May 23, 2017

TTWO’s Uniform Adjusted EPS’ is far greater than reported, implying valuations are not as expensive as they initially appear


  • TTWO’s profitability is materially distorted by accounting for R&D and stock option expenses under GAAP
  • As such, their UAFRS EPS’ is expected to grow to $4.43 this year, a 4x improvement, and well above $3.27 as-reported EPS levels
  • After making the appropriate UAFRS adjustments, TTWO is trading at a 13.0x Uniform P/E, which suggests a 0.62x PEG ratio, implying the firm remains undervalued, even after the run in share prices over the last year

 

Take-Two (TTWO) is expected to release Q4 2017 GAAP EPS of $1.57 today after the bell, which would represent a material, 3x improvement over EPS in the same period last year. Expectations for the next four quarters are similarly optimistic, and are for EPS to inflect positively, rising from -$0.05 in the four quarters ended Q3 2017 to $3.27 in the four quarters ended Q3 2018.  As markets have become optimistic about the firm’s ability to drive positive profitability, shares have skyrocketed, up 40% YTD, and over 90% since the same time last year.  Following this significant rally, it would appear at first glance that TTWO is overheated, and is due for a material pullback.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that profitability is actually greater than as-reported, growing more quickly, and valuations are less aggressive, suggesting there are fundamentals to support a continued run in share prices.

Specifically, under UAFRS, Uniform EPS (EPS’) is expected to grow by over 4x from already-positive levels in the next four quarters.  TTWO is expected to see EPS’ rise from $1.08 in the last four quarters to $4.43, well above projected $3.27 as-reported EPS levels.  This continues a trend of EPS’ holding above as-reported EPS that was seen in the 4-quarter period ended Q3 2016, when EPS’ was only at -$2.12, not -$3.82.  Given EPS’ that is well above as-reported, valuations are also much less aggressive than as-reported P/E suggests, implying further upside continues to be warranted.

The quarterly results show a similar trend, with EPS’ consistently stronger than traditional EPS 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 R&D and stock options. Once removed, it is apparent that EPS’ is actually far greater than as-reported, and growing at rates that support recent share gains.

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 TTWO’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. 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.

Strong EPS’ suggests further upside might be warranted at current valuations

After the recent run in share prices, TTWO is trading at a 32.2x traditional forward P/E, suggesting it may be approaching overvalued territory.  However, after making the requisite adjustments, it is apparent that the firm is actually trading at a 13.0x UAFRS-based P/E, well below corporate averages.

At this level, considering longer-term expectations for EPS’ growth, TTWO is trading at a 0.62x PEG ratio, implying that even after a 90% rise in shares, the fundamentals of the firm support further upside.

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 Take-Two Interactive Software, 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.