Name Your Own Earnings [Fool on the Hill] July 25, 2000

FOOL ON THE HILL: An Investment Opinion Name Your Own Earnings has taken the concept of pro forma earnings adjustments to the next level. Instead of ignoring just onetime and unusual charges, the company takes preferred stock dividends, payroll taxes on options, and supplier warrants out of its results. Until investors say enough is enough, the quality of earnings reports across the board is likely to deteriorate.

By Warren Gump (TMF Gump)
July 25, 2000 (Nasdaq: PCLN) has taken its name-your-own-price concept beyond its business model and into its earnings statement. With the deftness of one of its customers trying to get a $129 roundtrip ticket from Washington, D.C. to San Francisco, the company has played with its pro forma earnings statement in an attempt to make stockholders cheer by minimizing losses. Anyone looking into the matter, however, should be leery of buying the numbers that the company touts. Numerous expenses are excluded from these pro forma numbers.

Before proceeding, let me note that isn't the only company that has been taking certain costs out of its income statements. The practice of excluding "noncash" and other expenses is becoming more and more prevalent, as companies strive harder than ever to exceed analysts earnings estimates and justify their valuations. I was just so struck by the audacity of's press release that I'll be picking on the company for the rest of the column. As investors, we need to be much more vigilant in demanding that announced results truly represent company performance.

By now, almost everyone knows that records all of the revenue from its ticket sales in its top line. When sells a $200 ticket, they book all $200 as revenue and deduct the cost of the ticket in cost of goods sold. This contrasts with a normal travel agent, which only records the commission it receives (around $16 on a $200 ticket).'s practice meets Generally Accepted Accounting Principles (GAAP) since the company temporarily holds the plane seat in its inventory. Skeptical people like me, however, point out that the company doesn't really take inventory risk, since customers have prepaid for the tickets on their credit cards.

For people who evaluate companies on price-to-revenue ratios, this difference can be important. If both a travel agent and were valued equally and generated the same ticket sales, the travel agent would have a price-to-sales ratio around 12x higher than's. The numbers make look much more attractive, despite the fact that the two companies are basically identical from a business perspective. You have to keep accounting issues like this in mind any time you're evaluating a company's financial statements -- GAAP provides lots of latitude in many areas.

"Pro Forma" Operating Statement
While GAAP has been promulgated by the accounting profession and contains restrictions, pro forma financial statements can be constructed any way a company desires. No regulations or restrictions exist for this kind of statement. They have traditionally been used by companies undergoing serious transformations (mergers or restructurings) that distort GAAP-compliant statements. In addition to reporting GAAP results, the company also shows what the income statement would look like if the unusual events were excluded.

Over the past few years, pro forma income statements have become increasingly prevalent -- even if companies aren't undergoing transformations. Instead of excluding onetime costs, companies are now issuing pro formas that exclude "noncash" charges such as goodwill amortization and the few options-related expenses that GAAP records. has taken this one step further, excluding expenses that it doesn't think investors should concern themselves with, such as preferred dividends and options-related payroll taxes.

Below are the three items that excluded from its second-quarter pro forma income statement:

  • $7,191,000 in preferred stock dividends
  • $2,571,000 in payroll taxes on employee stock options
  • $381,000 in supplier warrant costs

    Preferred Stock Dividends
    The preferred stock dividends were paid to Delta Air Lines (NYSE: DAL) and were excluded because they were paid in stock rather than cash. Delta swapped 6 million common shares (which pay no dividends) for 6 million shares of preferred stock with a par value of $59.93 and an 8% dividend. Instead of paying the dividend in cash, however, pays the dividend with newly issued stock. The company seems to think that this payment methodology means that the preferred dividend isn't an expense. As an analyst, I disagree. I believe that the dilution caused by such a payment is a very real expense.

    Payroll Taxes on Options
    I don't understand why the company ignores payroll taxes it is required to pay on the exercise of employee stock options. I guess they feel that since GAAP crazily doesn't require them to take a charge against earnings for most employee stock options, there shouldn't be a penalty for any expense associated with this type of compensation. Well, I argue differently. This is a real cash expense that the company incurs when employees exercise options, and should be recorded as such.

    Supplier Warrant Costs
    When signs on partners to participate in its programs, it usually grants them options to buy shares of the company instead of paying them cash. Usually, the company writes these expenses off in big chunks when they happen (these have led to a good portion of the company's cumulative $1.2 billion in losses). The structure of the company's deal with Delta caused it to record a $381,000 expense on a quarterly basis this year. The company excludes this expense from pro forma results. By ignoring these transactions, investors aren't taking into account the dilution shareholders must endure to obtain partner company participation.

    In the highlights of its earnings release, touted its loss of $0.01 per share, which compared favorably to the $0.10 per share loss recorded in the prior year. Reading through all of the details, however, you learn that those numbers are based on the pro forma adjustments mentioned above. According to GAAP, which seems much more appropriate given the lack of unusual events this quarter, the company had a loss of $0.07 per share. This still compares favorably to the $0.10 per share loss of last year, but isn't nearly as impressive. isn't really at fault for putting the most positive spin it can on its earnings results. That's the job of its investor relations people. Instead, responsibility for the abuse of pro forma earnings statements lies squarely in the hands of analysts and investors who let companies get away with providing such distorted perspectives. Until people raise a stink, companies are going to become increasingly bold in their creation of pro forma income statements.

    Your Turn:
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