May 26, 2017

FL’s Uniform Adjusted EPS’ has not been growing, and the drop last week is just the market recognizing what was already apparent


  • FL’s profitability is materially distorted by accounting for operating leases under GAAP
  • As such, their UAFRS EPS’ only grew 9% last year, and is expected to remain roughly flat this upcoming year
  • After making the appropriate UAFRS adjustments, FL is trading at a 15.0x Uniform P/E post-drop, which is a discount to averages, but FL is only expected to grow EPS’ by 0%-1% annually, suggesting these valuations are warranted

 

Foot Locker (FL) released Q1 2018 EPS of $1.36 last Friday (5/19), which fell below estimates, and this – combined with a top-line miss and weaker than expected guidance – drove shares down over 15% during the day.  Immediately following this drop, some more bullish investors have come out suggesting this represents a buying opportunity, particularly considering FL’s strong EPS growth coming into this year.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that EPS growth is actually weaker than as-reported, and valuations are more aggressive, implying the drop was justified, and now the firm is likely fairly valued, not a cheap name.

Specifically, under UAFRS, Uniform EPS (EPS’) fell by 3% in Q1, from $1.69 in Q1 2017 to $1.64. Moreover, growth in the last four quarters was just 9%, from $5.58 in the four quarters ended Q1 2017 to $6.06, well below as-reported EPS growth of 24%. Slower-than-reported growth is expected to continue going forward and considering greater-than-reported valuations relative to earnings, this suggests FL is actually now fairly valued at best, not a cheap value name.

The quarterly results show a similar trend, with EPS’ not strong enough to support valuations seen before the drop on Friday.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases. Once removed, it is apparent that EPS’ is not growing materially, and even after the post-earnings drop, FL is fairly valued.

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

There are several adjustments required to make earnings representative of a firm’s true cash flows. For FL, the most important are related to operating leases.

FL’s operating lease expense is 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. Because FL materially spends on operating leases, as-reported metrics like EPS can materially understate the firm’s earnings power.

UAFRS-reporting adjusts for this traditional accounting distortion by treating all operating lease expenses as investing cash flows. 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.

Flat EPS’ suggests FL’s lower valuation is likely warranted

After making the requisite adjustments, it is apparent that although FL’s valuation compressed Friday, it is likely fairly valued now, not cheap.  Specifically, after the drop, FL’s UAFRS-based P/E (Fwd V/E’) fell from 17.5x to 15.0x, which when considering expected longer-term EPS’ growth expectations of sub -1% is likely justified, as although this now falls below corporate averages, growth is also well below average.

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 Foot Locker, 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.