“Adjusted” earnings are becoming an epidemic.
According to analysts at Bank of America Merrill Lynch, the percentage of companies reporting “adjusted” earnings has increased sharply over the last 18 months or so.
About 90% of companies now report earnings on an “adjusted” basis.
These earnings often exclude items a company deems “special,” or “one-time,” or “extraordinary.” Investors, then, are left with a muddier picture of what companies are really making.
A company would argue these are “clean” numbers that exclude things investors need not concern themselves with. In this sense, then, companies would like you to look at less of themselves to make a decision about their real value.
“We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power,” BAML wrote in a note to clients on Tuesday.
BAML adds (emphasis ours):
Consider that when US GDP growth was averaging 3% (the 5 quarters September 2013 through September 2014) on average 80% of US HY companies reported earnings on an adjusted basis. Since September 2014, however, with US GDP averaging just 1.9%, over 87% of companies have reported on an adjusted basis. Perhaps even more telling, between the end of 2010 and 2013, the percentage of companies reporting adjusted EBITDA was relatively constant and since 2013, the number has been on a steady rise.
We are increasingly concerned with this trend, as on an unadjusted basis non-commodity earnings growth has been negative 2 of the last 4 quarters, representing the worst 4 quarter average earnings growth in a non-recessionary period since late 2000.
GAAP earnings, or earnings that follow Generally Accepted Accounting Principles, are what many executives and analysts would have you believe is the “rough cut” of a company’s financial condition (and hence, less representative of the company’s underlying condition).
GAAP earnings, for example, include any charges a company may have incurred during a quarter — say, as part of selling a unit or something — and a bunch of other things. In an effort to “clean up” earnings, companies adjust these earnings to outline what management argues is the true picture of the company’s actual operations.
(A popular “clean” number to cite is a company’s EBITDA, or Earnings Before Interest, Tax, Depreciation, and Amortization. Charlie Munger has said, “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.” So there’s that. There’s also non-GAAP, which is not exactly the same thing but also a proxy for “adjusted” earnings.)
And as we’ve written before, this idea that there is an
actual operation to measure is itself just a mirage.
Ben Graham, the godfather of value investing, wrote at length about his concerns with regard to corporate accounting in his book “The Intelligent Investor.” Using Alcoa’s four different quarterly earnings figures from a quarter in 1970 as an example, Graham argues that the “true” value of a company doesn’t exist the way some on Wall Street would have you believe.
The over-arching point of Graham’s analysis is that you could claim anything that didn’t happen exactly the same way in the prior quarter is a “one-time item” for a company. The problem is that this sort of ignores how businesses actually work. Which is to say: things happen, sometimes once, sometimes more than that. Which of these things matters is the whole challenge of being an investor (perhaps, even, an intelligent one).
And in the current environment there is another related phenomenon also cropping up.
In a note late last year, Bank of America highlighted what it called “worrisome gaps” (lots of gap imagery here) in earnings reports. Basically, the number of companies beating on earnings has been increasing at the same time the number of companies missing on sales is also ticking higher.
The firm also noted that these “adjusted” earnings were beating GAAP earnings by about 30% on average, the most since the financial crisis.
This is a conundrum.
Common sense says growing profits while losing sales takes some kind of accounting wizardry to accomplish — outside of, say, a one-time (!) transformation that makes this possible — and the fact that roughly 60% of companies were beating on profit while 60% were missing on revenue is a concern. (It’s unclear what the overlap is here on a company-specific level, but the market-wide trend is the issue here.)
And like Graham’s discussion of the four alternatives for Alcoa’s quarterly earnings, we could argue about whether or not certain dynamics in corporate America have changed enough to make a credible case that it is possible, on a non-shenanigans basis, for industries to grow earnings while losing sales on a consistent basis.
But this is all sort of besides the point.
Earnings, like records, are made to broken. Or at least, played with. This is the fun part.
The challenge for the investor community, then, is to make decisions about which earnings are the “real” ones, which earnings have been altered too much or too little, and what is the actual value of the company’s business.
And the more companies that appear to changing things the more you might be inclined to think there’s something to hide.