Are adjusted earnings too adjusted? According to Mizuho, the lines are uncomfortably blurred to say the least.
They are not the only ones who have expressed concern. In May, the SEC issued a set of Compliance & Disclosure Interpretations (C&DIs) to address the excessive use of non-GAAP reporting measures, stating explicitly that non-GAAP measures can be misleading, especially if presented inconsistently between periods.
For Mizuho Securities USA (MSUSA) analysts Ann Hynes and Sheryl Skolnick, a more hard-nosed analysis of earnings reports is a necessity, not a suggestion. Finding many companies across their healthcare coverage to report questionable adjustments, they debuted and implemented a “MSUSA adjusted EPS” model in July to more accurately assess corporate strength.
Under the MSUSA model not all adjustments are automatically under the gun, say the analysts. In order to accurately assess the company, context matters. Adjustments must be judged differently if they portray a genuine, forward-looking business strength versus an exclusion of items to report the highest sum possible.
“We want the reported numbers and the numbers that we use to value companies to represent the truth about the intrinsic value and the earning power of the company,” said Skolnick to the The Wall Street Journal in a feature on Mizuho’s unique earnings approach.
Not a New Trend
Straying from standard reporting measures is anything but new. “Companies have fluffed up their performance for years by excluding certain ‘one-time items,’ in effect training investors to avoid actual performance,” TheStreet explains. “Companies have feasted on the ability to neatly present usually rosier non-GAAP earnings in order to win new investors and maintain their investor bases.”
With the SEC crackdown forcing a correction back to emphasizing GAAP earnings, “the results of many high-flying companies may come under more intense scrutiny.”
In their July reevaluation, Hynes and Skolnick found the biggest offenders under MSUSA’s healthcare coverage to include Amerisource Bergen (ABC), Team Health (TMH), McKesson (MCK), Quest Diagnostics (DGX), Walgreens Boots Alliance (WBA) and Kindred Healthcare (KND), where non-GAAP adjustments were deemed to be “overly-adjusted.” On the other side of the spectrum, CVS Health (CVS), Acadia Healthcare (ACHC), HCA Healthcare (HCA), United Healthcare (UNH) and HealthSouth (HLS) proved to be stronger quality.
However, Q2 earnings demonstrated a shift in thinking among many healthcare companies. For example, Kindred addressed concerns directly in its Q2 earnings call.
"We've worked extensively with outside counsel, our auditors, and other experts to understand this information and have made a number of meaningful changes in the presentation and content of our release," said Stephen Farber, Executive Vice President and CFO of Kindred. “We view this as an ongoing process,” he added.
Among others, Walgreen Boot Alliance Inc. and Quest Diagnostic Inc. also changed their tenor slightly by giving GAAP results a more prominent place in their Q2 earnings releases than in previous quarters.
More Than Letters in the Mail
As MarketWatch reports, companies across sectors that are not compliant with SEC reporting practices are receiving letters for further information. While the learning gap may be steep for companies looking to adjust their earnings practices to deliver a more realistic snapshot of their business, the costs may be just as high.
“The SEC has made it clear that, if companies’ behavior does not change with the new guidelines, the agency will be forced to issue regulations addressing the over-adjustments,” Mizuho’s Hynes and Skolnick confirm.
With more regulatory guidance to come, Q3 is expected to demonstrate increasing attention to compliant reporting. As Kindred alluded to, the shift represents an ongoing process, but that does not mean the SEC, analysts or investors will spare much leniency.
Simon Hylson-Smith
CEO, Paragon
Simon Hylson-Smith is a former financial industry editor and currently CEO of Paragon.