May 3, 2017

Uniform Accounting highlights ZG’s Adjusted EPS is expected to grow far faster than as-reported EPS, warranting continued upside


  • ZG’s traditional EPS is materially distorted by accounting for R&D and stock option expenses
  • After making the appropriate UAFRS adjustments, EPS’ is actually positive, expected to reach $0.18 in Q1, not -$0.09
  • Given the firm’s positive earnings, and consistent, strong growth, they are likely trading at a discount to fair value

 

Zillow Group, Inc. (ZG) is expected to release Q1 2017 as-reported earnings of -$0.09 per share on 5/4, representing a material improvement over -$0.27 levels generated during the same period last year. Full-year expectations are similar, and are for EPS improvements from -$1.22 in 2016 to -$0.13, though this does indicate longer-term projections are for EPS to remain negative.  As such, share prices have been volatile, and ZG still trades below peaks seen last summer, as markets are struggling to value a firm with negative earnings.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability at ZG is actually positive, and growing at a rate that may warrant further upside.

Specifically, not only has ZG actually generated positive earnings in each year since 2011.  Its EPS growth has been significant, contrary to what traditional EPS would have you believe in 2013, 2014, 2015, and in this past year.  Under UAFRS, Adjusted EPS (EPS’) is expected to grow by 64% in Q1 2017, from $0.11 in Q1 2016 to $0.18.  Additionally, EPS’ is expected to grow by 12% over the full-year 2017, from $0.95 to $1.06. As the chart below highlights, EPS’ is already materially greater (and directionally different) than as-reported EPS, and expected to sustain recent growth trends, indicating investors may not realize how strong ZG’s profitability really is.

zg1-20170503

The quarterly results show a similar trend, with EPS’ remaining positive in each quarter over this past year.  Given stronger-than-reported profitability trends, the firm can be valued based on a P/E basis, and at current levels, ZG appears to be cheap.

zg2-20170503

UAFRS, Uniform Adjusted Financial Reporting Standards, call for the removal of distortions from issues like the treatment of R&D and stock option expenses. Once removed, it is apparent that EPS’ is likely to grow quickly, and is already much stronger than as-reported EPS, suggesting the company can be valued on a P/E basis, and in this scenario, is potentially too cheap.

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 ZG, the most material is related to R&D expenses and stock options.

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 the 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 a 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 rebucketing stock option expenses into the enterprise value of the firm. These simple reclassifications remove a tremendous amount of accounting noise related to investment activities and improve investors understanding of the operating earnings of a business.

Positive EPS’ and sustained growth suggest ZG is fairly valued at worst and is likely undervalued should they drive expected profitability improvements

At current prices, ZG is not trading at an 80.3x forward P/E, like as-reported metrics suggest.  Instead, after making the requisite adjustments, the firm is trading at a 32.2x UAFRS-based P/E (Fwd V/E’), implying much more realistic valuations and market expectations.

At these levels, ZG is trading near internet service peers such as TWTR, LOGM, and Tencent, and at a material discount to application/service peers such as ANGI, RP, and DFNN, suggesting Zillow is fairly valued at worst, and more likely, further upside is 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 Zillow Group, 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 Research Committee, which is responsible for this article. Professor Litman is regarded globally for his expertise in financial statement analysis, fundamental research, and particularly Uniform Accounting, UAFRS.