Quality of Earnings, by Thornton O’Glove

I came across Quality of Earnings, written in 1987 by Thornton O’Glove (co-authored by Robert Sobel), in my quest to understand the history of “quality of earnings” analysis.

Thornton O’Glove worked as a stockbroker and financial analyst for various firms, with a particularly contrarian and skeptical approach compared to more bullish colleagues, and was the co-author of the “Quality of Earnings Report”, an institutional research newsletter containing concise analyses of widely held listed companies’ financial statements, searching for warning signs of earnings softness (see NY Times article).

Though less systematic than Financial Shenanigans, it is nevertheless an instructive read.

Below are the key lessons from the book:

Don’t trust your analyst:

• The pressure for sellside analysts to issue positive reports is strong.
• Being on good terms with management facilitates access to information.
• A “sell” report does not generate as much brokerage business, may cause difficult conversations with clients and may prevent investment banking business.
• Analysts have a tendency to fall in love with the firms they are following and to succumb to herd instinct.

Don’t trust your auditor:

• Many companies were issued clean opinions before collapsing.
• Clients engage in “opinion shopping”, i.e. choose pliable auditors or decide not to renew inflexible ones.
• Non-audit fees may be significant.

Read the reports thoroughly:

• A gold mine of information can be gleaned from reports, letters and filings. Behave like a detective and dig into the financial statements, shareholder letters, MD&A section and footnotes.
• Flip through them once and ask yourself if you feel good about these people. Then get into the details.
• Beware if the financials are not displayed prominently, if shareholder letters are contradictory or overly optimistic, if the reports contain warning flags of troubles or if government-mandated filings contain markedly different information from other documents.

To assess the quality of earnings, understand nonoperating and nonrecurring income…

• Operating refers to items connected with the normal and usual operations of the business.
• It pays to look at the evolution of NO/NR income over the years to determine if future earnings will be impacted.

… the positive and negative impact of one-time business changes…

• Foreign currency.
• Effective tax rate.
• Raw material prices.
• Advertising expenditures.
• Cost efficiencies.
• Write-downs.
• Accounting changes, e.g.:
  • Extending the useful life of machinery and equipment.
  • Switching to straight-line depreciation.
  • Raising the actuarial rate of return on pension assets.
  • Lengthening the amortization of prior service costs.

… the conservativeness of accounting policies…

• According to the methods used, a company can report a very wide range of earnings.
• In accounting, poor practices tend to drive out good ones, as the temptation to boost earnings and share price can be irresistible.
• More than 90% of top managers hold stock options, and many receive bonuses based on the level of earnings per share. To them, stock price is more than an ego trip, it can be a difference in millions of dollars.
• Examples of liberal policies include:
  • Using FIFO (vs LIFO) for pricing inventory.
  • Using straight-line (vs accelerated) depreciation.
  • Capitalizing (vs expensing) R&D costs.
  • Funding only the present value of pensions vested (vs the current pension costs, ie current service plus amortization of past service).
  • Granting stock options (vs paying cash bonuses).
    • Including capital gains in income (vs crediting them to surplus or treating them below net income).

… which can be spotted comparing shareholder reporting and tax reporting…

• Most corporations keep two sets of books: one for shareholders and another for tax authorities.
• The tax books can be obtained, but in any case annual reports usually contain a useful income tax section which can be used to spot the differences.
• There may be sizeable differences in revenue recognition and expense recognition (depreciation, cost capitalization, etc.).

…and of “big bath” accounting

• After previous management is forced from office, there is a tendency for new management to write down assets to as low a level as it can defend to its auditors and to take massive restructuring charges (which under GAAP are charged, using management estimates, in the year the decision is made), using accounting maneuvers in the process to overstate the negatives of the company.
• This results in tremendous losses, accompanied by share price declines, but makes way for stronger earnings and share price improvements in the future, and contributes to making new management look better. Wall Street analysts also favor the big bath over a series of write-downs.
• But big bath and restructuring are also a sign that an improvement may soon transpire (e.g. disposal of marginal operations, share repurchases, cost reductions and strengthening of the core business), with an associated share price increase, and that a careful monitoring of the stock is in order.

Accounts receivable and inventories are also important…

• DSO can illustrate the granting of more liberal credit terms, difficulty in obtaining payment from customers or shifting inventory to customers with hard sell or costly incentives.
• Higher trending inventories in relation to sales can lead to inventory markdowns and write-offs.
• An excess of inventories (especially finished goods) is a good indicator of future slowdown in production.
• An increase in raw materials inventories relative to WIP and finished goods inventories may mean that business is speeding up or that the company anticipates a price boost.

… as is debt and cash flow analysis

• Debt and cash flow analysis is useful to assess the company’s ability to service debt, but also its ability to grow and flourish.
• Calculate interest costs as a % of EBIT (to see the proportion of operating income tied up in interest payments) and total debt / equity (the resulting ratio to be analyzed in light of the company’s industry: a ratio deemed conservative in a stable and mature industry may be deemed speculative in a recent and untested industry).
• Do not take the company’s CFFO or similar terms figure for granted as the presentation may be inaccurate or misleading.
• Develop a working knowledge of how CFFO is calculated to assess the validity of the figure and adjust it if need be.
• Rearrange every item of the reported cash flow statement using a standardized worksheet, e.g.:
  • Sources of cash: CFFO (Income before extraordinary items + D&A + CIT – Change in WCR), Unusual gains, Non cash items, Borrowings, Sale of stock, Sale of plant & equipment, Other.
  • Uses of cash: Additions to plant & equipment, Additions to other non current assets, Reductions in debt, Purchase of stock, Other.
    • The result is the change in cash and marketable securities, which should reconcile with the change in balance sheet figures

Companies can thrive without paying dividends

• Rapidly expanding companies use excess cash to fund R&D, expand market share or enhance the value of the enterprise.
• Ailing corporations in stagnant industries, with little in the way of new opportunities, use surplus funds to increase payouts.
• Companies with low P/E multiples may increase dividends to establish a price floor and discourage raiders.
• Warning signals with respect to dividend policy include (i) regular boosts in dividends in the face or irregular earnings, (ii) refusal of management to lower dividends when earnings fall or capital requirements rise and (iii) borrowing mondey to pay shareholders.

I hope you have enjoyed this article. To support this blog, remember to order your copy of Thornton O’Glove’s book using the links below.

Quality of Earnings