April 3, 2020

The Key Research Question: Is a Company Sustainable?

by Tim Gaumer.

It’s not a question that’s typically top of mind, but in the current economic climate, the first question analysts should be asking themselves when researching a company is, “Is it sustainable?” Is the dividend sustainable? Is the business itself sustainable? In normal times, an analyst might first turn to the income statement to examine things like profit, margins and growth rates. Research teams that have added quantitative research to their traditional fundamental research process may turn to Refinitiv’s StarMine alpha models. But in times like these, turn first to the balance sheet and cash flow statement. This is where a couple of StarMine models will make the job easier. Let’s begin with the Smart Ratios Credit Risk (SRCR) model using, for illustration purposes, Dolby Laboratories (DLB.N)

The Smart Ratios model systematically examines measures of a company’s profitability, leverage, coverage, liquidity and the growth and stability of revenue, earnings and ROE. The model calculates the probability of default (PD%) over the next 12 months and maps that to a Model Implied Rating and to a 1-100 percentile rank, where low scores represent a higher PD%. Here in Exhibit 1, you can see that Dolby Labs has a low-risk score of 96 and an Implied Rating of AA- and has had a consistently high rating over the last 10 years.

Exhibit 1: Dolby Labs SRCR model score and 10-year model history

Source: Eikon by Refinitiv, StarMine

Exhibit 2 shows the inputs into the model. StarMine models are constructed with transparency in mind. Drilling down on the components makes financial statement analysis much more efficient that working with financial statements, analyst estimates and a spreadsheet.

Exhibit 2: Dolby Labs SRCR model component details

Source: Eikon by Refinitiv, StarMine

This model includes things that might otherwise be overlooked, like underfunded pension liabilities. Where applicable, it also includes industry-specific measures. And it considers not only historical reported financials, but also when available, forward-looking analyst estimates, using the StarMine SmartEstimates.™

When trying to answer questions about how sustainable or resilient a company may be, it’s useful at a glance to confirm that it’s profitable, has low leverage, has plenty of leeway when covering its interest expenses, and has plenty of cash on hand. You’ll find a collection of ratios that address those favorable characteristics on this Eikon app. Dolby Labs passes with flying colors.

Trailing Net Profit Margin is high, at 22.3% and analysts are still forecasting an improvement to 23.3% over the next 12 months (NTM). The company has over $900 million in cash and short term investments on its balance sheet and no debt other than if you count accounts payable, giving it a cash to total debt ratio of over 900 to 1. With no debt, interest coverage is a non-issue. Finally, the business appears to be a stable one.

In contrast, here’s an example of what this model can help avoid. The screen views in Exhibit 3 shows the score, model history and details for Whiting Petroleum Corp., which announced on April 1 that it filed for bankruptcy protection.

Whiting ranks in the bottom 1% of all companies in North America and in the bottom decile within the profitability, coverage and liquidity components. This model “downgraded” the company to a Model Implied Rating of CCC while a rating agency retained a much higher BB- rating. The model had been below the agency throughout this 2-year history, providing a useful red flag when the stock was still trading in the high fifty-dollar per share range. Our studies have shown that when the Model Implied Rating deviates significantly from an agency’s rating, the agency is four to five times more likely to revise in the direction of the Implied Rating rather than in the other direction.

In the component details section, we see that Whiting has been unprofitable, with negative profit margins, returns and free cash flows. There was essentially zero cash on the balance sheet.

Exhibit 3: Whiting Petroleum Corp.’s Smart Ratios Credit Risk view

Source: Eikon by Refinitiv, StarMine

As previously published in a StarMine Research Note, high quality companies in times like these tend to have better relative performance. We can take our sustainability analysis to the next step by turning to the StarMine Earnings Quality model. This model is designed to measure the reliability and sustainability of the sources of a company’s earnings. Globally, it consists of three major components: Accruals – those transactions for which no cash has exchanged hands (a less reliable source of earnings); Cash Flow – transactions backed by free cash flow (the sustainable source of earnings); Operating Efficiency – the return on net operating assets; and for U.S. companies, Exclusions – the degree to which pro-forma, or reported earnings differs from GAAP.

Exhibit 4: Dolby Labs Earning Quality model component details

Source: Eikon by Refinitiv, StarMine

When trying to evaluate how sustainable a company’s business and/or dividends may be, let’s first focus on cash flows. In today’s environment, those companies that are self-funding and don’t need to tap the capital markets to cover operating expenses or the dividend will be better off.

Dolby Labs receives a score of 85 out of a possible 100, meaning that it’s generating healthy free cash flows as we head into what’s almost certain to be a recession. Drilling into that component using the embedded fundamental time-series chart, we can see the basis for the high score. These charts are another time-saving tool for fundamental analysts.

Exhibit 5: Dolby Labs 10-year annual free cash flow history

Source: Eikon by Refinitiv, StarMine

In this bar chart, green represents the amount by which free cash flow exceeds net income, which is shown in white. Red shows the amount by which free cash flow falls short of reported net income. Dolby Labs has generated strong free cash flows in each of the last 10 years that are shown on the chart. In the most recent fiscal year, free cash flow was $231 million – easily more than covering last year’s $77.5 million cash dividend payout (shown in Exhibit 8).

Turning to operating efficiency, Exhibit 6 shows that over the last 10 years, Dolby Labs has generated a return on net operating assets well above the sector median returns (shown in gold). This implies a sustainable competitive advantage – also a good indicator of business resiliency.

Exhibit 6: Dolby Labs 10-year Return on Net Operating Assets history

Source: Eikon by Refinitiv, StarMine

In Exhibit 7, we turn to the Screener App. Not only does this help find new research ideas among a universe of companies most likely to prove sustainable during this economic downturn, it’s also useful in finding in one place many of the metrics we’ve been discussing. On the desktop, all these columns would be displayed in one row. I’ve split the screen between Exhibits 7 and 8 so that it’s easier to read on the page.

Exhibit 7: Eikon Screener App used to screen for and monitor a universe of companies

Source: Eikon by Refinitiv, StarMine

Any column can be sorted by ascending or descending order – shown here is a sort on the StarMine Combined Credit Risk model. It combines the Smart Ratios model discussed earlier along with a Structural Credit Risk model, that looks at leverage as the market value of assets vs. the level of liabilities and Text Mining Credit Risk model that used machine learning to identify key words and phrases in the unstructured text from conference call transcripts, news, permissioned broker research reports and company filings that are most predictive of future default events, including bankruptcy. Combined, this is our most predictive default model. While typically underutilized by equity analysts and portfolio managers during a bull market, these models may be especially useful now as risk mitigation tools.

Dolby Labs is third from the top, among a universe of U.S. large-cap dividend payers, with a score that places it among the top 2% of all companies in North America. Moving through columns to the right, as discussed earlier, it also scores well among U.S. companies using a model that uses credit ratio analysis.

A negative net debt figure indicates that cash on the balance sheet exceeds any outstanding debt obligations. The next column was added to show, for each company, whether debt has been rising or declining. Next, we see that Dolby Labs has $916 million sitting in cash and short-term investments. All companies at the top of this list have little or no debt, so interest coverage is not an issue. But this is a good one to use when monitoring existing holdings. That can be done in the app by choosing a customized list as the universe. Exhibit 8 picks up from here.

Exhibit 8: Continuation of the Screener App view

Source: Eikon by Refinitiv, StarMine

Dolby Labs is the highlighted row third from the top. Companies that had a relatively low dividend payout ratio as a percentage of income are more likely to be able to continue paying a dividend when income dips. Dolby’s is a modest 26%. While certainly not among the highest yielding stocks, Dolby’s 1.6% dividend yield is still a lot better than anything you’ll find in the Treasury market right now.

The Cash Flow Component score is from the StarMine Earnings Quality model shown earlier as Exhibit 4. All three entries get high marks. The next column shows that net debt is negative – balance sheet cash exceeds total debt, which you can see in the next column, for Dolby is zero. Finally, we see the cash dividends paid during the last fiscal year, referenced earlier.

Finally, Exhibit 9 is a screenshot of the Watchlist Pulse App. It’s a useful tool in keeping track of existing holdings. The data shown in these columns may be customized from the gear in the upper right of the screen. We’re displaying a subset of S&P 500 constituents along with a number of activity flags and StarMine model scores, including those discussed in this piece. Large model score changes are flagged, such as the two large declines in the Analyst Revisions Model (ARM) scores for GAP and HP. As a predictor of the direction of future revisions, this too may help monitor potential risks in a portfolio. Another among the activity flags helps with something similar. The Predicted Surprise measures the percentage difference between the StarMine SmartEstimate and the I/B/E/S Mean, or consensus, estimate. It is constructed by placing more weight on the more accurate analysts and the most recent revisions. It is also predictive of the direction of future changes in the consensus direction. When the SmartEstimate is significantly different from consensus (triggering this flag), it gets the direction of future earnings surprises correct 70% of the time.

Exhibit 9: The Watchlist Pulse App

Source: Eikon by Refinitiv, StarMine

Unusual times may call for unusual equity research techniques and the consideration of scenarios that few would have previously imagined needing to consider this year. Adaptation may be the key to mitigating risk and avoiding value traps. In this report, we’ve pulled together some of Refinitiv’s most unique content and applications that we believe, when added to the investment process, will give fund managers and analysts the upper hand in determining which companies may be the most (or least) resilient, with sustainable businesses and dividend yields.

For Eikon and Workspace subscribers, find all the StarMine models in its widget on any company Overview page. Alternatively, the Smart Ratios Credit Risk model is under the Debt & Credit tab and the Earnings Quality model is under the Financials tab. To navigate to the Screener App, type SCREENER into the search bar. Type PULSE for the WatchList Pulse monitor app.

Tim Gaumer, CFA, is director of fundamental research for Refinitiv.

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