“But, there were some who saw it coming. While the whole world was having a big old party, a few outsiders and weirdos saw what no one else could... These outsiders saw the giant lie at the heart of the economy, and they saw it by doing something the rest of the suckers never thought to do: They looked.”
-Opening monolog from The Big Short
What is Quality of Earnings?
Accrual accounting requires a company’s management to make many assumptions that impact the timing of revenue recognition, expense recognition, and the book value of assets and liabilities. Generally Accepted Accounting Principles (GAAP) give companies considerable leeway in making these assumptions, which provides material “wiggle room” in the earnings they report. Unrealistic assumptions can result in artificially high reported earnings and inflated asset values which, in turn, lead investors to believe that future growth prospects are higher than they really are.
Adding to the problem is the dramatic proliferation of non-GAAP reporting seen over the last few years. Studies indicate that in 1996, fewer than 60% of companies included non-GAAP figures in their presentation of results. Now, it is unusual to find one that doesn’t. Investors tend to focus on these numbers which often remove recurring items, don’t adjust for one-time benefits, and eliminate the full cost of acquisitions, all of which hides the decay in the balance sheet that can be seen in the GAAP results.
Why Quality of Earnings Problems Persist
The natural positive bias of Wall Street is no secret. Investment banking relationships and the desire to stay in good standing with companies to secure management meetings for clients incentivizes sell-side analysts to see companies though rose-colored glasses. This explains the fact that sell recommendations remain a small fraction of total Wall Street recommendations years after regulations were passed to encourage unbiased analysis.
So what about the buy-side?
The fact remains that earnings quality analysis may not be rocket science, but it does require a great deal of work and expertise. Simple “red flag” ratio analysis is merely a jumping off point. In our experience, such screens produce as many false positives as they do false negatives. A thorough job requires digging through footnotes, reading the fine print on press releases and then comparing the story the numbers tell to the story being told by management and Wall Street. The process is both left-brained and right-brained and requires patience to dig through reams of boring material looking for the one nugget of interesting information- work that not everyone likes to do.
Our Research Process
We go far beyond the automated screens that simply track accrual levels or make standardized adjustments to earnings. Our analysis involves the review of footnotes, conference calls, factors in the company’s end markets, and in many cases, years of experience following the company in question. Reviews 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 transaction costs, integration costs, and amortization of intangibles and/or using a longer amortization period for acquired assets vs. those developed in-house.
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 or removing closed stores.
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, increased receivables factoring, or unsustainable skimping on capital spending which will reverse in the future