May 30, 2017

VMW’s Uniform Adjusted EPS’ is greater than reported, implying the firm is cheap, even after the material rebound in share prices


  • VMW’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 $4.97 this year, 60% higher than as-reported EPS of $3.10
  • After making the appropriate UAFRS adjustments, VMW is trading at an 18.8x Uniform P/E, which is a material discount to 20 of the 25 US-based Systems Software companies in our database, and only a premium compared to companies with far worse growth prospects

 

VMware, Inc. (VMW) is expected to release Q1 2017 GAAP EPS of $0.53 on 6/1, which would represent material, 38% growth over EPS of $0.38 in the same period last year. Expectations for the next four quarters are similarly optimistic, and are for EPS to grow by 10%, from $2.81 in 2016, to $3.10. As markets have become more optimistic, shares have rebounded of off lows seen in early 2016, back toward previous historical highs. Any time a company approaches historical highs, with valuations at or above corporate averages, it can give investors pause, and the recent run, combined with valuations, could indicate a firm that is now fairly valued.

However, after making appropriate adjustments under Uniform Adjusted Financial Reporting Standards (UAFRS), it is apparent that profitability is actually greater than as-reported, and valuations are thus still at a discount to corporate averages, and as a result, further upside is likely warranted.

Specifically, under UAFRS, Uniform EPS (EPS’) is expected to remain at $0.95 levels in Q1, an 80% premium to as-reported EPS. Additionally, EPS’ over the next four quarters is expected to reach $4.97, 60% greater than expectations for as-reported EPS, and 2% greater than EPS’ in 2016. Given greater-than-reported EPS’, valuations are not at corporate averages, but instead VMW trades at a discount to all but a select few peers, and as such, continued upside is likely 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, suggesting the firm is much cheaper than peers, and potentially undervalued.

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 VMW’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. 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.

Strong EPS’ suggests VMW is trading at a discount to peers, potentially warranting further upside

After the recent rebound in share prices, VMW is trading at an 18.8x UAFRS-based P/E, which while a high over the last three years, is still near historical lows. Moreover, this represents a material discount to almost all of the firm’s peers.

Specifically, at this valuation, VMW is trading at a discount to 20 out of 25 of the US-based Systems Software companies in our database. Additionally, of the 4 companies that were cheaper on a UAFRS P/E-basis, only PRGS had positive EPS’ last year and positive expectations for EPS’ growth, suggesting VMW may be trading at too great a discount, warranting further upside going forward.

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 VMware, 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.