GAAP Vs Non-GAAP: Which Is The Better Measure Of Sustainable Earnings?

In any given quarter for almost every company, there is often a swirling vortex of different signals as to the long-term health and future opportunities for each particular firm. Within this conflux of signals, there are two that often cause investor stress and confusion when they contradict each other: the firm’s GAAP versus non-GAAP earnings.

The simple rubric that often comes to mind is that GAAP earnings are the more conservative figure for the firm [as these accounting standards are closely monitored and controlled by a governing board, the Financial Accounting Standards Board (FASB)], while its non-GAAP earnings are the more optimistic view (after being heavily tweaked and adjusted by management). However, this assumption does not always hold true. Often, a firm’s non-GAAP results will be the more accurate representation of its historical earnings power.

Although Gradient Analytics specializes in forensic accounting research and consulting to identify weak earnings quality for short idea generation, our expertise is also valuable for identifying solid earnings quality for the vetting of long candidates, as we discussed in a previous article. And with the impacts of the coronavirus still working their way through both the US and global economies, it is a certainty that the next twelve months of corporate financial reports will be littered with a variety of non-GAAP adjustments that will need to be deciphered.

With this flood of adjusted earnings about to hit the market, we felt it would be a good time for some examples to illustrate that not all non-GAAP adjustments are created equal, and although investors need to carefully consider when and how they use non-GAAP results, often they may be better served by focusing on non-GAAP earnings. 

Example 1:  Apollo Global Management

One example where the GAAP and non-GAAP results told a different story would be in the recent results from Apollo Global Management, Inc. (APO). In Q4 2019, APO reported GAAP earnings of $0.59/share, which was $0.15/share (or 20.3%) below the consensus expectation of $0.74/share. However, non-GAAP earnings of $1.10/share were a surprising 50.7% above the consensus expectation of $0.73/share. So, with each metric showing a different result, which signal should astute investors rely upon? The answer, as with many things in life, is complicated.

If we take a closer look into APO’s Q4 and 2019 results, we find that much of the gap between GAAP and non-GAAP earnings is largely due to two factors:  the firm’s unrealized performance fees as well as its unrealized investment income and gains. To that point, in 2019, APO’s net unrealized performance fees (after also netting out the associated unrealized profit-sharing expenses) amounted to $227.0 million. As APO beat its 2019 consensus earnings expectations by a combined $48.9 million, this was where a material portion of this outperformance came from.

Interestingly, in Q4 2019, management attributed approximately $0.20/share of its quarterly earnings to performance fees associated with transactions that it had previously expected to close in later quarters (i.e., early 2020). These performance fees were driven by a handful of realization events in Q4 for its private equity investments in Verallia, Presidio, and ADT. This $0.20/share boost amounted to a material 54% of the total non-GAAP outperformance ($0.37/share) in Q4 2019. Thus, it appears that much of this non-GAAP strength in Q4 was due to the early recognition of several deals.

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Disclosure: At the time of this writing, the author held no positions in the securities mentioned.

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