Even important industry players can sometimes run up against brick walls at Corp Fin. In a recent give-and-take with the SEC, Allergan was scolded for its use of certain non-GAAP financial measures in its press releases. While in its responses to the staff, the company cogently explained its reasoning, the staff did not ultimately agree with company’s view, putting to the test one of the staff’s most recent CDIs regarding performance versus liquidity per-share measures. Moreover, in conversations with the staff, the company apparently conveyed the impression that the practice disfavored by the staff was widely followed in its industry group, leading the staff to caution that it plans to evaluate practices in the pharmaceutical industry. Companies in that industry may want to pay attention.
While there were several staff comments related to non-GAAP measures in an earnings release through the string of correspondence, only the first comment was truly contentious and remained unresolved at the end.
In the initial comment letter, the staff noted that, since the beginning of 2014, the company had “reported GAAP net losses from continuing operations of $5.8 billion. During that same period, you have added back over $15 billion of expenses to those GAAP losses to arrive at non-GAAP net income from continuing operations of approximately $9.5 billion.” The staff requested that, “[g]iven the magnitude and frequency of your adjustments, please choose a different label for this measure that does not imply such a close relationship with GAAP.” Referring to CDI 102.05, the staff then advised the company to “discontinue presenting this measure on a per share basis because it is, in substance, a liquidity measure that is similar to your operating cash flows.”
SideBar: CDI 102.05 relates to the prohibition in Reg S-K Item 10(e) on the use, in documents filed with or furnished to the SEC (such as earnings releases), of per-share non-GAAP liquidity measures (which measure cash generated). In contrast, non-GAAP per-share performance measures “may be meaningful from an operating standpoint.” The CDI adds that “[w]hether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, even if management presents it solely as a performance measure. When analyzing these questions, the staff will focus on the substance of the non-GAAP measure and not management’s characterization of the measure.” [Emphasis added.] in a recent presentation, Corp Fin Chief Accountant Mark Kronforst noted that, in the past, the staff tended to defer to management’s view as to whether the measure was a liquidity or performance measure, resulting in the near extinction of per-share liquidity measures. In a change from the past approach, the staff would no longer defer to management’s interpretation. Kronforst observed that many measures are either at one end of the spectrum or the other — clearly related to net income or to operating or free cash flow. But some measures are really a mixed bag, about which reasonable people may differ. According to Kronforst, the staff’s focus — for now — will be the liquidity end of the spectrum. For example, if there are a dozen adjustments necessary to arrive at the measure from net income and only one adjustment to reach operating cash flow, he said, the measure will draw staff scrutiny. (See this PubCo post and this PubCo post.)
The company responded “that its non-GAAP net income and non-GAAP net income per share attributable to shareholders are, in substance, performance measures and not liquidity measures.” These measures, it contended, are useful to both management and investors in assessing current performance and future operations. More specifically, the company explained that, as a result of recent “radical transformative changes” that involved multiple transactions, each with unusual costs and non-recurring gains, performance was “distorted” and that, as a result, “non-GAAP net income enhances the comparability of our results between periods and provides additional information and transparency to investors on adjustments and other items that are not indicative of the Company’s current and future operating performance.” To support its contention that the measure was a non-GAAP performance measure, the company contended that, as a performance measure, this non-GAAP measure was adjusted for “both cash and non-cash items depending on the nature of the item being adjusted, whereas a non-GAAP liquidity measure would only adjust for non-cash items.” The company also emphasized that the adjustments had been consistently applied over the periods. Finally, the company contended that “analysts for our industry group base their third party consensus estimates on non-GAAP earnings per share metrics. We believe it is important that our industry group be able to report on this basis. The exclusion of such metrics from Allergan’s reports would cause confusion to our investors regarding our results and would affect the ability to compare our results with those of our peers.” The company agreed only to change its labels for these measures and to expand its “usefulness” descriptions.
The staff responded rather forcefully that, under CDI 102.05, “whether per share data is prohibited depends on whether the non-GAAP measure can be used as a liquidity measure, not on how management chooses to characterize it. Your non-GAAP measure bears a striking resemblance to your cash flows and differs drastically, including directionally, from your GAAP net income from continuing operations.” To convert the GAAP net loss from continuing operations to non-GAAP net income, the staff argued, required the elimination of several billion of “mostly non-cash charges. We believe that your per share presentation is inconsistent with both Commission and staff guidance and should be discontinued.”
In its response, the company again disagreed, identifying a different calculation that would undercut the staff’s calculation and result in a closer comparison. Moreover, the company asserted that, in addition to management, its investor group also viewed its non-GAAP net income per share metric as a performance metric and expected that guidance to continue on a consistent basis, notwithstanding the staff’s belief that it should be discontinued:
“In a situation where the Company were to miss earnings guidance, it would be of critical importance to report the miss on the same terms and using metrics already analyzed by investors. Given the investment community’s expectation that the Company will continue to provide its non-GAAP net income per share for the third and fourth quarter of this year and for the full year 2016, and the fact that investors and analysts will evaluate the Company on the basis of results in light of the current guidance, the Company will, at a minimum, need to continue to provide this information in connection with its earnings press releases for the third quarter of 2016 and the fourth quarter and full year 2016. The Company intends to reach out by telephone to discuss these issues with the Staff.”
But the staff continued to disagree on this point:
“We note from your response to prior comment 1 and our subsequent discussions that you continue to view your non-GAAP adjusted net income attributable to shareholders, including its presentation on a per share basis, as solely a performance measure. While we do not agree and believe that the measure you present is clearly and closely related to cash flows, we recognize that how you characterize it is a matter of significant judgment. While we also recognize that other companies, particularly in your industry, make these types of significant adjustments, it does not suggest that the magnitude of your departure from GAAP results nor the resulting similarity to cash flows is at all common.”
The staff then suggested that the company reexamine the CDI “and consider ending your practice of providing the per share data.” However, if the company chose to continue, the staff advocated several changes to make in the disclosure:
- “Retitle the measure to more clearly reflect the extent of its departure from the concept of earnings. For example, the title should be consistent with the fact that you typically exclude more than half of all operating expenses;
- Quantify the cumulative excluded cost of acquiring the intellectual property associated with revenue recognized (e.g., accumulated amortization for products currently being sold); and
- Clearly state that your non-GAAP results have not been, and never will be, burdened with any of the costs to acquire the underlying products that are currently generating revenue.”
Finally, the staff indicated that “in light of our discussions about this matter, we will evaluate the industry practices you described to us and consider whether additional comprehensive non-GAAP staff guidance is appropriate.” Although the staff expressly indicated that it did not agree with the company’s view, it completed its review and reminded the company that it “and its management are responsible for the accuracy and adequacy of their disclosures, notwithstanding any review, comments, action or absence of action by the staff.”