Smoke and mirror acronyms
Understanding a set of financial results is difficult even before management teams get the crayons out to add some creativity to the reported metrics. Faced with a raft of different earnings metrics, you need your wits about you.
Let’s start with what HEPS means. The acronym stands for headline earnings per share, a South African concept designed to stop companies from reporting utter nonsense in the same way that the Americans love doing. “Adjusted earnings before interest, taxes, depreciation and amortisation” (ebitda) is abused to incredible levels on the US market, allowing executives to pretend that all the minor inconveniences (an unsustainable cost base, for instance) don’t exist.
One of the favourite tricks among US managers is to split out stock-based compensation. This is complete rubbish, as staff members consider the share options or allocations to be part of their remuneration. If those stock options weren’t there, the cash remuneration would need to be increased or the total cost to company wouldn’t be compelling any more. Armed with that knowledge, how can it be correct for executives to reverse this out of ebitda and pretend that it isn’t a real expense?
The related (and perhaps even more irritating) trick is to use share buybacks to avoid dilution from issuing shares to executives. It’s described as “returning cash to shareholders” and uttered in the same breath as the dividend, but this is once again pure nonsense.
First, the buybacks are only necessary because what should be a cash expense (salaries and bonuses) is being thinly disguised as an equity-settled amount that gets split out of adjusted ebitda. Second, buybacks are only attractive when the share price is undervalued.
If the fair value of your share is $100 and someone gives you $100, are you somehow better off than you used to be?
Of course not. Are the other shareholders better off because you received fair value for your share from the company? No, they aren’t.
There are a number of South African companies that use buybacks properly. Lewis is the favourite example, turning a mediocre industry (furniture retail) into a source of strong returns for shareholders. For as long as the share price trades at a modest multiple, Lewis can repurchase its own shares and create value for shareholders who stick around.
When a company is trading on a huge multiple instead, the market is factoring in a great deal of growth. This growth requires capital investment, so it’s already strange to see a growth company executing substantial buybacks. Investors would raise their eyebrows at a high dividend payout ratio in a growth company, yet they have no issue with buybacks. Capital allocation is poorly understood in the market.
When companies get creative
Let’s bring it home and get back to discussing HEPS. Even this is not immune to some rather creative reporting from locally listed companies. HEPS already requires companies to reverse major distortions such as impairments, so any further adjustments should be treated with plenty of scepticism as a rule.
To give some credit to management teams, the world of international financial reporting standards (IFRS) has become so divorced from reality that many accountants are simply tired of it. A balance needs to be struck in the setting of reporting standards. The killer for me was the leases standard introduced a few years ago, which suddenly put rental payments under interest costs. So much for using ebitda, which would now exclude rental costs!
There are examples where IFRS distortions still find their way into HEPS, in which case adjustments might be warranted. There are also cases where the company has a justifiable reason for splitting out an element of the business and disclosing HEPS with and without that element, like Absa recently did with its exposure to sovereign instruments in Ghana. It helps to understand how the core banking business is doing, a number that is hidden by the macroeconomic crisis facing Ghana.
When companies start with such concepts as “normalised” or “core-adjusted” HEPS, be afraid. Be very afraid. This should be called “Oh dear, we won’t do it again HEPS”, or “Whoopsie, that was awkward HEPS”, which would be a more honest account of what happened.
The smell test is to look at the difference between HEPS as reported under the standard rules and whatever version of HEPS the company is hoping you’ll look at instead. The bigger the difference, the greater the need for scepticism. Yes, Discovery, I’m looking at you.