“We hope all danger may be overcome; but to conclude that no danger may ever arise would itself be extremely dangerous.”

-Abraham Lincoln

Behind the Numbers’ EQ Reviews evaluate the quality and sustainability of a company’s reported earnings and cash flows and the quality of its overall disclosure. Our universe generally includes large, widely-held companies. The research process is designed to ferret out any hidden risks in the numbers that could eventually result in earnings misses and stock price declines. Points of evaluation include:

• Traditional earnings quality red flags such as rising DSOs and DSIs, aggressive or changing depreciation periods, excessive restructuring charges, regular “one-time” gains, and increasing capitalization of expenses

• Evaluation of non-GAAP earnings adjustments looking for operational items being excluded such as adding back stock-based compensation or an acquisitive company adding back amortization of intangibles

• Never-ending restructuring charges where operational expenses may be getting lumped in and ignored by analysts – too many focus on the current 18-month plan and ignore that this activity has been going on for 15-20 years.

• Identifying “growth through acquisition” stories where organic growth is weak or negative

• Structural issues such as low ROI, excessive intangible assets vulnerable to write-down, large JVs or off balance sheet financing

• Evaluation of free cash flow quality looking for issues such as aggressive stretching of payables or unsustainably skimping on capital spending which will reverse in the future

• Unusual items such as core revenue growth benefiting from currency impact being adjusted out for segments operating in hyperinflationary countries, or same-store sales benefiting from including remodeled locations

Companies are assigned a score on our EQ Ratings scale between 1 (weakest) and 6 (strongest) with a + or – sign indicating if the quality is improving or eroding. Ratings are reviewed each quarter and updates published as new developments warrant. EQ Reviews can be used to:

• Identify positions in portfolios with hidden risks and avoid “torpedo stocks” which can dent performance

• Updates allow clients to detect early when managements are becoming more aggressive in their reporting and increasing the chance of future earnings disappointments

• Likewise, EQ Reviews identify companies with conservative accounting or undervalued assets where there is an increasing chance of reporting a positive earnings surprise

• Identify false positives where rising accruals are NOT a problem.

EQ Reviews often lead us to do more fundamental work on companies leading to the publications of both Sell recommendations and Buy Recommendations.

 Click for characteristics of typical sell recommendation