What You Don't Know About a Company's Earnings Can Cost You

 |  Includes: F, IP
by: David Trainer

Investors should focus on the core, recurring operating profitability of the business when valuing stocks. Otherwise, they risk getting fooled by one-time, non-operating expenses or income that artificially and temporarily distorts reported earnings. Often, one-time items are easy to find because they are clearly labeled as such on income statements. However, many times they are not easy to find because they are hidden inside normal, operating line items like “Cost of sales”. The only way to find these hidden one-time items is to scour the Management Discussion & Analysis (MD&A) and the Financial Footnotes in 10-K filings. Most investors will be surprised to learn that we found over 13,000 one-time items buried in normal line items in the MD&A and Footnotes of 10-K filings from 1998 thru 2/15/2011. And don’t think for a second that these one-time items are not material. During the last reported fiscal year, companies concealed over $41 billion in one-time items.

Some companies have concealed more than others. For example, since 2005, Ford has buried at least $1.7 billion annually of one-time charges within operating line items on its income statement. In 2008 alone, the company buried over $8.5 billion of one-time charges in line items like “Cost of sales.” These charges cause Ford’s reported earnings to understate its normal operating profitability, and drive F’s stock to $2 - its lowest level since 1982. Figure 1 suggests that investors placed too much importance on the $8.5 billion in one-time charges that sank Ford’s earnings in 2008. In the following years, once investors realized the normal profitability of the business was much better than indicated by 2008 GAAP earnings, the stock soared back to over $15 per share. To see our case study on how to find and rectify hidden items for Ford, click here.

Figure 1: F - Hidden One-Time Charges vs Stock Price Over Time

Source: New Constructs, LLC. and company filings. Data as of 2/16/2011.

The problem is that official (GAAP) accounting rules allow companies to obfuscate their true operating earnings. For example, SFAS 144 states that companies that impair long-lived assets that are still used in the business must include the impairment charge above both the “income from continuing operations” line and the “income from operations” line on the income statement. This broad rule enables companies to hide long-lived asset impairments in operating earnings.

And companies do take advantage of SFAS 144 and other similar accounting loopholes. Figures 2 and 3 show lists of the companies with among the most hidden expenses and income in the last fiscal year (note: data in this article is updated as of 2/25/2011 and does not reflect new 10-K filings since then).

Figure 2: Samples of Big Hidden Expenses

Source: New Constructs, LLC. and company filings. Data as of 2/16/2011.

(Click charts to expand)

Figure 3: Samples of Big Hidden Income

Source: New Constructs, LLC. and company filings. Data as of 2/16/2011.

The key take-away is that investors should focus on the core, recurring operating profitability of the business when valuing stocks. Otherwise, they risk getting fooled by hidden expenses or gains that artificially decrease or increase reported earnings.

We understand this advice is not easy to follow. Hidden one-time items are hard to find because companies often only report them in the MD&A and the Financial Footnotes. One has to read carefully the MD&A and Financial Footnotes of every annual report in order to find one-time items and get an accurate picture of a company's profitability history. In our experience analyzing the MD&A and Financial Footnotes of over 50,000 filings, we found that companies use a multitude of different names for one-time items within operating line items. Below is a list of common names for one-time items concealed within operating line items.

  • Long-lived asset impairments
  • Non-recurring write-down of inventory
  • Gain on sale of assets
  • Loss on sale of assets

The point above and the case studies below and in our free report provide further evidence that there are no short­cuts to ana­lyz­ing the MD&A and Finan­cial Foot­notes of 10-K fil­ings if investors want to know the true prof­itabil­ity of a company. Per our arti­cle, “XBRL: Digital Nee­dles In the Dig­i­tal Haystack,” XBRL does not address many of the intricacies of how companies report information in MD&A and Financial Footnotes.

Below, we provide a case study of how we found and rectified hidden items for International Paper (NYSE:IP). Note that this analysis is based on data available as of 2/25/2011.

International Paper Company hid more than $2.1 billion of one-time income in an operating line item in 2009. IP’s 2009 ROIC artificially increases from 2.2% to 7.6% if this hidden one-time income is not properly accounted for. Without this information, investors may fall under a false impression that IP is more profitable than it truly is and could lead investors to over-weight IP in their portfolio. Click here for a free report on IP and see how we rectify this and other accounting distortions to deliver truer earnings analysis for our clients.

Impact of Hidden One-Time Income on IP’s Historical Performance

Figure 4 shows the impact of the hidden one-time income on IP’s return on invested capital (ROIC).

Figure 4: IP - Impact of Hidden One-Time Income on ROIC

Source: New Constructs, LLC. and company filings. Data as of 2/16/2011.

In 2009 IP’s reported earnings got an artificial boost of $2.1 billion of income generated through a non-recurring Alternative Fuel Mixture Credit (AFMC). This boos causes the 2009 unadjusted ROIC to rise versus the prior year when the actual ROIC is declining.

How to Find Hidden One-Time Income: Example - IP

Figure 5: Hidden $2.1 Billion AFMC Tax Credit

Source: IP 2009 10-K, Note 5, Page 66

Figure 5 shows where the $2.1 billion one-time income is disclosed in the Financial Footnotes of IP’s 2009 filing. Figure 6, also taken from the Financial Footnotes, states where the $2.1 billion one-time income is concealed on the income statement. Note that 8 pages separate Figures 5 and Figure 6 in the 10-K. This disclosure adds additional complexity and further obfuscates the true economic earnings of IP.

Figure 6: Location of the Hidden $2.1 Billion AFMC Tax Credit

Source: IP 2009 10-K, Note 1, Page 58

In addi­tion to our pre­vi­ously released Red Flag articles on hid­den debt from off-balance sheet oper­at­ing leases and man­age­ment fail­ures related to asset write-downs, be on the look­out for more Red Flag Reports focusing on the fol­low­ing account­ing distortions:

  • Over/Under – Funded Pensions
  • Reserves
  • Dis­con­tin­ued Operations
  • Excess Cash
  • Uncon­sol­i­dated Subsidiaries
  • Accu­mu­lated Other Com­pre­hen­sive Income

See Cor­po­rate Dis­clo­sure Trans­gres­sions (pdf), sub­mit­ted to the SEC and the Sen­ate Bank­ing Com­mit­tee, for more exam­ples of Red Flags.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.