April 21, 2017

Uniform Accounting highlights that MRCY’s Adjusted EPS is stronger, and accelerating faster than as-reported EPS, supporting current valuations


  • MRCY’s traditional EPS is materially distorted by the accounting for R&D
  • After making the appropriate UAFRS adjustments, EPS’ growth is expected to be robust, at 27% over the next year, and EPS’ is already well above levels as-reported metrics would suggest
  • At current valuations, the firm is not trading at a 2x-5x PEG, but instead a 1.1x PEG ratio, implying the firm is likely fairly valued, not well overpriced

 

Mercury Systems (MRCY) is expected to release Q3 2017 as-reported earnings of $0.16 per share on 4/25, representing 18% growth from $0.13 levels during the same period last year. However, full-year EPS expectations are less aggressive, and are for only 8% growth year-over-year, from $0.58 over the last four quarters to $0.62 in the period ended Q2 2018.  Based on traditional valuations, it would appear that MRCY may be too expensive considering muted expected growth in as-reported EPS, especially after the 45% run in shares since the election.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability has actually been much stronger than as-reported metrics suggest, this will continue over the next four quarters, supporting more aggressive valuations.

Specifically, under UAFRS, Adjusted EPS (EPS’) is expected to grow by 74% in Q3, to $0.30, and by 27% in the next four quarters, from $0.97 in the past year to $1.24 in the period ended Q2 2018.  Moreover, this is following strong growth over the year ended Q2 2016, when EPS’ grew 49%, indicating investors may not realize how quickly MRCY profitability is improving.  After making the appropriate adjustments, the below chart highlights that MRCY not only has greater earnings than as-reported metrics suggest, but EPS’ growth is also accelerating much more quickly, and this supports aggressive valuations, indicating the firm is likely not as expensive as it first appears.

mrcy1-20170421

The quarterly results show a similar trend, with continued strength in EPS’ that is not expected to change soon.  As a result of greater-than-reported profitability, and greater growth, the firm is not overly expensive at current valuations, and instead is likely fairly valued.

mrcy2-20170421

UAFRS, Uniform Adjusted Financial Reporting Standards, call for the removal of distortions from issues like the treatment of R&D. Once removed, it is apparent that not only is EPS’ significantly greater than as-reported EPS, growth will also be far greater than traditional EPS suggests going forward.

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 MRCY, the most material is related to R&D.

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 the 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.

UAFRS-reporting adjusts for this traditional accounting distortion by treating all R&D as an investing cash flow. These simple reclassifications remove a tremendous amount of accounting noise related to investment activities and improve investors understanding of the operating earnings of a business.

Strong, accelerating EPS’ suggests that current valuations are not too aggressive

After the recent run in share prices, MRCY is currently trading at an as-reported P/E (Fwd V/E’) of 34.4x, and a UAFRS Adjusted P/E (Fwd V/E’) of 36.0x.  These prices may give investors pause, considering as-reported EPS growth that would not support such aggressive valuations.

However, considering strong expected EPS’ growth in the next several quarters, and 30%+ annual growth in EPS’ expected over the next three years MCRY is only trading at a 1.1x PEG ratio, which indicates that the firm isn’t overly expensive, and instead is near fair value.

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 Mercury Systems, 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.