Accounting Gumshoes

June 4, 2003, 3:15 PM ET

By John Dobosz

NEW YORK - Practically every month, we seem to be treated to another tale of accounting malfeasance. First there was the Enron debacle which brought down the merchant energy sector. Then Tyco International and HealthSouth.

Now mighty IBM (nyse: IBM) is facing an SEC probe because of questions about the way it recognized some revenue three years ago. There is a chance that the investigation will turn up nothing, but it also could discover that Big Blue has been playing accounting games and essentially misleading its investors.

It's a pretty well accepted tenet of equity investing that earnings growth and share price appreciation are inextricably linked over the long term. And since earnings growth is the key to valuation, figuring out whether or not current earnings (and growth) are real and sustainable is of paramount importance to most investors. In this new era of Sarbanes-Oxley and regulatory zeal, it comes as no surprise that advisory services have cropped up in an attempt to warn investors of company book-cooking.

For years, most of these advisory services focusing on earnings quality and dissecting company financial statements have been mostly the domain of professional money managers and other institutions.

One such high-end service is Dr. Howard Schilit's Rockville, Md.-based Center for Financial Research & Analysis, primarily an institutional shop that'll set you back $3,000 a month for real-time daily reports on accounting shenanigans at public companies. Schilit also wrote the book Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, and specializes in in-depth forensic accounting reports or case studies that dissect a company's financial statements. Recent case studies include Abbott Labs (nyse: ABT), Cisco Systems (nasdaq: CSCO) and Emulex (nasdaq: ELX).

Fortunately there are a number of lower-priced services now available. StockDiagnostics.com ($30 a month) provides a simple methodology for "diagnosing" stocks with what editor Michael Markowski calls "EPS syndrome"--when a company's operating cash flow goes negative to a degree that has a high predictive value of subsequent negative growth in reported earnings per share. "When these things go negative, the companies can be spectacular in their fall," says Markowski, a former analyst and broker for Merrill Lynch and Donaldson, Lufkin & Jenrette who developed his methodology based on post-mortem analysis of implosions at both Enron and Sunbeam. He puts out a weekly letter of alerts with both short and long ideas (the latter for companies with improving operating cash flow), and his site has a database searchable by ticker.

Markowski uses forest-based terminology to classify companies: seedlings and saplings are companies on the make, while kindling refers to companies with negative operating cash flow that are ready to go in flames. In this week's letter, his sapling of the week is wireless phone company Sprint PCS (nyse: PCS), which is showing five consecutive quarters of positive and growing operating cash flow. He also likes electronic-products maker Hubbell Inc. (nyse: HUB.b), which reported a 39% gain in first-quarter revenue, as well as 20 consecutive quarters of positive operating cash flow. Among his warnings: FedEx (nyse: FDX), which just reported its worst quarterly free cash flow ($519 million in the red) in five years. Combined with institutional and insider selling of the stock, and its current price near a 52-week high of $65, suggests to Markowski that FedEx shares are heading south.

One of last year's darling growth plays is Markowski's candidate for most likely to crash and burn in 2003: propane tank company Blue Rhino (nasdaq: RINO). "If I had to pick a disaster here, it's got to be RINO," says Markowski, who diagnosed the company with "EPS syndrome" at the end of January. (Incidentally, IBM shows strong and stable cash flow on StockDiagnostics' metrics and Markowski thinks investors would be wise to pick up shares of Big Blue at current prices.)

Our own Michael Ozanian puts out the monthly Forbes Earnings Quality Report, which uses a proprietary cash flow-based ranking system that highlights companies with low and high quality of earnings and projects whether or not a company is likely to meet its analysts' forecasts for earnings growth. Ozanian pores through financial statements for telltale signs that a company might be dressing up its earnings with things like aggressive pension plan assumptions or options issuance. In the past, Ozanian has flagged Starbucks (nasdaq: SBUX) and Quest Diagnostics (nyse: DGX) as companies with poor-quality earnings and recently wrote a scathing report on Weight Watchers (nyse: WTW), which he claims won't make its 25% EPS growth estimates because of weak cash generation and a high debt load. On the positive side, Ozanian's reports have praised the earnings of Home Depot (nyse: HD), eBay (nasdaq: EBAY) and Intel (nasdaq: INTC).