Zeev's Turnips Patch-No Politics (ZEEV)

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GRETCHEN MORGENSON NYT
What? They Never Heard of WorldCom?

Published: March 20, 2005
(edit-good discussion of the point of view that quality of growth in corporate america is NOT good--Welles/Max:)

WHAT a week.

Bernard J. Ebbers, founder of WorldCom, got to add felon to his already colorful curriculum vitae. Maurice R. Greenberg, dictator in chief at American International Group, the global insurance giant, was toppled after almost 40 years at his post. The Federal Reserve told Citigroup it could not make any major acquisitions until it cleaned up its compliance act. And General Motors laid a big, scary earnings egg.

Isn't it nice to know these incidents are anomalies and that most American companies are chugging along, reporting good solid earnings?

Sure would be. But contrary to popular belief, the quality of corporate earnings is on the slide again and, as a result, Richard Bernstein, chief United States strategist at Merrill Lynch, is advising investors to tread carefully.

"There is an impression that the quality of earnings has improved dramatically," he said. "That is true relative to the worst levels of post-bubble reporting, but relative to history, the absolute quality of earnings is quite poor."

And getting poorer.

Mr. Bernstein reaches this depressing conclusion by analyzing the difference between the earnings that Standard & Poor's 500 companies have reported under generally accepted accounting principles and operating earnings, the figures companies typically trumpet because they do not include write-offs and other unusual items.

The difference between the two figures, Mr. Bernstein says, is the G.A.A.P. gap.

And it is widening. In the most recent period - the fourth quarter of 2004 - the gap was 13.7 percent. In other words, operating earnings were on average 13.7 percent higher than reported earnings. While that figure is well down from the 40 percent gap reached in 2002, it is much higher than the long-term, pre-bubble average of 6.7 percent.

The result: while stock valuations may not be so high as they were before the bubble burst, the quality of earnings appears to be worse.

Of course, none of this might matter if investors bought stocks based on G.A.A.P. earnings. But too many buy shares based on what companies report in their press releases and on their quarterly conference calls, which are often heavily skewed to earnings before the bad stuff.

"The fact is, stocks trade on press releases, on what the headline number is," Mr. Bernstein said. "And on the conference calls, companies talk about whatever numbers they want to talk about. Investors should still be very skeptical of the quality of earnings."

Mr. Bernstein said that he thought the recent downturn in earnings quality began, not surprisingly, a couple of quarters ago, when the profit surge started to subside. "If times are good, companies are not under pressure to keep their growth profile up," he said. "In tough times, when you get a cyclical company that has been coined by the Street as a growth company, it feels pressure to keep up that profile." That's when the earnings games usually begin.

By focusing on operating earnings, rather than on more stringent reported figures, companies try to steer investors away from mistakes such as asset write-downs or restructuring charges. But these factors reflect bad choices by managers - such as overpriced acquisitions - and should definitely not be excluded from investors' analyses.

"The difference between operating and reported earnings is an indication of how well executives are managing the balance sheet of their company," Mr. Bernstein said. This is often lost on investors who pay little heed to the balance sheet.

The five companies with the widest gap between reported earnings and operating income currently, according to the Merrill Lynch analysis, are: Eastman Kodak; Georgia Pacific, a paper products company; Rowan Companies, an oil drilling concern; Ford Motor; and Clorox.

Mr. Bernstein said the vast majority of companies with the biggest gaps between reported earnings and operating income are of lesser-quality, those whose common stocks are ranked B or below by S.& P.; among the five with the widest gap, all are rated B or below except Clorox, which is rated A. So investors can often limit their exposure to earnings shenanigans by sticking with high-quality issues.

But such a strategy won't offer full protection. As Mr. Bernstein noted, 22 percent of the companies with the largest gaps between reported and operating earnings were rated B+ or better by S.& P.

Mr. Bernstein said he thought the earnings games would be curtailed sharply if the Securities and Exchange Commission required that all company communications with investors reflected figures computed in accordance with generally accepted accounting principles.

Then there would be no confusion among investors about what a particular company really earned in a quarter.

"The reason you have G.A.A.P. is so investors have consistent clear information," Mr. Bernstein said. "The U.S. has always prided itself on having the most transparent financial markets.

"But over the past 5 to 10 years, the U.S. market has become more opaque, and foreign markets have become more transparent. That has huge implications for the economy as a whole and for the cost of capital."
http://www.nytimes.com/2005/03/20/business/yourmoney/20gret.html