Naveen Selvaraj's  Instablog

As per my understanding, non-GAAP EPS values are supposed to provide a 'better' picture of a company's earnings power. While GAAP EPS might be skewed due to one-time charges, the non-GAAP EPS value was supposed to strip-out the effect on such one-time items and therefore provide the investor with a metric which can be compared across quarters. In case of most software companies, the non-GAAP numbers are not necessarily comparable and I would recommend that investors stick to the GAAP EPS numbers alone. Here's why:

Non-GAAP does not mean that 'simple' accounting should be overlooked!

I'm sure all students of accounting are familiar with the 'Matching' concept. The EPS Non-GAAP numbers which most software companies regularly report and also provide guidance on fails this concept. Let's take this example from a software vendor BlackBaud Inc(Nasdaq: BLKB) :

Exhibit I: Non-GAAP reconciliation table from Blackbaud's Earnings Release

Source: Gridstone Search

BLKB has added back stock-based compensation(SBC) expenses and Amortization expenses besides the deferred revenue component from an acquisition(Kintera) and provided a non-GAAP operating profit which is almost 70% higher than the GAAP operating profit of $10M for the Dec08 quarter. I have no problem with the add-back of deferred revenue since that is indeed revenue earned. But why does BLKB add-back(i.e not account for) SBC and amortization costs. Though these are non-cash charges, they are not one-time charges and have to be incurred on a recurring basis to garner incremental revenues and profits. SBC is an important part of employee compensation and that will recur every quarter and is a large component(usually 10% of OpEx) for most software companies.

The same holds true for amortization expenses. As long as the company carries intangibles(mostly acquired) which provide additional sources of revenue, amortization expenses will be incurred and only profits net of amortization provides the net operating profits earned from all technologies/Intellectual property at the company's disposal. In the example above, BLKB has added back revenue from a acquisition(deffered revenue) but seems to deduct (or add-back) the expenses, which are recurring in nature and instrumental for current revenues and also essential to garner future revenues, to arrive at non-GAAP numbers to investors. This is like saying that ' I will take the positive effect of acquisition but I will not take the negative effects while giving comparable numbers'. Therefore rather than providing a better picture to investors, the non-GAAP numbers end up being more misleading.

The list below is just a sample of software companies which report such non-GAAP numbers. If the GAAP and non-GAAP values are significantly different for one-two quarters, then we can atleast accept that the numbers are useful since they remove the effect of some period-specific events. However the list below clearly suggests that non-GAAP EPS is essentially a 'different' way of calculating EPS and so the difference between the GAAP and non-GAAP numbers remain consistent across quarters. If that is the case, are these Non-GAAP numbers necessary?

Exhibit II: EPS, GAAP an Non-GAAP for Some Software Companies

Source: Gridstone Research

The table below further gives evidence of how mis-leading non-GAAP EPS can be. When GAAP EPS grows, the growth of in non-GAAP EPS is almost always higher. And when GAAP EPS declines as is the case in the last two quarters, the magnitude of decline is much lesser in case of non-GAAP EPS. To take BLKB's case, from Dec07 to Jun08, while GAAP EPS increased by 6%,23% and 10% YOY repectively every quarter, non-GAAP EPS increased by 15%, 25% and ~14%. When GAAP declined in Dec08 and Mar09 by 25% and 44%, non-GAAP EPS increased in DEC08 by ~5% and declined by just 5% in Mar09. What are investors supposed to infer from these non-GAAP numbers? That BLKB earnings is pretty much unaffected by the slowdown and only GAAP rules make it look affected by the slowdown!!!

Exhibit III: YOY Change In EPS, GAAP and Non-GAAP for The Same Set

Source: Gridstone Research

The non-GAAP metric is thus more favorable to the company and does not necessarily make the numbers comparble because:

1. Amortization expenses will be continually incurred due to past acquisitions and intagible assets might again  increase signifcantly due to an acquisition in the future. Just to give a context, Oracle Corporation(Nasdaq: ORCL) carries $26B of intangibles against a total balance sheet size of $45B as of Feb09. And, these assets did'nt come free. They were paid for largely in CASH and partly in stock. Essentially, amortization expenses are capitalized 'revenue-generating' assets being expenses out and so cannot be ignored in any analysis of companies which have such assets in large quantum.
2. Personnel costs are the most important and largest expense for software companies and SBC is an integral part of personnel costs. For example, Adobe Systems Inc(Nasdaq: ADBE) had a SBC expense of $45M in the May09 quarter against a total Opex of $470M. So 10% of OpEx which is consistenly incurred cannot be  wished-away while doing a comparison.

Companies can knock-off one-times such as restructuring charges but not such recurring charges...

While I would welcome companies providing non-GAAP numbers by knocking off one-time charges like restructuring charges, impairment charges, it seems a bit odd to see companies make non-GAAP adjusments which ultimately make the non-GAAP values more skewed than GAAP figures. It looks like non-GAAP disclosures have lost their real purpose and are provided only to paint a more 'optmistic' view and not necesarily the 'right' view for investors.

Disclosure: No Positions

Note for folks interested in further exploration:

Here's a quick way to look for how different companies report Non-GAAP reconciliations using Gridstone Search. In Gridstone Search, doing a search for keywords 'Non-GAAP' across companies in the Industry - 'Application Sofware' gives direct links to tables from company SEC filings which show such GAAP to non-GAAP reconciliation. Filtering results by choosing the 'Tables' option will provide all the tables as below. My search for filings of the last year yielded ~800 such results. One such table(BLKB) output has been used as an illustration above.

Source: Gridstone Search