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Fool On The Hill

Tuesday, November 17, 1998

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

The Government Is Trying To Help!

Watch out, fellow Fools, Armageddon may be near. It appears as if a government agency is attempting to help you. The Securities and Exchange Commission (SEC) is apparently trying to make it a little easier to decipher financial statements. This morning's Wall Street Journal reported that SEC Chairman Arthur Levitt has announced plans to issue new rules that will require more disclosure on items such as restructuring charges, research and development write-offs, loss reserves, and revenues. Alleluia!

Now, I apologize in advance for discussing such a mundane topic, but it really is one that is important to individuals trying to understand the companies in which they are investing. As investors, we look at many different investment parameters. One of the most common, because of its simplicity, is the price-to-earnings (P/E) ratio. You simply take the price of the stock and divide it by the latest 12-month earnings of a company. As a stand-alone number it isn't terribly meaningful, but it becomes more so when you compare it to the P/E ratios of other companies in the industry and the growth rate of earnings over the longer term.

Of course, there are many other factors that investors should look for, depending on the company. You want to make sure a company has a strong balance sheet so that it can fund continued growth and won't be hampered by concerns about how it will pay its debt. It is also worthwhile to look at gross and net margin trends to try to learn more about the competitive dynamics of an industry and the business models of differing competitors. And of course, it is important to look at cash flow, which is the life-supporting oxygen to any business. While these factors (and many others) are worth studying and will likely improve investment analysis, my interaction with many investors indicates that earnings are by far the most prevalent statistics off of which stocks are evaluated.

But really, how valuable are income statements these days? Let's look at Toys "R" Us (NYSE: TOY). Yesterday's Q3 earnings report included a charge of $678 million ($1.93 per share, after taxes). Part of this charge is for "inventory markdowns of $253 million needed to clear excess inventory." This charge, which will be ignored as a one-time nonrecurring event by most investors, will boost the company's income statement over the next eight to ten months as the company clears out this merchandise! How, you ask?

Let's simplify the situation by looking at a fictional small toy company, Stuffed (FOOLdaq: STUFF), which sells only Barney and Teletubbies stuffed animals. The company pays its supplier $7 per animal and charges customers $10. In this year's first quarter, STUFF sells 10 of each animal, giving it revenues of $200 (20*10) and cost of goods sold of $140 (20*7), yielding gross profit of $60. Assuming no other expenses for simplicity, if the company had 20 outstanding shares, it would earn $3 per share. Looking at recent sales trends, however, management realizes that Barney sales are slowing down and those items will need to be put on sale for $5 to sell the 10 left in stock.

From a reporting standpoint, Stuffed can handle this transaction in one of two ways. The most straightforward would be to mark the price down to $5 per doll and account for the dolls as they are sold. Assuming this were to happen, and the company sold 10 of each doll in Q2, the income statement would include revenues of $150 (10*5+10*10) and expenses of $140 (20*7). Excluding other expenses, profit for the quarter would be $10, or $0.50 a share.

Alternatively, management could decide that it needed to take an inventory write-down on the Barney dolls in order to clear them out. To appease the regulators, the company may couch it with other restructuring activity, but we will again just focus on the pertinent transaction for simplicity. In Q1, the company takes a charge of $30 ($3.00 per doll) to write down the value of the stuffed Barneys on hand. When the Q2 income statement is produced, sales remain $150 (10*5+10*10). Expenses, on the other hand, will only be $110 (10*4+10*7). That means profit for the quarter is $40, or $2 per share.

How do our good friends, the Wall Street analysts interpret the above scenarios? In the first situation, the "straightforward" method, the analyst would likely downgrade the stock after the Q2 results were announced because of deteriorating margins at the company. In the second scenario, the analyst would probably come out after the Q1 write-off is announced and cheer management for taking "corrective steps" to its problems, completely ignoring the charge in his valuation models. Then when the Q2 results are reported, the analyst will laud management for being able to maintain its margins. Ummm, excuse me, isn't the underlying financial performance the same? Should the companies really be valued differently because one used more creative accounting?

Going back to the real-life Toys "R" Us example, The Wall Street Journal reported that the company's CFO, Louis Lipschitz, expected that most of the inventory being marked down will be sold over the next eight to ten months. This means, when looking at reported results over that period, you aren't going to really know what the company's gross margin is. What you'll really get is gross margin, favorably adjusted for inventory markdowns. I'd rather have the former. In fact, it would be even more helpful to have results reported using one of the most fundamental accounting principles: matching revenue and expenses.

We can't blame Toys "R" Us or any of the many other companies that are using these accounting techniques. Current accounting and governmental regulations do not prohibit them. In fact, the increasing use of such strategies by some companies is putting pressure on competitors to compare favorably on various financial metrics. By uniformly clamping down on the abuse of write-offs and restructuring charges, the SEC will level the playing field so that companies producing informative and useful income statements will not be disadvantaged. Many people, particularly management teams, will be putting pressure on the SEC to tone down its plans for changes. The folks arguing against these changes believe it is better to serve investors "sugarcoated" earnings statements that show nice, steady growth regardless of underlying economic fundamentals. As investors, we should encourage a tougher stance on restructuring and other "special" charges. Go get 'em, Chairman Levitt!


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