FOOL ON THE HILL
Don't Be Fooled by DuPont

Earlier this year, IBM got into some hot water for using a one-time sale of an asset to offset operating expenses. This juiced up its net margins pretty good, but investors who don't pay attention to the details are going to be fooled. Turns out DuPont, another Dow component, is doing the same thing.

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By Bill Mann (TMF Otter)
April 26, 2002

It can cause as many problems as it clears up. So many investors, it seems, look at a price-to-earnings ratio (what is this?) to be the be all and end all of determining whether a stock is "expensive." There have been some discussions as of late, for example, that E. I. DuPont de Nemours & Co. (NYSE: DD) is a screaming buy at a P/E just under 11. After all, this is one of the largest chemical and performance material companies in the world. It has had a tough year with the enormous rise in petroleum costs -- its major fuel stock requirement -- as well as tightening markets in some of its core products. Revenues at DuPont were down significantly, though this is a cyclical business. Swoons happen.

So how is it that DuPont's net earnings are up nearly 87% over last year's? Have the layoffs at DuPont already yielded such amazing efficiency returns? No. And DuPont has classified some things as operating expense offsets that don't seem like they should be. We can guarantee that they aren't recurring in nature. For investors who focus too much on ratios without looking at the meat behind them, such items can skew their perceptions of company economics quite badly. Long-time reader Fletcher Ray pointed out to me that it seems DuPont is doing something similar to what got IBM (NYSE: IBM) into some hot water in the past month: counting a one-time sale of an asset as an operating event.

At the end of 2001, DuPont sold off its pharmaceutical division, calling it, cleverly, DuPont Pharmaceuticals, to Bristol-Myers Squibb (NYSE: BMY) for $7.7 billion in cash. Net of all assets, the amount of pre-tax profit to DuPont for the sale was $6.1 billion, after tax $3.6 billion. All well and good -- companies, particularly ones with dozens of separate operating arms, buy and sell components of themselves all the time.

DuPont got paid, but are they 'earnings'?
But a look at the financial statements leaves me scratching my head. Why does DuPont count its gain of sales on DuPont Pharmaceuticals as an operating expense offset? The $6.1 billion drops DuPont's reported 2001 operating expenses down from what would have been $24.7 billion to $18.5 billion. A billion here, a billion there, right? Well, the amount of revenues DuPont generated was only $25.3 billion, so operating earnings that would have been in the range of $700 million suddenly spike up to $6.8 billion, an increase of more than 800%.

This isn't hidden or anything -- it's not buried deep down in DuPont's footnotes, � la Enron. It's right on the income statement. But how is the one-time disposition of an operating arm, or a capital asset, an operating gain? Of course, such a classification is allowed under Accounting Practices, but it's kind of deceptive.

Here's why it matters. Neither the operating margin nor the gross or net profits accurately describe the true performance of DuPont. And all of those services people look at for ratios -- our own Snapshot page, Multex, Yahoo!, and so on -- generate their ratios based upon these numbers. So, given DuPont's market capitalization of $43.8 billion, the P/E including the company's gain on the sale after taxes comes out to be just shy of 11. Remove this one-time gain, DuPont's actual P/E is well above 90.

Ouch.

Now, keep in mind, 2001 was a rough year for DuPont, so that 90 would probably be as deceptive as the 11. Here's what is strange about the whole thing. The last time DuPont had a sale of a big asset, it was its sale and then complete divestiture of Conoco (NYSE: COC) in 1999. In its financial statements for that year, which are listed right along its 10-K for comparison's sake, DuPont listed it in an account that was more appropriate: "DISCONTINUED OPERATIONS." If selling DuPont Pharmaceuticals wasn't "discontinuing" it, then what was it?

Of course, DuPont's end results for 1999 were skewed due to the sale just as 2001's are, so once again, its earnings were artificially inflated. But at least its net profit from operations number and its net margins were indicative. In this case, they are completely skewed.

What to do? Owners of Berkshire Hathaway (NYSE: BRK.A) can attest that this is a knife that cuts both ways. Quite often people ask me why it is that Berkshire Hathaway is considered by some to be the ultimate "value stock" when its P/E is so high. Currently Berkshire's P/E sits at 136, meaning that someone buying the stock today would be paying $136 for every $1 of current earnings. For a company that operates in reinsurance, paint, ice cream, carpets, and so forth, that is clearly absurd. Or is it? Berkshire, as a holding company, generates an enormous amount of wealth from its assets, stocks, etc. For this reason, Warren Buffett focuses on growth in Berkshire's book value as the test of performance. Ask him about Berkshire's P/E, and all I can say is that he's too much of a gentleman to laugh in your face.

Investors must be careful about extrapolating too much information from a basic ratio without knowing what goes into the assumptions being made. In DuPont's case, they're increasing net profits in no small part by calling a one-time sale an "operating event." That's bogus, and a quick glance at the balance sheet and the cash flow statement gives a much more accurate picture of DuPont's performance in 2001. The company increased its book value by $1.2 billion, or 8.7%, in no small part by significantly reducing long-term debt. On the cash flow statement, DuPont generated free cash flow (cash from continued operations -- purchases of property, plant, and equipment) by $900 million. These are not bad results, mind you. But for the investor who does not pay attention, the company's appearance is much, much different from reality.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann's favorite DuPont product is Lycra. At time of publishing, Bill had beneficial interest in Berkshire Hathaway. Please refer to his profile for a complete list of holdings. The Motley Fool is investors writing for investors.