March 24, 2017

Uniform Accounting Highlights Tencent’s EPS’ is greater than as-reported EPS, and growing at a significant rate, warranting upside at current valuations


  • EPS’, after making the appropriate UAFRS adjustments, has been significantly greater than as-reported EPS historically at ¥5.67 for 2016 vs traditional EPS of ¥4.33
  • EPS’ growth has also been greater than as-reported EPS growth at 54% in 2016 vs traditional 41% EPS growth
  • Materially stronger EPS’ at strong growth rates indicates valuations that look warranted on an as-reported basis, are actually too cheap, and upside may be warranted, with a reasonable 26.4x UAFRS-based P/E and 0.8x UAFRS-based PEG ratio
  • Tencent’s traditional EPS is materially distorted by the treatment of R&D and stock options on the as-reported accounting statements

 

Tencent Holdings Limited (SEHK:700) released Q4 2016 earnings of ¥1.11 per share on 3/22, representing a 46% growth rate over the same period last year (adjusted for special items). This was slightly greater than overall growth over the last year, with EPS on an LTM basis of ¥4.33, or a 41% growth rate over 2015 EPS, and projections for growth over the next four quarters, with NTM EPS projections of ¥5.70 representing a 32% growth rate.

Moreover, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that not only are these growth rates a result of actual economic improvements (versus management of earnings), but adjusted EPS (EPS’) is significantly higher than as-reported financials suggest, supporting higher valuations.

Specifically, under UAFRS, adjusted EPS (EPS’) has grown at a 54% rate in 2016, materially higher than as-reported growth of 41%, and is expected to grow in-line with traditional EPS growth rates of 32% in 2017. As the charts below highlight, EPS’ is already well in excess of traditional EPS, indicating investors may not realize the true earnings power Tencent currently generates. Tencent’s EPS’ is expected to reach ¥7.47 next year, up from ¥5.67 in 2016 and ¥3.68 in 2015, all of which are over 20% greater than as-reported EPS for the same periods. Given the firm’s relatively modest valuations relative to as-reported EPS, it is likely that the firm’s true EPS’ would support an even greater premium.

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The quarterly results show a similar trend, as not only have quarterly EPS’ grown at a greater rate than traditional EPS on a year-over-year basis, but they are also significantly higher (20%+ greater) already. Given that these trends are likely to continue into the foreseeable future, valuations may be discounted at current levels.

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UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D investments and stock option expenses. Once removed, it is apparent that real earnings growth would likely support even greater valuations should it sustain.

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 Tencent, the most important are related to R&D and stock option expenses.

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 as an investing cash flow and re-bucketing 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.

Higher than reported earnings and earnings growth support higher valuations

Tencent is currently trading at a 26.3x UAFRS-based P/E, which is around historical averages, and a nearly 20% discount to as-reported P/E levels of 32.4x. As-reported growth and valuations imply a PEG ratio around 1.0x, which would suggest the firm is trading near fair value, absent any material changes to Tencent’s growth outlook.

However, given the fact that the firm currently has significantly stronger EPS’ than as-reported, expected growth rates that are in-line with traditional growth rates at worst, and valuations are lower, its PEG ratio is closer to 0.80x-0.85x indicating that even if the firm only sustain growth at reduced levels seen in 2017, it appears to be an undervalued name.

Moreover, should EPS’ growth rebound levels seen in just this past year, its PEG would be closer to 0.50x, indicating a significantly undervalued name, potentially warranting material upside.

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 Tencent Holdings 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.