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How to decode ‘fake’ profits

The use of underlying earnings gets more tenuous by the day
September 2, 2016

‘Underlyingitis’, ‘fake profits’, ‘cherry-picking’ – whatever term is used, private investors know it when they see it. A company results statement is headed with underlying performance figures that bear no relation to the statutory figures on the income statement, down to the earnings per share for equity holders.

A sector that has come in for particular criticism along these lines is banking, with the UK’s largest lenders weighed down since the financial crisis by one-offs that have become two-offs, three-offs; the very contradiction of a regular exceptional item. Litigation costs are one example, but most prominent are provisions for past misselling of payment protection insurance, and never-ending restructuring costs.

"On an underlying basis, I have a six-pack and a 32-inch waist, but I’d hardly say that’s a true and fair description of my current physical condition," says Sandy Chen, analyst at broker Cenkos. "For banks that underwent tremendous change during the financial crisis, it made sense to try to present management’s view of the underlying business – but nearly a decade afterwards, it makes more sense to show shareholders the whole picture now."

The central charge, which is not limited to the banking sector, is that companies are regularly starting with a misleading view of their profitability by leaving out costs that should be considered run-of-the-mill. Hackles are also raised when executive remuneration is based on the adjusted figures.

Large corporates of all stripes are choosing to omit what some investors see as natural running costs: major pharmaceutical companies spend a lot of money developing a drug and then might choose to write off a failed drug trial as an exceptional item. Elsewhere, mining companies will exempt changes in the carrying value of their mines and disaster costs that are arguably par for the course.

“The bigger the company, the more they do it,” says Roger Lawson, deputy chairman of the private investor group ShareSoc, pointing to the small militia of auditors and other experts that are employed by the largest listed organisations. It is a problem that Mr Lawson believes is getting worse. “Companies have got more clever at hiding their real performance behind the smokescreen of adjusted figures,” he says.

A very dry joke

In some quarters, underlying earnings have become an open joke. A conversation on the subject with some of the private investor cohort on Twitter elicited some lively comment: “I ignore headlines and go straight to cash flow and balance sheet, then go back to the top and burst out laughing,” tweeted equity and property investor @rhomboid1MF. There is a sense that things have got worse. Fellow Twitterer and private investor @DianaEPatterson has witnessed “tenuous and widespread adjustments creeping in over the past 10 years”.

Accountancy has always been an art rather than a science, wrote @SmallCappy, and thus prone to abuse: “Reported earnings have always been something of a mirage. Forensic skills [are] needed.” @AnEarlofWisdom said: “I would consider all one-offs as normal course of business. Assess over more than one period as in most cases non-recurring [items] end up being recurring.” This is not just a matter of presentation. “It completely distorts their accounts because profits should turn into cash,” says Mr Lawson. Whether adjusted profits do is another matter

For a visual demonstration of this disparity, consider the chart above. It charts Royal Bank of Scotland’s (RBS) pre-tax earnings including unusual items against the same measure excluding unusual items. The Capital IQ figures do not equate exactly with the adjusted operating profit figure used by the bank, but the definition of excluded items (restructuring charges, goodwill impairments, write downs, legal settlements and other unusual items) is taken from the bank itself.

What the data demonstrate is how these one-offs have confused the picture since the financial crisis. The exemption of huge write-downs, goodwill impairments and restructuring costs have clearly weakened the link between pre-exceptionals and post-exceptionals profit figures. There is a reason why the bank trades at such a discount to book value.

But it is hardly alone in its challenges. Looking across the retail banking sector, including quoted and unquoted lenders, major ongoing charges have been redress costs for past sales of PPI and interest rate hedging (see the next chart). On the bright side, this country’s retail banks can look ahead with guarded optimism to the (delayed) 2019 deadline for PPI, but claims for packaged bank accounts are ready to take on the baton, and there is ongoing litigation in other areas such as small business banking and other hangovers from the credit crunch.

It is these big and regular one-offs that have led analysts such as Mr Chen to describe an ‘underlyingitis’ that has crept into corporate reporting. His frequent subject is Lloyds Banking Group (LLOY), a stock on which he has been bearish for some time. Mr Chen’s coverage has accepted some exceptional items such as disposal gains but has declined to strip out others such as PPI charges, restructuring charges and the bank levy.

Though these costs might not make management’s preferred statement of profits, they will reflect in statutory profits and work through to its tangible net assets and capital ratios, so are crucial for both the share price and the payment of dividends.

Cenkos has been something of a lone voice in the wilderness in that it forecasts based on statutory rather than adjusted numbers. “For the past several years, the statutory results have been a better indicator as to the direction that the tangible book value would take,” Mr Chen wrote of Lloyds more than two years ago.

Of course, analysts' use of adjusted earnings for the purpose of forecasting is widespread, and in many cases useful to give a sense of ongoing performance. But it has still come in for criticism from ShareSoc and other individual investors for not making clear what adjustments are being used.

(Adjusted) performance pays

Prominent City investors and activists are concerned not simply that adjusted profits do not feed through to shareholders, but that part of the executive pay package is based on the adjusted figure. This has driven a wedge between company managers and their investors, with Lloyds, RBS and Standard Chartered (STAN) coming in for criticism for using underlying profits to calculate at least part of their bonus payments.

This issue is a particular focus of New City Agenda, a think tank co-founded by Lord McFall, the one-time chair of the House of Commons Treasury Committee who is now a member of the House of Lords Economic Affairs Committee.

“Significant misconduct costs will continue to have a dramatic impact on the profitability of the UK’s retail banks,” Lord McFall says. The claims management industry is not going anywhere, and neither are provisions. In the first half of 2016, Lloyds set apart £70m for packaged accounts, £50m for insurance products sold in Germany and £215m in respect of “arrears related activities”, with an FCA investigation underway into its dealings with customers behind on their mortgage payments.

“It is in their best interests for shareholders to be leading the campaign to change bank culture and raise professional standards,” cautions Lord McFall. “They need to stop bonus levels being determined mainly by pre-tax profits and other ‘adjusted’ or ‘underlying’ profit measures which exist only in the minds of the executives.” New City Agenda also wants clarity from banks on how it arrives at the calculation of misconduct provisions, and better visibility on where future provisions might come from.

But there are also arguments against basing bonuses on statutory performance – given the influence on factors outside of management control such as gains or losses from pension scheme funding or insurance – and the desire to incentivise the bosses to encourage long-term performance. It’s a “matter of judgment”, says ShareSoc’s Lawson.

But the climate has certainly turned sour on pay which seems to bear no relation to conduct and current performance: whether that is the new prime minister’s promise to create a ‘shareholder society’ by making shareholder votes on pay packages binding, or the advisory vote against BP's (BP.) remuneration report, at the time of a substantial pay hike for a chief executive who had delivered a record annual loss to shareholders. The pay issue isn’t going anywhere.

There is change afoot

How could companies and regulators improve the situation? Few would argue that there are never one-offs that need to be exempted from headline performance.

There are two remedies commonly suggested. “The solution to this would be to have some clear rules about what can be considered exceptional, and what is not,” says Mr Lawson. Some private investors also want to see a better reconciliation of the adjusted profit figures with the statutory figures.

The former might be asking a bit much of regulators, considering the differences in reporting across sectors, the unique nature of proper ‘exceptionals’, and the difficulty without the use of hindsight to identify a non-recurring item.

Nevertheless, the authorities are on the case. Last year the European Securities and Markets Authority published its guidelines on ‘alternative performance measures’ (APMs). Back at home, the Financial Reporting Council is to follow up later this year with a report of its own on this subject. The FRC’s current position, informed by Europe, is that such measures “which are clearly presented and chosen to provide a balanced view of the company can be useful for investors” when they provide performance, financial position or cash flow information that cannot be presented using statutory financial measures.

Check your ingredients

ESMA defines alternative performance measures (APMs) as those derived from financial statements, usually by adding or subtracting certain items. Examples include earnings before one-offs, operating earnings, cash profits and so on.

European and UK guidance dictates that these measures should be defined, and the method of calculation given, including any assumptions used. They should be reconciled to the most relevant line item in the statutory accounts.

The people responsible for issuing financial statements should explain why APMs are useful for investors, and should accompany them with comparatives for the corresponding periods.

Crucially, the definition and calculation of an APM “should be consistent over time”, says ESMA. If they need to be redefined, the changes should be explained, including why they result in more relevant information, and the comparative figures should also be restated.

If a company stops issuing an APM, it should be explained why the measure is no longer relevant information.

The FRC does not prescribe specific measures, but does make clear that they should be “relevant and understandable… within the context of wider reporting responsibilities”. Those responsibilities could be undermined by the use of “overly optimistic or misleading” APMs such as non-recurring items that recur, or that include income but exclude directly related expenditure. They should also not be given more “prominence, emphasis and authority than the most directly reconcilable line items in the financial statements”, and a reconciliation should be given.

See the box for a summary of ESMA’s more detailed guidance. Clearly certain companies are falling short when it comes to recording recurring items as non-recurring, and giving more prominence to adjusted figures than statutory ones. Companies may do well to expect a slightly tougher line on this as the FRC continues its work.

It all ends up somewhere

The regulatory tone is sensible: there is clearly room for both adjusted and statutory figures in terms of interpreting companies’ prospects, if the former are clearly explained and defensible. The defence is fairly simple. “Many analysts and investors actually prefer underlying earnings as a measure of profitability, as it gives an indication of what they believe to be an accurate reading of the company's profit position,” says Garry White, chief investment commentator at Charles Stanley.

For Mr White it is down to the investor to look at the relevant line items that have caused the divergence, a process that can be instructive. “By identifying what the differences are, it can actually give you better insight into what’s going on at a company,” he adds. Adjusted profits are “not necessarily a bad thing” if investors are able to read between the lines.

Where to look? Professional investors, says ShareSoc’s Lawson, go straight to the statutory profits and the cash flow, and it is the latter that “really tells you if the company is making money”. Readers are advised to look back at our recent cash clinic on Marks & Spencer (MKS), a company for which post-tax profits and cash flow have been moving in opposite directions over the past few years (down and up, respectively).

As my colleague Algy Hall wrote, a stream of write-downs and charges have marred the income statement, “which arguably provides added reason to pay close attention to cash” ('Cash clinic: is Marks & Spencer's dividend safe?' IC 29/7/16). Reduced capital expenditure has lifted cash flows, providing support for shareholder returns in the near term. Indeed, looking at the conversion from cash profits to free cash flow is one method that investors use to assess a company's underlying strength.

For the banks and other companies valued on a net assets basis, there is always the “great leveller”. This is the term Schroders (SDR) fund manager Nick Kirrage uses for book value. “At the end of the day, it’s irrelevant whether something goes through the exceptionals line, and gets carved out of underlying, or not,” he said on our Lloyds special podcast earlier this year. “It all ends up impacting the book value.”

So it can be useful to consider one-off impairments in terms of how much they take off the banks' capital positions, which in the post-Lehmans world are the major criterion by which they are judged, and by which dividends are deemed acceptable.

No one wants to get mired in a discussion of whether a certain item is core or non-core. But if individual investors are tending more and more to ignore the front page of a results statement, while analysts use bespoke measures of profitability, that front page is at risk of becoming just a press release for the rushed news reporter. Returning some meaning to the term 'one-off', and providing a clear and prominent reconciliation of the underlying profits to the statutory profits, would be welcome first steps.