Newly minted doctors are required to take the Hippocratic oath and pledge their commitment to practice medicine ethically.
Perhaps corporate managers should be made to study the Hippocratic oath and apply it in earnest when they communicate with investors. In so doing, they would pledge to never knowingly harm investors and always refrain from showcasing metrics that misrepresent performance. That day seems way off in the horizon. Until it arrives, however, investors must be alert to the following three techniques that management can use to obfuscate:
Many people consider revenue growth to be an important and straightforward measure of the overall growth of a business. Companies also frequently provide additional data points to supplement revenue, providing investors with more insight into product demand and pricing power. Investors should welcome this additional information and analyze these supplemental non-GAAP (generally accepted accounting principles) revenue metrics to better assess the sustainable business performance. However, sometimes these revenue surrogates provided by management can be misleading and can harm investors if appropriate safeguards have not been put in place.
Revenue growth at retailers and restaurants is often fueled by the opening of additional stores. Logically, companies that are in the middle of a rapid store expansion show tremendous revenue growth, since they have many more stores this year than they had the prior one. While total company revenue growth may give some perspective on a company’s size, it gives little information on whether the individual stores are performing well. Therefore, investors should focus more closely on a metric that measures how the company’s stores have actually been performing.
To provide investors with that insight, management often reports a metric called “same-store sales”or “comparable-store sales.” This metric establishes a comparable base of stores (or “comp base” for short) for which to calculate revenue growth, allowing for more relevant analysis of true operating performance. For example, a company may present its revenue growth on stores that have been open for at least one year. Companies often prominently disclose SSS in their earnings releases, and investors use it as a key indicator of company performance. Many consider same-store sales to be the most important metric in analyzing a retailer or restaurant. We agree that if it is reported in a logical and consistent manner, same-store sales is extremely valuable for investors.
However, because same-store sales fall outside of GAAP coverage, no universally accepted definition exists, and calculations may vary from company to company. Worse, a company’s own calculation of same-store sales in one quarter may differ from the one used in the previous period. While most companies compute their same-store sales honestly and disclose them consistently, “bad apples” try to dress up their results by routinely adjusting their definition of same-store sales. Investors, therefore, should always be alert to the presentation of same-store sales to ensure that it fairly represents a company’s operating performance.
Compare same-store sales to the change in revenue per store. When a company experiences fairly consistent growth, same-store sales should be trending up consistently with the average revenue at each store. By comparing same-store sales with the change in revenue per store (i.e., total revenue divided by average total stores), investors can quickly spot positive or negative changes in the business. For example, assume that a company’s SSS growth has been consistently tracking well with its revenue per store growth. If a material divergence in this trend suddenly appears, with same-store sales accelerating and revenue per store shrinking, investors should be concerned. This divergence indicates one of these two problems: (1) the company’s new stores are beginning to struggle (driving down revenue per store, but not affecting same-store sales because they are not yet in the comp base), or (2) the company has changed its definition of same-store sales (which affects the SSS calculation but not total revenue per store).
This framework was used by the Center for Financial Research and Analysis (KKD) in 2004 and Starbucks Corp. (SBUX) in 2007, and to warn investors before these companies unraveled. As shown in Figure 1, Krispy Kreme maintained its high SSS level in 2003 and 2004, despite a tremendous drop-off in total revenue per store.to successfully identify problems at Krispy Kreme Doughnuts Inc. (
Watch for changes in the definition of same-store sales. Companies usually disclose how they define same-store sales. Once the definition is disclosed, investors should have little difficulty tracking it from period to period. Companies can manipulate same-store sales by adjusting the comp base in two possible ways. The first involves simply changing the length of time before a store enters the comp base (for example, requiring a store to be open for 18 months, versus 12 months previously). The second trick involves changing the types of stores included in the comp base (for example, excluding certain stores based on geography, size, businesses, remodeling, and so on).
Watch for bloated same-store sales resulting from company acquisitions. The comp base can also be influenced by unrelated company activities, such as acquisitions. For example, from 2004 to 2006, the universe of stores in the comp base of Starbucks kept changing each quarter as the company continuously bought up its regional licensees and put them into the comp base. As a result, Starbucks calculated same-store sales using a slightly different universe each quarter—hardly a comparable metric. If Starbucks had been purchasing its strongest licensees, this acquisition activity would have had a positive impact on SSS performance, thereby misleading investors about the company’s underlying sales growth.
As with Krispy Kreme, Starbucks’ 2006 same-store sales trend began diverging from its revenue per store trend. The gap widened in 2007, and in September 2007, Starbucks reported that U.S. traffic had fallen for the first time ever. When same-store sales in the United States turned negative in December, Starbucks announced that it would no longer disclose same-store sales, stating that it would “not be an effective indicator of the Company’s performance.”
Be wary when a company stops disclosing an important metric. Just as Starbucks stopped disclosing same-store sales when business went sour, Gateway stopped disclosing the number of computers sold when times were tough in late 2000. This metric had been an important data point provided to investors, and Gateway’s change in disclosure led the SEC to censure the company and label its actions “materially misleading” because it obscured the softening consumer demand for computers.
Look for strange definitions of organic growth. Affiliated Computer Systems (ACS) had an odd way of presenting its organic growth, or what it called “internal growth.” Rather than simply excluding all revenue from acquired businesses when calculating internal growth, ACS calculated a fixed amount to remove based on the acquired business’ revenue for the previous year. This meant that ACS was able to include in its own internal growth any large deals that the acquired company booked just before the acquisition.
When comparing key non-GAAP metrics across a peer group, it is important to ensure that these metrics are being calculated in the same way. For example, in the broadcast industry, a common metric analyzed is average revenue per user (, calculated as total subscription revenue divided by average subscribers. Calculating the average revenue per subscriber sounds like it should be simple; however, varying definitions of ARPU abound. Consider, for example, the different definitions at competitors Sirius Satellite Radio Inc. and XM Satellite Radio Holdings Inc. before they merged in 2008. Sirius’s calculation of ARPU included revenue from subscriptions, advertising, and activation fees. XM Radio, on the other hand, calculated ARPU using only revenue from subscriptions.
Since subscription-based businesses (e.g., research providers, telephone companies, newspapers, fitness clubs, and so on) rely on new subscribers for growth, it is helpful for investors to monitor subscriber levels in order to get a sense of the most recent trends in the business. Logically, the number of new subscriber additions each quarter is often a good leading indicator of upcoming revenue. Similarly, the level of cancellations (called “churn”) is important to know when assessing a business. If a company shows a healthy subscriber base with growth in new subscribers and shrinking churn, investors can expect strong revenue growth ahead. That is, unless the company is manipulating these metrics.
Consider AOL Time Warner’s (AOL) scheme to inflate the number of subscribers to its online Internet service. One of the ways in which AOL sold subscriptions was to sell “bulk subscriptions” to corporations, which would then distribute these subscriptions to employees as a perk. AOL did not include these bulk subscription sales in its subscriber count because it knew that many of these subscriptions would never actually be activated. When employees did sign up, they rightfully entered the subscriber count.
In 2001, AOL was struggling to meet its subscriber targets. So, the company began including the number of bulk subscriber sales in its subscriber count, despite the fact that the majority of these subscriptions were never activated. Moreover, AOL would ship these bulk subscription membership kits to customers immediately before the quarter end in order to meet targets for subscriber count.
Many companies disclose their quarterly “bookings” or “orders,” which are supposed to represent the amount of new business booked during the period. Companies may also disclose their backlog, which essentially represents their outstanding book of business or, in other words, all past orders that have yet to be filled (and recognized as revenue). “Book-to-bill” is also a common disclosure that compares current-period bookings to current-period revenue and is calculated as bookings divided by revenue.
If they are presented accurately, bookings and backlog are important indicators, as they provide investors with extra insight into upcoming revenue trends. However, since they are non-GAAP metrics, companies have plenty of leeway in how they define and disclose bookings and backlog. You would think that the calculations would be pretty straightforward, but indeed there are plenty of nuances in what should and should not be included. For example, different companies include the following types of orders differently in their presentation of bookings and backlog: cancelable orders, orders in which the quantity purchased is not defined, bookings for longer-term service or construction contracts, contracts with contingencies or extension clauses, bookings on noncore operations, and so on.
The varying definitions of bookings and backlog across companies make it extremely important for investors to understand exactly what the metric represents before putting any faith in it. Moreover, if the metric is a key performance indicator for a company, investors should use extra diligence to ensure that the company does not change its own definition of bookings in a way that flatters the metric.
Investment guru Warren Buffett (chairman of Berkshire Hathaway) has long poked fun at management teams that create dishonest pro forma metrics. He memorably compared this practice to an archer who shoots an arrow into a blank canvas and then draws a bull’s-eye around the implanted arrow.
Consider the bull’s-eye drawn by the archers at Global Crossing (GLBC). The company reported a net loss of $120 million in the March 2007 quarter. Desperate to show a profit, management removed expenses using a pro forma concoction reminiscent of its bad behavior during the dot-com bubble. First, management removed $97 million in expenses for interest, taxes, depreciation, and some other items to get to a metric it called “adjusted EBITDA” (earnings before interest, taxes, depreciation, and amortization). Then, it removed $15 million in non-cash stock compensation expense, bringing the company to an “adjusted cash EBITDA” of negative $8 million. Close, but not all the way to profitability, management then removed a host of charges that it deemed one-time in nature, propelling the company to a positive $4 million in what it called “adjusted cash EBITDA less one-time items.” Bull’s-eye!
|Quarter 1, 3/2007||($ Mil)|
|Provision for income taxes||12|
|Depreciation and amortization||50|
|Non-cash stock compensation||15|
|“Adjusted cash EBITDA”||-8|
|One-time item: regulatory charges||5|
|One-time item: Asian earthquake||1|
|One-time item: customer defaults||2|
|One-time item: severance||1|
|One-time item: cash portion of retention bonus||3|
|One-time item: utility credit||-2|
|One-time item: maintenance charge||2|
|“Adjusted cash EBITDA less one-time items”||4|
|Source: RiskMetrics Group.|
It is easy to be skeptical about Global Crossing’s three levels of pro forma, and it is hard not to laugh when looking at some of the “one-time” charges that the company removed (see Table 1). Last time we checked, expenses for “maintenance” are a normal cost of doing business and therefore should never be excluded from a pro forma calculation. Ditto for customer defaults (bad debts), employee retention bonuses, and routine regulatory charges. Do not be fooled into thinking that these items will not recur just because management decides to present them as one-time in nature.
Now you see it, now you don’t. On its June 2007 earnings call, flash memory manufacturer Spansion (CODE) proudly stated that EBITDA grew to $72 million from $61 million the quarter before. The following quarter, Spansion reported that EBITDA fell to $71 million; however, the company soothed concerned investors by claiming that EBITDA actually increased by $8 million if you excluded a one-time real estate gain received in the previous quarter. Conveniently, this one-time gain was not excluded from EBITDA when earnings were reported the previous quarter. So, Spansion essentially included the one-time gain to help show strong EBITDA growth in June, and then excluded the gain the next quarter in order to show strong EBITDA growth in September. You can’t have it both ways!
What’s in a name? That which companies call earnings, by any other name would smell as sweet . . . or so management would like you to think. Sometimes management insists that a foul-smelling “pro forma” or “adjusted” earnings metric (or any other earnings metric with a qualifying name) is a sweet and pure measure of earnings.
Pretending that recurring charges are one-time in nature. Peregrine Systems had so many bogus receivables that it also used pro forma tactics to hide the evidence of its chicanery. In addition to pretending to sell these receivables, Peregrine also took charges for these receivables, but inappropriately classified those charges as nonrecurring and related to acquisitions. This classification gave Peregrine the cover to exclude these charges from its pro forma earnings presentation so that investors would not be concerned (or at least those investors who always took the company at its word).
Pretending that one-time gains are recurring in nature. Trump Hotels & Casino Resorts also chose not to remove large nonrecurring gains from its adjusted income. Trump opened an All Star Café in its Atlantic City Taj Mahal Casino in 1997. All Star Café signed a 20-year lease; however, just two years later, its parent company (Planet Hollywood) went bankrupt. As a result, the lease was terminated, and all of the sports memorabilia and real estate improvements in the All Star Café became the property of Trump. Trump valued this property at $17 million and, in September 1999, recorded a one-time gain. (Shockingly, Trump put this gain in revenue!) However, when releasing its earnings results to Wall Street, Trump conveniently forgot to tell investors about this one-time benefit and failed to remove it from its pro forma numbers. As shown in Table 2, had Trump been more truthful in communicating with its investors and reported an honest measure of pro forma results, the company would have reported declines in both earnings and revenue—in contrast to the reported growth in both metrics.
Q3, 9/99, Excluding
|Pro forma revenue ($ Mil)||403.1||385.9||397.4|
|Pro forma net income ($ Mil)||14.0||3.0||5.3|
|Pro forma EPS ($)||0.63||0.14||0.24|
Changing the definition of adjusted earnings. In late 2005, Openwave Systems (OPWV) changed its definition of non-GAAP net income twice in two consecutive quarters. In the September 2005 quarter, Openwave began excluding expenses for restricted stock grants from its non-GAAP net income. According to a CFRA report in November 2005, this change added $0.04 to Openwave’s earnings, without which the company would have missed Wall Street’s expectations. Then, the very next quarter, Openwave changed the definition again, this time to exclude acquisition-related hedging costs from non-GAAP net income. The two changes combined to add $0.04 to earnings in the December quarter as well.
Non-GAAP cash flow metrics are less common than non-GAAP revenue and earnings disclosures; however, they do exist.
Sometimes companies create a pro forma cash flow metric in order to exclude a nonrecurring activity, such as a large litigation settlement. However, other times, companies may be looking to artificially enhance their cash-generation profile.
Companies sometimes present metrics like “cash earnings” or “cash EBITDA” (as we just saw with Global Crossing). Do not confuse these metrics with substitutes for cash flow! Many companies and investors alike believe that these metrics (as well as plain old EBITDA) are good surrogates for cash flow simply because the calculation includes the adding back of non-cash expenses such as depreciation.
A company’s cash flow consists of much more than just net income plus non-cash expenses. Ignoring working capital changes when calculating cash flow will provide you with a fictional portrait of a company’s cash-generation abilities, in the same way that ignoring accruals for expenses such as bad debts, impairments, and warranty expenses will give you an illusory sense of profitability. In reality, metrics such as EBITDA and cash earnings are poor representations of performance.
Moreover, for capital-intensive businesses, EBITDA is often an illusory measure of performance and profitability because all of the major capital costs run through the income statement as depreciation and therefore are excluded from EBITDA. Some companies abuse the investment community’s acceptance of EBITDA and use the metric even though it is completely unwarranted to do so.
For example, rent-to-own retailer Rent-A-Center, Inc. (RCII) purchases inventory (such as furniture and home electronics) and then rents the merchandise to customers for a monthly fee. Rent-A-Center records the rental fees as revenue, and the rental merchandise is depreciated over the rental life and recorded as “cost of rentals” on the income statement (similar to cost of goods sold). However, when presenting its EBITDA, the company excludes the impact of these costs because they can be considered depreciation. We find it completely inappropriate to exclude these costs from any legitimate measure of profitability, since they are indeed the cost of inventory.
Management at Delphi liked to mislead investors by presenting tricky cash flow metrics. For example, Delphi routinely talked about and headlined its “operating cash flow” in its earnings releases. No doubt, many people thought that Delphi was discussing its cash flow from operations; however, this was not the case. “operating cash flow” was actually Delphi’s deceptively named surrogate for GAAP cash flow from operations. Since the name is so close to its GAAP compadre, you can imagine how many investors were confused into thinking that this pro forma metric was Delphi’s actual cash flow from operations. In truth, this surrogate barely resembled GAAP cash flow from operations. As shown in Table 3, it was calculated as net income plus depreciation and other non-cash charges minus capital expenditures plus some huge mystery item labeled “other.”
|Net income (GAAP)||1,062|
|One-time charge for in-process R&D||32|
|Depreciation and amortization||936|
|“Operating Cash Flow” (non-GAAP)||1,636|
|Cash flow from operations (GAAP)||268|
Free cash flow (GAAP cash flow from
operations less GAAP capital expenditures)
In 2000, Delphi’s actual cash flow from operations (as reported on the cash flow statement) was $268 million, but its self-defined “operating cash flow” (as presented in the earnings release) was $1.636 billion—an astonishing differential of almost $1.4 billion. Since this cash flow surrogate includes the impact of capital expenditures, it may be more relevant to compare it to Delphi’s free cash flow (cash flow from operations less capital expenditures) of negative $1.0 billion—bringing our differential to an outrageous $2.6 billion.
In 2003, Delphi was still up to the same tricks, but the company was now showing a reconciliation between its “operating cash flow” and cash flow from operations as reported on the cash flow statement. Delphi’s “operating cash flow” was $1.2 billion in 2003, versus $737 million in cash flow from operations and negative $268 million in free cash flow. The primary differences included routine operating uses of cash flow, including pension plan contributions, payments to employees, and a decline in the sales of accounts receivable.
Any serious investor who looked at this presentation, as shown in Table 4, would be aghast at seeing such normal operating expenditures excluded from the calculation of operating cash flow. The old adage “where there’s smoke, there’s fire” is very applicable when searching for shenanigans. Delphi’s ridiculous cash flow surrogate deception was the smoke. The fraudulent revenue and cash flow was the fire.
|“Operating Cash Flow” (non-GAAP)||1,220|
|Cash paid for employee and product line charges||-229|
|Cash paid for lump-sum contract signing bonuses||-125|
|Decrease in sales of accounts receivable||-144|
|Cash flow from operations (GAAP)||737|
Free cash flow (GAAP cash flow from
operations less GAAP capital expenditures)
The real estate investment trustindustry uses the funds from operations ( metric as a standard for measuring company performance. While this metric was not promulgated by GAAP, it is widely viewed as a gauge of a REIT’s ability to generate cash flow and is often viewed as being more useful than traditional GAAP earnings or cash flow measures. In order to promote the consistency and legitimacy of this performance metric, the industry’s main trade group, the National Association of Real Estate Investment Trusts (NAREIT), laid out a strict definition of funds from operations. NAREIT defined FFO to be net income excluding depreciation, gains or losses from the sale of property, and income from unconsolidated joint ventures.
Some companies, however, are not really interested in conforming to voluntary industry standards, especially when they benefit from going rogue. American Financial Realty, for example, shunned the industry standard definition in 2003 and instead used its own more favorable definition, which, of course, inflated performance and helped management reach its bonus targets. The primary difference between American Financial Realty’s definition and the industry standard was that the company decided to include its gains from the sale of property, whereas NAREIT explicitly prohibits this. Had American Financial Realty excluded these gains from the calculation as dictated by the industry definition, the company’s 2003 funds from operations would have been cut by nearly half.
By now you should know that any time a company reports an important non-GAAP metric, you need to read and monitor the definition to ensure that you understand exactly what information that metric conveys.
This article is excerpted from Howard Schilit's book written with Jeremy Perler, “Financial Shenanigans,” third edition (McGraw-Hill, 2010).