Today I wanted to discuss something that most companies do and most investors simply accept as is – it is often provided by companies as something that “helps” investors understand the business performance better, and that is NON-GAAP P&L items.
With quarterly and annual financial updates, most companies provide their GAAP P&L and non-GAAP P&L and other relevant financial metrics. For those who are not familiar, GAAP stands for Generally Accepted Accounting Principles – this represents details, rules, and legalities around which companies must present their financials. Non-GAAP means financial metrics that are not on the high standards of GAAP – often there will be many add-backs and adjustments.
The original purpose of non-GAAP items was truly to help investors understand better about what is going on at companies – to provide more of “like-for-like” or “apples to apples” comparison for investors when they are comparing the latest quarter performance to last quarter or one year ago.
In normal environment, it has generally been fine to use non-GAAP figures when assessing high leverage companies, but with covid19 where there is demand shock to the system, it has become much riskier to rely on non-GAAP P&L to assess companies’ financial health, particularly those with high leverage, which leads to sliver of equity in the total capital structure.
I would like to discuss why it is important to dig deeper into non-GAAP during covid19 below
While non-GAAP reporting started as a convenient way to show financials on apples-to-apples basis to investors by removing one-off, on-recurring items, companies now began excluding non-cash items and non-GAAP P&L became non-recurring and non-cash P&L – even though non-cash items like share-based compensation are REAL costs to shareholders through heavy dilution.
We will use EBITDA as a example. EBITDA stand for Earnings Before Interest, Taxes, Depreciation, and Amortization. As a proxy for cash generative ability of a company, EBITDA is an important measure of profitability. However, adjusted EBITDA is becoming an extremely popular measure that companies report these days. Most of the times, companies are now adding back share-based compensation and call it adjusted EBITDA.
As shown below, you can really expand your margin profile SIGNIFICANTLY ON PAPER (i.e. looks better) if you start adding back a much of items. Just as an illustration, heavy add-backs makes a company look like it is to 50% EBITDA margin business even though it is actually a 35% margin business – this is a serious problem in today’s financial market.
Inflating EBITDA margin to 50% from 35% does not stop with just showing higher EBITDA that investors will use to apply EV / EBITDA multiple to value the company. Investors generally see that there is FUNDAMENTAL difference between a business that has 50% margin and a business than as 35% margin.
50% margin business is a MUCH better business – the margin profitability indicates the company’s pricing power, dominant market positioning, or even greater predictability of the revenue stream – this can lead to multiple expansion or investors ascribing higher multiple to an already inflated EBITDA – leading to overvaluation of the company.
And Valeant (now Bausch Health) was one of the most aggressive companies when it comes to add-backs and inflating P&L. As a result, the delta between GAAP Cash flow and non-GAAP / adjusted cash flow only expanded severely – as shown below in Allergan’s presentation.
Valeant’s story telling even got Pershing Square Capital Management to come on board for the equity story – below is the valuation slide from Pershing Square that laid out their case for investing in Valeant. Notice that Pershing Square is using “Cash EPS” to show that Valeant is undervalued on P/E basis – unfortunately the cash EPS was severely inflated. True P/E was actually much higher.
As you know, Valeant failed to acquire Allergan. Afterwards, Valeant stock price went down from $250 to $30 (Bausch is now $22 stock) within a few years through 1) high attention to drug price hikes, 2) short-sellers that flagged aggressive adjustments that inflated cash flow, and 3) revelation of its controlled specialty pharmacy (Philidor) that further inflated profitability.
The name “Valeant” became such a dirty word that when new management team came on board, they changed the company’s name to Bausch Health – borrowing the name of its strongest brand. They also changed the ticker to $BHC from $VRX.
Still, it is pretty much like putting lipstick on a pig – the products remain largely undifferentiated and the company is still levered very high from legacy acquisitions – which means fundamentals didn’t really change. In most recent presentation (JPM 2021), they appear to be still busy doing cherry-picking more promising areas of the company even though end-market dynamics still remain highly challenging due to covid19.
SO WHY SHOULD WE BE PARTICULARLY CAREFUL WITH NON-GAAP MEASURES DURING COVID19?
It is because demand shock is a killer for companies on the edge (particularly if it has very high leverage). Through strong economic growth over the past few years, many companies/zombies have turned into good companies on paper (using non-GAAP P&L), but actually have much lower cash flow than their non-GAAP P&L would suggest. These companies are often very vulnerable to sudden change in cash flow.
These companies carry high valuation despite bad fundamentals because they have management teams that are VERY good at selling their equity story. They manage investors very well (some investors disparagingly call them “hype-artists”) and continuously fund their operations by relying on capital markets – whether it be through equity raise or debt financing. However, when there is macro shock that shuts down capital markets, these businesses “suddenly” fall into crisis because of poor fundamentals. We should always be vigilant as this helps with avoiding massive losses.
This is another reason why I just like to pay expensive multiples for companies on sound fundamentals and management teams with high integrity – there is some implicit downside protection with investing in high quality business whose management teams are amazing at compounding capital by identifying projects that will have very high ROIC.
I also had my own share of big loss investments by overlooking this problem – what are your mega loss investments and what did you learn from it? Please note in the comment below!
*not investment advice
Nice post!