Here’s an article I wrote from my September letter to Tarpon Folio investors. Hat tip to Kirk Kinder of fee-only firm Picket Fence Financial for the idea and inspiration.

The Quality of Earnings in 2009

Most investors probably would not think that something as straightforward as the definition of a company’s earnings could be controversial. Welcome to Wall Street, where obfuscation is intentional, clarity is rare and earnings are not always earnings.

Publicly traded companies in the U.S. are required to publish their financial results in accordance with generally accepted accounting principles, or GAAP. A company’s profit under GAAP rules is considered
to be “reported earnings.” However, many companies emphasize a different version of earnings to their investors. Management teams often refer to “operating earnings” under the pretense of better
capturing the underlying trends in their businesses.

That idea makes sense when intentions are sincere. Referring to operating earnings in lieu of true reported earnings isn’t necessarily a bad thing, as the GAAP definition of earnings does include some slop. More specifically, GAAP earnings can include items such as write-offs, gains on asset sales, restructuring charges and goodwill write-downs that are one-time events with no bearing on the company’s core operational results. So when it comes to gauging a company’s true progress, GAAP earnings aren’t perfect.

The problem with relying on adjusted operating earnings, however, is that they can be seriously misleading. There is no industry standard that defines the term. Management teams can literally exclude whatever they’d like to in the operating earnings figures they publish.

An overemphasis on operating earnings, sometime called “Street earnings,” “core earnings,” or “pro-forma earnings” is not new. Analysts usually exclude items that are not part of a company’s normal operations in analyzing the businesses they follow. Since the early 1990’s companies have often emphasized operating earnings over reported earnings to their investors.

What is new, however, is that the operating earnings of many public companies now appear to be either excluding items that they should not be or that are not really non-recurring – to a historic degree.

In other words, companies are claiming things that happen routinely are one-time events in order to prop up the earnings figures they highlight to their investors.

Lately, many individual investors have felt pressure to get back into the market out of fear they will miss out on further gains. Much of that motivation is fueled by pundits and talking heads insisting that “the market is still cheap based on historical earnings.” Investors should understand that while the market as a whole may be attractively priced based on operating earnings, it’s a far different picture when
looking at companies’ true earnings.

The difference between true earnings and operating earnings has never been bigger than it is right now. Standard & Poor’s recently reported that GAAP earnings per share for the 500 biggest public companies is $7.21 per share, while operating earnings are $61.20. That $54 gap is an all-time record.

Why does it exist? Much of it can be explained by huge write-downs in the financial sector in addition to a high degree of write-offs in other industries address as more companies deal with their own impaired assets, too. Job cuts and declining production explains more of the gap. But to be clear, some companies appear to be abusing the notion of operating earnings, too.

Take the case of Alliance Data Systems, a Texas company that manages customer loyalty programs and provides private label credit cards. You’ll notice in the subheading of its most recent quarterly earnings release that the company highlights “cash earnings per share” and not GAAP earnings.

How does Alliance define cash earnings? By taking GAAP earnings and adding back certain expenses, including the cost of stock compensation given to management and employees. It also adds back a chunk of the premiums it pays to acquire credit card portfolios and customer lists. While GAAP considers such premiums the cost of doing business, Alliance considers them an intangible asset – meaning it can amortize them. And because Alliance adds back amortization expenses to get to its touted “cash earnings,” the earnings figure the company is highlighting grows larger – despite the fact that it is an expense that actually reduces profit.

Alliance’s “cash earnings” for the second quarter were 95 cents a share, but GAAP earnings in the period were 51 cents a share. The gap between the two figures was even wider in the first quarter, when Alliance reported “cash” earnings of $1.19 a share compared with GAAP earnings of 45 cents.

Only on Wall Street can a company take expenses, add them back to profits, point to that number as the primary indicator of serious business progress, and then see its shares hit a 52-week high. And would you care to guess what the primary metric is that Alliance uses when awarding its executives with company stock?

Unfortunately, Alliance is not alone in emphasizing non-GAAP earnings. Pfizer is another company with operating earnings that do not provide a picture as clear as you might be lead to believe. Pfizer prefers to publish “adjusted earnings” – ostensibly to ignore the impact from acquisitions – and the Street follows unquestioningly. Pfizer acquires firms every year, though, and even with the big hole in its pipeline that Pharmacia seems to fill, it seems likely that it’s still going to have to acquire growth pretty consistently in the future. If part of a business’ operations is consistently acquiring other firms, shouldn’t that be treated as a regular expense?

Kodak might also be considered a serial offender, in that constant restructurings and repeatedly closing factories over multiple years are not truly one-time expenses. Last year Kodak also adjusted its pension fund assumptions and, surprise, it happened to boost earnings.

In the telecom world, QualComm historically received a hefty percentage of its earnings from investments, as opposed to coming exclusively from the companies’ operations. Those investments had not been doing too well early this year, highlighting yet another reason why investors need to pay attention to the quality of company’s reported earnings.

Why does this distinction matter? Because, as described eloquently here, while the market has increased by more than 50% over the last few months, the actual aggregate GAAP earnings of companies have declined by 6%. Given the gap between actual earnings and the operating earnings figures used by many market commentators, there could be unpleasant surprises in store for investors who blindly buy into the market thinking that it is cheap.

It is not, and knowing the difference is critical.