March 17, 2017

Markets are pricing in expectations for ADBE’s recent EPS growth to last forever, propelling recent upside, but longer-term this is likely impossible to maintain


  • Uniform Accounting adjustments highlight that earnings have grown significantly in the last several years, driving significant equity upside
  • However, ADBE generates highly cyclical profitability, indicating these growth rates may be abnormal
  • At current valuations, the market is pricing in expectations for recent growth to continue into perpetuity, and if the firm disappoints, downside may be justified over the longer-term

 

ADBE is set to report Q1 2017 earnings on 3/16, with expectations for continued year-over-year growth that has driven recent improvements in share price. Last quarter, the company beat their Normalized EPS guidance by $0.04, coming in at $0.90 vs. $0.86 estimates, and they beat Q4 GAAP EPS by $0.17, recording EPS of $0.80 versus estimates for EPS of $0.63. Subsequently, the firm has continued to see material share price improvements, from $105 three months ago, to $120+ levels now.

As-reported metrics show an improvement in earnings in 2016, with expectations for continued growth in GAAP earnings in Q1 2017 on a year-over-year basis, driving the company’s recent stock performance. Additionally, analysis under Uniform Accounting Financial Reporting Standards (UAFRS) reinforces that ADBE’s earnings have been strong in recent quarters.  As the charts below highlight, ADBE’s UAFRS-based EPS grew significantly in 2016, growing from $2.08 to $3.31, a 59% growth rate, yet not as robust as as-reported EPS, which rose from $1.24 to $2.32, an 87% growth rate.  Moreover, both UAFRS and as-reported EPS are projected to grow by 28% in full-year 2017. This implies a robust 58% two-year growth rate for as-reported earnings, and a 44% growth rate on a UAFRS basis, implying the markets may continue to reward the firm for its growth in the near-term.

 

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ADBE is an excellent example of the distortions that arise from GAAP accounting. As the chart above shows, traditional EPS metrics consistently understate ADBE’s profitability. Meanwhile, UAFRS-based adjustments highlight that profitability has been steadily improving for the company, and that is likely to continue in 2017.

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The quarterly results show a similar trend. While as-reported EPS indicates that earnings are expected to degrade by $0.10 in Q1 2017, UAFRS-based adjustments highlight that EPS should be just $0.03 lower in the next quarter.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like R&D expense accounting. These are common in tech companies. Once removed, it is apparent that real earnings have been stronger than as-reported EPS would suggest historically, and are likely to remain stronger going forward, though growth is likely to slow, supporting a more bearish outlook in the long-term.

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 reports results in ways that are unrepresentative 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

Three key UAFRS adjustments have the largest impact to ADBE’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to excess cash, R&D, and operating leases.

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 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.

Meanwhile, corporations inherently need some level of cash to operate their business, without which they would have liquidity issues and customers and suppliers would be hesitant to build long-term relationships with them. However, companies with substantial cash balances (above what one might view as “operating” cash) can see as-reported ROA diluted because of the substantial portion of the balance sheet that ends up being taken up by cash that is earning limited or no return, especially in the current environment. As such, if excess cash is not removed from the asset base of a company before looking at performance metrics, a company can appear to have substantially lower operating profitability (in terms of ROA) than it actually has.

Finally, ADBE’s operating lease expense is material. 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 asst. 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 these traditional accounting distortions by treating all R&D and operating lease expenses as investing cash flow, and by removing excess cash from the firm’s balance sheet. These simple reclassification remove a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings of a business

Valuations are too aggressive when you look at the long-term picture

Although earnings growth has been robust, supporting recent stock price improvements, and potentially propelling further upside in the near term, valuations are pricing in expectations for this growth to continue over the long-term which may not be warranted.

ADBE is currently trading at a 30.0x UAFRS-based P/E, which is near historical highs. At these levels, the market is pricing in expectations for profitability to reach, and sustain, all-time highs. However, considering historical cyclicality in the company’s UAFRS-based Earnings, this may be unwarranted.

Upon further analysis, not only are these names likely overvalued relative to peers and the overall market, but compared to their own historical profitability, the market must be expecting a significant change in the operations of each company to warrant current valuations.

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Historically, ADBE’s Adjusted EPS has been cyclical, peaking and declining several times over the last ten years.  This indicates that recent acceleration in EPS growth may have just been standard improvements from a cycle low, to near-peak levels.  As such, it may be more valuable to consider normalized growth, which from 2011 peaks would be just 5.5%, significantly less than growth over the last two years, indicating that current valuations may be far too aggressive.

At a current 30x UAFRS-based P/E, this 5% growth suggests a 5-6x PEG ratio, which is significantly higher than average, and indicates further upside is likely unwarranted, even should recent growth continue in the short-term.

Moreover, it is likely that the firm is approaching a cycle-high in terms of earnings power, and also likely that valuations will begin reverting back to average levels as Earnings growth slows. Even should the firm succeed in transitioning to an improved business model, as they are priced for perfection, longer-term upside may be significantly more limited than near-term momentum would suggest.

To find out more about Adobe 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 Equities and Credit Research Committees, which are responsible for this article. Professor Litman is a recognized global expert in advanced financial statement analysis, corporate performance, and valuation.