Lombard Odier: Investment Strategy Bulletin - Summer 2009
Mind the GAAP!
The US Q2 2009 earnings season is ending, apparently on a good note as 73% of
corporates have beaten consensus expectations. Taking a closer look at corporate
earnings, we feel that we should qualify the current optimism surrounding the health
of Corporate America.
Every quarter, US companies have to publish their results under the defined US
GAAP accounting rules. These results are labelled as “Reported earnings”. However,
the most commonly looked at form of earnings are adjusted “Operating earnings”, on
which companies prefer to focus as they consider it better captures the underlying
trend in activity because it excludes non-recurring expenses, such as restructuring
charges, asset sales gains, major litigation charges, goodwill write-downs and other
“write-offs”. Whilst Reported earnings are based on strict accounting rules, adjusted
Operating earnings are at the discretion of companies in the sense that there is no
pre-defined set of exclusions. Neither measure is perfect but in the case of adjusted
Operating earnings, exclusions are currently so large that there is a removal of
information about the true state of companies and the market as a whole. When
exclusions tend to be persistent, the gap between adjusted Operating earnings and
Reported earnings can widen to the point that both measures deliver a different
message on the state of Corporate America. As of today, the Reported earnings per
share data for the S&P 500 companies gathered by Standard & Poor’s directly from
company publications is USD 7.2 (down 91% from 2007 peak) versus USD 61.2 on
an adjusted Operating basis (down 34% from 2007 peak). This USD 54 gap is the
biggest gap on record (see upper chart). As such, the current Reported GAAP
earnings are showing a more depressed situation for US corporates than suggested
by adjusted Operating earnings. Though reality is probably somewhere in between,
we prefer to focus on Reported earnings as they are based on an equal standard for
all. Digging into the data, we note that the current wide spread between the adjusted
Operating and Reported earnings is largely, albeit not exclusively, due to the
massive write-downs seen in the Financials sector. Ex-Financials, write-offs are also
at record highs as corporates are eager to toss out impaired assets during periods of
stress.
Furthermore, when looking at adjusted Operating earnings, it appears that most
corporates managed to beat analyst’s estimates thanks to production and jobs cuts.
Indeed, sales for the corporates of the S&P 500 are down 10% year-on-year and net
income margins are close to their lowest level on record. While Financials remain by
far the largest contributor to those declines, most sectors have also contributed, with
ex-Financials sectors’ sales and net income margins continuing their declines (see
lower chart).
All told, despite a seemingly positive quarter, at least based on adjusted versions of
accounting earnings (i.e. adjusted Operating earnings) that overlook large amounts
of expenses included under GAAP standards, we remain concerned by the health of
US corporates. Margins and most other profitability ratios outside of the Financials
sector still have room to fall before they breach the lows of the last two recessions,
leaving the door open for disappointments.
Useful link: Lombard Odier Darier Hentsch & Cie