June 23, 2017

MLHR’s Uniform Adjusted EPS’ is not projected to shrink, contrary to as-reported EPS projections, and at current valuations any growth would warrant material upside


  • MLHR’s profitability is materially distorted by accounting for operating leases and R&D
  • As such, their UAFRS EPS’ is expected to grow to $0.84 in Q4 2017, and EPS’ over the next four quarters is expected to grow by 2%, not shrink
  • At current valuations, markets are embedding expectations for 13% EPS’ shrinkage annually, which is directionally different than analyst projections for growth, warranting material upside

 

Herman Miller, Inc. (MLHR) is expected to release Q4 2017 GAAP EPS of $0.57 on July 5, 2017, which would represent a 19% shrinkage relative to EPS in Q4 2016.  Full-year estimates are less pessimistic, and are for EPS to only shrink by 2% in the next four quarters, from $2.17 in the four-quarter period ended Q3 2017, to $2.12.  Given a somewhat pessimistic outlook, shares have been fairly choppy in the past year, as although the company is cheap on an as-reported basis, negative expected growth is reason for pause.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that earnings growth will actually be stronger, and EPS’ will be greater than as-reported metrics suggest.

Specifically, under UAFRS, Uniform EPS (EPS’) is actually expected to grow to $0.84 in Q4 2017, a 9% improvement from $0.77 in the same period last year, and is expected to grow by 2% in the next four quarters, following 28% growth last year. EPS’ is expected to reach $3.23 in the next year, up from $3.18 in the four-quarter period ended Q3 2017 and +50% greater than as-reported EPS.  This indicates that at current valuations, markets may be overly bearish, and that upside may be warranted.

The quarterly results show a similar trend, with EPS’ expected to remain above as-reported EPS going forward, as it has in each of the last four quarters, and should EPS’ continue to grow at recent rates, this suggests valuations may be too cheap.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases and R&D. Once removed, it is apparent that MLHR’s profitability is improving, and that 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 MLHR’s financials.

Impact of Adjustments from GAAP to UAFRS

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

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, MLHR’s operating lease expense is somewhat 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 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 these traditional accounting distortions by treating all operating leases and R&D as investing cash flows. 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’ suggests MLHR’s is even cheaper than as-reported metrics suggest

At current prices, MLHR is trading at a 14.6x traditional forward P/E, and a 13.0x UAFRS-based P/E, which are both well below corporate averages, suggesting at first glance that the firm may be fairly valued or slightly cheap given expected EPS declines.

However, when considering the fact that EPS’ is actually expected to grow, MLHR is actually trading at a significant discount.  At a 13.0x UAFRS-based P/E, markets are embedding expectations for annual EPS’ shrinkage of 13% going forward, which is well below analyst projections for 2% shrinkage next year, and directionally different than expected growth in EPS’. As such, should MLHR just maintain growth in-line with analyst estimates, material upside would likely 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 Herman Miller, 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.