Don’t rely on APMs, disaggregate IFRS – GlaxoSmithKline

Alternative performance measures (APMs) can be helpful for investors, but not necessarily the figure itself. It is the disaggregation of performance that is the real benefit. Focusing solely on adjusted measures means you will miss important aspects of profitability.

We explain how you can use APMs to better understand performance, but without missing key elements. In our view this approach would provide a better basis for investor forecasts, as we demonstrate by disaggregating the IFRS earnings of GlaxoSmithKline.

There is frequent criticism of the common practice of companies reporting adjusted performance measures (APMs) – also referred to as non-IFRS or non-GAAP. Adjusted net income, underlying operating profit and other similar adjusted metrics show profit excluding some gains and losses or with the measurement of certain items modified. APMs are included in almost all management commentary and presentations to analysts. In many cases they are also included in the financial statements.

Some criticise the presentation of the adjusted measures themselves, arguing they simply represent misleading management spin. Others suggest that the adjustments are not the problem but rather the underlying IFRS accounting. In this view, management are trying to circumvent IFRS to provide investors with supposedly more useful measures. While there is an element of truth in both of these, we think these criticisms are overly simplistic.

Management spin

APMs are often criticised for being selective, with important items (most commonly losses) being omitted because they are not part of ‘core’ or ‘underlying’ profits are ‘non-cash’ or they are supposedly ‘non-recurring’. The suspicion is that some companies deliberately skew the metrics to create a more favourable impression.

Some companies, undoubtedly, try to spin and obfuscate by using adjusted measures. As a result, it is important for investors not to rely solely on such metrics when assessing and forecasting performance and to be particularly careful when APMs incorporate measurement methods that are inconsistent with IFRS..

However, we believe only a minority of companies abuse APMs. Most companies seek to be helpful to investors and use APMs to help achieve this. APM reporting can undoubtedly be improved (we have suggestions below), but the information and, critically, the disaggregation that this practice provides is generally in the interests of investors. The fact that some companies are opportunistic in their use of APMs is a reason to enforce better disclosure and to more tightly regulate rather than to eliminate APMs entirely.

That APMs are often higher than IFRS metrics does not necessarily indicate bias or management spin

As adjustments to reverse losses invariably dominate, some commentators claim that the higher adjusted performance metrics compared with the equivalent IFRS figures flatter performance. We would argue that more adjustments for losses are to be expected when financial reporting is largely based on historical cost and not current values. In historical cost accounting so-called ‘non-recurring’ losses will inevitably outnumber non-recurring gains.

In our view, the problem with APMs arises when companies present the metric as though it should be used instead of the reported IFRS result. Most companies might not do this explicitly, but the presentation of APMs can give this impression. Adding to the confusion is that companies often adjust IFRS measures by removing selected items to arrive at the ‘better’ non-IFRS APM measure. The implicit suggestion is that the omitted items are less relevant to the investor in assessing and forecasting performance. The use of descriptions such as ‘non-core’ or ‘underlying’ illustrates this. In our view, a simple way to avoid this is to modify the current ‘reconciliation’ disclosure – we discuss this below.

Claims that IFRS is flawed

Some companies claim that their use of APMs is motivated by perceived inadequacies in accounting standards. Most of these criticisms do not stand up to scrutiny and the accounting often simply reflects an inconvenient truth. IFRS standards can certainly be improved and some items that appear in financial statements can sometimes be difficult to reconcile with the underlying economics, but we do not believe this suggests there is a fundamental problem with IFRS.

Most adjustments included in APMs do not arise because companies think the underlying accounting is in need of change. For example, a common adjustment is to exclude asset impairment expenses. This is not done because management are asserting IFRS is wrong to require impairments to be reported in profit and loss when the balance sheet value of an asset can no longer be recovered. Rather, it is to differentiate between different types of expense that have different persistency and predictive value.

Reporting a profit measure before impairments and the impairment expense separately (rather than aggregating this expense with other expenditure that may have different characteristics) is very helpful for investors. The profit before impairment is clearly incomplete and few investors would be foolish enough to only consider this figure. Nevertheless, in terms of assessing management performance and forecasting future earnings and cash flow, separate presentation of impairments provides investors with better information.

It is also common to see APM adjustments after business combinations and the accompanying use of fair values for purchase price allocation. For example, at the point of acquisition the work in progress and finished goods inventory of the acquired company is reported at fair value in the group accounts, rather than at the book value reported in the subsidiary’s financial statements. The consequence of this is that the consolidated results show a lower profit, and hence lower margin, than the individual financial statements of the subsidiary itself. However, the consolidated results merely reflect the reality that the entity has a different product mix in the period, with revenue related to both items that have been purchased and others that have been manufactured.

In this situation IFRS earnings reflect the underlying economics, but it is also helpful if the entity disaggregates the loss (reduced profit) arising from the temporary change in product mix.

Using Alternative Performance Measures in equity analysis

Even though APMs are invariably incomplete, they can be helpful in their own right as they may provide more useful trend information. But this depends on the calculation being reasonable and consistently applied. Part of the problem with APMs is that they are generally presented outside the audited financial statements, with resulting greater uncertainly for investors regarding consistency and comparability.

However, the most significant benefit of APMs for investors is not the metrics themselves but the additional disaggregated information that is disclosed as a result. It is this disaggregation that adds most to your analysis.

Alternative performance measures can be particularly helpful where they provide additional disaggregation and analysis

The key to understanding the performance of a business is to have a clear view of the different drivers of profitability. This means thinking about growth, margins and returns, both for the business as a whole and for the different business segments. It is also important to understand the impact of external and internal forces on the different components of performance.  In addition, understanding attributes such as persistency and predictability of different gains and losses adds value to your analysis.

The problem with existing APM disclosures is that these generally take the form of a reconciliation from the IFRS metric to the APM. This can reinforce the view that the APM is superior and should be used by investors instead of the more comprehensive IFRS measure. What we would like to see instead is a clearer focus on a disaggregation of IFRS metrics into different components, based on their differing characteristics, that add up to the IFRS amount. The difference in approach may seem trivial – merely reversing the order and turning a ‘reconciliation’ into a ‘disaggregation’ – but we think it would promote a different and more informed debate.

Pharmaceutical company GSK provides an adjusted version of each subtotal in its income statement and extensive disclosures that explain the nature of those adjusted metrics and the adjustments made. This includes a reconciliation table, which we show below. The disclosures are clear, comprehensive and good, but in our view the wrong way round. We also think the disaggregation could be more comprehensive.

GSK ‘adjusted’ earnings reconciliation
Source: GSK 2018 annual report

We wholeheartedly agree with GSK’s explanation of the nature of the adjusted metrics …. “Non-IFRS measures may be considered in addition to, but not as a substitute for, or superior to, information presented in accordance with IFRS”. However, there seems to be a suggestion by the company that investors should focus more on the non-IFRS amounts …. “GSK believes that adjusted results are more representative of the performance of the Group’s operations and allow the key trends and factors driving that performance to be more easily and clearly identified by shareholders.”

We agree that non-IFRS measures can help investors identify “trends and factors driving performance”. However, we do not agree that non-IFRS measures are necessarily ‘more representative’ of performance, as they are inevitably incomplete. Our view is that non-IFRS measures can portray a particular component of performance very well, but that other components can be just as relevant to investors.

Turning the reconciliation of IFRS to APM into a disaggregation of IFRS, where the APM and other components sum to the IFRS total, is a simple change, but we think one that would enhance investor understanding. It presents the APM as a component of a more comprehensive performance metric. It also presents expenses as negatives and not the confusing positive values shown above.

Disaggregate and then disaggregate more

If the focus of the APM analysis by GSK was on disaggregating items with different characteristics, including persistency and predictability, then more disaggregation should perhaps be provided, particularly in respect of the “transaction related” items shown in the table. This relates to the remeasurement of the liability for deferred consideration for previous acquisitions, as well as the obligation they have to purchase the holdings of minority shareholders in subsidiaries (NCI puts).

Consider further analysis and disaggregation to identify what items are persistent and hence relevant in forecasting

It would be more insightful if this overall change were split into an interest accretion amount (the unwinding of the present value calculation) and a residual change in the liability due to other factors, principally changes in value of the subsidiaries. The reason is simple, the former has persistency and, in a forecast, would not be zero, whereas the latter is much more volatile, does not have persistency and in any forecast is likely to be zero.

Here is our alternative disaggregation-based view of GSK earnings for the last 5 years. It includes separate presentation of legal expenses and our additional (estimated) analysis of the transaction related items.

An alternative disaggregation of GSK IFRS earnings

Source: GSK financial statements and The Footnotes Analyst estimates

(1) The company does not provide an analysis of the post-tax and post-NCI deferred consideration and NCI put remeasurement. Our estimate is based on the balance sheet liability and the disclosed discount rate. However, for 2016 and 2017 additional disclosure of the pre-tax accretion amount was provided, which we use for the estimates in those periods.

(2) Legal expenses are aggregated with other items in the GSK reconciliation, although separately disclosed in supporting notes. We think this item needs to be separately presented in the disaggregation itself, given important differences in persistency. The definition of the legal expenses excluded from adjusted earnings was changed in 2016.

Clearly the majority of the adjusting items presented in this table are volatile and hence result in a very volatile IFRS earnings figure. It is difficult to get a sense of overall performance from this aggregated amount. Understandably management chooses to focus on the adjusted amount when communicating with investors, particularly when discussing trends. But what is also clear is that items such as restructuring, legal expenses and impairments are significant expenses that are almost certain to continue. The fact that these future expenses are likely to be volatile and difficult to forecast is not a reason to ignore them.

Key insights for investors

  • Analyse management APMs as a component of a more comprehensive disaggregation-focused analysis of the full IFRS based performance.
  • Pay attention to excluded volatile or so-called non-recurring items; they can still have significant valuation implications and it may not be appropriate to use zero in your forecasts.
  • Do further disaggregation and analysis if necessary, particularly where components of a gain or loss reported as a single item have differences in persistence.

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