Goodyear Tire & Rubber (GT) has displayed low earnings quality for 2011 and faces significant risk of future downward earnings reversion. Aggressive analyst estimates are setting up a scenario for Goodyear to fail to meet future earnings predictions. I discuss below the major factors facing Goodyear’s ability to meet current analyst forecasts.
Poor earnings quality as measured by The Accrual Review - My company, The Accrual Review, gives Goodyear an F rating for the first half of 2011 based on Goodyear’s above-market balance sheet accrual growth (earnings quality ranked bottom decile of S&P 500 “ex-financials” companies). High growth in balance sheet accruals is predictive of low earnings quality and increased risk of earnings reversion / restatements.
Aggressive analyst estimates - Although I believe Goodyear’s earnings quality and persistence factor to be low, over the past 90 days analysts have increased current year’s estimate by 53% ($1.59 vs. $1.04). Additionally, 2012 full year earnings are estimated to increase by 38% over the current year estimate ($2.19 vs. $1.59).
Accounts receivable and inventory increasing faster than peers – Two components of balance sheet accruals are accounts receivable and inventory. For the first half of 2011, Goodyear appears to have aggressively accounted for these two categories:
- Accounts receivables increased by 29% Q2 2011 from Q4 2010 (87th percentile of peers)
- Inventories increased by 35% Q2 2011 from Q4 2010 (98th percentile of peers)
Aggressively accounting for accounts receivable will overstate sales for the period. However, accounts receivable may be a lesser concern as Goodyear’s Days Sales Outstanding (DSO) ranked at the 24th percentile of peers. A lower DSO value means that Goodyear is more efficient at managing receivables compared to the amount of sales made.
Overstating inventories decreases costs of goods sold and increases operating income for the period. Goodyear’s increase in inventories definitely raises concerns as their Days Sales of Inventory (DSI) is at the 68th percentile of peers. A higher DSI value means that Goodyear has a large amount of inventory on hand compared to amount of sales made. This increases the risk that Goodyear may have to lower prices to push through excess inventory in the event of a slowdown.
Because Goodyear’s growth in these two categories is above their peers, this raises concern for Goodyear’s earnings quality and earnings persistence factor.
The following table displays metrics ranking Goodyear’s accounts receivables and inventory against their peers (as disclosed in their DEF 14A):
Historically low light vehicle sales – Although light vehicle sales rebounded in September to 13.1M units, this rate is still well below the 16M-18M unit run rate seen from 1999-2007. Given the risk of recession from the European debt crisis, another slowdown in light vehicle sales presents significant risk that Goodyear may be forced to reduce prices to work through excess inventory.
Significantly underfunded pension plans ($2.5B underfunded on an $8.3B PBO) – Due to the 2008 financial crisis, Goodyear’s pension plan became significantly underfunded. Currently, Goodyear’s plan assets are allocated ~70 equity / 30 debt, which puts Goodyear’s pension plan at risk of loss during another decline in global equity prices.
Further actuarial losses in Goodyear’s pension plan assets would require them to amortize additional accumulated other comprehensive losses (AOCL). From 2008 to 2009, amortization of AOCL increased from $87M to $186M caused by a pension plan return of -31.7% in 2008. In 2010, the amortization of AOCL declined to $168M due to a global rally in equities. For 2011, amortization of AOCL is on track to realize $172M ($86M through first six months).
If another global recession occurs, Goodyear’s pension plan will be hit hard. This will raise the 2012 pension expense and will make Goodyear’s plan even more underfunded.
Cheap valuation against peers suggests investors may be pricing in future earnings declines – Goodyear’s P/EPS (estimate current year) and P/EPS (estimate next year) ranks in the bottom decile among their peers. Either Goodyear is currently undervalued or investors believe that Goodyear’s prospects are weaker than current analyst estimates. Based on my additional aforementioned reasoning, I believe this is the latter.
The following table displays valuation metrics (based on 10/6/11 closing price) ranking Goodyear against their peers (as disclosed in their DEF 14A):