The Numbers Behind The Numbers

6/15/2015


During earnings season, a company's sales, per-share profits, and guidance dominate the headlines and tend to cause the biggest movement in its stock price.

Most companies enjoy some discretion in how they calculate their financial results. When growth slows, managers face the temptation to dress up key numbers and postpone the dreaded quarterly miss. For that reason, investors need to consider metrics beyond the headline numbers.

Using guidelines from the excellent book "What's Behind the Numbers?" by John Del Vecchio and Tom Jacobs, and our own observations, we present below key metrics that could portend trouble ahead.

Earnings check

Operating cash flow — the cash companies produce from running their business — should exhibit a fairly stable relationship with net income. When this holds true, reported earnings growth tends to signal improved operating results, rather than accounting machinations. For most healthy companies, cash from operations exceeds net income. Operating cash flow adds back to net income noncash costs (such as depreciation and amortization) and changes in working capital (including inventory).

A second check on earnings quality is allowance for doubtful accounts, the provision for bad debt. A sharp drop in doubtful accounts when receivables are rising can artificially boost revenue and, therefore, income.

Revenue check

Companies may be tempted to start down the path of aggressive revenue recognition, essentially stealing sales from future quarters to boost today's results. Unfortunately, this tactic leaves less in the channel for future quarters, increasing the likelihood that sales will eventually disappoint.

Days sales outstanding (DSO) can indicate that companies are offering discounts or special financing to encourage customers to place bigger orders than they otherwise would. This practice is called channel stuffing. Investors should be concerned if DSO is trending higher. To calculate DSO, divide accounts receivable by quarterly sales, then multiply the product by 91.25 (an approximation of the number of days in the quarter).

Deferred revenue, cash received before a service is performed, is viewed as a liability on the balance sheet and only recognized as revenue once the company fulfills its obligation to the customer. Management can exercise a lot of discretion with deferrals. A sudden, sharp drop in deferred revenue may hint that management took the liberty of converting deferred revenue into sales to meet its quarterly targets, again swiping future revenue. To steer clear of this scenario, consider days in deferred revenue (91.25 times quarterly deferred revenue, divided by total quarterly revenue).

Inventory check

By itself, rising inventory isn't a problem; we expect inventory to grow along with sales. But comparing total inventory to other metrics can ferret out problems. Inventory growing faster than sales can mask underlying weakness in profitability. If sales don't keep up with production, gross profit margins may shrink.

One useful metric is days sales in inventory (DSI), which measures the number of days required to sell inventory. Surging DSI can be a red flag for inventory buildup. To calculate DSI, multiply inventory by 91.25, then divide by quarterly cost of goods sold.

CHECKS ON EARNINGS, REVENUE, AND INVENTORY
We checked earnings, revenue, and inventory for our recommended stocks based on metrics in the nearby story. For doubtful accounts, days sales outstanding, days in deferred revenue, and days sales in inventory, we looked at the last quarter and the four-quarter trend. The stocks below look good for at least two of the five metrics and look bad in none.
Earnings Check
--- Revenue Check ---
Inventory
Check
Quadrix Scores
Company
(Price; Ticker)
Op. Cash
Flow
Exceeds
Net
Income
Doubtful
Accts.
Days Sales
Outstanding
Days In
Deferred
Revenue
Days
Sales In
Inventory
Value
Overall
Alaska Air
($61; ALK)
Good
NA
Good
Good
Good
82
96
Corning ($21; GLW)
Good
Good
Good
Good
Good
86
69
CVS Health
($102; CVS)
Good
NA
Mixed
NA
Good
49
67
HCA Holdings
($83; HCA)
Good
Mixed
Mixed
NA
Good
71
94
Kroger ($71; KR)
Good
NA
Good
NA
Good
53
89
Macy's ($69; M)
Good
NA
Good
NA
Mixed
74
75
Schlumberger
($92; SLB)
Good
Good
Good
NA
Mixed
65
62
Shire ($247; SHPG)
Good
NA
Good
NA
Good
49
92
Skyworks
($106; SWKS)
Good
Good
Good
NA
Good
29
93
Southwest Air
($34; LUV)
Good
NA
Good
Good
Good
86
91
Travelers ($99; TRV)
Good
NA
Good
NA
NA
94
72
United Rentals
($90; URI)
Good
Good
Good
NA
Good
89
97
Note: Quadrix scores are percentile ranks, with 100 the best.      NA Not available.

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