Some Analysts Have Disregarded Companies Reporting Large Write-Offs.

Wisdom among Wall Street stock analysts used to be that investors should ignore large write-offs because they provide little insight about future performance. With the large number of write-offs and increasing number of bankruptcy filings, that wisdom has not always held up.

Consider Bethlehem Steel. Three months before it filed for Chapter 11 it reported a $1.1 billion second-quarter loss, most of it a $1 billion "unusual noncash" charge against earnings to write off the value of a deferred tax asset.

Some stock analysts ignored the write-off saying it simply "masked what was essentially an improved second quarter”. Others gave the company’s stock a “buy” recommendation, with some predicting the stock price would more than triple.

Creditor’s should be aware that write-offs can be a clue to the company’s future—and in Bethlehem’s case, a foreshadowing of what was just over the horizon for its investors and creditors.

Almost any kind of write-off can send a message about the financial condition of a company, its growth prospects as well as the effectiveness of its management.

When a creditor sees a large write-down, it should raise a red flag, and you should start digging deeper for the underlying reasons for the charges and/or losses.

Size Does Matter

The increasing size and frequency of write-offs over the past ten years has made it increasingly important for today’s credit and finance professional to get a good handle on the signals that charges and losses give out. As recent as three years ago Standard & Poor's 500-stock index reported more than $165 billion of so-called unusual charges, more than in the prior five years combined. All this while Chapter 11 and Chapter 7 filings by publicly traded companies hit record levels. The increases continue today and with the upcoming implementation of the new bankruptcy legislation, these figures are expected to rise.

Even if a company appears sound and a bankruptcy filing seems remote these charges against earnings, which are often referred to as a "special," "one-time" or "nonrecurring" charge -- can provide an exit signal to investors. Creditors may view them differently however, continuing to ship merchandise and extend credit. Nevertheless, all eyes should be on that company’s next several quarterly results for declines in earnings (both for continuing operations and net) as well as more of these special charges

Sometimes the significance of special charges isn't always immediately clear. But some investors grow suspicious anyway, using the "cockroach theory": Where there's one problem, there probably are more. A weary eye and a close evaluation into how a company accounts for its business and whether a company is pushing the envelope is something to evaluate when reviewing everything from a debtor’s cash flow statement to its payment history and even its lien filings.

As for investors, we only need to look at the many short-sellers who raised their bearish bets on Enron Corp. a few years ago after it took a $1 billion charge primarily to write down the value of soured investments. Part of the charge was a $35 million write-off of investment losses at a partnership controlled by the company's CFO. Later, revelations about that and other partnerships, which weren't consolidated into Enron’s financial statements, resulted in the market losing faith in the company's financial results

It is important to keep in mind that special charges, whether they represent old baggage from the past or illuminate the future, be looked at from two sides before decisions are made as to a charges true meaning. On the one hand generally accepted accounting principles state that companies must use these charges in their official financial statements and that nearly all charges be treated as ordinary expenses. On the other hand some analysts feel that the best view comes from "pro forma" financial results -- calculated "as if" many expenses didn't really exist. The idea is that these expenses aren't relevant to future performance and should be looked upon as “on-time” occurrences.

There is a case to be made for this later stance but only a thin one--and an old one at that. The logic dates back more than 20 years when, during the 1981-82 recession, restructuring was a part of many company’s strategies. Companies took charges for streamlining, outsourcing and otherwise shedding costs to position themselves for recovery. Since earnings volatility made it hard to compare a company’s growth rate or price-earnings ratio, and since many charges weren't expected to recur, there was some logic to excluding them in order to come up with more consistent and reflective earnings trends. During that period investors came to look upon charges as evidence that firms had recognized past mistakes and had made tough decisions to become more efficient. Then the practice of “charging” got out of hand. Some companies became chronic restructurers. In fact, one study estimated that "operating earnings", at companies in the S&P 500 index, outstripped net income by more than 10% annually on average over the past two decades, and by as much as 20% annually in recent years. One reason is that while some companies exclude all sorts of special losses from their operating earnings, they are far less likely to exclude one-time gains, such as profits from asset sales.

Credit and financial executives should be aware that if a company borrowed to buy the assets it is writing down, it could find itself squeezed by debt. Excite At Home is a case in point. It announced a $5.43 billion net loss while reporting only $169.1 million in revenue. Much of the loss, $4.63 billion, reflected various write-downs of goodwill. One such write-down concerned the company’s purchase of an online greeting-card service. The company paid $1 billion in stock and cash for the service, taking on $350 million in debt. Unfortunately the company being purchased had little revenue. A year later, Excite took a $680 million charge for the goodwill it created by buying Bluemountain at a price far above its net worth. Excite’s chairman told investors and creditors that the charges had "no direct impact" on the company's operating performance. Some analysts fell in line, maintaining their buy ratings. Eventually, faced with growing cash needs for interest payments and service upgrades, Excite At Home filed for Chapter 11 protection with its stock being quoted at a penny. Excite was a "perfect example" of a charge overlooked by many analysts—a charge that was a red flag, predicting the company's future and a possible bankruptcy filing that eventually came to pass.

Stephen Bastien is a former corporate credit executive and publisher of the Credit Manager’s Daily Report on Troubled U.S. Companies as well as developer of the new credit manager’s website, http://dailybusiness.creditmanagers.biz where credit and collection professionals can track their debtors, at not charge. Every time there is business news on a company, that news is automatically emailed (within 24 hours) to the credit/collection professional so they can update their debtor’s credit repors. For more information call 800-407-9044 or email steve@creditnews.com

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