Bracing for an earnings hit
Expense options and disallow pension income and guess what earnings are? A lot lower.
July 17, 2002: 11:02 AM EDT
By Justin Lahart, CNN/Money Staff Writer

NEW YORK (CNN/Money) - The earnings investors base their valuations on could be wildly overstated.

As stocks have crumbled, a growing cadre of market watchers have begun to argue that shares have gotten downright cheap. "Look out above," was the title of the note Lehman Brothers strategist Jeff Applegate sent out in a recent note. Morgan Stanley global strategist Barton Biggs, once an extreme bear on U.S. stocks, has lately been telling investors to buy.

But while the benchmark S&P 500 might look cheap on, say, a price-to-earnings basis, the earnings part of that equation is dicey. Company results aren't nearly what they seem.

"The quality of reported earnings went down pretty badly during the bull market," said Jeff Matthews, who runs Conn.-based hedge fund Ram Partners.

It's not just all the high-profile scandals. The way companies account for options will pad results by 10 percent this year according to one recent report while another suggests that the way companies run pension funds will inflate earnings by another 4.5 percent.

Bad option

The way companies account for employee stock options is a growing bone of contention both on Wall Street and in Washington. The salaries companies pay employees are of course accounted for as expenses and detract from earnings. But employee stock options -- another form of compensation -- don't.

According to a recent study, Merrill Lynch found that if options were treated as an expense, total earnings for S&P 500 companies would have been 21 percent lower in 2001 than what was reported. Earnings in 2000 would be 8 percent lower. Earnings this year would be 10 percent lower.

Top tech offenders
Company2002 EPS*EPS with options expensed
Agilent Technologies-$0.67-$1.77
Apple Computer$0.44-$0.71
Comverse Technology$0.86-$0.14
Conexant Systems-$1.27-$2.73
Mercury Interactive$0.67-$0.71
Rational Software$0.29-$0.84
* Consensus expectations
Source:Merrill Lynch

Whether lawmakers ultimately decide that options grants should be treated as expenses is an open question. Some, like Senators John McCain and Carl Levin, think it should happen but lobbying from companies opposing the move has been intense, and so far they have carried the day. Small wonder companies are putting up a fight: Change the way options are accounted for and things start to look a whole lot different.

Notable non-techs
Company2002 EPS*EPS with options expensed
American Power$0.62$0.37
AOL Time Warner$0.91$0.59
Barrick Gold$0.47-$0.23
Charles Schwab$0.35$0.23
The Gap$0.16$0.07
Merrill Lynch$2.89$1.94
TMP Worldwide$0.86$0.25
* Consensus expectations
Source:Merrill Lynch

All of a sudden, stocks look a whole lot more expensive. The S&P trades at 18.2 times this year's expected earnings the way they're currently calculated, but start calling options expenses and its 2002 P/E is 20.2. Yipes.

Nowhere would the hit be harder than in the technology arena, where companies regularly use stock options to lure talent. According to the Merrill study, if options are treated as expenses S&P 500 tech earnings would have been 39 percent lower in 2001 than reported and would drop a whopping 71 percent in 2002.

The hardest hit on an absolute basis? Yahoo!, which would have lost $1.73 a share in 2001 against the 16 cent loss the company reported. Expense options this year and Yahoo! is expected to lose $1.47 versus an expectation of a 10 cent per share profit.

But all the tech faves would get hit. Cisco earnings would come in 67 percent lower this year if it expensed options, Merrill estimates. Intel's earnings would drop by 25 percent, and Microsoft's by 22 percent. JDS Uniphase would swing from a loss of 11 cents a share to a loss of 51 cents. Sun Microsystems would drop from a loss of 8 cents to a loss of 23 cents.

Pension tension

The bull market did wonders for pension plans and companies act like the good times are going to keep on rolling. Many continue to assume that their pension plans will earn as much as 10 percent a year, even though stocks have been woeful lately and bond yields are low.

"If they can make that much," joked Harvard Business School's David Hawkins, "they can have my money."

So what's the problem here? Company pension plans manage money laid aside for their employees' retirement, but sometimes that money earns more in the marketplace than the company needs to pay out to its former workers. The difference gets treated as income, boosting overall results.

There's more: In any given year, companies don't need to generate that outsized pension return to book the extra income. An accounting quirk lets them declare gains based on assumed rates of return even if actual return fall short. Many companies have been reporting pension income that they didn't actually have on the hope, it seems, that the market would catch up.

Heck, maybe it will -- but some investors fail to see what the pension income at, say, General Motors, has to do with building cars.

Pull that illusory pension income out of earnings and company profits take another whack. According to Morgan Stanley accounting guru Trevor Harris, pension income accounted for 7.2 percent of S&P 500 earnings in 2001. For this year he thinks it will come out to 4.5 percent of earnings. If you're keeping score at home, now our 2002 P/E is up to 21.4.  Top of page

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