Performance and Valuation Prime™ Chart
The PVP chart above reflects the real, economic performance and valuation measures of Delphi Automotive PLC (NYSE:DLPH) after making many major adjustments to the as-reported financials. The four panels explain the company's corporate performance and valuation levels over the past 10 years plus best estimates for forecast years based on quarterly financials and consensus estimates.
The apostrophe after ROA', Asset', V/A', and V/E' is the symbol for "prime" which means "adjusted." These calculations have been modified with comprehensive adjustments to remove as-reported earnings, asset, liability, and cash flow statement inconsistencies and distortions. To better understand the PVP chart and the following discussion, please refer to our guide here.
Under Generally Accepted Accounting Principles (GAAP), DLPH's as-reported financial statements and financial ratios do not reflect economic reality. The traditional ROA computation understates the company's profitability by incorrectly including certain items. The inclusion of goodwill ($656mn) and non-operating long-term assets ($228mn) inflates DLPH's total assets, resulting in a distortion of performance measures. Additionally, the firm's Adjusted Cash Flows from Operations is at $3.8bn, a far cry from as-reported operating cash flows of $2.1bn. The adjustments to operating cash flows are crucial because expensing items like R&D expenses and operating leases, rather than capitalizing them as part of a company's investments, makes comparing the company to its peers, and even to its own historical performance, impossible. In the case of DLPH, their large R&D expenditures of $1.3bn and operating leases of $112mn lead to a material understatement of the firm's operating cash flows.
After adjusting for these primary issues and a host of other GAAP-based miscategorizations, Valens calculates DLPH's Adjusted ROA as 15% in 2015. In contrast, most financial databases show a traditional ROA of only 12%. Additionally, analysis shows that the firm's Adjusted Forward P/E is at 2.5x, compared to a traditional P/B of 13.2x. Clearly, the profitability of DLPH's operations and its stock valuation are not what traditional metrics indicate.
The problem with Generally Accepted Accounting Principles (GAAP) is that they create inconsistencies when comparing one company to another, and when comparing a company to itself from year to year. By making adjustments, we aim to remove the financial statement distortions and miscategorizations of GAAP. Some of these can be automated through consistently applied formulas; however, many must be made manually. Manual adjustments that cannot be automated include mergers and acquisitions accounting, special charges, business impairments, and others. The practice of creating consistent, apples-to-apples comparable measures of financial performance is often considered either tedious or overly complex by even seasoned financial analysts.
Adjusted Return on Assets - ROA'
The top panel of the chart shows the firm's Adjusted ROA (a.k.a. ROA', or ROA Prime.) This measure is comparable from year to year and across peers as it "cleans up" the aforementioned GAAP accounting issues to provide consistent analysis.
As discussed above, DLPH's Adjusted ROA is 15% in 2015, or more than twice the U.S. average cost of capital, and higher than the traditional 12% ROA being reported. The spread between DLPH's Adjusted ROA and its traditional ROA is driven by an understatement in the company's adjusted earnings from operations (the numerator, Earnings'), and an overstatement of their adjusted total operating assets (the denominator, Asset'). Earnings' is understated because the traditional calculation, like most of the other DCF models, does not recognize R&D expenses and operating leases as part of the company's operating investments. The incorrect deduction of these items makes it near-impossible to objectively compare the firm to its peers and even to its own historical performance. These adjustments also resolve the accounting issues between the expensing and capitalization of certain expenses.
Additionally, by adjusting for the firm's $656mn goodwill, the returns earned by DLPH through its operations can be identified from those earned through their acquisitions. This adjustment provides better investment analysis because it separates the firm's profitability into: 1) organic ROA', which indicates how well management executes the business, and 2) acquisitive ROA', which shows how well management does when they acquire a business. With everything considered, DLPH appears to be more profitable than what traditional metrics might suggest. That is a major difference in context and concept for evaluating the firm's situation.
Growth in Adjusted Business Assets - A'
In the second panel of the chart, Asset' growth stands for "Asset Prime Growth" (or Adjusted Asset Growth), and is the real annual growth rate of the cleaned-up and properly adjusted asset base of the company. This metric shows the management team's propensity to reinvest or divest over time. When viewed in context of Adjusted ROA, the growth rate explains a lot about management's intended strategies and even their performance incentives.
After a peak of 9% in 2010, the company's Adjusted Asset growth slowed down to 1% from 2011-2012. Adjusted Asset' levels then grew by 3% in 2013 before shrinking by the same magnitude in 2014. The movement in Adjusted Assets is due to workforce reductions and plant closures. DLPH also incurred cash expenditures worth approximately $169mn, related to the ongoing restructuring on their manufacturing capacity and footprint in Europe and South America.
Valuation Relative to Adjusted Assets - V/A'
The third panel shows the Adjusted Value to Assets ratio (V/A'), a "cleaned-up" Price-to-Book Metric that compares the Adjusted Enterprise Value (V') of the company to its Adjusted Asset level (A'). The Adjusted Enterprise Value is the market capitalization of the company plus the total debt of the company, including off-balance sheet debt while the Adjusted Asset level reflects the total operating assets of the firm, necessarily adjusted for problematic accounting standards for reporting of the balance sheet. The Adjusted Asset level is the same as the denominator of the Adjusted Return on Assets calculation and the Adjusted Asset growth panel.
The firm's 15% Adjusted ROA, when the as-reported ROA is 12%, indicates that a current Adjusted Value to Assets ratio of 2.5x is fair. The current Value to Assets ratio is also much lower than the firm's traditional P/B of 7.9x because the classic calculation uses equity as the base in computing book value instead of using the actual value of the company's operating assets. Moreover, DLPH's large accumulated comprehensive losses in 2014 amounted to $1.0bn, artificially inflating the base of the valuation.
Valuation Relative to Adjusted Earnings - V/E'
In the fourth panel, we have another perspective of valuation to help triangulate the market's embedded expectations for company performance. We always want to know what is "priced in" to the stock price. In this case, Valens evaluates the Adjusted Enterprise Value (V') of the firm relative to the expected Adjusted Earnings (E') for the current year. Adjusted Earnings are earnings resulting from the company's core business operations, regardless of how it is financed, and adjusted to its current dollar value. This is adjusted to eliminate accounting distortions and shenanigans, enhance comparability across different companies, industries and geographies, to determine potential mispricings. The Adjusted Enterprise Value (V') numerator is the same as that in the Adjusted Value to Asset ratio.
DLPH's as-reported forward P/E is at 12.5x, indicating that the market may be undervaluing the firm's equity (since long-term P/E ratios average at around 15x to 17x). Our analysis finds that DLPH has an approximately 13.2x Adjusted Value to Earnings that supports the suggestion that their equity may be undervalued. If DLPH can grow aggressively while maintaining superior Adjusted ROA levels, there may be potential for equity upside.
As-reported financial statement information and financial ratios, which make up most of the publicly available financial databases, do not consider the extent to which distortions, miscategorizations, and misclassifications cause as-reported financial statements to depart from economic reality. Even the venerable "statement of cash flaws" - pun intended - is horribly distorted, as many items in the statement of cash flows are actually non-cash related. What is deemed cash flow from operations, investing, and financing activities are inconsistently booked from company to company and even just from year-to-year at an individual company. The distortions are material and directionally changing, and the mismeasurements that result are decision-changing issues.
A far better picture of the economic reality of Delphi Automotive PLC can be seen once those distortions are removed. The firm is generating returns higher than what most financial databases report and has an Adjusted Value to Assets ratio that is lower than traditional metrics and an Adjusted Value to Earnings ratio that is lower than long-term P/E averages. With that context of corporate performance and market valuation, we have a far better means for evaluating DLPH's prospects for the future of its stock.
Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article along with the lead analyst, Cheska Pablico. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Officers of Valens Research are engaged and have a beneficial interest in an investment management company, Kennebec River Capital, which has positions in Delphi Automotive PLC as of the date of this report.
Disclosure: I am/we are short DLPH.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Officers of Valens Research are engaged and have a beneficial interest in an investment management company, Kennebec River Capital, which has positions in Delphi Automotive PLC (DLPH) as of the date of this report.