After the fall of Enron, we had little doubt it would be an isolated incident or "company specific." The great bull market changed the rules of the games for companies played by. We have discussed before how the most aggressive companies were able to raise the most money and the most aggressive mangers were the ones that were promoted. Aggressive management combined with accommodative credit markets led to one of, if not the biggest, investment bubbles of all time. Influenced by Wall Street's desire for investment banking fees, companies raised capital for projects that were not economically viable. Accounting conventions were stretched, re-written, and ignored, to make the results more investor friendly. As long as stock prices kept rising, there were no worries. Now we are seeing the consequences of it all. What a fiasco!
With Arthur Andersen unraveling due to the fraud at Enron, auditors will now pay more attention to their role and be more diligent in conducing audits. Investors have started voting with their feet as well. Any hint at accounting improprieties causes stocks to fall precipitately. Increased scrutiny from auditors and investors should clean up corporate boardrooms, but it will take a while and it will not be a pleasant experience. A couple roaches have been found after the lights were turned on, but we have not started pulling off the baseboards. The public is beginning to ask what should happen to these "white-collar" criminals. Unfortunately, the answer is does not include jail time, or if it does, they will have a better golf handicap after they leave. I have been pondering… San Francisco's economy is hurting after the dot-com bubble. I think we have an opportunity to solve two problems. We can help spur San Francisco's tourism industry by sending all the corporate con-men to Alcatraz, while leaving it open to the public. After strolling by Al Capone's cell visitors could rattle the cage of their favorite corporate scoundrel. To help raise revenue visitors could rent paintball guns and take target practice while the cronies run around during recreation time. Just a little light humor to ease the mood during these chaotic times.
While hopefully fraudulent activity is the exception, a lot of gray areas have been trampled on. One of the most popular ruses was convincing investors that companies should be valued based on EBITDA (earnings before interest, taxes, depreciation and amortization). The reasoning for using EBITDA is that after it finished capitalizing its investments and servicing its debt, earnings would be similar to EBITDA. Also, investors have been led to believe that EBITDA is basically the same as cash flow. That is the theory. But, in theory Myron Scholes would still be earning excess returns at Long Term Capital Management.
The problem with using EBITDA as the primary valuation yardstick is it assumes that at some point the I, D and A will get significantly smaller. The logic is that the company had to undertake a massive capital project before it will have a viable business. Worldcom provides a good example. Worldcom needed to build-out a network for voice and data transmission. This was a massive capital expenditure that supposedly would not have to be repeated. Once the network was in place and paid for, Worldcom would be profitable and not have to raise additional capital. So at some point the interest would be reduced as the debt was repaid, and deprecation would decline after the network was fully depreciated. This would result in much higher earnings down the road. This was the fallacy of the entire telecom industry.
The other major category that focuses investors an EBITDA is the aggressively growing companies spending money on acquisitions or capital equipment. The hope is that initial heavy borrowing requirements will be dramatically reduced when companies' growth slows. Then the debt will be paid down and the capital expenditures will cut back and the company will become a "cash cow."
There are several problems with how this works in reality. First and foremost today, is the assumption of constant access to capital markets to raise funds needed to maintain growth. Also, analysts almost always underestimate the amount of capital expenditures required for requisite maintenance. The upshot is that companies will have to constantly spend money to keeps their networks up-to-date or risk losing customers to the competition. Lastly, a statement of cash flows does exist in the SEC filings. This has a line detailing the cash flow from operations, and with a little math, one can determine the free cash flow as well. Just because a company does not include the statement of cash flows with its pro-forma earnings release does not mean it is not worth careful examination.
The telecom bubble was based on investors embracing EBITDA valuations. Unfortunately, basing capital decisions on EBITDA, ignores interest payments. This causes the cost of capital to be neglected, which results in capital structures that have little chance for long-term survival. When entire industries are based on this model it cannot help be cause massive overinvestment.
As the second quarter comes to a close, investors will keenly focus on earnings while companies will begin providing guidance for the second half of the year. FirstCall's latest commentary indicates that S&P 500 companies will post earnings gains in the second quarter, albeit only 0.2% after adjusting for FASB 142. (The introduction of FASB 142 mandates that companies stop amortizing goodwill. This is the reason companies have been taking huge goodwill write-downs lately. Since amortization will not be expensed, earnings will be higher for companies that previously expensed significant amounts of goodwill.) Earnings growth was estimated at 2.4% at the beginning of the quarter, with pre-announcements having slowed from the pace of the past several quarters. In fact, this is also the most positive quarter for pre-announcements in a long time. Only 365 companies announced earnings would be below analysts' expectations, with 312 announcing that results would be better than analysts' expectations. Last year, 571 companies warned on the downside, with only 150 announcing earnings would be improved.
While this may sound bullish, analysts had reduced earnings estimates dramatically after September 11. Prior to September 11, analysts expected S&P 500 earnings in the second quarter to grow by almost 20%. Additionally, everyone had expected that technology would be the leading driver of earnings going forward. But sentiment is shifting after a flurry of high-profile disappointments. Last night, Micron reported a six cent loss, which was a dime worse than analysts expected. Micron said its average selling price of DRAM's pricing fell 50% from a peak in March. Additionally, total megabits sold fell 17% sequentially due to a softening in computer industry demand. Micron also noted that there is no strong evidence of a pick up in corporate IT spending. These results caused analysts to lower their estimates for Micron's fourth quarter and next year. Needham slashed revenue estimates for the year ending August 2003 to $4.9 billion from $6.2 billion. Even with these lowered estimates, Needham remains on the high side. FY 2003 revenue estimates for Micron range from $3.3 billion to $5 billion.
All we can say is that accounting fraud and dismal earnings are a very bad combination for the markets.