Colossal declines in the shares of Valeant Pharmaceuticals (NYSE:VRX) and Endo International (NMS:ENDP) wiped out billions of investor capital. The companies’ loose application of accounting guidelines has made the Generally Accepted Accounting Principles (GAAP) vs. non-GAAP (adjusted) debate a hot topic.
Unfortunately, when issues like this rise to significance exaggerations of the “facts” can distort reality. Fortunately, such circumstances create opportunities. Early in my investment career I became intrigued over the use of GAAP vs. adjusted earnings per share (EPS). The media has us thinking non-GAAP is this new evil invention. But it’s nothing new. When I started investing in the mid-1980s I did everything I could to learn how to gain an edge over others.
I am by no means an accounting expert. But with an open mind I learned to accept that even though aggressive non-GAAP accounting can misrepresent the true earning power of a company, a strict adherence to GAAP can also distort financials. The real issue is that companies can abuse GAAP and non-GAAP principles to boost their cosmetic appearance. In the end I want a number that best represents the financial condition and go-forward earnings power of a company. Ideally, I prefer to come across stocks where GAAP and adjusted EPS are fairly close to each other. But as the Rolling Stones put it, You Can’t Always Get What You Want.
The Irony of the GAAP vs. Non-GAAP Argument
The Security and Exchange Commission (SEC) requires companies to report financial numbers under a set of Generally Accepted Accounting Principles (GAAP). Companies use these principles as a guide to determine how they report/treat financial information on their income statements, statement of cash flows and balance sheets. In an attempt to increase transparency for investors, GAAP accounting can make a company appear more or less profitable than it actually is.
Adjusting financial statements to eliminate non-operating or non-recurring expense or income items is a valuable exercise to calculate a “cleaner” EPS number. This is referred to as adjusted or non-GAAP EPS. Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA) is another non-GAAP figure used by many investors. To complicate matters, management will often present GAAP and non-GAAP figures in press releases to appear more transparent. But in reality management teams have exercised a great deal of latitude in their calculation of non-GAAP financials to inflate earnings. I have come across some companies that present EPS that are actually EBITDA’s, add back cash expenses that are recurring in nature and distort financial statements by mis-categorizing clearly noncollectable receivables as assets and revenue.
Here are just a few examples that highlight some potentially “distorting” items:
- Gain/Loss From Sale of Land, Asset, Subsidiary or Investments
- Gain/Loss from Legal Settlement
- Legal Expenses dealing with a lawsuit
- One Time Acquisition Related Expenses
- Loss from Write Down of Assets
- Tax Benefits
- Shares given in lieu of cash to pay employee salaries.
- Writing off a bad investment
Your goal as an investor is to try to figure out which items are temporary (and how long they will impact the company), how they impact cash and which items are part of the normal course of business. So, while transparency is great in theory, items need to be added or subtracted to get the true earnings power of a company. This is what non-GAAP adjustments aim to accomplish.
For example, treating quarterly gains and losses from stocks and bonds as “business as usual” seems appropriate under GAAP for an insurance company. However, these items (when significant) for a tech company that happened to make a great investment years ago should probably be ignored when analyzing the company (non-GAAP adjustment). Or consider companies that add back acquisition expenses and related non-cash charges to derive adjusted EPS when the companies’ principal mode of growth is through acquisition. It can be argued that these “expenses” should not be ignored since they are recurring,
Ultimately, you can gain an information arbitrage advantage by building your understanding of these concepts that many investors blindly accept.
“It all comes down to the same theme. We need to perform our own research and calculations, even when it appears that management is being transparent. We only have ourselves to blame when we get complacent.” Maj Soueidan
Non-GAAP Information Arbitrage
Now, don’t get me wrong. Sure, over the years, the use of non-GAAP has been applied more liberally by management teams, calling into question some of their assumptions. And what was a common practice reserved for larger capitalized stocks is now being widely adopted among many microcap management teams. Regardless of your position on GAAP vs. non-GAAP, non-GAAP applications have their place in the research process. Opportunity exists at either end of the buy-short spectrum when companies only provide GAAP numbers. You will be in a position to buy cheap stocks that look overvalued on paper or short stocks where management may have been too aggressive in their accounting.
For example, we analyze the earnings press releases of all microcap stocks which ended up being 2450 through the first quarter of 2016 (encompasses Q4 2015 through Q1 2016). Here are some EPS stats: (some of the releases were only guidance updates)
- 1694 reported just GAAP
- 380 reported GAAP and non-GAAP
- ~35% of cases where non-GAAP was greater than GAAP
- ~19% of cases where non-GAAP was less than GAAP
- 1489 of companies where we made non-GAAP adjustments when only GAAP was reported
- ~53% of cases where non-GAAP was greater than GAAP
- ~25% of cases where non-GAAP was less than GAAP
- 37 of companies where we made adjustments to non-GAAP provided by companies
I am looking for instances where holes exist in GAAP or non-GAAP data. We are currently hot on the trail of a company that reported a sizable GAAP loss for its 2016 Q2, but actually earned a huge non-GAAP profit of $0.42. What is great about this lead is that the company trades under $10.00 and did not provide a non-GAAP EPS number in its press release. Also, the company had been reporting losses for several quarters so Q2 might have signified a change in its growth trajectory.**
So for all those in the media that keep “scaring” investors into believing that non-GAAP adjustments to EPS are the devil in disguise, you should instead educate investors on how to use the concept responsibly instead of just throwing out the whole concept.
Using Non-GAAP Adjustments to Find the Arbitrage
It takes time, but once you start to look for non-GAAP adjustments you will see that the process to calculate your own adjusted EPS becomes surprisingly easy. Your sources of information are simply press releases and SEC filings. When you need help diagnosing a line item, simply call the company or seek out friends and colleagues who can guide you through the process.
Read press releases to see if management provided commentary on cash expenses or gains that it is treating as non-recurring.
Read press releases to see if management provided commentary on non-cash expenses or gains it is treating as non-recurring.
Form an opinion on whether you agree with management assumptions.
Reference the related 10Q or 10K to diagnose financial statements to continue your “fact checking” mission.
Calculate your non-GAAP numbers.
In a follow up article I will discuss how I use financial statements to fact check management teams’ assumptions.
The SEC Speaks Up About Accounting Principles
More and more companies are presenting non-GAAP numbers alongside GAAP. Is something wrong with GAAP or are management teams taking advantage of the blueprint given to them by the SEC? Laura Anthony, Esq., founding Partner Legal & Compliance, LLC, touched upon this question in an article she published on securities-law-blog.
“Although I understand the SEC’s concern, I wonder about the continued and increasing proliferation of non-GAAP measures precipitating the controversy. If 90% of companies use non-GAAP numbers to explain their financial operations, perhaps the GAAP rules themselves needs some adjustment. If, on the other hand, the increase is due to greater economic factors, such as the fact that the US economy has been stagnant for six straight years with zero or near-zero interest rates and no real “boom” following the recession “bust” of 2008, then the SEC may be right in its recent hard-line stance. The pressure on public companies to display consistent growth and improved performance continues regardless of the state of the economy. More on that topic another day.”
I think it is a little of both. Smaller companies are playing catch up and bigger firms are finding ways to “skirt” the system. Some of the adjustments larger firms make to their financial statements are extremely questionable. Especially those that add back expenses and write downs related to acquisitions when acquisitions are their primary source of growth.
In 2003 the SEC adopted regulation G as a guide for companies to follow when disclosing non-GAAP measures. On May 17, 2016, the SEC staff
“updated its interpretive guidance on non-GAAP financial measures. The updated guidance provides clarifying examples in areas of frequent staff comment, including misleading non-GAAP presentations and non-GAAP measures with greater prominence than the comparable GAAP measures.” Pwc.com.
The issue of how to treat a non-GAAP expense adjustment when it seems to be business as usual is an SEC hot button. Referencing pwc.com once again:
“The updated guidance provides examples of potentially misleading non-GAAP measures that could violate Regulation G, including:
- presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business;
- Non-GAAP measures inconsistently between periods without disclosing the change and the reasons for change;
- presenting non-GAAP measures that exclude non-recurring charges but do not exclude non-recurring gains; and
- using individually-tailored accounting principles to calculate non-GAAP earnings. For example, presenting non-GAAP revenue that accelerates revenue recognition as though the revenue were earned sooner than for GAAP purposes.’
Closing Thoughts on Non-GAAP
I still believe that, if not abused, reconciliations to GAAP offers clarity for investors. I urge management teams to be realistic when preparing non-GAAP numbers. They need to understand the negative reputation that comes with pulling the wool over investors’ eyes. The market is not “stupid” forever. To quote President George Bush Jr.:
“There’s an old saying in Tennessee – I know it’s in Texas, probably in Tennessee – that says, fool me once, shame on – shame on you. Fool me – you can’t get fooled again.”
The SEC only requires companies to present its financials following GAAP in 10Q and 10K filings. They provide additional guidelines for companies to follow that choose to breakout non-GAAP items in filings or press releases. They should go a step further and require companies to include disclosures in their filings when they are present in press releases.
For now, you should salivate at the chance to use the GAAP vs. non-GAAP debate to identify investment opportunities. You might also find risk you didn’t even know existed in your portfolio.
** January 2023 edit
The company in focus and referenced in this passage was Bluelinx Holdings Inc. (NYSE:BXC), and was subsequently covered in case studies in the following articles
Sept 9, 2016 – Bluelinx – BXC – Information Arbitrage Takes Center Stage
January 3, 2023 – When Cyclical Stocks Become Relevant, Here’s A Strategy You Can Use [GeoWire Weekly No. 65]