GAAP vs non-GAAP: Which is the better measure of sustainable earnings?

Byron Macleod  by Byron Macleod
  Associate Director of Research, Gradient Analytics LLC (a Sabrient Systems company)

In any given quarter for almost every company, there is often a swirling vortex of different signals as to the long-term health and future opportunities for each particular firm. Within this conflux of signals, there are two that often cause investor stress and confusion when they contradict each other: the firm’s GAAP versus non-GAAP earnings.

The simple rubric that often comes to mind is that GAAP earnings are the more conservative figure for the firm [as these accounting standards are closely monitored and controlled by a governing board, the Financial Accounting Standards Board (FASB)], while its non-GAAP earnings are the more optimistic view (after being heavily tweaked and adjusted by management). However, this assumption does not always hold true. Often, a firm’s non-GAAP results will be the more accurate representation of its historical earnings power.

Although Gradient Analytics specializes in forensic accounting research and consulting to identify weak earnings quality for short idea generation, our expertise is also valuable for identifying solid earnings quality for the vetting of long candidates, as we discussed in a previous article. And with the impacts of the coronavirus still working their way through both the US and global economies, it is a certainty that the next twelve months of corporate financial reports will be littered with a variety of non-GAAP adjustments that will need to be deciphered.

With this flood of adjusted earnings about to hit the market, we felt it would be a good time for some examples to illustrate that not all non-GAAP adjustments are created equal, and although investors need to carefully consider when and how they use non-GAAP results, often they may be better served by focusing on non-GAAP earnings.  Read on....

Example 1:  Apollo Global Management

One example where the GAAP and non-GAAP results told a different story would be in the recent results from Apollo Global Management, Inc. (APO). In Q4 2019, APO reported GAAP earnings of $0.59/share, which was $0.15/share (or 20.3%) below the consensus expectation of $0.74/share. However, non-GAAP earnings of $1.10/share were a surprising 50.7% above the consensus expectation of $0.73/share. So, with each metric showing a different result, which signal should astute investors rely upon? The answer, as with many things in life, is complicated.

If we take a closer look into APO’s Q4 and 2019 results, we find that much of the gap between GAAP and non-GAAP earnings is largely due to two factors:  the firm’s unrealized performance fees as well as its unrealized investment income and gains. To that point, in 2019, APO’s net unrealized performance fees (after also netting out the associated unrealized profit-sharing expenses) amounted to $227.0 million. As APO beat its 2019 consensus earnings expectations by a combined $48.9 million, this was where a material portion of this outperformance came from.

Interestingly, in Q4 2019, management attributed approximately $0.20/share of its quarterly earnings to performance fees associated with transactions that it had previously expected to close in later quarters (i.e., early 2020). These performance fees were driven by a handful of realization events in Q4 for its private equity investments in Verallia, Presidio, and ADT. This $0.20/share boost amounted to a material 54% of the total non-GAAP outperformance ($0.37/share) in Q4 2019. Thus, it appears that much of this non-GAAP strength in Q4 was due to the early recognition of several deals.

As previously mentioned, APO’s unrealized investment income and gains were the other large source of its non-GAAP earnings. In the TTM period, these unrealized gains amounted to $224.6 million. Management noted that it was seeing strong performance from its private equity and credit businesses. As this investment income was unrealized, uncollected, and potentially could change in the future, these earnings were understandably removed from APO’s GAAP performance. However, we want an accurate picture of APO’s holistic earnings, not an overly conservative or aggressive view of its operations. In our view, these earnings are highly likely to be ultimately collected, thus we consider it to be more accurate to include this earnings stream in evaluating APO’s sustainable operations.

In aggregate, for this example, reported non-GAAP earnings are likelier a truer and more useful measure of the firm’s earnings. Interestingly, one can see that the firm’s non-GAAP earnings are much more stable ($1,214 million in 2019 and $953 million in 2018) while the firm’s GAAP earnings are substantially more volatile ($807 million in 2019 and -$42 million in 2018). Furthermore, when we look at other business metrics, we find that APO is outperforming, not underperforming. The firm’s assets under management (a core growth metric) was up 18% YOY in 2019. Furthermore, management decided to boost the firm’s dividend to $0.89/share in Q4 2019, a sequential increase of 78% from $0.50/share in Q3 2019. But if investors were solely focused on GAAP results, they likely would have dismissed this healthy and growing firm as a poor investment.

Example 2:  MetLife

Another example in which a firm’s non-GAAP results exceeded expectations but its GAAP results disappointed was in the Q4 2019 results of MetLife, Inc. (MET). In this case, the firm’s Q4 2019 non-GAAP EPS of $1.98 came in 43% ($0.60) higher than the consensus expectation of $1.38. However, MET’s GAAP results only amounted to $0.58, more than 55% below what the market was expecting from the company ($1.30/share). Once again, these earnings results are telling the market two different stories.

So, what was the divergence in reported results due to this time? Well, it appears that the gap in Q4 can be largely explained by two factors. The first and most material of these adjustments, MET removed $1.58/share in derivative losses from its calculation of non-GAAP earnings. Interestingly, this loss represented a marked departure from its YTD gain of $2.24/share that it had accrued as of Q3 2019. MET’s management specifically attributed the Q4 derivative losses to “mark-to-market losses on interest rate related derivatives that we hold to protect our balance sheet.” As this expense was created as a hedge against the firm’s natural exposure to interest rates (interest rates rose for MET in Q4 2019), it makes sense to include this loss in its normal operating activities. However, this loss was simply a reversal of the gain that the firm had accrued by the end of Q3 2019. As a result, it makes more sense to net both the gains and the losses over a longer period than a single quarter (the firm earned a net $0.66/share throughout all of 2019). Furthermore, this loss won’t be a recurring expense and was at least partially reversed in Q1 2020 when interest rates began to decline once again.

The second reason for the gap between MET’s GAAP and non-GAAP income was due to a one-time benefit of $0.45/share from two favorable settlements with the IRS in Q4 2019. Interestingly, the details of this one-time tax benefit were only disclosed deep in the footnotes of the company’s quarterly earnings announcement (8-K filed on 1/7/2020). On the last page of that announcement, the company stated that its Q4 results had been boosted by a $475 million gain from two favorable tax settlements with the IRS (one for $317 million and the other for $158 million).

So, how should investors be prioritizing MET’s GAAP results versus its non-GAAP results? Like the example with APO, the business is probably best viewed through a non-GAAP lens. Firstly, the large derivative losses and gains are a natural hedge for the firm. When we remove just one component, operating results suddenly become much more volatile and difficult to predict. While total 2019 GAAP earnings ($5.7B) were very close to total 2019 non-GAAP earnings ($5.8B), quarterly GAAP and non-GAAP results were very different. While non-GAAP EPS results were fairly consistent throughout the second half of 2019 ($1.27 in Q3 and $1.98 in Q4, a difference of $0.71), the firm’s GAAP EPS results were much more volatile over that same time frame ($2.30 in Q3 and $0.58 in Q4, a difference of $1.72). As a result, MET’s non-GAAP results (again, 43% above expectations) are likely a better reflection of the company’s latest results and forward potential.

Example 3:  Nike

My last example is Nike, Inc. (NKE), a large athletic apparel and equipment company with an easily understood business model. For Q4 2019, the firm reported GAAP results of $0.53/share, a slight 2% miss from its consensus expectation of $0.54/share. However, as you might have guessed, Nike actually reported non-GAAP results that were higher than expected. In Q4, the company reported non-GAAP earnings of $0.78/share, or 39% ($0.22) higher than expectations of $0.56/share. So, what was the difference due to this time? In this case, as explained by the firm’s Q4 press release, its GAAP results were lowered by “a $0.25/share non-recurring, non-cash charge associated with the transition to a strategic distributor model in South America.” That $0.25/share expense in Q4 entirely explained the $0.22/share gap between the firm’s results and its expected non-GAAP earnings.

So, should this expense be excluded from NKE’s recent results to provide a more accurate financial picture? Although management would like its investors to immediately arrive at that conclusion by coloring the expense as both “non-recurring and non-cash,” the truth is more complicated. It turns out that new partnership agreements in Brazil, Argentina, Chile, and Uruguay allowed the firm to classify its assets in these countries as “held for sale.” This accounting maneuver resulted in the immediate release of its cumulative foreign currency losses that were previously being stored on its balance sheet. Interestingly, the fact that this loss is non-recurring and non-cash isn’t terribly relevant in this case. First off, the fact that NKE experienced “non-cash” currency losses on assets that it bought and then sold, doesn’t make the losses any less relevant to current investors. Furthermore, while this is a “non-recurring” cost under only the most narrow definition, NKE is constantly buying, selling, and transferring assets among a wide variety of its worldwide locations. To suddenly exclude this cost, when the firm will continue to enter and exit other international markets, would amount to viewing the firm through rose-colored glasses.

In our view, for the most accurate assessment of NKE’s future earnings potential, we likely would include this cost in our summation of the firm’s historical operations. However, with that being said, we also would not want to allocate this cost only to Q4 2019, as that currency loss built up over the last several years. Instead, this cost actually should be allocated over a much longer timeframe. So, would this additional FOREX loss change our view of NKE’s aggregate historical results? Well, over the last three years, the firm reported total earnings before taxes of $14.0 billion. The $0.25/share cost to exit its South American operations only amounted to $400 million, so the aggregate earnings picture of NKE remains largely intact. Furthermore, including a small portion of its FOREX losses into its Q4 results wouldn’t change the overall picture for Q4 either as it beat its non-GAAP expectation by a healthy 39%. Once again, if investors had only looked at NKE’s GAAP results (a 2% miss), they might have missed out on a growing firm with impressive near-term results.

In summary:

Interestingly, neither GAAP nor non-GAAP results are a perfect measure of a firm’s trailing earnings. Often, the truth will be found somewhere in between the two. As we saw with the above examples, non-GAAP results sometimes can be the more accurate lens through which to view a company’s sustainable earnings. In any case, I consider it to be an absolute certainty that there will be a surge of non-GAAP adjustments from the impacts of COVID-19. With both an unprecedented magnitude and scope of impact on the US economy, the economic slowdown in H1 2020 undoubtedly will cause a spike in the usage of non-GAAP adjustments.

This also will allow firms “on the margin” to heavily skew their reported earnings. As a result, analysts need to be prepared to dig a bit deeper into the wide variety of non-GAAP adjustments that will be reported over the next four quarters (at least). While most firms likely will present a fair representation to investors, there will be others that instead find ways to show their firm performing at or above expectations, even if it is unwarranted.

I hope this quick primer helps to show that careful investors should be monitoring both a firm’s GAAP and non-GAAP results. A myopic focus on only GAAP earnings could mean missing out on many firms that report not only a more attractive, but also more accurate perspective, in its non-GAAP results. As non-GAAP adjustments rise in 2020 due to the coronavirus, we all should get used to critically evaluating how non-GAAP results are being adjusted and whether those adjustments are appropriate. As such, the analyst team at Gradient Analytics will continue to stand vigilant in support of our research clients!

Disclosure: At the time of this writing, the author held no positions in the securities mentioned.

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any opinions, commentary, rankings, or stock selections provided by Sabrient Systems or its wholly owned subsidiary Gradient Analytics. Sabrient Systems makes no representations that the techniques used in its rankings or analysis will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results. 


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