June 15, 2017

GIS’s Uniform Adjusted EPS’ is not projected to grow, contrary to as-reported EPS projections, and recent underperformance is therefore warranted


  • GIS’s profitability is materially distorted by accounting for long-lived assets and R&D
  • As such, their UAFRS EPS is expected to decline to $0.65 in Q4, not grow, and EPS’ over the next four quarters is expected to fall 1%, not grow 17%
  • After making the appropriate UAFRS adjustments, GIS is not trading at a 17.8x P/E, but a 24.5x UAFRS-based P/E, which is above valuations of many peers

 

General Mills, Inc. (GIS) is expected to release Q4 2017 GAAP EPS of $0.70 on 6/28, which would represent double-digit growth over EPS in the same period last year.  Moreover, full-year estimates are similarly optimistic, and are for EPS to grow by 17% in the next four quarters, from $2.70 in the four-quarter period ended Q3 2017, to $3.14.  That said, shares have remained roughly flat this year, down 4% YTD, and investors are starting to get more bullish, with a number of articles suggesting now is a buying opportunity (one, two, three).

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that earnings growth will not be as strong as traditional metrics suggest, and valuations are more aggressive, suggesting GIS is not a value play, but a potential value trap.

Specifically, under UAFRS, Uniform EPS (EPS’) is actually expected to fall to $0.65 in Q4, a 9% decline from $0.72 in the same period last year, and is expected to fall by 1% in the next four quarters, not grow. EPS’ is expected to fade to $2.93 in the next year, down from $2.95 in the four-quarter period ended Q3 2017 and 7% lower than as-reported EPS.  This indicates that valuations are not nearly as cheap as traditional P/E would suggest, and GIS is therefore trading at a slight premium to peers, not a discount, and further underperformance may be warranted.

The quarterly results show a similar trend, with EPS’ expected to fall below as-reported EPS going forward, a negative signal for shareholders who believe this to be a cheap name.

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 GIS profitability is poorer than it initially appears, and as such, shares are more expensive than investors may believe, suggesting further underperformance may be warranted.

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 GIS’s financials.

Impact of Adjustments from GAAP to UAFRS

Two key UAFRS adjustments have the largest impact on GIS’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to R&D and accounting for long-lived 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 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 GIS’ 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 10+ 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. 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.

Weaker-than-reported EPS’ suggests GIS is more expensive than it initially appears

At current prices, GIS is trading at a 17.8x traditional forward P/E, which is around corporate averages, suggesting at first glance that the firm may be fairly valued, or even cheap considering expected growth in as-reported EPS.

However, after making the necessary adjustments, it is apparent GIS is actually trading at a 24.5x UAFRS-based P/E, which is above peer levels, and suggests a firm that may be trading at a premium when considering expected EPS’ shrinkage. Specifically, when compared to peers in the Packaged Foods space, GIS is trading at a valuation above that of TSN (16.9x UAFRS P/E), CPB (19.6x), K (19.7x), and HRL (23.2x) among others, suggesting the firm may still be overvalued, and when looking at the peers to whom GIS is trading at a discount, most have greater growth prospects (KHC – 12% expected EPS’ growth, MDLZ – 34%, HSY – 13%), indicating that at best GIS is 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 General Mills, 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.