CRAIN’S New York Business - December 13, 2004 issue

It's pro forma: Firms play profit games

Adjustments lure unwary investors; actual accounting arrives much later

By Aaron Elstein
Published on December 13, 2004

In the early fall, Lucent Technologies had great news for investors. The company happily noted in a press release that after four years of losses it had bounced solidly back into the black, with a $1.14 billion profit in the fiscal year ended Sept. 30.

As it turned out, though, that feat was far less impressive than it first appeared. A closer look at the company's accounts reveals that the vast bulk of those earnings came not from selling phone equipment but from an $868 million credit taken from Lucent's employee pension fund.

Booking the credit is perfectly legal, but analysts say that doing so overstates the company's earning power.

"Without the pension fund, they were barely profitable," says Eric Buck, an analyst at Janco Partners Inc.

Welcome back to the age of corporate earnings alchemy, of spinning weak earnings into apparent riches as companies did with great--and ultimately disastrous--abandon in the boom years of the late 1990s. With increasing regularity, companies are back to telling investors one thing in their press releases and the government another thing months later in official filings. In between, they hope to boost their stock price.

Double the difference

One sign that this bad habit from the bubble days is back: The difference between what companies describe loosely as "operating earnings" and earnings as strictly defined under generally accepted accounting principles, or GAAP, has grown to about 20%. That's about double the average gap last year, when tough new regulations born of scandals involving Enron, WorldCom and others scared companies straight.

With profits growth for the Standard & Poor's 500 expected to slow to only 6% next year after two years of 20% gains, pressure will only grow for companies to replay the old games, such as describing operating expenses as "one-time" or "nonrecurring," or emphasizing "pro forma" or operating results that obscure companies' true health.

"We're seeing the gap between GAAP earnings and operating earnings grow again," says Howard Silverblatt, an equity market analyst at Standard & Poor's. "Things really improved a lot for a while, but now we're like an outfielder on the warning track looking up, and the ball is still rising."

In their defense, many companies point out that any investor who really wants to know the unvarnished truth about earnings can always turn to Securities and Exchange Commission filings, which contain only GAAP numbers. Sadly, it can take weeks for companies to disclose those numbers.

In the case of Lucent, a spokesman for the Murray Hill, N.J.-based company notes that the impact of the pension credit was disclosed--albeit weeks later--in the company's annual report and that officials had talked about the matter in conference calls with analysts. "It's something that people who follow us closely are aware of," the spokesman says.

Maybe so, but that didn't stop many investors from bidding up Lucent's shares after first hearing of the company's sharp bounce back to profitability.

In recent months, few companies have worked harder than AT&T Corp. to cast dismal numbers in a more favorable light. In October, the company announced that it had "adjusted" third-quarter earnings of $593 million, or 75 cents a share.

That's not bad, except that in GAAP results, AT&T actually reported a net loss of $7.1 billion, or $8.95 a share. The vast difference comes from adjusting for the huge costs of exiting the local telephone business--most definitely a one-time event that all agree has no bearing on the company's real performance.

Harder to explain was a $1.1 billion tweaking for "restructuring" charges related to laying off hundreds of employees. That charge, say analysts, is anything but unusual at the long-shrinking Bedminster, N.J.-based company. In fact, between 2001 and 2003, AT&T incurred $2.7 billion worth of such charges.

First-time occurrence

An AT&T spokesman notes that the third quarter was "the first time in recent memory" that the company had reported adjusted earnings. Barry Sine, an analyst at securities firm HD Brous & Co., says that is fine. But he argues that $1.1 billion of those adjustments--the restructuring charge--should never have been made. Including that charge, AT&T's adjusted results swing to a loss of 50 cents a share from the reported 75-cent gain.

"This is an egregious example of the games companies are playing again," says Mr. Sine.

Over at Computer Associates International Inc., the issue hinges on just how many times a one-time charge can be incurred. For the fiscal second quarter, ended Sept. 30, the Islandia, L.I., software company reported a $28 million one-time restructuring charge resulting from efforts to reduce the company's workforce by 5%, or 800 employees.

The odd thing about that is CA expects to take a second one-time restructuring charge of $12 million later this fiscal year.

A CA spokeswoman says it's legitimate to call the charges one-time because they stem from the same restructuring, which will take months to complete. "We can't take charges until people who are leaving are notified," she says.

Hugo Nurnberg, a professor of accounting at Baruch College's Zicklin School of Business, says that describing charges over different quarters as one-time could be reasonable if the company isn't incurring the same kinds of charges regularly. But layoffs are increasingly common at Computer Associates. In fact, CA took $15 million in restructuring costs only last year when it reduced its workforce by 450 people.

Mr. Nurnberg says he fully expects to see more companies doing everything they can to make their numbers look better than they really are, particularly if--as expected--profits start to drop again.

"It doesn't surprise me that we're starting to see a return to old habits," he says. "There's a natural tendency among companies to revert to the things that suited their purposes in the past."

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