by Wolf Richter, Wolf Street:
A scheme we call “consensual hallucination.”
Yesterday, we were bashing big pharmaceutical companies for jacking up prices of patent-protected drugs at obscene rates. Those double-digit price increases were largely responsible for the sales increases these companies reported. Drugs have become the largest wholesale category, at $54.3 billion in May, or 12.2% of total wholesales.
This boom is based on price increases at a great cost to US consumers and taxpayers. It’s cannibalizing the rest of the economy. But it’s made possible by the abuse of the patent system, the increasingly monopolistic structures in the industry after a tsunami of mergers funded by cheap credit and a soaring stock market – as planned by the Fed – along with legislators and regulators that have been compromised by the big money and the revolving door [read… This is What’s Cannibalizing the US Economy].
In its report released on Friday, FactSet projects that the health-care sector in the S&P 500 will show revenue growth of 7.8% in the second quarter. But even “adjusted” ex-bad-items earnings – a classic in American fiction – is expected to grow by only 2.2% (even as revenues and “adjusted” earnings for the S&P 500 overall are expected to fall once again).
But it’s even worse. As reported under Generally Accepted Accounting Principles (GAAP), which all publicly traded companies in the US have to use for their required financial reports, these Q2 earnings in the health-care sector are likely to drop.
For health-care, Q1 was better: revenues soared 9.2% and “adjusted” earnings 7.1% (even as S&P 500 revenues fell 1.5% and “adjusted” earnings dropped 6.7%).
So how much of this “adjusted” gloss is coming off under GAAP? The purpose of GAAP is to give investors some kind of semi-reliable idea about what’s going on in the company – to limit the games companies can play with their financial reports.
Companies can report other metrics, including “adjusted” earnings, to supplement GAAP numbers. But after years of benignly closing its eyes, the SEC is getting antsy about the practice of putting non-GAAP numbers in a dominant position during reporting season. Wall Street and its data gatherers, like FactSet, often don’t even include GAAP earnings in their tallies.
Credit Suisse, cited by the Wall Street Journal, just shed some light on how aggressive Big Pharma has become in massaging its financial data: in Q1, Big Pharma inflated its GAAP earnings by 38% to arrive at “adjusted” earnings.
And the practice is growing: in Q1 2014, “adjusted” earnings inflation was 22%.
It’s even worse: the difference is normally smaller in the first quarter than in other quarters. In total, for the last 13 quarters, Big Pharma inflated its earnings in this manner by 40%!
Big Pharma earned $139 billion under GAAP over those 13 quarters, but then inflated those earnings by another $55 billion to an investor-pleasing “adjusted” $194 billion.
Biggest culprit? Excluding amortization expenses from “adjusted” earnings. It accounted for two-thirds of the difference.
Amortization is like depreciation, but it’s used for “intangible” assets. For example, Merck & Co spent a chunk of money (in cash and stock) to acquire another company, paying more than the company is worth, which is standard procedure in M&A. The overpaid portion – paid for with cash or stock – isn’t expensed on the income statement right away. Instead, it’s temporarily parked on the balance sheet as an “intangible” asset, often called “goodwill,” and expensed over time.
Payment for that asset was very tangible (cash and stock). But once that expense is parked on the balance sheet, it becomes an intangible asset (the overpayment). When this goodwill is expensed (amortized), Merck and its analysts call it a “non-cash charge.” And this is the inherent deception: Since it’s now called a “non-cash charge,” it is expunged from “adjusted” earnings.
In Q1, for example, Merck reported earnings under GAAP of $0.40 a share, but then inflated this by 122% (!) by removing the bad items, such as amortization, to arrive at its “adjusted” ex-bad-items masterpiece of earnings fakery of $0.89 a share!
Big Pharma, in order to coagulate into ever bigger monopolies and to dodge US corporate income taxes (via “inversions”), has been on a merger binge, thus overpaying, and loading up on goodwill to be expensed later. So over the past 13 quarters, according to Credit Suisse, the exclusion of amortization expenses inflated “adjusted” earnings by $36.9 billion!
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