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A Financial Pandemic

July 19, 2018

 

Dear CEO, does your company suffer from poor growth, high costs and too many impairment charges? Do you sometimes feel a lack of motivation or drive and can’t get out of bed in the morning as a result of poor past decisions you’ve made? Are you constantly failing to live up to expectations? If so, please consult your CFO, as non-GAAP metrics may be the solution for you. Non-GAAP metrics are known for instantly enhancing your company’s profitability, making all past mistakes vanish and improving your compensation. Side-effects may include: addiction, loss of trust, and eventual outright destruction.    

 

There is a financial pandemic taking place. Yet, despite its far-reaching contamination, the outbreak has garnered little attention and public scrutiny. We hope to change this with this article as we shed light on this issue that is plaguing the financial industry: the rise of non-GAAP reporting.   

  

Accounting is “the language of business.” Through this language, management communicates the financial health of their business predominately in the form of financial reports. This financial information is then used by third parties in making many different types of decisions. For example, banks use this information to decide whether or not to provide a loan to a company, while fundamental investors, such as ourselves, formulate an investment thesis by analyzing the financial reports. As many parties rely on this information, its accuracy and representation of the health of the business is essential for a properly functioning financial system. Good financial reporting is what enables the capital markets to allocate capital to companies at the right price.   

 

To ensure companies present the public with accurate information, a set of uniform accounting practices outlining rules and standards for financial reporting have been implemented. These practices are known as Generally Accepted Accounting Principles (GAAP) and are required to be followed by U.S. companies (Canada follows the International Financial Reporting Standards). This ensures that the public is being provided with the most representative and accurate information about the business. In essence, GAAP ensures that all companies are speaking the same language so that comparisons between one and the other can be easily made.

 

However, recently companies have begun to adopt their own dialect by adjusting traditional GAAP compliant metrics and also presenting (and in many cases, prioritizing) these numbers to the public. Typically, such adjustments include excluding certain items required by GAAP or even including non-permitted items. Due to the non-compliance of these self-made metrics, they are referred to as non-GAAP.  Although the initial intentions of reporting adjusted non-GAAP metrics was to allow for better comparability of financial results to prior years, this trusted privilege has been abused as many of the adjustments being made are in an effort to mask costs and inflate company earnings. This allows businesses to appear healthier than they actually are. Since most senior executives get paid based on the price of the stock, which is directly related to the earnings provided, there is no shortage of accounting tricks being used in order to make the earnings numbers higher than GAAP would allow.

 

For example:

 

The number of companies partaking in such practices is astonishing and has skyrocketed in recent years. The CFA Financial Analyst Journal [Volume 73, Issue 2] showed that in 2014, of the non-REIT companies in the S&P 500 Index, 70% disclosed non-GAAP earnings compared to less than 50% in 2009. Furthermore, companies disclosing non-GAAP earnings made a total of 1,332 adjustments totaling $132.1billion. These are significant numbers and are unquestionably much higher today!  

 

There are many reasons that allowed non-GAAP adjustments to prosper, but the main factors can likely be contributed to the following:
 

  1. A switch in CEO incentive programs to be tied to non-GAAP metrics. This means that the CEO will receive a significant bonus should they meet their non-GAAP targets such as non-GAAP earnings. Intuitively this seems flawed, allowing CEOs to create their own financial metrics and be rewarded based upon them.  
     

  2. The rise in popularity of passive investing. With passive investing (simply buying an index ETF), the investor buys every company in an index without performing any company due diligence. Passive investing actually rewards companies that inflate their earnings. Higher earnings translates into a higher stock price which means a higher weighting in the ETF which in turn fuels more price insensitive buying of their stock. It’s a virtuous cycle. When a significant amount of investors are not doing their homework, this fosters an environment for CEOs to get away with misleading tactics.
     

The market narrative today has shifted to one solely focused and reliant on these non-GAAP results. With research analysts blindly following management into the abyss, the divergence between GAAP and non-GAAP metrics has never been bigger. This is worrisome, as it means that a lot of the stock valuations today are based off of potentially artificial earnings, and therefore not justified.

 

As we’ve seen historically, such misleading practices can dominate in the short-term, but long-term the company’s fundamentals always prevail. This means a big valuation reset may be in store. Take Valeant Pharmaceuticals for example. The CEO successfully persuaded investors into believing the validity of their non-GAAP metrics which allowed the company to reach a $75 billion valuation despite its non-GAAP net income being over 8,134% higher than GAAP net income at a point in time. If this wasn’t a red flag, I’m not sure what is.  

 

 

The earnings of a company should be highly correlated with its cash flow. A divergence between these two over an extended period of time is a warning sign. If earnings are not ultimately resulting in cash flow, than what exactly are these earnings providing to the shareholder? It is no surprise then that as the divergence between GAAP and non-GAAP increases, so too does the divergence between non-GAAP and cash flow. This should be a concern for investors as the value of an asset is a function of its future cash flow generation. With stock values now being justified based on non-GAAP metrics, current stock prices of many companies are no longer fundamentally justified by their cash generating abilities. Research analysts are either in denial or naïve of what is taking place as many analysts have disregarded such cash flow fundamental practices and switched to techniques reliant on the inflated non-GAAP earnings of a company (such as simply assigning a multiple to the inflated non-GAAP earnings). Using the same example as before:

 

  

This is an unsustainable problem and those investors that have not performed the proper company due diligence carry elevated downside risks in their portfolios. Stock prices will eventually revert back to the true worth based on company fundamentals, as they are a reflection of the cash flow the company can generate in the future. 

 

A common bias and tendency of investors is to become more complacent or lazy during bull markets and the sad reality is that company management has shown an eagerness to take advantage of this. Being in the later stages of a market cycle (as we are today), it is inevitable that growth will slow. Companies, reluctant to admit to this slower growth (to avoid a declining stock price and often lower compensation), will see an increased need to continue with adjustments to mask this slower growth. The long-term investors or the true owners of the business are those that will suffer as their shareholder’s capital gets eroded away. Although it is near impossible to escape the non-GAAP narrative today, it is vital to understand the reconciliation between GAAP and non-GAAP reported earnings, and to form an individual judgment as to the validity of management’s actions. Understanding and meeting with management to understand their intentions and the culture they are promoting is vital. Active management plays a critical role in weeding out the misleading companies. When this behaviour will be corrected is unknown, but investors today can mitigate their risk by doing their homework. It is never more important than today to know what you own!

 

The Summerhill Team

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