April 10, 2017

Uniform Accounting Highlights URI generates far greater EPS’ than as-reported EPS, and this supports current valuations even after a 200% rise in share prices


  • URI’s traditional EPS is materially distorted by their accounting for operating leases
  • After making the appropriate UAFRS adjustments, although EPS’ growth is weaker than as-reported EPS growth, this is because EPS’ is already materially higher
  • After a 200%+ share price run in the last year, investors may be wary of URI however, significantly stronger EPS’ supports current valuations, and potentially further upside should the firm drive additional growth

 

United Rentals (URI) is expected to release Q1 2017 as-reported earnings of $1.38 per share on 4/19, representing significant growth from $1.01 levels during the same period last year. Additionally, full-year EPS expectations are similarly aggressive, and are for as-reported EPS growth of 33%, from $6.49 last year to $8.66.  As the outlook for the firm has improved over the last year, the firm’s share price has rebounded significantly, from sub-$50 levels last year to +$120 levels now, leading to some investors believing the stock is now overheated.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability was just as strong last year, and has been stronger than as-reported metrics suggest, supporting a more bullish outlook even after the 200% increase in share price over the last year.

Specifically, under UAFRS, while Adjusted EPS (EPS’) growth is expected to be more muted, with full year growth only expected to reach 3% levels, and quarterly growth at only 5%, EPS’ is already materially stronger than as-reported EPS.  As the charts below highlight, the firm already generated EPS’ north of $10 in this past year, and is expected to do so again this year, implying valuations relative to earnings may not be as aggressive as as-reported metrics imply. As such, even after URI share prices have rebounded well past previous highs, this has been warranted, and there is the potential for further upside going forward.

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The quarterly results show a similar trend, with EPS’ in excess of traditional EPS in each quarter.  Given greater than as-reported earnings, traditional P/E ratios may be overstating the firm’s valuations, making it appear to be a less attractive investment than it may be in reality.

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UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases. Once removed, it is apparent that EPS’ has been well in excess of as-reported EPS, and this has implications for the stock at current valuations.

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 URI, the most material is related to the operating leases.

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

UAFRS-reporting adjusts for this traditional accounting distortion by treating all operating leases as an investing cash flow. 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.

Greater-than-reported EPS suggests valuations are not too aggressive at current levels

Given the recent run in share prices, investors may be wary of URI, believing it to be overvalued. However, after making adjustments to EPS’, it is apparent that the declines going into 2016 may have been unwarranted, and the resultant rebound was justified.  At current prices, the company is trading at a 17.5x UAFRS-based P/E, which is around average for the firm, and below current corporate averages.  Should the firm see EPS’ remain roughly flat going forward, it is likely fairly valued at worst, and should the firm drive any further growth at current valuations, additional upside may be warranted.

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 United Rentals, Inc. 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.