Guidance in IBM's (NYSE: IBM) fourth-quarter earnings announcement included the de facto standard for tech companies: non-GAAP earnings … a.k.a. "operating" earnings. This is a first for conservative IBM, and it should be a good thing for the stock.

The GAAP gap
Is there really much of a difference between operating earnings and GAAP earnings? That depends on the company. According to supplemental information from IBM, the difference between its GAAP and non-GAAP EPS in Q4 was 1.7%. In contrast, in NetApp's (Nasdaq: NTAP) most recent quarter, the difference between GAAP and non-GAAP EPS was a whopping 23.8%.

Funny thing: NetApp analysts focus on the (higher) non-GAAP number. For IBM, analysts focus on the (lower) GAAP number.

NetApp is hardly the most egregious beneficiary of non-GAAP EPS. For storage heavyweight and IBM competitor EMC (NYSE: EMC), the difference was an astounding 45% in the fourth quarter. Let's take a peek at the numbers for half a dozen tech leaders' most recently reported quarters.

Company

GAAP EPS

Non-GAAP EPS

Difference

EMC

 $0.29

 $0.42

45%
Oracle (Nasdaq: ORCL)

 $0.37

 $0.51

38%
NetApp

 $0.42

 $0.52

24%
Hewlett-Packard (NYSE: HPQ)

 $1.10

 $1.33

21%
Dell (Nasdaq: DELL)

 $0.42

 $0.45

7%
IBM

 $4.18

 $4.25

2%

Sources: Company reports.

For each of these companies -- except IBM -- investors focus on the higher non-GAAP earnings. Doesn’t seem fair, does it?

Boosting the P/E ratio
Published P/E ratios use the earnings that analysts focus on, be it GAAP or non-GAAP. And tech analysts almost always go for non-GAAP EPS, which is almost always higher than GAAP EPS. The bigger the EPS, the lower the P/E ratio. What does that mean for the P/E ratios of EMC, HP, and IBM?

Company

GAAP EPS

Non-GAAP EPS

Price

GAAP P/E

Non-GAAP P/E

EMC (2010)

 $0.88

 $1.26

 $24.48

 27.8

 19.4
Hewlett-Packard (FY10) 

 $3.69

 $4.58

 $45.55

 12.3

 9.9
IBM (2010)

 $11.52

 $11.67

 $159.00

 13.8

 13.6

Sources: Company reports.

For EMC and HP, P/E ratios based on non-GAAP EPS make a big difference. For IBM, not so much.

Apples to apples … and more
One reason IBM gave for moving to non-GAAP financials was to "enable comparisons to peers." Given the boost in P/E ratios that some IBM peers are getting from non-GAAP financials, that would seem reason enough.  

But IBM provided three more reasons:

  • Greater transparency into operational results and pension-plan performance.
  • Improved visibility into management decisions and operational effects.
  • A long-term view of the business.

To better understand these reasons, it helps to know what a company is excluding from GAAP earnings. That varies by company. It's up to management. That's why some observers refer to "operating earnings" as "earnings before bad stuff."

In IBM's case, non-GAAP financials exclude "amortization of purchased intangible assets, other acquisition-related charges, and certain retirement-related costs that the company has defined as non-operating." Had IBM used non-GAAP earnings in 2010, acquisition-related charges would have added $0.34 to EPS, and retirement-related expenses would have lowered EPS by $0.20. Rounded, it netted out to an increase of $0.15 or 1.3%.

Why bother for a measly 1.3%? Because acquisition and retirement-related expenses can vary a lot from year to year. In the future, it could amount to a much bigger difference.

In addition, variations in acquisition and retirement-related expenses make it hard for investors to see how IBM's operating businesses are doing from one quarter or year to the next. Looking past those numbers improves transparency and visibility. For example, IBM's estimate of its retirement-related income/expenses for 2015 is plus or minus a billion dollars . That's a $2 billion range. That's 13.5% of 2010 net income of $14.8 billion.

Where does the large uncertainty come from? Mainly from securities prices and interest rates, which really have nothing to do with IBM's operating businesses.

The move to non-GAAP financials also lets management provide guidance with confidence that it won't fall short because of volatile, unpredictable interest rates and/or stock markets. Here's the guidance it provided in its Q4 earnings release: "full-year 2011 … operating (non-GAAP) earnings per share of at least $13.00, which puts the company on track for the 2015 road map of at least $20 of operating (non-GAAP) earnings per share."

Foolish takeaway
I'm generally suspicious of non-GAAP EPS, but in this case it's a good move. The items IBM is excluding from GAAP financials are reasonable rather than overly aggressive. The move should improve transparency, reduce earnings volatility, and increase management's confidence in discussing the outlook. As IBM gets more credit for its solid and growing operating results, the stock's P/E ratio could expand and improve the stock's returns.

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