March 29, 2017

Uniform Accounting Highlights LNN’s EPS’ is accelerating out of cycle lows, supporting higher valuations, and running contrary to current popular short theses


  • Short-sellers are focusing on LNN, with multiples north of 33x on an as-reported basis not supported by weak, volatile as-reported EPS. However, after making adjustments according to UAFRS, it is apparent that premium valuations are warranted
  • More than simply rebounding from weak levels over the last four quarters, EPS’ has been growing and is likely to continue alongside accelerating growth trends
  • Expected EPS’ growth is north of 40% over the next year, supporting higher than average valuations as the firm drives EPS’ out of cycle-lows

 

Lindsay Corporation (LNN) is expected to release Q2 2017 earnings of $0.38 per share on 3/30, representing a significant improvement over negative EPS in the same period in 2016, and an over 4x improvement over Q1 2017 EPS.  Significant growth expectations also extend over the next four quarter period, with expectations for EPS in the 12-month period ended Q1 2018 to grow by 75%+, over an EPS of $1.33 over the last year. That said, investors appear to have written this growth off, considering it a rebound from significant (40%) declines over the period ended Q1 2016, with short interest at nearly 25% of outstanding shares as the shorts focus on currently expensive as-reported valuations.

However, after adjusting for accounting noise, it is apparent that although Adjusted EPS (EPS’) growth will likely be lower than as-reported growth in the next four months, earnings are already much higher than as reported metrics show, and not merely a rebound from low levels but a continuation of prior growth, describing a trend that may support current prices.

Analysis under Uniform Accounting Financial Reporting Standards (UAFRS) indicates that adjusted EPS (EPS’) are expected to grow by 45% over the next year, from $1.92 to $2.77, after growing from $1.80 levels in the four quarters prior.  As the charts below highlight, LNN’s EPS’ will not grow quite as quickly as traditional EPS suggests, but this is because EPS’ is already stronger than as-reported EPS, and isn’t rebounding from lows, but is instead seeing accelerating growth out of cycle lows.

lnn1-20170329

Below, quarterly results show a similar trend, with EPS’ significantly greater than as-reported EPS in every period over the last year and expected to continue into the next quarter and beyond.

lnn2-20170329

UAFRS, Uniform Adjusted Financial Reporting Standards, calls for the removal of distortions from issues like the treatment of R&D expenses. Once removed, it is apparent that real earnings growth may 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 LNN, the most important adjustments are related to R&D expenses.

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 it is hard to think of R&D on the same line 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 a company’s real profitability.

UAFRS-reporting adjusts for this traditional accounting distortion by treating all R&D 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.

Greater-than-reported improvements in profitability signal valuations are warranted

LNN is currently trading at a 31.5x UAFRS-based P/E (V/E’), which is above corporate averages, and at the higher end of valuations for the firm historically. The firm is similarly trading at a 33.7x as-reported P/E, potentially giving investors pause, as at these levels, they may believe valuations are too aggressive.  Supporting this are a number of recent Seeking Alpha articles such as “Still not seeing a bull thesis for Lindsay”, and “The short interest in Lindsay remains at an elevated level – are the shorters right?” highlighting the hesitation investors have in getting into this name.

However, while the stock may not be cheap, with growth beginning to accelerate out of cycle lows, a 30x V/E’ is likely not unwarranted, contrary to current short theses.  As such, although this is not an aggressively discounted company, it is also far from a solid short idea based on earnings and current valuations.

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. The comparability of a company’s earnings over time, trends in its corporate profitability and comparability in earnings power, and earnings growth across close competitors and different sectors all become far more relevant and reliable.

To find out more about Lindsay 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.