Quality is Job One by Alex Schay
The "quality of earnings" is an oft used phrase that describes
the relative proportion of a firm's earnings that are attributable
to growing sales and cost controls, as distinguished from
artificial profits created by inflationary values in inventories or
other assets. The phrase has a gravity to it -- in that it does more
than just encapsulate the inflationary element of earnings. The
fact that many "estimations" are made (according to less than
rigid GAAP rules) when companies prepare financial reports
makes for a situation where not all earnings are created equal.
Investors should be conscious of the fact that just because
those numbers say "earnings" at the bottom of the income
statement, that does not necessarily mean that they are
comparable from one company to the next. That's part of the
fun of investing though, discerning what is of quality and value
in the marketplace. Waste Management (NYSE: WMX)
shareholders weren't having much fun in February of this year
(until they were bought out by USA Waste) after the company
announced a $1.5 billion fourth-quarter charge. This sum was
added to the $2.9 billion in earnings that the company had to
erase from its books in an earnings restatement back to 1992,
thanks to faulty depreciation accounting for garbage trucks
and landfills.
Although it is difficult (if not impossible) for individual investors
to track the depreciation schedules of various assets, it's
important to know that they are a significant part of the
earnings equation for some firms -- as are loan loss reserves,
which can dramatically affect the quality of a company's
earnings. Despite the fact that Greentree Financial Corp.
(NYSE: GNT) provides a really ripe, juicy example in this regard,
a more interesting reference can be found in the trials and
tribulations of Boston Chicken (Nasdaq: BOST).
For many quarters the company had been chided for not
understating profits. That's right, it sounds strange, but
companies that are confident that they're building intrinsic
value will feel no compunction to overstate their earnings,
trusting that over a number of years the quality of their
earnings stream will be revealed. The company was
overstating its profit case by not taking loan loss reserves
against the value of over $1 billion in area developer debt
that it held. The resulting series of charges that eventually had
to be taken created implosions that track well with the
company's stock price. Another prominent element that can
affect the quality of a company's earnings are tax asset
valuation allowances.
The rapid adoption of SFAS No. 109, Accounting for Income
Taxes, in 1992 and 1993 has led to more and more firms
recording deferred tax assets for the value of net operating
losses. The ability to show better than "normal" earnings when
the allowance is reduced (which increases the asset) and the
subsequent income tax expense is lowered walks the fine line
between quality of earnings and "earnings power," another
loaded phrase. A good example of taxes and earnings power
is 3Dfx (Nasdaq: TDFX). The company had net operating loss
carry-forwards of $18.5 million in its Q4 1997 financials. The
difference was worth about $6.3 million in corporate income
tax the company was able to forego, as well as $0.05 more in
earnings per share that it was able to show.
The treatment of tax items can also work in reverse with
respect to assessing the quality of a company's earnings. For
example, the investment vehicle of Warren Buffet, Berkshire
Hathaway (NYSE: BRK.A and BRK.B), has tax liabilities that are
significantly overstated. Specifically, the company carries a
$10.9 billion+ deferred tax liability that is primarily due to the
appreciation of investments in companies such as Coca-Cola
(NYSE: KO) and Gillette (NYSE; G). Since those tax liabilities won't
be realized anytime soon (if ever), they can be looked at as a
long-term credit to owner's equity.
Overall, when assessing quality of earnings it is important to
consider -- what exactly is creating those earnings? The
answer, of course, is assets. In an interesting study performed
by Jack T. Ciesielski of the Analyst's Accounting Observer, the
Observer took a look at the asset composition of 20 of the
industrial companies contained in the Dow Jones Industrials
and how it has changed in this decade. The study began with
the assertion that "productive assets" are defined as current
assets and net property plant and equipment -- this is not to say
that the rest are unproductive assets, just that "the future
benefits associated with current assets and plant assets are
more certain than for other assets."
The study removed the financial companies that didn't have
current assets or plant assets that contributed meaningfully to
returns and looked at the resulting firms over the course of six
years between 1990 and 1996. The results showed that for the
group as a whole, the proportion of "other" assets (namely:
goodwill, intangibles, and deferred tax assets) to total assets
had increased by 24% during the period. The conclusion? The
kind of questioning attitude normally reserved for burgeoning
inventory and accounts receivable should also be focused on
a closer examination of all the "other" asset accounts as well. |
