January 20,
2000 |
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Portfolio Profits Boost Bottom Line, But Stir Controversy for
Some Firms
By GREG IP, GARY MCWILLIAMS and SUZANNE MCGEE Staff
Reporters of THE
WALL STREET JOURNAL
Happily tallying up your profits on the stock of Microsoft and Intel? They're nothing compared with what Microsoft
and Intel are earning on their stock investments.
The companies' profits from investments -- which are entirely
separate from their operating income -- are eye-popping: Intel
recently booked $327 million in quarterly earnings from sales of
stock it owns. Microsoft, in its latest quarterly report, had $773
million in profits from selling such investments.
It isn't just technology companies that are making lots of money
in the stock market: General Electric Co. and Delta Air Lines, among others, are making
significant investments in other companies, often venture-stage
enterprises, then sometimes realizing nice gains when the stocks of
those companies climb. To the extent the stocks are sold and the
gains realized, they flow to the companies' bottom lines.
While supercharging the profits of some big U.S. companies, these
stock-sale profits raise an interesting -- and to some a troubling
-- question: Are stock prices themselves giving a significant boost
to the very profits that are fueling the euphoric stock market? Or,
put another way, are stocks to some extent feeding on themselves
rather than on real growth in their businesses?
That is the worry of some market watchers who analyze company
earnings. The contribution these investments make to some companies'
earnings may be difficult to repeat, they note, and may mask the
quality of the underlying business. And if the stock market were to
correct sharply and the market for hot initial public offerings cool
off, many of those gains would dry up or perhaps even turn to
losses.
"If the companies' earnings growth is not coming from normal
recurring operating activity, the infrastructure is weak and a high
stock price is not going to be sustained," says Howard Schilit,
president of a for-profit group called the Center for Financial
Research and Analysis. "What a healthy business is all about is
having a core business producing an increasingly larger client base
..., not one where the revenue flattens out, margins contract, but
the company happened to luck out" on its investments.
Of course, even companies booking big gains on investments still
get the majority of their gains from producing things or providing
services. Moreover, their investments often complement their core
business operations, because larger companies can get valuable
insight and strategic advantage through a close relationship with
young, dynamic companies. In any case, U.S. companies are still far
less likely to have significant stakes in other enterprises than
their Japanese counterparts.
Purpose of Investments
But with companies pouring growing amounts of money into start-up
companies, analysts say it is becoming increasingly difficult to
tell whether these investments are motivated more by strategic
reasons or by the hope of stock returns. "More and more, the returns
seem to be the objective," says John Taylor, chairman of the
National Venture Capital Association. "One thing we're seeing a lot
more of is companies co-investing with traditional joint
venture-capital firms in deals that are very much
returns-oriented."
The companies themselves extol the strategic benefits of their
investments, while affirming they very much want them to be
profitable. Intel Corp.'s $327 million gain from sales of investment
shares boosted its net income to $2.4 billion and enabled it to beat
Wall Street estimates for the quarter; and Intel shares jumped about
13% last Friday on that earnings report. But Chief Financial Officer
Andy Bryant says the investments aren't made for purely financial
reasons. Intel makes investments in companies that "provide
strategic benefits" such as accelerating a new technology or market,
he says.
SmithKline Beecham PLC's $100 million
Philadelphia-based venture-capital fund, S.R. One Ltd., holds
investments in about 47 firms, almost all made in conjunction with
one or more traditional venture-capital investors. "That's because
we invest for the same reasons that they do: for return," says
Brenda Gavin, a partner at the fund. "The only difference is that
we'll invest only in companies that are of strategic interest to
us."
Microsoft Portfolio
The precise value of corporate America's holdings of equity in
other companies isn't known, but it appears to be growing. Microsoft
Corp.'s portfolio totals $19.8 billion. Intel's totals $8 billion.
Compaq Computer Corp.'s investment portfolio,
counting only publicly traded stocks, is $8.3 billion. Such sums
include stakes in both established companies, such as Microsoft's
holdings in AT&T Corp. and Comcast Corp., and many smaller, sometimes private
companies.
Indeed, corporate investors are an increasingly important
presence in funding early-stage start-ups. They accounted for as
much as 16.3% of the roughly $43 billion funneled into in venture
investments in 1999, compared with 7.5% of the $20 billion invested
in 1998, according to the National Venture Capital Association.
Not surprisingly, given the rampaging bull market, these
investments are making a growing contribution to some companies'
earnings. Normally that happens only when the companies sell the
appreciated stocks. But other stocks owned by a corporation can
benefit its bottom line even if they aren't sold; that happens when
a pension fund gets such a lift from rising stocks that the company
is able to book a profit instead of a pension expense.
The past week has seen much evidence of these equity stakes,
including Microsoft's report on Tuesday for its fiscal second
quarter. Microsoft's increased investment income contributed about
four cents to the company's 47 cents a share of net income
(excluding a charge), and it supplied most of the "upside surprise,"
that is, the amount by which Microsoft beat Wall Street's 42
cents-a-share consensus estimate.
Delta Air Lines Wednesday reported a pretax $596 million gain
from the sale of a portion of its stake in Internet ticket-seller Priceline.com and other investments. Including that
gain, Delta's quarterly net earnings came to $352 million.
And just Wednesday, America Online reported a pretax gain of $111
million on an investment in Sandpiper Networks. AOL's profit after
taxes, one-time gains and charges totaled $271 million.
Robert Willens, a tax and accounting analyst at Lehman Brothers,
says investors tend to ignore gains and losses on equity stakes when
evaluating a stock. "I don't think people are being misled by those
gains. I think the analysts are doing a real good job of calling
people's attention to that," he says.
Indeed, investors looked through Microsoft's strong earnings to
signs of weaker revenue growth and sent its stock down $8.3125 to
$107 in Nasdaq Stock Market regular trading Wednesday. That
accounted for most of the 71.36-point drop in the Dow Jones
Industrial Average to 11489.36.
But in some cases, investors need to consider whether to regard
companies as strictly operating companies or as some hybrid of
operating company and investment fund, akin to Berkshire Hathaway
Inc., which owns minority stakes in public companies but also has
full ownership of insurance and other operating companies.
Big portfolio gains are nothing new to Microsoft. Its new chief
financial officer, John Connors, says that while analysts shouldn't
stop viewing Microsoft as an operating rather than a portfolio
company, gains from investment are likely to recur, given the robust
stock market and Microsoft's huge portfolio of holdings. That
portfolio has quadrupled in value since September 1998.
While Intel's Mr. Bryant says the company has been selling some
positions quarter-by-quarter for three years, the size of the
portfolio -- which employs more than 100 people scouring the globe
for technology investments -- and the related gains now are so
large, Intel will hold regular monthly reviews of holdings.
But he also says Intel won't use its investment activity to
smooth earnings and meet Wall Street estimates. "We're not sitting
here trying to predict the market," he says. "All we're doing is
setting up a periodic program to bring some of the value back to the
corporation."
Compaq is about to more explicitly recognize its investment
activities. Chief Executive Michael D. Capellas says Compaq will
soon break the investment unit out of its strategy and technology
unit, making it a separate profit-and-loss division. "It's 20% of
the capitalization of the company," Mr. Capellas says. It has
certainly been a profitable unit. The value of Compaq's stake in the
AltaVista Internet search engine could ultimately approach the $9
billion Compaq paid in 1998 for its creator, former computer giant
Digital Equipment Corp. Compaq also has stakes in hot start-ups such
as Ask Jeeves Inc., NetZero Inc., Roadrunner Inc., and Internet Capital Group.
Further diverging from the portfolio's original purpose, Mr.
Capellas says he no longer will restrict new investments to
companies or technologies that directly benefit Compaq's computer
business. "We are in the business of predicting where technology is
going. So we are picking winners and losers," he says.
But such talk might give pause to investors, who generally base
their opinion of a stock on how the company's core business is
doing. In one sign of the shift, Wall Street earnings estimates for
Intel now incorporate stock sales. "If the market deteriorates,
Intel's earnings will as well. Intel's earnings are dependent on the
continued strong performance of the stock market," says Drew Peck,
an analyst at S.G. Cowen Securities. "We have never seen its value
attached to the stock market. We're in a world of New Age accounting
that raises the risk level."
It's not just technology companies where this is an issue. Chase Manhattan Corp.'s Chase Capital Partners,
which has stakes in newly public companies such as Cobalt Networks Inc. and Digital Island Inc., realized investment gains of
$1.31 billion in the fourth quarter, up from $244 million in the
year-earlier period. That helped the bank easily beat profit
estimates Wednesday.
San Francisco-based Wells Fargo, which merged with Minneapolis-based
Norwest Corp. in November 1998, saw its noninterest income soar 33%
in the most recent quarter, thanks to a $560 million gain recorded
by its venture capital division on the sale of Cerent Corp. to
Cisco.
Last year, General Electric's venture arm, GE Equity, invested
$1.5 billion, nearly three times the 1998 tally, much of that in
Internet and e-commerce firms. While its equity arm has been key in
helping GE learn more about the Internet culture, it also has been a
solid profit contributor, although GE doesn't break it out.
What worries some analysts is that investors may get used to the
contribution from these equity investments, then have a rude
awakening if the stock market falls and operations aren't strong
enough to pick up the slack. David Tice, president of an advisory
firm and fund manager bearing his name, cites the example of Coca-Cola. Coke "hasn't had that great sales growth
for some time, but they generated 20% earnings growth by selling
bottlers, so people got used to 20% earnings growth," he says. "When
they are unable to continue to generate those gains on sales,
suddenly investors wake up and say, 'Gee, this company is hardly
growing at all.' " Coke's stock is about 25% below its mid-1998
peak.
Coke has previously said that since it constantly invested in
bottling assets and then would sell them at the appropriate time,
those gains should be viewed as just another income stream, much
like selling concentrate. It dropped that explanation after analysts
protested.
Similar concerns surround some older companies whose employee
pension funds have enjoyed enormous gains from their stockholdings,
often enabling the companies to book pension income instead of
expense in their income statements. A Bear Stearns Cos. analysis
last fall found that 124 of the companies in the Standard &
Poor's 500-stock index had such gains in 1998, and that without
them, profits for the S&P 500 would have been 3% lower.
Mr. Schilit of the Center for Financial Research and Analysis
says Lucent Technologies Inc., for example, got 11% of
fiscal 1999's operating income from pension income. He doesn't fault
Lucent for the good fortune to have sizable pension income, but says
investors have to be aware that such income can mask problems in the
underlying business. Lucent's stock nose-dived earlier in January
when the company said its coming quarterly profit report would be
well short of estimates because of problems meeting customer demand
for certain products.
Lucent spokesman Bill Price says that by any measure, "we have
conservative accounting practices, and we focus on our core
businesses to help us grow revenues and earnings."
An interesting example is Comdisco Inc. of Rosemont, Ill. The leasing company
13 years ago started taking shares in small start-ups. On Dec. 22,
Comdisco surprised Wall Street with an unusual disclosure: Its
quarterly earnings would be 40% higher than consensus estimates
because of gains from the sale of some stockholdings. The company
has a portfolio of small stakes in about 430 companies.
Comdisco shares skyrocketed after an analyst concluded
unrecognized gains could be as high as $2 billion. But both the
company and Wall Street think the market might feel even better
about the company if the investments were broken off.
"We on the analytical side weren't going to value this as being
profits from continuing operations," says John B. Jones Jr., an
analyst at Salomon Smith Barney in San Francisco. Comdisco CEO
Nicholas K. Pontikes says the company expects to break out results
of its venture operation and create a "tracking stock" to reflect
the gains.
Yet Lehman's Mr. Willens, for one, suggests that "there's not a
fine distinction between investment gains and operating income,
where the investments are motivated more by strategic business
reasons. I would argue the investment gains should be considered
operating income ... because the those investments are also ways to
gain access to new technologies."
For stock-market investors, nasty surprises could be in store if
the types of income are mingled, warns Mr. Schilit of the Center for
Financial Research and Analysis. "If you're starting to see a
sizable portion of the income coming from selling investments, that
is clearly a weaker profile" for a company, he says. Then, to some
extent, "you're at the whim of the stock market."
-- David Bank contributed to this article.
Write to Greg Ip at gregory.ip@wsj.com, Gary McWilliams at gary.mcwilliams@wsj.com and Suzanne McGee at suzanne.mcgee@wsj.com |