Last week, I wrote this article about the earnings quality of Coca-Cola (NYSE:KO) and the importance of earnings quality for investors. I am glad to notice that the importance of earnings quality was discussed in several comments on this article. I believe this will contribute to the understanding of the importance of earnings quality and, hopefully, lead to better investment decision-making.
In my previous article, I introduced this model, drafted by the New York State Society of Certified Public Accountants (NYSSCPA), to measure earnings quality. As I mentioned in the article, NYSSCPA composed twenty criteria of earnings quality, drawn out of eight different research models, into one logic model. Therefore, the model drafted by the NYSSCPA should be very complete and cover all aspects of earnings quality (and managing earnings).
One of the comments on my article raised an interesting point regarding the equal weight of the criteria in the model. The question was, should all criteria have an equal weight or should there be a distinction in the weight of the different criteria? I believe that it is impossible for me to answer this question without statistical research. Still, I am confident that the outcome (score) of the model should at least give investors a good indication of Coca-Cola's earnings quality, regardless their mutual weight.
The comment did also ask for some citation and an insight in the analyses of Coca-Cola's earnings quality in order to use the model properly. Although I responded to this comment directly, I later realized that an additional insight in the considerations behind the criteria could be very useful for investors. In this follow up article, I will discuss these guidelines for all twenty criteria of the model I used to determine Coca-Cola's earnings quality.
By providing additional guidelines for the model, I would like to improve overall understanding of the model. As a result, investors should be able to better understand my conclusion that Coca-Cola has 'Good' earnings quality. This will eventually help investors to make a better judgment of Coca-Cola's earnings quality in case that they base (a part of) their calculations and/or investment decisions on the company's historical earnings reports.
1. Revenue recognition and 6. Expense recognition
Revenue recognition refers to shifts of revenues from one period to another period in order to improve short-term earnings. It is obvious that companies or industries known for its questionable revenue recognition score lower than more stable companies. To observe potential revenue recognition issues, investors should look at accruals on a company's balance sheet. For example, accrued revenue and revenue received in advance.
Another indicator for revenue recognition issues is the company's sort of business. A service provider is more likely to shift revenue than a company that only sells goods.
For example, Coca-Cola only recognizes revenue "when persuasive evidence of an arrangement exists, delivery of products has occurred, the sales price is fixed or determinable and collectibility is reasonably assured" (source: coca-cola.com). I find that Coca-Cola's business and recognition policy has a low risk. Therefore, I rated Coca-Cola's revenue recognition score a 5 (out of 5).
On the other hand, take Tesla (NASDAQ:TSLA), an electric car manufacturer. This stock revenue recognition policy has been subject of debate, especially regarding lease contracts. As a result, Tesla would have scored a much lower score for these criteria than Coca-Cola.
Expense recognition refers to the shift of expenses to other periods, again to improve earnings in the short term. Like revenue recognition, investors should find indications for expense recognition issues in illogical changes in accruals on a company's balance sheet. For example, prepaid expenses and expenses to be received. I did not find much special or odd changes in Coca-Cola's earnings, so I rated the expense criterion as a 5.
2. Gross margin/sales ratio, 3. Operating earnings/sales and 4. Earnings variability
Criteria 2 to 4 are discussed together, because I applied the same guidelines for these criteria. I focused on the comparison of gross margin/sales, operating earnings/sales and earnings variability from a historical trend and an industry perspective. In case that margins change significantly compared to historical data and/or compared to the industry average, this could indicate earnings management and poor earnings quality.
According to the model, high gross margin/sales and operating earnings/sales indicate good earnings quality as well, probably because it is assumed that gross margin and operating earnings give a good picture of the company's true earnings. However, I find this argument questionable. Why would a higher gross margin imply better earnings quality? Therefore, I suggest to generally focus on the comparison of historical and industry data.
5. Cash flow from operations exceeds net income
I believe cash flow from operations compared to net income to be one of simplest, but also most important criterion. I compared Coca-Cola's cash flow from operations with the company's net income. The higher cash flow from operations exceeds net income, the higher the score for this criterion. This makes sense, because strong cash flow from operations indicates that net income is not managed by accruals. As a result, net income shows a more reliable picture of the company's true earnings.
For example, take Coca-Cola's cash flow from operations. Cash flow from operations exceeded net earnings over the past three years. Therefore, I believe that Coca-Cola should be given a high score for this criterion. This should be an important indicator for reliable investment decision making, because most valuation models refer to the company's ability to earn cash. In Coca-Cola's case, this number is high and stable, so investors should be able to make a reliable calculation for future cash flows.
7. Operating leases
Like cash flow from operations versus net income, the amount of operating leases is not so hard to define. Any company is required to disclose the amount of operating leases in their annual report. I considered the trend of Coca-Cola's operational leases, as well as the distribution of the leases over the upcoming years. To determine a correct score for this criterion, investors should rate a sudden increase in operating leases or an illogical distribution over time with a lower score. Coca-Cola's operating leases were high but stable and therefore I rated this criterion with a score of 4.
Companies looking for cash might be tempted to sell assets and lease the assets back. This is called a sale-and-lease back transaction. Investors should be looking for these transactions, because the effect on earnings quality is huge. Not only the sale of assets result in a one-time gain or loss, the company increases off balance liabilities in the same transaction. I find these transactions particularly alarming with respect to earnings quality. Please note that I did not find these transactions in Coca-Cola's earnings reports.
8. R&D expenses
This criterion indicates that decreasing R&D expenses are referred to poor quality earnings. I believe the reasoning behind this criterion is that decreasing R&D expenses will eventually lead to less new products, lower sales, worse results etc. In that case, historic earnings are not a good starting point to neither calculate the company's future earnings nor its value. To determine the score, I suggest to mainly focus on the historical trend of R&D expenses.
9. Pension expenses and gains and 10. Stock option expenses
Companies are keen on reporting non-GAAP earnings. A logic explanation for the difference between GAAP and non-GAAP earnings per share is that companies do not recognize the amount of stock based compensation as a 'real' expense. True, like actuarial results, stock based compensation expenses are not immediate cash expenses. However, cash or non-cash, these expenses still are an expense. I focused on the impact of pension gains/expenses and stock option expenses on bottom-line earnings. In case that the impact is big, the score will be low.
11.Gain/loss from asset sales, 12. Acquisitions/disposals, 13. Discontinued operations, 14. Ongoing restructuring charges, 15. One-time items and 16. Extraordinary items
I believe criteria 11 to 16 to be the weakest part of this model. These six criteria somewhat cover the same issues, namely the risk that one-time items trouble the picture of a company's true earnings. However, the model requires to give a score for all six criteria. So I did.
Most of the one-time items, gains/losses from asset sales etc. are disclosed separately. So, investors should be able to make a sound judgment of these one-time items. First, I identified the number of one-time items over the past years. Next, I focused on the soundness of the disclosure. The combination of the historical trend and the disclosure should give an idea of the impact of the one-time items on true earnings. Large impact will obviously lead to a lower score.
One of Coca-Cola's latest moves is the acquisition of a 16.7% minority interest in Monster Beverage Corp (NASDAQ:MNST). The net proceedings will be around $2.1 billion, not an unusual high amount for a large-cap stock as Coca-Cola. However, an increasing number of acquisitions could eventually trouble Coca-Cola's earnings. Therefore, investors should consider pending acquisitions in their calculations as well.
17. Accounting changes and 18. Reverses prior charges
The number of accounting changes and reverses of prior charges will give an insight of the company's consistency of accounting principles and/or prior assumptions. For example, is the change of accounting policy unusual or did other companies in the industry follow this change as well? In case that a company's change in accounting policy is not followed by the industry, this could imply poor earnings quality and, as a result, lower the score. Further, an unusually high number of accounting changes is another indicator for poor earnings quality. Again, this will lead to a lower score.
I applied my approach for accounting policy changes to reverses of prior charges as well. More reverses of prior charges indicate that the company is not consistent in its assumptions. This decreases the comparability and reliability of the company's earnings. In the model, recurring reverses of prior charges will lower the score for this criterion.
I did not find any material and unusual accounting changes in Coca-Cola's earnings reports. This is a strong point from an earnings quality perspective, because historical data is comparable. This reduces the risk for investors to base their projections on data with the wrong accounting policies.
19. Tax rate percentage
The corporate income tax rate percentage determines whether a company optimizes its effective tax rate, for example with a structure of corporations abroad. In 2012, Amazon (NASDAQ:AMZN), Starbucks (NASDAQ:SBUX) and Google (NASDAQ:GOOG) were accused of diverting profit in the United Kingdom. A high difference between the Corporate Income Tax rate in the United States and the statutory tax rate implies active management of profit distribution in order to optimize tax position abroad. A high variance in tax rate over time is another indication for active earnings manipulation.
Coca-Cola's tax rate is far below the CIT rate in the United States, probably due to the company's international presence. The tax rate is around 25%, based on the latest second quarter earnings report and the annual report of 2013. This may raise the question whether Coca-Cola is due additional taxes in the United States or in other countries in the future.
20. Share buyback/issuance
Finally, share buyback versus share issuance. When a company repurchases its own share, earnings per share increases on a comparable basis. Therefore, large buyback programs could hide an actual earnings decrease from an EPS perspective. Therefore, investors should not focus on EPS alone, but on full bottom-line results as well. A large buyback program and/or issuance of stock will lead to a lower score in the model.
Coca-Cola has a large buyback program in place. The company returned a net $1.3 billion through share repurchases in the first six months of this year. Coca-Cola expects to return an additional $1.2 to $1.7 billion in the second half of this year. Considering my findings above, investors should be cautious to focus on Coca-Cola's EPS data and consider the full net income trend as well.
In this article, I provided additional guidelines for my model to measure Coca-Cola's earnings quality in order to increase the value of the findings in my first article. In this first article, I qualified Coca-Cola's earnings quality as 'Good'. This suggested Coca-Cola's financial statements are reliable and that investors can rely on historic earnings to predict future earnings. Based on the information in both articles, investors can apply the model to make more reliable calculations for Coca-Cola's future earnings per share and cash flow from operations, based on historical earnings reports. Hopefully, this contributes to more reliable calculations and better investment decision-making.
As a final note for discussion, could it be true that earnings quality is by definition better for defensive stocks, like Coca-Cola? The nature of their business give less options to manage earnings and, therefore, lower earnings quality. Given my findings in the two articles about earnings quality, I believe this could be true. Defensive companies, like Coca-Cola, often have strong cash flow (to pay a healthy dividend), not a complex business (selling goods), not much accruals on their balance sheet (no work-in-progress or revenue received in advance) etc.
Disclosure: The author is long KO, TSLA, GOOG.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.