June 2, 2017

KR’s Uniform Adjusted EPS’ is not as strong as traditional metrics suggest, and as such, valuations are more expensive than investors may realize


  • KR’s profitability is materially distorted by accounting for operating leases and long-lived assets
  • As such, their UAFRS EPS’ is expected to remain below as-reported EPS, reaching only $2.05 in 2017
  • After making the appropriate UAFRS adjustments, KR is trading at an 23.7x Uniform P/E, which implies a PEG ratio of 2.0x+, indicating longer-term underperformance may be justified

 

The Kroger Co. (KR) is expected to release Q1 2017 GAAP EPS of $0.58 on 6/15, which would represent material, 19% declines over EPS of $0.72 in the same period last year. Expectations for the next four quarters are slightly more optimistic, and are for EPS to grow by 6%, from $2.06 in fiscal 2016, to $2.18 next year.  Although analysts have a more optimistic full-year outlook, uncertainty surrounding quarterly earnings has led to material declines in KR shares since the beginning of the year. With the stock down over 10% since January 1st, at first glance this would indicate a potential buying opportunity given current as-reported valuations.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that earnings are actually below levels suggested by as-reported metrics, and valuations are at above-average levels, suggesting KR is fairly valued at best, not a value pick.

Specifically, under UAFRS, Uniform EPS (EPS’) is expected to shrink to $0.54 in Q1, from $0.65 in the same period last year, a 16% decline.  Additionally, although EPS’ over the next four quarters is expected to grow by 11%, to $2.05, this remains below as-reported EPS expectations, and does not support currently above-average valuations.

The quarterly results show a similar trend, with EPS’ falling below its traditional counterpart in each of the last four quarters, with expectations for this to continue going forward.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases and long-lived assets. Once removed, it is apparent that EPS’ is far weaker than as-reported EPS, and valuations are thus more expensive.

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

Two key UAFRS adjustments have the largest impact to KR’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to operating leases and adjusting for the true depreciation of the firm’s assets.

KR’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, given the long-lived nature of KR’s 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 8+ 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 operating leases 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 KR is fairly valued at best, not a value pick

After the recent decline in share prices, KR is trading at a 13.5x traditional Forward P/E, which suggests a name that may be undervalued given expected growth rates. However, after making the requisite adjustments it is apparent KR is actually trading at a 23.7x UAFRS-based P/E, which is above market averages.

At these levels, and considering expected long-term growth rates, KR is trading at a 2.0x+ PEG ratio, indicating the name remains fairly valued at best, and more likely overvalued, warranting further downside going forward.

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 The Kroger Co. 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.