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The Dangers Of Non-GAAP Earnings

Summary Non-GAAP earnings are not quality measures of business success. We’ve identified over 18 items that are removed from GAAP earnings, many of which are standard operating expenses. The exploitation of non-GAAP earnings only makes analyzing a company a more difficult task. It’s no secret that non-GAAP earnings allow management to directly manipulate their performance metrics. Investors must look past non-GAAP metrics to protect their portfolios. While non-GAAP tricks may provide some short-term boosts to stock prices, eventually reality sets in and the true economics of the business rule the day. Why Non-GAAP Can’t Be Trusted We spend lots of time explaining how GAAP earnings are not reliable measures of corporate profits, and non-GAAP earnings are worse. Most of the time non-GAAP earnings are blatant misrepresentations of profits for the benefit of corporate insiders at the expense of regular shareholders . Case in point is one of Bill Ackman’s favorites: Valeant Pharmaceuticals (NYSE: VRX ). That stock has cratered recently on the heels of long overdue coverage of its questionable accounting practices, about which we warned investors back in July 2014 . While arguments may persist over the future of Valeant, one thing is clear: the company’s use of non-GAAP earnings, or as they call it, “cash earnings”, has only misled investors while serving executives in four distinct ways . Since management wants investors to focus on cash, not earnings, we find the discrepancy between Valeant’s “cash earnings” and the company’s true cash flows alarming. Figure 1 shows: while the company’s “cash earnings” have been highly positive and grown from $421 million to $3.55 billion from 2010 thru the latest trailing-twelve-months (TTM), free cash flow has been highly negative with a cumulative -$38.4 billion in losses over the same time frame. Cumulate non-GAAP earnings, during the same time, are $11.2 billion. Figure 1: Valeant’s Non-GAAP Tricks Have Tells For Those Who Look Closely (click to enlarge) Sources: New Constructs, LLC and company filings Non-GAAP Leads Investors Farther Away From The Truth About Profits The key point for investors to remember about non-GAAP earnings is they are like lipstick on a pig. They only cover up the ugly, and they cannot change it. The more managers have to adjust GAAP, the worse the situation is likely to end for investors. Non-GAAP tricks may work for a while, but they cannot disguise a bad business forever. Another example is Demandware (NYSE: DWRE ). After rising 160% from January 2013 to June 2015, DWRE is down 30% since we placed it in the Danger Zone in July 2015 . Figure 2 shows how much Demandware tried to fool investors by peddling non-GAAP earnings while GAAP and economic earnings were headed in the opposite direction. Only after the stock has cratered do we see non-GAAP earnings decline. Note that the current decline in non-GAAP sets management up for an easier comparison in subsequent reporting periods as well. Figure 2: Demandware’s Non-GAAP Creates Illusion of Profits (click to enlarge) Sources: New Constructs, LLC and company filings Expenses Management Excludes To Create Non-GAAP Earnings Because non-GAAP earnings are entirely at the discretion of management, any number of items can be removed from traditional GAAP earnings. The following are just some of the items we have come across that companies remove from GAAP earnings to calculate non-GAAP or “adjusted earnings”: Stock based compensation Payroll tax expense related to stock based compensation Compensation expense related to contingent retention bonuses Acquisition related expense Depreciation and amortization Foreign exchange effect on revenue Purchases of property and equipment/ property and equipment purchased under capital lease Unrealized gain/loss on fuel price derivatives Deferred loan costs associated with extinguishment of debt Gains on divestiture Preopening expenses Management recruiting expenses Management and consulting fees General and administrative expenses Litigation expenses Integration costs Restructuring costs Gross profit deferred due to lease accounting As should be clear, companies are removing not only a large amount of items, but also items that should most certainly be included when determining a business’s profitability. We find it hard to accept any argument for the removal of certain, natural costs of doing business like consulting fees, recruiting costs and compensation costs. Details On How Companies Exploit Non-GAAP Earnings The following examples are just a sampling of how management is creating the illusion of higher profitability. Wex, Inc. (NYSE: WEX ) – Click here to see the non-GAAP reconciliation Wex adds back certain acquisition expenses, non-cash tax adjustments, stock based compensation, and amortization of intangible assets to calculate adjusted net income. The company also removes certain income items such as the unrealized gain on derivatives and gain on divestitures. When totaled in 2014, the adjustments actually caused adjusted net income to be lower than GAAP net income. While this may seem counter intuitive, this is not a problem because the magnitude of beating targets is not nearly as important as just beating targets when using non-GAAP earnings to boost executive pay. In addition, this lowered adjusted earnings number will set up an easy comp in 2015. Marketo, Inc. (NASDAQ: MKTO ) – Click here to see the non-GAAP reconciliation Marketo is very transparent about all the items it removes from GAAP earnings and actually breaks down how each item is removed from cost of revenues, gross profits, operating expenses, and net income. However, this doesn’t detract from the fact that Marketo removes these items to appear less unprofitable than they truly are. Marketo removed $25 million in stock based compensation in 2014, or nearly 17% of revenue to derive non-GAAP net income. Tesla Motors (NASDAQ: TSLA ) – Click here to see the non-GAAP reconciliation In addition to some of the other items mentioned above, such as removing $156 million in stock based compensation in 2014, Tesla treats its non-GAAP calculation in a unique manner. Rather than just removing expenses to derive a non-GAAP net income, Tesla adds back deferred profits due to lease accounting. By adding this profit to net income, Tesla was able to report a non-GAAP net income of $20 million in 2014, compared to a GAAP net loss of $294 million. Demandware ( DWRE ) – Click here to see the non-GAAP reconciliation As shown above, Demandware uses non-GAAP net income to appear profitable when GAAP income and economic earnings both would prove otherwise. In 2014, Demandware removed $26 million in stock based compensation (16% of revenue) and $3 million in compensation expense related to contingent retention bonuses. Overall, Demandware reported a GAAP loss of $27 million in 2014, despite a non-GAAP profit of $4 million. How Non-GAAP Could Harm Your Portfolio Look at the stocks in Figure 3 for a few more examples of how bad your portfolio can be burned if you trust companies using misleading non-GAAP results. Figure 3: Non-GAAP Only Delayed The Inevitable (click to enlarge) Sources: New Constructs, LLC The stock market can be a dangerous place if you do not do your homework. Wall Street and corporate insiders are not afraid to trick you, and I think we have shown they have the lawful right-of-way to trick you. Investors need to do their homework in order to make the right investments consistently. To learn even more about the Dangers of Non-GAAP Earnings, watch our recent webinar and ensure you don’t get burned by non-GAAP earnings. Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector, style, or theme.

NorthWestern Corporation – A Year After The Near $1 Billion Transaction

Summary Cash flow generation outpaced dilution from the acquisition. The debt level is acceptable. The stock isn’t cheap, but you are paying a fair price in exchange for stability. NorthWestern Corporation (NYSE: NWE ) is a utility company that operates in Montana, South Dakota, and Nebraska. The company is both a generator and a distributor of electricity and a distributor of natural gas. In November 2014, the company completed a significant transaction, buying up hydroelectric generating facilities for $904 million. The idea is that this will decrease the company’s overall risk profile, since this transaction would decrease the company’s reliance on purchasing agreements. This is similar to how Questar Corporation sources natural gas from its own subsidiary instead of just being a typical distributor. Thus far, investors have been indifferent, as the stock hasn’t gone anywhere in a year. Is there anything wrong? To complete the transaction, the company issued 7.77 million shares at $51.50/share and $450 million of debt at 4.2%. The debt seems cheap, but the share issuance increased total share count by 20%, so there was significant dilution. However, this doesn’t seem to be a problem, as the company has significantly increased its cash flow generation. Year to date, the company generated $304 million of operating cash flow versus $205 million from last year. This represents an increase of 48%, well above the dilution. If we ignore the working capital changes, the improvement is more subdued (+15% from $207 million to $238 million), but is still impressive nevertheless. From an earnings perspective, the company seems to have gotten into a bit of trouble in Q3, as EPS dropped 33% from $0.77 to $0.51. As we’ve discussed earlier, the company was quite healthy from a cash flow perspective, so what caused this discrepancy? The answer lies in the income tax expense. In Q3 2014, the company benefited from the release of some unrecognized tax benefit. This was not repeated in 2015. For that reason I think the company’s performance is better judged by its earnings before tax, which mirrored the cash flow growth, rising from $12 million to $30 million. Looking at the balance sheet, I don’t see any reason for investors to worry either. Although there is $2 billion of debt, there is no major redemption until 2019, when $250 million would be due. Considering the company’s high cash flow, I believe that the company should not have any problem paying it off or rolling it over. From a coverage perspective, the company currently has an EBIT/interest expense ratio of 2.8x in 2015. For companies in other industries, I would be very cautious, but since the company is in the utility industry, investors do not have to worry about wild swings that could jeopardize the company’s current capitalization. From a valuation perspective, the company’s P/E ratio has steadily climbed to 18x given the multi-year long bull market. While the stock is no longer cheap on an absolute basis, I believe if you are looking safety, NorthWestern Corporation will still fit the bill. In other words, you are paying a fair price in exchange for the company’s stability. Keep in mind that the stability I’m referring to is the company’s ability to generate a profit, not revenue. Due to swings in the commodity market, revenue will not experience steady growth, but as a utility company, the company should continue to generate steady profits. (See below) Takeaway The company has continued to deliver good results in 2015. I believe that the relative muted response from the market can be attributed to the overall pessimism in 2015. As we head towards year-end, it has become apparent that a multi-year long bull market is finally coming to an end. As we step into a more uncertain future, I believe that defensive investors should be very confident about holding on to a company like NorthWestern Corporation.

Employment Triggers A Green Light For A Fed Rate Hike, But…

By Jack Rivkin It’s still a slow-growth environment. Inflation is low. Investors can expect continued performance dispersion. Employment is off the table for the Fed As mentioned in our earlier video blog , the November employment gain of 211,000 combined with the upward revisions totaling 35,000 for September and October certainly took the employment issue off the table as a showstopper for a Fed Funds target rate hike this month. There are very few categories where the actual unemployment rate is above the 5.0% rate for the overall workforce: teenagers at 15.7%, blacks at 9.4%, Hispanics at 6.4%, those with less than a high school diploma at 6.9%, those with only a high school diploma at 5.4%, and I would highlight mining at 8.5% (versus 2.8% a year ago). I would posit that these levels are not the responsibility of the Federal Reserve to deal with. And, what is going on in the mining sector, which includes oil and gas extraction, may have added to the employment roles in other categories as lower energy prices increased both consumption and most companies’ (ex-energy’s) profit margins. The November beige book and the latest JOLTS report point to a tighter labor market with increased difficulty filling jobs and quit rates high, which point toward an increase in wage rates. The Fed does have to look at a tight labor market and make some judgments regarding this ultimate impact on inflation and the pace at which its 2% target is achieved. So what about inflation? The Fed’s preferred measure of inflation is the core personal consumption expenditure (PCE) index. That index is up only 1.3% year-over-year and was actually flat month-over-month in October. The general belief is that the US inflation rate may stay lower longer given the expected slow pace of global economic growth, the strong dollar and continued technological innovation. One cannot ignore the tragic events in Paris and San Bernardino as having an impact – on the margin, of patterns of consumer spending and, possibly, levels. This is likely to keep the Fed on a very slow path of target rate increases extending the runway for slow but steady real and nominal growth. I think this path will be followed until inflation actually picks up. I have some views on the timing of this, which I have been saving for this year’s Perspectives piece “What to Expect in 2016 (and Beyond),” but will provide a preview in a separate blog as a wild card to watch for. And what about the markets? In turn, these economic and financial results will likely produce slow growth – matching nominal GDP – in the US stock market if valuations stay close to current levels. The fixed income markets, on the surface, could also appear somewhat benign with a moderate increase in overall rates. No doubt, the slower pace of growth will produce specific credit issues – certainly in energy, but likely some other entities – but credit overall, may hold up reasonably well. The credit markets, at the moment, would appear to be pricing a broader disaster, particularly in the high yield markets. I think we will see some specific disasters – credit issues, but decent credit analysis can eliminate or reduce the impact. An actively-managed portfolio in high yield could be a logical allocation to a portfolio. Odds are some of the longer term trends in currency, commodities, and relative market performance will continue for a while with some bumps along the way when markets misread central bank actions or statements (à la Draghi) or geopolitical events cause temporary disruptions. So, how should one invest? In the table below, which looks at performance of the S&P 500 over the last several years, an interesting pattern emerges: When the market has been up or down double digits, all one really had to do was either own or sell the whole market. However, when we have experienced single-digit performance for the overall market, much as we are seeing this year, there has been significantly greater dispersion among stocks. This is an environment we expect to continue for some time-slow nominal growth in the economy and the equity markets, leading to dispersion of performance tied to active company management and active investment management. Why do we expect slow nominal growth to persist for several years making active management more important? There are at least four reasons (and I am sure some others): As Eric Peters of One River Asset Management recently reminded us, when the Fed takes action, which is typically designed to reduce the magnitude of an economic decline or surge, it has an effect on future patterns of growth. Easing pulls growth forward, while tightening pushes growth out, reducing the depth of the valleys and the height of the peaks and the distortions in employment and inflation those produce. We have been through an extraordinary pulling forward of future growth and it will take time for us to return to normal. The debt burden incurred by sovereign nations has been and continues to be enormous. If nothing else this will affect fiscal policy as the tool it could be to add to growth opportunities. China’s transition from a global engine for industrial production and consumption to a more internally-focused services economy, combined with the reversal of its own extraordinary steps to offset the impact of the western world recession – just look at the production and pricing of hard commodities beginning in 2009 – will be a damper on global growth for the foreseeable future. This bears watching to see how closely the yuan continues to track the dollar, or if it’s inclusion by the IMF as a reserve currency leads to a tracking of a basket of currencies and a different interest rate regime. Without putting too much weight on it, the “Buffett Rule” – future equity growth is problematic for a number of years when the total market value of equities exceeds the value of GDP – is operative. I discussed this anecdotally in a recent post . In a slower growth environment the likely dispersion of equity returns would push one away from index-hugging strategies toward active managers both long only and long/short managers. We have been suggesting this for a while. We would include private equity allocations in the active long only category if immediate liquidity is less of a need and the attractiveness of a potential illiquidity premium in a lower growth environment is magnified. We have these more active managers in our stable of funds, but others do as well. The key message is to adjust allocations to include more of these active strategies in the portfolio as one looks at the environment ahead. In the fixed income space, while there is risk of rate volatility affecting all debt classes, as big a risk would appear to be more specific credit issues. Does that mean one should be moving up the credit curve? I think the answer is in part, “yes.” But, the preferred way to do that would be similar to the approach on equities: Look for active managers – not benchmark huggers – who are analyzing specific credits and taking advantage of the homogenization of yields that comes from index buying and selling. The high yield index is offering a fairly significant yield spread over treasuries – very tempting as a category. But, just remember that around 18% of that index is in energy and hard commodity bonds. As shown below, the rest of the index, while at lower yields, is at spreads we haven’t seen for almost three and a half years. Historically, in a different energy regime, the rest of the index used to trade at higher spreads than oil and metals. At this stage, I would rather have someone looking at individual securities making up a diversified portfolio where the detailed analyses show relatively lower credit risks in the environment we foresee. Who knows? There may even be some energy credits that are worth holding but have been tarred by association. We see that in our own portfolios. There are certainly some credits in both high yield and investment grade where the credit default swaps don’t fully reflect the degree of risk at this stage. I want managers who are running portfolios where they can tell me the precise nature of the balance sheets of their individual holdings and the risks associated with the businesses. This is different from what has been required previously. One should not ignore the uncorrelated strategies, particularly systematic trend following. There are some long-term trends in place. While there are likely to be occasional reversals – some of which could turn into more permanent moves, I would rather use these managers to recognize the patterns and determine which foreign exchange, commodity, equity and fixed income indices should be included, negatively or positively, in the portfolio at any given moment in time given the environment we are facing. Allocations need to change It is hard to determine in isolation what the allocations in a specific portfolio should be. That requires a discussion. I know the allocations to active strategies should be higher. As I have been saying, past performance may not be the best guide for the future as opposed to a realization of a different pattern of future returns and an understanding of the volatilities and risks that exist in the environment we foresee. It is a less easy environment, with lower overall returns, but possibly a broader set of opportunities to meet one’s specific goals.