What Do Tesla And Alcoa Have In Common?

| About: Alcoa, Inc. (AA)

Summary

Tesla shareholders will argue that it is a cutting edge tech change agent with plans to reduce reliance of fossil fuels. They would be right.

Alcoa shareholders will argue that once the company splits it will unlock the value of its fast-growing Arconic segment. They may also be right.

There are commonalities that the companies share and not all are good. And these are not the only companies painting rosy pictures of themselves.

Tesla (NASDAQ:TSLA) is attempting to reinvent the century-old auto industry through disruptive technology from without. Alcoa (NYSE:AA) is attempting to reinvent itself as an established company within a century-old industry by disrupting itself. Two very different approaches but both applying disruptive technology to established, mature industries. I do not think we have seen anything yet in terms of disruptive forces changing mature industries. I still invest with a long-term perspective but I am always watching the trends for emerging tech that may disrupt one of my holdings. We live in interesting times to be investing.

Tesla builds luxurious, electric vehicles and has a good number of people (especially drivers of its cars) very excited about future possibilities. The company is a relatively new face in an industry that has been with us for over a century with six companies having annual revenue (2015) among the highest on the globe ranging from $150 billion to $237 billion (not all of which comes from auto sales). The company has a lot of huge competitors. I will not try to pass judgment on whether TSLA will change the world, or even become wildly profitable someday, as the future remains murky so far. There are a load of possibilities open to the company if it can ramp up sales aggressively with its new Model 3 sedan. I suspect there will be many bumps along the road to success and am not certain that the company, or its leadership, is quite up to the task. Time will tell.

Alcoa is an old tech company and fifth largest within its industry. The company is preparing a split into two companies, the Global Primary Products (bauxite, alumina, aluminum, casting, energy) and the Value-Add Company (global rolled products, engineered products and solutions, and transportation and construction solutions). If I am interpreting the press releases correctly, the idea is to unlock the growth value of the value-add business by unencumbering it from the more commodity price sensitive primary products business. There may be promise for shareholders if the plan works as expected.

The concern I have with both companies is in the reporting of earnings per share [EPS] in press releases. Both do report GAAP EPS but both emphasize non-GAAP EPS. The part that is concerning is the significant difference between GAAP and non-GAAP EPS. As you can see in the table below, in quarter 2 [Q2] 2013 both companies lost money on a GAAP basis but reported profits on a non-GAAP basis. Calculating a percentage difference does not produce a meaningful number when moving from a loss to a profit, but in Q2 2016 we can see that the percentage difference between GAAP EPS and non-GAAP EPS is significant. TSLA reported a loss in Q2 2016 but the loss was 49.3 percent better that it would have been under GAAP. The headlines for earnings press releases from both companies used the non-GAAP EPS. AA reported a profit in Q2 2106 that was 66.7 percent higher than GAAP EPS. Such large differences between GAAP and non-GAAP EPS should throw up some red flags for investors and raise some questions that need to be addressed in a due diligence process.

TSLA

Q2 2013

Q2 2016

GAAP

$ -0.26

$ -2.09

ADJ

$ 0.20

$ -1.06

$ 0.46

$ 1.03

NA

49.3%

AA

Q2 2013

Q2 2016

GAAP

$ -0.11

$ 0.09

ADJ

$ 0.07

$ 0.15

$ 0.18

$ 0.06

NA

66.7%

Click to enlarge

Examining the difference between GAAP and non-GAAP EPS

I chose these two companies for a reason: both reported EPS that provide a much better perception of the company than would be the case under GAAP. This article is not designed to make a recommendation one way or the other. Instead, I just want readers to take into consideration what sort of expenses are being removed from GAAP EPS to attain the much improved appearances provided by non-GAAP EPS. It is not a difficult process and all it takes is a look at the reconciliation of non-GAAP to GAAP usually provided in the press release.

I will look at TSLA first. Here are the lines from the TSLA press release used to reconcile the differences.

Stock-based compensation expense$67.3 million$0.48 per share

Non-cash interest expense$31.8 million$0.23 per share

Models S and X deferred profit from leasing$44.5 million$0.32 per share

All of this was added back to GAAP EPS to arrive at the reported non-GAAP EPS. I want to look at each line and consider if adding these expenses back to the GAAP EPS actually gives us a better understanding of the company's results.

Stock-based compensation is a non-cash expense and could be argued that it costs the company nothing. But it does cost the shareholders every penny of the compensation amount through dilution. This argument went around in circles years ago with technology companies using stock options as a form of compensation and not recognizing the expense on the income statement. While it is true that the expense does not come out of operating income or cash from the company, the expense is real enough for shareholders. That is why the decision was made to require such compensation to be reported as an expense. The company posted a GAAP loss of $293 million for the quarter of which 23 percent was a non-cash expense for compensation.

I can understand the reasoning from an executive point of view that it cost the company no cash. But it seems to me that the same executive is supposed to have a fiduciary responsibility to shareholders as his/her primary goal. If owned TSLA stock I would consider that money out of my pocket and would expect it to be reflected in the stock price at some point in the future. I am conservative by nature but this is a recurring expense that reduces (through dilution) the value of outstanding shares and thus would prefer to not have it added back. It can come out of the cash flow statement, but analysis of cash flow is a completely different process.

Non-cash interest expenses (related to convertible notes and other borrowing) is essentially an accrual of interest expense. This is expensed under GAAP accounting in order to match the cost of debt to the period during which it is used. It happens every quarter and is a recurring expense. The actual cash payment will go out during the next quarter and the remaining portion of the payment not already accrued will be expensed also at that time.

I do not like this coming out in the case of TSLA because the expense is rising over time. This is a form of reducing current expenses and delaying recognition. The debt was in place during the whole period and the cost of that debt should be included as an expense, whether it is cash or accrual. Until TSLA stops increasing its debt and the interest expense levels out this maneuver is merely an attempt to make the current period look better. The footnote does not explain the detail of the calculation so it is not clear if the portion of interest expense that was accrued in the prior period was added back making this a "net" number. Usually if that is done the description would include the term net. Either way, reducing the interest expense by more than half (from a total of $46.3 million) seems to be on the high side to be a net number. If so, TSLA may be subtracting the accrual but never adding back the prior period accrual which was paid during the current period. Since the company does not explain the details it is hard to be sure one way or the other, but this looks suspicious to me. Once again, I would prefer that this line not be used to reduce expense because I would rather have the actual expenses incurred during the period of operation. That is what an accrual does.

Deferred profit from leasing is also suspect. It means that TSLA is showing what it would earn on the leases if revenues were not deferred. I realize that the company states in its footnotes earlier in the release that revenues for leases are recognized at the time the revenues are collected over the terms of the lease. That is all fine and good, but recognition of the "profits" portion of those sales up front is an overstatement of current earnings. The company deferred the revenue because it has not "earned" it yet. The same treatment should be applied against earnings.

Now I will look at Alcoa's non-GAAP EPS to see what it decided should not be counted against earnings.

Has anyone noticed that the company recorded a gross gain of $223 million from the liquidation of company-owned life insurance policies during the quarter? After the exclusion of special items the company reported net income of $213 million for the quarter. The gain was reduced significantly by related taxes, but it appears that the majority of earnings this quarter came from this gain and a few others. In other words, operations did not do nearly as well as suggested. But I digress.

AA does not provide a reconciliation statement to show how it got from GAAP EPS to non-GAAP EPS, not does it provide a detailed break out of the expenses that were removed to make earnings look better. The company merely states that the adjustments to arrive at non-GAAP EPS were "special items separation costs, restructuring-related charges and associated tax impacts." The items were discussed but the details of each was not broken out. But I will do the best I can.

Separation costs really do relate to a one-time, non-recurring event that do not have a meaningful impact on operations and thus I agree that this expense should be removed from GAAP EPS in the adjustment to provide a better reflection of operations. The amounts were not provided.

Restructuring-related charges are generally considered a one-time, non-recurring event and would normally be removed from the GAAP presentation to provide a better interpretation of operations results. But in the case of AA, restructuring-related charges have occurred every year for at least the last six year; I checked. Management is supposed to fine tune operations regularly to improve productivity and margins. Such actions do not represent bonafide restructuring charges and are, in the case of AA, definitely not one-time events. The expense for the quarter only amounted to about $0.02 per share, but when a company has only $0.09 EPS total it becomes significant. It appears that AA has taken the concept of identifying ongoing expenses as non-recurring restructuring charges to an art form. When does an expense that occurs every year no longer qualify as a one-time event? I do not buy this one.

The associated tax impacts of special items refers, as best as I can determine, to both the gain on liquidating insurance and some separation activities (I assume sales of assets). When does it make sense to remove related expenses but not remove the related gains or income? Unless AA decides to remove the gains from sales of assets (which it should since one can only sell an asset once, therefore it is a one-time event) from the revenue side along with the associated expenses this appears to be mostly bogus to me. These events are not related to ongoing operations; that is clear. But recognizing the benefits and ignoring the expense does not provide a clearer understanding of actual operations. I suspect that if both sides were removed to provide a clear representation of operations AA would be reporting a loss instead of a profit.

Summary

This article is not intended to pass judgment or recommend the purchase or sale of shares of either company. Rather, my intent is to provide readers with a little better understanding of what goes into a proper due diligence inspection of a company rather than reading and accepting the headline numbers. If you really want to understand what you are buying you need to dig under the surface and not accept all that management says at face value. Management is doing its best to paint the best picture it can without making outright false claims. In other words, they tend to bend the truth and present it in the very best possible light. If the price of their company stock goes down those options are not worth as much.

Investors need to look out for themselves and that means doing the due diligence and understanding what is being reported. The analysis above is merely my opinion. Others may come to different conclusions. I recommend that those who are directly managing their own portfolios do the homework or find someone the trust to do it for them. Headline numbers can be very deceptive!

As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

For those who would like to learn more about my investment philosophy please consider reading " How I Created My Own Portfolio Over a Lifetime, or for those who would rather listen to a podcast on the same subject, you may want to consider my interview by IITF.com which can be found here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.