June 22, 2017

FDS’s Uniform Adjusted EPS’ is not projected to shrink, contrary to as-reported EPS projections, and recent underperformance is therefore unwarranted


  • FDS’s profitability is materially distorted by accounting for operating leases and stock option expenses
  • As such, their UAFRS EPS’ is expected to grow to $2.02 in Q3 2017, and EPS’ over the next four quarters is expected to grow by 8%, not shrink
  • At current valuations, markets are embedding expectations for annual EPS’ growth of 3%, which is only half of longer-term analyst projections, suggesting further upside is likely warranted

 

FactSet Research Systems Inc. (FDS) is expected to release a Q3 2017 GAAP EPS of $1.74, which would represent 7% growth over its EPS in Q3 2016.  However, full-year estimates are less optimistic, and call for EPS to shrink by 15% in the next four quarters, from $8.51 in the four-quarter period ended Q2 2017, to $7.25.  As such, FDS shares have been roughly flat over the past several years, ranging from $140-$180 and currently sitting in the middle of this range, as investors appear to have concerns about valuations and expected growth rates.

 

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that earnings growth will actually be stronger, and that EPS’ will be greater than as-reported metrics suggest.

Specifically, under UAFRS, Uniform EPS (EPS’) is expected to grow to $2.02 in Q3 2017, an 8% improvement from $1.88 in Q3 2016, and is expected to continue to grow by 8% in the next four quarters. EPS’ is expected to reach $8.43 in the next year, up from $7.78 in the four-quarter period ended Q2 2017, and 16% greater than as-reported EPS.  This indicates that valuations are likely fair at worst, not too expensive, and that upside may be warranted going forward.

Their 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 (notwithstanding Q4 2016), and should EPS’ continue to grow at recent rates, this suggests that valuations are not overly aggressive.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases and stock option expenses. Once removed, it is apparent that FDS’s profitability is improving, not declining, and that 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 FDS’s financials.

Impact of Adjustments from GAAP to UAFRS

Two key UAFRS adjustments have the largest impact on FDS’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to operating leases and stock option expenses.

FDS’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.

Meanwhile, stock option expenses are treated as an expense to the company in accounting statements, when they are 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 operating leases as an investing cash flow, and by rebucketing stock options into the firm’s 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’ suggests FDS’s valuations are not too rich

At current prices, FDS is trading at a traditional forward P/E of 22.1x, and a UAFRS-based P/E of 21.8x, which are both around corporate averages, suggesting at first glance that the firm may be expensive given expected EPS declines.

However, considering the fact that EPS’ is actually expected to grow, FDS is likely fairly valued at worst.  At a 21.8x UAFRS-based P/E, markets are embedding expectations for annual EPS’ growth of 3% going forward, which is only half expected longer-term growth rates of 6%. As such, should FDS maintain growth in-line with analyst estimates, further upside would likely 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 FactSet Research Systems 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.