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  • Why LeapFrog Enterprises' Earnings Are Outstanding 0 comments
    Jun 13, 2012 3:48 PM | about stocks: LF

    Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.

    Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.

    Calling all cash flows
    When you are trying to buy the market's best stocks, it's worth checking up on your companies' free cash flow once a quarter or so, to see whether it bears any relationship to the net income in the headlines. That's what we do with this series. Today, we're checking in on LeapFrog Enterprises (LF) , whose recent revenue and earnings are plotted below.

    (click to enlarge)anImage

    Over the past 12 months, LeapFrog Enterprises generated $61.7 million cash while it booked net income of $32.6 million. That means it turned 12.7% of its revenue into FCF. That sounds pretty impressive.

    All cash is not equal
    Unfortunately, the cash flow statement isn't immune from nonsense, either. That's why it pays to take a close look at the components of cash flow from operations, to make sure that the cash flows are of high quality. What does that mean? To me, it means they need to be real and replicable in the upcoming quarters, rather than being offset by continual cash outflows that don't appear on the income statement (such as major capital expenditures).

    For instance, cash flow based on cash net income and adjustments for non-cash income-statement expenses (like depreciation) is generally favorable. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable for the short term) or shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable; this is good to see, but it's ordinary in recessionary times, and you can only increase collections so much. Finally, adding stock-based compensation expense back to cash flows is questionable when a company hands out a lot of equity to employees and uses cash in later periods to buy back those shares.

    So how does the cash flow at LeapFrog Enterprises look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

    (click to enlarge)anImage

    Source: S&P Capital IQ. Data is current as of last fully reported fiscal quarter. Dollar values in millions. TTM = trailing 12 months.

    When I say "questionable cash flow sources," I mean items such as changes in taxes payable, tax benefits from stock options, and asset sales, among others. That's not to say that companies booking these as sources of cash flow are weak, or are engaging in any sort of wrongdoing, or that everything that comes up questionable in my graph is automatically bad news. But whenever a company is getting more than, say, 10% of its cash from operations from these dubious sources, investors ought to make sure to refer to the filings and dig in.

    With 13.8% of operating cash flow coming from questionable sources, LeapFrog Enterprises investors should take a closer look at the underlying numbers. Within the questionable cash flow figure plotted in the TTM period above, stock-based compensation and related tax benefits provided the biggest boost, at 8.1% of cash flow from operations. Overall, the biggest drag on FCF came from changes in accounts receivable, which represented 32.5% of cash from operations.

    Disclosure: I am long LF.

    Themes: Stock Analysis Stocks: LF
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