Watch Out for Tricky Technology Earnings

A Wall Street Journal headline from last June said it best: “Accounting Choices Blur Profit Picture.”
In other words, it is getting harder and harder to figure out what exactly you are buying when you purchase a company’s stock.
The very same WSJ article revealed that, as of the close of 2015, only 29 companies in the S&P 500 used GAAP (Generally Accepted Accounting Principles) exclusively. That is a mere 5.6% of the total and a sharp decline from the 25% level seen in 2006.
Most companies have switched to emphasizing pro forma, adjusted, or non-GAAP earnings. These all conveniently leave out some expenses and charges related to running the business.
And sadly, most Wall Street analysts treat these non-GAAP earnings as the preferred view of reality.
Stealing from recent headlines, I choose to call these ways of looking at earnings “alternative facts.”

Technology Earnings

Among the biggest practitioners of this “art” of massaged earnings are technology companies. As a Bloomberg Gadfly article said, “in the headquarters of technology companies, GAAP is becoming an endangered species.”
As of the end of 2015, 80% of technology companies used handpicked profit measures. These measures ignore a major cost of doing business for these companies, such as stock-based compensation.
At 70 tech firms looked at by Bloomberg, the annual net income using GAAP of $194 billion was “magically” transformed into a $234 billion figure.
Among the biggest tech users (or is it abusers?) of non-GAAP numbers are: Salesforce.com (NYSE: CRM), Microchip Technology (NASDAQ: MCHP), Twitter (NASDAQ: TWTR) and before its acquisition by Microsoft (NASDAQ: MSFT), LinkedIn.
Salesforce, for example, only looks profitable if one ignores the cost of stock paid to employees.
We’ve gone down this path toward “alternative facts” because executives’ compensation is often tied to presenting the best possible numbers. Present good numbers and the stock roars ahead and the cash register is ringing in the executive’s wallet.
So it is easy to understand why pro forma and other alternative earnings have become so popular.

The Maturity of Some Tech Giants

The Financial Times reported last July that of the U.S. technology companies worth over $100 billion, only Apple (NASDAQ: AAPL) and Amazon.com (NASDAQ: AMZN) do not report non-GAAP numbers.
Since then, other technology companies have made strides toward what I call “real accounting” for technology earnings. These include Facebook (NASDAQ: FB), Netflix (NASDAQ: NFLX) and Alphabet (NASDAQ: GOOG).
To me, this shows the “maturity” of these companies, not having to rely on “gimmicks” to make their results look good to the investing public.
The most recent example of maturity came from Alphabet. It announced in its last quarterly conference call that it would stop presenting a view of its earnings that ignores stock-based compensation costs.
That is huge. Last year, such compensation came to $6.7 billion. Based on 2016 numbers, such a move would have lowered its earnings figure by nearly 20%.
And if Amazon last year had overlooked the $3 billion in stock compensation costs, it would have raised its operating profits by more than 75%.

Stick With the Best

There are some on Wall Street and even in academia that say, in this new era, we need to use new methods of accounting. They say that the old methods are “arcane” and no longer useful.
As someone who has been in the investment business since the 1980s, that scares me.
It sounds a lot like what legendary investor Sir John Templeton called the four most expensive words in the English language: “This time it’s different.”
What in the world is wrong with reporting your actual business expenses?
If companies don’t, why not go all the way and just report earnings before expenses?
My advice to investors in the technology sector is to stick with the best. Say goodbye to the companies with tricky technology earnings and creative accounting. Invest in companies that are not afraid to report their true expenses and earnings.
Apple, Amazon and Alphabet are pretty good places to start.