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Dealing with Non-GAAP Charges

September 25, 2012 | About:
The Science of Hitting

The Science of Hitting

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In the recent past, there’s been an influx of articles about Microsoft (MSFT) that put the P/E ratio somewhere in the mid-teens and use that as justification for determining whether or not the company is fairly valued. I point to this because the P/E mentioned is the one found on the well-known finance websites, as well as the one that would pop up if you ran a stock screener – yet anybody who follows the company closely knows that as a measure of earnings power, the “E” used in this equation is inaccurate due to the impact of an impairment charge taken throughout the year.

The purpose of this article is not to debate that charge (though I think Microsoft investors should be asking whether the past few years of M&A spend from this management team has been an attractive alternative to returning capital to shareholders); my purpose is to show that these proclamations (“the P/E is blank, which means this company is over/under/fairly valued”) are a disservice to investors, and often riddled with nuance that can cause material investment errors.

One of the main ways this measure can mislead investors is through the use of non-GAAP earning figures, which are paraded out by one management team after another to give investors a look under the hood at the true earnings power of a business; while this often led to acceptance of the non-GAAP figure as the “true” measure of a company’s earnings, the reality is that it often requires much more than a cursory review.

A favorite example of the investment community (and one I’ve discussed before) comes from Salesforce.com (CRM), which has found a way to remove charges when they hurt the company’s performance presentation (in terms of earnings), yet add those same values back in when they make the results look stronger (via higher operating cash flows). Today, I’ll look at a different company to make my point: that company is Hewlett Packard (HPQ).

Let’s take a look at the company’s most recent earnings report to see how management describes the performance in the press release:

“HP (NYSE:HPQ) today announced financial results for its third fiscal quarter ended July 31, 2012. For the quarter, net revenue of $29.7 billion was down 5% year over year and down 2% when adjusted for the effects of currency.

GAAP loss per share was $4.49, down from earnings per share (EPS) of $0.93 in the prior-year period. Non-GAAP diluted EPS was $1.00, down 9% from the prior-year period. Third quarter non-GAAP earnings information excludes after-tax costs of $10.8 billion, or $5.49 per diluted share, related to the amortization and impairment of purchased intangible assets, the impairment of goodwill, restructuring charges, acquisition-related charges and charges relating to the wind-down of certain retail publishing business activities, including the previously announced charges related to the impairment of goodwill within HP's Services segment, the restructuring program announced in May 2012, and the impairment of the purchased intangible asset associated with the 'Compaq' trade name.”

Looking at that list, it’s easy to say, “Well, goodwill impairment is non-cash and restructuring programs should be a one-time item,” and accept the non-GAAP numbers as they are. However, a quick look at the 10-K will show why this is misguided; here’s the breakdown of restructuring charges that Hewlett-Packard has taken in the last ten years:

2002 $1,780M
2003 $800M
2004 $114M
2005 $1,684M
2006 $158M
2007 $387M
2008 $270M
2009 $640M
2010 $1,144M
2011 $645M
10-YEAR AVERAGE $762M


The reality is that HPQ has taken restructuring charges year after year; based on this, it would be more appropriate to add in a charge for the likelihood that they will once again surface in the future rather than to back out current charges as one-time items that don’t reflect the underlying operations. For example, here’s the wording from a 10-K in the early 2000s:

“In fiscal 2001, management approved restructuring actions to respond to the global economic downturn and to improve our cost structure by streamlining operations and prioritizing resources in strategic areas of our business infrastructure.”

Operating throughout economic downturns (and doing what it takes to survive, if necessary) is a real part of business and one that will be relived many times over if HPQ is around for decades to come; considering such costs one-time would be flat out inaccurate.

The point isn’t to single out HPQ (though they certainly fit the bill); there are plenty of companies that use non-GAAP earnings, and many times it is justified. One potential solution to this issue is to use ten-year averages as your estimate of earnings power, while spreading out one-time-type charges over a period of years to reflect their applicability to the operations in question. As always, this comes back to sitting in a room and diligently researching companies rather than looking for shortcuts; you must read SEC filings, and make case by case judgments on the applicability of charges as they appear to determine the true earnings power of a business.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

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Comments

swnyc2
Swnyc2 - 1 year ago
Science,

THank you for another nice article!

You seem to focus on stocks I am closely following or ones that I already own.

I'd be interested in your thoughts on HP.

It's very poorly valued by the market based on historic cash flow, probably mostly for secular reasons (both the PC market and printing market are down).

I think the market is too pessimistic and doesn't reflect substantial revenue from its other businesses.

In some ways it reminds me of the market's view of SPLS.

Which brings me to my next question.

What do you think of the anouncement by SPLS management today and how the market reacted?

During their last earnings call, SPLS management basically telegraphed their plans.

I was a bit surprised that the market reacted so negatively.

What do you think?
The Science of Hitting
The Science of Hitting premium member - 1 year ago
Swnyc2,

Thanks for the comment! On HP, I've never analyzed the company, so don't have much to say; maybe one day I will, but from what I've seen so far, I'm pretty sure I have no interest in the business (I'm trying to get away from these value-type plans; I want businesses where intrinsic value will be higher 10 years from now with near 100% certainty - and I've already got a few names where I'm not too confident making that statement).

In terms of SPLS, the market reaction is yet again odd, at least from my view. As you noted, the plan announced was essentially telegraphed; in terms of closing 15% of the NA real estate by 2015, I really think this is a case of (1) SPLS stores, on average, are much more profitable than OMX & ODP, so it's a much different decision than they're facing, and (2) both of those companies are going to announce sweeping changes for the future on their Q3 calls (or at least that's what I believe based on what I've heard from them to date) - which mean SPLS can play the waiting game, still make case by case decisions as lease renewals come up, and use the time (and new information) to their advantage (if OMX or ODP recently closed a store in the region, that will make the economics of the decision much different). Of course, as I've noted previously, these changes will all take time; hopefully Staples management will reward long term shareholders with increased buybacks and dividends (as we now see, the Corporate Express acquisition has materially under-performed in comparison to original expectations, and has resulted in a big impairment charge).

As always, I think intrinsic value is much more stable than these weekly moves of what seems to be 5-10% in either direction. Let me know if you have anymore questions or personal thoughts on this (would be interested to hear them); thanks for the comment!
The Science of Hitting
The Science of Hitting premium member - 1 year ago
By the way, I'll make sure to right an article on SPLS right after the Q3 calls :)

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