April 26, 2017

Uniform Accounting highlights NOW’s Adjusted EPS is actually positive, and valuations are fair at worst


  • NOW’s traditional EPS is materially distorted by accounting for R&D and stock option expenses
  • After making the appropriate UAFRS adjustments, EPS’ is actually positive, not negative, and will remain positive for the foreseeable future
  • Given the firm’s positive earnings and strong earnings growth, NOW trades at a 0.96x PEG, suggesting fair value at worst

 

ServiceNow, Inc. (NOW) is expected to release Q1 2017 as-reported earnings of -$0.35 per share on 4/26, representing a material improvement from -$2.06 levels during the same period last year. Full-year EPS expectations are similar, and are for a recovery from -$2.77 last year to -$0.93. Over the last year, the market has reflected uncertainty surrounding the firm’s negative earnings in its share price, with prices falling from $80+ per share at the beginning of 2016 to $50 levels and rebounding, though with significant volatility.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability is not nearly as weak as as-reported EPS suggests. The uncertainty surrounding the firm may be unwarranted, as the firm has had positive profitability historically, as well as growth that would support current valuations.

Specifically, under UAFRS, Adjusted EPS (EPS’) is expected to inflect positively in Q1 2017, from -$0.41 in Q1 2016 to $0.18 in Q1 2017. EPS’ is projected to grow by 100%+ over the full-year 2017, from $0.71 to $1.47. As the chart below highlights, EPS’ is directionally different than as-reported EPS, indicating investors may not realize the strength of NOW’s profitability. Positive, growing EPS’ also implies the firm can be valued on a P/E basis, and the uncertainty surrounding the firm’s valuation that has driven significant volatility is likely unwarranted.

now1-20170426

The quarterly results show a similar trend, with EPS’ remaining positive in each quarter other than Q1 of this past year. Given stronger-than-reported profitability trends, the firm can be valued based on a P/E basis, and at current levels NOW may be cheap.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of R&D and stock option expenses. Once removed, it is apparent that EPS’ has been positive, and will likely continue to grow materially faster than traditional EPS suggests.

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

There are several adjustments required to make earnings representative of a firm’s true cash flows. For NOW, the most material are related to R&D expenses and stock options.

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 improve investors understanding of the operating earnings of a business.

Positive EPS’ suggests the firm can be valued on a P/E basis, and on this basis it may be cheap

Using traditional metrics would suggest the firm cannot be valued based on P/E, as they have a negative as-reported EPS. However, after making the requisite adjustments, it is apparent the firm has positive earnings, and therefore a meaningful P/E.

At current prices, NOW is trading at a 55x UAFRS-based P/E (Fwd V/E’), which is well above corporate averages, but considering the firm’s expected growth is likely warranted. Over the next several years, NOW is projected to grow at nearly 60% annually, suggesting a 0.96x PEG, which implies the firm is fairly valued at worst, or potentially undervalued should they drive greater than expected growth.

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 ServiceNow, 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 Equities and Credit Research Committees, which are responsible for this article. Professor Litman is a recognized global expert in advanced financial statement analysis, corporate performance, and valuation.