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Fabrice Taylor

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Earnings by any other name

Fabrice Taylor

TORONTO (GlobeinvestorGOLD) — Shaw Communications shareholders have had a tough time of late. The stock, which was quoted at almost $35 at the beginning of the year, sank as low as $12.50 in August before mounting something of a half-hearted comeback in recent weeks.

Shareholders can be forgiven for wailing "What happened?" Cable, after all, is essentially a utility and many couch potatoes would sooner cut their food bill than their cable. What happened to Shaw, and other cable companies (besides being swept up in the controversy around AOL Time Warner, Adelphia and WorldCom), is that investors have finally realized that cable companies don't make much money, if any at all, and that growth is, well, wanting. Cable companies generate cash, not profit.

And it's this sort of a distinction, which can be revealed through just a simple review of company financials, that should determine whether the stock is a buy, sell or hold. Accounting terms, which for many investors have done nothing but obscure, obfuscate, blur, cloak, disguise and shroud the bottom line in recent years, should work for you, not against you.

Many shareholders in cable companies, for example, have ignored the bottom line, relying instead on some other, more exotic version of profit and loss. But not anymore, the shares seem to say. Have a look at Shaw's most recent quarterly earnings filing on Sedar.com.

The first set of numbers, which do not comply with Generally Accepted Accounting Principles, or GAAP, show the following:

Revenue:$493,605
Operating income before amortization:$171,757
Cash flow from operations:$98,559
Net income:($90,909)

Note the order of presentation: First cash flow, then net income. Or, put another way, first the good news, then the bad.

The question investors should ask themselves from the get-go is, "What's the difference between the two?" The difference is not only big — a swing of almost $200-million — but crucial to the decision whether to buy, sell or hold the stock.

A rose by any other name

For starters, let's parse the language carefully. Operating income before amortization. What's amortization? It's an accounting treatment that spreads a one-time cash payment out over time. It's sometimes called depreciation.

Shaw Communications Inc.
Quarterly Income Statement
Income Statement ($Mil) Aug 31* May 31* Feb 28*
Operating Revenue 494.6 495.2 472.2
Total Revenue 497.8 499.3 475.1
Depreciation, Amortization & Depletion 146.8 154.1 153.6
Operating Expenses 309.4 321.8 332.6
Income before Interest and Taxes -20.7 -245.5 -11.4
Interest Expense 68.1 67.3 68.6
Income before Tax -88.8 -312.8 -80.0
Income Tax -19.1 -23.0 -25.6
Minority Interest 0.0 0.0 0.0
Profit/Loss -70.6 -90.9 -74.4
EPS ($) -0.35 -0.44 -0.36
Diluted EPS ($) -0.35 -0.44 -0.36
Dividend per Share 0.02 0.00 0.02
Avg. Shares Outstanding (000s) 231,848 231,839 231,812
* * Three-month period in 2002, reported in C$

Cable companies own a great deal of technological equipment, from computers to routers to trucks to wires and so on. These have enormous up-front costs. You spend, say, $1-billion running wires into neighborhoods and hope to get your money back over time as people buy your service.

The cost of the original equipment — that $1 billion — will be amortized over its estimated useful life. Part of the amortization Shaw is omitting from its earnings is that initial capital outlay.

It's tempting to agree with the company, the argument being that the company won't have to spend that money again. But that thinking is flawed. First, all physical gear wears out eventually. It has to be maintained or you go out of business. Part of the amortization, or depreciation, charge on a proper financial statement is supposed to capture the cost of replacing property (other than land, which doesn't depreciate), plants and equipment: PP&E as it's called.

A mature business' depreciation and amortization expense will more or less cover that cost, which recurs just as salaries, electricity bills, rent and so on do. The actual cash spent on maintenance would not be as predictable; it will be lumpy, but it will be spent. You can't ignore it.

The other problem pertains very much to technology. Guess what? Technology changes, and fast. It's hard to believe, but eight years ago, the Internet as we know it didn't exist; commercial DTH satellite was in its earliest infancy and phone companies offered phone service, period.

Companies such as Shaw have to invest in technology to stay in business. Ignoring the amortization is even more dangerous.

Death, taxes, debt…and madness

Cash flow often goes by the name EBITDA, or earnings before interest, taxes, depreciation and amortization. A company investing more to stay competitive than it makes in EBITDA (Shaw's capital spending for the period was $185 million) is not creating value in the short term nor in the long term if reinvestment never ceases.

But there's another problem with EBITDA, which should be evident from the name. There are only two certainties in life, the old adage goes, death and taxes. From an equity holder's point of view, there's another: debt. Debt holders always get serviced before shareholders.

EBTIDA excludes this, which is madness, especially in the leverage-intensive telecom business. Interest payments at Shaw in the above period were $67.3 million, almost 40 per cent of Shaw's EBITDA earnings.

Simply put, cash from operations, or EBITDA, is a poor measure of profitability. Net income has its own drawbacks, but the retail stock investor is best served by concentrating on that.

Pro forma and other dead languages

Falling for EBITDA is not the only way investors have undone themselves as the bull market deflated. More retail investors are seduced by "pro forma" earnings than frat boys at Mardi Gras.

Take Celestica, for example. The company fell into the habit of reporting earnings with various exclusions. Some of these were non-cash (not that that makes it believable, as we've seen above) but others were cash, namely the cost of integrating newly acquired plants.

Celestica Inc.
Quarterly Income Statement
Income Statement ($Mil) Sep 30* Jun 30* Mar 31*
Operating Revenue 1,958.9 2,249.2 2,151.5
Total Revenue 1,963.5 2,253.3 2,155.2
Depreciation, Amortization & Depletion 53.7 77.5 22.0
Operating Expenses 1,986.5 2,089.7 2,076.1
Income before Interest and Taxes -105.7 54.2 53.2
Interest Expense 3.5 5.5 5.4
Income before Tax -109.2 48.7 47.8
Income Tax -18.6 8.3 8.1
Minority Interest 0.0 0.0 0.0
Profit/Loss -90.6 40.4 39.7
EPS ($) -0.40 0.16 0.15
Diluted Earnings per Share ($) -0.40 0.15 0.15
Dividend per Share 0.00 0.00 0.00
Avg. Shares Outstanding (000s) 230,100 230,200 229,800
* Three-month period in 2002, reported in US$

Now, clearly that's a one-time cost of doing business. A company buys a plant and invests in the technology to bring it on line. But it's a business cost, especially since a big part of Celestica's business is acquisitions. You may want to spread that cost out over time, but you can't simply exclude it from earnings.

Another earnings red flag at Celestica and other technological manufacturers is the writedown. Writedowns are required when management believes the economics of a particular asset are compromised. Celestica, for instance, written down physical assets (recently acquired, at that) and excluded them from its headline earnings.

The problem with this approach is that the writedown — which is typically not cash — is still a sign that bad decisions have been made or that there are company or industry has problems.

Hide and seek

Ironically, and dangerously, when writedowns are hidden, obscured or ignored altogether, they can help give the impression that earnings are improving. For instance, Cisco Systems last year wrote down the value of some of its inventory. Revenue, less the carrying value of inventory, less other costs, equals profit. By writing down the value of inventory, Cisco was inflating future earnings. Cisco, it should be noted, has maintained a huge relative lead in profit margins as the network industry craters.

Celestica's margins have held up quite well too, in part because of past writedowns. Is the industry improving? No, but in this case, by burying so-called one-time charges — which are often anything but — the outlook may appear healthier than it is.

The list of accounting dangers is long, and the few above only scrape the surface. But the point is that relying on GAAP, even though it's not perfect, will go a long way to preserving your capital. And as Warren Buffett puts it, there are three rules in investing: the first is to not lose any money. The second and third are not to forget the first.

Fabrice Taylor is Editor of The Globe and Mail's Vox column.

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