April 5, 2017

Uniform Accounting Highlights FRED’s Adjusted EPS will rebound quickly, contrary to market expectations at discounted valuations


  • FRED’s traditional EPS is materially distorted by GAAP treatment of operating leases
  • After making the appropriate UAFRS adjustments, earnings were actually positive in the four quarters ended Q3 2016, not negative, and although EPS’ was negative in the last four quarters, it is expected to rebound to positive levels far more quickly than as-reported EPS
  • While current valuations offer a floor to equity prices, the successful integration of RAD stores could push earnings further into positive territory, which could lead to equity upside

 

Fred’s Inc. (FRED) is expected to release Q4 2017 earnings of -$0.17 per share on 4/6, representing a continued decline in EPS, from -$0.11 levels during the same period last year, and a continuation of losses seen during the last two-quarters. This weakness is expected to continue going forward, with expectations for EPS of -$0.37 over the next four quarters driving suppressed valuations and increased pessimism surrounding the firm’s outlook.  Specifically, optimism related to the firm’s purchase of Rite Aid stores is fading quickly, and share prices have fallen from $20+ levels post-announcement back to recent $12-13 levels.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that markets should likely be significantly less pessimistic surrounding recent weakness in earnings.

Specifically, under UAFRS, while Adjusted EPS (EPS’) fell to negative levels over the past year, to -$0.43, this drop was less severe than as-reported levels show, and the inflection is expected to be short-lived.  As the charts below highlight, after falling to negative territory in the last four quarters, EPS’ is expected to inflect back to $0.43 over the next four quarters.  Given the fact that the firm is trading at a discount to its operating asset base, it is apparent that the markets are placing a greater discount on FRED than is warranted largely due to continued negative as-reported earnings.  However, as EPS’ will bounce back positively as soon as this year, and the company’s asset base will only be bolstered by the aforementioned store purchase, equity upside may be warranted going forward.

fred1-20170405

The quarterly results show a similar trend, with EPS’ not inflecting negatively until Q3 2017, as opposed to Q2, and with more aggressive expectations for a rebound in Q4 than as-reported earnings suggest.  As firms generally only trade at a discount to operating assets when they are facing credit issues, or sustained negative profitability, upside for FRED would be warranted if EPS’ rebounds as quickly as predicted.

fred2-20170405

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases. Once removed, it is apparent that EPS’ has been stronger than as-reported EPS, and will rebound quickly from negative levels, supporting upside at currently discounted 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 FRED, the most important are related to operating leases.

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

UAFRS-reporting adjusts for this traditional accounting distortion by capitalizing operating leases. This material adjustment removes a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings of a business.

Discounted valuations unwarranted should Earnings’ rebound quickly

FRED is currently trading at a 0.9x UAFRS-based P/B (V/A’), which is low since 2013 and indicates significant market pessimism.  When a company generates earnings near-zero or in negative territory, it is impossible to value the firm on profitability, and instead investors will often value the company against its book value. Often, when valuations relative to operating assets (UAFRS-based P/B) falls below 1.0x, it is an indication of market expectations for either credit issues or sustained weakness in profitability.

FRED has limited credit risk, with its nearest-term debt coming due in 2020, and with EPS’ expected to rebound to positive levels in the next year, markets may be overly pessimistic.  Should the firm struggle to integrate acquired stores effectively, the worst case is already priced in, limiting equity downside.  Moreover, should FRED succeed in rebranding and integrating the stores acquired from RAD, equity upside could be significant.

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 Fred’s, 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.