Monday, February 29, 2016

Earnings & Margins: Different Strokes

On the downbeat side for US stocks at the beginning of the year were Q4 corporate profits, which were reported during January and February. Thomson Reuters (TR) reported that S&P 500 operating earnings fell 0.7% y/y during Q4 to $29.45 per share. Standard & Poor’s (SP) reported a whopping 12.2% y/y decline to $23.49. The $5.96 divergence between these two measures is the biggest on record, exceeding even the $5.71 during Q4-2008. The biggest discrepancies were attributable to the Energy and Materials sectors, where SP showed much weaker results than did TR. (See our S&P vs. Thomson Reuters Earnings.)

The S&P 500 quarterly profit margin peaked at a record 10.7% during Q2-2015 and edged down to 10.2% at the end of 2015 according to TR. The SP data show the margin peaking at a record 10.1% during Q3-2014 and dropping to 8.1% at the end of last year.

Why is there such a divergence between SP and TR? Consider the following:

(1) GAAP rules are highly conservative. US public companies are required to report on EPS in their financial statements based on Generally Accepted Accounting Principles (GAAP). In short, GAAP earnings are fully loaded with all income statement line items pertinent to the reporting periods. Even when a judgment call exists, GAAP accountants will lean towards the outcome that reveals the least amount of profit. That’s because accountants are trained to follow the principle of conservatism in accordance with GAAP.

Public companies report on several variations of EPS. Those include basic and diluted EPS based on total net income, or loss, with further subdivision by continuing and discontinued operations. They will also report on other variations as discussed below.

(2) “Unusual” exclusions are usually not GAAP. Public companies typically want to demonstrate the best view of their results to investors, and so may wish to exclude (or include) items considered “unusual” in nature from their EPS calculations. Any such related financial measures would be considered non-GAAP. It’s no surprise that non-GAAP measures tend to be more favorable than GAAP as it tends to be more conservative. In a 2014 note, SP’s Senior Index Analyst, Howard Silverblatt, quipped: “[D]uring difficult times, the term ‘unusual’ appears to be used more liberally [by companies].”

Note that to avoid misleading investors, the SEC requires that any non-GAAP financial measures are presented and also reconciled against the most directly comparable GAAP measure.

(3) S&P’s “operating per share” is closer to GAAP. SP reports on two primary EPS series, namely “as reported per share” and “operating per share.” Here’s how the footnotes in S&P’s data release characterize the two: The former is derived from income from continuing operations as GAAP defines. SP’s “operating per share” further adjusts for “unusual” items based on SP’s own interpretation of such items. Importantly, SP does not always exclude (or include) the same “unusual” items as companies do. That’s because SP’s goal is to ensure comparability across industry groups.

(4) Majority rules for TR’s operating EPS. TR also collects data on a variety of different EPS measures including a GAAP and adjusted one. TR’s goal with its adjustments is to align its EPS data with analyst estimates. Analysts and companies often work together to ensure that forecasts are consistent with how “adjusted” earnings will be reported. So analysts tend to exclude (or include) the same line items that companies do!

TR’s July 2015 proprietary “Methodology for Estimates” notes: “When a company reports their earnings, the data is evaluated by a Market Specialist to determine if any Extraordinary or Non-Extraordinary Items (charges or gains) have been recorded by the company during the period. … If one or more items have been recorded during the period, actuals will be entered based upon the estimates majority basis at the time of reporting.

“Any submission of an estimate by a contributing analyst using a non majority actual or on a non majority basis results in a call from a Thomson Reuters Market Specialist requiring the contributing analyst to adjust to the majority basis or have their estimates footnoted for an accounting difference and excluded from the mean calculation for the fiscal years in question.”

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