Pro Forma Economics?

By James J Puplava CFP, February 13, 2002

First we have had to deal with pro forma earnings. This meant learning to interpret what a person's definition of "earnings" meant. We have now learned that earnings can mean whatever a company or the media want them to mean. Just as we have political spin, we now have the pervasive practice of financial spin. Most of the time the spin deals with the earnings numbers, but it has slowly been creeping into the economic reports as well. Today was a good example of that practice with the government reporting that retail sales fell last month. The Commerce Department reported retail sales fell last month by 0.2%. However, if we exclude sales for automobiles and car parts, which fell sharply despite incentives, retail sales rose 1.2%. Leave it to Wall Street, which has grown accustomed with pro forma earnings, to go with the pro forma economic numbers. In other words, by excluding and taking out of the report those elements that were bad (decline in auto sales), retail sales actually went up. No matter how they finagle the facts, actual sales were down.

This new economic reporting is a lot like the way earnings are reported by the financial media and hyped by Wall Street. By taking out write-offs, big expenses and big bath charges or investment losses, earnings were actually up. So we now have pro forma economic reports. Today, if the numbers don't look good, take out what doesn't look good and rearrange the report to fit the spin. During the fourth quarter when auto sales rose due to zero-percent financing, we counted auto sales in retail reports because they made the numbers look good. Now when auto sales go down, we remove them from the report to make retail sales look better. That way we always have reports that portray a sunny disposition for the financial markets.

Today's Truth is "Go Ahead, Pick Your Version"

I've included three versions from today's financial press to illustrate how Wall Street and the financial media spin the headlines. CNN MONEY's headline was "U.S. Retail sales Dip" which was the true headline. Bloomberg went with "U.S. Economy: Retail Sales Excluding Autos Rose 1.2%", a partial spin by emphasizing the positive aspects of the report. CBS.MarketWatch went with "Jan. Retail Sales Ex-Autos Soar 1.2 %". Although on their web site, the title was "January's Jump". The impression was that the economic numbers were getting better because retail sales were picking up even though auto sales, despite incentives actually fell. So we now have economic numbers that leave out vital but disturbing news so that investors always get a great picture to look at. It is similar to a weather forecaster in Arizona who always talks about nothing but sunny skies.

Conservatism Lost - Ratings Found

In another example in this bias in reporting, Barron's, the weekly publication of The Wall Street Journal is now using pro forma numbers for the major indexes in its calculation of the Price Earnings ratio and earnings yield number for the three major indexes: the Dow, S&P 500, and the Nasdaq. In that way. the P/E multiples will look much smaller and therefore the stock market more attractively priced. The current P/E multiples for the three major indexes are 28.5X for the Dow, 61.9X for the S&P 500, and a negative P/E for the Nasdaq since there are no earnings. One wonders how book value will begin to be reported when it is estimated that companies in the Wilshire Index this year will write off $1 trillion in impaired assets off their balance sheet this year. Will we then get pro forma book values?

This maneuvering is similar to the "New Math" taught in many of our public schools where 2+2 = whatever you want it to be. Whatever makes you happy seems to be the new mantra. I take that back. Whatever will make investors happy is the new way of thinking. This reminds me of the "double speak" in George Orwell's 1984. Just as companies have two separate sets of books [for many its 3-4 sets of books, one for annual reports, one for the IRS, one for analysts, and the real numbers for management], investors may have to become multilingual to understand finance and economics.

Ignorance to Some May Be Bliss

Today I heard a financial network analyst dismiss a story over Global Crossing and Qwest inflating their sales. Essentially, it was no big deal. Almost as if it was old news and should be ignored. The rationale for ignoring it is that the inflated sales number represented a smaller portion of their sales and therefore was irrelevant. One of the greatest ways in which earnings can be manipulated is to inflate the sales numbers. The inflated sales numbers travel directly to the bottom line. So in the case of Global Crossing and Qwest, the inflated sales numbers may have been a smaller portion of the top line number, but in reality, they became a bigger part of the bottom line number. This is just another example of how spin now controls much of what we know about economics and the financial markets. Is it any wonder than that investors, or for that matter the financial markets, would seemed so surprised when an Enron or Global Crossing appear.

Krispy Kreme -- Coming Clean on True Calories

Feeling the heat of not disclosing off-balance sheet debt, Krispy Kreme's chief operating officer said the company would now add $35 million in financing of a new factory on to its books. Krispy Kreme used what is often referred to as a synthetic lease to keep the new plant financing off its books. Many companies, including Kmart, use off-balance sheet financing in the form of operating leases to keep debt off their balance sheet. This is a widespread practice that can often make a company look in better financial shape than what they really are. In Kmart's case, they carried $7 billion in operating leases which were kept off their balance sheet.

Today's Market

Stock indexes rose today after the Commerce Department reported those better-than-expected retail sales numbers. Consumer, retail and financial stocks rose on this hypothetical better news. With earnings news so horrific, Wall Street and their partners in the media have now turned toward hyping the economic numbers. Without the spin of lower interest rates and earnings, investors have no reason to buy stocks. Now the media and Wall Street are giving them one called a "hypothetically improving economy" and lower priced pro forma indexes. The major indexes have risen in three out of the past four days. Analysts at First Call have now increased first quarter earnings losses to 8.3%. Profits have fallen 23.9% for the fourth quarter. With no more interest rate cuts on the horizon, and with earnings being revised downward, it may be one reason why the emphasis is now on pro forma economic numbers.

Even with the recent rebound in earnings, the major indexes are all down for the year. Besides poor earnings prospects, the other major reason is distrust over accounting irregularities. The SEC said today that it will release rules to close insider-trading loopholes and require companies to file comprehensive reports more quickly.

So, What's the ACTUAL story about H-P?

In other news Hewlett-Packard's profits rose and sales improved from the fourth quarter as consumers bought more computers. Net income jumped to $484 million. However, the company warned that next quarter sales will fall modestly with expenses little changed. An examination of the better-than-expected earnings came from a gain recognized for the early repayment of debt and an adjustment for a change in rules about recognizing revenue, net income in the year-earlier quarter was actually $141 million. Actual sales fell 8.2% from $11.4 billion from $12.4 billion. Brocade reported that its first quarter profits fell 64% as sales of its network switches fell. Maybe this kind of news is why we need to stick to pro forma accounting and economics. It will make us all actually feel better.

Investors flocked to technology stocks on the basis of better numbers from HP and bullish report coming from Applied Materials. Hardware and chip stocks rose on the hype. In the broader market, investors bid up shares of retailers following the pro forma retail report. Other areas doing well were financial, oil service, and cyclical shares. On the down side were airlines and biotech stocks. Volume picked up to 1.2 billion on the New York Exchange and the same on the Nasdaq at 1.6 billion. Breath improved with advancers beating decliners by 20-11 on the NYSE and by 20-15 on the Nasdaq.

Overseas Market

European stocks rose after a U. S. retail-sales report boosted optimism that economic growth is reviving in the world's biggest economy. The Dow Jones Stoxx 50 Index gained 28.60 points, or 0.8%, to 3544.94, erasing a drop of as much as 0.9% and narrowing its loss in 2002 to 4.4%. Benchmark indexes rose in seven of Europe's eight biggest share markets.

Asian markets continue to rally over economic optimism, The Nikkei rose .91% and Hong Kong market rose nearly 3%.

Treasury Market

Government bonds ended the session with modest losses. The 10-year Treasury note was off 1/8 to yield 4.995% while the 30-year government bond erased 1/32 to yield 5.455%.

James Puplava

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James J. Puplava CFP
PFS Group
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