"When everyone thinks alike, everyone is likely to be wrong."
- Humphrey Neill
We discuss a broad range of issues that are often investment-related, but not always so. We call it a 'thought blog'. Sagacious: Having or showing keen discernment, sound judgment, and farsightedness.
Quality of Earnings Deteriorating?
In what might be a sign that corporate earnings quality may not be as good in the near future as in the recent past, a recent WSJ article mentioned that the difference between GAAP and “pro forma” earnings has widened over the last two quarters. This is the second-largest percentage move in two years, according to the article, which sources information from a strategist at Merrill Lynch.
Why could this be worrisome? Well, a difference between GAAP earnings and pro forma earnings indicates the use of below the line, one-time “nonrecurring” charges that are often ignored when comparing period-over-period changes in earnings. Some analysts will simply back out the one time charge, adding it back to earnings (pro forma) since the charge is supposed to be non-recurring, unusual or extraordinary. The problem is, sometimes these charges should not be ignored and actually should, at least in part, be considered part of a company’s ongoing operations, despite their apparent one-time or unusual nature.
To see how these one-time charges affect economic value, watch the cash flow statement and read the footnotes. These charges, though one-time from a GAAP perspective, will continue to show up in cash flow as companies pay for severance packages or restructuring costs, for instance. Or they may be non-cash in nature, such as asset writedowns, which won’t affect cash flows until the asset is sold, or goodwill impairment.
Note that these “nonrecurring” charges can also be used to manipulate earnings. Taking the hit in the current quarter may benefit GAAP earnings in the next. Sometimes this will occur in the form of a “big bath” where, when times are tough, a company might “move” all of the next few periods’ plant shutdown costs into the current period, so that future “earnings” are not crippled by these expenses. It’s the “Let’s get all the bad stuff out of the way now” idea. This can come in the form of asset writedowns, layoffs, restructurings, etc., whose actual economic effects are not really confined to a single period.
If this widening continues into the third quarter, it could lead to a troubling trend. Stick with companies that have high quality earnings and where cash flows and earnings tend to approximate one another. If there is a persistent sharp disconnect, the company may be trying to hide trouble.
Why could this be worrisome? Well, a difference between GAAP earnings and pro forma earnings indicates the use of below the line, one-time “nonrecurring” charges that are often ignored when comparing period-over-period changes in earnings. Some analysts will simply back out the one time charge, adding it back to earnings (pro forma) since the charge is supposed to be non-recurring, unusual or extraordinary. The problem is, sometimes these charges should not be ignored and actually should, at least in part, be considered part of a company’s ongoing operations, despite their apparent one-time or unusual nature.
To see how these one-time charges affect economic value, watch the cash flow statement and read the footnotes. These charges, though one-time from a GAAP perspective, will continue to show up in cash flow as companies pay for severance packages or restructuring costs, for instance. Or they may be non-cash in nature, such as asset writedowns, which won’t affect cash flows until the asset is sold, or goodwill impairment.
Note that these “nonrecurring” charges can also be used to manipulate earnings. Taking the hit in the current quarter may benefit GAAP earnings in the next. Sometimes this will occur in the form of a “big bath” where, when times are tough, a company might “move” all of the next few periods’ plant shutdown costs into the current period, so that future “earnings” are not crippled by these expenses. It’s the “Let’s get all the bad stuff out of the way now” idea. This can come in the form of asset writedowns, layoffs, restructurings, etc., whose actual economic effects are not really confined to a single period.
If this widening continues into the third quarter, it could lead to a troubling trend. Stick with companies that have high quality earnings and where cash flows and earnings tend to approximate one another. If there is a persistent sharp disconnect, the company may be trying to hide trouble.
More on Dow Chemical
(continued from previous post)
The 4% dividend yield is a nice pad to total return. Over at least the past 17 years, the company hasn’t cut or reduced its dividend, which has grown at an annual rate of a little over 3%. The company is watching costs, having shut down more than 50 manufacturing facilities across the globe over the last three years amidst record profitability. And they’re using cash to pay down debt and buy back shares. Yet this has happened before, most recently from about 1994 through 1998, and from there debt levels and share count grew again.
We know the third quarter is likely to be a little rough, as the company will be taking about $600 million in charges for severance and asset writedowns as a result of plant closings. Look for earnings to be boosted in future periods, as this writedown will hit earnings in the third quarter of this year and not affect them in future periods. Don’t be fooled, though, as actual severance and plant shutdown costs will continue to impact the company’s cash flows into the future.
Let’s look at another metric, the current forward price-to-sales (P/S) ratio, which is around 0.75. This is near the lows of the past 10 years and most similar to the lowest forward multiples experienced in 1995-96 for the expansion years of 1996-97. Coincidentally (or not), the period most similar to now in level of margins and ROE was 95-96. The average forward P/S multiple during those years was under 0.90 (since 1995 Dow’s average P/S ratio is 1.00) , while Dow’s P/E ratio averaged 9.5, which looks strikingly similar to now. What does all this mean?
Purchased at the low prices of 1995-96, Dow would have returned about 8.6% annually to date (including the 10-yr average dividend yield of 2.6%). The S&P 500’s total return over that period is around 10% annually.
Historically, it has been more profitable to buy cyclical companies when P/Es are high and profits are bottoming. In this case, Dow has a low P/E ratio and its profits are (probably) at or near a peak.
If you think the stock has upside between now and January but don’t want to invest the cash, write a Jan 40 put and buy a Jan 40 call. Based on current prices, you’ll effectively own the stock at a little over $39 (slightly over market) but without any cash outlay. Be aware that you’ll need to have the cash to cover the trade in the event the stock is put to you come January.
Subscribe to:
Posts (Atom)