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You'll find our Special Sections, FoolWires, and earnings reports, on either the Evening News or Stock Research screens. In tonight's Fool on the Hill, MF Templar focuses on America Online. Enjoy!
JETFORM CORPORATION <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: FORMF)") else Response.Write("(NASDAQ: FORMF)") end if %>
1-800-408-3053 (passcode: 0910) -- replay avail. after 7 p.m. EDT
Healthcare software maker IMNET SYSTEMS, INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: IMNT)") else Response.Write("(NASDAQ: IMNT)") end if %> traded up throughout the day on news that James Gilbert was coming on board from HBO & CO. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: HBOC)") else Response.Write("(NASDAQ: HBOC)") end if %>. Gilbert was most recently Vice President and General Counsel at that healthcare information technologies powerhouse, and was a key player in integrating HBO acquisitions IBAX and the Health Systems Group of FIRST DATA CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FDC)") else Response.Write("(NYSE: FDC)") end if %>. While Bear Stearns recently downgraded Imnet on accounts receivable concerns, analyst Anthony Vallenti at UBS Securities reiterated a "buy" rating this morning. Vallenti told me this afternoon that he believes Gilbert brings excellent executive experience to Imnet and that his appointment will allow Chair Ken Rardin to focus on the things that Chairs should focus on, namely strategy and acquisitions. In addition, HBOC and Imnet recently signed a seven-year exclusive deal, in which HBO will integrate Imnet's document imaging software into HBO's products as well as distribute Imnet's products. Imnet closed the day at $18 1/4, up from $15 3/4.
IOMEGA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: IOMG)") else Response.Write("(NASDAQ: IOMG)") end if %> traded up $2 1/8 on heavy volume on the news that the company and Matsushita Communications Co. signed an agreement under which Matsushita is granted a nonexclusive worldwide license to produce Zip drives and sell them, under Matsushita's brand names and on an OEM basis, to companies like Toshiba. Toshiba, the top corporate laptop company with large mobile customers such as PROCTER & GAMBLE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PG)") else Response.Write("(NYSE: PG)") end if %>, recently showed a unit with Iomega's internal 15 mm. form-factor Zip. In Iomega's Q2 1996 conference call, CEO Kim Edwards identified such OEM deals as the company's primary objective for the current and near-future quarters. Iomega finished the day's trading at $15 7/16.
QUICK TAKES: ENCAD, INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: ENCD)") else Response.Write("(NASDAQ: ENCD)") end if %> was up big on positive revenues guidance from its management, moving up $4 3/4 to $33 1/4... PILLOWTEX CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PTX)") else Response.Write("(NYSE: PTX)") end if %> was fluffed up by $1 1/8, closing at $13 5/8 on a "buy" recommendation from Interstate/Johnson... LERNOUT & HAUSPIE SPEECH PRODUCTS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: LHSPF)") else Response.Write("(NASDAQ: LHSPF)") end if %> finished strongly at $3 1/2, moving from $23 on news that a British software company agreed to buy their products. An analyst at Hambrecht and Quist, which was part of the syndicate that brought L&H public, said that there will be news released soon that will make the company good buy... Interstate/Johnson was busy today, as analyst Kay Norwood upgraded GALEY & LORD INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GNL)") else Response.Write("(NYSE: GNL)") end if %> to "buy" today. When I spoke with Ms. Norwood and asked, "Why the upgrade?", she said, "That information is really intended for our clients." Thanks for the helping hand, Kay. Take care now, bye-bye. GNL finished up $1 1/4 to $12 3/8...
MORE QUICK TAKES: PLC SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: PLC)") else Response.Write("(AMEX: PLC)") end if %> shed some regulatory burdens and leapt $4 3/8 to $25 7/8... INTERLINK ELECTRONICS (NASDAQ/SC: LINK) announced a device allowing one-touch access for answering the telephone, playing a CD, or turning on the TV or FM radio -- for Toshiba's recently introduced line of Infinia multimedia home PCs. LINK finished trading at $7 3/8, up $15/16.... BIOVAIL CORP INTL <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: BVF)") else Response.Write("(AMEX: BVF)") end if %> continues up on the Barron's/George Soros/short sqeeze effect started yesterday, closing up $3 1/4 at $33 7/8... SUMMA FOUR <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: SUMA)") else Response.Write("(NASDAQ: SUMA)") end if %> announced after the bell a multi-million contract with INTERNATIONAL BUSINESS MACHINES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> to supply central-office switching equipment and finished up $2 1/4 to $15 3/4.
Lady Luck frowned on hotel/motel concern ITT <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ITT)") else Response.Write("(NYSE: ITT)") end if %> today. The company announced that it would miss earnings estimates, foreseeing earnings coming in around $0.56, compared with estimates of $0.82. The shortfall is being blamed, in part, on huge losses at the high-limit baccarat tables at its Caesars Palace casino. Apparently, a few gentlemen walked away from the table with over $15 million -- a significant chunk of the casino's gaming revenues. Caesars will have a hard time making up the loss as it is in the middle of a construction phase which is disrupting business. With the stock down $7 3/4 to $48 1/4, Caesars's bad luck has helped push down ITT's market capitalization over $900 million for the day.
Yesterday's strong rise is being tempered by profit-taking in the market today. COMPUWARE CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: CPWR)") else Response.Write("(NASDAQ: CPWR)") end if %> dropped $1 1/4 to $43 1/4 despite unveiling its service plan for Year-2000 solutions. STRATASYS INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: SSYS)") else Response.Write("(NASDAQ: SSYS)") end if %>, which received a Japanese patent for its prototyping technology and jumped up 25% yesterday, was down $1 13/16 to $20. NETMANAGE INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: NETM)") else Response.Write("(NASDAQ: NETM)") end if %> was up yesterday on news that its TCP/IP solutions had been approved for use with AT&T's CDPD, but retreated $13/16 to $8 9/16 today. ISOCOR <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: ICOR)") else Response.Write("(NASDAQ: ICOR)") end if %> was up 12% yesterday after signing a marketing and co-development contract for an integrated directory service product, but gave back $1 1/18 to close at $8 1/8.
And you thought everybody was enjoying cool weather this summer. Not the people at INTERNATIONAL FLAVOR & FRAGRANCE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IFF)") else Response.Write("(NYSE: IFF)") end if %>, who are expecting tasteless third quarter earnings per share (EPS) in the $0.47 to $0.49 range, well below estimates of $0.62 a share and $0.59 a year ago. The company indicated that lower flavor sales to the beverage, ice cream and yogurt industries, due the mild and wet summer in the U.S and Europe, were to blame for the shortfall. IFF said it expects to fall even further below estimates in the fourth quarter, and the stock traded down $1 1/2 to $43 3/8.
QUICK CUTS: Stock of trucking concern CALIBER SYSTEMS INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CBB)") else Response.Write("(NYSE: CBB)") end if %> was hauled down $1 to $16 3/8 after a brokerage firm reportedly cut its earnings estimates and the stock again made First Call's list of lowest-rated stocks of the week... Goldman Sachs made negative comments about the prospects for decision support software developer BUSINESS OBJECTS ADS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: BOBJY)") else Response.Write("(NASDAQ: BOBJY)") end if %>, pushing the stock down $2 7/8 to $13... OPINION RESEARCH (NASDQ: ORCI) was crushed for $2 to $4 1/4 after reporting EPS of $0.02 for the third quarter (compared with consensus estimates of $0.13) and indicating that it wouldn't come close to 4th quarter estimates of $0.16... PRAEGITZER INDUSTRIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NASDAQ: PGTZ)") else Response.Write("(NASDAQ: PGTZ)") end if %> announced that lower revenues and margins, combined with higher expenditures (always a bad combo!) would keep EPS below estimates for the quarter, dropping the stock $3 1/2 to $9 3/16.
An Investment Opinion
by Randy Befumo (MF Templar)
FOOL ON THE HILL
Accounting for America Online
America Online's accounting has been the subject of a lot of criticism, ranging from justifiable to crackpot. The noise generated by a number of cranks has obscured an already complicated issue. There are a number of components in America Online's publicly-reported earnings that are being conflated and confused by both well-meaning bulls and cranky bears. There is quite a bit of misunderstanding about Deferred Subscriber Acquisition Costs, Retained Earnings, Loss Carryforwards and the Statement of Cash Flows that I want to take some time today to examine in more detail.
America Online is a company that engenders strong feelings. There are several newsgroups dedicated to anti-America Online propaganda that accuse the company of being everything from a crusher of souls to a CIA front. Big Blue Triangle can be proud of the fact that the only other company people love to hate as much would seem to be Microsoft. Because of these strong feelings, opinions tend to get a little irrational whenever the company is discussed. Even those with credible arguments on either side of the investment equation tend to be derided by their "opponents" for being shills or psychopaths. The examination that follows is an attempt to shed light, not to obfuscate the truth, although anyone who disagrees will take great pains to prove the opposite.
Facts about America Online are more a matter of interpretation than for most other publicly-traded companies. This is a situation that is caused by America Online's protective policy of releasing material information to only a select group of analysts and keeping some even more vital numbers to themselves. I assume that America Online believes the information would be misunderstood by most people who would read it, which is why they would keep it close to the vest. Nevertheless, its absence from the public space fuels all kinds of ugly speculation. The lack of easy and unrestricted access to certain crucial pieces of information does more harm than good, allowing whisper campaigns and misinformation an extended half-life. A rededicated policy of openness toward those who "own" the company would best serve its long-term interests, even if it causes more short-term volatility.
Deferred Subscriber Acquisition Costs
This is the most difficult part of America Online's accounting to understand. First, let's go through some definitions. Subscriber acquisitions costs are those costs engendered when you bring someone online. This means that they get a disk, pop it in, create a screenname, enter in a credit card, and start using their free time. Subscriber acquisition costs include everything from postage for mailing disks to free time on America Online's massive network, the most expensive piece of the puzzle. The money spent to acquire a subscriber needs to be accounted for from the moment someone signs online for the first time and starts using their allotted time.
Now, America Online could just book all of its subscriber acquisition costs from the moment the subscriber starts using the service. This would be a relatively clean accounting, although earnings would be massively negative as a result. Between the costs of building out its network and the money spent acquiring subscribers, America Online would post quarterly losses -- much like cable, cellular and other subscription-based broadcast services. As with other capital-intensive, subscription-based enterprises, investors would simply need to value the company based on subscribers, the installed network or through some evaluation of the value of its franchise.
America Online chose a different path. Reasoning that it was selling a subscription like a magazine, the company decided to defer the full costs of bringing on a subscriber and amortize that cost over the projected lifespan of a subscriber. If it cost $120 to bring on Subscriber A, and the projected lifespan was twelve months, then America Online would charge themselves $10 a month over this time period. A staple of the magazine industry, amortization of subscriber acquisition costs is an attempt to match cash out-flows against the concomitant cash in-flows. If you are gonna get $240 in revenues over twelve months from the subscriber in $20 increments, why not match each $20 to the $10 in costs for that month and show positive earnings in all twelve months rather than one really negative month in the beginning and eleven overly positive months towards the end?
Critics of this decision are many, and even its supporters have to admit it is aggressive. When a magazine gets a subscription fee, it claims to get it all at once. If you were to subscribe to Time, you would pay your $60 in one lump sum. Time would recognize $5 of revenue each month and charge this against the amortized costs of acquiring you. Since it recognizes the revenues using accrual accounting, it makes sense to recognize costs in the same way. America Online, the critics contend, does not get the fee all at once, and therefore, is not justified in match accrual accounting of revenues with amortized subscriber acquisition costs. Sure, its revenues are monthly "accruals" -- only because at any point the subscriber can cancel!
The sharp contrast that those against the policy want to draw is obscured when you examine magazine subscription practices more closely. Giants like TIME-WARNER <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TWX)") else Response.Write("(NYSE: TWX)") end if %> or READER'S DIGEST <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RDA)") else Response.Write("(NYSE: RDA)") end if %> all practice some form of accrual accounting with their revenues, and amortize their cost of acquisitions. But many magazine subscribers now pay in installments, not all at once. However, these subscribers are accounted for as if they did pay all at once using the old methodology. Furthermore, a magazine subscriber can cancel at will and get the balance of the subscription back. Although they might be a little less likely to cancel if they have already given the magazine company the money, you can bet that if they do not like the product, they will try to get their money back. So the illusions that they get the money all at once or that having all the money at once is somehow more "certain" need to be dispelled when comparing the two set-ups.
Does it make sense for America Online to try to match its subscriber acquisition costs with its revenues from those subscribers? Conceptually, I think it does. America Online reports the deferred subscriber acquisition balance each quarter and amortizes an unspecified amount, which is part of the sales and marketing expenses on the Statement of Earnings. Should America Online specify exactly how much is being amortized? I think it should, in the interests of keeping its owners informed of material facts that enable them to value the business.
In the end, seeing its monthly revenue stream as an accrual stream rather than twelve isolated purchases makes sense to me. When you cancel a magazine, you don't cancel your mailing address. When you cancel an online service, you do. For anyone who has changed a mailing address, you know what a pain it can be to do this. This as much as any proprietary content or improved functionality will keep old subscribers around if the service is priced correctly. $10 a month with the option to use flashsessions to minimize online time is definitely competitive with even the most aggressive Internet Service Provider offerings, and I do not see many people migrating to save a buck or two a month at the expense of changing all of their business cards.
Loss Carryforwards and Retained Earnings
There has been a lot of noise on our America Online message board lately from some accounting-impaired individuals stressing something they are calling "loss carryforwards," and implying that these are a bad thing. They quote the following part of the most recent 10-Q (a document filed with the SEC detailing the quarterly earnings):
"As of March 31, 1996, the Company had available net operating loss carryforwards of approximately $394,237,000 for tax purposes, which will be available, subject to certain annual limitations, to offset future taxable income. If not used, these loss carryforwards will expire between 2002 and 2011."
A loss carryforward is a loss that has already been recognized on the Statement of Earnings that has yet to be used for tax purposes. This means that the loss has already been reported as a charge against earnings for a specific quarter, but the tax benefit of the charge has not been recognized. When you lose money as a business, the government actually lets you recognize the losses as negative taxes, i.e. money that they owe to you, the business. When you make money in the future, you are able to use the loss carryforwards to get out of paying taxes. If you have $2,000 of carryforwards, and owe $2,000 in taxes, you pay nothing to the IRS.
Quite frankly, loss carryforwards are a good thing if you think the company can make money in the future. They are definitely not in and of themselves a bad thing, unless you simply say they are an indication that the business model is bankrupt and future losses of this magnitude should be expected. Given the amount of these carryforwards that have resulted from expensing acquired research and development costs when America Online has bought a company, it is hard to say that they are part of the core operating model and imply anything at all. Those negative on the company are much better off focusing on the Statement of Cash Flows.
The Statement of Cash Flows
In the interests of full disclosure, I have to say at this point that I like America Online the company as well as the service. I have some qualms about how and why they report some material facts, but by and large I think this is a shareholder-oriented management and a company with a credible plan to turn online entertainment into a profitable business. However, when people say America Online is a "speculative" stock, looking at the cash flow it is hard to disagree with them. The reason why America Online has gone from $71 to $27 in the last few months is that the company began to eat a tremendous amount of cash without a lot of measurable benefits, as far as subscriber numbers go. For anyone out there banging their head against the wall trying to figure out why the stock is going down when the earnings are good, look no further than the Statement of Cash Flows.
Recently, someone on the America Online message board made a point of stressing that America Online uses "two books" to do its accounting. Of course it does -- every publicly-traded company does. The Statement of Earnings and the Statement of Cash Flows are two separate documents. The statement of earnings accounts for recognized costs accrued in generating the earnings whereas cash flow takes everything into account, reconciling the Statement of Earnings with the Consolidated Balance Sheet. Double-entry bookkeeping is one of the foundations of our culture -- that cash flows and earnings can diverge widely is simply a fact of life, not an effort to deceive.
Cash flow reconciles earnings with the balance sheet. What happens is that there are some things on the balance sheet that affect assets and liabilities which need to be accounted for along with earnings. A Statement of Cash Flows literally tells you where the cash flowed from and where it went to. It begins with reported earnings and takes into account every balance sheet item from inventories to financing proceeds. For America Online specifically, cash flow is really important. Because it has decided to amortize subscriber acquisition costs, what it does is put these costs as an asset on the balance and amortize a chunk of it every quarter. You see this money flow through the Statement of Cash Flows even though it is invisible on the Statement of Earnings.
In the third quarter, America Online ate up as much cash as it had in the past two quarters combined. It was a bad quarter for churn, and the company was justifiably concerned that unless it paid attention to that factor, it would chew through all of its money. When you have negative cash flow and you run out of money, it means you take on debt if you can or issue stock if you cannot. Although America Online has been getting a fair bit of cash from financing in the form of lump sum payments from overseas partners like Bertlesman or Mitsui, it also has had true secondary offerings and many were concerned the third quarter's results augured another one. Although I have not yet seen a Statement of Cash Flows from the fourth quarter, my assumption is that some of the negative action in the stock lately is a result of people who have this information or believe that they know what this information is. To my knowledge, it has yet to be filed officially.
Eating cash is not a good thing. Many very sensible investors never buy a company that eats cash -- including, ironically enough, a number of Fools. Conservative investors definitely steer clear and cash-flow negative companies are incredibly volatile. Yes, America Online reports quarterly earnings. But these earnings are diminished by various charges in the actual cash flow and in fact leave the company losing money from operations and only keeping up its net cash positive position through Cash Flows from Investing (selling assets) or Cash Flows from Financing (taking on debt or selling equity). Len Leader, America Online's chief financial officer, has said the company would be cash flow positive at the end of fiscal 1997, but until that comes to pass, there is cause for concern. In closing, the real bears in my opinion are the ones who understand the Statement of Cash Flows and the real bulls are the ones who understand brand, service and franchise. The real story will not be told for another four quarters, meaning that in the interim all the bears will declare victory to some degree or another.