If the Financial Accounting Standards Board has its way, corporate earnings will face yet another headwind in the second half of the year. In recent weeks, stocks have fallen sharply on
concerns that profit growth is about to slow down. Companies are facing a number of challenges in the third and fourth quarters, including higher oil prices, rising interest rates and tougher comparisons to last year. While analysts are fully aware of these issues and have been lowering their expectations for the fourth quarter, it's possible that these estimates will have to be revised down further if a proposed accounting rule is adopted by the FASB in December. The FASB, a private body that sets accounting guidelines, said last week that it wanted to standardize the accounting treatment for straight convertible bonds and contingent convertibles, a move that could reduce earnings at some companies by as much as 19% this year. Contingent convertible bonds, or CoCos, are similar to straight convertible bonds in that they have a strike price at which the investor can convert the bond into stock. The difference, however, is that CoCos can't be converted until a contingency requirement is met. Some companies, for example, might require the stock to trade at 110% of the conversion price for 20 out of 30 trading days. More importantly, while straight convertible bonds dilute earnings as soon as they are issued, contingent convertibles do not. Companies must account for straight convertible bonds as if they had been converted into stock on the day of issuance. This increases shares outstanding and lowers earnings per share. But issuers of contingent convertibles are not required to increase their share count or dilute their earnings until the contingency requirement is met. The FASB is hoping to change that. If that move is successful, some companies will be hit hard. General Motors ( GM), for example, could see 2004 earnings shaved by 17.3% in 2004 and 17.4% in 2005, according to David Bianco, head of the valuation and accounting group at UBS Investment Research. CenterPoint Energy ( CNP) could see profits shrink by 12% this year and next, while Comverse Technology ( CMVT) could see an 11% reduction in earnings per share. Omnicom Group ( OMC) would see earnings decline by more than 10%.
Bear Stearns accounting analyst Chris Senyek said the asset management firm Affiliated Managers Group ( AMG) could see earnings diluted by 19% in 2004 and 2005 if the accounting rules were to change. Emulex ( ELX), Lattice Semiconductor ( LSCC) and Yellow Roadway ( YELL) are among those that could see earnings fall by at least 10%, he said. While these numbers are alarming, there are reasons to think the impact to the overall market will be more muted. Bianco estimates that total S&P 500 earnings will be reduced by just 0.5% this year as a result of the new accounting rule. Profits at the 70 S&P companies that have issued convertible bonds will be cut by just 2% in aggregate, he predicted. Meanwhile, it's quite possible that some companies will take steps to prevent the earnings dilution. "While we do expect definitive guidance to be issued requiring CoCos to be accounted for consistently with other convertibles, perhaps effective as early as the fourth quarter of 2004, we think many companies will take steps to mitigate any negative impact to EPS," Bianco said. He noted that companies could modify existing aspects of CoCos or replace them with other forms of financing, particularly short-term borrowings. "In our view, replacing long-term borrowings like CoCos with short-term borrowings like commercial paper may help manage the risk to EPS, but is offset by increased interest-rate risk," he said. The FASB's rule is subject to public comment until Sept. 3 and is intended to take effect in December for some companies, or Jan. 1, 2005, for those companies that operate on a calendar year. The FASB also noted that prior earnings-per-share results should be restated to conform to the new rule. Another proposal by the FASB to enforce the expensing of all stock options at the start of next year faced a roadblock last week, as the U.S. House of Representatives passed a bill to limit option expensing to the top four highest paid executives, plus the CEO. A parallel bill in the Senate faces an uncertain future.
The expensing of stock options, like the CoCo accounting change, would dilute reported corporate earnings. And technology companies are particularly at risk, since these firms have issued more options in recent years than many traditional companies. Susquehanna Financial Group analyst David Haushalter conducted a recent study on this subject and found that the median technology company would have seen earnings slashed by 45% in fiscal 2003 had options been treated as an expense.