I've been an investor in a certain company for five years. The outfit has made money every quarter. It wasn't always smooth, but Business Week and Forbes tabbed them as the “fastest growing” in their sector. Earnings, when averaged out, ticked up 20% annually.
Just when the market swooned this year, they announced a quarterly loss. It wasn't teeny. It rounded out to $30 million. That put them in the hole for the year.
Naturally, the stock soared. By some $200 million in market cap. And I'm pleased.
What's going on? Irrational exuberance?
No. Ever-changing GAAP rules and the SEC make some earnings statements meaningless today. Only the shrewdest investors, some institutions, or anybody who ignores GAAP and digs down into true cash flows can hope to get it.
The man on the street? Forget him. He'll never catch up.
The last bubble began when cable networks started scrolling ticker prices across the screen. Tickers don't give real deep analysis. The SEC looked away while stocks soared and voters thought they were getting rich. EBIDTA and other measures that overlooked the cash outflows in leveraged businesses became acceptable yardsticks.
Examples?
Rhythms Net Connections went public, issuing EBIDTAL statements — presuming “L” (legal expenses) to be either nonrecurring or irrelevant. The stock shot up to several billions of worth despite having only a few millions in sales, but their EBIDTAL looked swell. Rhythms went bankrupt in two years. Waste Management decided that painting their trucks was a nonrecurring expense and excluded those charges from pro forma earnings. Enron kept getting tight on cash but showed great numbers in some convoluted forms of reporting.
But why did I like the quarterly loss in my company? And why did Wall Street?
Because the true cash flow, after interest payments, let them prepay about $20 million in debt while showing a loss that was even bigger than that pay-down. And revenues did set a record.
They'll show losses and pay income taxes all of this year. The IRS figures things differently. No wonder the guy on the street gets confused. (Remember a decade ago, when the IRS wanted to make business capitalize packaging and advertising expense? Yow. Talk about imaginative accounting. Of course, that would boost the tax man's take. But presuming advertising results are predictable and therefore those “investments” are a precise asset takes more chutzpah than even most Madison Avenue types can muster.)
Why does this investment of mine show a loss when the cash flow gushes up? Three reasons.
First and mostly, they made an acquisition. It's almost a publishing operation, with subscriptions sold and delivered over time, but the cash is collected upfront. Current GAAP and SEC rules won't let them book the acquired revenues until those subscribers renew. That's silly.
Second, the acquisition expenses must be charged, along with intangible write-offs. That's reasonable.
Third, this outfit uses stock options to incentivize management, adding another expense. This is a debatable cost, since, to see what's really happening in any company, all you need do is look at their true cash flow per diluted share. Then the cost of stock options is automatically factored in. But when those options are also charged against the income statement, it's then a double expense. Conservatism is good accounting. Double-costing to overstate expenses is not. It disguises what's really going on from the individual investor, and earnings per share figures get understated.
Expensing of options is supposedly rationalized with Black-Scholes. If you study those formulas, notice that the more volatile a stock is, the more valuable those options are supposed to be … and the higher the expense to the company. Do you value volatile stocks more than steady ones? Me neither.
In the specific case of this business, they expense several millions each quarter for options granted. About half of those outstanding options are at prices noticeably above current market. The only way those options will ever be exercised is if the stock rises dramatically. That's not such a painful expense for shareholders, eh?
The problem here is that the SEC, cheerleading the new math during the bubble, now won't allow rational disclosure in conservatively stated pro formas. That excludes the individual investor from understanding. Only the Wall Street gang can decipher what's really happening. That's a shame.
We've gone from abuse to confusion. â–
The author can be contacted at garysutton@san.rr.com. His book, Corporate Canaries, has gone into six languages.