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4 warning signs of funny numbers
Accounting issues still run deep, as Royal Ahold's revelations proved last week. You still can't trust the numbers -- but you can guess where scandal might pop up next.
By Jim Jubak
The names are different but the story is the same.
Last week, Royal Ahold (AHO, news, msgs), the worlds third-largest supermarket operator, admitted that it had inflated its operating earnings by at least $500 million in 2001 and 2002. The company sent its CEO and CFO packing, and the companys accountants, Deloitte & Touche, denied any responsibility for the problem.
Sounds familiar, doesnt it? Change a few details and the Ahold case is Lucent Technologies (LU, news, msgs), WorldCom (WCOEQ, news, msgs) and Xerox (XRX, news, msgs) all over again.
To understand why the accounting scandals arent over, go back to the basic causes of the epidemic.
Boards of directors set up pay systems that gave CEOs and other corporate managers millions of dollars in incentives if they delivered ever-faster revenue and earnings growth. Investment bankers and accounting firms were only too happy to earn their own millions in fees by creating accounting structures such as the off-the-books partnerships at Enron and the revenue swaps at Qwest Communications (Q, news, msgs).
What went wrong
What brought these structures tumbling down?
A slowing economy and a tumbling stock market gradually put more pressure on their accounting and made it necessary to tell bigger and bigger lies to keep revenue and earnings numbers growing. And at some point, the lies became so large that they couldnt be sustained by management or ignored by outside investors. Especially by outside bondholders and lenders.
Thats exactly what happened at Ahold. Like all grocers, Ahold faced extreme cost-cutting by Wal-Mart Stores (WMT, news, msgs). And a slumping stock market had put a hold on the companys growth-by-acquisition strategy that had added U.S. properties such as Giant and Stop & Shop. The slowdown wouldnt have been such a problem, except that Ahold has about $5 billion in debt that comes due by the end of 2005.
The accounting problems at Ahold are similar to those of other companies in its sector.
The Securities and Exchange Commission has launched an inquiry into the way Fleming Cos. (FLM, news, msgs), the countrys largest food wholesaler, accounts for discounts from suppliers, and it is conducting a formal investigation of similar issues at wholesaler Nash Finch (NAFCE, news, msgs).
Know the warning signs
Aholds problems suggest how investors can identify sectors in which funny accounting might break out.
One: Look for hot growth industries in which growth has been slowing lately.
The mortgage-banking sector fits that bill. Thanks to the mortgage-refinancing boom created by falling interest rates, a mortgage lender such as Washington Mutual (WM, news, msgs) has been able to grow earnings by better than 23% a year over the last five years.
But keeping that kind of growth going will be just about impossible if interest rates start to rise.
Two: Keep an eye out for industries whose accepted accounting practices leave companies a lot of wiggle room.
Accounting in the mortgage-banking sector can get pretty subjective. Regulators have recently warned that theyll be looking for evidence that lenders are overvaluing the mortgages in their portfolio. Another area to watch is whats called gain-on-sale accounting. Gains from selling mortgages to other bankers are tricky to calculate, and theyre hard to sustain if interest rates start to climb.
Credit-card companies deserve extra accounting scrutiny right now for pretty much the same reasons.
Three: Watch companies with ambitious growth-by-acquisition strategies.
The problem at Ahold seems at least partially the result of a company outgrowing its internal controls.
And four: Look to industries that have promised an earnings turnaround and havent been able to deliver.
The temptation here to do something to earnings appears to grow stronger every quarter. Id especially keep an eye on financial-services companies in the brokerage and investment-banking sectors.
Accounting isnt at the top of any investors list of short-term worries. But the issue of trust will still be around long after the threat of war has receded.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Lucent Technologies. He does not own short positions in any stock mentioned in this column.
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