Dealing with Non-GAAP Charges

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:

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