March 21, 2017

Uniform Accounting Highlights Negative Earnings Growth for PVH is a Trend, not an Outlier, Don’t Expect Upside Coming Out Of Earnings


  • As-Reported metrics indicate expected EPS declines are a recent phenomenon, and potentially an outlier, but in reality, UAFRS-adjusted EPS shows earnings power has been declining for a while
  • After the stock decline coming out of Q3, many investors have started to talk about PVH as a value buy, but valuations aren’t as cheap as as-reported metrics show, with P/E actually at 16.9x not 13.5x
  • Although UAFRS-adjusted valuations are at the lower end of levels over the past 5 years, the material decline in earnings growth the past 4 quarters and coming 4 quarters justifies this

 

PVH Corporation (PVH) is expected to release Q4 2017 earnings of $1.22 per share on 3/22 after the market closes. This would represent a decline not only over Q3 2017, but also over the same period last year. However, analysts appear to be perceiving this decline as an anomaly, evidenced by articles coming out this past winter following share price declines saying that now is the time to buy, that the firm is cheap at current valuations. However, this EPS decline is not an anomaly like as-reported metrics imply. They are instead declines indicative of negatively trending profitability that has already been in place for several quarters, which should be a warning sign for investors.

Analysis under Uniform Accounting Financial Reporting Standards (UAFRS) indicates that earnings have actually declined materially on an LTM-basis, and every quarter in 2017 compared with the same period in the prior year. As the charts below highlight, PVH’s UAFRS-based EPS have declined materially over the last four quarters, from $9.88 to $8.08, an 18% decline. In 2018, this is expected to continue, with another 3% decline expected for the four-quarter period ended Q3 2018, highlighting that recent profitability declines are not an irregularity, but instead a trend that warrants discounted valuations.

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PVH is an excellent example of the distortions that arise from GAAP accounting. As the chart above shows, traditional EPS metrics wrongly show a firm that had strong positive growth for the 4 quarters ending Q3 2017 and that will have flat as opposed to still declining earnings in the next 4 quarters. UAFRS-based adjustments highlight that the as-reported profitability trend is not real. In fact, fundamentals have been declining for some time.

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The quarterly results show a similar trend. While as-reported EPS indicates that earnings were strong heading into 2017, and still growing year over year in Q1 2017, in actuality, profitability was already declining on a year-over-year basis by this time.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases, which is common among retail companies. Once removed, it is apparent that real earnings have been steadily declining already, indicating declines expected in the next four quarters are not an anomaly, but instead a bearish trend.

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 PVH, the largest is related to operating lease expenses.

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

UAFRS-reporting adjusts for these traditional accounting distortions by treating all operating lease expenses as an investing cash flow and amortizing the lease asset over the life of the asset. 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.

Given declining Earnings’ trends, this company isn’t cheap; low valuations are warranted

PVH’s as-reported P/E is 13.5x, which makes the company appear very inexpensive, especially considering the company is coming off a year of 21% as-reported earnings growth. Even with flat earnings this year, the company is forecasted to average 11% earnings growth between this year and last.

However, PVH is currently trading at a 16.9x UAFRS-based P/E, 3 “turns” higher than the as-reported metric. This is at the lower end of valuations in the past 5 years, but considering Adjusted EPS is expected to decline over the next four quarters, which is a continuation of declines over the last four quarters, these valuations are warranted, or even somewhat aggressive.

While Adjusted EPS has grown by 16% annually since the Great Recession, year-over-year growth has been negative every quarter in 2017, with projections for this to continue into 2018. Given that Adjusted EPS actually declined over the last twelve months, compared to the twelve-month period prior, expected declines over the next four quarters are a continuation of a trend, and cannot be ignored for valuation purposes, warranting a more muted valuation, not valuations above as-reported levels.

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 PVH Corp. 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.