August 24, 2017

UFS’ Uniform Adjusted EPS’ is substantially lower than as-reported earnings suggest, and is expected to continue to decline, implying the firm may be much more expensive than it appears


  • UFS’ profitability is materially distorted by accounting for depreciation expense, as well as pension and OPEB expenses
  • As such, their UAFRS EPS’ was -$0.06 in Q2 and $0.19 in the last year, not $0.61 and $2.62, respectively, as GAAP accounting metrics report
  • At current valuations, markets are embedding expectations for 16% EPS’ growth annually, which is directionally different than adjusted estimates for $0.87 declines in the next four quarters
  • With substantially lower profitability than as-reported metrics suggest, and forecasts for declining earnings when markets expect growth, downside is likely at current valuations

 

Domtar Corporation (UFS) released Q2 2017 earnings on 7/28, beating on the bottom line, but missing on the top line. EPS came in at $0.61 for the quarter, beating by $0.06, while revenues missed by $90mn. While share prices fell by almost 5% in the following days, they have recovered back to pre-announcement levels in recent weeks, as investors have been lured back by a stock that appears fairly cheap relative to corporate averages and peers.

However, after making the appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that profitability is far lower than traditional EPS implies, and is expected to continue to decline going forward.

Specifically, under UAFRS, Uniform EPS (EPS’) actually only reached -$0.06 in Q2, well below GAAP EPS. Additionally, over the last four quarters EPS’ has been just $0.19, over 90% lower than as-reported EPS of $2.62 in the same timeframe.  This indicates that valuations may be much more expensive than they initially appear.

The quarterly results show a similar trend, with EPS’ expected to remain negative, and well below as-reported EPS going forward, and should EPS’ continue to decline as it is expected to, this suggests valuations may be quite expensive.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of depreciation expense, as well as pension and OPEB expenses. Once removed, it is apparent that UFS’ profitability is far lower than as-reported metrics suggest, and declining, which can have material implications for shares at current valuations.

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 UFS’ financials.

Impact of Adjustments from GAAP to UAFRS

Two key UAFRS adjustments have the largest impact on UFS’ income statement, to get from earnings to UAFRS-adjusted earnings. These are related to depreciation expense, as well as pension and OPEB expenses.

Given the long-lived nature of UFS’ 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 over 20 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 Uniform Asset base.

UAFRS adjusts for these traditional accounting distortions by estimating the age of assets and adjusting the asset value and associated depreciation expense to values reflective of what replacement cost would be in the year being measured. This simple adjustment removes a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings, and investment obligations, of a business.

The second key Uniform Accounting adjustment relates to the treatment of pension and OPEB costs. While this is generally viewed as a singular group of charges on the income statement, there are actually two significant different parts of these charges, one that is related to operating the business, and one that is certainly not.

A portion of the pension and OPEB cost is pension servicing costs.  These costs are operating costs for the business, representing the cost of the company funding current employees post-retirement benefits, a benefit they accumulate as they earn a salary each month.  As this is a real operating obligation of the company, a cost they are incurring each month, this is left in adjusted earnings, it is not “added back” to remove the expense.

However, the second portion of the pension and OPEB expense is what is termed pension and OPEB interest expense.  This represents the net increase in unfunded liabilities in a firm’s post-retirement benefit plans during a given reporting period. Essentially, this means that if a pension plan is expected to grow its assets by 10% during the year, but instead returns just 5%, the difference is recorded as pension interest expense. However, this expense is not an actual cash outlay, and more importantly, it is not an operating expense, it has to do with how the firm chose to go about financing their pension liability.   Because this is simply an actuarial adjustment as opposed to an operating expense, it is not included as an expense in the company’s Uniform Earnings.

To remove this complexity from the company’s income statement, UAFRS adds back all the company’s pension and OPEB expenses to earnings, and then, just the service costs that are related to the company’s operations are deducted to get to adjusted earnings, removing the accounting noise from understanding the company’s operating profitability.

Lower-than-reported EPS’ and expectations for further declines suggest valuations are much more expensive than as-reported metrics reflect

At current prices, UFS is trading at a 16.5x traditional forward P/E, which at first glance may indicate a fairly valued, or even cheap firm.  However, after making the requisite adjustments, it is apparent that the firm is actually trading at a UAFRS-based P/E of 90.1x, which is well above both corporate and peer averages.

Specifically, when considering the fact that EPS’ is expected to decline considerably going forward, valuations are much more expensive than they appear. At a 90.1x UAFRS-based P/E, markets are embedding expectations for annual EPS’ growth of 16%, which is directionally different than analysts’ estimates for a decline of $0.87 in the next four quarter. Moreover, UAFRS-adjusted analyst EPS estimates are projected to remain negative for the foreseeable future. As such, UFS is unlikely to meet markets expectations for continued growth, increasing downside risk.

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 Domtar 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.