Remember back in high school algebra when you were first introduced to the concept of imaginary numbers? That’s a good way to describe quarterly earnings reports these days — as imaginary numbers.
In the old days, when a company reported quarterly earnings, you had a pretty good idea of how they really did. These days, because of something called “pro forma” reporting, you have to play detective to find the real numbers. And if you don’t know how to play detective, you can be easily misled.
The term Pro Forma means “preview” or “provisional”. It was originally used to indicate that some of the detail is missing and will be provided at a later date. For example, a pro forma invoice is a preliminary invoice which is close to the true invoice that will come later. It’s a convenient way of generating a preview of a document before all of the supporting detail is available.
The concept or “pro forma” is a good one, because previews and provisional documents are often helpful and, in some cases, a necessary part of doing business.
But this whole business of pro forma earnings has gotten way out of hand. Today, the term pro forma, when applied to quarterly earnings, more accurately means “We’re going to make up our own accounting rules with regards to how we report earnings, and we’re going to provide some explanatory notes in the fine print that nobody reads in the hopes that the general public and most analysts will be duped into thinking our performance was much better than it really was this quarter.”
And sadly, it works most of the time — or at least until a company pro formas itself out of business.
As a case in point, lets compare the most recent pro forma quarterly earnings from Extreme Networks click here) and Foundry Networks click here).
At first glance, it appears that Extreme had a better quarter than Foundry in the sense that Extreme beat earnings expectations and Foundry missed badly. But let’s take a closer look at the numbers, shall we? Let’s look at the small print that nobody wants to take the time to understand.
Extreme reported a break even quarter against expectations of a loss of .01 a share. How did Extreme do this? Why, by arbitrarily excluding certain charges from their pro forma earnings statement. Specifically, the note in small print on Extreme’s earnings statement states that “the pro forma statements exclude the impact of charges relating to contract manufacturers of $12.5 million in Q1 of 2002, other costs associated with the carrying value of inventory of $19.0 million in Q1 of 2002, the amortization of goodwill, intangibles and deferred stock compensation in all periods, a provision for bad debts of $2.7 million in Q1 of 2002 and minority investment write-downs in Q1 of 2002 of $6.0 million.”
Now I will admit that it has become common and accepted practice to exclude goodwill charges from pro forma earnings statements. But what’s with the exclusion of $12.5 million dollars of charges related to contract manufacturers, a $2.7 million provision for bad debts, and inventory write downs of $6 million dollars? These are real dollars people, not funny money like “goodwill”. Factor these charges back into Extreme’s earnings statement and Extreme lost .17 a share instead of having a break even quarter.
And that doesn’t include the “other costs associated with the carrying value of inventory of $19.0 million” simply because I can’t figure out what the hell that statement means. However, it appears as if Extreme decided not to include inventory carrying costs in its pro forma numbers. If the Church Lady were here, we all know what she would be saying: “How convenient.”
What about Foundry Networks? Foundry reported earnings of $.02 a share this quarter against expectations of $.05 a share. Foundry’s CEO Bobby Johnson claims to have taken a charge against earnings this quarter as a provision for bad debt and inventory write downs. The actual number was not specified (which concerns me), but it was implied during the question and answer session that the charges are about $5 million in total. The $5 million charge, if it is real, was not excluded in Foundry’s pro forma earnings numbers. Had Foundry been using the same liberal / aggressive / misleading (choose your adjective) accounting practices as Extreme, Foundry would have reported quarterly earnings of $.06 a share instead of $.02 a share this quarter, beating earnings by $.01 a share instead of missing earnings by $.03 a share.
In fact, Foundry Networks has reported eleven consecutive profitable quarters without resorting to stupid accounting tricks. Yet because people don’t read or understand the fine print, Extreme Networks is afforded a higher stock valuation than Foundry, and a higher opinion from most analysts.
Look at the numbers more closely and you can find even more reasons to be concerned about Extreme in comparison to Foundry.
In the most recent quarter, Foundry managed to increase its cash position by $24 million. Extreme added only $3 million.
Extreme’s accounts payable jumped to $50 million dollars, an increase of $15 million from the previous quarter, whereas Foundry’s accounts payable are at $12 million, a decrease of $8 million. So Foundry increased its cash position while decreasing accounts payable.
What about cash flow? Extreme actually had an operating loss of $51 million dollars for the quarter, whereas Foundry had operating income of $2 million dollars.
About the only positive thing you can say about Extreme relative to Foundry is that Extreme had higher revenues than Foundry (although both companies posted lower sequential revenue numbers.) . But is this really a positive thing, or is it perhaps the source of Extreme’s problems? There was a hidden subtext in the question and answer session in Foundry’s conference call yesterday that may reveal the answer. When asked about declining sequential revenues, Johnson said (and I am paraphrasing here), “We have a motto here. We don’t care about revenues, we care about profits.” Johnson went on to state that Foundry had walked away from unprofitable business, implying that Foundry chose higher profits over higher revenues for the quarter.
The strategy appears to be working. By focusing on profits, expense management, and the accumulation of cash reserves, Foundry is positioning itself much better for survival during the recession, and for prosperity during the (hopefully) impending recovery. Financially, Foundry is a sounder company than they were six months ago. Not many companies can make that claim.
By focusing on creative accounting, Extreme Networks, in contrast, may be a Lucent waiting to happen.
I received so much feedback on my column (Stupid Accounting Tricks) that I thought I would respond en masse today and elaborate a bit on the subjects of pro forma accounting and managing earnings.BR>Stupid Accounting Tricks: Managing Earnings
By Alan Luber (December 16, 2001)
I received so much feedback on my column (Stupid Accounting Tricks) that I thought I would respond en masse today and elaborate a bit on the subjects of pro forma accounting and managing earnings.
First, the title of my column “Stupid Accounting Tricks” offended some. I don’t know why. But honestly, it was just a play on Letterman’s “Stupid Pet Tricks”, nothing more. I originally considered using “Who’s Zoomin’ Who?” as the title. I actually liked it a lot more, but I thought both the meaning and the source of the title would be a bit too obscure. And more importantly, I would be showing my age, as the song was from 1985. (For the record, I am 28 years old, have been now for 22 years, and hope to be for 30 more. So there.)
Secondly, I wasn’t trying to trash Extreme or praise Foundry per se. My main objective was to use two stocks that I follow — two competitors in fact — to point out the perils of pro forma accounting. I believe that the markets would have probably reacted quite differently to these two earnings reports if both companies used the same accounting rules. And I personally favor accounting practices that don’t require long, explanatory footnotes on the quarterly earnings report. Such notes are a red flag that the company is manipulating the numbers. I hoped that by pointing out the perils of pro forma accounting, I could help investors do a better job of evaluating earnings statements and balance sheets so that they could make better investment decisions. I intend to publish more about this in the future, offering specific tips on how to look for telltales signs that things are not what they appear to be.
Managing Earnings
Extreme Networks is by no means alone in the practice that is commonly referred to as managing earnings. Sometimes, a company manages earnings to make things look better than they really are (as I believe Extreme did), and sometimes a company manages earnings to make things look worse than they really are.
It’s fairly obvious why a company would want to make things look better, but why would a company want to make things look worse? To set the stage to make things look much, much better in the future. Sometimes a company has such a great quarter that it wants to defer some earnings to the following quarter. And sometimes, if a company is having a lousy quarter, they may make it look even worse than it really is to set the stage for a miraculous rebound in future quarters.
For example, it is not unusual for a company to clean up their balance sheets by taking a huge charge in one quarter to make things look better the following quarters. Another common practice is cookie jar reserves. This is the practice of overestimating liabilities in one period to create a reserve that can be used to bolster profits in future periods.
The phantom inventory write-off is another popular technique for improving profits in future quarters. If a company knows it is going to have a lousy quarter anyway, they make take a huge charge for inventory write-offs, claiming that the inventory is obsolete and can no longer be sold. That doesn’t mean they necessarily physically get rid of the inventory. It just gets the inventory off the books. Guess what happens when business picks up? The inventory is sold, and it is 100% profit. All of the sudden, earnings per share and gross margins go through the roof.
All companies manage earnings to some extent. Some very well known companies — Cisco and GE for example — are very skillful at managing earnings. When it is done within certain limits, managing earnings is not the worst crime in the world.
But there’s a fine line between managing and manipulation, and the line too often gets obliterated. And manipulation is not limited to creative accounting.
Back in the old days, I sold enterprise application software for Management Science America. One day, I was sitting in the back of the room while another consultant was performing a demonstration to a prospect at a corporate visit. I watched a consultant use smoke and mirrors to make it appear that the product could do something it couldn’t do — something that was very important to the prospect. The consultant didn’t tell an outright lie, but his presentation was clearly designed to cause the prospect to incorrectly infer that the product met their needs. Observing this, I muttered the word “sneaky” under my breath. An executive Vice President, who was sitting next to me and shall remain nameless, overheard me and whispered in my ear, “That’s not sneaky. That’s showing the product in the best possible light.”
Well that’s similar to what pro forma accounting often does — it shows the numbers in the best possible light. It’s not illegal unless a company really does something stupid. It’s not an outright lie. In some cases, it can even give the investor a clearer picture of results from ongoing operations by eliminating meaningless charges like goodwill. But it can be manipulative and it can lead to bad investment decisions when it is used to eliminate everything but the kitchen sink from consideration in calculating earnings.
Oh, by the way, Management Science America, or MSA as it was known, has been defunct for years. MSA spent too much time and effort showing their products in the best possible light and not enough time developing the best possible products, but that’s a story for another day if anyone is interested. Last I heard, the executive VP was a car salesman. Creative marketing, like creative accounting, can only obscure problems and salvage careers for so long.
Some Final Thoughts
It’s my contention that analysts and reporters are often no better at understanding earnings statements and balance sheets than the average investor. Now here’s a thought for you to ponder. In today’s world, where companies stretch the practice of pro forma accounting to its limits and beyond, I think that accountants make the best analysts. That wasn’t true in the old days before regulation FD. Back then, the best “analyst” was the schmoozer — the guy who had the relationships to get the inside scoop before anybody else. But now, everybody has access to the same information at the same time, and analysts can only add value by <gasp> performing analysis, and many so-called analysts are just not up to the task. So we see knee jerk upgrades and downgrades based what earnings press releases, instead of real analysis. Hence, the knee jerk downgrades of Foundry by two analysts yesterday. (Some would argue that the knee jerk upgrades and downgrades are themselves attempts by analysts to manipulate the stock, but I won’t go there — at least not today. No need to confuse things further.)
As an informed investor, you can take advantage of these knee jerk reactions. If you know from your analysis that the company’s results were really worse than they appeared to be, you can sell on the knee jerk upgrade. Conversely, if you know from your analysis that the company’s results were really better than they appeared to be, you can buy on the knee jerk downgrade.
Oh, and thanks for reading and thanks for writing. Keep those letters coming.
I received so much feedback on my column (Stupid Accounting Tricks) that I thought I would respond en masse today and elaborate a bit on the subjects of pro forma accounting and managing earnings.
Stupid Accounting Tricks: Pro Forma Accounting, Part 3
By Alan Luber (December 17, 2001)
(This is the third in a series of articles on Pro Forma Accounting. Here is where you can find part 1 and part 2. )
Well, I just can’t seem to get away from this subject. You all keep writing, and in doing so, engender material for follow up columns. Hopefully, this will be the last for a while, but a couple of letters bought up important points that I wanted to address today.
The Goodwill Games
One reader inquired as to why I described goodwill as “funny money” in my last column on the subject. Here’s my explanation:
When company A acquires company B, a premium is usually paid. This premium, often referred to as goodwill, is mathematically calculated as the difference between the price paid for the company and the value of the assets acquired. Some companies reflect this difference against their bottom line and write off the goodwill over a number of years. This is called purchase accounting. Some companies use a pooling of interests method of accounting, which blissfully ignores the premium it pays for companies. With the pooling of interest method of accounting, the earnings statements and balance sheets of the two companies are simply combined, hence the term “pooling of interests.”
The differences between these two accounting methods are described in detail in this Motley Fool article.
Earlier this year, new FASB standards went into effect that eliminate the pooling of interest method of accounting. But at the same time, it put into effect new rules that effectively enable companies to effectively ignore goodwill. All of which means that from this point forward, most companies will exclude goodwill on their financial statements.
I know that some would argue that goodwill is a good way to determine whether one company overpaid for another. I would caution people because such judgments are likely to change over time. Right now, for example, it appears that JDSU grossly overpaid for ETEK and SDLI. Perhaps three years from now, these acquisitions will look like bargains. One never knows. But even if JDSU did overpay, they overpaid with their own inflated stock.
Charge It (and Forget It)
Another reader asked how I felt about excluding one time expenses from earnings per share? Well I’ll tell you how I feel about that.
When I was a young newlywed, I developed a monthly budget. The first few months, we blew the budget due to the occurrence of some significant, unexpected “one time” expense that we could not have predicted and budgeted for. At first, our attitude was, “This won’t happen again. Our budget is realistic.” But as the months and years wore on, we realized that a month without some major unexpected one time expense was the exception, rather than the rule. We couldn’t exclude them from our budget, even if we couldn’t label them in advance. They may have been “one time expenses”, but they sure as hell were dilutive to my earnings.
And that’s how I feel about the exclusion of one time expenses on earnings statements. I think that they should be itemized on the earnings statement so that an investor can make judgments regarding the nature of such expenses, and that they should not be excluded from the consensus / headline statement of earnings per share. These are real expenses people, not funny money. Furthermore, have you ever noticed that once a company begins taking one time expenses for restructuring charges, that these one time expenses have a way of reappearing quarter after quarter? There’s no mystery here. Once a company begins restructuring, it is not at all unusual for a company to have to continue restructuring over a period of time — sometimes until the company restructures itself out of business! But everything sure looks good until they close the doors and turn out the lights!
Most restructuring charges are tantamount to management errors. We screwed up. We have to layoff people. To Ignore them is to ignore mismanagement. In my opinion, the single biggest folly in pro forma accounting is that of ignoring restructuring charges.
But if we are going to continue down this slippery slope of pro forma accounting, I would like to argue that it should be practiced in all businesses. That is why I am pleased to report that, by the magic of pro forma accounting, the Atlanta Braves won the series with the Arizona Diamondbacks. Ignoring the pinch-hit homerun in game 3 against Tom Glavine (a one time event), and the unearned runs scored by the Diamondbacks in games 4 and 5 (errors that obviously should be excluded from earnings), the Braves actually won games 3, 4, and 5, and hence the series.
