19 October 2017 Accounting Lifeguard Periodical GlobalCross-Discipline Accounting Lifeguard Date 19 October 2017 Deutsche Bank Markets Research Third-quarter watchlist As third-quarter results season hits full stride, there are two things we are watching for outside the usual gures. Both these accounting metrics showed record post-crisis reversals last quarter so, if the trend continues this quarter, investors may have new metrics to take into account. The rst relates to the “trade that won&39;t go away”– the accrual anomaly. This is where companies with higher accruals (the non-cash part of earnings) tend to have lower future market returns. Last quarter, we saw the biggest contraction between the spreads of prots and cashows of US stocks since the nancial crisis. Given that cashows have begun to drop while prots remained constant, the risk is that accruals may be increasing, thus giving a negative signal for the aected stocks. Similarly, European stocks are also seeing the variability of cashows and prots become closer, suggesting investors are applying the same logic to stocks on the continent. Among the most prevalent sectors are, consumer staples and discretionary, healthcare, technology, and utility stocks, however, the eect appears to be broad-based. The second metrics relates to the often-ignored deferred income gures. This metrics has experienced a steady fall since the crisis in both the US and Europe, however, the last two quarters have seen a signicant jump. This is concerning given the account is one of the main indicators of how companies will be aected by the new accounting rules (IFRS 15 or ASC 606 in the US) that come into force in 2018. The risk here is that companies may be ‘stockpiling’ revenues that will be released next year to shield against “rule-change shock”. Luke Templeman, CPA Research Analyst +44-20-754-17373 Deutsche Bank AG/London Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the rm may have a conict of interest that could aect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P)083/04/2017. Distributed on:19/10/201712:51:11 GMT 0bed7b6cf11c 19 October 2017 Accounting Lifeguard Accruals No matter how many people crowd the trade, the accrual anomaly is the “trade that wont&39; go away”. Essentially, it exists because companies with higher accruals (the non-cash part of earnings) tend to have lower future market returns. In theory, the anomaly should be fairly easy to trade away. Yet, although returns from this strategy vary over time, studies show that over the long term it remains a legitimate trade. Why No one can say for sure. A simple way to measure accruals is to compare operating cashow to prots. In the US, S&P 500 companies saw a four per cent fall in median cashows last quarter, the biggest drop since the crisis, yet prots were unmoved. As a result, we saw the biggest drop in operating cashows as a proportion of prots since the nancial crisis (gure 1). Essentially, the usual recovery in the June quarter, which follows a predictable rst-quarter slump, did not occur to the same extent as in prior years. We are watching this quarter to see if this becomes a trend. Figure 1: S&P 500: operating cashow as a proportion of prots 130% 140% 150% 160% 170% 180% 190% 200% 210% 220% 230% 9899000102030405060708091011121314151617 Note: based on four-quarter rollingaverage and excluding outliers Record post-crisis drop Strong rise since the financial crisisi Source: Factset, Deutsche Bank Furthermore, last quarter also saw a tightening in the spread between the variability of prots and cashow (gure 2). Figure 2: S&P 500: variance between operating cashows and prots -0.5 0.0 0.5 1.0 1.5 2.0 1.5 2.0 2.5 3.0 3.5 4.0 9899000102030405060708091011121314151617 Dispersion of profits - lhs Dispersion of operating cashflow - lhs Difference - rhsRecord gap appears to be beginning to close Source: Factset, Deutsche Bank Page 2Deutsche Bank AG/London 19 October 2017 Accounting Lifeguard This is even more signicant because, outside the crisis, the gap between the two sits at its highest level in at least two decades. Essentially, the variability of company prots is far wider than the variability of their operating cashows. Given that prots and cashows tend to track each other over time, a closing of this gap may suggest previously-overlooked accruals are reversing. If the third- quarter sees a continuation of this trend, the question is whether prots become more uniform or cashows become more dispersed – or a mix of both. Should the gap continue to close, there are signicant implications for investors in the stocks aected given the ‘accrual anomaly’ remains a persistent trade. If we look under the hood of market aggregates, we can see more detail about how the gap is shrinking. To start, the gap of the top and bottom ten per cent of stocks hasn’t moved much. Rather, it is the middle 80 per cent of stocks, which suggests a broad market eect. In terms of sectors, both consumer staples and discretionary were key contributors to last quarter’s movement, as were healthcare, technology and utility stocks. Again, given the broad range of industries aected, it indicates a broad market eect. Europe In Europe, we see a dierent eect to the US. Cashows have been rising a little relative to prots over the last two years, however, they are not materially dierent from the long-term average. Figure 3: Stoxx 600: operating cashow as a proportion of prots 60% 80% 100% 120% 140% 160% 180% 200% 990001020304050607080910111213141516 Note: based on four-periodrollingaverage and excluding outliers Source: Factset, Deutsche Bank Don’t ignore European companies, though. Over the last two semi-annual periods the gap between the variance of prots and operating cashows has shrunk by the most since the nancial crisis. This has been driven by falling dispersion between cashows. In other words, the cashows of dierent companies in the index have become more similar. Deutsche Bank AG/LondonPage 3 19 October 2017 Accounting Lifeguard Figure 4: Stoxx 600: Variance between operating cashow and prots -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 990001020304050607080910111213141516 Dispersion of profits - lhs Dispersion of operating cashflows - lhs Difference - rhs Record gap appears to be beginningto close Source: Factset, Deutsche Bank Similar to the US, the closing of the gap in Europe is due to a broad-based market move, particularly in consumer staples and discretionary, industrials, technology, materials, and utilities sectors. Deferred income Similar to the accrual anomaly metrics, something unusual is happening to companies’ deferred income balances. Since the nancial crisis, the general decline in these balances relative to revenue means they now sit around their two- decade average. And, on the face of it, there has been little change in this trend over the last few years. However, if we exclude the bottom quarter of companies in order to examine the main contributors, we can now see two quarters in a row of rising deferred income as a proportion of revenue, and the biggest jump since the nancial crisis (gure 5). Figure 5: S&P 500: deferred income as a proportion of revenue (ex. bottom quartile)2,000 4,000 6,000 8,000 10,000 12,000 14,000 if def revall Chart Title 20062016 0% 10% 20% 30% 40% 50% 60% 70% 80% if def revalldiff incr 6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0% 99000102030405060708091011121314151617 Four-quarter rolling average excluding outliers Record post-crisis jump Downwards trend sincethe financialcrisis Source: Factset, Deutsche Bank The level of deferred income is important for two reasons. First, it indicates how much additional revenue, and therefore prot, should be recognised in the future