A scheme we call “consensual hallucination.”
Yesterday, we were bashing big pharmaceutical companies for jacking up prices of patent-protected drugs at obscene rates. Those double-digit price increases were largely responsible for the sales increases these companies reported. Drugs have become the largest wholesale category, at $54.3 billion in May, or 12.2% of total wholesales.
This boom is based on price increases at a great cost to US consumers and taxpayers. It’s cannibalizing the rest of the economy. But it’s made possible by the abuse of the patent system, the increasingly monopolistic structures in the industry after a tsunami of mergers funded by cheap credit and a soaring stock market – as planned by the Fed – along with legislators and regulators that have been compromised by the big money and the revolving door [read… This is What’s Cannibalizing the US Economy].
And we said that investors were soaking up the money. But even investors are getting schemed.
In its report released on Friday, FactSet projects that the health-care sector in the S&P 500 will show revenue growth of 7.8% in the second quarter. But even “adjusted” ex-bad-items earnings – a classic in American fiction – is expected to grow by only 2.2% (even as revenues and “adjusted” earnings for the S&P 500 overall are expected to fall once again).
But it’s even worse. As reported under Generally Accepted Accounting Principles (GAAP), which all publicly traded companies in the US have to use for their required financial reports, these Q2 earnings in the health-care sector are likely to drop.
For health-care, Q1 was better: revenues soared 9.2% and “adjusted” earnings 7.1% (even as S&P 500 revenues fell 1.5% and “adjusted” earnings dropped 6.7%).
So how much of this “adjusted” gloss is coming off under GAAP? The purpose of GAAP is to give investors some kind of semi-reliable idea about what’s going on in the company – to limit the games companies can play with their financial reports.
Companies can report other metrics, including “adjusted” earnings, to supplement GAAP numbers. But after years of benignly closing its eyes, the SEC is getting antsy about the practice of putting non-GAAP numbers in a dominant position during reporting season. Wall Street and its data gatherers, like FactSet, often don’t even include GAAP earnings in their tallies.
Credit Suisse, cited by the Wall Street Journal, just shed some light on how aggressive Big Pharma has become in massaging its financial data: in Q1, Big Pharma inflated its GAAP earnings by 38% to arrive at “adjusted” earnings.
And the practice is growing: in Q1 2014, “adjusted” earnings inflation was 22%.
It’s even worse: the difference is normally smaller in the first quarter than in other quarters. In total, for the last 13 quarters, Big Pharma inflated its earnings in this manner by 40%!
Big Pharma earned $139 billion under GAAP over those 13 quarters, but then inflated those earnings by another $55 billion to an investor-pleasing “adjusted” $194 billion.
Biggest culprit? Excluding amortization expenses from “adjusted” earnings. It accounted for two-thirds of the difference.
Amortization is like depreciation, but it’s used for “intangible” assets. For example, Merck & Co spent a chunk of money (in cash and stock) to acquire another company, paying more than the company is worth, which is standard procedure in M&A. The overpaid portion – paid for with cash or stock – isn’t expensed on the income statement right away. Instead, it’s temporarily parked on the balance sheet as an “intangible” asset, often called “goodwill,” and expensed over time.
Payment for that asset was very tangible (cash and stock). But once that expense is parked on the balance sheet, it becomes an intangible asset (the overpayment). When this goodwill is expensed (amortized), Merck and its analysts call it a “non-cash charge.” And this is the inherent deception: Since it’s now called a “non-cash charge,” it is expunged from “adjusted” earnings.
In Q1, for example, Merck reported earnings under GAAP of $0.40 a share, but then inflated this by 122% (!) by removing the bad items, such as amortization, to arrive at its “adjusted” ex-bad-items masterpiece of earnings fakery of $0.89 a share!
Big Pharma, in order to coagulate into ever bigger monopolies and to dodge US corporate income taxes (via “inversions”), has been on a merger binge, thus overpaying, and loading up on goodwill to be expensed later. So over the past 13 quarters, according to Credit Suisse, the exclusion of amortization expenses inflated “adjusted” earnings by $36.9 billion!
Not that investors mind being deceived by Big Pharma and its Wall Street backers. When it comes to pumping up stock prices, every trick is fair. Investors know the tricks that are being used. They could dump the stocks, but they don’t. They don’t care about accurate information. All they want is higher stock prices. So they play along in a scheme we’ve come to call “consensual hallucination.”
On paper, Big Pharma is booming, even as the rest of the goods-producing sector is declining, but it’s a costly boom. Read… This is What’s Cannibalizing the US Economy
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As a retired CFO, I find “adjusted earnings” laughable.
However, investors are willing victims: they think using “adjusted earnings” make them more sophisticated (example EBITDA). 95%+ of investors have no idea what this means, why it’s of interest or when it might be useful.
AT&T under Robert Allen was a master at excluding “extraordinary items” from earnings – it worked for years until folks caught on that every period had “extraordinary items” – that tends to make them pretty ordinary.
It turns out there is no such thing as a perfectly accurate earnings statement for a huge, complex commercial enterprise. GAAP is far from perfect, but at least everybody more or less plays by the same rules.
Chip, the big difference is back in the days when investors found out about AT&T at least they acted surprised and shocked.
Now they are putting up with every single “extraordinary” financial trick, from Volkswagen unloading upon their Chinese dealerships 200 days of stock just to avoid slowing down production to Apple and Samsung resorting to barely legal variations of channel stuffing to prop up paer sales figures, to Google’s YouTube “ghost viewers”. Investors know this, as they know about Merck’s accounting tricks, but as Mr Richter say, they flat out don’t care as long as it pumps up stock price.
Hell, they don’t even care when authorities catch up with the game and start slapping huge fines: to get back at Volkswagen, they officially announced their little emission trickery will cost them $18 billion in the US alone. Did stocks tank or at very least dip? No, they stand where they were last November. Investors either just flat out don’t care or fully expect taxpayers to come to the rescue.
This is an extremely dangerous game. To stay in the healthcare field, in 2014 Theranos was values at a dizzying $9 billion. Nobody asked questions about healthcare researchers questioning the lack of peer-reviewed literature originating from the company or why the board of directors was stuffed to the gills with huge names like George Shultz but contained no healthcare professionals or even people with any biochemical experience.
What everybody thought and cared about was the minute Theranos would have its IPO. In short nobody cared a feather or a fig if Theranos’ biochemical machinery worked at least as well as Siemens’ or Fujirebio’s: what everybody was obsessing about was getting a slice of the pie at IPO and see it skyrocket in the following week, like the Chinese umbrella manufacturer which went public on the Shenzhen Small Caps early last year and saw its stock jump 1700% (you read that right) in ten days.
Fast forward to 2016. Theranos is now worth exactly $0. At least that Chinese company still manufactures umbrellas.
I don’t blame ATT for using every trick in the book to get over on the market. Isn’t that what auditors are for to protect the system by discovering the fraud? Maybe the accounting firms need to broken up as well, into accounting and auditing firms.
Auditors vs. Regulators. I saw a company that blamed its auditors for not telling them that their business model was causing them to fail, and then the regulators came in to enforce that. Sometimes company leaders just don’t want to be told that they are doing something wrong, unethical, bad or otherwise.
The sense of fiduciary and other duties to owners was lacking, and the owners themselves may be unaware and not interested in looking too closely at the details behind their ‘returns’.
Petunia
“Auditors detecting fraud” is a common and serious misconception of the investing public. There is simply is no way an independent audit firm with a few thousand audit hours can detect fraud in a multi-billion international firm with tens (or hundreds) of thousands of employees. Auditors statistically select transactions to verify they are processed according to corporate & GAAP standards. There can certainly be disagreements about accounting treatment for some transactions (this is usually mitigated by working with auditors for accounting guidance throughout the fiscal year).
Corporate management has the primary responsibility for detecting & preventing fraud. Capitalism is not served by management (technically, employees of shareholders) who lacks the ethics required to meet this very fundamental responsibility.
One would have thought Valent would have brought this in focus. I guess not.
Valeant had a lot more schemes up its sleeves than just “adjusted” earnings.
:-]
Valent had the distinction (among other nasty things) of adjusting both earnings and revenue – THAT’S VERY CREATIVE! These guys were not in the pharmaceutical business, they were in the financial engineering business as they went about massively destroying shareholder value.
Plus management flat-out lied to regulators and investors (including Bill Ackerman).
A fundamental part of Valeant’s scam was to pretend that drug stores it supplied were independent when they were actually owned by Valeant,. So Valeant was billing itself.
Seems to me we went through this “adjusted” earnings charade before…in the late 90’s/early 00’s, until the dot com bubble burst and Enron/Worldcom/Tyco imploded in a wave of exposed financial shenanigans. But history only rhymes, as they say…
Amazing. Wolf Street has done another good service.
Yesterday I saw another piece on Wall Street Week where they admit the market is in a massive bubble. They insist that because the bubble is going to get even bigger, this is a great time to get into the market. They are publicly admitting that there is no fundamental reason to invest. The point is to time the bubble to your advantage. If this isn’t a warning to get out I don’t know what is.
I would like to point out that one of they guys on that show ran a feeder fund for Madoff and is still in business. Louis Rukeyser must be rotating like a turbine in his grave.
It will get even bigger, that’s for sure. But the big problem is the phenomenon called “narrowing”, meaning how whole indexes are propped up by a dwindling number of megacaps.
This is effectively the same as going to the racetrack: you can get lucky and make a killing or you can see your savings mauled.
Just ask those who bought AAPL last year at $120 if not at $130 because it would get to $150 in “six/seven months at most”, or the fools who keep on buying Euro banking stocks because “they cannot go any lower than this” and “just wait and see what will happen when they get bailed out”. Trading penny stocks can be profitable, as long as you have any idea what you are doing.
Excellent article Wolf! Very insightful and educational.
Unfortunately, the ‘authorities’ will do little about any of these shenanigans. Our government has painted itself into a very small corner and really has no way out except to let the paint dry.
The government has covertly propped the stock market through a number of memes. They will continue to do so until they can’t. As such, it would not be useful to get too tough on schemes that keep stock prices up.
ZIRP and probably NIRP in the US is here to stay for a long time. The Fed cannot raise interest rates meaningfully.
The housing boomlet has run it’s course because the system is running low on people that can afford this high priced housing. I don’t think it will necesssarily collapse but another doubling from here is definitely not going to happen.
The mainstream economy is being supported by generous federal spending that is not being monitored, budgeted or otherwise controlled by the Congress. Congress is esssentially DOA.
After the new President takes office, the debt ceiling will come back into play and then we’ll see how much this last spending binge has cost us and future generations.
Essentially, we’re in a for a slow downward grind from here barring any black swans that collapse faith in the currency.
“Investors” LOL. Speculators and Central Banks are more apt descriptions. In which case, who cares? They are adults. And we all know helicopter money is coming anyways. Everyone will be bailed out in the end.
“Invest” in brooms and crying towels.
Brooms to sweep up the mounds of wind blown, worthless currency notes (a la German marks 1923) and commercial paper, while proffering the towels to said “investors” in an attempt to dry their crocodile tears!
Meanwhile “Big Pharma” will continue to shower Washington with as much of this phony wealth as it takes, to get it’s way.
Regulators? We don’t need no stinkin regulators!
Thanks to auto edit software for removing late night comment
Thought I was in previous post
auto edit software was off till just now. But it did do its jobs, belatedly.
:-)
Hey Mr Wolf why do you keep deleting my comments? Getting alittle too close to the truth am I?
I saw the World Trade Center come down with my own eyes and have zero tolerance for that sort of nonsense. So don’t post it here.
Public companies aren’t allowed to amortize goodwill, so that’s obviously not what they’re amortizing.