March 23, 2017

Uniform Accounting Highlights Negative Momentum for VFC Earnings Going Forward, but Valuations Don’t Reflect This


  • As-Reported metrics indicate lower-than expected 2016 EPS, with projections for stronger 2017 Earnings
  • The market reacted well to strong 2017 expectations, but UAFRS adjustments indicate this bullish sentiment is unwarranted
  • In reality, true operating earnings have been flat, and should decline in 2017, contrary to expectations for 15%+ growth
  • Additionally, after making Uniform Accounting adjustments, VFC is trading near historically high valuations, unwarranted considering expectations for declining earnings

 

VF Corporation (VFC) reported Q4 2016 earnings last month, on 2/17, with non-GAAP EPS coming in at $0.97, in line with quarterly estimates.  This represents only a $0.02 improvement over Q4 2015 results. Meanwhile, on a GAAP basis, the company missed expectations by $0.33, recording EPS of $0.63 compared to estimates of $0.96.

As-reported metrics show a decline in earnings in 2016, and expectations for a rebound in GAAP earnings in FY 2017, which has driven the stock up 8% over the past month. However, analysis under Uniform Accounting Financial Reporting Standards (UAFRS) indicates that earnings were actually largely flat from 2015 to 2016, and are expected to decline in 2017.  As the charts below highlight, VFC’s UAFRS-based EPS grew only slightly in 2016, from $3.32 to $3.39, a 2% growth rate.  In 2017, the trends are expected to reverse, with UAFRS EPS (EPS’) projected to fall slightly to $3.30, a 3% reduction, contrary to expectations for as-reported EPS to grow by a significant 17%, to $2.99. UAFRS metrics clearly show that recent bullish market sentiment is not justified, and equity downside may be warranted.

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VFC is an excellent example of the distortions that arise from GAAP accounting. As the chart above shows, traditional EPS metrics show a firm with somewhat volatile profitability, and with expectations for EPS to inflect positively in the next year.  However, UAFRS-based adjustments highlight that profitability has been fairly stable for the company, and although they had a stronger-than-reported 2016, EPS’ is expected to inflect negatively next year.

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The quarterly results show a similar trend. While as-reported EPS indicates that earnings are expected to degrade by just $0.10 in Q1 2017, UAFRS-based adjustments highlight that EPS’ should be $0.41 lower in the next quarter.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases and excess cash, which are common among retail companies. Once removed, it is apparent that real earnings have been less volatile than as-reported EPS would suggest historically, and are likely to begin fading going forward, supporting a more bearish outlook in the long-term.

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 VFC, the largest is related to operating leases.

VFC’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 VFC 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.

Even though Earnings’ are going to decline, valuations are still above long-term averages

VFC is currently trading at a 17.3x UAFRS-based P/E, which is near historical highs for the firm. At these levels, the market is pricing in expectations for profitability to remain flat, near all-time highs, or even continue improving. However, an analysis of the firm’s annual EPS’ for the last decade reveals that earnings growth has plateaued over the last several years.

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While EPS’ grew by an annual 8% over the last decade, since 2012, annual EPS’ growth has slowed to just 3%. Furthermore, over the last three years, the firm has experienced 1% annual EPS shrinkage, indicating that UAFRS-based projections for 3% EPS shrinkage in Q1 2017 appear justified, and current valuations may be far too aggressive, justifying potential equity downside going forward.

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 V.F. 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.