Edge and Odds

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It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

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GAAP vs Operating Earnings

NEW$ & VIEW$ (4 August 2016)

Heavy-Duty Truck Order Slump Deepens

An unusually high number of cancellations in orders of heavy-duty trucks caused net orders in North America to plummet to the lowest point in over six years, according to a new report by research firm FTR.

Trucking companies in July ordered 10,400 Class 8 trucks, used for long-haul routes, below expectations and 56% fewer than the same period last year, according to preliminary numbers from research firm FTR released Wednesday. It was the fewest number of orders since February of 2010.

Heavy-duty truck orders, which have been sliding for months, were hit with “several significant order cancellations,” which is uncharacteristic for this time of year, FTR said in its report. “The high cancellations are likely the result of fleets placing large orders at the end of 2015, for delivery a year out,” said Don Ake, vice president of commercial vehicles at FTR in the report. (…)

There are “too many trucks chasing too little freight,” said Steve Tam, vice president at ACT Research, which also tracks heavy-duty truck sales. Truck orders are low now asfleets adjust their overly optimistic expansion plans after seeing strong growth in 2014and early last year, he said. ACT reported 10,500 Class 8 orders for July.

“I think the trucking community had an expectation that [growth] was going to continue. But with 20/20 hindsight, that did not happen. Freight has been very flat for basically the last year,” he said. “There are anecdotal signs that freight is improving very modestly, but I would liken it to treading water but still below surface at this point.”

Here are the charts from Zerohedge:

Eurozone retail sales fall flat in June

Sales growth was 0 per cent in the single currency area – falling short of a small expected rise – and fell 0.2 per cent in the wider EU.

On a yearly basis, retails sales rose 1.6 per cent in June and were up 2.4 per cent across the 28-member bloc.

The FT was the only mainstream media to report this important data but this is all it gave its paying readers.

Here’s what my non-paying readers get:

Pointing up Q2 sales volume rose 0.6% (+2.4% a.r.) after a flat Q1. Ex-food, ex-gas, real sales rose 0.3% in June when gas sales dropped 1.3%. “Core” sales are thus up 4.0% annualized in Q2 after a flat Q1. And this is in spite of a pretty weak June in the U.K. (Data from Eurostat)

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  • And this from Markit on trends in July:

imageLatest Markit Eurozone Retail PMI® survey data showed the continuation of contrasting trends in sales performance across the bloc’s big-three retail sectors, with a further sharp drop in sales in Italy offsetting steady growth across Germany and France.

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About the U.K. (via The Daily Shot):

Bank of England Cuts Rates, Orders New Round of Money Printing
China’s Central Bank Plans to Keep Policy ‘Prudent’
OIL
Analysts Turn Bearish on Oil Again Investment banks have cut their outlook for oil prices for the first time in four months, concerned about the continued oversupply in crude that has already sunk this year’s market rally, according to a Wall Street Journal survey.

A survey of 13 investment banks by The Wall Street Journal predicts that Brent crude, the international oil-price benchmark, will average $56 a barrel next year, down by more than a dollar from June’s survey. The banks expect West Texas Intermediate, the U.S. oil gauge, to average $55 a barrel next year, down almost a dollar from the previous survey. (…)

The banks in the survey see oil prices staying below $50 a barrel until the end of this year and rising to $60 a barrel by the end of next year. Last summer, many of the same banks were predicting oil prices would rise to more than $70 a barrel this year. (…)

  • What Oil in the $40s Means for Oil Majors For how long can Europe’s big-five energy companies maintain dividend levels? Second-quarter results disappointed and the oil price fell about 20% in the past two months.

(…) The five big European groups, BP, Shell, Total SA, Eni SpA and Statoil ASA, began the year on consensus forecasts of $7 billion in total free cash flows for the next four quarters, according to Morgan Stanley analysts. By the end of June, that rolling four-quarter forecast had leapt to $25 billion.

That is far away from how the five companies have been performing. Free cash flows actually have been worsening and recent results took cumulative flows for the past four quarters at the big five down to minus $23 billion, according to Morgan Stanley.

Companies with negative free cash flow can support dividends with higher debt for a while if they think rising commodity prices are going to bail them out, but not forever. (…)

Despite second-quarter hiccups, analysts are still forecasting a big recovery in cash flows and profits in 2017 and beyond. But these depend on a pickup in oil prices: at UBS for example, forecasts are based on oil at $60 a barrel on average next year, $70 in 2018 and $75 thereafter.

And companies are working to lower breakevens, with BP aiming for a business that works at $50 to $55 a barrel. Brent crude has been below that level for most of the past year.

Nevertheless, payout promises will need to be revised if stuttering global growth and oil back in $40s is a taste of more disappointments to come.

Same in U.S. and Canada…

From the FT’s Lex column:

(…) The price crash last summer brutalised the US shale sector. According to law firm Haynes and Boone, 85 North American producers have filed for bankruptcy since early 2015. However, amid the wreckage, drillers have taken defensive action. Research firm Wood Mackenzie notes that of the $250bn of global E&P capital expenditure cuts in 2016 and 2017, two-thirds has come from US independent producers. It reckons that 56 US producers can now break even at $50/barrel.

The ultimate question for a recovery in prices is how output responds. Even though rig counts are down nearly 80 per cent since 2014, efforts to enhance well productivity have kept production resilient. From its April 2015 peak of 9.7m barrels per day, production is off less than a tenth. And for companies with efficient operations in low-cost regions, there is temptation to grow. Pioneer Natural Resources, focused on the desirable Permian Basin in Texas, said it would boost its oil production by a quarter in 2016, reasoning that even if prices are wobbly, incremental barrels remain profitable. Its investors are happy with the plan: it raised $2bn in new equity in March and its shares are up a quarter over the past year.

Pioneer and other marginal firms can survive, and even expand a bit, with a depressed oil price. But over time the decline in investment, productivity gains aside, is curtailing future output growth. Wood Mackenzie says that resultant production losses will be 4m barrels a day by 2020. Prices may have to snap back. A happy ending for those who have managed to survive to the end of the movie.

Pointing up By the way, here is the spread between Saudi and US oil production. It’s moving in the direction the Saudis want. (The Daily Shot):

SENTIMENT WATCH
Goldman Finds The Treasury Market No Longer Reacts To Economic Data

(…) Goldman’s Elad Pashtan writes, “the sensitivity of US Treasury yields to economic data surprises has declined to near record-lows over the last two years. We find that the pattern of reactions to data surprises across the yield curve matches pre-crisis norms—with higher sensitivity for short-term rates than longer-term rates—but the average reactions are much lower; for breakeven inflation reactions to growth data are not discernible from zero.”

So if it is not the economy, then what does the “market” respond to?  Take a wild guess:

In contrast, Treasury yields have reacted more strongly to Fed communication, at least according to one measure of policy surprises, and the sensitivity of exchange rates to activity news has increased. (…)

One possible explanation for this phenomenon is that investors are now more focused on Fed communications, rather than to economic data releases—perhaps due to uncertainty about the central bank’s reaction function. And we do see some evidence along these lines. (…)

Add this to the list of strange things happening at this stage of the cycle:

BTW: Turkey’s inflation jumped on higher food prices and weaker lira (after the coup). More inflation to come? (The Daily Shot):

Beware of Customized ‘Earnings Before Bad Stuff’ Companies that report significantly stronger earnings by using tailored figures like ‘adjusted net income’ or ‘adjusted operating income’ are more likely to encounter some kinds of accounting problems than those that stick to standard measures, according to new research.

(…) The study focused on companies in the S&P 1500 index. It found that just 3.8% of those exclusively using standard GAAP metrics had formal earnings restatements from 2011 to 2015. Among heavy users of non-GAAP measures—those whose non-GAAP earnings were at least twice as high as their GAAP net income—the rate was 6.5%.

Similarly, 7.5% of the GAAP-only group had material weaknesses in internal controls—flaws in their procedures to prevent financial errors and fraud—versus 11% of the non-GAAP group.

(…) the results suggest companies using non-GAAP metrics heavily “may be somewhat less rigorous in other accounting areas” than companies using only GAAP, said Robert Pozen, a senior lecturer at the MIT Sloan School of Management. (…)

Even critics acknowledge the tailored metrics can sometimes be helpful—showing a company’s results in constant currency is a legitimate adjustment, for instance, Mr. Pozen said.

But there is also a concern they are being abused, that companies are stripping out normal, ongoing costs to make themselves look healthier. (…)

  • Alliance Bernstein adds this (via ValueWalk)

(…) In 2015, about 87% of companies in the S&P 500 reported adjusted earnings, up from 73% in 2010. And the median size of the adjustment increased from 8% in 2010 to 25% in 2015. In aggregate, reported GAAP earnings were almost 22% below adjusted earnings last year. Overall, there has been a sizeable increase in both the frequency and the magnitude of the adjustments. (…)

Although earnings adjustments in 2015 were higher than the 10-year average in six out of ten sectors studied, the bulk of the increase was driven by energy and healthcare (Display). Energy companies have been writing down investments made when oil prices were a lot higher than they are now. In healthcare, a spate of deals and consolidation among the largest companies has led to steady growth in amortization of intangible assets, generally excluded from adjusted earnings. (…)

GAAP Earnings, GAAP Accounting

While the causes of the write-offs in these two sectors may seem different on the surface, they share a common root. In each case, managements were striving to grow earnings in a low-growth world—and, to put it bluntly, they overreached. Energy companies paid too much for drilling rights and development crews, banking on the idea that oil prices would remain at their historical highs or rise even higher. In the case of healthcare, high valuations for target acquisitions drove companies to make overly optimistic projections about their ability to raise prices, expand distribution and commercialize drug pipelines.

MIND THE GAAP?

The earnings ayatollahs are back in force and some readers are enquiring whether the Rule of 20 uses GAAP earnings or not.

It does not, and it should not.

GAAP earnings are useful when analysing individual companies. Some companies abuse the system and investors should do their work before investing. Many people will research the whole web before buying a toaster but will invest in a stock without first spending 30 minutes perusing the annual report, the 10-K and the notes to the financial statements looking for clues about management’s conservatism and/or integrity. Looking back over the years, one can quickly check if “non-recurring” or “one-time” charges actually recur more often then not, raising serious doubts on management’s competence and/or integrity. Always avoid investing in companies using very liberal or doubtful accounting practices. Most corporate executives are pretty smart; those who also feature dubious morality can be highly dangerous to your financial health.

When it comes to index earnings, I use “operating earnings” for the following reasons:

  • companies included in the main indices are seasoned, widely followed and generally run by honest people.
  • the main earnings aggregators are also serious companies which understand the game. Most will actually adjust the reported operating earnings to make sure they are representative of the company’s actual operating performance and coherent within the index and with history.
  • The objective is to be objective, that is using numbers that reflect as closely as possible the true earnings power of companies composing the index. For example, a company may have to write-down an asset or restructure its organization, often incurring large one-time costs that reduce profits for that particular year. Blindly using reported earnings will likely distort the earnings potential of the on-going entity.

Asset write-downs or write-offs generally culminate during recessions when companies often need to streamline their operations or even simply bring an asset value down to its true value since, under GAAP, assets must be carried at the lesser of cost or value. Goodwill created in an acquisition must be periodically tested for impairment. Sharp economic downturns usually bring goodwill impairments which can seriously reduce an index GAAP earnings during the recession year but will often improve the continuing earnings potential. Blindly or dogmatically utilizing GAAP earnings will likely result in lost investment opportunities like was the case in 2009.

Here’s what I wrote on March 3, 2009 (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years):

Since the mid-1980’s companies have been showing 2 sets of earnings: “reported” GAAP earnings and “operating” earnings or GAAP earnings excluding non-operating profits and losses and write-offs. Companies which record “non-recurring” gains or losses or which book write-downs or write-offs in asset values in a given year also provide “operating” earnings so that investors get a “more accurate” picture of a corporation’s “true” profits from continuing operations and its realistic earnings power going forward.

The pros and cons of “operating” earnings are that:

  • It makes sense for corporations to segregate from operating earnings those gains or losses which are deemed outside of the normal operations of a company (e.g. asset sales, discontinued operations). This is also useful to investors who can better appreciate the recurring profit generating capabilities of companies.
  • Write-offs and write-downs are more debatable since they reflect a loss in value of certain specific assets which management or auditors deem inflated in a company’s books given present and expected circumstances. On the one hand, such losses in values reflect the inability of management to extract acceptable or appropriate returns from these assets at their current book values, justifying their inclusion in earnings. On the other hand, to the extent these write-offs or write-downs are one-time non-recurring events, excluding them from “operating” earnings provide a more accurate picture of the company’s earnings power under its new adjusted asset base.
  • There is admittedly a degree of discretion for corporations to classify gains or losses as “recurring” or “non-recurring”. Some companies have used this discretion in such a way that they report “non-recurrings” so often that they become recurring non-recurrings.

Reported vs operating earnings has only been a big factor in market valuation in early 2000, when the tech bubble burst, and …now.

And now. The main culprit this time is the sharp drop in oil prices which has compelled producers to revalue their assets to reflect the lesser of cost or value which, for many, meant taking big write-downs. The stocks of oil producers have adjusted down to their new earnings power long before the accounting charges have been recorded. Large asset write-offs by energy companies do not change the earnings power of non-energy companies nor should they affect their valuations.

RBC Capital charts the ratio of write-offs to “pro-forma” (operating) earnings to reveal the magnitude of recent energy write-offs and the fact that, outside of energy, write-off trends remain within their normal range.

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This chart plots operating EPS as a percent of “as reported” since 1988. The so-called conspiracy has not gotten worse:

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Both GAAP and non-GAAP EPS of S&P 500 ex-Energy companies are expanding.

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