Saturday, August 07, 2010

The Hurd Instinct: One Fiction Leads to Another

“HP had momentum…”

—Talking Head, CNBC, August 5, 2010

So it was that one of the many talking heads competing for air time with the hosts of CNBC last night summed up his thoughts—so-called—as to why the removal of Hewlett Packard CEO and Wall Street Fave Mark Hurd came as such a shock to so many people both on Wall Street and off it.

Momentum,” of course, is one of the most overused expressions on Wall Street, along with “Our thesis is still intact,” generally employed by Wall Street’s Finest when a company begins losing “momentum,” and “We’re throwing in the towel,” which is generally employed when a company has so completely lost momentum that it can no longer be defended with a straight face, even by one of Wall Street’s Finest.

“Momentum” is, after all, at once descriptive (a company that manages to “beat and raise” its earnings every quarter is said to have it), and meaningless: after all, companies always seem to have momentum...until they somehow don’t.

So to describe HP as a company with “momentum” struck us as the most singularly vacuous comment in a string of vacuous comments from the HP-defending cognoscenti called together to discuss the “shock” at Hurd’s ouster, which seemed to be everywhere.

We here at NotMakingThisUp, however, admit to no such shock.

Longtime readers know that we never subscribed to the Myth of Mark Hurd, and said as much in these virtual pages nearly one full year ago, in “Including the Good Stuff while Excluding the Bad Stuff: Come to Think of It, We Will Get Fooled Again!” from August 25, 2009.

The gist of our argument, (see, was simple: by reporting so-called "non-GAAP" earnings, HP was able to include good stuff from the EDS deal (EDS-related earnings), and exclude the bad stuff (EDS-related costs).

That kind of "non-GAAP" earnings management was a practice we thought had ended with the fall of Enron, WorldCom, and the many other Dot-com-era practioners of earnings fakery whose eventual falls from grace yielded losses for investors, howls of indignation from the halls of Congress, and calls for the elimination of "non-GAAP" earnings from the vocabulary of Wall Street's Finest.

Yet HP was able to revive the practice, and make something of an art of it, with the complicity of Wall Street, its analyst community, and even the press: our Bloomberg, for example, reports only the non-GAAP earnings in its HP earnings page, without so much as an asterisk.

What prompted us last August to look at how HP had become a “beat the number” machine under Hurd?

It was a quarterly earnings report in which the company had managed to earn exactly one penny per share more than Wall Street’s Finest were expecting, despite an aging business profile and an exceedingly complex operating entity:

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.

—JeffMatthewsIsNotMakingThisUp, August 25, 2009

Yes, you are reading that correctly: merely by the use of “non-GAAP” earnings, Hurd’s HP turned a 16% GAAP earnings decrease into to a 6% non-GAAP earnings increase.

And Wall Street’s Finest ate it up.

Call it the Hurd Instinct for playing to the madness of crowds: Mark Hurd did possess a genius for it. And that genius pervades HP today, for the same Hurdesque numbers manipulation continued right up to yesterday’s press release announcing Hurd’s resignation, in which the company announced that HP managed to, somehow, “beat and raise” once again:

HP announces preliminary third quarter results; raises full-year outlook for revenue and non-GAAP EPS

HP is announcing preliminary results for the third fiscal quarter 2010, with revenue of approximately $30.7 billion up 11% compared with the prior-year period.

In the third quarter, preliminary GAAP diluted earnings per share (EPS) were approximately $0.75 and non-GAAP diluted EPS were approximately $1.08. GAAP and non-GAAP EPS were negatively impacted by $0.02 pertaining to one-time charges relating to the previously announced U.S. Department of Justice settlement. Non-GAAP diluted EPS estimates exclude after-tax costs of approximately $0.33 per share, related primarily to restructuring, amortization of purchased intangible assets and acquisition-related charges.

—Hewlett Packard Press Release, August 5, 2010

Like my dog Charles, who gets easily distracted by shiny metal objects, fleeing squirrels, lumbering raccoons or anything else that happens to cross his line of vision, Wall Street’s Finest remain easily distracted by the inflated earnings figures at HP that became a fixture under Mark Hurd.

In fact, just to make certain Wall Street’s Finest continue to be easily distracted by earnings that are not prepared according to Generally Accepted Accounting Principles, HP’s Interim CEO, Cathie Lesjack, again waved the magic non-GAAP number across the Finest’s line of vision during last night’s hastily assembled conference call to explain the Hurd outster.

Said Ms. Lesjack, when asked whether the $1.08 per share so-called non-GAAP earnings was net of the 2 cent per share charge related to the Department of Justice settlement:

“That is correct. So, apples to apples, when you look at the consensus that was set, we delivered $1.10.”

Thus the fiction of HP’s reported earnings continues, even beyond Mark Hurd.

All that said, one might very well ask—as did several of the talking heads thrashing the issue to death last night—why the mighty Mark Hurd, who built HP into a “make the numbers” machine much to the satisfaction of the lazy spreadsheet-builders on Wall Street (and the even more immense satisfaction of HP shareholders thanks to the roughly $50 billion added to the market value of HP during his tenure), was expelled from a company for some measly expense-account misstatements?

We here at NotMakingThisUp don’t know the full story, although we do know a few things about Mark Hurd that have never made it into the so-called research reports of Wall Street’s Finest (never trust a CEO who colors his hair, for starters).

But as we see it, a guy who can fool all of Wall Street’s Finest all of the time—by among other things, turning 75 cents worth of earnings into $1.08 worth of earnings through the magic of numbers prepared using accounting principles not generally accepted by accountants—could certainly convince himself that a great deal else can be accomplished through the magic of other principles not generally accepted elsewhere in life.

In other words, one fiction may reasonably lead to others.

Whatever the true story behind the story, however, one thing we know remains true: the more things change on Wall Street, the more they stay the same.

Jeff Matthews
I Am Not Making This Up

© 2010 NotMakingThisUp, LLC

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: 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: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.


Anonymous said...

Professor Jeff:

Thanks for this post. Your post is an instructive one for readers and investors on the concept of earnings quality. When I screen for possible stocks I hope to invest in, one of the factors I use is determining whether the company conservatively uses GAAP accounting in calculating quarterly and/or annual earnings.

If I see that a company is using non-GAAP earnings to meet and/or beat analyst estimates, then I, as an investor, head for the exits. Non-GAAP earnings are not the same quality as GAAP earnings are. Sadly, there are more than a few publicly traded companies using non-GAAP earnings to manipulate earnings and "goose" the share price by beating analyst earnings estimates.

Hopefully, one day, both individual and institutional investors will "boycott" those companies practicing earnings manipulation using non-GAAP figures and invest more of their capital in the conservatively-run companies who don't use non-GAAP to "make the numbers".

Again, greatly appreciate your post Jeff, and I hope you'll continue this "lesson" to help readers and investors determine how to spot companies practicing poor "earnings quality" such as HP.

Full Disclosure: no investment position (long/short) in HP.

Anonymous said...

Thanks Jeff, great reporting throughout.

As an aside, I don't really buy into the "colors his hair" or "pinky ring" school of thought. In my experience it means little in isolation, you don't know who or what compelled him to do that one thing. A whole lot of those things in combination is a different story of course.

PS - this is anonymous because Google Account is acting up again. This happens a lot by the way and I am no stranger to computers.

Joe said...

"HP announces preliminary third quarter results; raises full-year outlook for revenue and non-GAAP EPS"

This reminds me of a true story from my youth: With a November birthday, I was always young for my grade. As the time came for us to start exploring bars and clubs, fake IDs proliferated. One night, not having a phony driver's license on me, I decided to simply brazen it through by showing the doorman my real id. He glanced it, and waved me in. It was never clear to me whether he couldn't do the math in his head or he figured that no one would show him an obviously real driver's license unless it showed the driver to be of appropriate age. Either way, I got what I wanted.

Fast forward to HP and, as with me showing my real driver's license even though I was underage, it's the sheer effrontery of the act which disarms the bouncer / analysts. "Sure these are non-GAAP financials. We said so right in the press release. Whatcha gonna do about it?"

Brilliant, and brilliantly illuminating.

But What do I Know? said...

That whole story of Hurd being kicked out for expense account juggling seemed a little too unbelievable to me--thanks for making sense out of it. For most of the number-creators, there comes a time when you just can't hide it any more, and the time to leave is a few quarters before it happens (I'm talking about you, C. Michael Armstrong). I'll bet you dollars to doughnuts there'll be a big writedown (non-cash, WSF will say) when the new CEO takes over and can have a free ride for a quarter or two. . .

BobE said...

One of the primary duties of a board of directors is to have a management succession plan. At the very least, discuss scenarios and know who your go-to person is if the CEO drives his/her car into a tree and is pronounced DOA. It appears the H-P failed to do much, if anything, about this.

Anonymous said...

You're giving Mark Hurd too much credit. He didn't invent the latest cycle of non-GAAP sucker bait for ignorant and lazy Wall Street analysts, and he wasn't even the cleverest practitioner. All of the tech companies are doing it. The market is awash in tech stocks trading at multiples of 100+ times GAAP earnings that aren't growing at all, or are shrinking -- but only 70 times non-GAAP earnings that are strenuously manipulated every quarter to maintain the illusion of growth. All you need to find is a tech company (especially if you call it a "cloud computing" company), with flat revenues, flat GAAP earnings - but if you keep expanding the categories of costs that you exclude each quarter, non-GAAP earnings are growing. The analysts will put a strong buy on that company every time, at least until the next crash comes.

Anonymous said...

Most of the non-GAAP earnings adjustments related to non-cash amortization charges. Yes, they do add back restructuring charges and acquisitions charges, but one can easily adjust for those. I do not think HP is being misleading and I don't think the Street is being misled. The Street is valuing this at 8.5x 2011 EPS, a huge discount to the S&P's multiple.