Two interpretations of S&P 500 (SPY) corporate earnings for the fourth quarter of 2012 tell two very different stories. Considering how wide the divide between these numbers has become, I think investors should understand how both are being calculated in order to determine for themselves what realistic valuations are today. Operating earnings, as reported by S&P Dow Jones Indices, have continued to decline week after week to what is now just $23.28. Other earnings aggregators, including S&P Capital IQ and Thompson Reuters, calculate operating earnings to be $26.13. This provides both bulls and bears with ammunition to argue their respective outlooks, as $23.28 represents the second consecutive quarterly and year-over-year decline in profits, while $26.13 results in record earnings. In sympathy with the recent multi-year highs for the S&P 500 index, it is no surprise that the stronger number has garnered all of the media attention. It has been a focal point for the majority of sell-side Wall Street firms whose life's blood is to see higher equity values, but this in no way devalues the significance of the lower and foreboding figure.
What is allowing for this widening disparity in conclusive earnings numbers is that there is no legal definition for the operating earnings used to determine the "E" in P/E ratios. GAAP (Generally Accepted Accounting Principal) earnings leave no room for interpretation, because the standards contained in GAAP are uniformly defined for all companies by the Financial Accounting Standards Board (FASB). Operating earnings exclude "unusual" items from GAAP, but what is considered "unusual" varies from one company to another. It also varies from one analyst to another, and the aggregators are all collecting data from different analysts. Normally, this variance in operating earnings is negligible, but today it is substantial. The culprit in this case is pension expense, and whether it is being considered an "unusual" expense or a normal and recurring cost directly associated with operating the business. I would argue the latter.
Most companies have assumed an annualized rate of return on pension assets to smooth out performance, which reduces the volatility of the impact on earnings and cash on the balance sheet. This approach was acceptable when asset prices consistently rose during the 1980s and 1990s, but during the lost decade for equities, and as yields on fixed-income plunged, enormous unfunded liabilities grew to what is today estimated to be $347 billion. Companies are being forced to fund the shortfalls that have resulted from not achieving expected rates of returns, which has resulted in large one-time charges to operating income for companies like Verizon (VZ), United Parcel Services (UPS) and General Motors (GM), to name a few. Future liabilities have also risen as a result of the plunge in long-term interest rates due to the Federal Reserve's efforts to compress yields with monetary policy. A pension fund's discount rate is the hypothetical rate the plan can earn on a high-grade bond today in order to pay its future liabilities. As long-term interest rates on investment-grade bonds have plunged, the amount of income potential has declined, and liabilities have soared.
Had companies been accounting for this expense on an annual basis, it would have been difficult to make the case that it was an "unusual" charge to operating income, but delaying what is clearly an ongoing and recurring employee expense has allowed many companies to appear more profitable than they really were for many years. Some companies are deceptively restating earnings for previous years to account for what would have been losses, so that there is no impact on operating earnings moving forward. There are now a handful of companies, like Boeing (BA), that are considering accounting for pension gains and losses as they occur on an annual basis.
I believe the more accurate interpretation of what a company is earning reflects all of its employee expenses, including pension expenses, as accounted for in the operating earnings provided by S&P Dow Jones Indices. Additionally, the International Accounting Standards Board (IASB) has already adopted changes that account for pension expense, effective as of Q1 2013, which will require companies to mark-to-market the gain or loss in pension assets, consequently accounting for those gains or losses in operating earnings each year. The Financial Accounting Standards Board (FASB) last addressed pension accounting in 2006 when it required companies to report the funded status of their pension obligations on the balance sheet. FASB is now refocusing on pension accounting, and I think the logical next step would be to align with international standards, meaning that all companies would move to mark-to-market accounting. Expenses would impact operating earnings based on how assets in the plan performed and how the discount rate was impacted by changes in long-term interest rates.
There will be more clarity on the exact impact pension expense has had on Q4 earnings from S&P Dow Jones Indices when all of the quarterly filings are completed. What is certain is that these expenses will continue to grow and impact operating income moving forward. Verizon , AT&T (T) and Honeywell (HON), for example, have already adopted mark-to-market accounting. I think what investors need to consider is that should the consensus on Wall Street begin to incorporate pension expense as a normal and recurring operating expense, as S&P Dow Jones Indices is doing today, the valuation of the S&P 500 could rise markedly in a short period of time. It would likely occur with a change in sentiment, which we all know can turn on a dime.
As an example, if you assume the $23.28 estimate to be accurate, then earnings are an annualized $93.12 and declining rapidly over the past six months. This lends credence to the expectation that earnings will decline year-over-year in 2013, undermining one of the key tenets to a bullish outlook. If you assume the $26.13 estimate to be accurate, then you have record earnings, annualized at $104.52, with a high probability that the $111 estimate for 2013 is within reach. The bottom line is that it is the consensus view of what earnings are today that determines valuation. There is a minority view circulating that states earnings are significantly lower than what the consensus purports them to be, and the grounds for that view are not trivial. I am in the minority. Regardless of your position, I think it is worthwhile to be knowledgeable about how both numbers are determined.
So as not to be labeled a bear by readers after just a handful of articles in the past month, I will leave the bulls with some food for thought. The impact on discount rates from declining bond yields is a double-edged sword, and here lies the potential investment opportunity for investors willing to dig into the details of quarterly filings. Companies that have eliminated pension liabilities by one means or another, and lowered their discount rates to what is prevailing today, could potentially realize a significant increase in earnings as long-term interest rates rise. This is because as long-term interest rates rise in the years ahead, the discount rate would also rise from a very low level, thereby reducing their future pension liabilities. If FASB decides to follow the lead of the IASB and dictate that mark-to-market accounting for pension plans assets is the standard moving forward, then the perception that pension fund gains are accretive to operating earnings could be a catalyst for share prices.
Additional disclosure: Disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Clients of Fuller Asset Management may hold positions in the securities mentioned in this article. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.