Re: [CANSLIM] Now Xerox?

From: Sam Funchess <sam5@mindspring.com>
Subject: Re: [CANSLIM] Now Xerox?
Date: Fri, 28 Jun 2002 15:36:31 -0400
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Canslim Members,
<p>Been a while since my last post.
<p>With that being said, I think the "scandal's" are very good for the
long term benefit of CANSLIMers and the market.&nbsp; Its been a while
since I've read HTMMIS so I can't quote chapters or such, but I recall
him talking a lot about the fear factor.&nbsp; We have not had the "Fear"
in the market yet.&nbsp; I think that there is no sustainable upside to
the market until the fear has hit the market.
<p>Just my thoughts.
<br><br>
Sam
<p>Katherine Malm wrote:
<blockquote TYPE=CITE><style></style>
Here's some background on earnings
from Briefing.com for those less familiar with EBITDA, etc.&nbsp;--Katherine&nbsp;PS
Xerox's accounting woes go back *years*.... P-U....==========&nbsp;&nbsp;
<table CELLSPACING=0 CELLPADDING=4 WIDTH="100%" >
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<td class="header">The Earnings Confidence Problem - Part I</td>
</tr>

<tr>
<td><b><font face="Verdana"><font size=-2>25-Jun-02 14:18 ET</font></font></b></td>
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<td HEIGHT="8"></td>
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<td>[BRIEFING.COM - Robert V. Green] In the midst of the more scandalous
market problems, the earnings confidence problem is not receiving the attention
it should. Here is more on the topic.&nbsp;
<h3>
The Market Problems</h3>
The current market suffers from the following ailments:&nbsp;
<ul>
<li>
Distrust of management - from excessive comp to outright fraud. Tyco is
the best example.&nbsp;</li>

<li>
Distrust of accounting - Andersen&nbsp;</li>

<li>
Distrust of analysts - Blodgett</li>
</ul>
These three problems get all the press and attention.&nbsp;
<p>But a deeper problem is afflicting the buy side - a growing concern
about the validity of earnings reporting.&nbsp;
<h3>
The Earnings Problem</h3>
Accounting rules have always been flexible enough to allow most companies
a far amount of flexibility both in revenue recognition and expense recognition.
Even when earnings reporting was somewhat standardized, some companies
were criticized for how they recognized revenue and expense.
<p>But in the last five years, the <i>types</i> of earnings that companies
have driven Wall Street to focus upon have become questionable.&nbsp;
<p>There are four different basic types of earnings today:
<ul>
<li>
GAAP earnings: Generally Accepted Accounting Principles - A standards board
that publishes rules on how expenses should be booked. Generally, all types
of expenses are deducted.&nbsp;</li>

<li>
As reported: Earnings excluding extraordinary items (as defined by GAAP),
changes in accounting charges, charges related to discontinued operations
(plant closings, etc.)&nbsp;</li>

<li>
Operating earnings: As reported earnings but excluding "one-time" charges
which do not fit the GAAP definition of "extraordinary"&nbsp;</li>

<li>
Proforma earnings: Loosely defined "as if" analysis. Originally designed
to provide comparison data for mergers.</li>
</ul>
<b>GAAP</b> accounting principles are guidelines for accountants, not investors.
The GAAP standards are guidelines for how a company should keep its books,
not how the company should report earnings.&nbsp;
<p>For example, a basic principle behind GAAP is that revenue must be booked
over the time period for which services and product are delivered. If a
two year $200,000 contract is pre-paid in cash, up front, the entire $200,000
cannot be booked in the quarter in which the contract is signed. However,
the revenue does not have to be booked as $25,000 per quarter for two years.
A fair amount of flexibility, sometimes negotiated by auditors, is possible
for how much of a contract can be booked in each quarter.&nbsp;
<p>GAAP covers expenses as well as revenues, of course.&nbsp;
<p><b>As reported</b> earnings are the historical standard for earnings.
Until the mid-eighties, in fact, there was little debate over how earnings
should be reported as everyone used "as reported" earnings as a standard.
For the most part, there was no difference between "as reported" earnings
and any other methodology because one-time charges were not as common.
Furthermore, companies did not actively seek, as they do today, to have
certain expenses classified as "one-time."&nbsp;
<p><b>Operating earnings</b> are designed to allow comparisons between
quarters and years for a company. One time charges in any quarter are excluded
because these would distort the comparison. Operating earnings became important
when it became clear that Wall Street would completely ignore any "one-time"
charges, and focus solely on earnings growth. This provided a strong incentive
for companies to classify large expenses as one-time charges.&nbsp;
<p>An example of one company's aggressive attempt to get charges classified
as one-time was Excite's 1997 $40 million marketing deal with Netscape.
Now long forgotten, Excite paid Netscape up-front for a four-year deal
to be the principal search engine at the Netscape web site. Excite tried
to classify the entire $40 million payment as a one-time charge in a single
quarter. By doing so, Excite was almost profitable. At Briefing we highlighted
this event as an indicator of the times. The SEC later forced Excite to
restate the payment as a four-year expense. But many, many companies were
successful in getting major expense outlays classified as "one-time" which
improved income statements.&nbsp;
<p>The focus on operating expenses led to the development of the "EBITDA"
concept, which is "Earnings Before Interest, Taxes, Depreciation, and Amortization."
The EBITDA concept, which has to be calculated from the line items shown
on an operating earnings report, was designed to show the basic business
model of the company, without regard to cost-of-capital. If capital were
free, then EBITDA would be earnings.&nbsp;
<p>The focus on EBITDA has fallen from favor in recent times for one single
reason: <i>Interest.</i> The interest payments on bonds, which are excluded
from EBITDA calculations, has ruined many debt-ridden.&nbsp;
<p>Only through focusing on EBITDA projections could a company like Exodus
Communications raise so much debt that their interest payments exceeded
their gross margin. That won't happen again for decades.&nbsp;
<p><b>Pro-forma earnings</b> are very hard to define today. The original
purpose of pro-forma earnings calculations was to show the effects of a
merger in a format that allowed a single income statement to combine only
the operating models of each company, and exclude the actual costs of making
the merger.&nbsp;
<p>Under the pro-forma for merger guidelines, pro-forma calculations could
only be used for one year, after which the company should start reporting
as-reported earnings for the combined entities.&nbsp;
<p>However, companies soon learned that as long as they made a new merger
each year, they could continue reporting pro-forma earnings indefinitely.
This "flexibility" in how earnings could be reported led to "pro-forma"
meanings that were never intended, including stock option compensation
expenses and R&amp;D "in-progress" write-offs.&nbsp;
<h3>
The Erosion of Earnings Confidence</h3>
The now long-departed CFO of Amazon.com, Joy Covey, was the unsung hero
of bringing pro-forma earnings to the popularity they enjoyed. She did
so by diverting attention away from standardized earnings reports.&nbsp;
<p>Ms. Covey invented the concept of "EBITMA" which was defined "EBITDA
plus marketing." She was successful in convincing Wall Street that <i>marketing
costs were equivalent to capital investment,</i> a concept which looks
ridiculous in retrospect. But in the early days of the internet, marketing
and brand development was equated with capturing "territory" which, presumably,
everyone thought could never be lost. (Tell that to investors in Excite.)&nbsp;
<p>Nevertheless, Joy Covey was successful in convincing investors, particularly
convertible bond investors, to focus on the EBITMA concept. It was a crucial
element in selling the $2 billion in Amazon.com bonds that built the company.
After all, if you ignore the interest payments on the bond, and you consider
spending the bond principal on marketing as "not an expense," Amazon's
income statement would look great!.&nbsp;
<p>The problem, of course, is that bond holders don't care about earnings
statements. They just care about the payments. The jury is still out on
whether Amazon.com will eventually be able to pay the principal on their
bonds. (See the Stock Brief of: <a href="http://www.briefing.com/scripts/sub/stocks/PowerAnchor.asp?varArticleID=SB20010514082806rvgreen">14-May-01
Amazon.com's Bond Problem.</a>
<p>After Joy Covey established the principle of EBITMA, internet companies
began using all types of non-earnings related statistics to show growth.
Page views, registered users, unique monthly visitors are just some of
the meaningless examples that became popular. (Surely you remember.)
<p>When "non-revenue statistics" becoming drivers of stock prices, (around
1998) pro-forma earnings increased in popularity. After all, a pro-forma
income statement that showed <i>some kind of earnings</i> progress looked
a lot more "real" than the phony statistics being coughed up by internet
companies.&nbsp;
<p>But when the bubble collapsed, <i>everyone </i>began questioning earnings
quality. It didn't happen overnight, and it didn't happen all at once.
But as a long, slow evolutionary force, earnings confidence has eroded,
and is still present today.&nbsp;
<h3>
The Aftermath</h3>
The evolution of earnings focus over the past 10 years has led us to today's
situation: a basic lack of confidence in many companies income statements.&nbsp;
<p>Amazon.com still reports earnings on a pro-forma basis. In their Q1
income statement, you can take your choice of earnings:&nbsp;
<ul>
<li>
Pro-forma: $25 million profit&nbsp;</li>

<li>
Operating: $2 million profit&nbsp;</li>

<li>
Net (as-reported): $(23) million loss</li>
</ul>
The earnings format <i>you choose</i> is not relevant, frankly. It is far
more important to the stock value what format <i>the guy next to you chooses.</i>
<p>After all, value <i>to you</i> is primarily determined by what someone
else will pay, not by what you pay.&nbsp;
<h3>
Even GE</h3>
Even solid companies like General Electric have come under scrutiny because
of the extremely complex financial situations. Unraveling a GE earnings
report has now become a major task. Where GE only had to beat earnings
estimates by $0.01 each quarter to count on an ever increasing stock price,
today that is not enough.
<p><i>GE stock is down 50% in the last two years despite having only missed
one earnings estimate in the last four years and having continual year-over-year
growth in earnings averaging 15%.&nbsp;</i>
<p>This bears repeating: GE, as representative a stock as you can get of
the overall economy, is down 50% since September 2000. During that time
period, they have grown earnings at over 11% (year-to-year basis) and beat
or met earnings estimates every quarter except one. The one shortfall was
October 2001, the quarter of the Attack on America and GE was only one
penny short.&nbsp;
<p>Why can't GE get any respect? The only definable long-term culprit is
a decline in confidence in GE's earnings numbers. During the same eight
quarter time-period, GE revenue growth rate has been consistently falling.
From a growth rate of 24% and 20% in 00Q1 and 00Q2, growth has steadily
fallen, and even was negative for most of 2001.&nbsp;
<p>Flat or declining revenue combined with continuing increasing earnings
leads to only one conclusion: <i>you can't keep this up forever. </i>Eventually,
GE will be unable to book the earnings number higher than previous years.
When (if), that happens, GE stock will be further devastated. Until then,
the slow erosion of confidence causes the stock price to decline.
<p>GE is just one good example of how confidence in earnings numbers has
been eroding over time since the bubble collapse. Until greater confidence
in earnings numbers is established, you can expect further difficulties
in the market overall.&nbsp;
<p>Standard &amp; Poors is now pushing for a standardized calculation for
earnings reporting, called Core Earnings. We will have more on this concept
in Part II of this story, to appear later this week.
<p>Comments may be emailed to the author, Robert V. Green, at <a href="mailto:rvgreen@briefing.com">rvgreen@briefing.com</a><!--(RVG)--></td>
</tr>
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<blockquote 
style="PADDING-RIGHT: 0px; PADDING-LEFT: 5px; MARGIN-LEFT: 5px; BORDER-LEFT: #000000 2px solid; MARGIN-RIGHT: 0px">
<div style="FONT: 10pt arial">----- Original Message -----</div>

<div 
  style="BACKGROUND: #e4e4e4; FONT: 10pt arial; font-color: black"><b>From:</b>
<a href="mailto:wlittle1@peoplepc.com" title="wlittle1@peoplepc.com">Winston
Little</a></div>

<div style="FONT: 10pt arial"><b>To:</b> <a href="mailto:canslim@lists.xmission.com" title="canslim@lists.xmission.com">canslim@lists.xmission.com</a></div>

<div style="FONT: 10pt arial"><b>Sent:</b> Friday, June 28, 2002 9:47 AM</div>

<div style="FONT: 10pt arial"><b>Subject:</b> Re: [CANSLIM] Now Xerox?</div>
&nbsp;They all used EBITDA.. which Warren Buffett in May said is the currency
of a
<br>crook ... they all have a smell about them.
<p>----- Original Message -----
<br>From: "Kelly Short" &lt;<a href="mailto:kelly.short@neoris.com">kelly.short@neoris.com</a>>
<br>To: &lt;<a href="mailto:canslim@lists.xmission.com">canslim@lists.xmission.com</a>>
<br>Sent: Friday, June 28, 2002 9:46 AM
<br>Subject: [CANSLIM] Now Xerox?
<br>&nbsp;
<p>Enron, WorldCom- nothing. Xerox off by $6B. (Yes- that's "B" as in boy!)
<p>Kelly
<br>&nbsp;</blockquote>
</blockquote>

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