June 5, 2017

SJM’s Uniform Adjusted EPS’ is expected to decline, not grow, and at current valuations, this may have implications for share prices


  • SJM’s profitability is materially distorted by accounting for operating leases and R&D
  • As such, their UAFRS EPS’ is expected to shrink by 7% in the next four quarters, not grow by 10%
  • After making the appropriate UAFRS adjustments, SJM is trading near corporate averages, at a 19.2x Uniform P/E, rather than a 16.4x traditional P/E, indicating it is not cheap, and declining earnings suggest it may be a value trap

 

The J.M. Smucker Company (SJM) is expected to release Q4 2017 GAAP EPS of $1.38 on 6/8, which would represent a material, 14% decline over EPS of $1.61 in the same period last year. Expectations for the next four quarters are slightly more optimistic and are for EPS to grow by 10%, from $5.76 in the four quarters ended Q3 2017 to $6.34 in the next year.  Shares are off of year-lows seen in mid-May, though still below highs seen last August, and given an optimistic full-year outlook, improving share prices, and what appears to be a cheap stock, SJM may initially appear like an interesting potential investment.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that earnings are actually expected to decline next year, not grow, and after making the requisite adjustments, SJM is not cheap, it is actually trading around corporate averages.

Specifically, under UAFRS, Uniform EPS (EPS’) is expected to shrink to $1.89 in Q1, from $2.44 in the same period last year, a 15% decline.  Additionally, EPS’ over the next four quarters is expected to shrink as well, by 7%, to $8.43, which suggests declining fundamentals at SJM that markets may not be pricing in.

The quarterly results show a similar trend, with EPS’ expected to continue recent declines going forward, suggesting potentially concerning fundamental outlook for the firm.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of operating leases and R&D. Once removed, it is apparent that is expected to shrink next year, not grow, and at current valuations, this can have implications for stock prices.

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 a material impact on SJM’s financials.

Impact of Adjustments from GAAP to UAFRS

Two key UAFRS adjustments have the largest impact on SJM’s income statement, to get from earnings to UAFRS-adjusted earnings. These are related to operating leases 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.

Moreover, SJM’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.

UAFRS-reporting adjusts for these traditional accounting distortions by treating all operating leases and R&D as an investing cash flow. These simple reclassifications remove a tremendous amount of accounting noise related to investment activities and improve investors understanding of the operating earnings of a business.

Declining EPS’ suggests SJM is not an interesting potential investment, but instead a potential value trap

At current prices, SJM is trading at a 16.4x traditional forward-P/E, which considering expected double-digit growth, suggests the firm looks undervalued at first glance.

However, after making the necessary adjustments, it is apparent SJM is actually trading at a 19.2x UAFRS-based P/E (V/E’), which is around corporate averages, not cheap.  Moreover, considering expected declines in EPS’ going forward, this suggests the company is likely fairly valued at best, and at worst, is a value trap even with share prices near annual lows.

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 J.M. Smucker Company 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.