Threading the needy
Fact checking a popular thread about non GAAP from the weekend
I’m not a fan of conflict. I don’t like to jump in comments and call people out nor quote tweet snark. However I do think that content which is factually incorrect needs to be rebutted. Especially when that content calls on investors to bet big on erroneous insights from someone who by the credentials listed should know better.
Over the weekend a thread was posted by a Fintwit account with over 50k followers. So far the thread as garnered over 1000 likes and hundreds of retweets. As I read it, I was appalled by the inaccuracy of some of what I was reading. I went backed and fact checked the entire thread. Here is a result of a thorough fact check on the content of this popular thread…
While the overall point of the author about being careful with Adjusted Net Income is certainly true…the majority of the claims made in this thread are either partially or entirely incorrect and/or misleading. Given the reference point of a trader being up 350% this year by similar tactics, it moves beyond the misleading category to that of potentially dangerous. Even more so since it encourages fintweeters to “bet big.”
Tweet 1: Net Income vs “Adjusted Net Income” Just met a trader who’s up 350%+ in 2022! His strategy: 1. Look for one-time expenses the Street is missing. 2. Recalculate adjusted net income. What’s that? Let’s do a deep-dive. 7 One-time items an investor should NEVER overlook
Fact Check Tweet 1: Slightly misleading. Every Company uses different Non-GAAP financial measures. However GAAP Net Income is listed on every financial filing and is provided to all analysts on the street. For a list of different Non-GAAP financial measures, see examples below
Amazon — Free Cash Flow (Operating Cash Flow - CAPEX)
Microsoft — Constant Currency (GAAP Income adjusted for Currency Exchange)
Google — GAAP Income + Stock based compensation - Tax effects of SBC
NVIDIA — GAAP - SBC - Acquisition and One Time Costs - IP Related Costs - Gains/Losses from Investments - Interest Expense related to Amortization of Debt Discounts - Tax impacts of excluded items.
One of the premises of the thread here is that investors need to recalculated adjusted net income for one time expenses. However in the case of Amazon, Google and Microsoft, many of these one time expenses are actually baked into their Adjusted Income! Furthermore…rather than make a thread about it…you could just state that investors should rely on GAAP financials rather than non GAAP, as every company is required to disclose GAAP financials clearly and prominently. But I suppose that’s not a good path to get to 50k followers.
Tweet 2: Why care about net income? It’s supposed to reflect the company’s steady-state revenues minus expenses — what investors project into perpetuity to set fair value. Why adjust? Investors want to remove “noise” (i.e. 1-time items) cuz not sustainable
Fact Check Tweet 2: Wrong. Net Income is the net after tax profit a business records in a certain financial reporting period. It is NOT supposed to reflect future earnings or be used to project into perpetuity.
Some companies provide guidance. Other’s provide LT targets. Often Wall St. Analysts attempt to project future earnings in their forecasts.
Net Income DOES NOT REFLECT FUTURE EARNINGS. That’s because Net Income SHOULD ONLY REFLECT THE NET INCOME FOR THE PERIOD STATED!
Adjusted Net Income on the other hand is often included with earnings calls, statements and press releases to give investors a “better view” of the performance of the company by removing certain expenses which management deems would impair investors ability to accurately value the future cash flows of the company. For the record, I too share the original authors skepticism as to the validity of the claims to many management teams in this regard. I just think the authors way of explaining it is inaccurate and could lead to bad investment results.
Tweet 3: Why not just rely on ‘adj EBITDA’ or ‘adj Net Income" metrics reported on 10K/10Qs - adj metrics are non-GAAP, i.e. TOTALLY UNREGULATED! - so management con do whatever…it wants - which 1-time costs to add back and which sales to remove — totally up to CFO discretion
Fact Check Tweet 3: Wrong. 10-K and 10-Q filings DO NOT USE NON-GAAP ADJUSTED METRICS. They can not add and remove costs…that is called securities fraud. Management can not add back whatever it wants. It can add in certain categories however it must disclose reconciliation on it’s press releases stating how they derive the Non GAAP metrics from GAAP.
The only place adjusted metrics might appear within SEC Filings is in the Key Metrics footnote.
Were a company to insist on filing adjusted metrics in it’s comprehensive statements of income, the Auditor should state that the numbers reported DO NOT ACCURATELY AND FAIRLY REFLECT the financials of the business.
Side note…adjusted EBITDA (earnings before interest, taxes, depreciation and amortization) is not the same thing as adjusted Net Income (earnings AFTER interest, taxes, depreciation and amortization).
Tweet 4: How can u profit from PROPERLY calculating your own adjusted earnings metrics? 1. make a checklist of red flags to look for in financial statements (this thread is a start) 2. If the Street is missing/overlooking any items, bet big that skeletons in the closet will come out soon
Fact Check Tweet 4: Misleading and Dangerous…big skeletons often take years to come out of the closet. History is full of investors who detected frauds early and lost money waiting for the skeletons to come out. Retail investors could lose their life’s savings if they bet big and are early.
Think about how a retail trader would bet big that skeletons in the closet will come out soon? Put options and shorting would be the obvious candidates. However these are extremely risky and should be for sophisticated investors only. Put options because they have a fixed expiration date, and shorting carries borrowing costs along with the risk of getting short squeezed (SEE MELVIN CAPITAL).
Tweet 5: Write-down on investments Tech Co.’s these days are increasingly investing in other tech co.’s for strategic purposes. Esp. now, those investments can take a nose-dive (or moon) e.g. In Amazon‘s Q1 2022 earnings the Street found out it took a $7.6B write-down on Rivian!
Fact Check Tweet 5: Misleading. Publicly traded investments are generally accounted for at fair value (as measured by share price). However, Private Investments which make up the MAJORITY of these investments, are often measured at cost instead of fair value since these have no recognizable market price.
Even this is an over simplification as it’s also important to consider whether the investment is consolidated or if it’s treated using the equity method. The accounting methods used are disclosed on the footnotes of a company’s 10-Qs and 10-Ks. While what was stated about Rivian is true…this was known information. Ford also had a write down on Rivian, but it’s stock didn’t respond in the same way. The problem for Amazon was less about Rivian and more about slowing sales growth, margin pressures on it’s logistics from fuel costs and high capital expenditures.
Tweet 6: Egregious 1-time Stock-Based Comp (SBC) SBC is another super timely item to watch out for now! As SaaS stocks have plummeted, some engineer’s offer packages have lost 90%
To preserve talent, they’re issuing MOAR STOCKS!
Yes, diluting share price even more!
e.g. SHOP
Image…highlighted quote from Shopify Earnings that SBC for the quarter increased 70%
Fact Check Tweet 6: Wrong and misleading. Stock based compensation depends heavily on the mix of options to RSUs as well as vesting periods. An increase in SBC percentage says nothing about options/RSUs issued and more about which vested. It is a trailing expense!
To understand stock based compensation you need to understand how it’s accounted for.
Most companies generally rely on 2 forms of stock based compensation (we’re excluding equity performance awards as these are rarely issued to anyone beyond management):
Restricted Stock Units. These typically have a vesting period. They are accounted for at the price they were issued at, and they are recognized on the income statement when they VEST.
Stock options. These may or may not have a vesting period. They are accounted for at fair market value. This fair market value is often substantially less than the price of the exercise price as the company has to evaluate the likelihood of these being exercised and what the value of the stock would be at time of exercise. Because of this generally RSUs hit harder as Stock Based Compensation than do options.
Now using the Shopify example which was quoted in the tweet.
Notice the Weighted Average Grand Date Fair Value of RSUs in 2021. $1400+
Compare that to the 2020 Value. $645+
So as those RSUs which were issued in 2021 vest (they vest over 4 years, 25% per year) the company will recognize 150k plus RSUs per year at an average value of 1400.00 (share price at time of issuance).
So the actual quantity of RSUs issues isn’t what’s pushing the SBC up 70% it’s the massive increase in fair value due to the stock price increase IN THE YEAR WHEN THE RSUs WERE ISSUED.
Of course RSUs being issued this year will cause SBC to drop next year (once they start vesting). But for now the income statement is going to look very painful. This is why many investors prefer to look at diluted shares outstanding (a GAAP metric). It tells you the maximum number of shares that are floating around that haven’t vested or been converting. Seeing the % change in Diluted Shares Outstanding is a much better way of measuring how SBC impacts you as a shareholder.
Tweet 7: Restructuring charges
Have you ever met a company that IRL restructures every quarter?
No never!
How bout on paper?
What does “restructuring costs” even entail? Sometimes, just means that CFO needs to add back 2.5B to reported adj EBITDA
Image…Quote the FTSE 100 spent 8.2bn pounds on restructuring their business last year, up 30%
Fact Check Tweet 7: Misleading. Restructuring costs may be legitimate expenses (although they can be abused). Severance packages and one time downsizing expenses may be included in restructuring costs. So too can new hire bonuses and other one time expenses for expansion. These may also include certain write offs. They are allocated to the different components of the income statement. If a company fires and hires people every year, it may have legitimate restructuring costs every year.
Restructuring costs will show up on financial statements as a foot note, however they do not show up as a category on the income statement. Many do not include them in Adjusted Income as they consider them one time expenses. Not sure where the 2.5B to adjusted EBITDA came from, considering the FTSE100 is not 1 business, but 100. Not saying it hasn’t happened as there have been major write downs and impairments on businesses before. However making leveraged bets against a business just based on restructuring costs is a sure recipe to lose money. Unless you are betting on impairments…more on this later.
Tweet 8: Loss from early retirement of debt
When interest rates fall, co’s retire bonds early. Cuz why pay 8% when the mkt rate is suddenly 3%
But to extinguish debt, co’s often gotta pay more than par. Such loss is often hidden in some vague verbiage.
e.g. ‘accumulated other loss’
Fact Check Tweet 8: Wrong. Accumulated other loss is from unrealized gains/losses which are excluded from net income because the gains have not been realized. It includes gains/losses from fluctuation in fair value items which are not readily determinable. Gain/Loss on extinguishment of debt is a REALIZED expense. Extinguishing debt at a gain/loss would affect cash (assets), loans payable (liabilities) and retained earnings (owners equity).
It is true that company’s retire debt early when interest rates fall. As do individuals (we refinance our mortgage when rates are low). It’s the smart thing to do. Would you want to bet against the homeowner who trades in 8% mortgage rate for 3%? Neither would I. Paying a premium over the remaining principal (carrying) value to save on interest makes perfect sense.
Tweet 9: FX Write-downs if u pay suppliers in China but sell to US, there’s huge FX mismatch btw revenues in & costs out! Plus finance depts notoriously suck at hedging. Beware!
Fact Check Tweet 9: Legitimate. Currency risk is a real risk, and companies should disclose it in the footnotes of their financial statements. However some are more opaque than others which is a legitimate red flag.
So currency risk is a legitimate concern and there isn’t much to say about this tweet. Maybe just a more in depth explanation. Earnings must be reported in USD. So if you earn money in a foreign currency, those transactions must be converted into USD using the exchange rate which existed at the time of the transaction. Since there is a delay between the time a transaction and takes place, and the time payment takes place, you have a risk that the currency rate slips and you end up taking a write down on the transaction. Conversely you can also benefit from exchange rates. It is possible to identify companies who are overly exposed to currency risk, and sometimes their financials will indicate what a theoretical shift in currency would have done to their previous earnings.
Tweet 10: Asset impairment
This one I say u usually shouldn’t adjust out.
But most investors + management does.
When to leave it in?
Ask: is the affected asset special/secret-sauce?
If yes, i say keep the cost in ur net income calcs
Like an amputated leg affects the rest of ur life
Fact Check Tweet 10: Confusing. GAAP requires company to plainly disclose any asset impairment. Investors shouldn’t count on historical cash flows from impaired businesses as the purpose of impairment is to tell investors that they do not expect to make the return on the asset that they previously stated they would.
Impairments mean different things in different circumstances. An asset may be impaired due to a change in it’s expected life. Or it may be impaired due to a change in it’s recovery value. Sometimes the impairment is to goodwill or the excess price to book value which was paid to acquire a company. Investors should most definitely look at how impairment affects the business precisely for the reason stated…an amputated leg affects the body for the rest of the life. However, the key question in the thread is whether an impairment is a one time expense you should adjust out? That’s irrelevant for the purpose of making future decisions.
Market’s are forward looking and making a speculative bet based on a mispricing of a company’s past earnings due to an impairment is a foolish bet. What you should do is to determine what the future effects of said impairments mean for the whole of the business.
Tweet 10: Extraordinary legal costs
Management will always obfuscate legal costs / stuff ‘em into “other expenses.” Why?
Increase in legal fees == smoking gun for much bigger (possibly existential) problems.
Where red flags may manifest: - a change in “Risk Factors” language in 10K
Fact Check Tweet 10: Wrong. GAAP requires companies to allocate legal fees to General and Administrative Expenses. Other Income is for income/expenses derived from sources that are not related to the main activity of a business. An example being Amazon’s Rivian Investment, Foreign Currency Impact, Etc.
Factually the statement here is wrong. Any company doing this would be in violation of GAAP and the Auditor should flag this. Not saying that auditor’s are infallible. They are fallible and corruptible (paging Arthur Andersen). However investors shouldn’t bet big on the bad information presented here.
Final Tweet:
End/Happy weekend!
PS I met this amazing trader who returned 350%+ YTD at the @FinTwitConf. Great event! Thanks so much @JonahLupton for inviting me to speak!
P.P.S if u r here, come say hello!
Fact Check Final Tweet: Partially True I suspect
Have no reason to doubt that she met a trader claiming 350%+ YTD at the FinTwit Conference. I also have no reason to doubt she was invited by Jonah Lupton to speak. This all seems about right.
Finally, if any of you would like to really learn how to do proper accounting…I would encourage you to sign up for this free to audit Financial Reporting Specialization class via Coursera. The professors are from the University of Illinois and it’s part of their iMSA (i-Masters of Science in Accountancy) curriculum.
Until the next time I feel like diving into a rabbit hole like this for no reason whatsoever other than this innate urge to either right a wrong or spout off about some crazy thought.