June 6, 2017

RHT’s Uniform Adjusted EPS’ is expected to remain well above traditional EPS, suggesting investors may believe incorrectly that the stock is expensive


  • RHT’s profitability is materially distorted by accounting for stock options and R&D
  • As such, their UAFRS EPS’ is expected to reach $3.17 in 2018, nearly double projected as-reported EPS of $1.64
  • After making the appropriate UAFRS adjustments, RHT is trading near peer averages, at a 29.6x Uniform P/E, below average valuations of US-based Systems Software companies, suggesting the firm is likely fairly valued at worst

 

Red Hat, Inc. (RHT) is expected to release Q1 2018 GAAP EPS of $0.29 on 6/20, which would represent a material, 13% decline from EPS of $0.33 in the same period last year. However, expectations for the next four quarters are more optimistic, and are for EPS to grow by 18%, from $1.39 in fiscal 2017, to $1.64 next year.  Shares have rebounded materially after falling in late-December, up nearly 30% as analysts have grown more optimistic surrounding the firm’s full-year outlook.  After this run, shares are trading near highs not seen since the internet bubble, and given weak expected growth in Q1 2018, this is likely to give investors pause, especially considering high as-reported valuations.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that earnings are actually far stronger than as-reported EPS suggests, and valuations are not as aggressive, supporting the recent price run and implying RHT is not likely overvalued.

Specifically, under UAFRS, Uniform EPS (EPS’) is expected to remain flat at $0.65 in Q1 2018, and grow by 15% in fiscal 2018, to $3.17.  At these levels, this suggests as-reported EPS understates RHT’s real earnings by nearly half, and as such valuations are also overstated.  Given strong expected EPS’ growth, and EPS’ that is well above as-reported EPS, valuations are likely not overvalued, and instead warranted.

The quarterly results show a similar trend, with EPS’ expected to remain well above as-reported EPS going forward, as it has in each of the past four quarters.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of stock option expenses and R&D. Once removed, it is apparent that RHT profitability is far greater than it initially appears, and as such shares are not as expensive as investors may believe.

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 RHT’s financials.

Impact of Adjustments from GAAP to UAFRS

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

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, stock option expenses are treated as an expense to the company in accounting statements, when it is 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 R&D as an investing cash flow and rebucketing stock option expenses into the enterprise value of the firm. 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 RHT is not overvalued, but instead is likely fairly valued

At current prices, RHT is trading at a 34.8x traditional forward P/E, which indicates RHT is significantly more expensive than the average US company.

However, after making the necessary adjustments, it is apparent RHT is actually trading at a 29.6x UAFRS-based P/E, which is around peer averages, and when considering expected growth rates in EPS’, suggests RHT is fairly valued at current prices. Specifically, the average UAFRS-based P/E of the 10 US-based non-RHT companies in our database with a Market Cap of +$2.5bn is 37.0x, with SYMC (70.14x) and NOW (60.90x) both trading at multiples over double that of RHT, suggesting further room for upside should RHT drive greater growth 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 Red Hat, 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.