The Truth in Earnings

November 23, 2009

If you’re serious about making money in 2010, the only way to beat the market is to invest in stocks with high-quality earnings.

The majority of third-quarter results for S&P 500 component stocks seemed to be pretty positive. About 80% of companies beat expectations, 6% matched and 14% missed estimates. These percentages make great headlines, but what do the numbers really mean?

Yes, earnings are improving (up 73% from last quarter), but the percentage of companies that beat the Street is still down from a year earlier (-15%). But the reality is that a lot of the profits reported by U.S. companies came from cost-saving measures like layoffs, plant closures and project cancellations—not because of meaningful revenue growth. Unless companies can increase sales, cost-cutting can only boost profits for so long until it ultimately hinders future performance.

This is why smart investors have to do their homework and look at the quality of those earnings on a stock-by-stock basis. Beating estimates or growing quarterly profits simply isn’t enough. An excellent example of “low-quality” profits is the financial sector, which is reporting the highest earnings growth—more than double a year earlier—and posting the biggest surprises.

Let’s take a closer look at Citigroup’s (C) latest earnings report so you can see what I mean. The banking giant beat estimates by 29% in the third quarter. That may be a high surprise, but it’s certainly not based on high-quality growth, which is why I told investors not to go near the stock with a 10-foot pole. The company added $800 million to its loan-loss reserves, providing a sobering reminder that it is still being anchored down by bad consumer debt.

The point here is that just because a company beats estimates in a big way doesn’t mean that it has high-quality earnings. Citigroup trounced expectations, but still reported a 27-cent loss per share. This is not the sign of a healthy, growing company. If Citigroup’s results teach us anything it is that the risk of owning this stock still outweighs the reward. As investors, we should take this lesson and apply it to our strategy in order to reap the lion’s share of the profits in 2010.

So how can we identify a company with quality earnings?

As you can see, high earnings aren’t nearly as important as high-quality earnings. So how do we distinguish between the two? Let me break it down for you:

#1: One-time charges and one-time gains

A company might see its earnings surge because of a one-time gain, like the sale of an important asset. In the second quarter, Citigroup reported a 49-cent per share profit (analysts were looking for a 37-cent loss), trouncing expectations by 232%. But the company’s earnings beat had more to do with a one-time multibillion-dollar gain associated with the sale of its Smith Barney investment banking division. As the company demonstrated in the third quarter, this earnings performance was not repeatable. Absent another massive one-time windfall, Citigroup is out of luck.

On the flipside, a perfectly good company could see its earnings come under pressure due to a one-time charge. For instance, if a firm goes on a buying spree to snatch up other companies or upgrade its operations, the acquisitions and business enhancements show up on the books as a cost. Baidu (BIDU), China’s leading Internet search company, is a good case study of this. After reporting a 42% increase in quarterly profit on a 39% jump in revenue over last year’s quarter, Baidu cautioned that revenue might take a hit during the fourth quarter of 2009 as it upgrades to a new advertising system. The negative impact this cost will have on the company’s bottom line is really only a temporary setback. In the big scheme of BIDU’s business plans, this is only a one-time cost of doing good business that will be more than compensated for over the long term.

#2: Cash in the bank

I’ll be honest—there are a lot of factors that can influence earnings that are out of a company’s control. Think about the impact of exchange rates on businesses with an international footprint. A falling U.S. dollar will boost the earnings of a company that must convert its overseas profits from a stronger currency like the euro. Another factor that can lift earnings is inflation, which gives companies an added boost when products are sold at higher prices.

So what can a company control?  Simply, the cash it has on hand after expenses are subtracted from revenues. This is called cash flow—or the money a company has left over after paying for the costs of its business. This is a crucial indicator of success because brisk sales and revenue don’t always add up to big profits or an ability to expand. If every cent of a company’s cash is tied up paying bills, a big sales number has a limited impact. If a company is flush with capital and on top of its game, it will deliver shareholders big profits.

Dolans Media (DM) is the second-largest publisher of law periodicals and third-largest publisher of local business journals in the U.S. Unlike the mass media that provides the public with general information, Dolans targets niche audiences with sophisticated and specific legal information. One of the company’s strategies has been to acquire businesses to expand its professional services, and this has resulted in rapid sales growth.

Just look at the numbers—in the third quarter, DM’s sales rose 30.1% to $62.3 million (versus $47.9 million last year), which in turn boosted earnings 122.2% to $6 million (versus $2.5 million). These profits are of the highest quality. Why? Because DM can take them straight to the bank.

#3: A willingness to look towards the future

“Guidance” is another crucial part of determining the quality of a company’s earnings. When management makes forward-looking statements about what it expects its company will do in the future, investors can use these comments (in combination with the financial results) to forecast a business’s earnings potential.

The economic downturn discouraged a lot of companies from making predictions about future performance because there was so much uncertainty about macroeconomic trends. But now that the cloud has been lifted and a global economic recovery is becoming clearer by the day, it’s a bit easier to take a longer term view.

Home-improvement retailer Home Depot (HD) reported a smaller-than-expected profit loss last week, topping estimates by 13.9% thanks to lower expenses during the quarter. The company even went so far as to raise its full-year forecast as a result. While this might seem like a positive step in the right direction, the reality is that Home Depot’s outlook calls for a 13% decline in operating earnings, and is 13 cents below Wall Street’s consensus. As long as demand remains weak for home-improvement products, HD is going to have a hard time convincing investors of its bright future.

A better stock whose future we can get excited about is China Green Agriculture (CGA). This company is part of the green revolution in China, bringing environmentally responsible fertilizers and agricultural products to rural farmers. China Green recently reported that its profit for the first quarter increased 50% compared with last year and its total sales jumped 27%. These results indicate that demand is booming for China Green's fertilizer products, and the company's management expects this trend to continue, which is why CGA lifted both its sales and earnings guidance to ranges above Wall Street’s consensus. The company’s CEO also said that the company has recently increased its production capacity, enabling the firm to create even bigger revenue and earnings going forward.

The bottom line

The way earnings are treated on Wall Street has more to do with the size of the surprise than the quality of it. The financial news media and investors tend to focus on actual cents per share, indicating that size matters more.

But as I said earlier, if you’re serious about making money in 2010, you need to chisel through the hype and look for stocks with quality earnings if you want to beat the market in the year ahead. On average, these stocks tend to outperform the market for longer and deliver sizable profits to the savvy investors who bank on them.

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