GAAP accounting, for all its good intentions, increasingly misses the mark for many investors. In their bid to predict future company performance, buy-siders instead turn to non-GAAP metrics and intangible assets, and typically conduct their own analysis of the numbers.
These topics were discussed during Clermont Partners’ recent “The Rise of Non-GAAP” webinar. The event featured:
- Baruch Lev, Professor of Accounting and Finance, New York University Stern School of Business
- Christopher J. Marangi, GAMCO Investors
- Elizabeth M. Lilly, Crocus Hill Partners
- Elizabeth Saunders, Partner, Clermont Partners (moderator)
As background, Clermont Partners conducted a survey with active investors to reveal how buy-siders factor GAAP and non-GAAP measures, intangible assets and non-financial metrics into their stock selection process. The results (click here) were a springboard into the conversation.
Highlights – Opening Points
- 74% of our survey respondents said they rely more on non-GAAP versus GAAP reporting.
- 44% believe that non-GAAP measures have become more important over time.
- 90% make their own adjustments to GAAP results to come up with what they believe to be relevant numbers.
- 36% think that GAAP paints a true picture of a company’s finances, and 47% don’t agree that GAAP provides an accurate picture.
- One investor from a large institution said, “Half of our firm is very focused on old-style GAAP measures, and half of our firm takes GAAP numbers and adjusts them. Then we get into a room and talk about the same company with a different set of numbers.”
Dr. Baruch Lev:
- Financial reporting information – GAAP-based information – is fast losing its value to investors.
- Thirty years ago, an investor’s perfect prediction of companies that beat or meet estimates would have gained an annualized 26%-27% return above benchmark. Over time, those gains have all but disappeared. The conclusion is that earnings no longer reflect what they should reflect: value changes and growth prospects of companies.
- One study of private sector companies found a dramatic rise in intangible asset investment and a fall in tangible asset investment beginning in the mid-1980s. Since intangible assets – a driver of future value – must be expensed in the GAAP income statement like regular expenses, this tends to destroy the income statement and balance sheet of companies, and is thus a major contributor to the erosion of GAAP financials as a way to value companies. As an example, Tesla reports an accumulated loss of more than $3 billion, but its huge market value means that investors completely ignore the financial reports.
- In writing our book, “The End of Accounting,” we carefully examined hundreds of conference calls in five major sectors of the economy to fully understand what is important to investors. We found that what matters most are strategic assets that create unique value for each company. For example, a product pipeline of a biotech company, or customer metrics for an internet services company.
- Degradation of GAAP accounting or “the end of accounting” has been an evolution over many decades, as the nature of the economy has changed and as the financial sector has gotten larger and become more sophisticated.
- When we look at a company, we ask: (1) What is the true cash flow power of a company today? (2) How fast will that cash flow grow? And (3) how predictable and how defensible is that cash flow? Those questions are primarily informed by non-GAAP measures, which are strategic assets, intangibles, hidden assets, and non-financial metrics that I call “key performance indicators” (“KPIs”), like subscribers, churn and customer trends.
- As fundamental investors, we try to add value in looking at those non-GAAP measures. We have an acronym here called GAPIC, meaning Gather, Array, Project, Interpret, Communicate. That’s what the analysts are supposed to do.
- We like to see transparency and consistency in reporting from different companies, but we do our own work, we make our own adjustments, and we just look for the information to be available.
- Big data and artificial intelligence are predicted to change and accelerate the move away from GAAP accounting. In fact, there may be some investors who know more about the state of a company’s business intra-quarter than the company itself because of the big data sources they’re investing in.
- The more correlated the GAAP and the non-GAAP metrics are, the more comfortable we are. It’s incumbent upon the analyst to do the math themselves and determine what’s non-recurring, what’s extraordinary and what’s unextraordinary.
- Companies develop their non-GAAP figures, and they’re not always forthright. One of the aspects of this that we find fascinating is that, ironically, the non-GAAP restatements are always higher than the GAAP, which is an interesting point. Rarely do you see companies taking their GAAP numbers and adjusting them and the non-GAAP is lower. They’re trying to portray their businesses in a better light.
- Stock-based compensation is a good example. Tech companies tend to take out stock-based compensation because it’s not a direct cash payment, but it does involve an outlay of company shares and it’s a transaction that dilutes ownership to other shareholders. Twitter is very famous for this. In 2015, they reported a $520M loss on a GAAP basis, but they said, “Hey, what we really want you to focus on is that we reported a net $277M profit on a non-GAAP basis.” And yet, it excludes $682M in stock-based comp.
Discussed by the panel:
Serial acquirers: Views on how “serial acquirer” companies present non-GAAP:
- Companies that consistently purchase smaller companies and exclude the acquisition-related costs can be problematic because acquisition costs are material expenses, and revenues are included. You never truly know or understand what the ongoing earnings of the organization are because they’re obfuscated by these charges, and you never really understand what the top-line growth is. We’re very leery of serial acquirers, particularly because they don’t deal with the accounting in a very clear and transparent way, and it’s very hard to get at the real numbers. – Elizabeth Lilly
- Best practice: Show the organic growth in the quarter pre-acquisition, similar to 12-month, same-store sales numbers that restaurant or retail companies provide. If serial acquisitions are part of the company’s ongoing business strategy, don’t constantly carve out acquisition-related expenses. – Elizabeth Lilly
Providing strategic asset or nonfinancial information: Key examples:
- Pharma and biotech provide information around the product pipeline. If you provide this type of information, it’s important to be consistent from year to year and quarter to quarter. – Dr. Baruch Lev
- Other industries that provide good non-GAAP information are most media, telecom and insurance companies. Customer measures like policy renewals are incredibly important and much more objective than customer satisfaction surveys. – Dr. Baruch Lev
- Disclosure in the media industry, particularly among the cable distributors, has gotten much better over the last decade. They provide some very useful KPIs, customer trends, churn, and average revenue per user. It’s gotten more detailed and is shown in a consistent way. – Christopher Marangi
- When we talk about intangibles, we’re conflating two things: (1) The intangibles that are truly intangible – things like brands, which go more toward the sustainability of a company’s cash flow that essentially provide a moat that allows Mondelez, for example, to have pricing power over Oreos. (2) Then there are hidden assets that we spend a lot of time looking for, which aren’t necessarily visible on the balance sheet. Things like excess real estate, spectrum, some patents – access patents that can be monetized for more than they are currently being utilized. I can’t think of anybody who’s really done a great job of disclosing hidden assets, and that’s why they’re hidden. That’s why we’ve got to look for them. – Christopher Marangi
Opinion on ASC 606 – Revenue Recognition Standard
- The rule didn’t change fundamentals. Revenues are recognized when the good or the service is delivered and when cash or a reasonable accounts receivable is being received. This thing, which takes me exactly ten seconds to explain in class, is still the backbone of the 709 pages. – Dr. Baruch Lev
- This will be an interesting test of just how powerful and important non-GAAP metrics have become in the market, because if we believe that non-GAAP metrics are really what’s driving valuation, then this GAAP accounting change, which really doesn’t affect cash flow, shouldn’t have much effect at all. – Christopher Marangi
Implication of Tax Law Changes:
- What is going to be really interesting is the repatriation of cash from international operations. It’s going to be very challenging for these IR departments, the financial departments and the CFOs to discuss. – Elizabeth Lilly
- Investors are going to want to hear more about how the next tax policy impacts their financing decisions, the capitalization policy. The fact that the threshold for interest deductibility has been lowered – that means companies are going to take on less debt. For example, what did companies do from the cash windfall that may come from lower tax rates, etc.? – Christopher Marangi