Caution: Nonoperating Income Ahead [Fool on the Hill] July 6, 2000

FOOL ON THE HILL: An Investment Opinion
Caution: Nonoperating Income Ahead

Nonoperating income is becoming a larger portion of the earnings stream at many companies. While this keeps net income rising, these gains aren't always sustainable and may distort earnings growth rates. You should dig deeper into the financial statements of these companies to ensure you understand the company's value.

By Warren Gump (TMF Gump)
July 6, 2000

Companies have several legal options to meet estimates if they're a little bit shy in a specific quarter. Most of these strategies revolve around recording nonoperating income, earnings not derived from the core operations of the business. Examples of nonoperating income are realized gains on investments, gains from the sale of operations, interest income, and the recapture of excessive charges in prior periods.

Realized gains from the sale of investments are the most common source of nonoperating income these days. The increasing presence of minority ownership stakes and venture capital investments combined with a tremendous bull market has left many companies holding a huge amount of unrecognized gains. These are profits that a firm has earned off an investment that won't be recorded on the income statement until the security has been sold and the profit realized.

If you're the chief financial officer at such a company where business is slower than expected, you can just sell some of your appreciated securities and record the gain on the company's income statement. Voila! Recorded earnings will meet or exceed expectations and everyone can be happy.

(Investment gains are not always timed to boost earnings. Companies have many business reasons for selling investment stakes, such as reaching a perceived fair value, changes in corporate strategies, or a merger transaction where the investment must be sold.)

When such a number is clearly a one-time event, they are usually ignored like the all- too-common restructuring charge. In other cases, analysts and investors embed these gains into recurring income streams because (1) management convinces them that it's part of an ongoing operations, (2) they really believe the income stream will be permanent, and/or (3) they blindly believe that the company can do no wrong.

While the nonoperating income will boost results (and the company's stock price) when things are going well, the downside can get really ugly. If the nonoperating income stops flowing in, the earnings level off which investors evaluate the stock will fall along with the multiple investors will pay for those earnings.

The Thermo Stumble
I have some close experience with this situation on the downside. A few years ago, Thermo Electron (NYSE: TMO) spun out minority stakes in subsidiaries as public companies. After spinning out new businesses on a fairly regular basis for a couple of years, investors starting incorporating these gains as regular, recurring earnings. That worked well while the public markets were receptive to IPOs coming out of the company.

Challenging business and market conditions, however, caused the spinoff pace to slow to a trickle and then stop. When investors realized these gains wouldn't continue on a regular basis, they removed them from the ongoing earnings calculation. The loss of this earnings stream, combined with lackluster underlying earnings, resulted in the stock price falling from over $40 per share to less than $15 in six months. Had the one-time gains consistently not been considered recurring, the stock price probably wouldn't have risen so high nor fallen so far.

Intel and Microsoft
In this year's first quarter, Intel's (Nasdaq: INTC) recurring EPS (excluding goodwill) is recorded on First Call at $0.71, up 25% from the prior year. If you look on the income statement, you see a slightly different outcome. Operating income (excluding goodwill and charges) increased 12% to $3 billion, but interest and other income shot up 84% to $640 million. The magnitude and impact will be even greater in the second quarter: Intel recently announced it expects a nearly eight-fold increase in interest and other income over the prior year.

Another company with similar exposure to nonoperating income is Microsoft (Nasdaq: MSFT). Over the past three quarters, investment income moved up to represent about 20% of net income compared to 16% of net income in the prior year periods. Put another way, Microsoft's operating earnings grew 20% to $8.4 billion, but investment gains ramped up 56% to $2.1 billion. Combining the two together, you have 25%+ earnings growth, even though the core business only improved profits at a 20% rate.

Since these gains have been a constant part of Intel and Microsoft's earnings stream for the past few years, investors complacently include these gains in recurring EPS. That will work fine so long as the investments do well. But if the returns on investments slow down from the current pace and the companies run out of gains to realize, investors could face a not-too-pretty situation where earnings and earnings growth rates will be lower than expected.

Finding and Evaluating These Companies
These two companies are not the only places where nonoperating income is playing an increasing role in boosting net income. The situation can present itself almost anywhere companies have large slugs of cash or investment pools (e.g., internal corporate venture capital funds). The easiest way to find these firms is looking on the balance sheet for cash, investments, or marketable securities. If the number is big relative to company size, you'll probably find that the income statement has a noticeable amount of interest and investment income.

These gains aren't bad. Indeed, they reflect shrewd moves by management to maximize the value of company assets. You do, however, need to take a more cautious approach to valuation and be sure not to give too much credence to these earnings streams. Instead of valuing reported net income as a multiple of earnings, it might make sense to segregate investment portfolios from operations. Then, value cash and investments at their market value (companies often provide this information) and put a multiple on operating earnings (based on the growth of that income stream). Such analysis takes more time, but it could prove to be valuable down the road.

Your Turn:
Do you think it makes sense to separate investment portfolio returns from operations? Post your thoughts on the Fool on the Hill discussion board.

Suggested Links:

  • Intel discussion board
  • Microsoft discussion board