CNET’s Creative Accounting

Correction: In the following item I was wrong about CNET’s relationship to Snap, the Internet portal site it co-owns with NBC and its effect on the company’s future earnings. Candidate for most absurd business headline of the month, if not the year: “CNET Surprises Wall Street by Posting an Operating Profit,” from today’s Wall Street Journal.

CNET is the San Francisco-based online media company/would-be portal site/news provider that spent a great deal of time in the news recently after it announced a partnership with NBC to transform its Snap search engine into a portal site that could challenge Yahoo and Excite. CNET’s roots are in the world of hardcore Internet users, and CEO Halsey Minor says his company is on its way to becoming “the definitive computing and technology portal for Internet users,” but CNET’s ambitions seem to be broader than that.

Regardless, a crucial part of its portal strategy is building name recognition and credibility as a real contender for the portal throne. Increasingly, an important element in that strategy–which nearly all Internet companies are following–is demonstrating that you can be a profitable company. Although the conventional wisdom about the Net remains that you should not worry too much about the bottom line right now, and instead spend what’s necessary to gain mindshare, in the past year that wisdom has been complicated a bit. The ability of Yahoo to continue to grow in popularity while simultaneously turning a profit has made red ink mildly (though only mildly) less attractive to investors and, perhaps, to the business community in general.

In any case, CNET has taken that wisdom to heart and in its latest quarterly earnings report, released yesterday, it has left no depths unplumbed in its quest to present itself as a profitable company. The Journal headline merely reflected the first sentence of CNET’s press release, which said, “CNET today reported operating income of $1.1 million for the third quarter ended September 30, 1998, compared to an operating loss of $6.3 million in the third quarter of 1997.” The key word here, of course, is “operating,” since it means that CNET earned that $1.1 million from its continuing operations, the ones that it can be expected to rely on in the future, and that all one-time charges and one-time revenue gains (from stock sales, and the like) have been excluded.

Now, operating income is what really matters if you want to know how strong a company’s underlying business really is. (Well, actually cash flow is what really matters, but for the purposes of this argument the two things are similar enough). If General Motors makes $4 billion in a particular quarter from selling off one of its divisions, after all, that doesn’t really help you figure out how its real business is doing, since it’s not going to be able to make that $4 billion every quarter. Similarly, if GM takes a $600 million charge for restructuring costs in a given quarter, that’s not all that important, either, since it’s not going to be restructuring every quarter. (At least GM hopes not.)

The distinction between “operating” and “net” income isn’t always crystal clear–some companies seem to dump operating expenses into restructuring charges–but it’s generally pretty obvious. Unfortunately, CNET–like other Internet companies, including Excite – seems bent on obscuring that distinction in order to make itself look better.

Here’s how: In the latest quarter, CNET reported a gain of $5.3 million from selling part of its stake in a company called Vignette, and a $3.1 million loss from its “proportionate ownership of Snap.” It grouped those two transactions together as extraordinary items, and calculated its operating income without either of them.

Now, the Vignette transaction was clearly a one-time thing. Eventually, that stake will be all sold off, and CNET will reap no more revenue from it. But the loss CNET suffered from its investment in Snap is not a one-time thing. On the contrary, Snap is an essential part of CNET’s strategy going forward, and is the main reason why the stock has done as well as it has in the last six months. CNET devoted a whole section of its press release to Snap’s performance in the last quarter, calling it the “fastest-growing search engine,” and Minor’s “portal” comment makes no sense if you exclude Snap. So in what sense could Snap’s results not count as operating income (or rather losses) for CNET?

In no sense, if CNET were being honest. But if you include Snap’s results, then CNET actually lost money in the last quarter, and the Journal doesn’t get to run that headline. In the quest for profitability, any attempt to present an honest picture of how the company is actually doing gets trampled.

The funny thing, though, is that if CNET was trying to trick the Street, it didn’t work. Although the stock opened way up this morning, with people presumably buying without looking too closely at the numbers, it was down 5 points from its high by the end of the day, five percent below where it closed yesterday. As I argued a few weeks ago in another article about accounting, in the end the market will figure out what the real numbers are. Smoke and mirrors only work for so long.