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” http://investorrelationsmusings.blogspot.com/2013_06_01_archive.html ) 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?” http://investorrelationsmusings.blogspot.com/2012/03/wheres-beef.html )

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.” 

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.