Hello, everyone. It's nice to be back after taking off a couple weeks. Things went a bit differently than I thought when I wrote my last column. I was fortunate enough to be able to take our three-year-old son Trick-or-Treating, and we were blessed to welcome our second son, Daniel, into the world at 11:05 Halloween night. The break from all things financial I mentioned in that article ended up being longer than expected. It really was great to spend some time with my family, and having a long-term approach to investing kept me from fretting over the performance of my portfolio during these topsy-turvy times.
Last night, Rich wrote a column to discuss Coca-Cola (NYSE: KO), net income, and cash flow from operations. Tonight, I'd like to continue the discussion on why we're more interested in a company's cash earnings or operating cash flow than its net income under Generally Accepted Accounting Principles (GAAP).
There's an article in this month's CFO Magazine that discusses the divergence of earnings and cash flow, what it can mean, and why cash flow is so important, particularly when the market has been performing as erratically as it has lately.
The article also includes a table listing the 100 companies in the S&P 500 that have seen the largest gap in growth between net income and cash flow from operations between 1997 and 2000. If you take a look at the table, you'll find that Rule Maker Microsoft (Nasdaq: MSFT) is #51 on the list, and former holding Gap (NYSE: GPS) holds the #71 spot.
One of the points the author makes is that executives will cook up better GAAP earnings in their belief that "many investors care more about earnings estimates than about whether or not those extra pennies of earnings have anything to do with a company's operations." This is something that I believe is likely the case at Pfizer (NYSE: PFE), as discussed in this article.
In an article I wrote last year, I mentioned ways in which companies can manage earnings. It's an important topic, since investors must be able to get a clear look at a company's financial picture, and this often means digging below the surface of the financial statements.
One of the easiest ways for companies to make net income look better than cash flow is to use restructuring charges or other non-recurring items to make operating income look better than it really is. According to the CFO Magazine article, DuPont (NYSE: DD) is one of the worst offenders. It's important to note that, while this practice is allowed by GAAP, it can distort the income statement.
How does this happen? Let's take a look at Pfizer, a Rule Maker that has recently taken a restructuring charge.
To see what's happening, we can take a look at one of the tables in Footnote 9 of Pfizer's restated financials for 1999. Here we see that, in 1998, Pfizer had a restructuring charge of $270 million, an amount that was excluded from its operating income. The restructuring charge was included in Pfizer's balance sheet in the form of a reserve. A reserve is merely an estimate of an expense that the company expects to incur. We also see that, in 1998, it actually incurred $151 million of these charges. An additional $84 million was incurred in 1999. That leaves a balance of $35 million (approximately 12% of the original accrual) that still hasn't been realized. You'll also note that this footnote says that the restructuring was substantially completed in 1999.
We don't know yet whether the remainder of this charge will actually be incurred. If it's not, then the amount could be released back into income to help Pfizer overcome a future earnings shortfall. It will be interesting to look at the footnotes in Pfizer's 2000 annual report for an update. If the additional restructuring charges haven't been incurred and are released back into income, based on the number of shares outstanding Pfizer's earnings could be higher by about a little more than half a penny. That might sound insignificant, but to a company that's trying to meet or exceed the earnings expectations of the Wise, it could be meaningful.
Alternatively, the remaining reserve could be used to offset an expense that Pfizer incurs in the future. Once again, the net impact would be that net income would be increased by the amount of the unused reserve.
At this point, it's not certain Pfizer won't actually incur the remaining amount accrued for its 1998 restructuring. All I'm trying to point out here is what can happen and how you can become aware of it. Remember, Pfizer excluded this charge from its 1998 operating income. Investors should ask themselves whether they agree with this treatment in the first place.
The other important issue to keep in mind is that, if you simply track cash flow from operations (CFO), you'll see that the restructuring charge only impacts CFO as cash is actually expended. Some of the items to which this charge is related aren't even part of CFO (e.g., the write-off or write-down of intangible assets; and property, plant, and equipment). These items appear in the investing section of the cash flow statement, not the operations section.
If you believe, as I do, that what really drives the value of a business is its ability to generate cash, then you should keep a watchful eye on CFO and look at reported net income with skepticism because the accruals that are allowed under GAAP can often allow companies to report figures that can mislead investors.
Phil Weiss, TMF Grape on the Discussion Boards, and "daddy" at home.