Analysis: When the Bottom Line Isn’t a Top Priority

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Analysis: When the Bottom Line Isn’t a Top Priority

By MARK LACTER

Staff Reporter

The first thing they used to teach you about public companies was to always look for the bottom line. All companies eventually must make money for their shareholders, and if they don’t, there had better be a good reason.

Only then, according to this old fogey-ish investment view, should attention focus on revenue. In lieu of net income, revenue sometimes indicates a company’s direction, but it’s often foolhardy to judge performance based on this number, even when the number is steadily growing. A business might see its revenue jump by virtue of buying up a bunch of other companies, but paying for those acquisitions could eat into profitability.

So here we have the case of Global Crossing a company that has yet to make an annual profit since going public four years ago. Revenue, meanwhile, has been skyrocketing, to $3.8 billion in 2000 from $424.1 million in 1998. For an upstart telecom that required huge start-up costs, is that so terrible?

Company out of whack

Global Crossing insists that it’s not. And yes, there are explanations for the lack of profitability starting with huge capital costs required to lay fiber-optic pipe and the debt service to pay off the lenders and the insistence by Wall Street that they tell a good story, even if it meant finagling the numbers.

But when all those elements get so out of whack that they mask a company’s chronic ills and this clearly happened with Global Crossing you wind up with a mess. Or in this case, a Chapter 11 bankruptcy filing and lots of creditors and investors who never will be repaid.

Consider, just as an example, the company’s financial results for the third quarter of 2000. Here the focus was not on net income but “cash revenue from continuing operations.” It was an impressive number: $1.4 billion, compared with $1.2 billion for the like quarter the year before.

The company also reported something called pro-forma recurring adjusted earnings before interest, taxes, depreciation and amortization. The number reported was $379 million, compared with $198 million the year earlier. Somewhere amid all that jargon is the word “earnings” but don’t confuse that for net income.

“Pro forma” statements allow companies to neutralize the effect of acquisitions and other financial events on an income statement. EBITDA, sometimes called operating income, leaves out unusual nonrecurring items, which companies can pretty much define as they wish.

Thus, “pro forma EBITDA” is a number not based on normal financial measures, but on measures that made Global Crossing look good at least as good as possible, considering that the company never made any real money. Look further into the earnings report that quarter to find the really bad news: a net loss of $572 million.

What’s instructive was the reaction to those results. Thomas Casey, at the time Global Crossing’s chief executive, announced that “We are very pleased to have once again exceeded our financial targets and we continue to see strong demand.” Casey later told analysts during a conference call that growing Internet demand will enable the company to meet its growth targets. “The market is so big we think our growth rate is very achievable,” he said. (Casey has since left the company and is not talking.)

One other thing: Global Crossing made sure to note that its third quarter “exceeded the consensus estimates of analysts who follow the company.” And sure enough, Global Crossing shares were sharply higher on the morning of the conference call as several analysts urged investors to buy the stock. “We continue to expect strong upside given the positive momentum developing,” gushed Goldman Sachs analyst Frank Governali.

Aggressive accounting

But how do they keep coming up with good numbers? Remember that by late 2000 the stock had tumbled into the teens, from its 1999 high of $64, and that demand for fiber-optic transmission was starting to tap out.

It was about this time that Global Crossing began to make more aggressive swapping deals with other telecoms. Capacity was sold to other carriers and the incoming cash was booked as revenue. But when capacity was then bought from carriers, the transaction was considered an asset purchase and therefore not part of the operating results. Thus, the company got the benefit of booking additional revenues without the drag of an operating expense.

But no amount of financial distortion could hide the fact that Global was losing big money: around $600 million in each of the first three quarters of 2001. By then, Wall Street was less willing to buy into the accounting gamesmanship.

So what now? For all the attention given to investigations by the Securities and Exchange Commission and the FBI, it’s far from certain whether any action will be taken against the executives and directors. There is, after all, nothing inherently illegal about how a company books its telecom swaps (though regulators are certain to restrict its future use). Nor is it illegal at least in the strictest sense to offer executives lavish compensation or to give insiders the chance to make millions of dollars on the company stock. These public outrages, only getting attention because of the Enron-esque similiarities, undercut what the Global Crossing saga is all about.

That is, Wall Street or specifically, Wall Street’s insistence on measuring short-term performance. There’s no telling how the company would have counted its telecom revenues were there less pressure to post a positive quarter. But as with other fledgling companies, the focus on meeting or beating analyst expectations must have been so intense that it’s easy to imagine how the rules got stretched to the breaking point all for the sake of a higher stock price.

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