In Search Of Quality Earnings

9/2/2013


One key to successful investing is avoiding the big mistake. Companies that suffer a sudden reversal in earnings growth, restate prior results, or come under investigation by the U.S. Securities and Exchange Commission can torpedo an otherwise sound portfolio.

Take, for example, VeriFone Systems, ($19; PAY), a maker of electronic payment systems. Last December, the unrated VeriFone seemed to have everything the Forecasts seeks in a stock. With a  Quadrix Overall rank of 95, VeriFone enjoyed rising operating profit margins, solid cash flow, favorable trends in analyst revisions, and an attractive valuation.

Yet the next eight months brought a parade of quarterly misses and downward revisions to the guidance, ultimately costing VeriFone's CEO his job and causing the stock to plunge. How did everything go so wrong? More importantly, could investors have foreseen these troubles?

You can improve your odds of avoiding imploders by ensuring earnings are persistent and sustainable. Profits consist of two components: cash and accruals. The accruals portion reflects dozens of subjective decisions made by management, such as inventory valuation, deferred taxes, accounts payable, and depreciable assets. By dissecting earnings, investors can identify how heavily companies relied on their own discretion. Not all profits are created equal.

Earnings at the extremes — high or low — tend to revert to normal levels over time. After all, highly profitable product lines tend to attract new competition, while companies abandon underperforming business ventures. When earnings consist mostly of accruals, they tend to revert back to norms at a faster pace than primarily cash earnings.

Multiple studies have found that stocks with small or negative accruals tend to outperform peers with high accruals. In addition, rapid growth in accrual profits is often unsustainable, leading to sharp reversals. Profit restatements and SEC enforcement actions occur more often among companies that rely heavily on accruals for their profits.

Accruals serve a crucial accounting function, matching costs with revenue. But management can sometimes make up for an earnings shortfall in the current quarter by dipping into accounts meant for the future. Of course, even assumptions made in good faith can prove inaccurate. Either way, accruals have a tendency to self-correct, so companies with accrual-driven profits should merit lower valuations.

We can measure a company's accruals in two ways:

1) The balance-sheet accruals ratio equals the year-over-year change in net operating assets divided by average net operating assets over the last five quarters. To calculate net operating assets, subtract cash from total assets, then subtract total liabilities excluding debt. Accruals measure the change in assets excluding cash and debt, which are essentially free of management
discretion.

2) The cash-flow accruals ratio starts with quarterly net income minus the sum of cash provided by operations and cash provided by investments. That total is then divided by average net operating assets. Cash-flow accruals work better for companies that have made a lot of noncash acquisitions.

Returning to our VeriFone example, the stock had an elevated balance-sheet accruals ratio — 68% in the October 2012 quarter and higher in previous quarters — suggesting accruals prolonged the company's operating momentum beyond the point when its business began to falter.

WHAT THE ACCRUALS TELL US
Profits derived largely from accruals are more likely to deteriorate than those comprised mostly of cash. Below, we consider stocks' earnings quality, as measured by the balance-sheet accruals ratio and cash-flow accruals ratio. Low or negative ratios are most desirable. The top table features recommended stocks, while the bottom table focuses on those with B (average) or C (below average) ranks.
Balance-sheet
------- Accruals Ratio -------
Cash-Flow
------- Accruals Ratio -------
Company (Price; Ticker)
Current
(%)
1 Year
Ago
(%)
5-Year
Average
(%)
Current
(%)
1 Year
Ago
(%)
5-Year
Average
(%)
Quadrix
Overall
Score
Earnings look safe
American Express
($72; AXP) 
(9)
(6)
(5)
1
3
(1)
81
Celgene ($137; CELG)
(2)
NA
31
0
NA
22
88
Comcast ($42; CMCSa) 
(6)
(3)
5
1
(1)
0
96
Google ($850; GOOG)
6
55
21
8
56
13
60
Helmerich & Payne
($63; HP) 
5
16
11
(1)
7
2
98
Macy's ($43; M)
1
(3)
(11)
1
1
(2)
77
Proceed with caution
Duke Energy
($66; DUK)
52
4
18
NA
NA
NA
51
United Technologies
($100; UTX) 
40
(7)
9
(1)
41
2
62
UnitedHealth Group
($72; UNH) 
32
5
10
0
1
2
75
Walgreen ($47; WAG) 
33
7
12
(2)
(5)
2
47
Note: Quadrix scores are percentile ranks, with 100 the best.     NA Not available.

Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com