About those Q2 earnings…
They’re not real. Corporate earnings, as interpreted by most analysts and journalists, are optimistic at best. At worst they’re just manipulated or phony. So while I hate to keep harping on this issue, the latest wave of bullish Q2 profit headlines has motivated me to do so.
The perceptional-delusion index is near record highs. Why so skeptical? Part of the problem is widespread use of “operating income” (aka pro-forma or non-GAAP) to support the bull-case. This distorted version of earnings excludes many so-called “nonrecurring” costs. Operating income is sold as being what a company would normally have earned. You just have to ignore certain sections of their books.
Exhibit A: Intel
Take Intel’s Q2 2009 press release, which touts “non-GAAP operating income of $1.4 billion“. That number excludes a $1.45 billion fine from the EU. Excluding this charge seems fairly reasonable at first. I mean, how often does a continent slap a $1.45b fine on you? But even when you exclude the $1.45 billion charge, “operating income” is still down $820 million from Q2 2008. You won’t find that in the bullet points.
The real problem is that these so-called “nonrecurring” events have become a regular quarterly tradition. Since the 90’s, companies have shifted the focus to OE. Common expenses, including fines, acquisition costs and investment losses are routinely excluded from headline numbers. Take a look at the highlights from Intel’s Q2 2008 release:
- Operating Income up 67 Percent Year-over-Year
- Net Income $1.6 Billion; EPS 28 Cents
The emphasis is clearly on operating income. Problems arise when the public starts basing their analysis on these numbers. Journalists who want an eye-grabbing headline can simply run with “Intel Income up 67%”. Analysts are guilty of steering the focus towards operating earnings.
“Nonrecurring” charges, boom or bust
In boom-times companies can lump costs like stock options and acquisitions into the nonrecurring category. During rough years, things like severance, layoffs and plant closings get dropped. No matter the economic climate, earnings will be presented in a way that reflects best-possible-scenarios. These “nonrecurring” or “one-time” costs are a part of doing business, and should be reflected as such in income statements.
Nonrecurring gains, you say? Oh yeah, let’s include those.
Conversely, one-time gains are often highlighted in corporate press releases and media headlines. Case in point: Visa’s Q2 2009 report. AP Headline: “Visa quarterly profit jumps 73 percent”. But that includes a one time gain from a Brazilian investment IPO. If you exclude it, the jump was 43% from last year, a huge difference.
Differing from traditional reporting
Pseudo-earnings are NOT the norm historically. Sweeping inconvenient charges under the rug is a fairly new phenomenon, which only took off during the 1990’s. In 2001 the SEC even issued a warning against Pro Forma earning manipulation.
So next time you hear someone say what a bargain stocks are, or see a chart of historic P/Es, check the data. If the methodology is not specified, assume the most optimistic multiples are being used. Permabulls invariably use the rosier version. Bears are also accused of using the version that supports our view. But there’s an important difference; Our version represents the actual bottom-line as traditionally measured. It’s not pessimistic, just realistic.
Effect on P/E Ratios and Historic Comparisons
According to most analysts and media, the S&P 500 currently trades at a P/E 0f ~16. Where they get this number, I don’t know. As we noted earlier this month, the real 12-month trailing multiple is 134x (as of June 30 2009, according to S&P). That’s reported profits, aka real earnings, bottom-line.
David Pauly had a nice Bloomberg editorial today on the issue, with specific examples (notably absent from the homepage, wouldn’t want to spoil the rally). He puts most of the blame on analysts, but I think media shares it. Excerpts:
In analystspeak, Intel Corp. wasn’t hit with a $1.45 billion fine from the European Union in the second quarter for anticompetitive practices.
As Wall Street tells it, the employee stock options Google Inc. granted in the second quarter didn’t cost its shareholders $293 million.
By similar Wall Street reckoning, the expense of cutting jobs and selling an asset that reduced McGraw-Hill Cos. second quarter earnings per share by 10 percent was immaterial.
Previous BN pieces on earnings distortion:
Disclosure: Long Google, no other positions in stocks mentioned.