Uniform Accounting Highlights The Seeds Of Much Weaker Earnings Growth Than Markets Perceive At MON, And Bayer May Regret When They Reap Them

• MON’s traditional EPS is materially distorted by the age of their assets, and the resultant depreciation charges
• After making the appropriate UAFRS adjustments, EPS’ was significantly lower than as-reported EPS last year
• Adjusted EPS growth has also been poorer than as-reported EPS growth, and is projected to continue to be weaker going forward, limiting adjusted EPS upside
• Materially weaker EPS’ at muted growth rates indicates the firm is very expensively valued currently, and Bayer may have overpaid for the acquisition

 

Monsanto Company (MON) is expected to release Q2 2017 earnings of $2.66 per share on 4/5, representing a 10% growth rate over the same period last year, a continuation of improvements on a year over year basis since Q4 2016.  During this timeframe, the company’s share price has rebounded from late-2015 lows, back toward highs last seen in late-2014 on the back of Bayer’s bid for the company, highlighting Bayer and investor’s optimism surrounding the name.

Although on an LTM basis, EPS has been roughly flat compared to last year (ended Q1 2016), coming in at $3.66 compared to $3.70, it is projected to accelerate over the next four quarters and reach $4.32 during the period ended Q1 2018, representing 18% growth and driving improved investor sentiment.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), that earnings wasn’t flat year over year, the projected growth in Q2 and the next four quarters is just a rebound after a weak four quarters ended Q1 2017, and profitability is still weaker than as-reported EPS suggests.

Specifically, under UAFRS, Adjusted EPS (EPS’) fell 25% over the past four quarters, materially in excess of as-reported earnings shrinkage of 1%, and is only expected to rebound 10% over the next four quarters.  As the charts below highlight, this is significant, as EPS’ is now well below traditional EPS, indicating investors may not realize the significance of weakness in current profitability at MON.  The firm’s EPS’ is expected to only reach $3.43 next year, up from $3.11 for the four quarters ended Q1 2017, but still down from $4.19 in the four quarters ended Q1 2016, and over 20% lower than as-reported EPS. Given the firm’s somewhat aggressive valuations relative to earnings that Bayer is offering to pay for the company, it is likely that Bayer and the market are failing to recognize the firm’s faltering profitability.

The quarterly results show a similar trend, with EPS’ significantly lower than as-reported EPS in each of the last four quarters, with expectations for further weakness. Given that these trends are likely to continue into the foreseeable future, valuations may be too strong at current levels.

UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like the treatment of excessively aged, or relatively long-lived assets. Once removed, it is apparent that EPS’ has been weaker, and will likely continue to be weaker 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 MON, the most material is related to adjusting for true depreciation of the firm’s assets.

MON has not actively invested in its business over the last several years, leading to its asset base aging somewhat considerably since 2010.  Generally, companies with older assets tend to have lower cash flows than they would have otherwise, once they have to spend more on maintenance capex.  MON has been milking their asset base, allowing assets to depreciate until they approach fully depreciated levels on their balance sheet.  Once assets are fully depreciated, but continue to be used, the depreciation expense associated with those assets disappear and as-reported net income will appear improved as the company has the same earnings power, but no depreciation expense on the assets generating that revenue.  This continues to be true until management does spend on maintenance capex.  Since MON has been milking their asset base, their depreciation expense, a proxy for maintenance capex, is being understated currently.

Moreover, given the long-lived nature of MON 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 almost 10 years ago for many of MON’s 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 Adjusted Asset base.

UAFRS-reporting adjusts for these traditional accounting distortions by estimating the age of assets and using a GDP deflator to adjust the asset value and associated depreciation expense into the values reflective of what replacement cost would be in the current year being measured. This calculation removes a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings of a business.

Weaker than reported earnings and muted growth don’t support current valuations

MON is currently trading at a 24.9x UAFRS-based P/E (Fwd V/E’), which is near peaks since 2010.  Considering recent declines in EPS’, and only modest expectations for a rebound, longer-term EPS’ growth expectations of 5%-10% imply a PEG ratio is around 2.5x-5.0x, indicating Bayer has truly paid a premium for a firm with declining fundamentals.

As costs associated with replacing aging assets creep up, the market will gain a clearer view into the firm’s earnings power, however unfortunately this may be Bayer’s problem to reap, even though it was sown before the company was acquired.

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.

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