Investors were not overjoyed at the conclusion of the Q3 earnings season, thanks to lukewarm results for many significant companies. According to Bloomberg, earnings for the S&P 500 are expected to fall 0.5% for the year as a whole, and some have even called it the worst earnings season since the “Great Recession”.
Adding to this gloomy forecast are the many voices questioning the increased prominence given to non-GAAP results as an alternative to the more conservative metrics sanctioned by GAAP. Some companies appear to be applying their own silver linings to their earnings announcements. Typically, companies announce both GAAP and non-GAAP earnings, and analysts tend to focus on the latter.
In this post, we look at some trends in non-GAAP reporting among the S&P 500 component companies.
- 88% of the S&P 500 disclose non-GAAP metrics in earnings releases.
- Non-GAAP adjustments increase net income 82% of the time.
- The average quarterly impact of non-GAAP income adjustments was an increase of $176 million.
- Acquisition and divestiture adjustments were the most common type of non-GAAP income items.
The data presented in the following tables was collected from 8-K Item 2.02 filings filed by the S&P 500 companies between July and September of 2015.1
As we can see from the table, 88% of S&P 500 companies presented at least one non-GAAP metric during the period in question. 426 companies presented more than one, while some used as many as 33 separate non-GAAP adjustments. This fits with research recently discussed over at Footnoted, where they found an exponential increase in the frequency of the mentions of “adjusted EBIDTA”.
The next table presents the major types of non-GAAP metrics. Audit Analytics identified five overarching categories of non-GAAP metrics: (1) income related metrics; (2) EPS related; (3) cash flow related (such as free cash flow); (4) EBITDA (including Adjusted EBITDA); and (5) Funds from Operations (including Adjusted FFO). Some of the categories (such as Adjusted EPS) are common across the board, while others (such as AFFO) are industry specific.
Nearly 71% of S&P 500 companies presented at least one income-related metric, while 28% non-GAAP had a cash flow presentation. (The overlap between the first two categories is not surprising – companies that use Adjusted Income metrics are very likely to also present Adjusted EPS.)
Next, let’s look at some of the attributes of the non-GAAP metrics. As we discussed in our previous posts, one obvious consideration is whether non-GAAP presentations makes a company appear more profitable than it really is. While any individual instance would depend on the particular factors, there is reason to believe that non-GAAP metrics tend to paint a rosier picture than GAAP numbers might. In the following table, we present some details about the impact of non-GAAP income adjustments.
Not surprisingly, 82% (228 of 278) of the time, non-GAAP adjusted income was greater than GAAP income. The average positive adjustment of these companies was $247 million, while the average negative adjustment was only ($147M). It is important to note that these are only quarterly impacts. For the annual presentations, the total value of the adjustments would be much higher.
Regulation G requires companies to reconcile non-GAAP results to the most comparable GAAP item. This allows us to estimate a company’s reliance on non-GAAP presentation by counting the number of items eliminated to arrive at non-GAAP. In theory, the more items are removed, the greater the prominence given to non-GAAP presentation.
As we can see from the table above, the average Adjusted Net Income reconciling table had about seven lines. The number of items by company ranged from three lines to as many as 27.
Lastly, let’s take look at the most common types of items that get eliminated.
As evident from the presentation above, more than half of the Adjusted Net Income companies used at least one acquisition- or divestiture-related item to derive non-GAAP numbers. acquisition- and divestiture-related charges typically include acquisition-related costs and gains and losses on acquired or disposed of businesses.
Interestingly, while impairments were only fifth in terms of total reconciling items, they comprised almost 50% of the total dollar difference between GAAP and non-GAAP income ($23.971 million). Low oil prices and the downturn in the oil and gas industry are to blame: five oil and gas companies (Apache Corp, Chesapeake Energy, Cimarex Energy, Denbury Resources, and Soutwestern Energy) recorded $10.7 billion in impairment charges among themselves.
Looking at the findings of this preliminary analysis, it appears that many are right to be concerned about the impact of non-GAAP disclosures on the quality and transparency of financial reporting.
Non-GAAP discussions played a role in the controversy surrounding Valeant Pharmaceuticals. Some analysts suggested that Valeant’s growth was mostly based on what those analysts called “fantasy numbers”. The company’s non-GAAP presentation excluded a variety of items, most notably acquisition-related charges. For a company growing primarily (if not exclusively) by acquisitions, such an exclusion is very significant and can give a distorted perspective.
We have written about non-GAAP metrics several times ourselves. In one post, we provided evidence that companies giving high prominence to non-GAAP presentation might be more prone to one-time adjustments, such as changes in estimates or out-of-period adjustments.
In another entry we used GNC as an example while discussing our approach to evaluating non-GAAP presentation. In that post we mentioned that the non-GAAP section could be used to provide insight into the business and regulatory challenges that a company might be facing.
The major argument used by non-GAAP proponents is that such metrics shed light on the business side of things through the eyes of the management. Yet, the apparent imbalance between positive and negative adjustments raises questions about whether non-GAAP metrics are likely to be used to downplay long-term negative trends. Either way, it is clear that the increasing use of non-GAAP metrics will continue to be controversial.
1. Data for Q3 Item 2.02 announcements was not available for analysis at the time of writing. For the population of S&P 500 companies, we included any company that was a component part between 10/1/2014 and 9/30/15. ↩