Commentary: Putting on a Grim New Face

By David Henry

Brace yourself for what may be the ugliest quarter ever for corporate earnings. For years, companies used every trick in the book to make their results look better than they really were. Now, many will be taking the opposite tack: loading costs and charges onto their income statements in an all-out effort to make an already horrid year look even worse.

Crazy? Not a bit. The aim of the game this time around is to engineer a dramatic surge in earnings in 2002. The stakes are huge. Analysts such as Edward Keon Jr., quantitative strategist at Prudential Securities Inc., say that companies in the Standard & Poor's 500-stock index, the cream of Corporate America, could display earnings gains of 30% to 40% by this time next year.

Sadly, the September 11 terrorist attacks are making it easy for companies to massage the results they present. Of some 150 warnings of earnings shortfalls in the ensuing two weeks, nearly two-thirds cited the attack as a cause, according to Thomson Financial/First Call. "You're going to see a lot of companies use this as cover for missing their numbers," says Tobias M. Levkovich, stock market strategist at Salomon Smith Barney.

Many of Wall Street's highly paid analysts are cheering them on. "There is a tolerance bordering on a thirst for earnings management," says Sean Ryan, bank analyst at brokerage Fulcrum Global Partners. "As irrational as it may be, the market is likely to reward banks that ball up all of their problems and take big hits in the second half of this year."

"OPEN SEASON." Regulators seem helpless to stop the rot. Indeed, officials of the Financial Accounting Standards Board (FASB), which is charged with setting minimum requirements for corporate accounting, essentially threw in the towel on the issue on Sept. 28. Its Emerging Issues Task Force had struggled for two weeks to lay down rules for what companies could classify as extraordinary costs as a result of the attack. But the group gave up, declaring that it couldn't come up with fair rules to cover the widespread and varied losses of different sorts of companies. As a result, "it is open season" on investors as companies spin their earnings any way they like, says Charles L. Hill, research director at First Call.

The consequence for investors is severe. Without a good fix on the true earning power of companies,they're at a loss to know whether the stock market is a buy even after the S&P 500 has fallen 20% since the start of the year.

In reality, investors would have had a hard job even if the FASB hadn't ducked the issue. Regardless of the FASB's decision, companies would be finding ways within existing rules to manage earnings down now and then back up later. For example, many will write down assets such as plant and equipment, increasing this year's costs but reducing depreciation expenses in the future. Or, they may delay booking sales arranged in December until the new year. Some businesses have even more scope. Ryan expects banks to hurry up and write off bad loans to corporations and belatedly boost reserves for consumer loans. "There is going to be a tendency to overestimate the economic impact of the attack because it allows managements to shift responsibility for their own mistakes to Osama bin Laden," says Ryan. "That clears the deck for earnings in 2002."

It is likely to be a wild ride. Even before the earnings manipulation starts in earnest, Wall Street strategists were slashing their earnings estimates. On Oct. 3, strategists were forecasting a 31% drop in third-quarter earnings from ongoing operations of S&P 500 companies, nearly double the 18% decline they had been expecting the day before the terrorist attacks, according to First Call.

GUESSING GAME. Even the strategists' revised numbers are just a guess based on their economic forecasts. Usually, investors can also look to estimates compiled by hundreds of analysts who study individual companies. But the analyst estimates are still incomplete or out of date. Many analysts lost their offices and computers in the attack, and more are at a loss deciding how much of the earnings declines of each company they follow should be ignored as exceptional.

Earnings guidance from companies is variable in quality. The financial giant Citigroup Inc. (C ) said insurance claims would cut 10 cents a share, and the closing of the stock market 3 cents, from third-quarter earnings. Auto maker Ford Motor Co. (F ) initially said its earnings would fall short of analysts' estimates because it was cutting production after parts were not delivered immediately after the September 11 attack. Later, it also blamed zero-cost customer financing that it started on Sept. 17 to jump-start sales. On neither occasion did Ford put a figure on the shortfall. Clothing retailer Men's Wearhouse Inc. announced on Oct. 3 that the "dramatic consumer reaction to the recent events" is depressing sales, and that third-quarter earnings would be half of analysts' estimates. "It is going to be tough to sort out what is valid and what isn't," says Hill.

Investors trying to value any earnings bounce next year face an added complication. Months ago, the FASB decided to end the obligatory amortization of goodwill--the premium that companies had paid for past acquisitions--from the start of next year. Only when the assets lose value will they have to be written down in the future. While the change was needed, it alone will artificially boost reported earnings in 2002 by about 5% for the S&P 500, again making the rebound look stronger than it really is. Including the change, strategists estimate earnings will climb 17 1/2% for all of 2002.

Of course, there's a risk that there will be no rebound at all. The whole two-step strategy of depressing and then inflating earnings is based on a gamble that the economy will follow the same trajectory--diving, then soaring in a V shape. But there might not be a V of any kind if there are more devastating terrorist attacks or if the Federal Reserve and the government fail to lift the economy.

Even a big improvement next year will leave earnings far short of those in 2000. Strategists estimate earnings per share of the S&P 500 in 2002 will be $52.16, up from $44.38 in 2001, but still well below the $55.12 hit in 2000. Earnings won't reach 2000 levels again until 2005, says economist Steven Wieting of Salomon Smith Barney.

Logically, the uncertainty about companies' true earnings power should weigh on their stock prices over the next year or two. But from week to week, the mood of investors and traders will largely determine whether the market accepts next year's reports of gains at their face value or tries to see through the accounting games. If they feel optimistic, as they would if the counterattacks on the terrorists go well, they'll be inclined to believe in the earnings rebound--just as they accepted overblown valuations in the late-1990s bull market--and bid the market higher. So, if the outlook for a rebound holds, it should support the market in a few months. "People will look past [2001's] depressed earnings," says Levkovich.

Maybe so. But this is truly a confidence game now. If investors don't feel sure the economy is coming back, they won't buy anybody's numbers, no matter how well massaged.

Associate Editor Henry covers accounting issues.

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