Quarterly financial reports frequently don't tell all

The Insider

Your Money

April 18, 2004|By BILL BARNHART

INVESTORS learned to their horror a few years ago that quarterly financial reports by corporations sometimes lie.

Enron Corp. and WorldCom Inc. masked fatal problems within generally accepted accounting principles.

But as prosecutors sift through the wreckage, green eyeshades are out of fashion. With the economy and stock prices up from a year ago, investors have relaxed.

"As the tide lifts, those rocks tend to get covered up," said investment manager Brian Langenberg of Langenberg & Co.

Recent action on Wall Street, where stock prices dropped and interest rates rose, suggests the tide of good news may be ebbing.

Quarterly reports and outlooks now being issued provide clues to how the companies will fare in this transition. But you must look behind the headlines.

"I'd be watching the quality of earnings," said Tobias M. Levkovich, chief U.S. equity strategist at Citigroup Smith Barney.

Kenneth Shea, director of equity research at Standard & Poor's, said the level of one-time charges has declined, and the number of companies recognizing expenses for employee stock options has increased.

"There's a continuing improvement in the quality of earnings," he said.

Most companies posted record or near-record-high profit margins last year. That's a tough act to follow.

And "how much of it is clean at the margin?" Levkovich asked.

A cheaper dollar, which inflates sales and profit and lowers taxes for multinationals, does not represent a sustainable strategy, he said. Ditto for lower taxes and interest rates.

Greater productivity - squeezing more work out of employees - has limits.

"A lot of big numbers coming are being driven by cost-cutting rather than top-line [sales] growth," said Pat Dorsey, director of stock analysis at Morningstar. "After a few quarters, that sponge will be dry."

Yesterday's cost-cutting story is old news. The current question: How will companies grow with the economy and protect lofty profit margins?

The ratio of inventory to sales is at an all-time low in corporate America, Levkovich said. "What you're not seeing is companies producing more than demand so they can restock the shelves and get more sales."

Merrill Lynch & Co. Inc. told investors it plans to hold expenses at set levels as much as possible, rather than follow the rule in the investment banking business of tying expenses to revenues.

That's hard to do in a personnel-heavy business, unless competitors follow suit, Dorsey said. "As soon as one of them doesn't, everybody goes there."

Higher raw-material costs present another challenge.

"How much pricing power do companies have? Will they be able to pass those costs along to their customers?" Dorsey asked.

The guide to such key issues is the statement of "cash flow from operations," in companies' quarterly 10-Q reports.

"Enron and WorldCom have shown that earnings numbers have limitations," said Brian Hamilton, chief executive of Sageworks, a financial data firm. "We try to look at the cash that a company is generating."

Yet most companies fail to provide a cash-flow statement at the time they issue quarterly earnings announcements.

"To me, it's just being a little disingenuous," said Dorsey. Not a lie, but not the whole truth.

Bill Barnhart is a financial columnist for the Chicago Tribune. E-mail him at yourmoney@tribune.com.

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