Keeping Tabs on Earnings Quality

A few weeks ago, I wrote about some ways you can spot accounting blowups before they happen. However, it's important to distinguish between earnings manipulation, which is done with intent to deceive, and earnings generation from low-quality sources, which won't cause a blowup, but which is still unsustainable.

Over the long haul, businesses increase their economic value by selling more stuff, raising prices on the stuff they already sell, selling new stuff, or (rarely) buying other businesses. If earnings growth isn't coming from one of these areas, it's probably not sustainable.

Taxes, Cost-Cuts, and Share Counts
The three big areas to watch are tax rates, cost-cutting, and share repurchases. Paying less in taxes to Uncle Sam is nice and does result in more money left over for shareholders at the end of the day--but what the tax code giveth, the tax code can taketh away. Tax breaks can expire or be rescinded, and there's a limit to how low a firm's tax rate can go.

Cost-cutting is similar. All else equal, I'd rather own a more efficient firm than a less efficient one, but cost-cutting has limits. At some point, all the low-hanging fruit will be plucked, margin expansion will slow, and so will earnings growth.

Finally, we have share repurchases, which, contrary to popular wisdom, are not an unadulterated positive. Firms can keep earnings per share rising at the same time they're destroying economic value by pursuing buybacks when the shares are trading at a rich valuation. In this case, the firm is overpaying for each share, which destroys value because the future return on the investment is likely to be lower than the firm's cost of capital. Since the overall share count is decreasing, however, earnings per share keep moving up.

Big Blue in the '90s
 IBM (IBM) during the 1990s was a great example of what I'd call "manufactured earnings growth." Big Blue's earnings-per-share growth was pretty good starting with its turnaround in the early 1990s through 2000--close to double-digits most years, which is not at all bad for a company of this size. But operating income increased much more slowly, and sales growth was stuck around 5% on average. (You can see all of these growth rates at a glance under the Key Ratios tab of IBM's stock report on Morningstar.com.)

So what in the world was driving those great earnings-per-share results that Lou Gerstner's IBM kept turning out like clockwork? A whole host of items: For one thing, the firm's tax rate plunged, and for another, IBM cut overhead spending quite a bit during the 1990s--a laudable accomplishment, given the bureaucratic nature of the firm, but not a sustainable long-term source of earnings growth.

IBM also bought back almost more than 20% of its shares during the latter half of the 1990s, and fewer shares outstanding means more earnings per share. (IBM also benefited from an overfunded pension plan that boosted earnings, but that's neither here nor there.)

Again, none of this was illegal, immoral, or wrong--it's just not sustainable over the long haul.

Colgate and Cost-Cutting
If a firm you own is generating earnings growth through cost-cutting, tax breaks, or share repurchases, be happy it's becoming leaner and meaner, but don't forget that at some point, the firm will need to increase revenues if it's going to keep growing.  Colgate-Palmolive (CL) is a great example of this. Revenue growth has clocked in at a whopping 3% per year over the past decade, but operating income has increased almost three times as fast--around 10% per year on average.

It's easy to see why once you take a look at Colgate's income statement--the company's cost of goods sold as a percentage of revenue has declined dramatically and consistently over the past several years, from around 52% in 1995 to 45% recently. That's caused a big increase in profitability, which is why operating income outpaced sales by such a large margin.

The problem is that cost-cutting--while laudable--does have its limits. At some point, Colgate is going to find that it has become as efficient as possible, at which point sales and earnings growth will converge unless the firm manages to boost revenue growth.

So, when you see a firm with earnings gains being driven by cost-cutting, make sure you cast a skeptical eye on the sustainability of those cuts.