Is there a truth gap in corporate earnings numbers? According to some pundits, yes. To them, companies highlighting pro-forma earnings (i.e., what you’ll typically see cited in the news) instead of those tabulated according to generally accepted accounting principles (GAAP) are masking weaker overall growth. Which means reality is actually worse than reported. In our view, however, this is creating an issue out of a non-issue. Not only are GAAP earnings accessible (and imperfect), they also share a well-known headwind that’s similarly skewing pro-forma earnings: the struggling Energy sector.
GAAP earnings (as one may deduce from breaking down the acronym) adhere to a uniform standard, which draws from both policy board recommendations and “commonly accepted ways of recording and reporting accounting information.” GAAP establishes a minimum, common baseline for companies providing financial statements—not a bad thing. However, a general, wide-ranging standard also means important context can get overlooked. For example, if a company restructures and incurs large, one-time costs, it may provide an adjusted earnings number that excludes those costs. Pro-forma earnings figures take these nonrecurring events into account.
Per Standard & Poor’s, Q4 2015 GAAP earnings growth is -15.7% y/y as of February 29, 2016. However, per FactSet, Q4 2015 pro-forma, or non-GAAP, earnings growth is -3.3% y/y in the week ending February 26, 2016. That’s a significant difference—so which one is right? The inconvenient answer? They both are. Neither standard is necessarily “right” and the other “wrong”: Both are pieces of the puzzle, with their respective pros and cons. Generally, non-GAAP earnings have an upward bias while GAAP has a downward bias. Per GAAP standards, assets on public firms’ balance sheets are carried at the lesser of cost or market value. Hence, firms will write down an asset value when it’s less than market value. However, they most often won’t write it up if market value exceeds cost, so GAAP will generally skew more to the lower end. Warren Buffett’s recent comments in his most recent shareholder letter highlight the difference:
I won’t explain all of the adjustments—some are tiny and arcane—but serious investors should understand the disparate nature of intangible assets. Some truly deplete in value over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses. Conversely, the concept of recording charges against other intangibles, such as customer relationships, arises from purchase-accounting rules and clearly does not reflect economic reality. GAAP accounting draws no distinction between the two types of charges. Both, that is, are recorded as expenses when earnings are calculated—even though, from an investor’s viewpoint, they could not differ more.
However, regardless of the one-offs and exclusions that do or do not get included, they don’t negate the larger point: The struggling Energy sector is corporate earnings’ primary detractor. As we wrote recently, Energy (and to a lesser extent, Materials) has dragged down earnings growth, as falling oil prices over the past 18 months have roiled producers in an industry where profits are price-sensitive. Energy asset write-downs have skyrocketed since Q4 2014, and the trend continues today. GAAP earnings tell this story but amplify it significantly. Using non-GAAP methodology, Energy earnings have dropped –72.6% y/y in Q4.[i] In GAAP terms, Energy earnings have plunged an astronomical -760.5% y/y.[ii] And this isn’t a new thing. GAAP earnings were skewed massively by bank writedowns in the period after 2008, artificially boosting earnings growth due to the artificially depressed base.
While it may seem intuitive, the growing gap between GAAP and non-GAAP measures isn’t a big, bearish surprise lots of folks are overlooking. GAAP isn’t revealing something hidden or absent in non-GAAP figures. This is just a matter of different calculation methods used to arrive at a similar conclusion: Energy has gotten hammered recently.
Some have also suggested that companies are featuring non-GAAP earnings over GAAP figures to hide reality. And hey, there are some cases where pro-forma is excluding items we figure aren’t one-time, nonrecurring expenses. However, alleging this is problematic is an incomplete statement. While public companies can present non-GAAP figures, they also have to report GAAP figures, as dictated by the SEC. This is one of few upsides in 2002’s overall onerous Sarbanes-Oxley Act of 2002, which attaches criminal liability to errors on public company balance sheets. Unless CEOs of publicly traded companies want to risk going to jail, GAAP figures are available. Heck, this is largely why the media could easily identify the divide between GAAP and non-GAAP and determine what companies are excluding. GAAP earnings just usually aren’t as widely discussed mostly because of the aforementioned reason: They are extremely volatile. Ultimately, though, any investor who wants to see them can.
That some have brought GAAP back into the conversation shows the chasm between perception and reality. Folks are digging deep for evidence of economic weakness, scrounging up little-used metrics with plenty of caveats to make their point. In our view, this demonstrates just how dour sentiment really is—and has been for quite some time. While stocks have bounced back a bit from their rough start to the year, we believe they still have more wall of worry to climb.
[i] Source: FactSet, as of 3/3/2016.
[ii] Source: Standard & Poor’s, as of 3/2/2016.