April 11, 2017

Uniform Accounting Highlights HNI is likely to see declines in UAFRS EPS’ going forward, but is trading at a premium to peers with a better outlook


  • HNI’s traditional EPS is materially distorted by their accounting for operating leases and R&D
  • After making appropriate UAFRS adjustments, it is apparent that while EPS’ is greater than as-reported EPS, EPS’ is expected to decline next year, not grow significantly like as-reported metrics suggest
  • HNI is also trading at a premium to other furnishing peers with greater growth prospects, indicating the markets have yet to recognize the firm’s poor outlook, and equity underperformance is likely warranted

 

HNI Corporation (HNI) is expected to release Q1 2017 as-reported earnings of $0.17 per share on 4/19, representing a significant decline from $0.26 levels during the same period last year. However, full-year EPS expectations are much more aggressive, and are for a significant acceleration in as-reported EPS growth in the back half of the year, driving overall growth of 50%, from $1.88 last year to $2.81.  Although this growth would largely be a result of a rebound in EPS after a weak 2016, when EPS fell from $2.32 in 2015, shares are up significantly from trough levels in early 2016, indicating market optimism for the firm is again improving.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability has been flat for the last several years, and is expected to decline in 2017.

Specifically, under UAFRS, while Adjusted EPS (EPS’) has been greater than as-reported EPS, with full year EPS’ expected to reach $3.08, this actually reflects shrinking profitability, from EPS’ levels of $3.16 last year.  As the charts below highlight, while the firm already generated EPS’ north of $3 in this past year, it is expected to see declines in earning power, which would warrant a less positive outlook for the firm. Given that current valuations are pricing in expectations for stability in earnings, should the firm fail to avoid expected declines, equity downside may be warranted.

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The quarterly results show a similar trend, with EPS’ in excess of traditional EPS in each quarter, but declining materially quarter over quarter.  Given expected declines in EPS’, current valuations imply an overly positive outlook, indicating the firm is likely fairly valued at best.

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UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases and R&D. Once removed, it is apparent that the market may not be pricing in expected declines in the firm’s true profitability.

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 HNI, 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, HNI’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 HNI materially spends on operating leases, as-reported metrics like EPS may not accurately reflect the firm’s earnings power.

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 EPS’ suggests valuations are too optimistic

Following the recent run in share prices, HNI’s UAFRS-based P/E has reached 18.0x, or roughly corporate averages, implying a market outlook for at least stable EPS going forward.  At these levels, the firm is trading at a premium to other commercial/industrial firms such as Herman Miller, as well as other large retail furnishing stores such as La-Z-Boy and Select Comfort, all of which have better growth prospects than HNI.

Considering the premium at which HNI is trading over firms with better growth prospects, current valuations may be too aggressive. As such, multiple compression and equity downside may be warranted as the market realizes weakness in the firm’s growth outlook.

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 HNI 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.