April 18, 2017

Uniform Accounting highlights CLW’s Adjusted EPS is far below as-reported EPS, and as a result, valuations are far more expensive than traditional metrics suggest


  • CLW’s traditional EPS is materially distorted by the age of their assets, and the resultant depreciation charges
  • After making the appropriate UAFRS adjustments, EPS’ has been significantly lower than as-reported EPS, and will continue to be lower going forward
  • As such, traditional metrics materially understate valuations relative to the earnings of the firm, and CLW is far more expensive than investors may realize

 

Clearwater Paper Corporation (CLW) is expected to release Q1 2017 as-reported earnings of $1.16 per share on 4/20, representing 10% growth from $1.05 levels during the same period last year. Moreover, full-year EPS expectations are fairly aggressive, and are for 42% growth year-over-year, from $2.87 last year to $4.07.  As the earnings outlook for the firm has improved, share prices have rebounded significantly, and are back near all-time highs after a poor 2015.  Moreover, even after rebounding by 50% to $50+, value investors remain fairly bullish on the name, citing its current P/E of 16.1x, which is fairly cheap for a firm expected to grow earnings by 42%.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability is actually far weaker and valuations are more expensive, suggesting the company may be overvalued now, not cheap, which would support longer-term underperformance should the company fail to drive significant earnings growth.

Specifically, under UAFRS, Adjusted EPS (EPS’) fell significantly over the past four quarters, shrinking 15% from the prior year, and although it is expected to rebound to $3.11 in 2017, this remains well below as-reported EPS, indicating investors may not realize the significance of weakness in CLW’s profitability.  Given EPS’ that has been 25% weaker than as-reported EPS, and expectations for this trend to continue, valuations are far more expensive relative to earnings than as-reported metrics suggest.

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The quarterly results show a similar trend, with EPS’ remaining well below traditional EPS in each quarter, with no indication this will change.  As a result of weaker-than-reported profitability trends, valuations are far more expensive than a 16.1x P/E indicates, and this has implications for investors who believe this to be a cheap stock.

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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. Once removed, it is apparent that EPS’ has been weaker, and will likely continue to be weaker than traditional EPS suggests.

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 CLW, the most material is related to adjusting for true depreciation of the firm’s assets.

CLW has not actively invested in its business over the last several years, leading to its asset base aging somewhat considerably over that timeframe.  The firm has been milking their asset base, allowing assets to depreciate until they approach fully depreciated levels on their balance sheet. 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.  However, this is only true to an extent, as 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 CLW has been milking their asset base, their depreciation expense, a proxy for maintenance capex, is being understated currently.

Moreover, given the long-lived nature of CLW 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, which happened almost 30 years ago for many of CLW’s 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.

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. This calculation removes a tremendous amount of accounting noise related to investment activities and improves investors’ understanding of the operating earnings of a business.

Weaker than reported earnings mean valuations are more expensive than they appear

Investors looking at as-reported EPS to derive price multiples will find CLW to be an attractive stock at current prices, with a 16.1x P/E and expected EPS growth warranting higher valuations. However, once accounting distortions are removed, it is apparent that CLW is not trading at below-average valuations with a 16.1x P/E, but instead closer to a 28.3x UAFRS-adjusted P/E (V/E’), which is well above corporate averages, indicating the firm would need material growth prospects to support current prices.

Moreover, while EPS’ is expected to grow fairly robustly in 2017, this is a result of the firm seeing a rebound from a poor 2016, and longer-term EPS’ projections suggest annualized 5%-10% growth, or a 2.5x-5.0x PEG ratio. At these levels, the firm is significantly more overvalued than as-reported metrics suggest, and equity downside may be warranted going forward.

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 Clearwater Paper Corporation. 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.