Company News: The Good, the Bad, and the Ugly
Posted by Larry Doyle on April 16, 2009 8:04 AM |
We have had a stream of earnings results from banks this week. The earnings from Wells Fargo, Goldman Sachs, and JP Morgan have all surprised to the upside. Interestingly, though, the degree of transparency and “quality” of earnings has been decidedly different with each of these institutions.
JP Morgan just released earnings this morning. Earnings per share came in at .40 versus an expectation of .32. The quick snapsot of the numbers reveals broad based positive results across retail banking, equity trading, and fixed income trading. JPM significantly increased loan loss reserves and CEO Jamie Dimon cautioned that the bank may have to further increase reserves given the challenging economic environment. The bank also took significant markdowns in private equity investments.
The lifeblood for any bank is the deposit base, the ultimate source of relative cheap funds. JPM’s deposit base has grown 62% year over year with the acquisition of Washington Mutual.
Dimon and JPM distinguish themselves as the true leader in U.S. banking.
Goldman’s earnings gamed the calendar as they did not make an apples to apples comaprison versus a year ago. What does that mean? Goldman changed its reporting calendar from a December-November reporting period to January-December reporting. In doing so, Goldman did not fully highlight the disastrous numbers in December 2008. While Goldman’s franchise and risk management are superb, the headline report was not totally forthcoming.
Let’s revisit the Wells Fargo report. Many analysts initially questioned the lack of transparency and overall quality of earnings reported by Wells. Jonathan Weil of Bloomberg again stands out by the depth of his analysis. He reports Wells Fargo Profit Looks Too Good To Be True. Weil highlights 4 gimmicks:
Gimmick 1: Cookie Jar Reserves
Wells’s earnings may have gotten a boost from an accounting maneuver, since banned, that it used last year as part of its $12.5 billion purchase of Wachovia Corp. Specifically, Wells carried over a $7.5 billion loan-loss allowance from Wachovia’s balance sheet onto its own books — the effect of which I’ll explain in a moment.
First, a quick tutorial: Loan-loss allowances are the reserves lenders set up on their balance sheets in anticipation of future credit losses. The expenses that lenders record to boost their loan-loss allowances are called provisions. As loans are written off, lenders record charge-offs, reducing their allowance.
Once it took control of the reserve from Wachovia, Wells was free to start dipping into it to absorb new credit losses on all sorts of loans, including loans Wells had originated itself. (Think of a child raiding a cookie jar.)
The upshot is that Wells could get by with reduced provisions until the $7.5 billion is used up, boosting net income.
Wells, which completed its purchase of Wachovia on Dec. 31, wouldn’t have been allowed to carry over the allowance had it completed the acquisition a day later. On Jan. 1, new rules by the Financial Accounting Standards Board took effect prohibiting such transfers. A Wells spokeswoman, Janis Smith, declined to comment.
Gimmick 2: Cooked Capital
The most closely watched measure of a bank’s capital these days is a bare-bones metric called tangible common equity. While the term doesn’t have a standardized definition under generally accepted accounting principles, it typically means a company’s shareholder equity, excluding preferred stock and intangible assets, such as goodwill leftover from past acquisitions.
Measured this way, Wells had $13.5 billion of tangible common equity as of Dec. 31, or 1.1 percent of tangible assets. Yet in a March 6 press release, Wells said its year-end tangible common equity was $36 billion. Wells didn’t say how it arrived at that figure. Nor could I figure out from the disclosures in Wells’s annual report how it got a number so high.
Investors shouldn’t have to guess. Under a Securities and Exchange Commission rule called Regulation G, companies that release non-GAAP financial measures are required to disclose “a reconciliation of the disclosed non-GAAP financial measure to the most directly comparable GAAP financial measure.” (The rule applies to press releases, as well as formal SEC filings.) That way, anyone can see how the numbers were calculated.
Wells didn’t do this in its March 6 release. A spokeswoman, Julia Tunis Bernard, declined to tell me the math Wells used. Silly me — I thought the SEC’s rules apply to Wells Fargo, too.
Gimmick 3: Otherworldly Assets
Look at Wells’s Dec. 31 balance sheet, and you’ll see a $109.8 billion line item called “other assets.” What’s in that number? For that breakdown, you need to go to a footnote in Wells’s financial statements. And here’s where it gets comical.
The footnote says the largest component was a $44.2 billion bucket that Wells labeled as “other.” Yes, that’s right: The biggest portion of “other assets” was “other.” And what did this include? The disclosure didn’t say. Neither would Bernard.
Talk about a black box. That $44.2 billion is more than Wells’s tangible common equity, even using the bank’s dodgy number. And we don’t have a clue what’s in there.
Gimmick 4: Buried Losses
How quickly investors forget. One week before Wells’s earnings news, the FASB caved to pressure by the banking industry and passed new rules that let companies ignore large, long-term losses on the debt securities they own when reporting net income.
Wells didn’t say what its first-quarter earnings would have been without the rule change, which companies can apply to their latest quarterly results. As of Dec. 31, though, Wells had $12.2 billion of gross losses on securities held for sale that weren’t included in earnings. Of those, $4.2 billion were on securities that had been worth less than their cost for more than a year.
The bottom line: Net income isn’t necessarily income. And it means nothing without complete financial statements.
Investors should have learned this lesson by now.
In layman’s terms, “would you buy a used car from an outfit like Wells Fargo?”
One final story needs to be highlighted. Bloomberg reports General Growth Seeks Chapter 11 Bankruptcy
General Growth Properties Inc., the second-largest U.S. shopping-mall owner, filed for bankruptcy after failing to refinance more than $27 billion of debt, most of it racked up through acquisitions.
General Growth, which owns more than 200 shopping malls in the U.S., sought Chapter 11 protection in U.S. Bankruptcy Court in New York. The company listed $29.5 billion in total assets and debts of about $27.3 billion, making it the largest real estate bankruptcy in U.S. history.
“While we have worked tirelessly in the past several months to address our maturing debts, the collapse of the credit markets has made it impossible for us to refinance maturing debt outside of Chapter 11,” Chief Executive Officer Adam Metz said in a statement today.
The filing lists Eurohypo AG, a unit of Commerzbank AG, as General Growth’s largest unsecured creditor with claims totaling $2.6 billion under two loans. Noteholders are owed about $4 billion in total. Much of the company’s debt can be traced to its $11.3 billion purchase of commercial-property developer Rouse Co. in 2004.
The Chicago-based company lost 81 percent of its market value in six months after saying repeatedly it may have to file for bankruptcy. General Growth closed at $1.05 in New York Stock Exchange composite trading yesterday, valuing the company at $329 million. The shares traded as high as $67 in March 2007.
Regrettably, GGP represents the first in a likely stream of commercial real estate companies filing for bankruptcy. This corner of the market will also severly impact insurance companies and bank holding companies also holding large amounts of commercial real estate.