Morning in Arizona

Morning in Arizona

The Headline Animator

Wednesday, May 04, 2016

Earnings Gimmicks

Financial Review

Earnings Gimmicks


DOW – 99 = 17,651
SPX – 12 = 2051
NAS – 37 = 4725
10 Y – .02 = 1.78%
OIL + .24 = 43.89
GOLD – 7.30 = 1279.40

Private-sector employment gains slowed in April. According to Automatic Data Processing employers added 156,000 new jobs in April; it was the lowest level in 3 years. The ADP report is an early indicator of Friday’s non-farm payroll report from the Labor Department. The Friday jobs report is expected to show about 200,000 new jobs in April, but that’s before the weak report from ADP.

The productivity of U.S. businesses and workers fell by a 1% annual rate in the first quarter, marking the fourth decline in the past six quarters. Over the past year productivity has risen at a 0.6% pace, well below the historic 2.2% U.S. average. In the first quarter, output of the goods and services businesses sell edged up 0.4%. Yet the amount of time employees worked rose a much faster 1.5%. As a result, unit labor costs climbed 4.1% in the first quarter, the biggest increase since the end of 2014. Still, unit labor costs have risen just 2.3% in the past year, little changed from the prior quarter. Higher productivity is the key to better pay and an improved standard of living.

The U.S. trade deficit shrank in March by almost 14% to $40.4 billion — the lowest level in more than a year — but the plunge reflected a tough climate for American exporters and more caution on the part of consumers. U.S. exports fell 0.9% to $176.6 billion in March. Imports fell an even steeper 3.6% to $217.1 billion and touched a five-year low. The decline in imports offers more evidence that consumers are cautious and reluctant to spend.

The Institute for Supply Management said its non-manufacturing index rose to 55.7% in April from 54.5%, marking the highest level of 2016. The index surveys executives in industries such as retail, health care, hospitality, finance and technology that employ the vast majority of American workers. In April, the new orders index climbed 3.2 points to 59.9%. The employment gauge rose 2.7 points to 53% — the highest reading of the year. Readings over 50% signal more businesses are expanding instead of contracting.

The drop in crude prices is snowballing into one of the biggest avalanches in the history of corporate America, with 59 oil and gas companies now bankrupt following this week’s Chapter 11 filings by Midstates Petroleum and Ultra Petroleum. According to Reuters data, the number of U.S. energy bankruptcies is closing in on the 68 filings seen during the depths of the telecom bust of 2002 and 2003. A 60 percent slide in oil prices since mid-2014 erased as much as $1 trillion from the valuations of U.S. energy companies, according to the Dow Jones U.S. Oil and Gas Index, which tracks about 80 stocks. This has already surpassed the $882 billion peak-to-trough loss in market capitalization from the Dow Jones U.S. Telecommunications Sector Index in the early 2000s.

Some oil producers appear to be holding on, hoping the price of crude stabilizes at a higher level. Until recently, banks had been willing to offer leeway to borrowers in the shale sector, but lately some lenders have tightened their purse strings. A widely predicted wave of mergers in the shale space has yet to materialize as oil price volatility makes valuations difficult, and buyers balk at taking on debt loads until target companies exit bankruptcy. In the debt market, there are signs that lots of money could be lost this time around, especially in high-yield bonds. U.S. oil and gas companies sold about $350 billion in debt between 2010 and 2014, the peak years of the oil-and-gas boom, with junk bonds making up more than 50 percent of all issuance.

Worldwide merger deals have declined sharply from the intense pace that pushed them to record levels in 2015, a sign that could reflect broader weakness in the American economy and vulnerability for U.S. stocks. So far in 2016, the dollar value of completed deals is 22% below the same period last year, while the number of transactions is down 13%, as expectations of higher interest rates and more government regulation is making mergers seem more expensive and risky.

Brazilian prosecutors have filed a civil claim against iron miner Samarco and its owners BHP Billiton and Vale, demanding damages over the deadly collapse of a dam last November. The $44 billion lawsuit is the result of a six-month investigation into the catastrophe, which led to the pollution of a major river and killed 19 people.

Target is cracking down on suppliers as part of a multi billion-dollar overhaul to speed up its supply chain and better compete with rivals. The retailer plans to tighten deadlines for deliveries to its warehouses, hike fines for late shipments, and could institute penalties of up to $10K for inaccuracies in product information. The moves, effective May 30, are the first major steps Target has taken to fix supply problems that emerged after it expanded offerings, including fresh food, several years ago.

This is a busy week for earnings reports. For many traders, earnings reports don’t mean a hill of beans but many investors like to pore over the numbers. Stocks can be affected by central bank policies, macro-global events, and existential crises. But in spite of, and especially in the absence of those “big-picture” market impactors, it’s earnings that drive stock prices in the longer term.

And because there is so much riding on earnings, there is a concerted effort by companies and Wall Street analysts and the media to make the earnings look a lot better than they really are. Headline earnings numbers fed to us by companies, analysts, and the media are more often than not jacked-up by means of creative accounting tricks.

The headline earnings reports investors take as gospel every quarter when the dog and pony shows start up, are non-GAAP, pro-forma, “Street” earnings, not bona fide earnings based on Generally Accepted Accounting Principles. As you know, the difference between non-GAAP and GAAP earnings can be huge and can trap investors.

Last year is just another example of the disparity between real and unreal earnings numbers. According to the Wall Street Journal, headline or pro-forma earnings for companies in the S&P 500 in 2015 were 25% higher than GAAP earnings. That’s the biggest disparity since 2008. A CNBC.com analysis found a similar gap in 2015 earnings.

In February 2016, regarding 2015 earnings, FactSet reported that: 67 percent of the companies in the Dow Jones Industrial Average reported non-GAAP earnings per share and, on average, that the difference between the GAAP and non-GAAP earnings per share for these companies was approximately 30 percent, representing a significant increase from approximately 12 percent in 2014.

The first quarter earnings season has crossed the midway point with more and more companies coming out with positive earnings surprises. According to Zack’s Earnings Trend report, out of the 310 S&P 500 members that have reported as of last Friday, 71.9% of them have beaten earnings estimates with 57.1% beating on the revenue front.

However, total earnings for these companies are down 7.2% year over year on a 2.4% decline in sales. First-quarter earnings for S&P 500 companies are now expected to dip 7.3% year over year on 1.1% lower revenues with the Energy sector being a major drag.

That’s really quite amazing; earnings are down but companies still beat estimates; not just a few but 71.9%. That’s a lot of beats. Analysts have been furiously ratcheting down their earnings estimates since January, while company accountants, with executives standing tall over them, have been making “adjustments” right and left in their earnings and expense columns.

The regulators have noticed because you would have to be blind not to notice. The SEC is worried about how investors are being misled. SEC chief accountant James Schnurr criticized the rampant use of non-GAAP measures in a recent speech, saying, “SEC staff has observed a significant and, in some respects, troubling increase… in the use of, and nature of adjustments within, non-GAAP measures.” So, the next question is – what will the regulators do about this non-GAAP gimmickry? And we all know the answer is that the regulators will do nothing.

What can you do? Well, if earnings really matter to your analysis, then be sure to pay attention to the numbers they aren’t talking about on the earnings calls. Compare Non-GAAP and GAAP numbers side by side. Make sure there is a reasonable explanation for the adjustments represented by Non-GAAP numbers. Look at all numbers sequentially.

For example, look at changes in top-line revenue sequentially over the past four quarters to a year ago, because how a company is doing in sales and generating revenue is hard to mess with. If you look at earnings numbers sequentially, it’s easier to spot anomalies that you might miss if you just compare this quarter’s numbers to the same quarter a year ago.

Here’s what you can learn from Non-GAAP numbers: they can show you how often a business will resort to bending the rules in their reporting; they have a use when comparing extraordinary items, like gains or losses from sales of major production assets; they have a use if the types of events keep getting repeated; and the recurring use of Non-GAAP might be valuable in letting you know the report is full of garbage. In other words, it makes it easier to identify the stinkers.

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