European companies are starting to report earnings, so we decided to find some that are likely to have sustainable and strong results – as well as some that may suffer from poor earnings quality. The StarMine Earnings Quality model consists of three components: accruals, cash flow and operating efficiency. We chose an even half dozen – three that may be winners and three that may be also-rans.
Poor Earnings Quality
ACCP.PA: Accor : Hotels Restaurant & Leisure : Earnings Quality Model Score : 6
Accor is a French hotel operator that is facing increasing pressure from online competitors such as AirBnB. In order to improve its online presence, the company has been increasing its investment in technology, reflected in increased capital expenditures over the past year.
However, those capital expenditures are not being supported by cash from operations. As you can see in the chart below, capital expenditures have exceeded cash flow from operations in four of the last five semi-annual periods. In the last period, Accor generated €148 million from operations, but spent €1.05 billion.
Source: Eikon/StarMine
Cash flow woes
That has translated to poor free cash flow, which is negative in four of the last five quarters. Earnings that are not supported by strong cash flows tend to be of weaker quality and less sustainable in the long run. In the last semiannual reporting period, the company had -€897 million free cash flow, despite having positive net income.
Further, in each of the last three annual reporting periods, the company reported pro forma earnings that were higher than GAAP earnings. That means the company asks investors to exclude certain items that it does not consider part of the core business. In the long run, GAAP earnings tend to prevail. For these reasons, Accor scores poorly on the StarMine Earnings quality model with a score of 6, indicating that the earnings may not be coming from sustainable sources.
BARN.S: Barry Callebaut : Food Products : Earnings Quality Model Score : 8
Switzerland is famous for its chocolate, but with cacao prices on the rise, chocolate makers are likely to take a big hit, and that includes Swiss based Barry Callebaut. Cacao is the main ingredient of chocolate, and even before the price increases show up on Callebaut’s financial statements, the company has signs of poor earnings quality.
Source: Eikon/StarMine
Weak base for earnings
Free cash flow lags net income in each of the last four semiannual periods, and in the period ending February 2014 the company had negative free cash flow (outflow) of – CHF197 million while earning CHF119 million in net income. Earnings that are not supported by strong cash flows tend to be less sustainable in the long run and are a sign of poor earnings quality.
Return on net operating assets (RNOA) is a measure of how efficiently management is generating returns on its assets. Barry Callebaut has seen RNOA fall precipitously in the last two semiannual periods. After being comfortably above the industry median just a year ago, the company now has a RNOA of just 12%, more than a percentage point below the industry median and almost seven percentage points below the levela year ago. Falling RNOA is a sign of poor earnings quality and is one reason the company scores just 8 on the StarMine Earnings Quality Model.
OPL.WA: Orange Polska :Diversified Telecom : Earnings Quality Model Score : 11
Orange Polska, a subsidiary of Orange S.A., is one of the main wireless players in Poland. However, it is facing intense competition from smaller players and its market share is eroding. Although the company is seeing positive cash flows from operations, they have steadily been on the decline, from over PLN 8 billion (Polish Zloty) ten years ago, to just over PLN 3 billion. Free cash flow at PLN 1.1 billion is a fifth of what it was ten years ago. That is a weak trend and cash flows are likely only to continue to deteriorate as the country has a spectrum auction coming up that Polska is likely to enter.
Source: Eikon/StarMine
Margins getting slimmer
In another sign of poor earnings quality, Polska Orange has seen operating margins continue to erode as stiff competition is affecting pricing power. The latest trailing 4Q operation profit margins are at 4.9%, the lowest in more than ten years and far below the industry median of 15.3%.
Operating profit margins are one component of return on net operating assets, a measure of efficiency. That’s also fallen to ten-year lows of 3.6%, and trails the industry median. All these are signs of poor earnings quality and justify the poor StarMine Earnings Quality score of 11.
Strong Earnings Quality
BT.L: BT Group Plc : Diversified Telecom : Earnings Quality Model Score : 96
While Polska Orange may be facing stiff competition and poor earnings quality, not all telecom companies are in the same boat. BT Group has a distinct advantage — a base of over 28 million landline customers that it can tap, which gives it a big advantage over other wireless providers. While the company does not have a large mobile footprint, analysts expect it to make an acquisition and use its advantage with bundling services to accelerate growth and unlock synergies.
Source: Eikon/StarMine
Margins climbing
In the meantime, the company has seen operating margins steadily increase over the past five years. Operating margins are now at five-year high of 19.6%, 1.5 percentage points over the industry median as BT continues to be successful in monetizing its TV sports content and controlling content costs.
BT also generated strong cash flows, and cash flow from operations consistently exceeds net income, a sign of strong earnings quality and one reason why analysts think BT could potentially burst open the mobile market with a strategic acquisition. The company scores a high 96 on the StarMine Earnings Quality Model.
DC.L: Dixons Carphone Plc : Specialty Retail : Earnings Quality Model Score : 98
An electrical and telecommunications retailer formed by the merger of Dixons Retail and Carphone Warehouse Group, Dixons Carphone is a retailer that could weather the weak European consumer environment and displays signs of strong earnings quality. The company has seen strong free cash flows in the last two semiannual periods, and is seeing improving margins, both good signs in a weak economic environment.
Source: Eikon/StarMine
Strong cash flow
In each of the last two semiannual periods, Dixons has seen positive free cash flow far exceeding net income, which historically has been a sign of sustainable earnings. Analysts expect synergies to kick in for the next three years as Dixons and Carphone Warehouse build on each other’s strengths. That is likely to improve cash flows further. In the last semiannual period, Dixons generated £237 million in free cash flow compared to net income of £75 million.
Dixons is also seeing improving margins, and that is likely to continue since one of its main competitors, Phones4U, collapsed. That is also likely to improve market share for Dixons Carphone. While operating margins are still below the industry median, the meaningful improvement is noteworthy and likely to continue. Analysts seem excited about Connected World Services (CWS), which focuses on large corporate clients that need to integrate electronic and telecom services. It’s a potentially high margin business in the future.
PSMGn.DE: Prosieben Sat.1 Media Ag : Media : Earnings Quality Model Score : 94
Media companies in Germany are benefiting from strong advertising revenues. That trend helps Prosieben, which has experienced strong audience growth. The company offers five free channels and earns ad-based revenues. Prosieben is also experiencing growth in other markets around Europe.
Source: Eikon/StarMine
Good strategic position
When earnings are supported by strong cash flows, it is a sign of high earnings quality. In Prosieben’s case, we can see that in each of the last 12 quarters, free cash flow far exceeded net income. It looks like free consumers and advertisers are still excited about free channels, despite the onslaught of cable. In the last quarter, the company reported free cash flow that exceeded net income by €210 million. A strong balance sheet and strong free cash flow means that the company has the ability to take advantage of opportunities.
Management has come up with a five year plan to improve efficiency and earnings. That plan seems to be off to a good start as return on net operating assets has soared over the past six quarters. The RNOA is currently a healthy 29%, compared to the industry median of 7.3%. While the rest of the industry has not been struggling with efficiency, Prosieben has actually soared, creating a great platform for the coming years. That’s why it scores a 94 on the Earnings Quality model.
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