Performance and Valuation Prime™ Chart
The PVP chart above reflects the real, economic performance and valuation measures of HD Supply Holdings, Inc. (NASDAQ:HDS) 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.
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.
Under GAAP, the as-reported financial statements and financial ratios of HDS do not reflect economic reality. The traditional ROA computation understates the company's profitability by incorrectly including certain items. The distortion of both profitability measures and valuation metrics of HDS are primarily driven by the inclusion of the firm's goodwill ($2.9bn), which inflates the firm's asset base, and by incorrectly expensing operating leases ($146mn) rather than treating them as part of the company's investments.
After adjusting for similar issues and a host of other GAAP-based miscategorizations, Valens calculates HDS' Adjusted Return on Assets as 25% in FY 2016. In contrast, most financial databases show a traditional ROA of only 8%. Additionally, our analysis shows that HDS has an Adjusted Forward P/E of 18.6x, compared to the firm's traditional forward P/E at 10.7x. The profitability of HDS' operations and their equity's true value are therefore not what traditional metrics originally indicate.
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.
HD Supply Holdings' Adjusted ROA was 25% in 2016. This is not only close to 4x the U.S. average cost of capital, it is also thrice that of the traditional 8% ROA being reported for the firm. The spread between HDS' 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 are understated because the traditional calculation of net income does not recognize operating leases ($146mn) as part of the company's operating investments. The incorrect deduction of these expenses makes it near-impossible to objectively compare the firm to its peers and even to its own historical performance. Our adjustments resolve the accounting issues between the expensing and capitalization of certain expenses.
Furthermore, by adjusting for the firm's goodwill of $2.9bn, the returns earned by HDS through its operations can be identified. This adjustment provides better investment analysis because it separates the firm's profitability into: 1) organic Adjusted ROA, which indicates how well management executes the business, and 2) acquisitive Adjusted ROA, which shows how well management does when they acquire a business.
With everything considered, HDS appears far more profitable than what traditional metrics 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 the Adjusted ROA, the growth rate explains a lot about management's intended strategies and even performance incentives.
After constant 8% Adjusted Asset growth in fiscal years 2014 and 2015, Adjusted Asset growth ramped to 15% in FY 2016 because of a large increase in deferred tax assets (from $325mn in FY 2015 to $708mn in FY 2016) despite the sale of their Power Solutions business worth $825mn.
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, and less excess cash (or non-operating cash balances). Meanwhile, 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.
HDS is trading toward the high end of historical valuations relative to asset values with an Adjusted Value to Assets ratio of 3.8x, much lower than the firm's traditional 9.4x P/B. The classic P/B figure is distorted because the traditional calculation utilizes the firm's book equity value as the denominator, as opposed to the total operating assets of the company.
However, even though traditional metrics are overstating the firm's valuation relative to assets, this does not necessarily imply that HDS is cheap. Considering that the firm's Adjusted ROA of 25% actually warrants a V/A' of 3.8x, the firm's equity may already be fairly valued relative to its assets.
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 their expected Adjusted Earnings (E') for the next 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, and to 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 Assets ratio.
HDS' as-reported forward P/E is at 10.7x, making their equity appear undervalued by the market. However, our analysis finds that HDS is trading at the peak of historical valuations with an Adjusted Value to Earnings ratio of 18.6x. The traditional P/E calculation distorts equity valuation because it focuses on equity and ignores debt. Considering that HDS is already trading toward the high end of historical valuations, their stock may not be as cheap as markets perceive.
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 mis-measurements that result are decision-changing issues.
A far better picture of the economic reality of HD Supply Holdings, Inc. can be seen once those distortions are removed. The firm is generating returns thrice what most financial databases report. However, adjusted valuations indicate that HDS' stock price may not be as cheap as traditional valuations indicate. With that context of corporate performance and market valuation, we have a far better means for evaluating HDS' stock price prospects.
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, Rafael Formoso. Professor Litman is regarded around the world for his expertise in forensic accounting and "forensic fundamental" analysis, particularly in corporate performance and valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.