May 11, 2017

Uniform Accounting highlights DIS is likely to see further downside after Q2 earnings, not a rebound


  • DIS EPS’ was actually $1.48 in Q2, not $1.50 as traditional EPS implies, and was even lower over the past year when compared to as-reported earnings
  • After making the appropriate UAFRS adjustments, valuations are slightly above corporate averages as well, but with weak growth, PEG ratios are 5x+, supporting further downside should DIS not deliver stronger earnings growth
  • DIS EPS’ is materially distorted by accounting for depreciation under GAAP

 

The Walt Disney Company (DIS) released Q2 2017 GAAP earnings of $1.50 per share after the bell on 5/9, beating bottom-line estimates, but missing top-line, and giving weaker-than-expected guidance, driving shares lower. This follows a material run-up in shares from $90 levels this past fall, indicating markets likely failed to anticipate fundamental weakness in Disney’s outlook.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability has been weaker than what was reported historically, and is growing slightly more slowly than as-reported metrics suggest, implying markets should not have been surprised by a poorer outlook for the firm.

Specifically, under UAFRS, Adjusted EPS (EPS’) only reached $1.48 in Q2, and although this represents double-digit growth over EPS’ in the same period last year, full year-growth was slower than reported. Specifically, EPS’ at DIS only grew from $5.28 in the four quarters ended Q2 2016 to $5.55 in the last four quarters, a 4% growth rate.

Moreover, EPS’ at these levels is lower than as-reported EPS of $5.74, indicating markets may not have realized the weakness in DIS’ earnings power. Given weaker-than-reported earnings, DIS is also trading at a greater valuation than as-reported metrics would suggest, implying further downside may be warranted going forward.

As the chart below highlights, this trend has been apparent even on a quarterly basis, with EPS’ falling below as-reported EPS in each of the last four quarters, and growing more slowly. This would imply that investors using as-reported metrics may not realize how poor DIS profitability has been, signified by surprise at a weaker outlook described on the call.

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

Given the long-lived nature of DIS 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 10 years ago for many of Disney’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 simple adjustment removes a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings of a business.

Poorer profitability implies greater-than-reported valuations, and further downside might be warranted

Given lower than as-reported earnings, valuations for DIS are actually higher than as-reported P/E would imply. At current prices, DIS is trading at an 18.2x forward P/E, which is around corporate averages, suggesting DIS is likely fairly valued.

However, after making the requisite adjustments, it is apparent that DIS is actually trading at a 22.6x UAFRS-based P/E, above corporate averages. Moreover, considering expected growth rates of roughly 4% annually in EPS’, this suggests a PEG ratio of 5x+, indicating a firm that is well overvalued, warranting the gap-down following earnings. In addition, should the outlook for DIS not improve materially, further downside would 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 The Walt Disney 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 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.