May 12, 2017

Kohl’s Uniform Adjusted EPS’ is shrinking more quickly than reported, implying it is not as cheap as it initially appears


  • KSS’s profitability is materially distorted by accounting for depreciation under GAAP
  • As such, their UAFRS EPS’ only reached $0.33 this quarter, not $0.39
  • In addition, EPS’ is expected to shrink 13% next year, far more than expectations for as-reported shrinkage of 1%
  • After making the appropriate UAFRS adjustments, KSS is trading at a 17.8x Uniform P/E, which is near corporate averages, and considering material expected profitability declines, further downside may be warranted

 

Kohl’s Corporation (KSS) released Q1 2018 EPS of $0.39 on 5/11, beating analyst estimates slightly, and growing significantly from the same period last year. However, with comp-store sales down and a weak outlook for the firm, the stock was down over 6% during the day. The full year-outlook for the firm appears to support the more bearish market outlook, with expectations for EPS over the next four quarters to fall 1%, to $3.39, from $3.43 levels in the year ended Q1 2018.

Additionally, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability has been even weaker than as-reported, and considering this trend is expected to continue, further downside for KSS is likely.

Specifically, under UAFRS, Uniform EPS (EPS’) actually only reached $0.33 in Q1 (a 14% discount to as-reported EPS), and is expected to fall even faster than as-reported EPS going forward. Expectations are currently for next four quarter EPS’ to fall to $3.13, a 13% decline from $3.59 levels in the last four quarters. This indicates that investors who are disappointed by as-reported outlook may face further disappointment given the true economic declines as KSS. As such, the firm is not cheap like as-reported P/E suggests, but instead is finally trending towards fair value.

The quarterly results show a similar trend, with EPS’ falling below traditional EPS in each of the last three quarters, with expectations for this to continue going forward.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of excessively aged, or relatively long-lived assets. Once removed, it is apparent that EPS’ is fading more quickly than as-reported, suggesting the firm is not an interesting value play, and instead may be a value trap.

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.

Impact of Adjustments from GAAP to UAFRS

There are several adjustments required to make earnings representative of a firm’s true cash flows. For KSS, the most material is related to adjusting for true depreciation of the firm’s assets.

Given the long-lived nature of KSS assets, the true maintenance capex costs related to their assets is much higher than depreciation, which is reflective of the cost of those assets when the company bought them, which happened 7-10 years ago for many of KSS’s assets.  As such, nominal asset values should be restated into constant-currency values to improve the reliability of business performance metrics, and the related depreciation (maintenance capex) expense should then be calculated off of the value of the Adjusted Asset base.

UAFRS-reporting adjusts for these traditional accounting distortions by estimating the age of assets and using a GDP deflator to adjust the asset value and associated depreciation expense into the values reflective of what replacement cost would be in the current year being measured. This simple adjustment 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 declines in EPS’ suggests KSS is not as cheap as it appears

At current prices, KSS is trading at an 11.1x as-reported forward P/E, suggesting the firm is cheap, even when considering expected EPS declines. However, after making the requisite adjustments, it is apparent that KSS is actually trading at higher levels, which may be unwarranted considering expected profitability declines.

Specifically, the firm is actually trading at a 17.8x UAFRS-based P/E (Fwd V/E’), which is actually around corporate averages. Given expected long-term EPS’ declines, this is likely unwarranted, and should the firm fail to reverse recent profit declines, downside may persist following the gap down post-earnings.

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 Kohl’s Corporation 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.