Tableau Software, Inc (NYSE:DATA) reported Q4 earnings last week on 2/2 after the bell, with non-GAAP EPS coming in at $0.26, crushing quarterly estimates of $0.13. The market loved these results, and the stock was up over 10% after-hours, to $55+.
However, Uniform Accounting (UAFRS) adjustments signal that the market likely should not have been so positive on these results. Specifically, they highlight that while the firm had a strong quarter, it will likely only serve to mask recent declines in profitability, making expected weakness in 2017 even more alarming.
When uniform financials are applied, the year over year decline that DATA has seen is less severe than it initially appears on an as-reported basis. DATA actually only saw EPS fall from $1.87 in 2015 to $1.85 in 2016, after seeing Q4 EPS of $0.75, not $0.26 like the firm reported on a non-GAAP basis. This is contrary to as-reported numbers, which show EPS having declined from $0.50 to $0.08 for the year, due to accounting distortions.
However, although the firm saw stronger profitability in 2016 than as-reported numbers suggest, this only serves to set a more stark contrast to expected levels of profitability in 2017. Although the firm is expected to maintain positive EPS on a UAFRS basis in 2017, EPS is expected to fall by 70% over the next four quarters.
DATA is an excellent example of the distortions that arise from GAAP accounting, especially for tech companies. As the chart above shows, traditional EPS metrics show a firm that has seen declining fundamentals and is going to see a continuation of poor results in 2016 going forward. UAFRS-based adjustments highlight that profitability actually has been robust for the company, but it is likely to fall off a cliff in 2017.
However, annual results mask the fact that DATA only appears to have driven stable UAFRS EPS as a result of a strong Q4. Other than this strong quarter, earnings have been declining each quarter relative to the prior year, and are expected to decline further going forward.
While negative as-reported EPS in Q1 and Q2 make expected negative EPS in Q1 2017 appear to be possibly a seasonal trend or at least in line with history, UAFRS-based EPS has not fallen into negative levels once in the last three years, making expected -$0.02 EPS in Q1 troublesome.
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.
Once removed, it is apparent that real earnings have been stronger than as-reported EPS would suggest historically, but that this is going to change materially in 2017 for the worse. The biggest driver of this decline in 2017 is, while the company's as-reported earnings streams are going to be only slightly worse in 2017, when factoring in how much the company has been investing in the business and how much investment they would need to maintain to continue to generate current earnings, earnings are actually dramatically weaker.
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
Other than stock-option expenses, which DATA already adds back to non-GAAP earnings, one key UAFRS adjustment has the largest impact to DATA's income statement, to get from earnings to UAFRS-adjusted earnings. This is specifically related to 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, something that DATA does already, but is inconsistently applied across firms. 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. 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.
With earnings projected to decline and fall to levels that are well below the company's cost-of-capital, current valuations for DATA appear unreasonably high.
The company currently is trading at a 3.4x price relative to the company's UAFRS adjusted asset base (V/A' or Uniform Adjusted Enterprise Value / Assets). Generally, companies trade at a multiple to their adjusted assets that is consistent with the company's earnings power relative to its cost of capital. If a company is earning its required rate of return (it is earning its cost of capital) the company will trade at its book asset value, or a V/A' of 1x. If it earnings 2x its required rate of return, the V/A' will rise to 2x, or more if the company is growing.
However, when a company's earnings power falls below cost of capital levels for a sustained period of time, the company should not see V/A' sustain above 1x. For DATA, UAFRS-adjusted EPS is projected to fall from 4x their cost of capital to well below required levels, however its V/A' has remained at 3.4x levels. The market appears to not yet be fully punishing the company for the projected sustained decline in earnings the company is going to have in 2017 and 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.
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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/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.