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How to Determine Earnings Quality (Part 3)

August 25, 2014

Company-Issued Guidance

Company-issued guidance is simply comments that management provides publicly about what it expects in the future. These comments are also known as forward-looking statements and generally focus on earnings, sales, and margin expectations. Company guidance is given so that investors can evaluate the company’s growth potential. Under current regulations, it is the only legal way a company can communicate its expectations to the market.


Analysts use this information in combination with their own research to develop earnings forecasts. Company-issued guidance plays an important role in the investment decision process because management knows its business better than anyone else and has firsthand information on which to base its expectations. Be aware, however, that management can use guidance to sway investors. For example, in a bull market some companies have given optimistic forecasts because the market wants momentum stocks with fast-growing earnings per share. In bear markets, companies have tried to guide expectations lower so that they can beat the earnings projections.


Companies generally issue guidance at or near the time a quarterly earnings report is released. Let’s say that along with reporting stronger than expected earnings, the company issues guidance for the upcoming quarter and the rest of the year, projecting much better earnings ahead. For example, the company may say that for the next quarter it expects to earn $0.10 to $0.12 a share more than it previously predicted, and it also increases the expectation for year-end results by $0.30 to $0.35 a share. Not only has the company beaten the expectations for this quarter, it feels confident enough that it will have good results the next quarter to go public with a statement to that effect. Because companies are conservative about their earnings guidance, we know that a statement like this won’t be issued unless management thinks the results will not only meet these higher expectations but also beat them. This is exactly what I’m looking for: better than expected earnings along with positive earnings guidance. A company should not only be doing well but be doing better than analysts anticipate.


Depending on what a company says about its business prospects going forward, positive or negative, the response of the stock price could be dramatic. In some cases, the reaction to earnings guidance is stronger than the reaction to the actual earnings report when it is announced. By tracking what a company says and then what develops later on, you can ascertain the quality and tendencies of the company’s guidance.



Long-Term Projections

When obliged to fess up to bad news, a publicly traded company will often try to spin the message. It may announce a stock buyback or some other “positive” news at the same time it reports a disappointing quarter in an effort to soften the blow and offset any potential negative effects. This generally doesn’t work.


One feeble tactic is to issue an upbeat long-term projection at the same time they deliver bad news about an upcoming or current quarter. In dealing with future earnings, it’s important not to look too far out. Growth investors tend to have a “what have you done for me lately” mentality. Therefore, focus on what the company is saying about the upcoming quarter and the current fiscal year My rule of thumb is to take long-term forecasts with a grain of salt. No one, not even management, can accurately forecast what a company will earn or what its rate of growth will be a year or two down the road. If they say, “Business conditions will be tough this year, but we see improvement coming next year,” that’s not positive guidance. That’s spin.



Analyzing Inventories

Back when I first started trading stocks in the early 1980s, public companies were not required to report inventory figures; now those figures are readily available. Inventory figures can be found in the published balance sheets of a corporation, which are available in 10-Q (quarterly) and 10-K (annual) filings to the Securities and Exchange Commission (SEC). Companies post the filings on their websites; corporate filings also are available on the SEC’s EDGAR database.


With a manufacturer or retailer, inventory and accounts receivable analyses can provide a heads-up as to whether business conditions are likely to improve or if the good times are coming to an end. In late 2003–2004, the price of copper was going through the roof. This rapid escalation in the price of a raw material, I knew, would enable manufacturers of copper products to pass along a price increase to customers.


By examining the inventory figures in the quarterly reports of several manufacturers, I found my candidate: Encore Wire (WIRE). Encore possessed significant copper inventories and met the criteria of my SEPA stock analysis. I knew I had a potential big winner in sight. Encore had a stockpile of copper it had bought at lower prices. With the price of copper significantly higher, Encore could charge its customers significantly higher prices than it paid, which accounted for expanding profit margins.


Compare Inventory with Sales

For certain industries, such as manufacturing, the comparison of inventory and sales is crucial. Specifically, I look at the breakdown of inventory (i.e., finished goods, work in progress, and raw materials) and how each segment relates to the others. The inventory breakdown also helps put sales in perspective.For example, a strong gain in sales may look impressive; however, the company could be pushing on a string if in fact inventories are growing much faster than sales. If the finished goods portion of inventories is rising much more rapidly than the raw materials or work-in-progress segments, this could mean that product is piling up. Therefore, production will slow because the company already has a stockpile of finished goods.


If that inventory of finished products is highly depreciable—such as computers and certain retail goods—this could spell trouble ahead. A company sitting on a large stock of depreciating merchandise will have to slash prices to get rid of it. Also, that aging inventory will compete in the marketplace with newer product lines. Higher-trending inventories can lead to markdowns and write-offs, a scenario ripe for a hit on future earnings, causing the company to report a disappointing quarter. Keep in mind that the amount of inventory by itself is not that meaningful to your analysis. It’s the trend in inventories versus sales and the percentage increase or decrease within the inventory chain that yield valuable information.


Think of inventory as merchandise waiting to be sold. Under most conditions, inventories should rise and fall in a pattern similar to that for sales. Management tries to anticipate future sales and stocks inventory to meet demand or expected demand. When inventory grows much faster than sales, it can indicate weakening sales, misjudgment by management of future demand, or both. These scenarios are likely to undermine earnings. The more rapidly inventory depreciates, the more excess inventory will be detrimental. Dell’s Solution for Inventory Buildup Companies that control their inventory the best in an environment of falling prices have the potential to hold up best and outperform the others, especially during an economic downturn. Dell Computer responded to this problem with its revolutionary “build-to-order” business model.


The model transformed the manufacturing business by lowering inventory stockpiles and decreasing the risk of holding depreciating computers. Other companies have since adopted this simple concept even in industries outside the computer business. Dell’s model is based on orders taken over the phone and on its website. Computers are not put into production until an order is placed. This dramatically reduced the number of days inventory was held and increased the company’s inventory turnover ratio to more than three times that of its rivals.This unique new business model allowed Dell to capture higher profit margins than its competitors, gain market share, and dominate the computer market during the 1990s. The reason this concept worked so well in the computer business is that the product was highly depreciable.


Virtually all of Dell’s competitors relied on a business model that involved stocking retail stores with merchandise. When business turned down, Dell’s competitors were holding large inventories of merchandise, the value of which was eroding with time and advances in computer performance and capabilities. To keep their merchandise from spoiling like fruit in the sun, Compaq, Hewlett-Packard, and Gateway were forced to cut prices to unload their stockpiles. This condition will often show up in inventories, with finished goods usually rising and trending upward faster than sales and raw materials.


Not all inventory buildups are bad. Maybe a company has to fill the shelves of 20 new stores it just opened. The real red flag arises when an inventory buildup is unexplained or the explanation isn’t a good one. If you spot an unexplained inventory buildup, you can call the company or go on an investor conference call to ask for an explanation. On the flip side, if raw materials are suddenly building up, this could be an indication that the company believes business will be picking up. If that’s the case, sales should show signs of acceleration shortly afterward to confirm that the raw material buildup was indeed in anticipation of stronger demand.


Analyzing Receivables

In addition to inventories, a part of a company’s balance sheet that merits attention is receivables. Accounts receivable are what the company is owed for sales it has already made. Some receivables are to be expected in the course of doing business; it’s normal to have a reasonable delay between delivery of products or services and receipt of payment. However, if receivables are increasing at a far greater rate than sales or if the trend is accelerating, this could be a warning that the company is having trouble collecting from its customers. If receivables and inventories are both increasing at a greater rate than sales (twice or more without explanation), this could be double trouble.


Think about it. We know from the previous discussion that when inventories—particularly of finished goods—rise faster than sales, that means product is building up. The company has made more than it can sell in current market conditions, assuming that there isn’t a good reason for the buildup, such as the need to stock new retail outlets. This is even a bigger problem if the inventory stockpile is of highly depreciable goods. When receivables are also rising, the company hasn’t been paid for what it has sold to its customers.


This is a double whammy that often forecasts trouble ahead: Consumers aren’t buying, and retailers aren’t selling and therefore aren’t able to pay for the product they’ve got. The manufacturer isn’t collecting on what it sold, and its warehouses are full of more product than it can ship. There could be a reasonable explanation for the rising receivables, such as a new product line or new customers in a different industry that have been given longer credit terms.


Maybe orders have not shipped as expected because of a production delay. Whatever the reason, it’s worth investigating to see if this is a red flag or a situation that’s easily explained. In the example below, the rate of increase in total inventories is four times that of sales and receivables are up three times the rate of sales. More troubling is the fact that finished goods and work in progress are up big relative to raw materials. This could indicate an unusually large stockpile of goods. To the extent that those goods are depreciable, the product on hand will be worth less and less as time goes by, eroding margins and ultimately earnings. This type of scenario should raise a red flag.


Differential Disclosure

When a company says one thing in one document and something quite different in another, you have differential disclosure. This happens far more often than most people think. The reason is simple. Guidelines for reports to shareholders are far less restricted than those for reports submitted to the SEC. An example is shareholder reporting versus tax reporting. Make a point to compare footnotes and other disclosures related to taxes under the cash-basis accounting rules required for the Internal Revenue Service (IRS) with the earnings reported to shareholders under accrual accounting. If you spot a big difference, this is a red flag. In a similar vein, if a company is reporting great earnings but is not paying much in taxes, be skeptical.


Excerpt from the best-selling book Trade Like A Stock Market Wizard; How to Achieve Superperformance in Stocks by Mark Minervini

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