May 22, 2017

HEICO’s Uniform Adjusted EPS’ stronger than as reported, implying it is not as expensive as it initially appears


  • HEI’s profitability is materially distorted by accounting for R&D under GAAP
  • As such, their UAFRS EPS’ is expected to reach $2.88 over the next four quarters, far higher than as-reported EPS of $2.06
  • After making the appropriate UAFRS adjustments, HEI is trading at a 24.5x Uniform P/E, which is far more reasonable than as-reported P/E of 35.9x, suggesting it is not as overvalued as investors may believe

 

HEICO Corporation (HEI) is expected to release Q2 2017 EPS of $0.50 on May 24th, which would represent double-digit growth over EPS of $0.45 in the same period last year. Expectations for the next four quarters are similarly optimistic, and are for 6% growth in EPS, from $1.94 over the last twelve months to $2.06 in the next year. As the market has remained optimistic on the firm’s growth outlook, shares have continued upward, with HEI up over 15% YTD. That said, on an as-reported basis, the firm is beginning to look expensive, driving some investors to grow more cautious, sparking a downgrade at Zacks and Stephens’ recently lowered price target.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that while profitability is likely to remain flat, this is because EPS is already materially stronger than as-reported, implying valuations are actually lower than reported, and near fair value.

Specifically, under UAFRS, while Uniform EPS (EPS’) is expected to remain flat in Q2 2017, at $0.70, this represents a 40% premium to as-reported EPS. Moreover, while full-year EPS’ is expected to stay at $2.88, this is also a significant, 40% premium to as-reported EPS. Considering EPS’ that is well above as-reported EPS, valuations are much more manageable at current levels, justifying recent share gains, and suggesting recent downgrades may have been unwarranted.

The quarterly results show a similar trend, with EPS’ consistently above as-reported EPS, suggesting valuations are not as aggressive as they appear at first glance.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for the removal of distortions from issues like the treatment of R&D. Once removed, it is apparent that EPS’ is actually far greater than as-reported, suggesting the firm is less expensive than investors may realize, and that recent downgrades were unwarranted.

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 HEI, the most material is related to adjusting for R&D expenses.

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 is hard to think of R&D along the same line 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 a company’s real profitability.

UAFRS-reporting adjusts for this traditional accounting distortion by treating all R&D as an investing cash flow. 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.

Greater-than-reported EPS’ suggests HEI is cheaper than it initially appears

After the recent run, HEI is trading at a 35.9x as-reported forward P/E, suggesting the firm is getting overheated, leading to investors becoming more cautious on the name. However, after making the requisite adjustments, it is apparent that HEI is actually trading at a lower valuation, supporting recent upside, and suggesting downgrades were unwarranted.

Specifically, the firm is actually trading at a 24.5x UAFRS-based P/E (P/E’), which is only slightly above corporate averages. Given expected long-term EPS’ growth following this year, this is likely warranted, and should the firm meet growth expectations, the firm is likely not overvalued as investors may believe.

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 HEICO Corporation 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.