Non-GAAP earnings are in the Danger Zone this week. Companies usually pitch these alternative metrics as “supplementary” data to help investors get a “better” view of the profitability of the business. Instead, we see red flags, not a better view. Non-GAAP statements are unaudited, so companies can do whatever they want with them. Most of the time, they use them to make the company look as profitable as possible. In other words, the goal is not necessarily to better inform investors.
In reality, non-GAAP earnings tend to be more misleading than GAAP earnings, much more. Have you ever seen non-GAAP earnings below GAAP earnings? I doubt it.
Non-GAAP Greatest Hits
We’ve called out several companies for their creative non-GAAP accounting in the past. Below are some of the worst offenders:
Tesla Motors Inc. (NASDAQ:TSLA): Its chief offense is removing stock compensation expense from non-GAAP earnings. This omission provides a big boost, $84 million in 2013, to non-GAAP results because Tesla relies heavily on stock for compensation (as cash can be harder to come by). The Financial Accounting Standards Board officially ruled in 2004 that stock options are a real cost of running a business and should be captured in earnings. As TSLA’s $4.2 billion employee stock option liability shows, the company has not been shy about diluting the interests of current shareholders by paying employees with more stock.
The fact that Tesla’s non-GAAP earnings still include the unusual, non-cash gain of $12 million from foreign currency exchange fluctuations reinforces that it is a tool to inflate earnings.
Exclude the bad stuff but include the good stuff. Must be fun to write your own rules for reporting profits.
Callidus Software Inc. (NASDAQ:CALD): CALD is a consistently unprofitable company that uses non-GAAP earnings to present the appearance of profitability. Many dot com companies used this same trick during the tech bubble in the late 1990s. CALD’s biggest excluded expense was stock-based compensation, but its most creative practice is repeatedly lumping recurring expenses into “restructuring” costs, which it also excludes. CALD has incurred restructuring costs for seven straight years, which makes it hard to argue that these are really “one-time” costs.
Valeant Pharmaceuticals (NYSE:VRX): Valeant is one of the most prominent and controversial cases of non-GAAP earnings in the market today. According to GAAP numbers, Valeant lost $866 million in 2013, but by their own non-GAAP metrics Valeant earned $2 billion in profit. This disconnect comes from Valeant excluding the costs related to its numerous acquisitions, especially amortization of intangible assets. These exclusions are particularly offensive to me because they allow Valeant to obscure the major misallocation of capital from the firm’s acquisition-driven strategy. The truth is Valeant overpaid when it bought other companies and to obscure the shareholder value destroyed by the company’s touted acquisition strategy is blatantly misleading.
Additionally, John Hempton at Bronte Capital has outlined how Valeant may be putting recurring costs into excluded items.
Valeant also tried to sell investors on the idea that it was valued cheaply compared to the rest of the market by comparing its P/E with non-GAAP earnings to the unadjusted P/E’s of its competitors and the S&P 500.
This Week’s Non-GAAP Offender
Trimble Navigation Limited (NASDAQ:TRMB) takes all the non-GAAP games from above and puts them together.
“One-time” restructuring charges that occur year after year? TRMB has those, as it has incurred restructuring charges in nine out of the past 10 years. In 2013 it excluded $7 million in restructuring charges.
Excluding stock compensation as a way to mask the real cost of paying employees? TRMB excluded $36 million (2% of revenue) in stock-compensation expense in 2013.
Removing amortization of intangible assets in order to mask overpayment for past acquisitions? TRM excluded $163 million (7% of revenue) in amortization of purchased intangible assets.
Excluding these costs allowed TRMB to double its reported earnings, from $219 million on a GAAP basis to $442 million on a non-GAAP basis.
Investors should be wary of companies that play games with non-GAAP earnings. These companies usually have something to hide. In TRMB’s case, it’s hiding the fact that it’s overvalued and makes negative economic earnings.
The Alternative…No Substitute For Diligence
Don’t take my criticism of non-GAAP earnings to mean that I think investors should rely on GAAP net income. Regular readers know my opinion on that front. Accounting earnings were designed for debt investors, not equity investors, and contain their own rules and loopholes that allow companies to manipulate reported earnings.
Investors cannot rely on either audited GAAP numbers or unaudited non-GAAP results to show the true operating profitability of a company. Instead, thorough due diligence is required in order to adjust GAAP net income and find net operating profit after tax (NOPAT). We read over 3,000 10-K’s and perform tens of thousands of adjustments to get from reported earnings to NOPAT.
NOPAT strips away financing and unusual income and expenses to get at the recurring, core operating profits of a company. Unlike GAAP, it’s designed for equity investors, and unlike non-GAAP it’s an independent metric that is comparable across all companies.
If an investor just looked at TRMB’s non-GAAP earnings, it would look as though the company had an excellent return on invested capital (ROIC) of 13% and that the stock was only moderately expensive based on current earnings. If we look at TRMB’s actual NOPAT, which was $247 million for 2013, we can see that its ROIC was only 8% and that it has a price to economic book value (PEBV) of 5.8, which is very expensive.
Investors who rely on TRMB’s reported numbers would think that it’s a high quality company at a moderately expensive price, when in fact TRMB earns negative economic earnings and is significantly overpriced. Companies will always paint a rosy picture when they can make their own rules for disclosure. Investors must rely on due diligence to understand the underlying economics of a business.
Sam McBride contributed to this report.
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.