Who Cares About Earnings? Show Me the Cash-Flow

The concept of real profit growth or earnings growth in this environment is an oxymoron . Many a recession has come and gone over the years, but this one is tainted by ghosts of loose notional values (think derivatives) and excess leverage.

However, some management teams are better than others when it comes to earnings quality, cash flow and the clarity of accounting used in presenting them.

We are big fans of dual cash-flow analysis and this unconventional method is the first stop on our research journey. Cash-flow is the oil which drives a company’s engine and the DCF technique helps us determine if the motor running a business is sufficiently “lubricated” or not.

The DCF screen we developed is based on the pioneering work of Harry Ernst and Jeffrey Fotta back in the mid-nineties. It was originally designed to help corporate managers of fast growing firms balance liquidity needs as a tool to build equity over time.

The key difference between dual and standard cash-flow analysis is in how the numbers are defined. For example, unlike more traditional methods, dual-cash analysis considers changes to accounts payable and receivable as a component of balance-sheet cash flow rather than operating cash-flow.

Rising operating cash flows with declining balance sheet cash flow usually indicates stronger earnings quality. Likewise, falling operating cash flows with rising balance sheet cash often suggests a deterioration of earnings quality.

Our “dual” model has been tweaked a lot over the years and we have added some bells and whistles, such as accrual ratios, revenue metrics and capital productivity tools. The purpose of this exercise helps us to determine how much of reported earnings are generated from paying customers and how much gets created via accounting changes.

Energizer Holdings (ENR) is a perfect example of how this odd combination of analysis can be useful in identifying potential trouble ahead for a stock.

Last year, we issued a report to a client wanting a comparison of the earnings quality between several consumer discretionary stocks (PG, CL, CHD and ENR). This particular study was for a five quarter period ending June 2008.

We knew the credit markets were in turmoil, so it wasn’t surprising to see many of the stocks in our study tighten up days-sales-outstanding and accounts receivables, or stretch out payables further.

As you can see in the chart below, dual cash figures for CHD, CL and PG are fairly consistent and positive throughout the study period. In contrast, dual-cash figures for ENR are negative and well below the others.

Our accrual analysis also revealed some potential problems brewing at ENR. The accrual ratio screen we use is adapted from the work of Richard Sloane.

You will notice again in the chart below that CL, CHD and PG run in the same pack so to speak. They are using accruals sparingly while ENR goes parabolic and into nose-bleed territory!

Note: Accrual figures of -5 < are considered bullish. Anything > +5 is considered bearish. There are many companies who fall between these extremes, but it is the trend you should pay attention to.

Capital productivity varied amongst each firm, but it was the June 2008 period when these structural changes became more evident in the financial statements.

What we discovered over the years though (through trial and error), is that a combination of dual-cash flow study and accrual analysis provides a uniquely predictive tool to handicap the potential future direction of a security’s price.

To be sure, market corrections like we experienced this past year don’t differentiate between good or bad earnings. Fear is as fear does when it comes to market sentiment.

However, as you can see below, ENR (blue line) suffered far more damage than its peers during a period of otherwise wholesale market slaughter. Dual cash-flow analysis isn’t a crystal ball, but it goes a long way in keeping us out of trouble.

The table below lists several stocks we believe display improving earnings quality and a few stocks we’d avoid for now. Note: analysis period is for the five qtrs. ending March 2009.

Improving Earnings Quality
Psychiatric Solutions	PSYS	Modest but steady improvement in asset quality for this leading provider of mental health services.
Cintas Corp.	CTAS	Strong balance sheet will help this well run industrial services company navigate a difficult economy.
Lindsay Corp.	LNN	Improving accrual trends bode well for this maker of water and irrigation products.
Deteriorating Earnings Quality
Hertz Global	HTZ	Deteriorating operating cash-flow trends hurt earnings quality for this auto rental services company
Varian Medical	VAR	Rising use of accruals and declining capital productivity more than offset otherwise bullish dual-cash flow trends for this maker of medical equipment.
Cytec Industries	CYT	Specialty chemical maker hampered by declining operating cash-flows in recent periods

Disclosure: Author is long CTAS common shares and CYT bonds.