August 15, 2017

CRM’s Uniform Adjusted EPS’ is substantially greater than as-reported earnings suggest, and expected to continue growing, implying it is not as overvalued as it may initially appear


  • CRM’s profitability is materially distorted by accounting for R&D and stock option expenses
  • As such, their UAFRS EPS’ is expected to be $0.43 in Q2, and EPS’ over the next four quarters is expected to be $1.96, not near-$0 like as reported EPS suggests
  • At current valuations, markets are embedding expectations for 26% EPS’ growth annually, which is only slightly higher than analyst projections for growth, implying shares may be fairly valued, not a short play

 

salesforce.com (CRM) is expected to release Q2 2018 GAAP EPS of $0.01 on 8/22, which would represent a 96% decline relative to EPS of $0.33 in the same period last year. Moreover, full-year estimates are somewhat bearish, with projections for EPS to decline by 13% in the next four quarters, from $0.19 in the four-quarter period ended Q1 2018, to $0.16. After a material rise in share prices in early 2017, this bearish outlook, combined with what appear to be significantly bullish valuations, has led to a stall in share gains, and some investors believing this may now be an interesting short opportunity.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that although earnings growth has stagnated recently, profitability is far higher than traditional EPS implies, and is expected to grow in the coming quarters.

Specifically, under UAFRS, Uniform EPS (EPS’) is actually expected to be $0.43 in Q2, a mere 10% decline from $0.48 in the same period last year. Moreover, EPS’ is expected to grow by 15% in the next four quarters, following 14% growth last year. EPS’ is expected to reach $1.96 in the next year, up from $1.71 in the four-quarter period ended Q1 2018, and more than 10x greater than as-reported EPS. This suggests that valuations may not be as expensive as they initially appear.

The quarterly results show a similar trend, with EPS’ expected to remain above as-reported EPS going forward, as it has in each of the last four quarters, and, should EPS’ continue to grow as it is expected to, this suggests CRM is not a compelling short idea.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D and stock option expense. Once removed, it is apparent that CRM’s profitability is far greater than as-reported metrics suggest, indicating that the firm is not nearly as expensive as as-reported metrics would suggest, which can have material implications for shares at current valuations.

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.

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 CRM’s financials.

Impact of Adjustments from GAAP to UAFRS

Two key UAFRS adjustments have the largest impact on CRM’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to R&D and stock option expense.

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 it’s 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.

Additionally, CRM has had material non-cash stock option expense since the company was founded. 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.

UAFRS-reporting adjusts for these traditional accounting distortions by treating all R&D as investing cash flows and re-bucketing stock option expense into enterprise value. These simple reclassifications remove 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’ and expectations for growth suggest shares may be fairly valued

At current prices, CRM is trading at a 63.4x traditional P/E, suggesting a firm that may be overvalued unless they can continue to drive robust earnings growth. However, after making the requisite adjustments, it is apparent that the firm is actually trading at less aggressive valuations, with a UAFRS-based P/E of 46.9x, which, while still high, is on par with other high growth stocks.

When considering the fact that EPS’ is expected to continue to grow, high valuations may be warranted. At a 46.9x UAFRS-based P/E, markets are embedding expectations for annual EPS’ growth of 26%, which is not too removed from analysts’ projections for 15% growth next year. As such, should CRM drive any unexpected improvements in profitability, equity would likely be fairly valued.

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 Salesforce.com, 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.