To be sure, Motorola also faces profit-margin pressure in several key business segments. In semiconductors, which account for about 20 percent of sales, margins are only in the high single digits. But part of the profit pressure is offset–at least on the income statement–with nonoperating gains. The most noteworthy example came during the quarter that ended last March 31, when Motorola sold an investment booked to the wireless segment. By classifying the gain as operating income, Motorola managed to turn a 41 percent year-over-year decline in quarterly operating income into a 35 percent increase, according to the analyst who requested anonymity.
Investors often ignore investment gains because they have no assurance that they will recur, and so consider them one-time events that have little bearing on a company’s ongoing fortunes. Whether such gains should be ignored is another matter. Some analysts contend they should not be, at least under narrowly defined circumstances.
In the February issue of SoundBytes, a technology newsletter published by Credit Suisse First Boston, analyst Michael Kwatinetz argued that Cisco Systems Inc.’s investment portfolio, for instance, should be considered part of its ongoing business under four conditions. First, the amount of gains realized in a given quarter must be less than 7 percent of the total (therefore foreshadowing about four years of such gains). Second, the company must intend to consistently take this level of gain. Third, the gains must be a result of investments in related businesses. And fourth, the company’s investment track record must support the notion that further gains are likely. Because Cisco’s investment portfolio meets all four conditions, Kwatinetz wrote, “we believe it’s operational in nature.”
Motorola, for its part, evidently believes its own gains pass muster. How else to explain the fact that such income is used to reduce the figures it reports for sales, general, and administrative expenses? Again, that isn’t necessarily a violation of GAAP. “This use of investment gains is usually disclosed in a footnote,” says another analyst. But he notes that that’s sufficient for purposes of GAAP if the company can claim the impact isn’t material.
Motorola is far from alone in masking operating weaknesses in this fashion. IBM, for instance, used the gain on the sale of Global Network, its telecommunications technology business, to AT&T to reduce its SG&A in 1999 by $2 billion. Cost cutting, of course, translates into more operating cash flow as well as net income. But again, critics contend the accounting treatment, while not a technical violation of GAAP, is misleading. And the fact remains that IBM’s growth in operating cash flow for the three years that ended last March trailed that of its net income by 35 percent. (At #102, IBM narrowly missed inclusion in our list.)
Some companies on the list that have significant investment gains don’t account for them in this fashion. Texas Instruments, for example, enjoyed a big gain from selling a piece of its equity holding in Micron Technology Inc. earlier this year, a stake it acquired in return for selling Micron its memory-chip business in 1998. TI still holds quite a bit of Micron stock. But rather than treat the recent gain as part of its operations, using it to reduce its SG&A and boost its operating income, TI chose to account for it as an extraordinary item. By treating such nonoperational results as noncash items, says CFO Aylesworth, “we get to operating results that are most meaningful.”