Image Source: SEC
By Brian Nelson, CFA
Too many investors have been hurt.
Management teams want to present their results the best way they can within the boundaries of the law, to bolster their holdings. Some analysts want to “pitch” their stocks in the most optimistic light possible, to preserve their jobs. The consumers of such research want the future to always be bright, so they want to believe the “good news.” The result: there are now very few places to find objective, unbiased research and analysis. It therefore has become more important for companies to provide the most accurate and helpful information possible, and non-GAAP earnings presentation isn’t it — in fact, it has gotten way out of whack. The SEC noted March 16 that it is looking at “rein(ing)” in some of the liberties management teams enjoy by presenting adjusted earnings. We like the news and have been calling for a reevaluation of what types of metrics management should be able to pass off to investors for some time.
In particular, we had warned investors in master limited partnerships that the non-GAAP metric “distributable cash flow” was nothing but nonsense within the valuation context, and the informative value of such a metric that ignores tangible expenses and all of the growth capital spending used to drive net income, which itself is a component of distributable cash flow, was a severe imbalance that was sure to get investors in deep trouble. The dividend cut at Kinder Morgan (KMI), now a corporate, was one such example, but the fallout in equities in the midstream energy MLP space has been nothing short of disastrous. Even today, investors are beholden to the non-GAAP metric distributable cash flow, as if it somehow is more informative than the actual GAAP financials. It’s not. It’s “made up.”
Management teams are also having a field day enjoying the standard adjustments by the rating agencies when assessing leverage, sharing them. Things have gotten so out of whack that in some cases, in Energy Transfer Equity (ETE) more specifically, investors believe what management and the credit rating agencies tell them, instead of actually looking at the financial statements. For example, in this case, a close look at the actual reported financials revealed an MLP that is more than 7x leveraged on a net debt to EBITDA basis, far more than the 4.5x presented in any communications. We’re not picking on Energy Transfer Equity, which recently lost its CFO and had to issue convertible shares to help pay for the Williams (WMB) deal, as such mismatches are rather widespread. Energy Transfer Equity’s recent convertible offering was effectively a dividend cut, and participants have had to sacrifice a portion of their income streams.
For sophisticated investors that can cut through the “fluff” in investor presentations, non-GAAP distributable cash flow and leverage metrics that make little sense when compared to GAAP results may not be a big deal, but there are thousands of individuals and advisors that depend on getting the best information, the correct information. We’re doing our best to give that to them, but while we warned readers far in advance of the goings-on in the energy master limited partnership space, the reality is that with better disclosures by management, investors that “fell” for the non-GAAP information or are still holding on wouldn’t have gotten involved in the first place.
We hope the SEC really cracks down on such adjusted earnings metrics and the sooner the better.
A version of this article appeared on our website March 2016.