Lipstick on Pigs: How accounting distorts S&P500 earnings

lipstick2We don’t trade individual stocks, so we don’t often watch corporate earnings reports. But we’re making an exception for ALCOA, (AA) which reported its Q3 earnings Thursday evening, because we think what is happening to ALCOA is likely to happen to a lot of large companies, especially those in the S&P500. And we think it won’t be pretty.

Alcoa is the first major US company to report earnings in each quarter, so it sets the tone for the earnings season. This time the tone ain’t good.

AA reported “adjusted” earnings per share of $0.07, just about half the amount analysts expected. (Revenues also missed expectations). The kicker is that these are “non-GAAP” earnings, which often exclude substantial one-time charges.

GAAP is short for Generally Accepted Accounting Principles, which dictate how companies report their financial performance, and they are supposed to make sure everyone is reporting income and profit in the same way.

Companies argue that GAAP standards understate earnings-per-share (EPS) from on-going operations, so they frequently announce “adjusted” earnings which exclude some or all one-time charges. The effect is to make the adjusted EPS look better, which translates into a higher stock price.

On a GAAP basis, Alcoa’s Q3 generated a very modest $44 million in net Income, down 70% from a year ago. That translates into 2 cents per share. Quite a difference.

Since Q2 2013 Alcoa has “added back” to net income restructuring charges of about $2.4 billion. In the past year, the GAAP net Income was $538 million; the non-GAAP net income was $1.154 billion – more than double.

These are phantom earnings. It is not money that comes in the door – in fact it is money that has gone out the door – but it still shows up in “adjusted” net income.

There’s nothing illegal in this; what Alcoa is doing is accepted practice across large-cap companies. And that’s the problem, especially as it relates to the S&P500, which we do trade.

How this affects the S&P

The price of the 505 stocks that make up the S&P500 (that’s not a typo; look it up) are heavily influenced by reported earnings-per-share, and there are two practices that are distorting that number for the index as a whole.

One is very large stock buy-backs by major companies (some $8 billion for IBM, for example) which reduce the number of shares outstanding, thus increasing the EPS. The other is the use of “adjusted” earnings which include some portion of “add-backs” of non-recurring costs effectively added directly to net income. An estimated 11% of the S&P 500 EPS is due to these add-backs. That’s the lipstick on the pig.

Alcoa CEO Klaus Kleinfeld told the Associated Press he thought the results encouraging. AA has had a nice little bump, up 20% in the rally that has lifted the S&P500 for the last eight days, although it faded in overnight trading.

But we’re waiting for the other shoe to drop. Deutsche Bank has predicted overall earnings for the S&P500 will be down this year, the first such prediction from a major firm, and is contributing to that outcome by pre-announcing a Q3 loss of $7 billion for their own account. Other companies have prepared analysts for bad news, and the consensus now is for a ‘disappointing” earnings season.

The markets have been impervious to bad news before, and may be again. Just be a little cautious about this rally.

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