by Sridharan Raman.
A successful voyage depends upon setting the proper course and taking advantage of favorable conditions – but it also means avoiding the rocks.
With that in mind, the StarMine team used the StarMine Earnings Quality model to identify three North American companies that are exhibiting poor earnings quality. Previously, we identified three with strong earnings quality here. 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.
No wind in the sails
Our picks for companies with weak earnings quality are — ViaSat Inc. (VSAT.O), Mattress Firm (MFRM.O) and Ascena Retail Group (ASNA.O). The chart above shows the price action of each, compared to the S&P 500 over the past three months of market uncertainty.
Quality is rewarded more in some market environments than others. Judging by the underperformance of these equities over the past three months, the market and our model may be in agreement. What is potentially a flight to quality seems to be leaving these stocks behind. Let’s take a closer look at each of our three companies with weak earnings quality and some of the inputs driving their model scores: accruals, cash flows, and operating efficiency.
R&D heading upward
Viasat supplies satellite broadband and wireless services, infrastructure, and technology. It is working on a ViaSat-3 satellite while its ViaSat-2 is waiting for final clearances before launching in the beginning of 2017. While that will help increase bandwidth, especially with new contract wins like the one recently signed with American Airlines to service its 737-MAX fleet, it also increases costs and expenses in the short term.
R&D expenses have been projected to be higher for this program already, which will be a headwind for earnings in the coming quarters. Management, which has historically given guidance on expenses, has held back, which led some analysts to anticipate even higher expenses going forward. How these expenses are treated is also an important decision, and management has not been clear about how much will be capitalized.
A look at the chart above shows that historically, pro-forma earnings have exceeded GAAP reported earnings (by the red part of the bar). This happens when management asks investors to ignore certain expenses that it may consider not part of the core business or unusual in nature. However, in the long run, GAAP earnings tend to be a more accurate measure.
Debt climbing higher
As you can see, capital expenditures (blue bars) have exceeded cash flow from operations in five of the last six quarters. While the new satellites may improve cash flow, this trend is not sustainable in the long term without raising more capital.
Long term debt has steadily increased over the past five years as the company spends money to launch more satellites. That however, leads to higher interest expenses. In the last four quarters, interest expenses of $26 million account for more than half of the $41 million operating income. While the American Airline deal is likely to help ViaSat in the near term, the ability to win more big contracts in the coming years will be critical to success.
Mattress Firm is one of the largest mattress sellers in the country and recently acquired Sleepy’s, another mattress retailer. However, sales trends in bedding may not be helping this company. Analysts note that mattress sales across the country are slow. As the quality of mattresses improves, customers tend to keep them longer.
Mattress Firm is seeing falling operating efficiencies, increased debt load and shrinking margins. This company performs poorly on almost every StarMine Model including the Earnings Quality model with a score of 4 out of a possible 100.
Sagging profit margins
Expenses associated with converting the Sleepy’s branded stores to the Mattress Firm brand are likely to affect earnings in the near term. With the acquisition of Sleepy’s, the company has already added to its debt, now at a high of $1.4 billion. Goodwill on the balance sheet is also at an all time high of $1.6 billion. Goodwill is an intangible asset that represents the amount the company overpays for an asset.
The waterfall chart above starts with operating income, then shows all the adjustments required to end up with net income. In the last four quarters, interest payments of $54 million accounted for 60% of total operating income. The increased debt load means that interest payments are only likely to be higher. The chart also shows that there have been several charges categorized as “special items,” amounting to $132 million. Most of these arise from store closings from the Sleepy’s acquisition, and the company wrote the costs and assets off as an impairment charge.
These moves come as operating profit margins have been falling over the past three years. While revenues have increased, this has come at a price. As you can see in the headline chart, trailing 4Q operating margin was at a healthy 9.5% just three years ago. Now it is hovering around the 3% mark, and far below the industry median of 7%.
Mattress Firm has likely had to discount its inventory in order to move it, and that could hurt earnings. This has led to a fall in return on net operating assets which also reached a three year low of 6.5%. This is an indication of falling operating efficiency and is one of the metrics we use to measure earnings quality. Analysts seem to have taken note. There are now fewer buy and more sell and hold recommendations than there were just 30 days ago. Analysts have also lowered estimates for the quarter and for the rest of the year in anticipation of higher than expected R&D spending.
Ascena is the parent company for clothing brands such as Ann Taylor, LOFT and Dressbarn. Despite a very poor year (four consecutive quarters of negative Same Store Sales growth), the current quarter is expected to see only a 0.6% SSS growth. Margins are down and debt on the balance sheet is at an all-time high — all recipes for poor earnings quality. The waterfall chart above starts with operating income, then shows all the adjustments required to end up with net income. In the last four quarters, interest expenses of $78 million exceeded operating income. As debt levels rise, interest payments take up a larger portion of operating income, which leaves less money to reinvest in the business.
RNOA is one measure of operating efficiency. Ascena has seen trailing 4Q RNOA fall for the last five years from a healthy 40% to an anemic 3%. The factors contributing to that falling RNOA:
It seems like the shorts are piling onto this stock. It scores a weak 9 out of a possible 100 on the StarMine Short Interest model. With 15.2% short interest, it falls in the bottom decile of all companies in the region.
Analysts have been bearish on earnings prospects. They have lowered revenue estimates by 1.9% for the whole year and have lowered estimates for next year too. Earnings estimates for this year and next are down by 9.2% and 9.7% respectively in the last 90 days. The share price is down more than 50% in the last two years proving to be the proverbial “falling knife,” and while the stock does appear cheap by our valuation models, it could prove to be a value trap.
While the EQ model helped us zero in on potential companies to look at, the fundamental charts on Eikon make financial statement (or fundamental) analysis a lot faster. If the markets do indeed favor companies with high quality earnings, the StarMine EQ model is a good starting point to screen for both long and short ideas.