At the end of each earnings season, the StarMine team at Thomson Reuters uses the StarMine Earnings Quality model to identify companies with strong or poor earnings quality – two in each category.
The Earnings Quality model employs a quantitative multi-factor approach to predict the persistence of earnings. It differentially weights the sources of earnings based on analysis of their relative sustainability.
Our picks for companies in North America for this quarter that display good earnings quality are — O’Reilly Automotive Inc. (ORLY.O) and Ciena Corp. (CIEN.N). We’ll publish the other two with poor earnings quality in a subsequent post.
O’Reilly Automotive Inc. (ORLY.O)
Source: Thomson Reuters Eikon/StarMine
Lower oil prices driving demand
As drivers spend more time on the road due to lower fuel prices, the need to fix their cars increases — hence the demand for an O’Reilly Automotive pit stop. This chain of auto parts stores has seen revenues increase by more than 10% per quarter for each of the last four quarters. What makes their earnings high quality is the rising return on net operating assets (RNOA). As you can see in the chart above, trailing 4Q RNOA has steadily improved over the last five years, reaching a high of 48.3%, far exceeding the industry median.
That improvement has been driven by two things:
- Improving operating margins – which reached a five-year high of 19% in the last quarter. This indicates that O’Reilly has not had to discount to attract customers. The rest of the industry has seen margins fall in the same period.
- Improving net operating asset turnover – which reached a five-year high of 2.5. This indicates that O’Reilly has been efficient at generating revenues from its asset base.
Source: Thomson Reuters Eikon/StarMine
Getting in gear
Despite strong revenue growth, management has done a good job of controlling inventories. Inventory days have fallen (YoY) in each of the last four quarters. In the last reported quarter, inventory days were at 274 days, 14 days lower than a year ago.
In another sign of strong earnings quality, cash flow from operations has been healthy at O’Reilly, exceeding net income in every quarter for the last five years. When earnings are backed by strong cash flows, they tend to be more sustainable in the long term. These factors all explain why O’Reilly scores a very strong 94 out of a possible 100 on the StarMine Earnings Quality model, and indicates that earnings may continue to remain good in the coming quarters. Continued expectations of lower oil prices and the busy summer driving season approaching all bode well for O’Reilly.
Ciena Corp. (CIEN.N)
Source: Thomson Reuters Eikon/StarMine
Strong demand from AT&T
With the rise of streaming video, the demand for networking solutions to optimize and improve performance has never been stronger. Ciena is on the cutting edge of this area and saw revenues increase to the record height of $692 million. One of their largest customers, AT&T, accounting for 15% of revenues, showed strong demand for their products, and is expected to continue to favor their products in the coming quarters, based on management’s comments. Ciena is showing strong earnings quality based on improved operating efficiency, strong inventory management and strong cash flows.
Source : Thomson Reuters Eikon/StarMine
High-definition indicators
Revenues have not grown at the cost of margins. Trailing 4Q operating margins reached a five- year high of 5.5%, as Ciena was able to price its products competitively based on its performance. That led to increased operational efficiency as measured by the return on net operating assets. RNOA has increased steadily over the past five years and reached a five year high of 18.5%. The rest of the industry has not fared as well, and in the last two quarters, Ciena’s RNOA has exceeded the industry median. That is a good sign for future earnings.
Ciena has also done a good job of managing inventories. Inventory days were at a five-year low of 42, and in fact, the strong demand increased backlog. This could be a double edged sword though, as the company rushes to fulfill those orders. However, it is a sign of robust demand, and with key customers keen to improve their service by using Ciena solutions, it could mean strong earnings for the coming quarters. Management talked about solutions for AT&T being received positively.
Ciena has also generated positive free cash flows in each of the last seven quarters that have exceeded net income. Earnings backed by strong cash flows are a sign of strong earnings quality and are likely to be sustainable going forward. Based on the very strong StarMine Earnings Quality model score of 99 out of a possible 100, it looks like earnings quality will be a tailwind to future earnings.
