Microsoft, Intel, Apple: What Numbers Matter? [Fool on the Hill] July 19, 2000

FOOL ON THE HILL: An Investment Opinion
Microsoft, Intel, Apple: What Numbers Matter?

Three big technology companies reported on the same day. All three had results that were greatly affected by investment income. In Microsoft's case, investment income masks the fact that operating income is lower than last year. Intel, with a big investment windfall this quarter, could be setting up unrealistic expectations for investors -- something Apple is suffering from now.

By Bill Mann (TMF Otter)
July 19, 2000

Yesterday three of the bellwether technology industry companies reported their earnings, and two of the three were very good on the surface. Apple (Nasdaq: AAPL) was the odd man out; it "disappointed" largely due to tough comparisons with last year's second quarter. But I would argue that Apple's quarter was solid, and the company that actually had the worst earnings was Microsoft (Nasdaq: MSFT), while Intel's (Nasdaq: INTC) performance was astounding. But all three of these companies' earnings statements have a common thread -- the fact that they were largely impacted by investment income.

As do many companies that have excess free cash, these three companies plow funds into other public and private ventures. Oftentimes companies purchase stock shares on the open market, but they deploy capital as part of strategic alliances just as frequently. This is nothing new -- it is how financial and insurance companies have always made the majority of their revenues. It's another form of return on invested capital (ROIC). And there is no question that in many circumstances this is a more intelligent deployment of capital than having it molder in a bank vault. After all, common stocks have returned better on average than any other investment over the long haul.

The question is how we as investors should treat these gains. They are one time in nature, they are not sustainable, and they do nothing in and of themselves to create future cash flow for the company (more on this later). But investment gains also significantly skew a company's Price/Earnings ratio, and are one reason that, for companies that do not traditionally derive most of their earnings from investing activities, I believe that the P/E is such a poor measure of company operating strength.

There's a great line in the movie Kingpin in which Bill Murray, upon being asked if something is legal, says "I don't know, but it sure is fun, isn't it." That's the way I look at earnings from investments. Not that it's illegal, but it certainly allows companies to color their overall performance in a much more positive light. Since companies are allowed to subtract one-time acquisition and amortization expenses in pro forma earnings, doesn't it make sense that one time gains would be ignored as well?

This is all allowed under GAAP, but it is a situation that is ripe for abuse. The media squawked last night and this morning about whether these earnings reports would cause their respective companies' stock to go up. But investment income, as a series of one-time events, cannot be counted upon as recurring. There is no future discount for the present value of investment earnings because they cannot, or should not, be projected. In other words, not only should investment income not cause a stock price to go up, it is the wrong question to ask in the first place.

Intel's pro forma earnings report for the second quarter was that the company earned $0.50 per share (adjusted for the coming spilt on July 30). This includes some $2.4 billion in operating profits and $2.3 billion in interest and investment income. Almost as much came in from non-operating activities, counted as investment income, as operating income. But the company's press release, and much of the dutiful press reports to follow, focused on Intel's net income, inclusive of those investment gains. This is not a small deal. With the investment gains added in, Intel's per share revenue increased by 92% over the prior year. Take out the investment gains for both quarters, and the growth rate of profits from operations is more like 8%.

Don't get me wrong. I am blown away by Intel's quarter. It had a 23% increase of revenues to $8.3 billion, and its gross profit rate remained over 60% in spite of a charge against sales of $200 million related to replacing faulty MTH motherboards.

But by focusing upon earnings including non-operating activities, Intel is setting its bar nearly impossibly high for future quarters. In the second quarter 2001, for example, if Intel does not sell the same level of its investments it will suffer by comparison to this one, even if it grows operating revenue at a 20%+ rate. The thing that concerns me is that Intel could have come off smelling like a rose by focusing more upon its revenues from operations.

One only need look at the stock market response to Apple's third-quarter report for an example of a company suffering by comparison to a previous quarter with large investment gains. In Apple's case, it has seen its operating earnings increase by 43% over the same period last year. But the headline and sound-bite news reported instead that Apple had earned $0.55 per share this quarter as opposed to $0.60 for the same period last year.

Perhaps I'm selling investors short here. Perhaps they know to look at operating earnings to figure out the sustainable portion of a company's earnings. But given the news coverage of these events, I doubt it.

Yesterday Microsoft's earnings came out, and it also had huge gains from investment sales, accounting for nearly 30% of EBIT. So Microsoft showed a gain of 16% in net revenues over last year. But a look at the company's income statement shows something else entirely: gross revenues increased by only 1% over last year, and earnings from operations declined by almost 15%. Were it not for the 200% plus realized gains from investment sales, Microsoft's quarterly report would have looked awful.

Foolish investors would be well served to focus on operating profits, since performance here is how companies ultimately sustain themselves. Investment income (I'm speaking here about non-financial companies, of course) is a boon, but it is not something that investors should expect to be higher -- or even stable -- from one quarter to the next.

Intel may not have done itself any favors for the future as it will eventually have this quarter, with its huge investment gains, as a baseline for future performance. It would be a shame to see Intel have a solid operating quarter but compare unfavorably as a result. The news media as a rule should take care in how it reports earnings, as investment gains (or one-time charges) can significantly mask the operational performance of a company.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion Boards