April 17, 2017

Uniform Accounting Highlights SLB’s EPS’ has remained positive, and is greater than as-reported EPS, suggesting valuations are not as expensive as they initially appear


  • SLB’s traditional EPS is materially distorted by the treatment of R&D and operating leases under GAAP and IFRS
  • UAFRS-based EPS shows that while earnings growth will be slightly more muted than as-reported metrics, this is because EPS’ is already much stronger, and less volatile
  • SLB’s UAFRS-based P/E  of 32.6x is much lower than P/E of 44.4x on an as-reported basis, and considering expected EPS’ growth rates, this suggests the firm may still be cheap

 

Schlumberger Limited (SLB) is expected to release Q1 2017 earnings of $0.27 per share on 4/21, representing significant 32% shrinkage from the same period last year, but a positive when compared to deeply negative full-year results.

In 2016, the firm saw earnings crater from relatively strong levels the year before, in the wake of sustained weakness in oil prices, with EPS of -$1.18, representing a $2.79 decrease from FY 2015. However, the firm is projected to see a material rebound in profitability, not just in Q1, but throughout the next year.  Full-year projections for 2017 EPS are a robust $1.74 currently, which is massive $2.92 improvement over 2016 EPS, and a $0.13 improvement over 2015. That said, over this time-frame, SLB stock prices have remained relatively muted, and are still down 20% from peaks seen in 2014, indicating continued market pessimism related to volatile, negative earnings, and concerns about aggressive valuations.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that earnings have not been as volatile of late, and although SLB’s earnings will not surpass 2015 levels, they are also greater than investors may realize.

Specifically, under UAFRS, adjusted EPS (EPS’) is expected to grow from $0.66 in FY 2016 to $2.37 in FY 2017.  Also, although earnings did decline in during FY 2016, they didn’t turn negative, as traditional metrics imply, but rather fell by 80% and remained in positive territory. Although EPS’ is not expected to surpass 2015 levels next year, it will likely remain well above traditional EPS, and given that the firm has been able to sustain positive profitability, valuations may be pricing in expectations that are too bearish.

slb1-20170417

The quarterly results show a similar trend. After the decline in EPS’ in Q2, it quickly rebounded to positive territory, and while having remained largely flat for the past several quarters, has remained well above traditional EPS metrics. This is projected to continue going forward, supporting current valuations, and potential upside should the firm sustain EPS’ growth.

slb2-20170417

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D investments and operating leases. Once removed, it is apparent that real earnings are less volatile, and greater, than as-reported metrics would imply, supporting current valuations, and even upside should growth persist.

UAFRS EPS 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 SLB, the most important are related to R&D and operating leases.

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.

Moreover, SLB’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 SLB 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 R&D and operating lease expenses as investing cash flows. These simple reclassifications remove a tremendous amount of accounting noise related to investment activities and improves investors’ understanding of the operating earnings of a business.

Less robust UAFRS earnings growth suggest current valuations are too rich

Using as-reported metrics for earnings and earnings growth, it would be challenging to accurately value the company due to negative earnings in recent quarters, and given materially weaker EPS relative to Adjusted EPS’, even on a forward basis the firm looks incredibly expensive.  The firm is currently trading at an expensive 44.4x forward P/E (as-reported), which may worry investors who do not believe the recovery in earnings will be quick.

However, after making the requisite UAFRS adjustments, it is apparent that SLB is not as expensive as as-reported metrics suggest, and is currently trading at a 32.6x UAFRS-based P/E. Considering EPS’ growth is expected to sustain 40%-50% levels over the next several years as the firm sees recovery from trough levels, this indicates a 0.6x-0.8x PEG ratio, implying the firm is fairly valued at worst, and even cheap at current levels, supporting further equity upside 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 Schlumberger Limited 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.