August 29, 2017

SMTC’s Uniform Adjusted EPS’ is greater than as-reported earnings suggest, and projected to grow materially, implying valuations may be too cheap


  • SMTC’s profitability is materially distorted by accounting for R&D and stock option expense
  • As such, their UAFRS EPS’ is expected to be $0.43 in Q2 2018 and $1.85 in the next year, not $0.25 and $1.09, respectively, as GAAP accounting metrics report
  • At current valuations, markets are embedding expectations for 9% EPS’ growth annually, which is substantially lower than analyst projections for +30% annual EPS’ growth, warranting material equity upside should the firm meet estimates

 

Semtech Corporation (SMTC) is projected to release Q2 2018 GAAP EPS of $0.25 on 8/30, which would represent 79% growth from EPS of $0.14 in the same period last year. Additionally, full-year estimates are bullish, with projections for EPS of $1.09 in the next four quarters, representing 22% growth from $0.90 in the four-quarter period ended Q1 2018. Despite this bullish outlook, shares have fallen almost 10% from their 52 week high, as investors have become cautious in the face of valuations near all-time highs.

 

However, after making the appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that profitability is greater than traditional EPS implies, and is projected to continue to grow materially going forward.

Specifically, under UAFRS, Uniform EPS (EPS’) is actually projected to be $0.43 in Q2, an 87% increase from $0.23 in the same period last year, and is also projected to grow by 82% in the next four quarters, following similar 65% growth in the four-quarter period ended Q1 2018. EPS’ is projected to expand to $1.85 in the next year, from $1.01 in the last year, almost 70% higher than GAAP EPS. This suggests that valuations may be less expensive than they seem at first glance, and SMTC may actually be undervalued.

The quarterly results show a similar trend, with EPS’ expected to remain positive, and well above as-reported EPS going forward, as it has in three of the prior four quarters. As such, should EPS’ continue to grow as it is expected to, this suggests valuations may actually be cheap.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D and stock option expense. Once removed, it is apparent that SMTC’s profitability is greater, and therefore valuations are cheaper, than as-reported metrics suggest.

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 SMTC’s financials.

Impact of Adjustments from GAAP to UAFRS

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

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’s 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.

Additionally, SMTC has had material non-cash stock option expense since the company was founded. This is 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 investing cash flows and re-bucketing stock option expense into enterprise value. 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’ and expectations for growth suggest valuations may be too cheap

At current prices, SMTC at a UAFRS-based P/E of 20.5x, which is around corporate averages, and is likely too cheap considering the firm’s material growth prospects.

At these valuations, markets are embedding expectations for annual EPS’ growth of 9%, which is markedly lower than long-term analyst estimates for +30% annual EPS’ growth. As such, should SMTC simply maintain growth in-line with analyst estimates, material equity upside would be warranted.

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 Semtech 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.