Earnings, but Without the Bad Stuff; Managers of companies that have generated only losses, like Twitter, are happy to suggest metrics that they think are better suited for assessing their operations

November 9, 2013

Earnings, but Without the Bad Stuff


Twitter’s red-hot stock offering last week makes clear that, as in the first Internet bubble, investors will pay up for a company even if it hasn’t turned a profit. And managers of companies that have generated only losses, like Twitter — and even those that are profitable — are happy to suggest metrics that they think are better suited for assessing their operations. Managements’ recommended measures, typically not found in generally accepted accounting principles, have an uncanny way of burnishing a company’s results. They do so by eliminating some pesky costs of doing business. As such, these benchmarks are also known as earnings without the bad stuff. They were central to the valuations that propelled Internet stocks skyward in the late 1990s. Then, the higher the market climbed, the kookier the metrics became.My favorite measure was used by analysts to hype the prospects of Homestore.com, a web-based provider of real estate services. They lauded its potential because of the “share of mind” it enjoyed among its customers.

That “share” may have been meaningful in early 2000, as the company’s stock hit $489, but it vanished quickly when Homestore.com crashed in 2001. (Stuart Wolff, a former C.E.O., was sentenced to prison in 2010 after pleading guilty to conspiracy to commit securities fraud.) The company now operates as Move Inc.; its stock closed Friday at $16.09.

What costs do companies want investors to remove from the income statement? Among the most popular are those associated with stock-based compensation, like options and restricted stock. Because these forms of pay aren’t made in cash, the theory goes, they should be backed out of a company’s expenses.

Twitter’s recent prospectus serves as an example. Its management suggests that investors not focus solely on its $134 million net loss for the first nine months of 2013, a figure calculated under generally accepted accounting principles. If you want to see the company’s operating results “through the eyes of management,” the prospectus suggests, look at its “non-GAAP net loss” of $44 million for the period.

To get to that figure, Twitter backs out two large costs. Stock compensation for the first three quarters of 2013 is the biggest, at $79 million. Twitter also removes $11 million in costs associated with amortizing or reducing the value of intangible assets it acquired previously.

There’s nothing improper in Twitter’s filing. But the idea that these items don’t cost the company is nonsense, says Jack T. Ciesielski, an accounting expert at R.G. Associates in Baltimore and publisher of The Analyst’s Accounting Observer.

“When they back out stock-based compensation they’re basically saying that management is working for free,” Mr. Ciesielski said. “And we know that’s not the case.”

Ditto for the intangibles, he said. “When they acquired a company, they spent money for things like in-process research and development, contracts and customer lists,” he added. “To back out those intangibles is bogus.”

Twitter is just one of many companies that point shareholders to rosier earnings measures. And when they do so, they’re adhering to a 2002 rule prescribed by the Securities and Exchange Commission in response to the Enron and WorldCom accounting frauds. That rule, known as Regulation G, allows companies to use nontraditional metrics in financial reports, but only if they present generally accepted accounting measures alongside so that investors can compare the two.

If the S.E.C. wanted its rule to discourage accounting gimmickry, it failed, Mr. Ciesielski said. “The S.E.C. inadvertently legitimized the practice with Regulation G,” he added. “It’s defining behavior down — once people start doing this, everybody’s got to be on the same page. If company Y is backing out stock-based compensation, why wouldn’t company X do the same? Its results would only look worse if it didn’t.”

To plumb the popularity and pervasiveness of such metrics, Mr. Ciesielski and his associates analyzed filings from technology and health care companies in the Standard & Poor’s 500-stock index. They identified those that presented nontraditional figures to investors and compared those results with the companies’ actual earnings for 2011 and 2012.

Technology and health care industries are both heavy users of adjusted earnings measures in their financial statements, Mr. Ciesielski said. Of the 69 technology companies in the index, he found that 56 used non-GAAP earnings presentations; of the 54 health care companies, 45 used them.

Among technology companies in 2011 and 2012, Mr. Ciesielski found that nontraditional metrics resulted in so-called earnings that were 19.5 percent higher than actual profits in 2011 and 36 percent higher in 2012. And in the health care group, earnings using the adjusted measurements were 39 percent and 45 percent higher, respectively, than reported profits in those years.

The nontraditional calculations almost always produced better-looking results than those reported under accounting rules, Mr. Ciesielski said. Only seven companies’ figures resulted in flat or lower earnings. They were Analog Devices, Yahoo, Agilent Technologies, Waters, Eli Lilly, WellPoint and Regeneron Pharmaceuticals.

Five companies on Mr. Ciesielski’s list managed to transform losses into gains when applying their nontraditional earnings metrics. Those were First Solar, Hewlett-Packard, Salesforce.com, Boston Scientific and Forest Laboratories.

For technology companies, stock and deferred compensation accounted for 25 percent of the difference between real earnings and nontraditional results last year, Mr. Ciesielski found. Among health care companies, adjustments related to acquisition costs accounted for 40 percent of the difference between managements’ favored metrics and reported profits.

Companies are within their rights to accentuate the positive in their operations, and the regulations still require the company to present standard GAAP accounting as well. If investors choose to look beyond management’s cheerful opinions, they can find numbers more grounded in reality.

But Mr. Ciesielski said companies’ creativity in accounting metrics was on the way to becoming ridiculous. “You are almost getting back to share of mind and share of eyeballs again,” he said.

The Wall Street herd might favor these measures, Mr. Ciesielski said, but it is worth remembering that net income captures more of a company’s economic activity than metrics that exclude expenses.

Investors would be well served, Mr. Ciesielski added, if the S.E.C. policed these disclosures more assiduously and called out some of the more aggressive tactics. “It would be helpful to readers and users of financial statements,” he said, “to make income mean something again.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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