Tuesday, August 25, 2009

Including the Good Stuff while Excluding the Bad Stuff: Come to Think of It, We Will Get Fooled Again!

One of the first books we bought on our new Kindle was “Bill and Dave,” Michael Malone’s 2007 account of “How Hewlett and Packard Built the World’s Greatest Company.”

Having written a book, and knowing how hard it is to actually do that, we’re not going to say anything remotely disparaging about “Bill and Dave”—it’s a good, readable account of what the title says it’s about.

In fact, whether you agree that HP is, or was, “The World’s Greatest Company,” anybody with an interest in HP—now run by Mark Hurd, the genius who built a sleepy technological has-been known as NCR into a make-the-numbers machine favored by Wall Street’s Finest—ought to read it.

You’ll be reminded how hard it is to not only build and run a business, but how to maintain that business when it depends almost entirely on technological innovations to stay relevant.

Just ask the boys at Eastman Kodak.

Also, it’s an interesting journey back to the beginnings of the electronics era—the very, very beginning—when the two men met in the fertile climate of Stanford University and the San Francisco Bay area, where entrepreneurs were putting up radio antenna and trying to figure out how to make money on this strange idea of broadcasting, while headstrong individuals were quitting one pioneering company to start their own company seemingly every ten minutes.

It’ll remind you of the dot-com boom, in a good way.

But that’s all gone—as are Bill and Dave. Their legacy, however, continues to exist. In fact, just last week “The World’s Greatest Company” reported quarterly earnings.

And, as you might expect, under the earnings-obsessed Mr. Hurd, “The Number” the company reported was exactly 1 penny above the Wall Street consensus: 91 cents per share compared to Wall Street’s Finest’s expectation of 90 cents per share.

“Gosh, how’d they do it?” a reasonable person might ask.

And it’s a great question.

HP is, after all, a $100 billion-a-year company with more than 300,000 employees manning far-flung operations across the globe. Two-thirds of its revenues are derived in foreign currencies that fluctuate every day.

Not only that, but four of the company’s five major businesses experienced sales declines of 20% or more in the quarter.

Of the five businesses, one looks doomed to eventual irrelevance (personal computers), a second looks doomed to brutal competition as far as the eye can see (servers and storage) and a third is exposed to the kind of technology shift that brought about the collapse of the aforementioned Eastman Kodak (printers.)

Oh, and the one business that showed growth in the quarter did so entirely thanks to the fact that the company spent $13 billion buying EDS, in a deal that closed one year ago tomorrow.

With all that going on, one might reasonably wonder how in the world it is possible for anybody, even the heroically numbers-obsessed Mr. Hurd, to beat “The Number” by the requisite penny?

The answer—aside from brutal cost-cutting—is that HP waves “Non-GAAP” earnings of 91 cents a share, up nicely from last year’s 86c a share, in front of Wall Street’s Finest, thus distracting the thundering herd from actual GAAP earnings, which are more of a downer.

Like, 25% more of a downer.

That’s right: HP’s July quarter GAAP earnings were only 67 cents a share—25% below the 91 cent so-called “Number” used by HP management and Wall Street’s Finest—and down, not up, from last year’s 80 cents a share GAAP earnings.

Defenders of “The Number” will note that the 25% difference in HP’s GAAP versus non-GAAP earnings calculation lies mainly in expenses related to EDS. Those expenses include:

1. $379 million worth of amortization relating to purchased intangible assets.
2. $362 million worth of “restructuring charges.”
3. $59 million worth of “acquisition-related charges.”
4. Netted against these are $232 million of book income taxes.

Voila! Thus does $0.67 a share in standard GAAP earnings become $0.91 a share in non-standard, non-GAAP “earnings.”

And a poor-looking GAAP operating margin of 8% becomes a healthier looking, non-GAAP operating margin of 11%.

Now, defenders of the faith, and Wall Street’s Finest, will no doubt defend the non-GAAP number-jiggering by noting that HP’s acquisition of EDS resulted in many “non-recurring” expenses, in addition to the non-cash amortization charges that don’t have a bit of impact on the economics of the underlying business.

And they would be absolutely correct.

But if HP is going to exclude those EDS-related expenses, shouldn't they also exclude EDS-related revenues and profits?

How is it that companies get to include the good stuff, and exclude the bad stuff?

After all, EDS is the whole key to HP’s recent mirage of growth: without EDS, revenues would have been down 20% or so, and the company is not shy about bragging about EDS.

Paragraph four in the press release begins by trumpeting “Record profit in Services”—the EDS portion of the business. A bit later the company begins the individual segment reporting by noting with pride the benefit from EDS:

“Services revenue increased 93% to $8.5 billion due primarily to the EDS acquisition.”

So how is it that HP gets to brag about newly acquired revenues from EDS, yet at the same time delete from “The Number” newly acquired expenses from EDS?

Like “Bill and Dave,” all this reminds us of the Dot-Com boom, only in a bad way. This is, after all, precisely the kind of thing Dot-Com companies used to do.

And it is precisely the kind of nonsense Wall Street’s Finest swore off after all that came to grief—vowing never to be fooled again.

Meet the new boss…same as the old boss!

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business by Mr. Matthews: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Anonymous said...

One also wonders exactly to what extent these expenses are truly non-recurring, especially given the “Non-GAAP Out Clause”. For example, are they allocating a portion of their in-house (read: fixed recurring) legal costs to these charges? Lots of other similar allocations available in a non-GAAP world.

Mark said...

This is a serious question:

Does "big money" (or, for that matter, smaller-but-still "smart" money) even bother to look at earnings rather than free cash flow when analyzing a company these days? I know I only do as part of a preliminary screening process, or perhaps when I'm wearing my "trading" (rather than "investing") hat and think that someone else will buy my position based on that misleadingly enticing number.

jmf said...

Moin from Germany,

looks like HP is modest with their "creative accounting".... :-)

Alternative yardsticks for US earnings tell different stories
By Paul Marson via FT

Today reported earnings per share for the S&P 500 companies gathered by Standard & Poor's is $7.2 per share, down 91 per cent from the 2007 peak.

On an adjusted operating basis, earnings are $61.2, down 34 per cent from the 2007 peak.

This $54 gap is a record.

Anonymous said...

I'm japanese. I read "Pilgrimage to Warren Buffett's Omaha". That was a good book for me to learn more about Warren Bufett. I'm interested in him and his way of investing.
Thank you.

Anonymous said...

I'm japanese. I read "Pilgrimage to Warren Buffett's Omaha". That was a good book for me to learn more about Warren Bufett. I'm interested in him and his way of investing.
Thank you.

Jeff Matthews said...

Dear Japanese Reader: Thank you!

The Japanese edition was beautifully done, but I have not a clue how it reads.

I'm very glad you enjoyed it.


Kevin said...

Does HP provide "organic revenue"? A lot of companies, GE among others, do. It backs out revenue from acquisitions and dispositions made in the past year and also adjusts for currency fluctuations. It's supposed to show whether existing operations are growing - kind of like same store sales. Given HP's size and forex exposure, it would seem relevant. If they don't provide it, I wonder why... especially if their competitors do.

In any event, I thought Reg G was supposed to cure us of all our Non-GAAP ills. Just the same way Sarbanes-Oxley was going to cure us of all the fraud, mismanegement and waste emanating from the C-Suite. Well, good to see that that worked out. Maybe all Washington needs to do is impose a "Risk Czar" that will oversee appropriate levels of risk-taking for corporate America. The RC would have oversight over all systemically important entities - i.e., if their failure would result in a negative impact on the unemployment rate, they qualify for oversight. THAT, comrade, would cure what ails us.

Floyd Perry said...

Dear Jeff,

As a fellow author, you are right on about how hard it is to write a book. Tush in the seat, write, revise, rewrite, and revise again. Then maybe, just maybe, you will connect with readers. Since you mention that you have a Kindle, I presume it is the DX. Which means you paid north of $400. Note in this afternoon's WSJ that Apple will soon come out with their own device. I am guessing it will be sleeker, cheaper, and able to hold more books. Please feel free to download MY new book to your Kindle. It has business relevance as it is the authorized biography of Mark Whitacre, the former ADM executive who was an FBI mole & nailed ADM for price-fixing. MARK WHITACRE AGAINST ALL ODDS did not enjoy an editor or a traditonal publishing house as your fine book did, just 58 rejection letters.

As for ADM, during the decade prior to the price fixing revelations, it generated average annual total returns to investors of something like 21% per annum. It would be interesting to see you run the numbers SINCE the revelations. Whitacre ended up embezzling the modest sum of $9.5 million from ADM and thus did almost ten in "cooking school." That was 5X the sentence of the ones who were price fixing. There is a quote, possibly in Charley Ellis's CLASSICS I, to the effect that "fame on Wall Street is often followed by a prison sentence." Spot on: Whitacre was crazy enough to do a Fortune cover article interview (4 Sept 95 issue)and soon went to prison. He is about to appear on the cover again. Kurt Eichenwald wrote a better book than mine a decade ago entitled The Informant. Eichenwald's book has now been made into a movie of the same name and stars Matt Damon as Whitacre (The trailer is at http://theinformantmovie.com).

Lest you think I am trying to make money by posting an irrelevant comment to your fine blog entry on HP that just promotes my book, not so. I may be free associating to some extent as I write this, but all royalties go to a non-profit for bipolar disorder, which Whitacre may have had or may still have.

I hope there is relevance here. Shake it like a polaroid picture -- ADM, Mark Whitacre, perhaps something on publicly traded prison companies -- and you have lots of grist for the mill, including the fact that Howie, son of el Oracle de Omaha, was a director of ADM, a full-time employee at ADM, and a close friend of Whitacre's during the time the latter went undercover for the Feds. Howie is not quite Forrest Gump, but you can officially classify him as only a fair-weather friend, because he did not write Whitacre the entire time the latter was in prison, and he has not reached out to Whitacre in any way since W. was released from prison in 2006. Nor, as the future Chair of the Board of the house that Daddy built, is he likely to comment on W. or the movie or the book or ADM or anything else that might conflict with Daddy's carefuly orchestrated reputation management.

In deference to Mark Whitacre, I was not critical of either Dwayne Andreas or ADM in the book. I think it would be great if someone as articulate as you would take at least one of them to task, perhaps look at ADM today and see if they are still getting billions in government subsidies, yet ethanol is no cheaper than a gallon of regular gas at the pump. And why hasn't ethanol lived up to its promise? How much does ADM spend now on lobbyists and PACs and politicians, because it was a herculean sum, on both sides of the aisle, back when Dwayne was running the company.

A tip of the hat if you post this comment. -- Floyd Perry

Anonymous said...

Please corporate America wake up to the smoke and mirrors used by Mark Hurd. His strategy is to ride the recession by raping EDS, then moving on to the next company.

Just this week he has also cashed in $4.3 Million of stock at the same time as he is firing people and forcing massive paycuts.

HP is a company of lies.

Anonymous said...

HP has been stumbling downhill since Bill and Dave left the place, 30 years ago.

John Young was a case study in ego-driven management, and Carly Fiorina is a showboating outsourcer who was never qualified to run a real technology company. HP is going to end up in a dumpster, right next to Sun Microsystems.

Funny book-keeping is just the latest symptom.

Gone to the blogs said...

I agree with the point of your post, but I do take issue with one thing you wrote. Specifically:

"...in addition to the non-cash amortization charges that don’t have a bit of impact on the economics of the underlying business.
And they would be absolutely correct."

The non-cash amortization charges reflect the deferred recognition of that which was spent to acquire productive assets. Conceptually, it's no different from a widget company buying a piece of equipment (i.e. a productive asset) but spreading out the cost over time. The fact that the sell side habitually gets led around by the nose and is willing to look past these "non-cash" costs is funny and sad at the same time.

And to answer Mark's question above, I can personally assure you that "big money" pays little attention to the "headline" EPS numbers. A multi-national giant can print any number they (or the barking seals) want using any number of accruals and deferrals. Free cash flow is vastly more important, and any buy sider worth their Bloomberg terminal knows this.

Anonymous said...

I'm old enough to remember when HP was a really great company and a wonderful innovator. My father purchased an HP35 (?) calculator for me when I was a freshman in college - what a fantastic improvement over my (circular) slide rule.

My partners and I now have a reasonably sized regional commercial construction company, doing much technology work. A couple of years ago HP told us that their new "construction purchasing" strategy was to procure construction services using an on-line "reverse auction" strategy.

We declined to participate. And they seemed mystified why that would be so.

Perhaps coincidentally (I think not) the most recent products I have purchased from HP (an inkjet printer and a calculator) have both been defective right out of the box. The printer took many, many hours of dealing with support people (from India, etc, etc) finally resulting in complete replacement. I've stopped using the calculator.

I'll never purchase another HP product again. It's a terrible destruction of a once-wonderful company.

Anonymous said...


This post should apply to EMC as well. EMC excludes option expense, while HP includes it. If you thing these two guys are bad, take a look at QCOM. They exclude an entire operating segment from in their non-GAAP results. How the SEC allows that is beyond me. There are plenty more examples - I wish the SEC would just come down on these companies with a hammer.