its future prospects. It's essentially deciding to increase shareholder value by trimming the number of shares outstanding rather than drilling for more oil.

    Anadarko did not provide complete balance sheet data in its earnings announcement, but it was clear at least that long-term debt increased significantly as the company continued its aggressive acquisition campaign. At the same time, stockholders' equity decreased substantially, reflecting the correction of the aforementioned accounting error.

    Investors have been willing to brush off Anadarko's $1.7 billion accounting mistake because energy in general may be ready to rebound if war in the Gulf region breaks out. But the company's accounting methods bear examination before making long-term commitments.
    At the time of publication, Jon Markman owned shares in none of the equities mentioned in this column.

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