March 9, 2017

Uniform Accounting Highlights the Drop in Profitability for National Oilwell (NOV) will be Short Lived, Contrary to Market Expectations


  • NOV posted a narrower-than-expected loss on 2/7, driving the stock higher, as analysts applauded the company for improving cost efficiencies
  • Given the market’s pleasure with Q4 results, it is likely that they will continue to be pleased, as UAFRS adjustments indicate that the turnaround will be quicker than as-reported EPS results suggest
  • After making Uniform Accounting adjustments, NOV is trading at valuations consistent with a company that markets expect to see with persisting profitability weakness, and considering their strong historical performance, this is likely too bearish

 

Written by Joel Litman

National Oilwell Varco, Inc. (NOV) reported Q4 earnings on 2/7, with non-GAAP EPS coming in at ($0.15), beating quarterly estimates by $0.14. The market loved these results, as well as the top-line beat, and the stock was up nearly 8% as a result. Analysts were positive on the release, lauding “demonstrable results” in terms of cost cutting efficiency, and rewarding the company for its continued turn-around.

Uniform Accounting (UAFRS) adjustments signal that although the stock saw an 8% jump, there should be further upside ahead, as the turn-around should be even quicker than as-reported EPS numbers would suggest, with profitability inflecting positively as early as Q3 of this upcoming year.

When Uniform Financials are applied, the year-over-year decline that NOV has seen is less severe than it initially appears on an as-reported basis. NOV actually only saw EPS’ (EPS “prime” or Adjusted EPS) fall from $3.53 in 2015 to ($2.28) in 2016, after seeing Q4 EPS’ of ($1.46), not ($1.90) like the firm reported on a non-GAAP basis. This is contrary to as-reported numbers, which show EPS having declined to ($3.83) for the year, erasing profits from the year prior, all due to accounting distortions.

Moreover, in addition to the firm seeing more resilient EPS’ than as-reported, it is likely that the rebound in 2017 will be quicker, and more robust than as-reported EPS projections would suggest. Specifically, EPS’ is likely to inflect positively by Q3, not Q4, and full year 2017 profitability should be positive, indicating NOV only saw negative full-year profitability for one year, in 2016, and should be rewarded for this quick turnaround.

nov1

NOV is an excellent example of the distortions that arise from GAAP accounting. As the chart above shows, traditional EPS metrics show a firm that has had poor profitability, with expectations for EPS to remain negative in the next year. However, UAFRS-based adjustments highlight that profitability actually was robust for the company, and although they had a terrible 2016, EPS’ is expected to inflect positively as early as next year.

nov2

Although EPS, even on a UAFRS basis, was poor in 2016, profitability was not negative in all four quarters like traditional metrics would have investors believe, and instead only inflected negatively in Q2. Furthermore, while as-reported EPS is expected to remain negative until Q4 2017, UAFRS adjustments highlight the firm’s profitability will actually inflect positively as early as Q3. This indicates that the firm, which has had historically strong profitability, is likely to only experience five quarters of negative earnings, versus nearly two years of negative profits, highlighting a firm with a management team capable of a quick turnaround, not a company that will languish over the long-term.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like lease expenses and stock option expenses.

Once removed, it is apparent that real earnings have been more resilient than as-reported earnings, and although EPS’ inflected negatively in Q2 2016, they are expected to rebound by Q3 2017, a much shorter period of negative earnings than as-reported. Moreover, even during Q4 2016, the firm’s worst period of profitability, EPS’ was not nearly as bad as reported, even after adjusting for special items, and lost less in 2016 than they earned in 2015, contrary to as-reported metrics would suggest.

 

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

This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation HERE.

nov3

As the chart above highlights, NOV’s operating lease expense is somewhat 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.

NOV also has somewhat material non-cash stock option expenses. This is 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.

Because NOV materially spends on operating leases, and has somewhat material non-cash stock option expenses, as-reported metrics like EPS can materially understate the firm’s earnings power.

UAFRS-reporting adjusts for these traditional accounting distortions by treating all rent expense as an investing cash flow and amortizing the lease asset over the life of the asset, and rebucketing non-cash 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.

To see the adjustments, and the performance of NOV once these adjustments are made, please click here.

 

Valuations

With earnings projected to remain at levels that are well below the company’s cost-of-capital for the near-term, current valuations for NOV based on Earnings are unreliable. However, in this case it is possible to look at valuations relative to the firm’s asset base to consider what markets are expecting.

The company currently is trading at a 1.6x multiple relative to the company’s UAFRS adjusted asset base (V/A’ or Uniform Adjusted Enterprise Value / Assets). Generally, companies trade at a multiple to their adjusted assets that is consistent with the company’s earnings power relative to its cost of capital. If a company is expected to earn its required rate of return (or earn its cost of capital) the company will trade at its book asset value, or a V/A’ of 1x. If earnings are expected to be 2x its required rate of return, the V/A’ will rise to 2x, or more if the company is growing.

Considering current valuations at just a 1.6x V/A’, the market is pricing in expectations for muted profitability to persist. However, NOV has historically generated earnings 2x-4x the cost of capital, warranting historical valuations upwards of a 2.0x V/A’. Should the firm rebound quickly, as UAFRS-metrics suggest, then these expectations are too low, and equity upside may be justified as the firm again sees earnings inflect positively.

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 National Oilwell Varco, 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.