Zillow Group (NASDAQ:ZG) is expected to report Q4 earnings on Tuesday, with analysts projecting the firm to see EPS, excluding unusual items, of $0.11, continuing its historical trend of generating positive Q4 EPS, and building on positive Q3 2016 EPS results, the first time ZG has generated positive normalized EPS outside of Q4 since 2012. This positive surprise led to a 6% jump in ZG share price on 11/2, after several quarters of disappointing as-reported results.
Uniform Accounting (UAFRS) adjustments signal that the market shouldn't have been surprised by the firm's ability to generate positive profitability, as it has actually been a very profitable business historically. In the chart below, we highlight Zillow's UAFRS-based earnings per share on an LTM basis, both for this past year, last year, and projected for the next four quarters.
Not only has ZG actually generated positive earnings in each year since 2011, its EPS growth has been significant, contrary to what traditional EPS would have you believe in 2013, 2014, 2015, and in this past year.
When uniform financials are applied, the firm has generated consistently positive, growing EPS historically with EPS growing from $0.09 in Q1 and $0.22 in Q2, to $0.29 in Q3, not inflecting from negative levels as as-reported numbers would have you believe. Over the last 12 months, EPS has actually been $0.87, not the ($0.29) traditional analysis reflects. Moreover, the firm has grown EPS each year by 30%+, and although this growth is expected to slow somewhat, it is projected to remain at significantly stronger levels than investors may realize.
ZG is an excellent example of the distortions that arise from GAAP accounting, especially for early-stage tech companies. As the chart above shows, traditional EPS metrics show a negative profitability firm historically. As-reported EPS also shows a company that is projected to take a leap forward in profitability in 2017, with earnings inflecting materially positive. That's not reality. In fact, EPS growth is just going to continue as it has the last few years, growing by 42% year over year in Q4 compared to 50% growth YoY in Q4 2015.
Zillow has had far more robust UAFRS-adjusted EPS than reported EPS over the last several quarters, as earnings have been positive, not negative. As-reported metrics make ZG appear to have negative earnings power, and make the recent inflection to positive earnings appear much more surprising due to timing issues and one-off distortions.
UAFRS, Uniform Adjusted Financial Reporting Standards, call for removal of distortions from issues like R&D expensing and option expense accounting. These are common in tech companies, especially those in early or growth stages.
Once removed, it is apparent that the real earnings have been growing consistently year over year, and also quarter over quarter, ranging from $0.09 to expected $0.37 in each quarter this year, rather than ($0.21) to $0.11 like 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
Two key UAFRS adjustments have the largest impact to ZG'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 re-bucketing stock option expenses into the enterprise value of the firm. This simple reclassification removes a tremendous amount of accounting noise related to investment activities and improves investors' understanding of the operating earnings of a business.
In addition, considering that Zillow actually generates positive earnings, contrary to what traditional metrics show, it is possible to analyze the firm using traditional valuations, and PEG ratios. At current valuations, ZG is trading around a 21.2x UAFRS-based P/E ratio, which is roughly around corporate averages currently.
In the context of the company's expected earnings growth rates, that means that the company actually is trading at a 0.27x UAFRS-based PEG ratio. Generally, a PEG below 1x is viewed as undervalued.
Also, most investors would assume the negative to positive inflection in as-reported EPS growth rate for the next four quarters means the firm cannot be analyzed based on a PEG ratio, or that the growth rate from Q3 to Q4 expected EPS of 275% is unsustainable, and unusable. However, when accounting distortions are removed, expected growth for the next four quarters is 76%, in line with prior UAFRS-based EPS growth rates, which have been in the 30-80% range since 2013, and Q4 EPS growth relative to Q3 is actually a relatively modest 28%. Using this uniform accounting metric, the 0.27x UAFRS-based PEG ratio the company currently trades at looks compellingly cheap.
By using UAFRS adjustments, which remove the earnings distortions above, a standard P/E analysis also shows the company to be much cheaper. Due to the misstated earnings power of the company using as-reported numbers, ZG's current as-reported P/E ratio is at 118.3x, an impossibly high number that borders on meaningless. However, at a 21.2x UAFRS-based P/E ratio, in the context of the company's projected and historically sustained robust earnings growth, the company's valuations do not appear aggressive.
When the distortions that are caused by traditional accounting analysis are removed, UAFRS-based analysis shows a company with a much stronger, sustainable earnings profile that warrants higher valuations.
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 Zillow Group, 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.
Disclosure: I am/we are long ZG.
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.