April 17, 2017

Uniform Accounting Highlights QCOM will see declining EPS’ going forward, meaning it’s not a value name, but potentially a value trap


  • QCOM’s traditional EPS is materially distorted by their accounting for R&D and stock option expenses
  • After making the appropriate UAFRS adjustments, it is apparent that while EPS’ is greater than as-reported EPS, EPS’ is expected to decline next year, not grow significantly like as-reported metrics suggest
  • Given declines in EPS’ expectation in the next four quarters, QCOM equity may not be as attractive a value opportunity as valuations would initially suggest

 

QUALCOMM Incorporated (QCOM) is expected to release Q2 2017 as-reported earnings of $0.95 per share on 4/19, representing significant growth from $0.78 levels during the same period last year. Full-year EPS expectations are similarly bullish, and are for a continuation of a strong 8% as-reported EPS growth seen over the past year, with expectations for overall growth of 16% in the next four quarters, from $3.28 last year to $3.81 in the four-quarter period ended Q1 2018. However, during this same period, QCOM shares have fallen to near-five-year lows, suggesting a potentially interesting value opportunity for investors considering the firm’s potential earnings growth.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that although profitability has improved for the last several years, it is expected to decline in the next twelve months, warranting more muted valuations.

Specifically, under UAFRS, while Adjusted EPS (EPS’) has been greater than as-reported EPS, with NTM EPS’ expected to reach $4.35, this actually reflects shrinking profitability, from EPS’ levels of $4.55 last year. As the charts below highlight, while the firm already generated EPS’ well above $4.00 in this past year, it is expected to see declines in earnings power, which would warrant a less positive outlook for the firm. Although valuations are currently inexpensive, given these declines in EPS’, it is likely that this is warranted, and there is limited potential upside for the name.

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The quarterly results show a similar trend, with EPS’ in excess of traditional EPS in each quarter, but declining lately. Given expected declines in EPS’, QCOM equity may not be as attractive as it initially appears at current valuations.

qcom2-20170417

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D and stock option expense. Once removed, it is apparent that the firm’s equity is likely fairly valued, contrary to a more bullish value thesis as-reported metrics suggest.

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 QCOM, the most material are related to R&D and stock option expense.

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 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.

Meanwhile, stock option expenses are treated as an expense to the company in accounting statements, when it is actually a way for the company to give employees an ownership stake in the company. As such, this non-cash expense should be treated as dilution to equity holders and another claim against the Enterprise Value of the firm, as opposed to it being treated as an annual expense. This is especially true as, unless the company uses cash to buy shares (to suppress dilution for equity holders from the option grants being exercised), there is no cash impact on the company.

UAFRS-reporting adjusts for these traditional accounting distortions by treating all R&D expenses as investing cash flows, and by rebucketing stock option expenses into the enterprise value of the firm. 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.

Declining EPS’ suggests QCOM should not be a value pick

QCOM currently trades at a UAFRS-based P/E of 12.0x, which is near historical averages, and cheap compared to US corporate averages. At these levels, paired with projected as-reported EPS growth of 16%, QCOM’s 0.75x PEG looks attractive, and the firm may initially appear undervalued.

However, UAFRS reveals currently muted valuations are warranted, as the firm’s EPS’ is projected to decline over the next twelve months, suggesting weakness in the firm’s fundamental outlook. Furthermore, the potential for continued antitrust lawsuits further erodes the undervalued narrative.

Considering QCOM’s negative forward-looking growth profile and high possibility of event risk, current valuations are not as attractive as they may initially appear. As such, the firm is likely fairly valued at best, and a value trap at worst.

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 QUALCOMM Incorporated 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.