March 24, 2017

Uniform Accounting Highlights DRI EPS’ growth is likely to subside in Q3 and going forward, no longer supporting above-average valuations


  • After making UAFRS adjustments, DRI is projected to see EPS drop by $0.02 in Q3 2017 to $1.35, as opposed to a projected as-reported rise by $0.14 for Q3
  • After making UAFRS adjustments, earnings growth for DRI over the next four quarters is projected to slow to near-0% levels, as opposed to 10% growth in traditional EPS
  • Traditional growth rates would support above average valuations, with a UAFRS-based P/E of 20x+, but lacking adjusted EPS growth suggests markets are pricing in a best-case scenario and downside may be warranted
  • DRI’s sizable operating lease expense causes major distortions with as-reported accounting statements that need to be adjusted under UAFRS to identify the company’s earnings power

 

Darden Restaurants, Inc. (DRI) is expected to release Q3 2017 earnings of $1.27 per share on 3/28, representing a 12% growth rate over the same period last year (adjusted for special items).  This would be in-line with growth over the last year, with EPS on an LTM basis of $3.70, or a 13% growth rate over the 4 quarter period ended Q2 2016, and projections for growth over the next four quarters, with NTM EPS projections of $4.07 representing a 10% growth rate.  However, DRI actually is not going to grow earnings that fast, when the accounting noise is removed DRI is going to have negative earnings growth in Q3.  That is offset by the fact that DRI profitability is actually greater than as-reported metrics would suggest, but without earnings growth, the equity is getting expensive.

Analysis under Uniform Accounting Financial Reporting Standards (UAFRS) indicates that adjusted EPS (EPS’) is expected to actually remain roughly flat over the next year, with shrinkage on a year-over-year basis in the final two quarters of 2017.  Specifically, in Q3 DRI is projected to have EPS’ drop from $1.39 last year to $1.35 this year, contrary to the projected rise in as-reported metrics.

As the charts below highlight, DRI’s EPS’ have not grown quite as quickly as traditional EPS suggests, from $3.99 in the four quarters ended Q2 2016 to $4.36 in the last four quarters, a 10% growth rate, with expectations for just 0.36% growth over the next four quarters through Q2 2018, which would not be robust enough to support above-average valuations.

dri1-20170324

DRI is a good example of the distortions that arise from GAAP accounting. As the chart above shows, traditional EPS metrics show a firm that is expected to sustain double-digit growth next year.  However, UAFRS-based adjustments highlight that profitability growth is likely to drop off somewhat materially instead.

dri2-20170324

As mentioned above, the quarterly results show a similar trend. While as-reported EPS indicates that earnings are likely to increase markedly in Q3 2017, in actuality, profitability is likely to actually decline year-over-year.  This divergent trend includes in Q4 2017.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases and stock option expenses. Once removed, it is apparent that real earnings growth, while robust, may not support currently expensive 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 DRI, the most important are related to operating leases.

DRI’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 DRI materially spends on operating leases, as-reported metrics like EPS can materially understate the firm’s earnings power.

UAFRS-reporting adjusts for these traditional accounting distortions by treating all operating leases as an investing cash flow. 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.

Reduced profitability growth signals valuations may be too rich

DRI is currently trading at a 20.4x UAFRS-based P/E, which is above corporate averages, and although at recent lows, above historically average levels for the firm.  These valuations would be justified if DRI was going to grow earnings 5-10%+ as suggested by as-reported metrics; however, considering EPS’ growth is expected to halt over the upcoming year once accounting distortions are removed, the market may already be pricing in a best-case scenario for the firm.

Even should EPS’ growth rebound quickly to historical levels, at current valuations the market is likely already pricing this scenario in, limiting equity upside.  More worrisome, if EPS’ growth is stagnant over the long-term, material equity downside may 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 Darden Restaurants, 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 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.