April 7, 2017

MMM Q1 Earnings Preview – Uniform Accounting shows 3M (MMM) earnings are growing slower than investors realize – UAFRS EPS on Valens Research


  • MMM’s traditional EPS is materially distorted by how they are milking their PP&E and the resultant distortion in depreciation charges, as well as the accounting of their R&D investments
  • After making the appropriate UAFRS adjustments, EPS’ growth is growing more slowly than as-reported metrics suggest
  • At current valuations, markets are pricing in expectations for growth prospects that are likely unrealistic, which may pressure multiples

 

3M Company (MMM) is expected to release a Q1 2017 as-reported earnings of $2.06 per share later this month, representing immaterial growth from the $2.05 levels during Q1 2016. However, FY 2017 EPS expectations are more aggressive, particularly for growth acceleration in the back half of the year to drive as-reported EPS from $8.16 in FY 2016 to $8.50 in FY 2017.  As the outlook for the firm has improved over the last several months, so has the firm’s share price, which has risen to $190+ levels from $175 in early February 2017.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability growth is actually decelerating, warranting weaker valuations than those at which the firm is currently trading.

Specifically, under UAFRS, Adjusted EPS (EPS’) is expected to fall in Q1 2017 compared to Q1 2016, and FY 2017 growth is only expected to reach 1% levels.  As the charts below highlight, this is a continuation of slower than as-reported EPS growth in 2016, indicating decelerating growth trends that do not support currently aggressive valuations.  The firm’s EPS’ only grew from $8.18 in 2015 to $8.57 in 2016, a 4.7% growth rate below as-reported 7.6% growth rates, and is only expected to reach $8.69 for 2017, a 1.4% annual growth rate below the projected as-reported 4% earnings growth rate. Given the firm’s aggressive valuations relative to earnings, it is likely that markets are failing to discount the firm appropriately for its declining, near-zero growth.

mmm1-20170407

The quarterly results show a similar trend, with EPS’ in excess of traditional EPS in each quarter, but not growing nearly as quickly.  Given weaker-than-reported growth trends, aggressive valuations relative to earnings are unwarranted and longer-term underperformance may be warranted as investors realize weakness in the firm.

mmm2-20170407

UAFRS, Uniform Adjusted Financial Reporting Standards, call for the removal of distortions from issues like the treatment of excessively aged, or relatively long-lived assets, as well as R&D expensing. Once removed, it is apparent that EPS’ growth is slowing faster than as-reported metrics suggest, and this has implications for the stock 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.

Impact of Adjustments from GAAP to UAFRS

There are several adjustments required to make earnings representative of a firm’s true cash flows. For MMM, the most material are related to adjusting for the true depreciation of the firm’s assets, as well as the capitalization of R&D.

MMM has not actively invested in its business over the last several years, leading to its asset base aging somewhat considerably.  Generally, companies with older assets tend to have lower cash flows than they would have otherwise, once they have to spend more on maintenance capex.  MMM has been milking their asset base, allowing assets to depreciate until they approach fully depreciated levels on their balance sheet.  Once assets are fully depreciated, but continue to be used, the depreciation expense associated with those assets disappears, and as-reported net income will appear improved as the company has the same earnings power, but no depreciation expense on the assets generating that revenue.  This continues to be true until management does spend on maintenance capex.  Since MMM has been milking their asset base, their depreciation expense, a proxy for maintenance capex, is currently being understated.

Moreover, given the long-lived nature of MMM 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; nearly 10 years ago for many of their 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.

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 reality these are investments in a company’s future operations. They may be good investments or bad investments, but it is hard to think of R&D along the same line 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 that 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.

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 costs would be in the current year being measured, and by capitalizing and amortizing R&D across its useful life. These calculations remove a tremendous amount of accounting noise related to investment activities and improve investors’ understanding of the operating earnings of a business.

Slowing growth makes aggressive valuations even more worrisome

Using traditional metrics would suggest that the firm may be fairly valued; however, once accounting distortions are removed, it is apparent that MMM is trading at above-average valuations with a 24.8x UAFRS-based P/E, which is above corporate averages and near historical highs for the firm, indicating that they would need to have material growth prospects to warrant further upside.

However, recent growth trends and expectations for flat growth in EPS’ in 2017 indicate that this is not the case. With projections for 2%-3% annual growth in EPS’ going forward, a P/E at well above market average levels appears unwarranted.

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. The 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 all become far more relevant and reliable.

To find out more about 3M Company 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.