Special Charges Not So Special

10/5/2009


Special charges can be easy to overlook because they are excluded from operating earnings, the metric most analysts and investors use to assess company performance.

Companies have a lot of latitude when determining what qualifies as a special charge. Restructuring costs, severance payments, disaster losses, legal settlements, asset write-downs, costs for retiring debt, and other nonrecurring items can be classified as special charges.

Special charges — also known as unusual or exceptional charges — made headlines after the market meltdown of early 2000, when a growing number of prominent companies began using these charges to gloss over large expenses and losses, some of which should have been included in operating earnings. The temptation is obvious, as excluding special charges from earnings can help companies meet profit targets.

While special charges gained a higher profile in 2000, they are far more prevalent now.

The idea of excluding costs from corporate earnings doesn’t sit well with everybody, and such prominent pundits as billionaire investor Warren Buffett and former Federal Reserve Chairman Alan Greenspan have criticized the practice. Some charges are more “special” than others, and when companies begin to blur the line between operating and nonoperating expenses, they call the quality of earnings into question.

Should you be worried if one of the companies you own takes charges against earnings? Our data suggests some caution would be wise.

As the table below shows, S&P 1500 companies with fewer special charges or smaller amounts of charges relative to operating income have outperformed the average stock by an average of at least 0.4% in rolling 12-month periods since October 1994. However, companies that avoided special charges outperformed by a large margin during periods when the market declined and underperformed by a small margin when the market was up.

SPECIAL CHARGES MORE USEFUL IN DOWN MARKETS
Based on a back-test of 12-month periods since October 1994, the top one-fifth of S&P 1500 Index stocks as measured by the number of special charges or special charges as a percentage of operating income outperformed the average stock in the index by an average of more than 0.4%. The top quintile contains stocks with the least special charges. Stocks with the fewest and smallest charges tended to outperform during down markets, while the biggest chargers underperformed.
————— Average 12-Month Return —————
—— Top One-Fifth ——
— Bottom One-Fifth —
Selection Date
Average
S&P 1500
Stock
(%)
No. of
Special
Charges
(%)
Special
Charges
As % of
Oper.
Income
No. Of
Special
Charges
(%)
Special
Charges
As % of
Oper.
Income
Periods when
market fell
(16.2)
(13.4)
(13.8)
(19.0)
(21.3)
Periods when
market rose
19.0
18.8
18.9
18.5
20.9
All rolling periods
since 1994
10.4
10.8
10.9
9.3
10.5
Note: The Quadrix score for number of special charges considers how many of the last eight quarters included a special charge. The score for special charges as a percentage of operating income also considers statistics for the last eight quarters.

Data from the negative side is sloppier, though it tells a fairly similar story. The worst-one fifth of stocks as measured by the number of special charges averaged 12-month returns 1.6% below those of the average stock, lagging during both upward and downward markets. Companies with the highest special charges as a percentage of operating income averaged a return slightly higher than that of the average stock, although they underperformed by more than 5% during periods when the market was down.

The one-fifth of S&P 1500 stocks with the smallest number of special charges generated an annualized return of 12.8% since 1994, versus 11.5% for the average stock in the index. Companies with the fewest charges as a percentage of operating income also outperformed, and both strategies revolving around special charges generated returns with less volatility than those of the S&P 1500.

Be wary of companies that take a lot of charges or very large charges, because those charges can sometimes obscure their true operating results. For a look at special-charge data for S&P 1500 stocks, visit www.DowTheory.com/Charges.

Special charges offer investors a couple of ways to look at companies’ quality of earnings. Here are a couple more tools for further assessing earnings quality.

Cash flow versus net income: To determine operating cash flow, we add several noncash expenses back to net income, then account for changes in working capital. Operating cash flow exceeds net income for most companies — when income is higher, it suggests the company may be padding profit numbers.

Receivables versus revenue: Receivables, which reflect amounts customers owe to a company, should grow at roughly the same rate as sales. If receivables grow much faster than sales, it suggests the company may be either booking sales too aggressively or pilling up orders for customers who cannot pay. Neither is a good sign for future earnings.

The table below lists 13 companies that do not take excessive charges. In an effort to limit the list to companies with the highest earnings quality, we also considered the two factors listed above. Two of the companies in that table are discussed below.

DirecTV ($27; DTV) has taken just one small special charge in the past eight quarters, but that dearth of charges is not the only reason for confidence in DirecTV’s earnings quality. The pay-television firm relies on a rigorous customer-screening process to avoid customers who don’t pay. While many companies have seen an increase in dubious accounts during the recession, DirecTV’s receivables as a percent of sales have declined over the last year. DirecTV spent heavily to add customers during that period, and profit margins are down. But the sales growth is genuine, and it should translate to profit growth in the year ahead.

In May, DirecTV agreed to merge with Liberty Entertainment Group ($31; LMDIA), a deal that should simplify DirecTV’s ownership structure and possibly pave the way for a takeover. Strategic partner AT&T ($27; T) has been named as a potential suitor, but some speculate that Verizon Communications ($30; VZ) could make a play for DirecTV. Verizon wants to expand in video, an area where it has invested heavily in the past couple years as phone operations have shrunk. The purchase of DirecTV would give Verizon the second-largest base of pay-TV customers in the U.S., behind only Comcast ($17; CMCSA).

Whatever the outcome of the merger speculation, we believe DirecTV, earning a Quadrix® Quality score of 95, remains an attractive investment in its own right. DirecTV is a Focus List Buy and a Long-Term Buy.


In the past year, Sigma-Aldrich ($54; SIAL) shares have risen 5%, while the S&P 1500 Index declined 4%. Sigma-Aldrich did not take any special charges in that time — or, for that matter, in its last eight quarters. Just once in the past eight quarters did Sigma’s net income exceed operating cash flow, and receivables have declined as a percentage of sales over the last year. Profit growth is consistent (on pace for seven consecutive years), and the profits are of high quality.

With a robust product portfolio, Sigma supplies customers in 160 countries. Sigma sells chemicals to research labs, universities, and industrial companies, clients that typically continue long-term projects regardless of economic conditions. More than 70% of revenue is tied to research, an area experiencing modest growth that could also benefit from government stimulus spending.

The consensus anticipates per-share earnings will rise 3% this year, then return to double-digit growth in 2010. Sigma is one of the Forecasts’ smaller stocks, but it boasts a solid balance sheet and strong cash flows. The company has a history of sharing those cash flows with shareholders. Sigma has grown its dividend for 17 consecutive years and reduced its share count in each of the last five years. Sigma-Aldrich is a Long-Term Buy.

EARNINGS-QUALITY LEADERS
All of the 13 companies listed below have posted special charges in no more than two of the last eight quarters, and those special charges account for less than 2% of net income. All 13 consistently deliver operating cash flow higher than net income and have not seen receivables grow substantially as a percentage of revenue over the last year. Lastly, all earn Quadrix Quality and Overall scores above 60. The Quality score measures long-term growth rates, earnings predictability, and returns on earnings, investment, and assets.
No. of Qtrs.
with Special
—— Charge ——
Special Charges
as % of Oper.
—— Income ——
Qtrs. w/
Cash Flow
Above Net
Income (Last 8
Qtrs.)
Receivables
– as % of Sales –
– Quadrix Scores * –
Company (Price; Ticker)
Mkt.
Value
($Bil.)
Last 8
Qtrs.
Quadrix
Rank *
Last 8
Qtrs.
Quadrix
Rank *
Last
Qtr.
(%)
4 Qtrs.
Ago
(%)
Quality
Overall
Advice
Aflac ($43; AFL)
20.0
2
56
0.4
75
8
8.6
9.8
77
89
Buy †
Automatic Data Proc.
($39; ADP)
19.8
2
56
0.5
74
6
11.9
11.8
90
87
Neutral
DirecTV ($27; DTV)
26.9
1
70
0.3
76
8
6.7
7.1
95
91
Focus
Buy †
Gilead Sciences
($46; GILD)
42.0
2
56
0.8
72
6
20.8
21.8
99
95
Neutral
Kohl’s ($56; KSS)
17.2
0
89
0.0
89
6
0.0
0.0
79
89
Neutral
Lowe’s ($21; LOW)
31.3
1
70
0.1
77
7
0.0
0.0
69
66
Neutral
Oceaneering Int’l
($57; OII)
3.1
2
56
1.4
68
7
21.1
21.6
96
94
Focus
Buy
Procter & Gamble
($58; PG)
169.0
0
89
0.0
89
6
7.4
8.3
82
70
Neutral
Questar ($38; STR)
6.5
1
70
0.1
77
8
7.5
13.7
77
66
LT Buy
Sigma-Aldrich
($54; SIAL)
6.6
0
89
0.0
89
7
14.2
15.0
89
79
LT Buy
Target ($47; TGT)
35.5
0
89
0.0
89
6
11.3
12.3
77
82
Neutral
Union Pacific
($59; UNP)
29.8
1
70
1.6
66
8
4.0
5.1
83
70
Neutral
WESCO Int’l
($29; WCC)
1.2
2
56
1.1
70
6
13.8
15.9
82
70
Neutral
* Quadrix scores are percentile ranks, with 100 the best.      † Also qualifies as a Long-Term Buy. 

 


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