June 7, 2017

ADI’s Uniform Adjusted EPS’ is well above traditional EPS, and the recent pullback post-earnings release was therefore unwarranted


  • ADI’s profitability is materially distorted by accounting for R&D
  • As such, their UAFRS EPS’ reached $0.82 in Q2, and $3.85 over the last four quarters, well above traditional EPS of $0.27 in Q2 and $2.66 over the past year
  • After making the appropriate UAFRS adjustments, ADI is trading at a 0.44x PEG ratio, indicating valuations are much too pessimistic

 

Analog Devices, Inc. (ADI) released Q2 2017 earnings on 5/31, beating on the top and bottom line, but after rising that day, shares have since fallen over 5% as investors appear to be taking profits on what initially appears like a less-than-cheap name.  EPS came in at $0.27 for the quarter, and non-GAAP EPS came in at $1.03, beating by $0.19, and revenues beat by $100mn, and shares rallied +3% throughout the day.  However, this has been short-lived, as the firm is trading near all-time highs, and traditional valuations suggest ADI is fairly valued, leading to profit-taking, which has driven shares back to $80 levels.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that earnings are actually far stronger than as-reported EPS suggests, and valuations are not as aggressive, supporting higher prices, and suggesting the recent decline post-5/31 has been unwarranted.

Specifically, under UAFRS, Uniform EPS (EPS’) actually reached $0.82 in Q2 2017, over 3x GAAP EPS, and over the last four quarters has been $3.85, a 45% premium to as-reported EPS of $2.66 in the same timeframe.  This indicates that valuations are not nearly as high as traditional P/E would suggest, and instead of taking profits near perceived highs, investors should consider ADI a value stock with growth that would warrant further upside.

The quarterly results show a similar trend, with EPS’ expected to remain well above as-reported EPS going forward, as it has in each of the past four quarters.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D. Once removed, it is apparent that ADI’s profitability is far greater than it initially appears, and as such shares are far cheaper than investors may believe, suggesting recent declines in share prices were unwarranted.

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 with management’s use of them.

The UAFRS Advisory Council has identified over 130 accounting and financial reporting inconsistencies (some of which can be found here), of which several have material impact on ADI’s financials.

Impact of Adjustments from GAAP to UAFRS

One key UAFRS adjustment has the largest impact on ADI’s income statement, to get from earnings to UAFRS-adjusted earnings. This is related to R&D.

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.

UAFRS-reporting adjusts for this traditional accounting distortion by treating all R&D 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 ADI is likely a value name worth investigating

At current prices, ADI is trading at a 17.6x traditional forward-P/E, which is around corporate averages, suggesting at first glance that the firm may be fairly valued.

However, after making the necessary adjustments, it is apparent ADI is actually trading at a 6.7x UAFRS-based P/E, which is a significant discount to peers, and suggests a firm that may be trading at a deep discount. Specifically, given expected growth rates in EPS’, current valuations drive a PEG ratio of 0.44x, indicating a potential value position, even near all-time high stock prices, and implying the recent pull-back in shares has been unwarranted.

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 Analog Devices, 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.