April 18, 2017

Uniform Accounting highlights CCK’s Adjusted EPS is going to decline, not grow, and valuations are not as cheap as it appears using as-reported metrics


  • CCK’s traditional EPS is materially distorted by the accounting for operating leases and R&D
  • After making the appropriate UAFRS adjustments, EPS’ growth has been weak, and EPS’ is actually expected to decline next year, not grow
  • Traditional metrics materially understate valuations relative to the earnings of the firm, and CCK is more expensive than investors may realize

 

Crown Holdings (CCK) is expected to release Q1 2017 as-reported earnings of $0.70 per share on 4/19, representing 20% growth from $0.57 levels during the same period last year. Additionally, full-year EPS expectations are less aggressive, but still positive, and are for 7% growth year-over-year, from $3.56 in 2016 to $4.82.  At these growth levels, and muted as-reported valuations, CCK would initially appear like an interesting value name.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability is actually expected to decline next year, and growth has been muted over the last several quarters, warranting limited share price gains and weaker valuations.

Specifically, under UAFRS, Adjusted EPS (EPS’) is expected to be flat in Q1 at $0.76, compared to $0.76 in the same period last year, and is expected to fall over the full year 2017, from $4.27 last year to $4.09.  Moreover, this is following the weak growth in 2016, when EPS’ only grew 9%, compared to 26% growth suggested by as-reported EPS analysis, indicating investors may not realize the declining profitability trends at CCK, which would warrant poorer valuations.  It is apparent that CCK is not an interesting value stock, but instead fairly valued at best, and potentially overvalued should EPS’ declines continue going forward.

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The quarterly results show a similar trend, with continued weakness in EPS’ that is not expected to change soon.  As a result of weaker-than-reported growth in profitability, valuations are far more expensive than a 13.5x P/E indicates, and this has implications for investors who believe this to be a cheap stock.

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Uniform Adjusted Financial Reporting Standards (UAFRS), call for removal of distortions from issues like the treatment of leases and R&D. Once removed, it is apparent that EPS’ growth has been weaker than traditional EPS suggests, and EPS’ will actually decline next year, not grow.

UAFRS EPS 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 CCK, the most material are related to 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, CCK’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 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. Because CCK materially spends on operating leases, as-reported metrics like EPS may not accurately reflect the firm’s earnings power.

In the case of CCK, 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 treating all operating leases and 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.

Declining earnings power and higher valuations imply CCK isn’t as cheap as investors may believe

Not only are earnings declining faster than as-reported EPS suggests, but after making a host of other adjustments, it is apparent that CCK is also more expensive than the 13.5x P/E implies.  In reality, CCK is trading at an 18.6x UAFRS-adjusted P/E, which is around corporate averages, not cheap.  Compared to companies with similar expected declines in EPS’, they are trading at a premium.

Once making the requisite adjustments, it is apparent that CCK is not a value stock, but instead is fairly valued at best.  With UAFRS-adjustments the firm does not look like a cheap stock with growing earnings, it looks expensive with declining fundamentals.

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 Crown Holding 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.