Recently, I wrote Seeking Alpha readers about how to review a corporate balance sheet and cash flow statement. The community response was remarkable. By request, this follow-on article attempts to provide a similar overview for the income statement.
The income statement (aka profit-and-loss statement, or P&L) captures a business' ongoing financial performance over a period of time. This differs from the balance sheet; that doc is a "snapshot," or point-in-time of a company's financial foundation. The income statement aggregates revenue, expenses, and records net profit or loss, as governed by sometimes arcane GAAP accounting rules.
In an effort to reflect the performance of the ongoing operation, corporate management may create two income statements. The first one is the SEC-mandated GAAP (Generally Accepted Accounting Principles) document. The second is a non-GAAP "operating earnings" income statement. More on this subject later.
Folks, I'm no financial guru; there's no alphabet soup after my name. My objective is to identify what I believe are basic, practical investor due diligence markers.
For today's exercise, I selected Intel Corp (NYSE: INTC) to be the case study. Intel designs and manufactures semiconductors and other digital platforms. It's the world's largest such corporation.
I selected Intel Corp because the company exhibits a relatively "clean" income statement. Nonetheless management provides investors GAAP and non-GAAP versions. It presents these in a straightforward, easy-to-read format. The 1Q 2016 specifics lend itself to the subject matter as outlined below.
Income Statement Basics
The income statement contains 3 key segments: revenues, expenses, and net profits. When reviewing a P&L, there are myriad items to check. However, for this article, we will concentrate upon what I believe are the most important investment drivers:
- Revenue comps and trend
- Margin analysis
- Interest coverage ratio
- EPS comps and earnings estimates
Listed corporations must file a SEC standard income statement. In conjunction with a quarterly earnings release, companies typically provide an unaudited statement. The SEC filing is published a few days to a few weeks later.
Please find below the most recent Intel Corp 10-Q Consolidated Statement of Income. It includes 2016 data through April 2, 2016.
Revenue Comps and Trend
Healthy things grow.
Revenue, also referred to as "Sales," or "the top line," is compared with previous periods. At minimum, this includes year-over-year figures. As the fiscal year progresses, aggregate year-to-date totals should be examined. In general, I focus upon year-over-year numbers. Indeed, most businesses run via a seasonal cycle.
Of course, sometimes a linked quarter check is necessary. For instance, certain financial sector companies tends to grow (or not) in each successive quarter; the underlying drivers are highly secular in nature, not seasonal.
For Intel, we see 1Q 2016 revenues totaled $13.7 billion, thereby advancing 7.2% versus the quarter one year earlier.
I pay close attention to the top line. It's difficult to "fiddle" with revenue. In addition, businesses cannot "save their way to profitability." This is not meant to minimize the fact expense management is a necessary and worthy battle. However, long-term profitable growth requires upward trending revenue.
While the income statement reports one or two prior period comps, diligent investors may wish to compare the current quarter or fiscal year with multiple previous years' results. This affords a better feel for the long trend.
Margin analysis is imperative to good investing. Typically, margins are expressed as percentages of revenue. There are 3 common types of margin analysis.
Gross margin is Revenue less COGS (Cost Of Goods Sold). COGS are the direct cost of labor and materials used to make whatever the company produces. For Intel, it's semiconductors. This figure is divided by Revenue and converted to a percentage.
In 1Q 2016, Intel's as-reported gross margin was $8.13 billion. Total revenue was $13.70 billion. Therefore, GAAP gross margin percent was 59.3%. This was down from 64.3% a year earlier.
Op margin is net Operating Income as a function of Revenue. Regular operating expenses are included in this figure, but Interest and Taxes are out. So are other non-operating expenses. Operating income may be referred to as EBIT (Earnings Before Interest and Taxes).
In the first quarter of this year, Intel recorded an 18.7% operating margin. That's down from 20.5% in 1Q 2015.
Net margin is simply Net Income over Revenue. It's the "all-in" number. Net margin is the same as the profit margin.
We find first quarter net margin dropped significantly: from 20.9% in 1Q 2015 to just 14.9% in 1Q 2016.
Stopping to Think
Armed with this data, an investor can now noodle a bit on the facts.
Despite improving revenue, we learned Intel's GAAP margins fell across-the-board. In particular, net margins took a big hit. That can't be good, right?
This leads us to management operating earnings and associated "adjustments."
Within the quarterly press release report, Intel management includes non-GAAP or "operating" adjustments along with the unaudited GAAP income statement. Many times, these differences are acceptable. Other times, not so much. It is up to the investor to ferret out and decide what's OK and what's not. This requires work and thought, but it separates serious investors from those "playing the market."
In the 1Q 2016 earnings release, Intel management presented a table highlighting GAAP and non-GAAP data.
Since we're talking margins here, I've highlighted gross margin. Note how GAAP gross margin fell by 1.2 points, while non-GAAP margin rose 1.3 points. But wait! Where were these management adjustments?
Well, these are found at the back of the earnings release. The following supplemental table was provided.
OK boys and girls, here's the kicker.
Good investors seek to understand these adjustments and accept or reject them. That takes work. This is one reason I strongly encourage regular investors to limit the number of stocks held. Without taking the time to perform this sort of evaluation, one becomes likely to just accept what management dishes out.
This can be a big mistake.
I have long espoused it takes one hour, per week, per stock (on average) to adequately monitor, analyze, think about, and update a corresponding investment thesis.
Furthermore, I contend the less time you spend doing this.....you begin to transition from an investor to a trader or gambler. The stock market isn't a good place for retail investors to roll the dice.
Back to Intel: after reading the earning release notes and reviewing the table above, I was willing to accept the "Inventory valuation adjustment." I rejected excluding "Amortization of acquisition-related intangible assets." The "Deferred revenue writedown" might be ok; I'm wasn't sold on it, but since the figure was small, I played along.
After "Ray's adjustments," I'm at 61.1% adjusted gross margin versus 61.4% in the prior period. Therefore, I believe the YoY operating margin did not improve. It fell.
Interest Coverage Ratio
Before getting to the bottom line (earnings or profits), let's take an excursion to discuss the Interest Coverage Ratio. This ratio is a helpful way to analyze how comfortably a company's can service its debt.
Interest Coverage Ratio = EBIT / Interest Expense
Conceptually, the objective is to measure how well a business can cover debt service as a function of core earnings. EBIT omits interest expense, income taxes, and may exclude other corporate expenses. The reasoning behind this is to isolate base operations. As-reported first quarter EBIT was $2.57 billion.
In 1Q 2016, Intel booked $82 million net interest expense (plus some "other" expenses). We see the YoY net changed from black to red. 10-K management discussion notes this was a result of borrowing $1.5 billion for the Altera acquisition.
In any event, the Interest Coverage Ratio is greater than 30x. Servicing the debt isn't a concern. At what level would interest coverage become a concern? While somewhat industry-specific, I begin to ask questions when the Coverage Ratio is less than 4x.
Customarily, when computing interest coverage, analysts roll up multiple quarters of data. Using figures from just one quarter may reflect an aberration or otherwise distorted input.
EPS Trend and Estimates
Having reviewed the top line, margins, and a view of a firm's ability to service its debt, we get to the bottom line: net earnings (profit) and EPS (Earnings Per Share).
Certainly, we want to see bottom line earnings growth. But there's a bit more to it than just that.
First, it's important to look into the numbers and associated earnings narrative to better understand how the growth was obtained. This is referred to as earnings quality. A second key consideration is how the company fared versus estimates. Third, we must examine as-reported, or GAAP results versus management non-GAAP "operating results."
Earnings quality is somewhat subjective. The idea is to understand what drove earnings. Did EPS rise due to organic revenue growth, sound expense management, and operational excellence?
Or were the numbers driven by (or affected by) non-core, one-off, or oddball items?
These may include:
- tax rates affected by audit adjustments or unique circumstances
- extra days in the reporting period
- legal settlements
- depreciation or amortization accounting adjustments
- acquisition or divestiture related adjustments
- share repurchase
Continuing with our Intel example, we note the year-over-year tax rate dropped from 25.5% to 18.4%. This improved earnings by ~$177 million or 3.6 cents per share. Significant.
An extra week 1Q 2016 versus 1Q 2015 boosted revenue. This resulted in at least a penny tailwind.
Intel reduced the diluted share count by 39 million shares. This earnings impact was small.
However, all-in these items may have boosted EPS by a nickel. Off the as-reported $0.42 EPS, that's meaningful. It detracts from the reported YoY earnings per share increase. I submit Intel's 1Q 2016 earnings quality was so-so at best.
Actually, there's two estimates.
The first estimate is provided by many shareholder-friendly management teams. Senior leadership offers a quarterly and / or annual EPS target or target range. It may be indirect. Often, operational and financial forecasts are given to allow an investor to model a build-up to the bottom line.
Intel provides investors enough input to formulate a reasonable model. From the 4Q 2015 earnings release, here's what they provided to estimate 1Q 2016 GAAP and non-GAAP operating results:
Running the numbers, I estimated ~$0.38 first-quarter EPS. My estimate required making a few basic assumptions; for example, the tax rate and the share count were not provided explicitly. We see management states the other figures have some "slop" built in by adding the word "approximately." That's ok.
Based upon company input and my model, the Intel beat its first-quarter 2016 GAAP estimate: it recorded $0.42 EPS versus a $0.38 estimate. However, we revealed how 1Q results inflated by a soft tax rate, and a longer quarter. Weak "earnings quality" took some shine off. So I'd call it more of a wash.
Now the second, or "real" earnings estimate is the Street estimate. The Street estimate is the consensus of Wall Street analysts. Notably, they often run as a herd. In addition, it's important to note Street estimates reflect non-GAAP "operating" results.
There are numerous online sources to check Street estimates leading up to the earnings release date, and how the actual operating earnings fared versus these expectations.
INTC 1Q 2016 results compared with Street estimates is highlighted below:
courtesy of ameritrade.com
Like it or not, the Street estimates often carry more weight than management guidance. This is due to several reasons that go beyond the scope of this article.
An Excursion: GAAP versus non-GAAP operating EPS
Investors must think critically about the genesis and derivation of the non-GAAP operating results. To often, the Street simply accepts what management dishes out. Sometimes it's a clear picture of the true underlying operation reflecting reasonable puts and takes; however, other times a stew of "ifs, ands, and buts" that simply inflate earnings numbers.
Unfortunately, the use of non-GAAP earnings figures, and the difference between GAAP and non-GAAP earnings is heading in wrong direction.
The following chart was created by FactSet (NYSE:FDS):
Currently, about 90% of the S&P 500 companies report non-GAAP or operating earnings, up from only 72% in 2009.
Clearly, just over the past year, the spread between GAAP and non-GAAP operating earnings widened....a lot.
Let the buyer beware. Do the homework.
Now Back to Intel
Intel reported year-over-year operating earnings of $0.54 in 1Q 2016 versus $0.45 in 1Q 2015. As outlined above, I questioned some of the non-GAAP adjustments. "Ray's" operating earnings were ~$0.48. Going through a like process for 1Q 2015 operating results, I suggest operating EPS was ~$0.42 for the period.
The YoY 6-cent improvement is robust; until an unusually-low tax rate and an extra week in the 1Q 2016 quarter is considered. Those items bumped EPS by $0.05 or so. That pales the comp.
On balance, operating results were respectable, but no blockbuster.
Perhaps Mr. Market recognized these observations?
Post the first quarter earnings release, INTC stock traded with the NASDAQ average until the week of June 3. It has outperformed since that time. Recent headline news may be the reason.
Second quarter Street earnings estimates have been flat to down slightly. Current EPS consensus is $0.53. With a week or so before the 2Q release, the Street has aligned itself with Intel management's 2Q 2016 EPS guidance of approximately $0.51. For information, management guidance provided in conjunction with the 1Q press release is found below.
Please stay tuned..
A Word About EBITDA
As my regular readers are aware, I am not a fan of EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). My view is this measurement is a contrived income statement derivative. "Adjusted" EBITDA is even worse. If the measure is meant to be a surrogate for cash flow, then I suggest turning to the cash flow statement.
Nevertheless, EBITDA is utilized by certain business types and bankers; especially with respect to determining financial leverage. EBITDA is also used to run some economic valuations models. Therefore, I acknowledge the metric. From time-to-time, it's necessary to consider it. But I don't like it.
I look forward to your questions and comments.
Please do your own careful due diligence before making any investment. This article is not a recommendation to buy or sell any stock. Good luck with all your 2016 investments.
Disclosure: I am/we are long INTC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.