Two Flavors Of Earnings

1/25/2016


It goes without saying that investors pay incredibly close attention to corporate profits.

But earnings don't always tell a clean story. Take Johnson & Johnson ($96; JNJ), which reported per-share earnings of $4.33 for the nine months ended September, down 10% from a year earlier. At the same time, the health-care giant announced operating earnings of $4.76 per share, a decline of only 5%. How could that be?

Reported earnings conform to generally accepted accounting principles (GAAP), a set of U.S. rules that includes most expenses and charges. But many companies exclude unusual, one-time, or special items from operating earnings, often to satisfy Wall Street expectations. Corporate bosses have a lot of leeway when determining special charges, which include restructuring costs, acquisition expenses, and even employee stock compensation — items that to some extent reflect the cost of doing business.

For example, in the first nine months of 2015, J&J's operating earnings exclude litigation expenses ($0.04 per share), integration costs related to acquisitions ($0.03), and expense for a replacement-hip program ($0.05). All told, the company stripped out $0.43 in special items, putting per-share operating profits 10% higher than reported results.

S&P 500: REPORTED VERSUS OPERATING EARNINGS
The table below shows that among S&P 500 companies, the gap between operating and reported earnings has fluctuated, impacting growth rates and P/E ratios. Full-year profit estimates for 2015 and 2016 are provided by Standard & Poor's. Historical P/E ratios reflect year-end prices for the S&P 500 Index, while ratios for estimated earnings use the current price.
---------- Per-Share Earnings ----------
--- Earnings Growth ---
------- P/E Ratio -------
Year
Operating
($)
Reported
($)
Operating
EPS Gap
(%)
Operating
(%)
Reported
(%)
Operating
Reported
2016 Est.
124
122
2
17
28
15
15
2015 Est.
106
95
12
(6)
(7)
17
19
2014
113
102
10
5
2
18
20
2013
107
100
7
11
16
17
18
2012
97
87
12
0
(1)
15
16
2011
96
87
11
15
12
13
14
2010
84
77
8
47
52
15
16
2009
57
51
12
15
243
20
22
2008
50
15
233
(40)
(78)
18
61
2007
83
66
25
(6)
(19)
18
22
2006
88
82
8
15
17
16
17
2005
76
70
9
13
19
16
18
2004
68
59
16
24
20
18
21
2003
55
49
12
19
77
20
23
2002
46
28
67
19
12
19
32
2001
39
25
57
(31)
(51)
30
46
2000
56
50
12
9
4
24
26

A growing number of companies are getting in on the act. In the September quarter, by our count, nearly 62% of S&P 500 Index companies announced operating earnings above reported profits. That's up from 57% in the year-earlier period and the average of 58% over the last two years.

Our advice

The disparity between reported and operating earnings can make it challenging to gauge a company's fundamentals. Operating earnings often provide a more accurate picture of a firm's core operations and allow for easier peer comparisons. Importantly, Wall Street profit estimates typically use operating earnings.

Among the 27 stocks on our Buy List, 16 posted operating earnings that outstripped reported profits in their most recent quarter. While we generally pay extra attention when companies exclude charges or expenses to boost earnings, we're comfortable owning select stocks, partly because we pore over their fundamentals to gauge earnings quality.

The table below lists 12 earnings-quality leaders, all of which have delivered solid growth in sales, cash flow, and operating earnings over the past year. All 12 generate operating cash flow above net income, suggesting healthy earnings. In addition, they have returns on equity, assets, and investment — as well as gross and operating profit margins — above three-year averages. Lastly, all earn solid Quadrix Quality and Overall scores. Four of the stocks are profiled below.

CBRE Group's ($28; CBG) quarterly operating profits tend to exclude a litany of items: write-offs related to financing costs, various acquisition-related costs, and some compensation expenses. Yet the stock's other metrics reveal strong underlying fundamentals. Sales, up 17% for the 12 months ended September, and cash from operations, up 27%, are keeping pace with per-share operating profits, up 16%. Cash from operations also exceeds net income, a key signal of earnings quality, suggesting management doesn't rely on accounting maneuvers to inflate growth. Finally, returns on assets and investment have marched higher for the last six years, rising to their highest levels since 2007.

CBRE, a provider of commercial real estate services, appears well able to maintain recent operating momentum. Analysts expect the company to report per-share profits of $0.78 for the December quarter, up 15% on 22% sales growth. Results are due Feb. 3. Looking ahead to 2016, earnings per share are projected to climb 14% on 20% higher revenue. CBRE is a Focus List Buy and a Long-Term Buy.


Disney's ($93; DIS) operating profits rose 19% to $5.15 per share in fiscal 2015 ended September. These results excluded $0.23 per share in a deferred tax asset write-off linked to Disneyland Paris and $0.02 in restructuring and impairment charges. Although Disney frequently excludes items from its operating profits, its quarterly operating cash flow consistently exceeds net income, which boosts our confidence in the company's earnings quality. Both operating cash flow and net income rose 12% in fiscal 2015; operating earnings per share rose 19%. Despite the strong operating results, Disney's stock trades at 18 times trailing earnings — its lowest valuation since 2013.

In fiscal 2015, Disney's operating margin crept toward 30%, a benchmark last reached in 1998. Margins have improved even as its largest business, media networks (44% of fiscal 2015 sales, 53% of operating income) got squeezed by a 2% decline in U.S. subscribers and 11% higher programming and production costs last year. But operating profit margins expanded by at least one percentage point for Disney's four other business segments. Returns on assets, equity, and investment reached their highest levels since 1995. Disney, projected to grow earnings per share 10% in fiscal 2016, is a Long-Term Buy.


Despite declining traffic at U.S. malls, Foot Locker ($62; FL) continues to generate steady growth. Same-store sales rose in 23 straight quarters — and have grown more than 5% in each of the past eight quarters. Foot Locker has also churned out eight straight quarters of higher operating profit margin — no other S&P 1500 apparel retailer has done so for more than five consecutive quarters. The retailer's return on equity ranks in the top one-third of its industry. These trends appear sustainable, given robust demand for athletic gear and the improving economy in Europe, which accounts for 20% to 25% of Foot Locker's revenue.

Rival Finish Line ($18; FINL) continues to endure self-inflicted wounds. The retailer blamed its 3% decline in November-quarter sales on inventory problems caused by its new warehouse-management system. In January, Finish Line dumped its CEO and announced plans to close up to 25% of its stores.

Foot Locker likely benefited from Finish Line's execution missteps in November, snapping up some of its rival's lost sales. Finish Line says same-store sales rose about 6.2% in December, which could indicate that concerns of a slowdown in basketball footwear, a crucial area for Foot Locker, are overblown. Foot Locker, yielding 1.6%, is a Focus List Buy and a Long-Term Buy.


In fiscal 2015 ended September, Skyworks Solutions' ($62; SWKS) return on assets reached its highest level since at least 1981. Operating profit margin expanded more than seven percentage points to 37.5% last year, also a level not seen in at least 35 years. Yet the stock has shed 26% of its value since the end of November, dragged down by reports that Apple is cutting iPhone orders. Reflecting those concerns, analyst estimates are trending lower, with the consensus projecting Skyworks grew December-quarter earnings per share 25% on 14% revenue growth. Skyworks will post results on Jan. 28.

Nevertheless, the stock offers a rare blend of low valuation, stout balance sheet, and strong growth prospects. Skyworks' net cash exceeds $5 per share. Its per-share profits are projected to rise 16% over the next 12 months (ninth-highest among the S&P 1500's 33 semiconductor stocks). Excluding net cash, Skyworks trades at just nine times expected year-ahead earnings, second-lowest valuation in the industry. The company's trailing P/E has dipped to 12, its lowest level since 2009. Skyworks is a Buy and a Long-Term Buy.

EARNINGS-QUALITY LEADERS
Below we list 12 A-rated stocks positioned for solid growth, reflecting their quality of earnings. We required growth in sales, operating earnings, and cash flow over the past 12 months. All 12 are also poised to grow sales and profits in fiscal 2016. Each generates more cash flow than net income. All 12 boast returns on equity, assets, and investment, plus gross and operating profit margins, higher than three-year averages. Finally, the stocks earn Quadrix Quality and Overall scores above 80. Stocks on our buy lists are listed in bold.
12-Month Growth
Cash
Flow/
Net
Income
Est. Growth,
Fiscal 2016
------------------- Profitability Ratios -------------------
-- Quadrix Scores --
Company (Price; Ticker)
Sales
(%)
EPS
(%)
Cash
Flow
(%)
Sales
(%)
EPS
(%)
Return On
Equity
(%)
Return On
Assets
(%)
Return On
Investment
(%)
Gross
Margin
(%)
Oper.
Margin
(%)
Quality
Overall
Alaska Air
($67; ALK)
5
58
30
1.7
5
15
37
13
28
3
28
99
99
Amgen
($155; AMGN)
9
19
19
1.5
3
6
24
9
11
90
49
88
83
Apple ($97; AAPL)
28
43
36
1.5
1
4
43
20
33
45
35
99
96
CBRE ($28; CBG)
17
15
27
1.3
21
15
25
7
13
12
12
95
96
Disney ($93; DIS)
7
19
12
1.3
7
10
18
10
14
30
30
93
85
F5 Networks
($90; FFIV)
11
22
25
1.9
7
6
27
16
27
85
32
97
81
Foot Locker
($62; FL)
4
21
7
1.3
4
20
21
15
20
34
14
94
95
Kroger ($38; KR)
2
24
13
2.2
1
16
35
7
13
22
5
93
89
Lam Research
($70; LRCX)
20
29
36
1.4
12
19
16
9
12
49
23
87
98
Robert Half Int'l
($42; RHI)
10
23
13
1.2
9
15
35
21
35
42
12
97
87
Skyworks Sol.
($62; SWKS)
42
63
29
1.2
10
14
28
24
28
53
37
100
92
Southwest Air.
($39; LUV)
5
83
4
1.7
6
19
26
9
20
36
25
98
99
Note: Quadrix scores are percentile ratios, with 100 the best.

 


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