March 28, 2017

Uniform Accounting Highlights VRNT’s EPS’ has actually been positive and is growing going forward, contrary to the as-reported results, warranting upside at current valuations


  • VRNT’s traditional EPS is materially distorted by the treatment of R&D and stock options on as-reported accounting statements leading it to appear materially negative for the last 3 quarters
  • UAFRS-based EPS shows earnings have consistently been positive for the last 4 quarters, and have steadily been rising since the Q1 lows, with a forecast for a material jump in Q4, warranting premium valuations
  • VRNT’s UAFRS-based P/E (Fwd V/E’) is too modest compared to peers considering their strong, not negative, earnings and strong projected earnings growth

 

Verint Systems Inc. (VRNT) is expected to release Q4 2017 earnings of $0.30 per share today, on 3/28, representing flat earnings over the same period last year.

Though Q3 earnings had actually been weaker year over year, with EPS on an LTM basis of ($0.32), representing a $0.39 drop from the prior four quarters. Projections for NTM EPS (Q4 2017-Q3 2018) are a robust $0.53, which is an $0.85 improvement over LTM EPS, and a $0.46 improvement over four quarters ended Q3 2016.

As a result of the firm’s inconsistent and periodically negative as-reported earnings, investors may potentially find it difficult to assign a value to this company based on a traditional price-to-earnings (P/E) ratio, leading to muted valuations. However, when the accounting noise is removed, it is apparent that VRNT’s earnings have been consistently positive, and although they have been somewhat volatile as well, this likely merits higher valuations.

After making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that this company can be valued by its adjusted earnings, and that earnings growth should be strong over the next twelve months, supporting a premium to current valuations.

Specifically, under UAFRS, adjusted EPS (EPS’) is expected to grow from $1.41 in the four quarters ended Q3 2017 to $2.03 over the next four.  Also, although earnings did decline in the 12 months through Q3 2017, they didn’t decline by 533% and turn negative, as traditional metrics show, but rather only fell by 40%.  Considering the strong projected 44% growth in EPS’ for the next 4 quarters, and the more stable EPS overall, this is a much stronger company than what investors may perceive.

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The quarterly results show a similar trend. After the decline in EPS’ and EPS in Q1 EPS’ has steadily recovered.  Not only have quarterly EPS’ rebounded quickly on a quarter-over-quarter basis, but on a nominal basis they are also significantly higher, and directionally different, compared to the as-reported results. This trend is projected to continue going forward, at least on a year-over-year basis.

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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 are stronger than the as-reported metrics make them appear to be, and are likely to continue to show strong earnings growth going forward.

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 VRNT, 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 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.

Higher than reported earnings and earnings growth support higher valuations

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.  However, given the fact that the firm currently has significantly stronger, consistently positive EPS’, it is possible to value the firm relative to profitability, and compare these valuations to historical levels for the firm, as well as against comparable peers.

VRNT is currently trading at a 20.0x UAFRS-based P/E (Fwd V/E’), which is slightly above historical averages, but at a low since 2014, likely driven in part by consistent as-reported EPS dips into negative territory. The 20x adjusted P/E’ is well below averages for other mid-cap firms in the application software space.  Of mid-cap application companies in the Valens Research database with positive economic profit, the median valuation relative to Earnings’ is 26.1x, a 30% premium to VRNT’s current valuation, further supporting a bullish thesis on the name.

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 Verint Systems 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.