Friday, March 28, 2014

It’s the Quality of Disclosure, Stupid

When Bill Clinton was running for president for the first time, one of the catch phrases of his campaign was, “It’s the economy, stupid”.  One of the things meant by this (with Bill Clinton, you’re never sure if you’ve captured all of the intended meanings) was that people should focus on the main issue and stop talking about the many smaller peripheral issues that can distract voters from what is important. That’s the way I feel about many earnings press releases I read.
Take, for example, Walgreens recently released second quarter 2014 earnings. Readers of this blog will know that I often write about Walgreens, but when you write, its best to write about something you know, and having worked at Walgreens, I think I know it better than the average investor (I also own the stock). There are a lot of things going on in the second quarter earnings release, and to a certain extent, Walgreens finds itself boxed in by all the adjusted earnings they’ve reported in the past. Having elected to report “adjusted earnings” (see my post from June 26, 2013 “The Slippery Slope of Adjusted Earnings” ) Walgreens now finds itself in the uncomfortable position of reporting that what they consider core earnings reflecting the true underlying nature of the business are 5% lower than they were a year ago. This compares to earnings only being down 1% on a GAAP basis. I give them full credit for continuing to report this way, as many companies would have stopped reporting on an adjusted basis the moment it didn’t serve their purpose, but it just goes to show how you can get boxed in by these adjustment shenanigans. 
However, what really caught my eye in the earnings release was a claim of combined synergies for Walgreen and its strategic partner, Alliance Boots, of approximately $236 million in the first half of fiscal year 2014.  When I see a claim for such a big number, a red flag always goes up in my mind and I start looking for where all this money has filtered into the earnings statement. After all, if you are claiming a synergy, you either have to be buying better and thus reducing your cost of goods, or lowering your expenses, reducing your selling, general and administrative expense. Synergies of $236 million on a base of $37.9 billion should result in savings of .62% in these ratios for the first half of the fiscal year. Yet when I compare the cost of goods and S, G & A ratios from year end 2013 to 2Q2014, I find that cost of goods have actually gone up 10 basis points, so they’re not buying better as a result of the acquisition. The S, G & A ratio on the other hand, has declined 60 basis points to 23.3% from 23.9%. So maybe they are within shouting distance, 8 basis points, but then I have to ask, “Does this synergy number mean that your earnings would have been worse by $236 million if you had not done the acquisition?” I suspect not, and I think you would very quickly get an answer from the company that the calculation of synergies does not tie directly to earnings.
Unstated in all of this is that “synergies” is a non-GAAP term, not constrained by the bounds of normal accounting. Companies can and do throw all sorts of “opportunity costs” and hypothetical savings into the pot when calculating these sorts of things. It is sort of an alternative accounting universe that does not have to tie out to the earnings statement. (I’ve also written about this before, see my post of March 3, 2012, “Where’s the Beef?” )

Which brings me full circle. These types of claims detract from and make it look as if the company is trying to obscure what is really going on - “Look at the great synergies we’re getting, not at the fact that earnings are down”. So my advice to companies that engage in this sort of junky accounting is: “It’s the quality of disclosure, stupid.” 

No comments: