Golden
Capital Securities
Investment Outlook
November 2000
For most of the month of October, while New York was consumed with the
World Series, the markets were rocked with High Technology companies
pre-announcing earnings that were below what analysts were expecting.
Even the mighty Nortel (NT-T),
who announced operating earnings that were above expectations; 18 cents a
share, one cent above the expected 17 cents, lost around $80 Billion
Canadian in
market capitalization. The reason for the drop? The quality of
the earnings were not what analysts were expecting.
"Quality of earnings" refers to the amount and purity of income generated from the company's core businesses, the accounting policies adopted to recognize that income and what other business areas and income statement line items affected the net earnings of the company. Although North American accounting rules are much more restrictive than other areas of the world, the flexibility allowed by both the Canadian and US GAAP (Generally Accepted Accounting Principles) still leaves a great deal of interpretation up to the companies.
For instance, Nortel's recently announced third quarter 2000 revenues grew significantly to $7.31B USD from $5.15B USD (a 42% year over year growth), but 1) those revenues were at the low end of the projected range due to capacity bottlenecks, 2) some pending revenues were not reported due to timing of the recognition of those sales as revenues and 3) lower than expected growth in optical equipment which is currently the main source of growth for the company. The quality of the revenues were not what analysts were expecting; Strike One against the company.
Nortel's earnings releases consist of two sets of numbers. The most frequently reported in the press is the figures relating to the costs directly associated to their business or "Operating earnings". The "Reported Earnings" is more of an accounting statement and reflects the non-cash items such as depreciation and income generated from sources that are not directly from their business operations, for example investment income.
Nortel Network's Third Quarter 2000 Income Statement (in millions of US Dollars)
| Reported Q3 '00 | Operating Q3 '00 | Comments | |
| Revenue | $7,314 | $7,314 | Up to R&D Costs both statements were the same |
| COGS | 4,096 | 4,096 | |
| Gross Profit | 3,218 | 3,218 | |
| Administration | 1,.380 | 1,380 | |
| R&D | 1,016 | 1,016 | |
| In Process R&D | 22 | - | None of this is included in the Operating figure as they do not directly affect operations. |
| Amortization of Intangibles | 1,311 | - | |
| Stock Option Compensation | 31 | - | |
| Operating Profit | (542) | 801 | Notice the large difference in Operating Profit, over 1 billion dollars!! |
| Equity Earnings in Associated Companies | (16) | (1) | |
| Other Income | 236 | 67 | |
| Interest Expense | (39) | (39) | |
| EBT | (361) | 828 | Still over a $1B difference |
| Tax Provision | 225 | 254 | |
| Net Earnings | (586) | 574 | $1.16 B difference!!! |
| EPS Diluted | (0.20) | 0.18 |
The second strike against Nortel came as the layers of the financial statements were peeled back. The $0.18 cents US of operating earnings included very little of the amortization, depreciation and other non-cash charges that would normally be included by any other reporting company. Although I will admit that the amortization is not a true expense in that it does not use up cash, it is on the financial statements to reflect the cost of replacing the equipment, computers and facilities based on their projected useful life. Nortel did not include this in their 18 cent earnings figure, and this would further over-estimate earnings. Strike Two.
In their defense, it doesn't really matter what number you quote to the public as the earnings number as long as 1) the number quoted is constructed in a similar manner each period and 2) that it accurately reflects the business in which the company is involved. Does a difference between an 18 cent profit and a 20 cent loss sound like an accurate reflection to you?
Finally, the third and a commonly used method for "enhancing" earnings is the line item called Investment Income or Other Income. Let me state right off that I do feel that this is an important part of the financial statements and that it has a necessary role in full and complete disclosure. However, the percentage of a company's earnings that this income can represent is often substantial. Nortel reported two hundred and thirty six million dollars of other, non-operational income, not bad for a company that is not involved in the securities industry. The magnitude of this Other Income relates to a 10 cent a share increase in the Earnings Per Share, remove that income and Nortel lost 30 cents a share if you consider the company a going concern that has to replace its equipment and buildings and expense the excess amounts that it paid for its acquisitions. Strike Three, You're Out $80 Billion Canadian in market-cap!!!!!!
However, Nortel has historically had relatively small "Other Income" entries compared to some of its high tech compatriots in both Canada and the United States. Research In Motion (RIM-T, or RIMM-NASDAQ) is an excellent example. Based on the February 29th, 2000 year end, RIM reported Earnings Before Taxes (EBT) of slightly over $16 million, which translated into net earnings of $0.16 per share. However, of that earnings number almost 40% came from "Investment Income", a non-operational source of income, a similar amount occurred in 1999. In 1998, Investment Income reversed a $698 Million loss into earnings of $621 M. Do you think that investors who are paying 1,100 times earnings are aware that 40% of those earnings are coming from RIM's investment activities rather than from two-way pagers sales?
Even the really big companies have similar reported "Other Incomes":
| Company Name | Ticker | Other Income | EBT | % of Earnings | Current P/E |
| Cisco Systems | CSCO | $1,108 M | $5,451 M | 20% | 133 x |
| CMGI | CMGI | 894 | 749 | 119% | n/a |
| Intel Corp. | INTC | 3,188 | 14,416 | 22% | 27 x |
| Microsoft Corp. | MSFT | 3,338 | 17,613 | 19% | 36 x |
Figures based on most recent fiscal year-end.
Many analysts, and many more investors, do not segment the earnings into those coming from their core businesses and those coming from their extra-curricular activities. You can see what a significant difference it can have on the earnings, but whether breaking out the Other Income will affect what someone is willing to pay for a company all too often depends more on market sentiment rather than true fundamentals.
Quality of earnings is very important when reviewing the overall health of a public company. Canadian and US GAAP permit a significant amount of latitude for companies to tailor financial statements to "accurately" reflect their business, and many companies take full advantage of this ability. Therefore, a healthy dose of cynicism is often required when reviewing a company's financial statements.
As the Holiday season descends upon us, are you dreading heading into the crowded mega-mall? You and your closest 10,000 friends fighting over the one remaining parking spot that is so far away from the entrance that you really should have walked if it wasn't for the 4 inches of rain (Vancouver) or 12 inches of snow (Calgary) on the ground?
To avoid this horror, some of you may have attempted to purchase some or all or your gifts on-line last year. At the time it likely seemed like a terrific idea: no lines, no indifferent sales people, no inclement weather. Just you, a warm cup of tea and your high bandwidth modem connecting you to over 1,000 possible merchants at prices significantly cheaper than the retail stores. It appeared to be Utopia.
That was until the afternoon of the 24th of December when none of your gifts had arrived and the countless e-mails sent to on-line merchants had gone unanswered. At that point you are forced to the mall to attempt to scrape together enough of the remaining clearance merchandise to fill half of one stocking. Or, if you were lucky enough to get through to the e-tailer, finding out that your package hadn't been sent, isn't being sent and won't be sent until some time in March: "We can guarantee you that it will be there before Easter".
The Holidays of 1999 were the first real test and the first real failure for e-commerce.
This year will be a significant test for the e-tailers as the Internet using public is a little more knowledgeable and a lot more wary of purchasing items on-line. A recent survey of world-wide on-line purchasers by American Express indicated that as many as 40% of Canadians with access to the Internet will be purchasing something on-line this holiday season, up from 19% last year. However, there are significant differences in the purchasing characteristics between countries. For instance, although Canada has one of the highest penetration rates of computers and is one of the fastest adopters of high tech gadgetry, we also have one of the lowest on-line purchase rates of developed countries. Canada's 19% purchase rate last year compares to countries like the US and Hong Kong where 39% and 54% of Internet users, respectively, purchased items on-line.
Internet Analysts have speculated about the reasons behind the disparity, but there seems to be several common issues that have limited on-line purchases in Canada. First and foremost, most on-line stores, being American, only accept US Dollars. The combination of a relatively weak Canadian dollar, additional shipping costs, duty and taxes makes what were once good deals, no longer appear that special. The American Express report says that most purchasers have said that they would prefer to purchase items in their home currency, therefore as more Canadian-based Internet stores come on-line this problem should reduce itself.
Secondly, there is a feeling, whether warranted or not, that there is an increased risk of credit fraud over the Internet when compared to purchasing in person at a store. On-line merchants have attempted to reassure customers that their orders are being placed on "secure" sites and each of the major credit card companies has launched a type of e-wallet to add an increased level of security and convenience to on-line transactions.
One of the largest complaints from last year and the biggest ongoing concern is the level of service from the on-line companies. If you purchase something, can you track it? If it is not right, can you return it? And if so, where and how? A study done of business-to-consumer websites in the Spring of this year by IDC indicated that 20% of the sites were going to implement some form of interactive customer service. This could take the form of e-mail, telephone call centre and even on-line support where a little box pops up and you can actually see with whom you are talking / chatting over the Internet. However, what are the other 80% doing?
Finally, the study also indicated that 90% of Canadians would still rather make some or all of their purchases in person. We appear to be willing to do our research on-line, but would rather have the tactile sense of shopping before making the final commitment. Even though one-quarter of those with Internet access admit that there are better deals on-line, they would rather forfeit some of the savings to visit the bricks and mortar retailer.
So, the Internet will likely be a significant source of information and purchases for Holiday shoppers this year. The real test of success will be whether the e-tailers have been able to combine the low prices, quality service and on-time shipping that shoppers will expect. Good luck, although I hope you won't need it.
Until next month.