Wednesday, June 26, 2013

The Slippery Slope of “Adjusted” Earnings

I’m just a simple guy. I tend to like my food without fancy sauces, and when it comes to ice cream, I favor simple flavors such as chocolate and vanilla. And when it comes to reading earnings reports, I prefer a simple, understandable description of what the earnings were in accordance with generally accepted accounting principles. 

I have a simple rule of thumb – the more “adjustments” that a company makes in reporting its earnings, the less I believe them. I’m not so unsophisticated that I won’t concede that there are times when special circumstances have occurred and reporting the effects of those special circumstances is helpful for investors. In fact, I am a proponent of more disclosure rather than less. But the fact of the matter is that companies have a large amount of discretion about what goes into and out of accounting reserves and adjustments. And when there is discretion, there is always the temptation to make the numbers look better by playing with the adjustments. 

So it was with some interest that I read Walgreens third quarter earnings report yesterday. (Disclosure – I own Walgreen Co. stock.) The first thing that caught my eye was that the release led with a statement that adjusted earnings per share increased by 18.1%, compared to a 4.8% increase in GAAP EPS. This is a pretty large discrepancy, so I naturally I went looking for the reasons. And to their credit, in the third paragraph of the release, Walgreens details all the adjustments they make in arriving at their adjusted earnings number. The paragraph goes on for a bit, and it will never win a prize for clear expository prose, but when you add things up, Walgreens adjusts their earnings in the third quarter for six items, adding back $.20 to GAAP earnings of $.65. In other words, Walgreens wants you to believe that earnings were a full 30% better than generally accepted accounting principles require them to report. 

Thirty percent is a bit of a stretch, but if it helps you to understand the basic business, then it could be helpful. So I went through all of the adjustments and applied a simple rule of thumb; if the adjustment related to something outside of Walgreens control, meaning that the charge didn’t result from something management elected to do, then it was a legitimate adjustment. When you do that, then only one item, a settlement with the DEA, was really from an outside agency. Everything else, related to acquisition costs, a LIFO charge, a tax related to Alliance Boots, and the change in value of warrants, was caused by decisions management made in entering into transactions or electing an accounting treatment. If we are to judge a company not only on their earnings, but on the quality of decision that management makes, then these are charges that the company is responsible for and should be reported as such. 

Back in the height of the internet bubble, you had a lot of companies reporting in this manner. People referred to it as “earnings without the bad stuff” and it gave the impression that management was trying to divert investors’ attention from problematic performance. I can only hope that Walgreens, a company long known for its integrity, is not going down that slippery slope.