Playing the Numbers Game: How Many Can You Trust?

By ANTHONY PALAZZO

Staff Reporter

Numbers don’t lie, usually.

When numbers are presented fairly, they can be a crucial ally to investors seeking insights and truths about a company’s prospects.

But numbers are open to interpretation, and in the world of corporate accounting, innumerable judgment calls factor into their compilation.

Too often in recent years, the numbers have been used to paint a picture of a company that looks more profitable than it really is, benefiting inside executives bent on cashing in stock options, at the expense of investors.

No doubt some of them were na & #271;ve, some were greedy, even crooked. But no matter, too many outside investors reached mistaken conclusions about companies based on information later found to be faulty.

So take this year’s list of L.A.’s best-performing companies, ranked by three-year return on equity, with a bagful of salt. It’s sure to contain some nuggets companies whose managers have worked hard to deliver concrete results to their shareholders. But there is likely more than one company at which things aren’t exactly what they seem.

“Are most of the bad apples out in the open now? I don’t think anyone can tell you whether they are or they aren’t,” said Lynn Turner, a Colorado State University accounting professor and former chief accountant at the Securities and Exchange Commission.

The Business Journal list of most profitable public companies published in April 2001 shows that several of top names turned out to be the area’s best-performing stocks. There aren’t many investors who outdid the return of KB Home over the past 14 months, for example.

KB Home made last year’s list of best return-on-equity performers in the previous one- and three-year periods. It’s up 68 percent since last year’s list.

On the other hand, this is the world of corporate accounting, where the message is often concocted first, and the numbers shaped afterward to support them.

In past years, some real duds have made it onto the list repeatedly. Gemstar-TV Guide International (see accompanying story), a perennial on the ROE list, has lost 81 percent of its value since last April.

Another company that’s remained high on this year’s list is Optical Communications Products, based in Chatsworth. Its stock is down 88 percent, despite one-year and three-year return-on-equity of 13.6 percent and 43.6 percent, respectively. Its stock trades below $2. Revenues for the quarter ended March 31 fell 79.9 percent from the year-ago period.

Better picture

The Business Journal chose return on equity a measure of the region’s best-performing companies because it gets to the main indicator of a company’s performance profitability while also taking into account its efficiency and capital structure.

Generally, ROE is defined as operating earnings divided by shareholder equity total assets minus total liabilities and then expressed as a percentage. It’s a good way to measure a company’s strengths, but like any other number, it won’t give a complete picture on its own. And as many investors found out, the ingredients that make up ROE can be manipulated like any others.

The numerator of the ROE equation is earnings. Earnings performance always generates a lot of attention, and recently the reliability of reported numbers has been called into question. But the factors that make up the denominator, assets and liabilities, can also skew ROE figures.

Now is a particularly dicey time to be relying on ROE figures, said Chuck Hill, director of research at Thomson First Call, because of recent changes in accounting rules that required many companies to write down the value of impaired “goodwill,” or assets related to acquisitions, on the balance sheet.

“It’s reflecting something that truly should be written down, but maybe not all at once,” Hill said. “But you don’t have any way to allocate how it was deteriorating over time.”

Effect of writedowns

Additionally, in a recession cycle like today’s, companies take a lot more traditional asset writedowns, Hill said.

While such writedowns aren’t good for shareholders, they have the effect of boosting future ROE calculations by lowering the denominator in the equation. At the same time, past ROE calculations may have been based on assets that were valued too high. “It’s one of those things where you need to read the footnotes,” Hill said.

Further, the deadline for implementing the new accounting rules was the first quarter of 2002. Some companies took writedowns early, so they’re included in 2001 financial statements. Some didn’t.

Even a company’s reported debt figures the other part of the ROE equation’s denominator can be skewed with undisclosed off-balance-sheet obligations. Recent tailspins at Enron Corp. and Adelphia Communications illustrate this point.

Regardless of those concerns, the biggest questions recently have swirled around the reliability of companies’ reported earnings.

Restatements are up dramatically a recent study by Huron Consulting Group in Chicago found that they rose 25 percent in the past two years.

“It probably points to the fact that there are more than one or two bad apples, it’s more of a systemic thing,” Turner said. Turner doesn’t believe investors will return to the markets until they can be assured that the most egregious problems have been cleaned up. That won’t happen, he believes, unless Congress passes accounting reform measures proposed by Sen. Paul Sarbanes, D-Md.

“It will eliminate a lot of the auditors’ conflict with their clients. It will result in much stronger oversight of the audits (by an independent audit committee), and it does a lot to shore up the independence of analysts,” Turner said.

Others are attempting their own solutions.

Standard & Poor’s recently said it would revise the method it uses to calculate “core” earnings for companies listed in the S & P; 500 Index. Among the major changes: stock option grants, restructuring charges, writedowns of depreciable assets and pension costs are included as operating expenses, while pension gains and goodwill impairment charges are excluded.

S & P; hasn’t determined the impact of these changes, but Ken Shea, managing director of S & P;’s global equity research, said he expects newly calculated core earnings for the S & P; 500 to come in slightly below member companies’ as-reported net income in 2001.

The as-reported numbers, which conform to generally accepted accounting principles, were already 36 percent below the companies’ operating earnings the numbers most investors use to gauge profitability.

Just the impact of one of these changes, the inclusion of stock options as an expense, increased Cisco Systems Inc.’s reported 2001 loss by 164 percent, on a per-share basis, Shea said. Microsoft Corp.’s net would have slipped by 29 percent, and International Business Machines Corp.’s, by 16 percent.

At Amgen Inc., L.A.’s most valuable company, core earnings using S & P;’s new method were 17 percent lower than operating earnings during 2001, largely due to the inclusion of stock-option grants.

Northrop Grumman Corp.’s core earnings were 89 percent lower using S & P;’s new measurement, largely due to the exclusion of pension income. (Northrop does separate pension income from operating income on its earnings reports.)

At Walt Disney Co., the impact of including stock options was offset by the elimination of $820 million in goodwill impairment, resulting in an S & P-derived; core operating income figure of $471.7 million for the year ended September 2001, compared with income of $237 million using previous methods.

Shea said S & P; decided to make the changes as a result of increasing calls for better corporate disclosure from many fronts, including from its own analysts.

“Accounting is not a precise science, there’s a lot of judgment calls here,” Shea said. “There are no black and white answers to a lot of these things, but there’s been a tendency for companies to push the limits to a point where investors are being done a disservice in not getting an accurate picture of what’s going on.”

The fall-out probably isn’t over. Regulators, lawmakers, investors and academics have all turned up their scrutiny of corporate accounting. And the loss of Arthur Andersen is having an unforeseen impact, said Tom Schulte, managing partner at the accounting firm RBZ LLP in West Los Angeles.

“New auditors are coming in and they’re taking a look at positions taken by Arthur Andersen, and they’re saying, ‘We don’t have to stick our necks out like that,'” Schulte said. Right now, the potential reversal of those accounting policies is being debated in boardrooms across the country, he said.

Case Study: Gemstar

Gemstar International-TV Guide International was once a star of L.A.’s annual return-on-equity rankings. Now it’s an also-ran, with a discredited management and a slew of uncertainties hanging over its head.

Chief among these: a looming writedown of existing assets in the neighborhood of $5 billion, alleged barter transactions, and revelations that substantial chunks of reported revenues came through transactions with related companies or by assuming that the company would be able to obtain disputed licensing fees in court.

Gemstar hasn’t revised any of its reported numbers, yet.

At the center of the controversy is Chief Executive Henry Yuen, the one-time inventor who built Gemstar through technology but who now is facing increasing scrutiny from his biggest shareholder, News Corp.

After a number of embarrassing financial disclosures, Rupert Murdoch sent an aide, Jeff Shell, to act as Gemstar’s co-president and chief operating officer. Meanwhile, many on Wall Street are calling for the ouster of Gemstar’s longtime chief financial officer, Elsie Leung.

While the company defends its accounting techniques, shareholder lawsuits accuse executives of misrepresenting the results.

In a lawsuit filed in April, Stull Stull & Brody alleges that Gemstar failed to disclose $20.8 million in barter revenue in an exchange of intellectual property with a company called Fantasy Sports during fiscal 2001. The figure made up more than 20 percent of the $101 million in sales reported by Gemstar’s interactive group, the law firm said.

Another $58.9 million in licensing revenues reported in 2001 was related to accruals that Gemstar made based on set-top boxes shipped by Scientific-Atlanta Inc. Gemstar will only receive the money if it wins a federal court ruling in a civil lawsuit in Georgia.

A judge at the U.S. International Trade Commission was expected to rule late last week on a similar lawsuit that likely will have an impact on the Georgia proceedings.

Gemstar officials didn’t return a call seeking comment. The company said in a Securities and Exchange Commission filing that the allegations from 15 shareholder lawsuits are without merit and said it will defend the cases vigorously.

Gemstar’s stock, which traded as high as $88.50 in January of 2000, traded last week in the $7-$8 range.

Even without any restatements, results have slipped dramatically.

Gemstar posted outstanding return on equity during 1998, 1999, and even 2000 when it grew operating profits off of a small asset base. Gemstar’s main product for the early part of that time was a system called VCR-Plus, which made it easy to program videocassette recorders to capture television programs.

As of last April, Gemstar’s return on common equity ranked it 22nd, 6th and 4th, respectively, among L.A. companies for the previous one, three, and five-year periods.

But Gemstar’s profile changed after it purchased its main competitor in the field of interactive programming guides, TV Guide Inc., in 2000. Now Gemstar is a magazine publisher as well as a technology company.

Revenues surged after the purchase, but so did debt, and losses.

In 2001, Gemstar reported a loss of $599.6 million, compared with a loss of $213.1 million a year earlier. Revenues were $1.4 billion vs. $731.1 million in 2000.

On the horizon is a writedown of assets that the company estimates at about $5 billion. Gemstar paid $14.9 billion for TV Guide in stock and debt.

Anthony Palazzo