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  • Non-GAAP Abuser Of The Week - Merck

    In my last Instablog I described how investors are having the wool pulled over their eyes with the proliferation of non-GAAP reporting. I made the case that because it is becoming so ubiquitous, references to market PEs are becoming useless and hide the fact that the market is extremely overvalued at this time.

    This week, we saw Merck ($MRK) go full-tilt on non-GAAP reporting.

    A review of Merck's earnings announcement exemplifies my point.

    Q1 Non-GAAP EPS = 85 cents/share

    Q1 GAAP EPS = 33 cents/share (-42% yoy)

    2015 Non-GAAP EPS guidance = $3.35 to $3.48 (raised)

    2015 GAAP EPS guidance = $1.58 to $1.85/share (reduced)

    All the headlines read how the company did so well in the quarter, how outlook and guidance are so good, etc.

    Stay tuned - it will be interesting to see how far companies go in the next few quarters to hide the deterioration of their earnings.

    Apr 30 8:24 AM | Link | 1 Comment
  • The Emperor Is Naked!

    Not a week goes by that we don't see a few articles on investment sites and stories on CNBC and Nightly Business Report where some well-known financial figure is justifying why the markets are overvalued, undervalued, or just right. Invariably, most of the justifications have some basis in corporate earnings and PE vs. historical levels of earnings and PE.

    The problem with these expert arguments is that they all tie back to EPS - company-reported EPS. This begs the question, what is "EPS"? We see two prevalent definitions of EPS these days:

    1. GAAP EPS - this is EPS based on "Generally Accepted Accounting Principles". If you read any company's income statement, this is what the bottom line EPS is.

    2. non-GAAP/adjusted/pro forma EPS and EBITDA - these are what we call "Whatever the company would really like their reported-EPS to be at this time". The company will start with the bottom line GAAP EPS, then add back common expenses that they prefer not to include - thereby giving the ability to boost their reported earnings. In discussing non-GAAP EPS in his book Financial Shenanigans, Howard Schilit provides the following:

    SEC Not Amused by Pro Forma Chicanery

    The SEC has taken note of these schemes. In a March 2001 speech, the agency's chief accountant, Lynn Turner, attacked company disclosures that appeared to "turn straw into gold." He described how the fixation on corporate profits has led companies to move from reporting EPS (earnings per share) to creating the turbo-charged pro forma EBS - Everything but the Bad Stuff.

    The company and analyst justification for reporting non-GAAP EPS is basically "these are one-time non-recurring expenses and don't give a true picture of the business operationally". Only problem is that these expenses occur every quarter and are in fact on-going/common/expected expenses that are part of the operations.

    Where we run into more problems is that historically, companies did not widely report non-GAAP EPS - EPS meant GAAP EPS. It really was not until Internet Bubble (IB) 1.0 that the use of non-GAAP measures began to infiltrate Wall St. and the financial markets. We all know that valuations donned on most internet stocks of the period were bogus, and the use of non-GAAP measures provided a means to inflate many and have some justification. Though we have gone through the purging of IB 1.0, and the sock puppet has died, non-GAAP EPS has not only lived on, but it's thrived and is now the norm. When discussing EPS these days, it is almost a given that what is being discussed is non-GAAP/adjusted/pro forma EPS - AND THIS IS BAD!

    What is bad is that analysts and financial "experts" are now using this concocted EPS in arriving at the proper PE ratio. If you have a bogus EPS, certainly you therefore have a bogus PE. Our contention is that across all the equity markets, we are looking at phony PE ratios and in actuality they are significantly higher. As a result, most of the US equity market is currently wildly overvalued and indexes deserve to be significantly lower.

    One company we follow, that has consistently abused non-GAAP reporting is Speed Commerce ($SPDC). Take a moment to read through SPDC's recent earnings announcement - notice the liberal use of non-GAAP metrics everywhere with only a single, almost hidden reference to the GAAP EPS numbers. At the end of the earnings announcement, the company includes the boilerplate "Use of Non-GAAP Information" statement and they've washed the blood from their hands.

    To summarize:

    • Use of non-GAAP EPS is now more prevalent than ever
    • Importance of GAAP EPS is being trivialized by the investment community
    • Barometers and historical metrics used for determining company and market valuations are now ineffective because of the ubiquitous use of non-GAAP EPS
    • As the economic recovery is maturing, financial engineering is becoming more widespread to mask weakening corporate performance
    • At some point, we believe there is going to be "The Emperor has no Clothes" revelation and it will be followed by a massive "reset". When this happens, things are going to become very ugly for those companies that rely upon and emphasize the use of non-GAAP/adjusted/pro forma EPS reporting.
    Apr 12 1:42 PM | Link | 1 Comment
  • It's Time To Pull Back

    To cut right to the chase, we're recommending extreme caution investing for the remainder of 2015. We see many red flags in the US and world economies, and believe the level of froth in the US equity markets is pushing the indexes into bubble territory.

    Below are some of those red flags we see. We leave the thought and investigative process to the reader. Our belief is that each on its own requires caution. When taken together as a whole, it screams for extreme caution.

    1. The entire world is now following the US lead of economic stimulus, taking actions similar to the QE and bond buying the Fed has done over the past few years and is now ending.

    2. Most of the world also has a near-zero (or negative) interest rate policy attempting to drive domestic investment.

    3. The Fed will give an interest rate increase by the end of 2015. The amount and timing of it is really of little importance, just that it will happen and signal that further rate increases will be following.

    4. Oil will remain below $75 for an extended period, possibly years.

    5. Earnings quality is falling, being bolstered by share repurchases and a good deal of financial engineering.

    6. PEs are rising and there is not good justification for it.

    7. Volatility has been increasing and we've been seeing wild swings in the US indexes.

    8. Apple is now worth over $700 billion, is a holding of most mutual fund and professional investment portfolios, and has been added to the DJIA.

    9. We have concerns about continued/blind money flows into index mutual funds.

    The investor should read each of the above points and objectively consider what the implications are for the equity markets and individual companies he/she has invested in?

    Yesterday, our concerns continued to be bolstered as we read the following article:

    We've been trimming our portfolio over the past few weeks into market rallies because of our concerns. Our plan for the remainder of 2015 is to remain with a heavy cash bias while making select investments based on our approach of letting insider purchases guide us. We still see bargains in many small regional and community banks and believe the banking sector will be beneficiaries of the coming interest rate increases.

    In conclusion, we believe that it's time to trim your portfolio and build cash. It's not a call to exit the market and it's not yelling fire in a crowded theater. It's a recommendation for each investor to take a look around, consider the gains you've taken out of the market over the past 6 years (have you taken gains or are they all paper gains?), and be extremely cautious in the near to intermediate term.

    Mar 24 8:44 AM | Link | Comment!
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