June 1, 2017

COO’s Uniform Adjusted EPS’ is not growing as fast as traditional metrics suggest, and at current valuations that may be reason for concern


  • COO’s profitability is materially distorted by accounting for R&D and long-lived assets
  • As such, their UAFRS EPS’ is expected to only grow by 12% this year, not 38%
  • After making the appropriate UAFRS adjustments, COO is trading at a 26.1x Uniform P/E, which implies a PEG ratio of 2.75x, indicating longer-term underperformance may be justified

 

Cooper Companies, Inc. (COO) is expected to release Q2 2017 GAAP EPS of $1.95 today (6/1) after the markets close, which would represent material, 28% growth over EPS of $1.52 in the same period last year. Expectations for the next four quarters are similarly optimistic and are for EPS to grow by 38%, from $6.07 in the four quarters ended Q1 2017 to $8.39 in the next four.  As markets have become more optimistic, shares have rebounded off of lows seen in early 2016, well past previous historical highs, with investors continuing to pour into what appears to be a cheap, growing company.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that growth is actually decelerating, and given higher-than-average valuations, continued upside is unwarranted, and downside may be likely as the market realizes COO’s weaker outlook.

Specifically, under UAFRS, Uniform EPS (EPS’) is expected to grow by just 11% in Q2, from $2.06 in the same period last year, to $2.28.  Additionally, EPS’ over the next four quarters is expected to grow by just 12%, to $9.77, which while strong does not support current valuations that are pricing in a much more positive growth outlook.

The quarterly results show a similar trend, with EPS’ growth beginning to falter, which may not support currently above-average valuations.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D and long-lived assets. Once removed, it is apparent that EPS’ is actually not growing as fast as traditional EPS, and this indicates valuations may be overly aggressive.

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

Two key UAFRS adjustments have the largest impact to COO’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to R&D, and adjusting for the true depreciation of the firm’s assets.

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, given the long-lived nature of COO’s assets, the true maintenance capex costs related to their assets is much higher than depreciation, which is reflective of the cost of those assets when the company bought them, which happened 5+ years ago for many of these assets.   As such, nominal asset values should be restated into constant-currency values to improve the reliability of business performance metrics, and the related depreciation (maintenance capex) expense should then be calculated off of the value of the Adjusted Asset base.

UAFRS-reporting adjusts for these traditional accounting distortions by estimating the age of assets and using a GDP deflator to adjust the asset value and associated depreciation expense into the values reflective of what replacement cost would be in the current year being measured, and 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.

Weaker growth in EPS’ suggests COO is trading at an unwarranted premium, warranting downside

After the recent run in share prices, COO is trading at a 26.1x UAFRS-based P/E (V/E’), which suggests market expectations for material growth. Specifically, considering longer-term EPS’ growth expectations, COO is trading at a 2.75x PEG ratio, which implies should COO not materially exceed current analyst projections for profitability growth, longer-term underperformance 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 Cooper Companies, 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.