by Sridharan Raman.
In times of uncertainty and market volatility, there’s often a flight to quality. With Brexit and the market uncertainty, this may be an especially good time to focus on companies’ earnings quality. As with every earnings season, the StarMine team uses the StarMine Earnings Quality model to identify three companies with strong and three companies with poor earnings quality. 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.
Fly, drink and paint
Our picks for companies with strong earnings quality are — Southwest Airlines (LUV.O), Dr Pepper Snapple Group (DPS.N) and Sherwin-Williams Co. (SHW.N). The chart above shows the price action of each, compared to the S&P 500 during the aftermath of Brexit. Southwest initially fell sharply but quickly recovered and added some gains. Each of these stocks has outperformed the S&P 500 benchmark, indicating that the market may be favoring high quality names. Another factor in these companies’ favor is their low exposure to U.K. sales. Let’s take a closer look at each of these three examples of strong earnings quality and some of the inputs driving their high model scores: accruals, cash flows, and operating efficiency.
Southwest Airlines (LUV.O)
Strong margins, increased traffic
Lower fuel prices have been great news for airlines, lowering costs, boosting margins and filling planes with more bargain-seeking passengers. Southwest Airlines has been one of the beneficiaries. It’s seen revenues increase for eight consecutive quarters (YoY). What contributes to the high quality earnings is the rising return on net operating assets (RNOA).
Trailing 4Q RNOA has steadily improved over the last 5 years, reaching a high of 60.3%, exceeding the industry median. That improvement has driven improving T4Q operating margins, which reached a five-year high of 21% in the last quarter and far exceeded the industry median. While margins may have peaked as oil prices have stabilized, that margin is still much higher than the industry median of 15%.
These high margins and full planes are generating a lot of cash! In the last quarter, the company reported cash flow from operations of $1.6 billion, the highest in more than five years. Cash and short term investments more than cover the debt on the balance sheet, which seems strong.
While the number of airplanes in the fleet has increased steadily over the last five years, passenger load factors still remain strong at more than 80%. The company plans to limit the number of new planes and focus on other metrics to improve profitability.
The strong Earnings Quality model score of 93 is an indicator that this is likely sustainable. Southwest Airlines has limited exposure to Europe, which should insulate it to some extent (compared to other airlines servicing the region) from the fallout of Brexit.
Dr Pepper Snapple Group (DPS.N)
The beverage industry is extremely competitive and regulation on sugary beverages threatens to dampen profits, but that doesn’t seem to be hurting our next pick. Dr Pepper has a StarMine Earnings Quality score of 96 out of a potential 100. That is driven by improving efficiency, strong cash flows and an increasing presence in the lucrative Latin American markets, specifically Mexico.
Return on net operating assets is our measure of operating efficiency and as you can see in the chart above, Dr Pepper has seen RNOA increase steadily over the past three years. In fact in the last quarter, trailing 4Q RNOA was at 29%, the highest in more than five years. In the same period the median RNOA for the industry is down to 19%, a full 10 percentage points below Dr Pepper.
That improvement is driven primarily by better operating margins — also at a five year high. Dr Pepper finds itself in a sweet spot, with those improving margins coming with eight quarters of year over year revenue increases. When improving margins come with revenue growth, it’s a good sign for future earnings.
Dr Pepper also enjoys strong positive cash flows, another sign of good earnings quality. In each of the last four quarters, the cash flows from operations have been the highest for that quarter in more than five years. The company has a strong balance sheet, and the strong cash flows are likely to support the 2.25% dividend yield. With interest rates likely to remain low for the foreseeable future, that dividend looks even more attractive.
Sherwin-Williams Co. (SHW.N)
Color it green
Sherwin-Williams has benefited from the construction boom around the country. And, as housing prices soar in many regions, people may be choosing to spruce up rather than trade up. Demand for its paint has been strong.
Revenues have increased for eight straight quarters, although the growth has slowed down a bit. Other factors also point to strong earnings quality, such as return on net operating assets (RNOA). As you can see in the chart above, Sherwin Williams’ trailing 4Q RNOA has increase steadily for the last five years, and reached a peak of 58% in the last quarter. This is especially impressive given that the rest of the industry has struggled in the same period (orange line) and RNOA is lower than it was five years ago. Management says it wants to continue to improve efficiency by reducing costs and improving quality.
Painting a fine picture
What’s causing the RNOA improvement?
The company is also generating strong cash flow from operations — another source of sustainable earnings. Analysts seem bullish about SHW’s prospects, with 12 buy and strong buy recommendations, and no sell recommendations.
That wraps up our three highlights for Q2. Some of these companies are old friends. Both Southwest Airlines and Sherwin-Williams have featured in this column during the past few years. Both have gone on to turn out good performance and once again appear in the top ranked list of our highest earnings quality companies in the US. We’ll be back shortly with three examples of companies not faring as well.