orporate accounting practices can complicate earnings reports, but investors
ed to look out for outliers. ByAlRoot
TheNumbersGames
ThatCompaniesPlay
taking inadequate depreciation expense.
“There are so many types of aggressive (but
not fraudulent) accounting practices to choose
from,” he says.
Let’s look at five:
Excessive capitalization of “period” costs
Thismeansthatacompanyistreatinganexpense
likeacapitalasset—puttingexpensesonthebalance
sheet and spreading the recognition over many
years;inotherwords,depreciatingregularspend-
ing as if it were a building, factory, or a machine.
ThepracticeisonereasonthatshortsellerBen
Axler of Spruce Point Capital Management took
aim at precision-measurement-equipment maker
Mettler-Toledo International (MTD) in July.
Mettler disclosed in 2008 that it was capitalizing
somespendingonnewsoftwaresystems,aproject
the company calls Blue Ocean. So, instead of a
chargeagainstearnings,thecompanycreatedan
assetonitsbooks Thisisallowedbygenerallyac
atedalotoflittleexpensesformanyyears.Axler
believesthatthesoftwareprojecthasbeengoing
on too long—Mettler still talks about Blue Ocean
on earnings conference calls—and the accounting
treatmentisbeingusedtosmoothoutfluctuations
inearnings.Mettlerhasn’tmissedWallStreetana-
lyst earnings estimates as far back as 2008.
“WestronglydisagreewithSprucePoint’sself-
serving report, which is filled with inaccurate and
misleading claims,” a Mettler spokeswoman tells
Barron’s .Sheaddsthatthetotalamountofmoney
spentonsoftwarethathasbeencapitalizedonthe
balancesheetisdisclosed.Itamountsto“$471mil-
lion, which includes our Blue Ocean program. ”
Accounting reserves
Accountingis“accrualbased,”meaningthatcom-
paniesrecognizeexpensesandincomeevenifcash
isn’tcomingin(orgoingout)thedoor.Companies,
accordingtotherulessetters,aresupposedtodo
theirbesttomatchallexpensesintheperiodwhen
they occur. So companies take reserves—or non-
cashexpenses—forthingslikewarranties,product
returns, and even bad debts.
When a car is built, for example, the auto
maker recognizes an expense when it is shipped
to a dealer for future warranty claims. It repre-
sents the company’s best guess for required re-
pairs and recalls. The actual cash outflow for war-
ranty repairs happens far in the future and
doesn’t affect earnings when the cars are actually
in the shop.
Makingminoradjustmentstosuchreservesis
one way to save money for a rainy day—or for a
bad quarter. That’s why reserves like those de-
scribedaresometimescalled“cookiejar”reserves.
Such adjustments can sometimes send the
wrongmessageaboutearnings.Ifearningsnum-
bersaredrivenmorebyfluctuatingaccrualsthan
the health of the underlying business, that’s an
issue for investors.
Adjustments to earnings
S&P 500 companies reported $1.4 trillion in ad-
justedprofitsfor2018.Thenumberrecordedusing
GAAP was closer to $1.2 trillion. The $200 billion
differenceisn’tsmallandismadeupof“abnormal”
items, like restructuring charges and other gains
and losses that are excluded from numbers that
companiesprefertopresentbecausetheyaresup-
posed to be nonrecurring.
Someadjustmentstoearningsareprobablyin-
evitable.Thegap,however,betweenadjustedearn-
ingsandGAAPnumberisgrowing.In2016,thedif-
ference was closer to $60 billion.
Appliancemaker Whirlpool (WHR)usesearn-
ingsnetofrestructuringexpenseswhenitreports
earnings.Inthesecondquarterofthisyear,forin-
stance, the company reported $4.01 in per share
earningsonan“ongoing”basisand$1.04pershare
accordingtoGAAP.Includedinthedifferencewas
$60 million in restructuring spending.
Overthepastfiveyears Whirlpoolhasrecorded
“Thereare
somany
typesof
aggressive
(butnot
fraudulent)
accounting
practicesto
hf
”
RE’S A LITTLE SECRET THAT ISN’T SO SECRET ON
llStreet:Companiesliketodressuptheirearn-
s statements.
Itisn’tsomethingnefariousorillegal.Accepted
ounting practices allow companies at times to
sentnumbersthat,whileaccurate,maynotpro-
e the clearest picture to investors.
A debate over corporate accounting practices
emergedwiththeallegationsbroughtbyforen-
accountant Harry Markopolos, who says that
neralElectric (ticker:GE)hasbeenmisrepre-
ntingthehealthofitslong-termcareinsurance
iness.GEhasrejectedhisclaimsas“meritless.”
hers have said his analysis was simplistic.
What’s the lesson here?
When it comes to accounting issues, investors
ed to learn to ask the right kinds of questions
dlookintherightplacesinthefinancialstate-
nt.
AccountingexpertRobertWillenssaystolookin
ticularforcompaniesusingexcessivecapitaliza
ings reported and $2.5 billion in total
GAAP earnings reported. The differ-
encesraiseanimportantquestionforin-
vestors:Whichnumbersarebestusedto
value the company? If restructuring
doesn’t end, it makes sense to include
charges on ongoing earnings.
Whirlpooldidn’trespondtorequests
for comment.
Depreciation
Ifacompanylengthenstheusefullifeof
an asset, then the annual depreciation
charge for that asset shrinks. There
might be good reason to lengthen an
asset’susefullife,suchasbettermainte-
nance or higher quality goods, but the
consequenceisthatthedepreciationex-
pense shrinks.
Keurig Dr Pepper (KDP) increased
the maximum useful life for buildings,
machinery, and customer relationships
from 2014 to 2018. The company as-
sumed that its capital assets would last
longer today than in the past. There is
no way to calculate the precise effect
that changing useful-life assumptions
has on earnings, and, of course, auditors
sign off on changing assumptions. Still,
even subtle changes could affect re-
ported earnings by shrinking deprecia-
tion expenses and shifting the costs into
later years.
Keurigdidn’trespondtorequestsfor
comment about useful-life assumptions.
Pension accounting assumptions
Pensions are another area where a com-
pany has discretion over important as-
sumptions. And it’s complicated.
Companies make assumptions about
interestrates,andwageinflation,aswell
asexpectedstockmarketreturns.Itisn’t
easytogeneratea“pensionexpense”for
financial reports. What’s more, calcula-
tions required by pension oversight au-
thorities are different than calculations
required by accountants.
There are literally two sets of books
for pensions: one widely available to in-
vestors and one required by regulators.
Twenty-nine companies in the S&P
500 increased assumptions for pension
assetreturnsfrom2016to2018.Higher
returns on pension assets means more
moneymadeand,therefore,lessmoney
requiredtobeputintotheplantocover
retiree benefits. The pension expense
comes down—increasing reported earn-
ings per share.
These are just five examples. It
should be a flag for investors when a
co p n o g o pofco p nie h n
McKesson, AT&T, and D.R.
Horton are now relatively
cheap and showing signs of
improvement. ByJackHough
3Stocks
Forthe
Impatient
U.S. INTEREST RATES ARE HEADED FROM
low to lower, and momentum stocks are
again racing past cheap ones. An investor
who put money into the 10 best three-
month performers in the S&P 500 index
at the end of last year is up 32% so far
this year. That compares with 12% for an
investor who bought the 10 stocks with
the lowest forward price/earnings ratios.
So why not go all-in on momentum?
Too risky. When momentum stops work-
ing, investors can find themselves loaded
up on expensive shares or sector bets.
Three of the top four performers over the
past three months through August are
semiconductor companies. The fourth, the
bond trading platform MarketAxess
Holdings (ticker: MKTX), is growing
earnings per share at a midteens rate
and trades at 73 times forward earnings
estimates.
Here’s a safer approach:Search for
inexpensive stocks with a dash of recent
price momentum. Investors who do so
won’t find the absolute lowest valuations
or the top performers. But they may un-
cover some flawed companies that are
showing signs of improvement, while
avoiding perpetual turnaround candidates
that never seem to make good.
Think of this as a screen for impatient
value investors; ours recently turned up
McKesson (MCK), AT&T (T), and D.R.
Horton (DHI).
McKesson is the largest U.S. drug
distributor, delivering a third of the pre-
scription medicines in North America.
Five years ago, the stock traded at a pre-
mium to the S&P 500 relative to earnings.
Today, at less than 10 times earnings, it
trades at a 40% discount to the market.
One e on i th t polic ke e
Amazon.com (AMZN) shows signs of
interest in the drug trade. At the same
time, litigation over opioid deaths could
cost manufacturers, distributors, and re-
tailers billions of dollars.
To the first two points, McKesson
operates dozens of distribution facilities
and repackaging centers and has operat-
ing margins below 2%—not an obvious
target for a profitability crackdown or
new competition. Free cash flow of about
$3 billion a year should be enough to
cover legal settlements. Revenue growth
last quarter was strong, giving shares a
boost. An opioid settlement over the
next year could lift more worry.
AT&T combines thriving wireless and
business wireline services with weakness
in entertainment and DirecTV, which is
losing subscribers. The company has a
long-term plan to replace satellite-TV
installations with a self-installed, An-
droid-powered video box that hooks into a
standard broadband line. Later this year,
it will give more details on a planned
ThreetoGo
Stocks that look cheap and have some price
momentum.
3-Month
Recent Price Forward
Company/Ticker Price Change P/EAT&T / T $35.87 13.5% 9.
D.R.Horton / DHI 50.27 13.7 11.
McKesson / MCK 142 79 10 2 9 8
streaming service for WarnerMedia,
which could bundle HBO service.
For now, investors should watch the
big picture. AT&T stock comes with a
5.7% dividend yield, funded by a free-
cash yield of about 10.5%. That leaves
enough for investments in the wireless
network and streaming content, along
with debt reduction in coming years. A
debt falls, investors are likely to warm
the dividend—especially when 10-year,
high-quality corporate bonds are paying
about 3.2%.
D.R. Horton beganExpress Homes,
focused on building value-priced houses
five years ago; today, the business ac-
counts for over 30% of its houses sold.
That gives Horton a first-mover advan-
tage among its peers in what could pro
to be an attractive part of the market f
years to come.
Millennials of prime house-buying ag
will peak in six years at 29 million—thre
million more than the baby boomer peak
- Falling mortgage rates are helping
with affordability. In an April survey by
Bank of America Merrill Lynch, 64% of
millennials said they were extremely, ver
or somewhat likely to buy a house in the
next two years, up from 53% a year earl
Near the end of July, Horton reporte
third-quarter house sales and profit ma
gins that both exceeded estimates, and
shares jumped nearly 6% in response.
The di idend ield i 12% nd the co