September 4, 2017

RS’ Uniform Adjusted EPS’ is greater than as-reported earnings suggest, and projected to continue to grow, implying valuations may be too cheap


  • RS’ profitability is materially distorted by accounting for operating lease expense
  • As such, their UAFRS EPS’ was $1.68 in Q2 and $6.16 in the last year, not $1.40 and $4.44, respectively, as GAAP accounting metrics report
  • At current valuations, markets are embedding expectations for 1% annual EPS’ shrinkage, which is directionally different than adjusted estimates for 6% growth going forward
  • With higher profitability than as-reported metrics suggest, and forecasts for improving earnings when markets expect declines, valuations appear fairly cheap

 

Reliance Steel & Aluminum Co. (RS) released Q2 2017 earnings on 7/27, beating estimates on both the top and bottom line. EPS came in at $1.40 for the quarter, beating by $0.03, while revenues beat by $30mn. However, despite solid fundamental performance, shares have fallen almost 5% since, as investors have become concerned about the firm’s future growth prospects.

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

Specifically, under UAFRS, Uniform EPS (EPS’) actually reached $1.68 in Q2, 20% higher than GAAP EPS. Additionally, over the last four quarters EPS’ has been $6.16, almost 40% higher than as-reported EPS of $4.44 in the same timeframe. This indicates that valuations may be even cheaper than they appear, and with growth potential for the firm, this could lead to material upside.

The quarterly results show a similar trend, with EPS’ expected to remain positive, and well above as-reported EPS going forward, as it has in each of the last four quarters. As such, should EPS’ continue to grow as it is projected to, valuations are likely too cheap.

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 RS’ profitability is greater than as-reported metrics suggest.

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 RS’ financials.

Impact of Adjustments from GAAP to UAFRS

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

RS 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’ and expectations for growth suggest valuations may be too cheap

At current prices, RS is trading at a UAFRS-based P/E of 14.4x, which is below both corporate and peer averages. When considering the fact that EPS’ is projected to continue to grow going forward, below-average valuations appear unwarranted.

Specifically, at these valuations, markets are embedding expectations for annual EPS’ shrinkage of 1%, which is directionally different from long-term analyst estimates for RS to see 6% annual EPS’ growth. As such, should the firm simply maintain growth in-line with analyst estimates, equity upside 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 Reliance Steel & Aluminum Co., 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.