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Morningstar | Fidelity's Non(Sensical)-GAAP Adjustments Are Malarkey

We have said for a while that narrow-moat Fidelity National Information Services' accounting and adjusted earnings metrics are misleading and that GAAP earnings and free cash flow, although imperfect numbers, are better measures of performance. The SEC also had a few questions as the company received a comment letter from the SEC in September regarding its use of adjusted EPS. Previously, Fidelity added back amortization expense resulting from acquisitions to its adjusted earnings. In response to the SEC inquiry, Fidelity will now add back not only amortization resulting from acquired intangibles, but also all remaining depreciation and amortization. We are dumbfounded by this. Moreover, it supports our contention that Fidelity’s adjusted numbers are of little use to investors and shouldn’t be used as a basis for a fair multiple. For now, we’ll be maintaining our fair value estimate at $68 per share. Currently, Fidelity trades at an EV/operating income of close to 30. To us, shares in the company look highly overvalued, especially considering we expect Fidelity’s top-line growth to struggle.

For the quarter, the company reported GAAP earnings of $0.91 per share, modestly below our expectations. Non-GAAP earnings under the new presentation method were $2.07 per share, 127% greater than GAAP earnings and 21% higher than GAAP free cash flow per share. Fidelity generated revenues of $2.2 billion. Management says organic growth was 3.2% from the previous year, but we'll note that this growth rate uses a highly questionable adjusted 2017 base. Simply put, we think the company's growth is worse than what management is presenting.

During this quarter’s earnings call, management said this about its updated method for calculating adjusted EPS: "After several lengthy discussions with the SEC, which included comparisons of our peers, analyst, and investor expectations, we agreed on an approach with the SEC that will exclude all depreciation and amortization from our adjusted EPS." It appears Fidelity is saying the SEC asked the company about its adjustment for amortization, and in response, management and regulators decided Fidelity should get more aggressive in its use of non-GAAP adjustments by excluding depreciation. We highly doubt this. Furthermore, Fidelity management said in its discussions with the SEC that it included peer comparisons. We’re not aware of any peer adding back depreciation to calculate adjusted earnings per share. Currently, close rival Fiserv adjusts for some amortization, but not depreciation. Jack Henry, which we think has Exemplary stewardship, uses some non-GAAP metrics, but does not appear to add back any amortization or depreciation. We cannot find a reason any company should be able to exclude depreciation from its adjusted earnings as depreciation is a real, ongoing expense reflecting necessary investment in the company.

Management presented its 2019 guidance as well. The company expects GAAP revenue to be flat while organic revenue will grow in a range of 3.5%-4.5%. In 2019, Fidelity will unwind its Brazilian JV, which will result in an annualized decrease in revenue of around $200 million. It appears guidance assumes a significant acceleration in growth in the second half of 2019. To us, the easiest way for Fidelity to hit these numbers would be through M&A. Based on management's statement that "consistently inorganic activities (acquisitions) will play a role in our strategy," we suspect an acquisition is coming though it's not apparent to us what Fidelity will acquire. Nevertheless, acquisitions only mask the problem of slowing growth within the company's asset-management and capital-markets customers.