Gradient Insights: How to discern earnings quality amid wide use of non-GAAP charges

Rachel Bradley  by Rachel Annis
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

In any given quarter for almost every publicly traded company, there is often a swirling vortex of signals as to the firm’s long-term health and future opportunities. Within this conflux of signals, there are two that often cause investor stress and confusion when they contradict each other: 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 more accurately represent its historical earnings power.

But it’s not clear-cut. As the global economy struggles to emerge from the severe and diverse impacts of the pandemic, corporate financial reports have been littered with a variety of non-GAAP adjustments that need to be deciphered and analyzed, particularly as investors transition from a speculative “recovery rally” mindset (that has bid up valuations) to a greater focus on fundamental earnings quality.

Gradient Analytics specializes in forensic accounting research and consulting to discern weak versus strong earnings quality, which has proven valuable for both short idea generation and vetting of long candidates, as we have discussed in a previous article. So, with the current flood of adjusted earnings, we felt it would be a good time for some examples to illustrate that not all earnings adjustments are created equal, and although investors must be judicious in deciding when and how they use non-GAAP results, they often may be better served by focusing on non-GAAP.  Read on....

Example 1:  Bristol-Myers Squibb

One example where the GAAP and non-GAAP earnings told a different story would be in the Q4 2020 results from Bristol-Myers Squibb Company (BMY), a large biopharmaceutical company. In Q4, the company reported non-GAAP earnings of $1.46/share, or 3% higher than expectations of $1.42/share. Despite this outperformance, the firm reported a GAAP loss of $4.45/share, which was a significant deviation from its consensus expectation of $0.09/share gain. So, with each metric showing a different result, which signal should an astute investor rely upon? The answer, as with many things in life, is complicated.

A closer look into BMY’s Q4 earnings release shows that much of the divergence between GAAP and non-GAAP earnings was due to an $11 billion in-process R&D (IPR&D) charge recognized for GAAP purposes but not for non-GAAP purposes. During Q4, the company acquired MyoKardia, or more specifically mavacamten, a new medicine for the treatment of obstructive hypertrophic cardiomyopathy (OHCM). Phase III trials were complete in Q4, and since then the U.S. Food and Drug Administration (FDA) accepted the firm’s application and assigned a target action date of January 28, 2022. In Q4, BMY paid $13 billion in cash for this asset and immediately expensed 87% of its value.

Immediately expensing IPR&D is the appropriate accounting treatment if technological feasibility has yet to be established and there are no alternative uses. However, this has important implications for performance metrics. BMY used the multi-period excess earnings method to value the IPR&D, which uses inputs that are subjective, and the quality is heavily dependent on the users’ expertise and judgment. To compare, if mavacamten had alternative uses then the $11 billion IPR&D charge would have been capitalized and amortized over the useful life.  On the other hand, if management were to over allocate expense to IPR&D that is immediately charged off, it would understate earnings in the current reporting period to the benefit of future earnings, in the form of a reduced amortization expense.

In our view, for the most accurate assessment of BMY’s future earnings potential, we likely would include the IPR&D cost in our summation of the firm’s historical operations and examine the alternative accounting methodology described above. With that being said, we also would not want to allocate this cost only to Q4 2020, as that IPR&D loss built up over the last several years and is associated with future projected earnings. Instead, this cost should arguably be allocated over a much longer timeframe. So, would this additional loss change our view of BMY’s aggregate historical results? I estimated an incremental annual amortization charge of $763 million by applying the high end of the useful life range that BMY estimated for acquired product rights, 15 years. For scale, this would represent 5% of TTM non-GAAP earnings, so the aggregate earnings picture of BMY remains largely intact. In this example, if investors had only looked at BMY’s Q4 2020 GAAP results (a sizable miss), they might have missed out on a growing firm with impressive near-term results.

Example 2:  Becton, Dickinson and Company

Another example in which a firm’s non-GAAP results exceeded expectations but its GAAP earnings disappointed was in the recent results from Becton, Dickinson and Company (BDX). In Q2 FY2021, BDX reported GAAP earnings of $0.94/share, which was $1.25/share below the consensus expectation. However, non-GAAP earnings of $3.19/share were a surprising $0.15 (5%) above the consensus expectation of $3.04/share. So, what caused the difference? In this case, as explained by the firm’s Q2 press release, its GAAP results were lowered by a $333 million legal defense and product remediation charge. Currently, the SEC and the Department of Justice are investigating the firm surrounding its Alaris infusion pumps and Pyxis devices. Non-GAAP integration and restructuring adjustments also drove divergence between these earnings metrics, albeit to a lesser degree.

Interestingly, the elimination of the product liability defense costs for non-GAAP purposes drove the entirety of the non-GAAP earnings surprise. In fact, as BDX only beat its Q2 consensus earnings expectations by $41 million, and absent the $333 million legal and remediation costs it would have underperformed analysts’ expectation. Because legal expenses do not relate to the core operations of the firm, they were understandably removed for non-GAAP earnings purposes. However, an investor should want an accurate picture of BDX’s holistic earnings, not a conservative or aggressive view.

So, should this expense be excluded from BDX’s recent results to provide a more accurate financial picture? Once again, the truth is, it’s complicated. In aggregate, for this example, reported non-GAAP earnings are a more useful measure of the firm’s earnings because it excludes several other noncore costs like amortization of acquired intangible assets, the impact of debt extinguishment, purchase accounting adjustments, etc. However, myopically focusing on non-GAAP metrics provides an overly optimistic view of the firm’s sustainable earnings power. In this case, a holistic view of the extent of the product liability exposure as well as the total remediation and legal costs might influence an investor’s perception. Furthermore, BDX has excluded integration and restructuring costs from non-GAAP earnings each quarter in the last five years. The persistent nature of these adjustments suggest that a portion of these costs should be assumed in the firm’s continuing cost structure.

Example 3:  Capri Holdings

My last example is Capri Holdings Limited (CPRI), a luxury fashion group with iconic brands like Versace, Jimmy Choo, and Michael Kors. In this case, during Q4 FY2021 CPRI reported a GAAP loss of $1.21/share, which was $1.28 below the small profit the market was expecting. However, as you might have guessed, Capri reported non-GAAP results that were higher than expected. The firm’s non-GAAP EPS of $0.38 came in $0.36 higher than the consensus expectation of $0.02. 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 FQ4 can be largely explained by three factors. The first and most material of these adjustments removed $1.19/share in impairment charges from its calculation of non-GAAP earnings. This impairment related to operating lease right-of-use assets as well as Jimmy Choo goodwill and brand intangible assets. The other reasons for the gap between GAAP and non-GAAP income were a $0.22 charge related to COVID-19 and a $0.06 restructuring charge.

So, how should investors prioritize CPRI’s GAAP results versus its non-GAAP results? Like the example with BDX, the business is probably best viewed through a non-GAAP lens but not all non-GAAP exclusions should be completely ignored. Clearly, the coronavirus pandemic had an anomalous impact on the business. Over the last two years, non-GAAP impairments, COVID-19 related charges, and restructuring costs added up to $7.13/share. However, CPRI has consistently recorded impairment charges every year for the past five years and restructuring charges for the past four years, which indicate that some of these costs should be assumed for the firm’s ongoing cost structure. Furthermore, goodwill and other intangibles currently represent 47% of the firm’s total assets. If the firm faced another period of declining sales, then it may face further impairments. So, once again, non-GAAP results are likely a better reflection of the company’s latest results and forward earnings potential; however, it is important to critically assess each non-GAAP charge and add back those that over-optimistically distort the picture. Accepting reported non-GAAP earnings without analyzing all non-GAAP charges may lead an investor to miss early warning signs of weakness in the business.

In summary:

Neither GAAP nor non-GAAP results can be considered a perfect measure of a firm’s trailing earnings. Often, the truth will be found somewhere in between the two. As illustrated in the above examples, non-GAAP results often can be the more accurate lens through which to view a company’s sustainable earnings. In any case, there has been a surge in non-GAAP adjustments due to the impacts of COVID-19 as well as other charges over the past year.

This has allowed firms “on the margin” to heavily skew their reported earnings. As a result, analysts have needed to dig deeper into the wide variety of non-GAAP adjustments that are employed. While most firms present a fair representation to investors, there always seem to be others that instead find ways to show financial performance at or above expectations, even if it is unwarranted.

I hope this quick primer helps to show that a careful investor should be monitoring both GAAP and non-GAAP results. A myopic focus on only GAAP earnings could mean missing out on an attractive company that is more accurately represented by its non-GAAP results. As non-GAAP adjustments have become increasingly common and impactful, investors should accept the importance of critically evaluating how non-GAAP results are being adjusted and the significance of each of those adjustments. As such, the analyst team at Gradient Analytics continues 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. 

Earnings Quality
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