…BUT THE ANALYSTS HAVE IT ALL FIGURED OUT: SAY THE DISCOUNT PENSION INCOME WHEN JUDGING PERFORMANCE

Companies that pump up corporate earnings by including pension income with operating income aren’t fooling the pros who follow the stocks.

Analysts say they already discount pension income when analyzing how well a company is performing. That’s in large part because most analysts consider such earnings unsustainable or low quality.

Among those using their pension surpluses to paint prettier pictures: The Boeing Co., Lucent Technologies Inc. and Northrop Grumman Corp.

“Many analysts don’t consider pension surpluses when looking at a company’s earnings,” says Syl Marquardt, research director at John Hancock Funds in Boston, which owned 854,000 shares of Lucent as of June 30, according to First Call Share Watch of Boston (formerly CDA/Spectrum).

Around 15% of Lucent’s operating income is from its pension surplus, according to a report by Bear Stearns Cos. Inc. in New York, which studied the companies in the Standard & Poor’s 500 stock index and found that in 1998, 17 adjusted operating income by 15% or more above what was reported as operating income by adding in investment income from their pension funds.

“My view is that including pension surpluses overstates earnings. We look at the quality of earnings. Anything that’s non-durable would not have the same value as recurring earnings,” says Mr. Marquardt.

The pension income is actually a temporary benefit, or penalty, depending on whether it’s a bull or a bear market, Mr. Marquardt adds some firms are changing the way they report earnings. “They are using an economic value-added approach, reporting cash returns on cash investments. We expect to see more and more of this.” That, in turn, would eliminate the pension surplus reporting.

Mike Holton, an investment analyst who follows Boeing at T. Rowe Price Associates in Baltimore, says: “When you look at the Boeing earnings, it doesn’t matter if they have added in their pension income, because their earnings level has been so low to begin with. Earnings in 1998 were higher than in 1997, because of the pension surplus. But it’s not a big number anyway and no one would buy it based on that.”

T. Rowe owned 37 million shares of Boeing as of June 30, according to First Call.

Pension income boosted Northrop Grumman’s earnings by as much as $3 per share, Mr. Holton says. T. Rowe Price owned 88,000 shares of Northrop as of June 30, according to First Call.

Joel Litman, director at Holt Value Associates in Chicago, says companies are supposed to include pension income with their earnings under the Financial Accounting Standards Board regulations, but it can be difficult to understand what is truly coming from operations.

says many favor a change

“Companies are supposed to explain what is pension income in their footnotes, but they could include more information. It’s not the easiest thing to dig it out.”

His firm calculates cash flow returns on investments so investors can see the true performance of a company. Mr. Litman believes a lot of analysts would like to see a change in the reporting methods.

Keith Patriquin, a senior analyst at Loomis Sayles & Co. LP in Boston, says including pension income in operating earnings muddies the waters. “If pension income per share changes earnings considerably, we tend to exclude it. If it’s an insignificant amount, we might not. But if it’s significant, it should be subtracted and we do.”

Pension income is “very significant at Northrop Grumman,” Mr. Patriquin says. “For 1999, we expect the company to report earnings of $6.59 a share. Of that, $3.30 is pension income. If you subtract that, it brings the figure to $3.29 a share. Then we add $2.90 in good-will amortization from Northrop’s acquisitions of units of Westinghouse Electric Corp. and Grumman Corp., and it comes to $6.19. That is the number I will look at.”

Loomis owned 165,000 shares of Northrop and 253,000 shares of Boeing as of June 30, according to First Call.

Mr. Patriquin does the same computations when comparing earnings of competitors such as Boeing. In that case, he says, he subtracts 40 cents a share of pension income from the $1.50 in earnings the company is expected to report for the year, and then adds $1.05 a share for the good-will amortization for acquisitions of Martin Marietta Corp. and Loral Corp., bringing the final earnings number to $2.15.

Those numbers are understood by most institutional investors, Mr. Patriquin says. They allow investors to assess companies in terms of risk-reward factors. However, he worries that investors who use quantitative screens may not look at all the details he does.

“If a stock’s earnings change a lot, some investors might buy or sell the stock based on the change, without considering the quality of the earnings.”

The earnings figures that are reported each quarter are filtered through First Call, which publishes consensus earnings estimates based on an average of what analysts at major retail brokerage firms expect companies to earn.

These analysts, known as sell-side analysts, view earnings differently from the buy-side analysts who work at money management firms running money for big institutional clients.

Chuck Hill, director of research at First Call, says sell-side analysts never break out pension income.

“They choose to keep it there. The issue has not come up. It’s not even on the radar screen. We look at earnings from continuing operations, and go with what a majority of analysts want to do. Maybe it (including pension income) should be discussed more, but we don’t set policy. It’s set by the analysts we survey.”

Buy-side analysts don’t publicize their estimates, so they’re not included in the First Call surveys.

Mr. Patriquin says if a company reports earnings that appear high and the stock then trades up on momentum buying, a lot of investors might not realize why the earnings are so high or what’s going on.

Crain News Service