April 6, 2017

Uniform Accounting Highlights HOG’s Adjusted EPS Growth is Limited, And Valuations Relative to Earnings Are Not As Inexpensive As They First Appear


  • HOG’s traditional EPS is materially distorted by the age of their assets, and the resultant depreciation charges
  • After making the appropriate UAFRS adjustments, EPS’ is significantly lower than as-reported EPS last year, and will continued to be lower going forward
  • At current valuations, markets are pricing in expectations for growth prospects that are likely unrealistic, indicating the potential for pressure on multiples

 

Harley-Davidson, Inc. (HOG) is expected to release Q1 2017 as-reported earnings of $0.98 per share later this month, representing significant shrinkage from $1.36 levels during the same period last year. Full-year EPS expectations are not significantly better, and are for shrinkage from $3.81 last year to $3.77.  However, the markets have ignored these declines, and HOG has rallied over 20% over the last year, and up 30%+ since the beginning of 2016, as the company continues to look somewhat cheap on an as-reported basis, trading at a 15.7x forward P/E.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability is actually weaker, and thus, valuations are more aggressive, supporting longer-term underperformance should the company fail to drive significant earnings growth.

Specifically, under UAFRS, Adjusted EPS (EPS’) fell over the past four quarters, as opposed to as-reported EPS growth of 5%, and is expected to remain muted going forward.  As the charts below highlight, this is significant, as EPS’ is now well below traditional EPS, indicating investors may not realize the significance of weakness in current profitability at HOG.  The firm’s EPS’ is expected to only reach $3.55 next year, flat compared to the $3.54 EPS’ in 2026, but still down from $3.59 in 2015, and 6% lower than as-reported EPS. Given the firm’s somewhat aggressive valuations relative to earnings, it is likely that the market are failing to recognize the firm’s faltering profitability.

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The quarterly results show a similar trend, with EPS’ remaining well below traditional EPS in each quarter.  Given weaker-than-reported profitability trends, valuations may not be as cheap as a 15x P/E indicate, and investors may not realize the scope of weakness in HOG profitability.

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

HOG has not actively invested in its business over the last several years, leading to its asset base aging somewhat considerably over the last several years.  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.  HOG has been milking their asset base, allowing assets to depreciate until they approach fully depreciated levels on their balance sheet.  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 in reality, no depreciation expense are recorded on the assets generating that revenue.  This continues to be true until management does spend on maintenance capex.  Since HOG 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 HOG 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 HOG’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

Using traditional metrics would suggest the firm is still undervalued even after the recent stock price run; however, this is contrary to the earnings trend of the firm. Once accounting distortions are removed, it is apparent that HOG is not trading at below-average valuations with a 15x P/E, but instead is closer to a 19x UAFRS-adjusted P/E (Fwd V/E’), which is above corporate averages, indicating the firm needs to have material growth prospects to warrant further upside. However, recent growth trends and expectations for flat growth in EPS’ in 2017 indicate this is not the case.

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 Harley-Davidson, 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.