Swallow this

Pro-forma results are usually a sugar-coated, but ultimately bitter, pill for investors to swallow

In the late 1990’s I was European Financial Controller for a NASDAQ-listed, Boston-based multinational corporation. I was responsible for financial reporting and analysis of all of the corporation’s businesses outside of the US including Africa and Asia-Pac, which my colleagues in New Jersey called collectively (and slightly dismissively) the “Rest of the World”. I had a counterpart in Boston who collated the results from various offices around the US. We worked closely together, and between us we could see the full picture for the whole corporation.

It was always interesting to compare our “full picture” with what was reported by the corporation to the “Street” ie. Wall Street. The differences were usually central provisions or adjustments made or released by the corporate accounting group, as a response to the mantra from the CFO (like all CFOs at that time) that “We gotta hit the numbers every quarter”. This smoothing of results was the duller side of a broad range of financial adjustments being made by accounting wizards in US corporations, as the pressure of meeting expectations for ever increasing quarterly results become more relentless. The most worrying of these adjustments (especially if you were a shareholder of course) was pro-forma results.

Pro-forma results are, by their nature, not subject to any regulation or accounting standards. In extreme cases during the 1990’s, companies would exclude anything which made the performance look worse; such as interest, tax, depreciation and amortisation creating pro-forma results showing EBITDA. The rationale was that EBITDA reflected the true operating performance without messy non-cash items like depreciation, or annoying costs like interest and tax, overlooking that these all impact net assets and profit before tax which is ultimately the calculation that is used to be able to pay dividends to shareholders.

Earnings Before Bad Stuff

The running joke was that the next step in pro-forma reporting was the acronym EBBS; “Earnings Before Bad Stuff”, but to be honest once a company had reported EBITDA excluding non-recurring items there wasn’t much bad stuff left. Those days of wizardry in financial reporting continued into the dot-com era at the turn of the century but then came to a gradual halt following 9/11, Enron and Worldcom as investors came to expect companies’ CFOs to again display some of the caution and prudence CFOs once used to be known for.

Now, just when we thought we might have learnt the lessons of that period, pro-forma results are making a come back. Last time around the economic climate was favourable and their use was driven by pressure from the “Street”. Ironically, their return now coincides with a harsher economic environment which may be driving companies to use pro-forma results to deny the impact of the recession or mask sloppy decision making by management teams during the good times of the last few years.
  
Pro Forma Examples

In recent weeks a number of companies have released announcements showing pro-forma results, some of them usefully such as Digital Marketing Group plc, which used them to show the impact of acquiring its Cyber and Gasbox divisions during the year.

However, you don’t need to look too hard to find companies producing results announcements following the EBBS approach. A recent example is the results of the insurance broker, CBG Group plc, which in its’ interim results refers to Adjusted EBITD, their definition of which is about as broad as in the dot com era;

 “Earnings before interest, tax, depreciation, amortisation, exceptional operating expenses, negative goodwill credited and share option charges”.

 This Adjusted EBITD which I expect is intended to show the company in a good light is down 42% compared to the same period last year. Bad? Not when you compare the actual Profit before tax, which is down 82% year on year!

Amusingly, though not if you’re a shareholder, the company has recorded exceptional operating expenses in the last two periods as well as in the current period. You have to wonder when exceptional expenses become so frequent that they’re not really exceptional any longer.

So, do pro forma results fool anyone or do most people see through the blatant attempts at manipulating the numbers?

Well in the case of CBG, no one seems to have told the Chairman about the pro-forma style results, and so in his statement he is claiming these to be “another strong set of interim results” despite the fact that EPS is down to 0.77p from 4.75p last year. He may well not be aware of that figure though because in the highlights section of the announcement (which is the only part some people will read) the company refers only to the “Adjusted diluted earnings per share”, no doubt because this is down only 53% from 6.26p to 2.93p.

Bitter Pill

Clearly some people can be fooled, and some shareholders will swallow the line from management teams that the pro forma results better reflect the performance of the company. That may be true in some cases but for the large part shareholders should not swallow the story of the need for sugar coated pro forma results; in most cases it will be a bitter pill which at some point will leave a nasty taste in the mouth of the investor.

As we head into the reporting season for June period end results, don’t be surprised to see the words “pro forma” crop up in your investee companies’ results announcements. Just be sure that you spend the time to look in detail at the actual results and ask the management team questions about the company’s real performance not the performance less the bad stuff!

Ash Mehta
ash@orchardgrowth.com