For the first six months of this year, glass emporium Corning (NYSE:GLW) has been rolling in profits. As a result, its stock is currently tracking Space Shuttle Discovery's trajectory (currently located about $18 north of Greenland). But as a follow-on result, its profits have taken a serious hit.
Say it with me, all together, now: "Huh?"
I'll explain. On the one hand, Corning is doing great business. Its sales in H1 2005 exceeded its sales in the year-ago period by 21%; its profits, by more than 150%. And as a general rule, when a company makes a lot of money, investors bid up its shares. Logical, right? But this also creates a certain chicken-and-egg dilemma for Corning's accountants.
You see, once upon a time, Corning had some asbestos problems. Specifically, a lot of plaintiffs brought a lot of claims against Corning and its subsidiary, Pittsburgh Corning Corporation (co-owned at the time by PPG Industries (NYSE:PPG)), alleging that the subsidiary's asbestos pipe insulation had made them ill. To resolve the litigation, in March 2003, Corning agreed to settle the legal claims against it by contributing, in addition to other cash and property, 25 million shares of Corning stock to a fund to compensate injured plaintiffs. Of course, those 25 million shares were worth something, and Corning took a charge against its earnings equal to what the stock was worth. Then.
By now you're probably starting to get the picture. As Corning's stock has risen in value, all of Corning's stock has risen in value. Including the stock contributed to the asbestos claims settlement fund. Consequently, the value of the losses Corning has to record against its earnings is increasing in lockstep with the rise in the company's stock price. Pretty much every quarter, the company's earnings report includes a section titled "Special Items," in which an adjustment to earnings is made to reflect the meanderings of Corning's stock price over time.
Because of the stock's 40% rise over just the past three months, this quarter's adjustment was sizable. At $0.09 per share, the recorded charge equaled nearly half of what Corning would have earned per share prior to the charge being assessed.
So with Corning's generally accepted accounting principles earnings subject to this Catch-22, how can an investor get a clear read on the company's true cash profitability? By skipping the statement of operations and proceeding straight to Corning's cash flow statement. There you'll see that regardless of the theoretical effect of a skyrocketing stock price on Corning's accounting earnings this quarter, the company still generated a healthy $168 million in free cash flow.
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Fool contributor Rich Smith does not own shares in any company mentioned in this article.
