FOOL ON THE HILL
Pro Forma Earnings: Not the Whole Story

In a time when a disappointing earnings number can cause a company's stock to tumble, more and more companies are focusing on "pro forma" earnings to back out some distorting factors. This is supposed to give investors a clearer view of a company's operations, but since there is no regulatory guidance for pro forma earnings, companies have increasingly used them to make their earnings look better. An expense may be non-cash or one-time in nature, yet still have significance.

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By Bill Mann (TMF Otter)
May 4, 2001

I had an interesting discussion with Motley Fool Radio Show producer (and all around king among men) Mac Greer that clarified for me the need to discuss one of the toys used increasingly by companies when presenting their earnings: the use of "pro forma" numbers.

The conversation went something like this:

Mac: Hey, Bill, I saw a news report that said Expedia (Nasdaq: EXPE) recorded its first-ever profit on a pro forma basis.

Bill: Yeah? What was their actual earnings number?

Mac: Pro forma was $0.09. But if you add everything in, they lost money. Does that make them profitable?

Bill: Well, that depends on what they excluded.

Mac: So how do you know?

Bill: Unless they reported in GAAP (generally accepted accounting principles) on their press release, we have to wait until their reported earnings are available in a few days.

Mac: So you're saying that all these media organizations are reporting whether or not companies are profitable based on rules that the companies themselves get to make up?

Bill: Yep. Doesn't make much sense, does it?

Actually, chalk the above conversation up as a dramatization. And don't you hate how I keep answering questions with more questions? The point is, "pro forma" is a toy companies use to show their results in the light that THEY want them shown. In this age of trading on headlines, just-in-time news, soundbites, and hypertrading, and where an earnings "miss" can send a stock down 20% or more, I'm sure some investor relations departments view pro forma earnings as part of their public relations mechanism. (Business Week, coincidentally, wrote a feature on "The Numbers Game" this week.)

It's understandable. Expedia achieves profitability when it backs out non-cash amortization of goodwill from prior acquisitions and stock-based compensation, which amounts to approximately $22 million. In this case, Expedia's pro forma report is exactly as it should be: It provides both pro forma and GAAP numbers, and the company doesn't try to back out any "one-time charges." Still, on a GAAP basis the company actually lost $0.37 per share, and even though amortization and compensation charges are non-cash -- meaning, they are recorded as an expense though no cash was spent on them -- their existence is not irrelevant.

Cable companies, for example, almost never make an operating profit because they are constantly writing down huge depreciation costs for the decline in value of their networks. Backing out such non-cash charges is, in such a case, helpful to see what the actual cash-on-cash profit would be. (One could also use free cash flow (FCF), which is generally defined as all cash generated from operations minus capital expenditures, both of which are found on the cash flow statement.)

Pro forma statements have no rules
But those who blindly accept pro forma earnings statements are simply aping what the companies want them to hear. This isn't to say companies are being dishonest with pro forma earnings: In general the numbers are not being manipulated, as pro forma statements don't constitute fraud. But when reading non-GAAP earnings, being serially skeptical may end up saving you big money.

When companies are allowed to determine just what constitutes a "one-time expense," you've got to be awfully careful not to accept them at face value. Some companies, for example, make a habit of taking "one-time" charges, writing off inventory instead of selling it at discount, and taking the resultant hit on the balance sheet. If this is a recurring tactic, it's a warning sign that the company may be trying to mask underperformance and boost earnings.

Investors should be mindful of pro forma figures not only when tracking one company's performance, but when comparing it to competitors using multiples of earnings or other measures. Since companies may use pro forma figures differently -- or not at all -- it's important to ensure that the information used in such an analysis creates a true "apples to apples" comparison. 

The Securities and Exchange Commission (SEC) does not have any authority over company press releases unless outright fraud has been committed -- if, for example, a company reported sales that never actually happened. Still, it has voiced concerns about companies that seem to shove all their bad news into the non-pro forma category in a play to make results appear better. (Amazingly, I've yet to see a pro forma statement come out from a company that shows it in a worse light than GAAP would have.)

Some examples:

i2 Technologies (Nasdaq: ITWO) recently reported its first-quarter pro forma earnings of $0.02 per share. In i2's case, the company excluded "amortization of intangibles, write-off of in-process R&D and acquisition-related expenses, non-recurring items, employer taxes on stock option exercises, and net losses realized on minority investments." i2 does a good job explaining its changes for pro forma, most of which took the form of a $768 million amortization charge. Still, the company also included some cash charges due to their one-time nature. Taking those charges into account, i2 lost money for the quarter.

Inktomi's (Nasdaq: INKT) most recent quarterly press release states only the pro forma earnings in the text. You have to go all the way to the bottom of the statement to find its GAAP earnings in a table. In this case, the company went from a $0.22 per share loss under pro forma, to a $0.46 loss in reported earnings. The press release text makes no mention whatsoever of its wider loss under GAAP provisions. Inktomi has by no means done anything wrong, but they're not exactly going out of their way to do something right, either.

Fred Barbash from The Washington Post recently noted that the definition of the accounting term "pro forma" is "hypothetical." Barbash goes on to suggest that whenever you read the words "pro forma" that you replace it with "hypothetical." This is great advice, for the very reason that "hypothetical" is much more descriptive to the non-Latin scholars among us. "Hypothetical" is defined by The American Heritage Dictionary as "suppositional" or "uncertain."

In the last week, two professional associations representing financial and investor relations executives released a guidance document to help public companies adopt standard practices, including language that shows the path from pro forma to GAAP results in their press releases. I applaud those organizations, and hope their suggestions bring about a "Generally Accepted Communications Principle" among public companies.

As it is, it's not clear that the use of pro forma results benefits the investors whose job it is to interpret and use them in their analysis -- though their benefit to the reporting companies is much plainer.

Incidentally, the SEC is currently conducting an online survey of investor habits in order to help with its investor education efforts -- in case you'd like to check out and participate.

Bill Mann is set adrift on memory bliss of you. His stock holdings can be viewed online, as can the Motley Fool's disclosure policy.