An Earnings Mirage

The value investing equivalent of judging a book by its cover is judging a company by its trailing-12-month results. This is the perfect way to overpay for a business whose future isn't nearly so bright as its past.

Yours truly is guilty on this front. In 2000, I bought Monster Worldwide (Nasdaq: MNST  ) (back when it was TMP Worldwide) based on its "low multiple" to what turned out to be peak free cash flow. In 2002, I made a similar mistake with Integrity Media (Nasdaq: ITGR  ) , which looked dirt-cheap based on its not-to-be-repeated 2001 free cash flow.

Needless to say, I'm hopeful that I've learned my lesson. Nowadays, when my partner Zeke Ashton and I see a company that has unsustainably high profits over the past year, we refer to those profits as a Trailing Twelve Month Mirage.

Need an example? I recently did due diligence on AMN Healthcare (NYSE: AHS  ) , the largest nationwide provider of travel nurse staffing services. Initially, I thought I'd found a real winner. The company stood out for its price-to-free cash flow below 10 and return on invested capital of nearly 20%. What's more, it had recently bought back a massive slug of its own stock -- about 23% of the company for $175 million in a tender offer this past October.

Nine times out of 10, this is the stuff of a shareholder-friendly management team and a bargain stock. Not this time, however. Let me give you some background, and then I'll explain.

So much for the shortage of nurses
During the late 1990s, a chronic shortage of nurses made temporary health care staffing a growth industry. From 1996 to 2000, the industry grew at a compound annual growth rate of 13%, and this accelerated to 21% from 2000 to 2002. AMN used this growth phase to capture a position of nationwide leadership through the acquisition of five regional nurse-staffing companies.

In late 2001, near the tail end of this demand- and acquisition-fueled growth surge, AMN went public at a price of $21.65 per share. The stock reached a high of $37.40 in June 2002 before investors realized the company's growth was about to climax.

Sure enough, as 2003 got underway, demand for temporary nurse staff began to decline due to a number of factors. First, after six years of nurse shortages, hospitals increased their internal nurse recruitment efforts (surprise, surprise). Hospitals also stretched the productivity of permanent staff and maximized the cost-effectiveness of outsourced staffing solutions. In addition, because of the weak employment picture, permanent hospital staff increased their willingness to work overtime and were less likely to leave their positions.

All told, by 2003, there were fewer permanent nurse vacancies and thus fewer opportunities for AMN to place temporary nurses.

But while 2003 brought a drop-off in demand, the hit to AMN's revenue and earnings was slower in coming. Not because of anything good that AMN was doing, but simply because there's a significant lag time (several months) between when a client will place a nurse order and when that nurse will actually begin working and creating billable revenue for AMN. As such, for the first half of 2003, AMN was still earning revenue on nurses it had placed in late 2002.

Thus, even though order demand was drying up at the outset of 2003, AMN's quarterly revenue growth didn't decline in earnest until the second half of the year:

Quarter Revenue Growth*
Q1 '03 14.8%
Q2 '03 -4.1%
Q3 '03 -15.7%
Q4 '03 -22.9%
*Year over year

It wasn't until the fourth quarter of 2003 that AMN's income statement fully reflected the reduced demand for its services. This explains why it looked so cheap on the basis of its trailing-12-month results: Its free cash flow in the first three quarters of 2003 was unsustainably strong. That's the deception of the Trailing Twelve Month Mirage.

Putting a value on forward earnings
The lesson of AMN is really a lesson that applies to all equities -- the only earnings that matter are future earnings. (The same can be said of free cash flow, or whichever flavor of profits you prefer. And as Rex Moore explains in this fine column, it's best if that figure represents a profit you'd be happy with if you owned the business.)

For AMN, this means looking ahead to significantly lower net income in 2004 versus 2003. A year ago, it was generating quarterly net income of $10 million to $12 million. This year, I'm expecting quarterly cash net income in the $6 million to $8 million range. This assumes that nurse-staffing demand has finally stabilized (as AMN management claims), and that the company can maintain its Q4 '03 cost structure, specifically including a gross margin of 22.8% and SG&A spending of about $24.3 million per quarter.

My assumptions are probably giving AMN every benefit of the doubt. Even so, I arrive at 2004 cash net income of only around $30 million, or $0.95 per share. This is well above the consensus analyst estimate for only $0.83. At best, then, AMN is likely facing a 25% decline in cash net income this year vs. the $42.1 million achieved in 2003. (Incidentally, the percentage decline on a per-share basis will be much lower -- probably around 10% -- but that's only because of the massive share buybacks this past year.)

This brings us finally to the question of AMN's value. At a current price of $18, the company trades for 18.9 times my generous estimate of 2004 cash earnings and 21.7 times the consensus analyst estimate. These are awfully rich multiples for a company that's already shown a high vulnerability to supply/demand forces beyond its control. Even if you think we're in for a long-term shortage of nurses in this country, I can't imagine AMN's growth being anything beyond the high single digits. Nor is it an acquisition candidate considering that it's already the largest player in its industry.

Simply put, there's no reason AMN deserves a 20-times forward-earnings multiple.

Conclusion: direction trumps location
So AMN looked cheap on past results, but is actually expensive on future results. And the future is all that matters when it comes to a company's value (which, by classic definition, is the present value of all future profits).

All of this can be summed up in Tom Gardner's quip, "Direction is more important than location." Let that phrase echo in your mind as you evaluate companies, particularly when judging multiples based on trailing-12-month results.

Need some help figuring out which stocks are heading in the right direction? Give Tom Gardner's Hidden Gems a test drive.

Guest columnist Matthew Richey has been a long-time contributor to The Motley Fool and is a portfolio manager at Centaur Capital Partners LP, a money management firm based in Dallas, Tex. At the time of publication, Centaur did not hold positions in any of the companies mentioned in this article. Please send your feedback to mrichey@centaurcapital.com.


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