Adjusted Earnings: Which Adjustments Are Legit And Which Are Overly Aggressive

by: Jeremy Blum
Summary

Managements, analysts and investment services are increasingly using adjusted earnings instead of GAAP earnings.

Twenty five of the most commonly used earnings adjustments are analyzed to determine which are overly aggressive and which are acceptable.

A discussion of each of the 25 most commonly seen earnings and EBITDA adjustments is included.

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Companies are increasingly using adjusted earnings and adjusted EBITDA (earnings before interest, depreciation, taxes and amortization). They also show adjustments for things like gross margin and operating expenses. The amount of adjustments being made per earnings report continues to increase. The types of different adjustments used have also gotten increasingly complex. Company managements are increasingly ignoring GAAP earnings and commenting on adjusted earnings. Quite often, the actual GAAP earnings and EBITDA will be briefly mentioned, then the rest of the earnings report will focus on adjusted earnings and EBITDA.

Based on these developments, it is important that we understand which adjustments they are claiming are legit and which are overly aggressive. This article sorts through 25 of the most commonly used adjustments to determine which are overly aggressive and which are acceptable.

Despite the many abuses discussed below, showing adjusted earnings and EBITDA benefits investors. When done correctly, it shows the underlying core earnings of the company by factoring out the noise. It tries to normalize the current earnings so investors can see the current run rate of earnings and EBITDA. This can often give a better indication of future earnings than GAAP earnings.

The criteria used to determine if the adjustments are legitimate are quite simple. Items adjusted out should be non-recurring items and/or non-operating items. Non-recurring items are items that do not occur regularly. Non-operating items are those not from the operations of the business. Also, these adjustments look forward not backward. The current run rate of the business looking forward is more useful to investors.

I have broken earnings and EBITDA adjustments into three categories: usually legitimate, not legit, and sometimes legit (adjustments that can be used in certain circumstances). Keep in mind, most adjustments used for EBITDA are also used for earnings.

On some of the items below there may not be a consensus, and I am using and supporting my opinion. I am very open to debate on any of the points below.

Usually Legitimate

1. Executive Severance - This is the cost a company pays to get rid of the rascal/a poorly performing executive. Most executives of publicly traded companies have severance agreements that require them to be paid a large sum if they are dismissed, unless dismissed for cause. These expenses are not recurring (they only get fired once) and are not from the operations of the business.

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2. Amortization of intangibles from an acquisition - Amortization is the “A” in EBITDA. It is a non-cash expense used to periodically reduce intangible assets. Amortization is different than depreciation, which is also a non-cash expense. Depreciation for the most part is real, fixed assets (generally other than real estate) tend to go down in value as they age. They eventually need to get replaced. Intangible assets from the purchase of a business do not need to be replaced and have no value on their own - it’s simply an accounting entry. While it is recurring, it is not real, so adding it back is legit. There are other types of intangible assets - such as mortgage servicing rights, licenses and patents - that may have value, and amortization of these should not be added back as adjustments. Those like fixed assets tend to go down in value over time, so the amortization is real.

3. Goodwill impairment - A goodwill impairment is similar to adding back amortization discussed above. Companies are not allowed to amortize goodwill anymore like they can amortize intangible assets. So, the goodwill from an acquisition just sits there unchanged. However, when the value of the business acquired goes down, a writedown of the goodwill associated with that purchase is required by GAAP. It is management’s acknowledgement that a business is worth less than they paid for it. It is legit to add back to earnings and EBITDA, as it is usually non-recurring - it's an accounting entry that does not affect tangible net worth, debt, or cash flow.

4. Restructuring expenses - Restructuring expenses are cash and non-cash expenses used to transform the business through cost cuts, re-alignments, and abandoning assets, among other things. They are not part of the day-to-day operations of the business. The question is, are they recurring? Some larger and/or more complex companies have restructuring expenses almost every quarter. If that is the case, then they are recurring and some or all shouldn’t be added back. You will need to look at the specific restructuring expense to see if happens frequently. For most companies, restructuring expenses are not recurring.

5. Loss on prepayment of debt - Most commercial bank loans to publicly traded companies have prepayment penalties if the loan has a fixed rate and is paid off well before maturity. Sometimes, if the company’s financial health has improved or interest rates have declined, it makes financial sense to pay off the loan early and eat the prepayment penalty. Financing activities are not part of operations.

6. Discontinued operations - Companies will at times declare a certain part of their business is no longer core to the business or, due to financial stress, needs to be sold to raise cash. Selling a business segment is a financing activity and not part of the operating activities of most companies. It is also non-recurring. An exception to this rule is business development or investment companies whose business is to buy and sell businesses. For them, this is a recurring and operating item.

7. Acquisition costs - Acquisition costs are investment bank fees and restructuring and other costs directly associated with a closed or upcoming acquisition. These are similar to other financial advisory fees and restructuring costs. I would argue even if a company is a serial acquirer, these should be adjusted out. The reasons for this are that each acquisition only happens once and the company can stop acquisitions at any time.

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8. Valuation allowance on tax deferred assets - Many companies have large amounts of tax-deferred assets. These are usually derived from net losses and can be used as a tax shelter in the future. However, if the accountants do not believe the company is likely to be profitable enough to use all of its tax assets, then a writedown is required. This is a non-cash item of an asset similar to goodwill, as tax-deferred assets cannot be sold on their own. So, they should be treated similar to amortization.

9. Startup costs - These are costs to start up a new business segment or store. Most new businesses lose money initially. However, you usually only start up a new business or store once, so it is non-recurring. Adjusting for start-up costs allows investors to look at the core business. For pre-revenue companies still developing their first product or service, this is not applicable - they are expected to lose money, and investors need to see the bleed rate.

10. Losses from business held for sale - For various reasons, sometimes a business segment is held for sale. If it is labeled "discontinued operations", then the Board has decided it is no longer a core operating business. More often than not, a sale or liquidation then actually occurs. Losses or gains from that business are shown as a non-operating item and not as part of cost of goods sold or operating expenses. Since investors look forward, this allows them to see the core operating results of the company after the sale or liquidation.

11. Advisory costs - These are fees paid to financial and efficiency consultants. They tend to revolve around a single initiative, such as cost cuts, accounting investigations, and major lawsuits. Some professional fees may be recurring.

12. Foreign exchange - This measures the impact of changes in foreign currencies versus the home country currency. They tend to impact revenues the most. Foreign exchange impacts go both ways, positive and negative, and often offset each other over time. This is a bigger issue when doing a lot of business in countries that have continuously declining currency, such as Argentina. In that case, a foreign exchange adjustment may not make sense.

13. Tax adjustment of all previous adjustments added back - This calculation multiplies the applicable tax rates by the amount of all items listed as adjustments. It should always be a part of the calculation, unless there is no tax impact. It is done to see the after-tax impact of adjustments to net income.

Not Legit

1. Employee stock compensation - This one is the greatest abuse by companies. If you come away with one thing from this article, it’s that most employee stock compensation should not be added back to net income and EBITDA. It’s a real, operating, and recurring expense. Companies that grant options or restricted stock to employees usually do so under pre-approved plans, making them recurring. Employee stock compensation is usually used in lieu of paying employees cash for their services. It is a form of compensation with essentially the same impact to shareholders as cash compensation. While cash is not being used to reduce net income and EBITDA, dilution is. So, after dilution, the impact to shareholders is similar. Tech and biotech companies use employee stock compensation heavily and usually add it back to net income and EBITDA in their adjustments. Many do it because their peers do. This practice should be banned in most cases, as it is highly misleading and overstates the profitability of the company. There is a situation where adding back employee stock compensation is legit. That is when the company is struggling and measuring cash flow available to pay debt service becomes the primary concern of shareholders over profits.

2. Restructuring if it occurs most quarters - As mentioned above, restructuring expenses if they are recurring, despite them being for different items, should not be added back. This is usually only the case for large complex companies with many factories or fixed assets.

3. Non-cash interest expense - This is interest expense paid by increasing the principal of the loan instead of paying cash. Unless the interest qualifies to be capitalized (an example being many construction projects), it is reducing tangible net worth just like cash interest. It is also a recurring expense. All that is happening is the company is deferring when it has to pay the interest, and is probably paying for that with a higher interest rate.

4. Amortization of debt discount - This is when the company receives less cash from its lender than the face amount of the loan. It is required to amortize that discount. It acts the same as noncash interest.

5. Management fees - Everything can be outsourced these days, including management. Management fees are usually only paid for smaller, less complex businesses. Often, the fees are going to an affiliated party, making these ripe for abuse. If management was not outsourced, the company would have to pay hired executives a similar amount.

6. Equipment sales for trucking and equipment rental companies - This is for trucking and equipment rental companies that own the equipment they use in their operations. That equipment ages rapidly and needs to be replaced. Selling the old and buying newer ones is part of their operating activities and recurring.

7. Hedging - There are three primary types of hedging: for interest rates, currency, and commodities. Hedging is an operating activity, as it locks in pricing the company needs to pay for some of its expenses or reduces swings in revenues. It is also generally a recurring activity.

Hedging for interest rates involves swapping an adjustable rate for a fixed one or vice versa. It is generally used as a tool by management to keep the company from being adversely impacted by changing interest rates.

Hedging for currency allows a company to reduce the impact of changes in foreign currency to the home country currency. If done correctly, it reduces fluctuations in revenues and expenses.

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Hedging for commodities allows companies that use a large amount of a raw material, such as crude oil, wheat, or pork, to stabilize the price they pay instead of being subject to rapid changes in prices.

8. Deprecation of capitalized software costs - While legal, capitalizing funds used for software development costs is an aggressive accounting procedure, in my opinion. R&D, which is similar, is not generally capitalized. Once capitalized, it needs to be amortized, and that amortization is often adjusted back to net income and EBITDA.

Sometimes

1. Lawsuit settlement or judgments - For most companies, lawsuits for or against are a fact of life. However, unless the company is a patent portfolio company, gains and losses from lawsuits are not from the normal operations of the business. If the company is constantly being sued over the same item, then it would be a recurring item. An example of that is a pharmaceutical company being sued in hundreds of cases over a drug that adversely affected people taking them.

2. Stock offering costs - This is primarily a fee paid to an investment bank and legal firm to issue stock. Finance activities are not core operations at established companies. However, some companies (especially startups) are serial equity raisers. If it is unlikely they will stop their cash bleed anytime soon, then measuring the cash bleed becomes important, and stock offering costs should not be adjusted out.

3. Change in insurance reserves - Insurance companies are required to maintain reserves for future payouts on the policies they have entered into. The calculation used to determine the right reserve amount is extremely complex and requires highly trained statisticians. That’s because it is looking forward at the amount of future claims. It is not hard to get it wrong. If the company seems to have an expense here most years, then it can be considered recurring. If the change was due to a secular change in the industry, such as rapidly increasing costs in long-term care insurance, then it should be considered recurring, as it may happen again. If neither of those situations is clear, then it would be appropriate to add them back.

4. Inventory fair value adjustment or LIFO adjustment - If it is clear that the book value inventory on hand is above market value, then an adjustment to write it down often occurs. The test here is whether it is a recurring or an unusual item. If it is recurring, then it shouldn’t be added back.

Takeaway

Managements make all kinds of adjustments to their income statements when coming up with adjusted earnings and EBITDA. Many stock analysts and services such as Yahoo Finance blindly use managements' adjusted numbers. Some companies can look a lot more profitable than they really are due to aggressive use of earnings adjustments. The biggest abuse is with employee stock compensation expense. You as an investor need to decide which expenses are legit and which are not. That is because sophisticated investors are already doing so.

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.