The Non-GAAP Craze Gets Crazier

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Includes: DIA, QQQ, SPY, TWTR
by: Scott Fearon

Earnings, as the old Wall Street adage goes, are "the mother's milk of stock prices." But not all earnings are the same. More and more companies believe they can hoodwink investors into accepting the myth that non-GAAP earnings are a better measure of corporate progress than numbers produced by generally accepted accounting principles. In 2016's first quarter, 19 of the 30 Dow companies reported both GAAP and non-GAAP earnings.

In theory, filing non-GAAP numbers can give a clearer picture of a company's health by excluding expenses managements consider (or hope) to be nonrecurring, such as charges for divestitures, acquisitions, and foreign currency adjustments. In practice, non-GAAP figures increasingly allow managements to present wildly distorted pictures of their firms' financial health by omitting the most troublesome aspects of their balance sheets. Valeant (NYSE:VRX) is all over the news now for doing just that. But the biggest and, mystifyingly, least talked about expense omitted in non-GAAP numbers is stock-based compensation.

For many technology companies, stock-based comp is a massive liability: Twitter's (NYSE:TWTR) first quarter 2016 stock-based compensation was $151M, a staggering sum vs. Twitter's $595M first quarter revenues. This albatross largely explains why Twitter reported a first quarter GAAP loss of $80M, yet posted first quarter non-GAAP net income (or, rather, "income") of $103M. Analysts expect Twitter to have $700M in full-year 2016 stock-based comp, or almost 25 percent of estimated 2016 revenues.

According to FactSet Research, 2016 first quarter non-GAAP earnings were 29 percent higher than GAAP earnings for all US companies that reported both numbers. In 2015's first quarter, non-GAAP earnings were 20 percent higher than GAAP earnings. This growing emphasis on non-GAAP earnings masks a troubling trend: corporate earnings, the "mother's milk" of stocks, are shrinking.

In 2015, S&P 500 GAAP earnings fell below $100 per share, down from $104 in 2014. Earnings are estimated to fall further in 2016. They dropped 4 percent in the just-finished first quarter, which marked the fourth consecutive quarterly earnings decline. Revenues also fell, and are projected to drop another one percent in 2016's second quarter. Combine this downward trend in earnings with the inevitable fact that the Fed will eventually raise rates again, and it's hard to feel positive about the outlook for stock prices.

As the S&P has recently inched its way back toward 2100, the market's price-earnings ratio has also moved higher. If S&P 2016 GAAP earnings are $90 per share, then the market is now selling at a nosebleed 23x. Worse, select technology companies (like the FANG stocks anointed by TV pundit Jim Cramer over a year ago) sell at vastly higher valuations, which means downside risk is large, even for relatively strong businesses like Google (NASDAQ:GOOGL) (NASDAQ:GOOG) and Facebook (NASDAQ:FB). Shaky companies like Twitter, which is a nifty service but a questionable business, could fall much further when/if a widespread market selloff occurs.

Twitter has over $3 billion of cash, but also nearly $2 billion of debt, and advertisers are second guessing the value of advertising on Twitter and other social media sites. Just a few months ago, Wall Street analysts predicted Twitter's 2016 revenues would be $3 billion (almost all from ads), vs. $2.2 billion in 2015. Today, analysts predict Twitter's 2016 revenues will be below $2.7 billion. If Twitter has a 26 percent EBITDA margin (the company only gives full yearly EBITDA and capital expenditure guidance), the company's full-year EBITDA will be about $680m or around $1/share. Less capital expenditures of $300-$425M, Twitter will once again produce less than 50 cents/share in free cash flow. Its stock, short of an acquisition, could get cut in half again.

Though I see value in its service, I remain baffled why anyone would own Twitter's stock. I can only assume that many of its investors are true believer users. This blind allegiance reminds me of people who have been in psychotherapy for decades. They happily fork over huge amounts of money to some dodgy guru who probably attended a third rate university, all the while boasting about the benefits they are reaping from the process. Meanwhile, their wallets keep getting lighter and lighter.

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