Seeing GAAP earnings move in the opposite direction of Core Earnings raises red flags about the quality of reported earnings while also raising the risk of earnings misses in subsequent quarters. In other words, 3Q23 and 4Q23 earnings seasons could be ugly. These results also underscore the more stable nature of Core Earnings. Because I remove unusual gains and losses, Core Earnings are not prone to the large swings seen in GAAP Earnings.
This report is an abridged version of S&P 500 & Sectors: GAAP Earnings’ Misleading Rise Continued In 2Q23, one of the quarterly series of reports on fundamental market and sector trends. Based on the latest audited financial data, which is the calendar 2Q23 10-Q in most cases. Price data as of 8/15/23.
GAAP Earnings Rise Is Again Misleading in 2Q23
My firm’s superior fundamental data protects investors from being misled by false trends in un-scrubbed GAAP Earnings. The recent rise in GAAP Earnings, which I first highlighted in 1Q23, explains part of Wall Street’s recent bullishness and my bearishness on certain stocks. Looking beyond the headlines reveals that the recent rise in GAAP Earnings may be an illusion for three reasons:
- Understated GAAP earnings in prior quarters set up easy comps. The kitchen sink effect in in full effect.
- Unusual gains are artificially elevating GAAP Earnings and cannot persist forever.
- Core Earnings heading lower suggests GAAP Earnings will normalize and do the same soon.
If the rise in GAAP Earnings proves to be an illusion, investors could be in for a rude awakening in the second half of 2023, especially if they’ve been investing in expensive stocks.
Generally Accepted Accounting Distortions
GAAP Earnings for the S&P 500 meaningfully differ from Core Earnings for the fifth consecutive quarter. Corporate profits, as measured by Core Earnings, have been much less volatile than GAAP earnings suggest, especially since 1Q20. For example, per Figure 2, in the TTM ended:
- 1Q21, GAAP earnings trend differs from Core Earnings by 20%.
- 2Q22, GAAP earnings trend differs from Core Earnings by 7%.
- 3Q22, GAAP earnings trend differs from Core Earnings by 4%.
- 4Q22, GAAP earnings trend differs from Core Earnings by 7%.
- 1Q23, GAAP earnings trend differs from Core Earnings by 2%.
- 2Q23, GAAP earnings trend differs from Core Earnings by 7%.
Figure 1: S&P 500 Core Earnings Vs. GAAP Earnings QoQ Percent Change: 1Q20 – 2Q23
Core Earnings analysis is based on aggregated TTM data for the sector constituents in each measurement period.
The August 15, 2023 measurement period incorporates the financial data from calendar 2Q23 10-Qs, as this is the earliest date for which all the calendar 2Q23 10-Qs for the S&P 500 constituents were available.
GAAP Earnings Understate Core Earnings for Nearly Two-Thirds the S&P 500 (by Market Cap)
64% of the companies in the S&P 500 reported GAAP Earnings that are lower than Core Earnings for the TTM ended 2Q23. Overstated companies include all companies with Earnings Distortion >0.1% of GAAP earnings.
When GAAP Earnings understate Core Earnings, they do so by an average of 57%, per Figure 2. GAAP Earnings understated Core Earnings for 320 companies in 2Q23, compared to 335 in the TTM ended 1Q23.
Figure 2: S&P 500 GAAP Earnings Understated by 57% On Average
I use Funds from Operations (FFO) for Real Estate companies rather than GAAP Earnings.
The 320 companies with understated GAAP Earnings make up 58% of the market cap of the S&P 500 as of August 15, 2023. Companies with understated GAAP earnings made up 64% of the S&P 500 market cap in 1Q23 and 48% of the S&P 500 market cap in 2Q22.
Figure 3: Understated Earnings as % of Market Cap: 2012 through 8/15/23
Key Details on Select S&P 500 Sectors
Six of eleven sectors saw a QoQ rise in Core Earnings through the TTM ended 2Q23, which was up from just four sectors in 1Q23.
The Consumer Cyclicals sector saw the largest QoQ improvement in Core Earnings, which rose from $163.9 billion in 1Q23 to $170.1 billion in 2Q23, or 4%.
At $447.5 billion, the Technology sector generates the most Core Earnings and saw Core Earnings rise 2% QoQ in 2Q23. On the flip side, the Real Estate sector has the lowest Core Earnings at $23.5 billion. The Energy sector had the largest QoQ decline in 2Q23 at -16%.
Below I highlight the Consumer Cyclicals sector and a stock with some of the most negative Earnings Distortion (i.e. understated GAAP earnings) in the sector.
Sample Sector Analysis: Consumer Cyclicals Sector
Figure 4 shows Core Earnings for the Consumer Cyclicals sector, at $170.1 billion, rose 4% QoQ in 2Q23, while GAAP earnings, at $141.8 billion, rose 12% over the same time.
Figure 4: Consumer Cyclicals Core Earnings Vs. GAAP: 2004 – 2Q23
Core Earnings analysis is based on aggregated TTM data for the sector constituents in each measurement period.
The August 15, 2023 measurement period incorporates the financial data from calendar 2Q23 10-Qs, as this is the earliest date for which all the calendar 2Q23 10-Qs for the S&P 500 constituents were available.
GAAP Earnings Understatement Details: General Motors
GM
GM
Below, I detail the hidden and reported unusual items overlooked in GAAP Earnings and captured in Core Earnings for General Motors (GM). After adjusting for unusual items, I find that General Motors’ Core Earnings of $12.0 billion, or $8.43/share are much higher than reported GAAP Earnings of $10.2 billion, or $7.17/share.
General Motor’s Stock Rating is very attractive, in part due to its positive economic earnings, high free cash flow yield, and low price-to-economic book value (PEBV) ratio of 0.3. I made General Motors a Long Idea in March 2018. and while the stock has underperformed, it remains highly undervalued.
Below, I detail the differences between Core Earnings and GAAP Earnings so readers can audit my research.
Figure 5: General Motors’ GAAP Earnings to Core Earnings Reconciliation: TTM through 2Q23
More details:
Total Earnings Distortion of -$1.26/share, which equals -$1.8 billion, is comprised of the following:
Hidden Unusual Expenses Pre-Tax, Net = -$1.36/per share, which equals -$1.9 billion and is comprised of:
-$1.5 billion in hidden restructuring expenses in the TTM period based on
- -$246 million in Buick dealer strategy charges on page 29 in 2Q23 10-Q
- -$875 million in voluntary separation program charges on page 26 in 1Q23 10-Q
- -$99 million in Buick dealer strategy charges on page 26 in 1Q23 10-Q
- -$256 million in restructuring and other initiatives in the TTM based on $511 million charge on page 90 in the 2022 10-K
- -$1 million impairment charges in 4Q22 based on -$12 million impairment charge on page 72 in 2022 10-K
-$529 million in cruise compensation modifications based on -$1.1 billion charge on page 27 in the 2022 10-K
$76 million benefit from GM Korea wage litigation no page 29 in the 2Q23 10-Q
Reported Unusual Expenses Pre-Tax, Net = -$0.06/per share, which equals $79 million and is comprised of:
-$542 million in other expenses in the 2022 10-K
$1.5 billion in interest and other non-operating income in the TTM period based on
$238 million in licensing agreements income in 2022 10-K
-$236 million in revaluation of investments in 2022 10-K
$1.0 billion contra adjustment for recurring pension costs. These recurring expenses are reported in non-recurring line items, so I add them back and exclude them from Earnings Distortion.
Tax Distortion = $0.16/per share, which equals $225 million.
Disclosure: David Trainer, Kyle Guske II, Italo Mendonça, and Hakan Salt receive no compensation to write about any specific stock, style, or theme.
Appendix: Calculation Methodology
I derive the Core Earnings and GAAP Earnings metrics above by summing the Trailing Twelve Month individual S&P 500 constituent values for Core Earnings and GAAP Earnings in each sector for each measurement period. I call this approach the “Aggregate” methodology.
The Aggregate methodology provides a straightforward look at the entire sector, regardless of market cap or index weighting and matches how S&P Global (SPGI) calculates metrics for the S&P 500.
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