Saturday, October 13, 2012

(BN) Profit Amputations Are ‘Just a Flesh Wound’

If the stock market were a Monty Python movie, Zynga Inc. (ZNGA) would be the character known as the Black Knight, who cheerily yelled "just a flesh wound" after losing both of his arms in a sword fight. Anyone can see the company is bleeding profusely. Yet it won't admit defeat.

Consider Zynga's Oct. 4 news release, in which the maker of online games said it expected to report a third-quarter net loss of $90 million to $105 million. But never mind those figures. Zynga has developed its own rules for measuring financial performance. And under this approach, which doesn't comply with generally accepted accounting principles, the company said its loss would be only $2 million to $5 million.

Why such a big difference? Here's where the numbers get comical. Zynga paid $183 million in March to buy another games company called Omgpop. Then last week, Zynga said it would write down that acquisition by $85 million to $95 million. Zynga excluded the writedown from its non-GAAP results for the third quarter, and encouraged others to do the same.

The notion is absurd. The $183 million that Zynga paid for Omgpop was cash. It's writing down about half of the purchase price. Zynga bought Omgpop less than seven months ago. In other words, Zynga's management wasted a lot of money and acts as if it doesn't matter.

Investors didn't buy into the ruse. The shares fell 12 percent on Oct. 5, the day after the warning. They closed yesterday at $2.43, down 76 percent since Zynga's initial public offering last December, giving the San Francisco-based company a $1.8 billion stock-market value.

Numbers Spinning

Why bother with spinning the numbers this way? In addition to requiring a complete reconciliation to GAAP, the Securities and Exchange Commission's rules for non-GAAP financial metrics say companies must provide "a statement disclosing the reasons why the registrant's management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the registrant's financial condition and results of operations."

"Non-GAAP net loss" is one of a few nonstandard metrics that Zynga publishes. Here's the explanation from its Oct. 4 press release: "We believe these non-GAAP financial measures are useful to investors because they allow for greater transparency with respect to key financial metrics we use in making operating decisions and because our investors and analysts use them to help assess the health of our business."

That reasoning is circular. All Zynga said is that the information is useful because it's useful. That can lead to only one conclusion: If Zynga's executives actually make decisions based on such numbers, this might explain why the business is such a disaster. When asked for a comment, a Zynga spokeswoman, Stephanie Hess, referred me to the company's public disclosures.

The spread of hokey non-GAAP financial metrics in corporate-earnings releases became a big issue during the late 1990s stock-market bubble. The practice seems to have gotten out of hand again. Zynga is merely an extreme case.

About half of the companies in the Standard & Poor's 500 Index presented non-GAAP earnings for their most recent quarters in ways that made their results look better, according to data compiled by Bloomberg. Only about one-fifth of the companies showed non-GAAP earnings that looked worse. These numbers wind up in a vast information food chain, where they often are repeated in the financial press and used as benchmarks for Wall Street stock analysts' earnings estimates.

Showing Profits

Hewlett-Packard Co., for example, showed a profit of about $2 billion for the quarter ended July 31 -- excluding almost $11 billion of restructuring charges and asset writedowns, all of which are considered ordinary expenses under GAAP. HP said its net loss was $8.9 billion.

News Corp. reported a $1.6 billion net loss for the quarter ended June 30. Meanwhile, its Aug. 8 earnings release highlighted a $783 million non-GAAP profit. That excluded about $2.4 billion of writedowns and restructuring charges, as well as expenses related to phone-hacking investigations at the company's U.K. newspapers.

This week, Alcoa Inc. reported a third-quarter net loss of $143 million, but a profit of $32 million "excluding special items." The items were a lawsuit settlement and costs from an environmental cleanup, which are nothing special. This is a metals company. Lawsuits and environmental hazards are routine.

Do these companies' executives think they are fooling anybody? They must. Otherwise they wouldn't do it.

In the 1975 movie "Monty Python and the Holy Grail," the Black Knight kept trying to provoke his adversary, King Arthur, even after getting his legs cut off, too. "Come back here and take what's coming to you! I'll bite your legs off!" he shouted.

In life, as in art, some people just won't accept reality.

(Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own.)

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