Bank of America: Limited Earnings Power Is Prompting More Companies to Put Lipstick on a Pig Each Quarter
Something to watch for this earnings season: the number of companies that eschew the use of generally accepted accounting principles, commonly called GAAP.
For example, Valeant Pharmaceuticals International, a company under fire for its accounting practices, focuses on "cash earnings per share" as its key profits metric and has made generous use of accounting adjustments known as add-backs to bolster its financial performance ahead of acquisitions.
While the specialty pharma company's use of adjusted earnings may have been more aggressive than that of most enterprises, there's no denying that the practice has gone mainstream. The increased prevalence of presenting adjusted earnings to investors, often in an attempt to flatter bottom lines and lower borrowing costs in the high-yield debt market, shows that corporate profitability is challenged—and not just in the troubled commodities sector.
"We are increasingly concerned with the number of companies (non-commodity) reporting earnings on an adjusted basis versus those that are stressing GAAP accounting, and find the divergence a consequence of less earnings power," wrote credit strategists led by Michael Contopoulos at Bank of America Merrill Lynch.
Like peers at Société Générale, Bank of America's team finds China to be an ill-fitting catch-all causation for the fact that the appetite for risk has shrunk sharply early in 2016. Robust non-farm payroll growth overstates the strength of the U.S. economy at a time of slowing global demand, they argue, highlighting the decoupling of top- and bottom-line growth. They compared the use of adjusted earnings to putting lipstick on a pig.
At present, the difference between adjusted non-commodity corporate profits and unvarnished earnings before interest, taxes, depreciation, and amortization (Ebitda) according to the strategists, is growth or contraction.
"We are increasingly concerned with this trend, as on an unadjusted basis non-commodity earnings growth has been negative two of the last four quarters, representing the worst four quarter average earnings growth in a non-recessionary period since late 2000," the strategists write.
Beautified earnings belie an environment in which high-yield bonds will struggle to break even amid rising defaults, according to Bank of America.
"Not only are spreads not cheap from a historic perspective, but in our view, there is no question that defaults are going higher in 2016 and that investors are not being compensated for an increase in credit losses," concluded the strategists. "It is our fear that many of the signs we see in high-yield (poor earnings, poor recoveries, risk aversion, the changing face of issuance), ultimately foreshadows further economic and risk asset malaise in 2016 and 2017."