August 29, 2017

HDS’ Uniform Adjusted EPS’ is forecast to decline in the next year, contrary to what as-reported metrics suggest, indicating the name may be a value trap


  • HDS’ profitability is materially distorted by accounting for operating lease expense
  • As such, their UAFRS EPS’ is projected to decline by 3% in Q2 2018, and 13% in the next year, a sharp contrast to expectations for stable GAAP EPS
  • At current valuations, markets are embedding expectations for 4% EPS’ growth annually, which is in-line with long-term adjusted projections for 3% annual EPS’ growth, implying equity is likely fairly valued at best
  • Given near-term projections for declining profitability, the risk of underperformance appears elevated, and investors should be wary of a potential value trap

 

HD Supply Holdings, Inc. (HDS) is expected to release Q2 2018 GAAP EPS of $0.49 on 9/6, which would represent no growth from the same period last year. Moreover, FY 2018 estimates are similarly muted, with projections for EPS of $1.46 in the next four quarters, representing no growth from $1.46 in the four-quarter period ended Q1 2018. Despite this muted outlook, shares have rallied almost 10% from their 52 week low, as investors have been drawn in by what looks like a fairly undervalued name.

However, after making the appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that, while profitability is greater than traditional EPS implies, it is projected to decline going forward.

Specifically, under UAFRS, Uniform EPS (EPS’) is actually projected to be $0.54 in Q2 2018, a 3% decline from $0.56 in the same period last year, and is also projected to decline by 13% in the next four quarters, following a dramatic 73% decline in the four-quarter period ended Q1 2018. EPS’ is projected to fall to $1.64 in the next year, from $1.89 in the last year, a sizeable decline relative to the flat EPS levels that GAAP accounting metrics report. This suggests that valuations may be more expensive than they seem at first glance, and HDS may be a value trap.

The quarterly results show a similar trend, with EPS’ projected to remain above as-reported EPS going forward, but still projected to decline year-over-year despite sequential improvement. Should EPS’ continue to decline as is projected, this suggests valuations may not be as cheap as they appear.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases. Once removed, it is apparent that, while HDS’ profitability is greater than as-reported metrics suggest, it is projected to decline going forward, which can have material implications for shares at current valuations.

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 HDS’ financials.

Impact of Adjustments from GAAP to UAFRS

One key UAFRS adjustment has the largest impact on HDS’ income statement, to get from earnings to UAFRS-adjusted earnings. This is related to operating lease expense.

HDS has had consistent, material operating leases each year. The decision management makes between investing in capex and investing in a lease is not a decision between an expense and an investment, but rather a decision in how management wants to finance their investments. If they would rather spend cash up front for the asset, they will spend capex. However, if they want to spread the cost of the asset over several years, they will instead choose to lease the asset. That said, as-reported accounting statements treat one as an investment, and the other as an expense that does not impact the balance sheet.

UAFRS-reporting adjusts for this traditional accounting distortion by treating all operating leases as investing cash flows. This simple reclassification removes 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’ is no substitute for growth, suggesting valuations may not be cheap

At current prices, HDS is trading at a 13.3x as-reported forward P/E, which at first glance may appear cheap relative to the firm’s competitors. However, after making the requisite adjustments, it is apparent that the firm is actually trading at a UAFRS-based P/E of 21.4x, which is around peer average valuations, despite projections for near-term EPS’ declines.

At this valuation, markets are embedding expectations for annual EPS’ growth of 4%, which is in line with UAFRS-based long-term adjusted analyst projections for just 3% annual EPS’ growth. As such, equity appears fairly valued at best, and, should projected near-term declines in EPS’ sustain longer than analysts expect, equity downside would be warranted.

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 HD Supply Holdings, 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.