July 19, 2017

CVLT may have Uniform Adjusted EPS’ that is 10x above as-reported levels, but with valuations pricing in 12% earnings growth, and the company forecasted to grow at 5%, expectations still appear too high


  • CVLT’s profitability is materially distorted by accounting for R&D and stock option expense
  • As such, their UAFRS EPS’ is expected to grow to $0.35 in Q1 2018, and EPS’ over the next four quarters is expected to grow 5%, not 2,439%
  • At current valuations, markets are embedding expectations for 12% EPS’ growth annually, which is substantially higher than analyst projections for growth, warranting material downside should the firm disappoint

 

Commvault Systems, Inc. (CVLT) is expected to release Q1 2018 GAAP EPS of -$0.07 on 7/25, which would represent $0.02 shrinkage relative to EPS in the same period last year. However, full-year estimates are very bullish, with projections for EPS to grow by $0.21 in the next four quarters, from $0.01 in Q4 2017, to $0.22. Despite such a bullish outlook, shares have been fairly choppy in the past year, as the company appears expensive on an as-reported basis, muting upside potential related to growth.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that although earnings growth will be slightly weaker than as-reported, this is because profitability is far higher than traditional EPS implies.

Specifically, under UAFRS, Uniform EPS (EPS’) is actually expected to be $0.35 in Q1 2018, a $0.07 decline from $0.42 in the same period last year, but is expected to grow by 5% in the next four quarters, following 24% growth last year. EPS’ is expected to reach $2.04 in the next year, up from $1.94 in Q4 2017, and almost 10x greater than as-reported EPS. This suggests that as-reported valuations, which have reached 50x levels in the last several years and have caused investor skepticism, are overstating valuations materially.

The quarterly results show a similar trend, with EPS’ expected to remain positive, and well above as-reported EPS going forward, as it has in each of the last four quarters. As such, it is apparent that as-reported valuations are incorrect, and could lead to incorrect decision making by investors.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D and stock option expenses. Once removed, it is apparent that CVLT’s profitability is far greater than as-reported metrics suggest, indicating that the firm is not wildly overvalued, and is instead likely fairly valued at current prices.

UAFRS vs. As-Reported EPS

Investors make major decisions about which companies to own based on quarterly company earnings, the most common metric mentioned in traditional corporate investment analysis.

However, more often than not, the earnings that companies report in any given quarter can swing wildly and lead investors to completely wrong conclusions, because GAAP and IFRS rules force management to report results in ways that are not representative of the real operating performance of the business.

While there is a case to be made that some management teams can use “creative accounting” to adjust numbers, the research would show that more often than not, the real problem is with the accounting rules themselves, not management’s use of them.

The UAFRS Advisory Council has identified over 130 accounting and financial reporting inconsistencies (some of which can be found here), of which several have material impact on CLVT’s financials.

Impact of Adjustments from GAAP to UAFRS

Two key UAFRS adjustments have the largest impact on CLVT’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to R&D and stock option expense.

GAAP and to a lesser extent IFRS (which allows for capitalization of a portion of R&D expense) treat R&D investments as expenses, when in actuality these are investments in a company’s future operations. They may be good investments or bad investments, but it’s hard to think of R&D as cost of goods sold.

In the case of R&D expense, this is often a multi-year investment in a firm’s future offerings. Expensing R&D violates the basic matching rule of accounting, that expenses should be recognized in the period the related revenue is recognized.

Expensing R&D can also dramatically increase earnings volatility, as the timing of R&D related to multi-year projects can create lumpy earnings volatility, distorting understanding of a company’s real profitability.

Additionally, CVLT has had material non-cash stock option expense since the company was founded. This is treated as an expense to the company in accounting statements, when it is actually a way for the company to give employees an ownership stake in the company. As such, this non-cash expense should be treated as dilution to equity holders and another claim against the Enterprise Value of the firm, as opposed to it being treated as an annual expense. This is especially true as, unless the company uses cash to buy shares (to suppress dilution for equity holders from the option grants being exercised), there is no cash impact on the company.

UAFRS-reporting adjusts for these traditional accounting distortions by treating all R&D as investing cash flows and stock option expense as dilution. These simple reclassifications remove a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings of a business.

Greater-than-reported EPS’ cannot disguise lofty valuations and slowing growth rates

At current prices, CVLT is trading at a 48.3x traditional P/E, suggesting a firm that is likely overvalued unless they can continue to drive exponential earnings growth. After making the requisite adjustments, it is apparent that the firm is trading at lower valuations, with a UAFRS-based P/E of 27.6x. However, this is still near recent highs, and is pricing in much stronger 12% earnings growth than the company is forecast to produce.

Additionally, when compared with the 23 other US-based Systems Software companies with positive earnings in the Valens Research database, CVLT has a UAFRS-based P/E that is higher than 14 other names, indicating valuations are above average for their peer group.

By using Uniform Adjusted Financial Reporting Standards (UAFRS), investors see a cleaner picture that distorted GAAP and IFRS metrics cannot show. By standardizing financial reporting consistently across time and across companies, corporate performance and valuation metrics improve dramatically. Comparability of a company’s earnings over time, trends in corporate profitability and comparability in earnings power and earnings growth across close competitors and different sectors becomes far more relevant and reliable.

To find out more about Commvault Systems, Inc. and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Research Committee, which is responsible for this article. Professor Litman is regarded globally for his expertise in financial statement analysis, fundamental research, and particularly Uniform Accounting, UAFRS.