May 5, 2017

Uniform Accounting for CMI shows that investors may not realize how poor earnings actually are and the recent stock run was not warranted


  • CMI’s EPS’ was not $2.36, it was actually $1.49 in Q1, and earnings shrunk by 18% year over year, contrary to as-reported metrics which show a 16% growth rate
  • After making the appropriate UAFRS adjustments, CMI is trading at a 25.6x P/E, not an 18.6x P/E, and a 2.5x-3.0x PEG, suggesting EPS’ growth does not support currently aggressive valuations
  • CMI’s profitability is materially distorted by accounting for R&D and depreciation

 

Cummins, Inc. (CMI) jumped by 7% on 5/2, following the release of better than expected Q1 earnings. As-reported EPS came in at $2.36 for the quarter, a 26% improvement over $1.87 levels in Q1 2016.  This also implied a 16% growth rate in the four quarters ended Q1 2017 over the four quarters ended Q1 2016, from $7.55 to $8.73. Strong growth is expected to continue for the next four quarters as well, with expectations for EPS to reach $9.38 in the next year, an 8% growth rate over EPS on an LTM basis.  Continued optimism surrounding the firm’s earnings have driven nearly 100% returns since the beginning of 2016, as shares have now recovered back to all-time highs.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability at CMI actually declined in this past year, and is not as strong as what the traditional EPS suggests.

Specifically, under UAFRS, Uniform EPS (EPS’) actually only reached $1.49 in Q1, which represents just 8% growth over the same period last year, and remains well below as-reported EPS. Additionally, EPS’ over the last four quarters is just at $6.32, not $8.73, and this represents an 18% shrinkage compared to EPS’ of $7.67 in the four quarters ended Q1 2016. As such, investors in CMI may not realize how poor profitability has been, and how strong valuations are currently, which indicate the firm is expensive, not cheap.  The firm is growing much more slowly, potentially warranting an underperformance going forward.

cmi1-20170505

The quarterly results show a similar trend, with EPS’ remaining far below its traditional counterpart, and not growing at a rate that would support currently aggressive valuations.  As such, longer-term underperformance, or even downside may be warranted.

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UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of excessively aged, or relatively long-lived assets, and R&D. Once removed, it is apparent that EPS’ is weaker-than-reported, and not growing at a rate that would support 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 CMI, the most material are related to R&D and adjusting for true depreciation of the firm’s assets.

CMI has not actively invested in its business over the last several years, leading to its asset base aging somewhat considerably over the last several years.  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.  CMI 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 disappear 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 CMI has been milking their asset base, their depreciation expense, a proxy for maintenance capex, is being understated currently.

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.

In the case of CMI, profitability has not been improving materially, instead the firm has been reducing expenses which are in reality investments in its operating business. 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, and by treating all R&D as an investing cash flow. 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.

Below, we have included in tabular form, all of the adjustments required to get from Net Income to UAFRS Adjusted Earnings:

cmi3-20170505

Worse-than-reported profitability indicate CMI valuations are overly aggressive

At current prices, CMI is trading at a 18.6x as-reported forward P/E, suggesting the firm is trading around corporate averages, and is cheap when considering expected growth rates, even after the run in share prices in the past year.  However, after making the requisite adjustments, it is apparent that CMI is actually far more expensive, and considering expected growth rates, is significantly overvalued.

Specifically, the firm is actually trading at a 26.2x UAFRS-based P/E (P/E’), which is well above corporate averages. Given expected long-term EPS’ growth rates of 9%, CMI is currently trading at a 2.5x-3.0x PEG ratio, indicating a firm that is overvalued, and longer-term underperformance is likely 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 Cummins, 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.