Don't Get Too Worked Up Over PriceSmart's Earnings

Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.

Calling all cash flows
When you are trying to buy the market's best stocks, it's worth checking up on your companies' free cash flow once a quarter or so, to see whether it bears any relationship to the net income in the headlines. That’s what we do with this series. Today, we’re checking in on PriceSmart (Nasdaq: PSMT  ) , whose recent revenue and earnings are plotted below.

Source: S&P Capital IQ. Data is current as of last fully-reported fiscal quarter. Dollar values in millions. FCF = free cash flow. FY = fiscal year. TTM = trailing 12 months.

Over the past 12 months, PriceSmart generated $28.6 million cash while it booked net income of $61.8 million. That means it turned 1.7% of its revenue into FCF. That doesn't sound so great. FCF is less than net income. Ideally, we'd like to see the opposite.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from nonsense, either. That's why it pays to take a close look at the components of cash flow from operations, to make sure that the cash flows are of high quality. What does that mean? To me, it means they need to be real and replicable in the upcoming quarters, rather than being offset by continual cash outflows that don't appear on the income statement (such as major capital expenditures).

For instance, cash flow based on cash net income and adjustments for non-cash income-statement expenses (like depreciation) is generally favorable. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable for the short term) or shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable; this is good to see, but it's ordinary in recessionary times, and you can only increase collections so much. Finally, adding stock-based compensation expense back to cash flows is questionable when a company hands out a lot of equity to employees and uses cash in later periods to buy back those shares.

So how does the cash flow at PriceSmart look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

Source: S&P Capital IQ. Data is current as of last fully-reported fiscal quarter. Dollar values in millions. TTM = trailing 12 months.

When I say "questionable cash flow sources," I mean items such as changes in taxes payable, tax benefits from stock options, and asset sales, among others. That's not to say that companies booking these as sources of cash flow are weak, or are engaging in any sort of wrongdoing, or that everything that comes up questionable in my graph is automatically bad news. But whenever a company is getting more than, say, 10% of its cash from operations from these dubious sources, investors ought to make sure to refer to the filings and dig in.

With questionable cash flows amounting to only 4.5% of operating cash flow, PriceSmart's cash flows look clean. Within the questionable cash flow figure plotted in the TTM period above, stock-based compensation and related tax benefits provided the biggest boost, at 4.3% of cash flow from operations. Overall, the biggest drag on FCF came from capital expenditures, which consumed 62.2% of cash from operations.

A Foolish final thought
Most investors don't keep tabs on their companies' cash flow. I think that's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home-run stocks that provide the market's best returns.

We can help you keep tabs on your companies with My Watchlist, our free, personalized stock tracking service.

Seth Jayson had no position in any company mentioned here at the time of publication. You can view his stock holdings here. He is co-advisor of Motley Fool Hidden Gems, which provides new small-cap ideas every month, backed by a real-money portfolio. Motley Fool newsletter services have recommended buying shares of PriceSmart. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 06, 2012, at 10:55 AM, tomd728 wrote:

    Seth........I'm not the least bit upset.

    I only lost 12.00 points of equity in PSMT.

    What ? Me worry ?

    Tom

  • Report this Comment On January 06, 2012, at 11:01 AM, Pandorabelle wrote:

    Down over 18% at 11am...some people are pretty upset by this ER. What a ridiculous overreaction.

    Never mind the fact that the entire market is a nervous wreck--even more than usual.

  • Report this Comment On January 06, 2012, at 12:34 PM, jjs90405 wrote:

    Is it just me or is this report contradictory? I see where you talk about ignoring earnings and looking at cash flow and I see that graph with cash flow declining. Then I see where you talk about high quality cash flow and the graph shows increasing accounts payable which equates to non-high quality cash flow. I am left thinking that you just proved we shouldn't be buying PSMT. Someone please help me understand this.

  • Report this Comment On January 06, 2012, at 3:13 PM, Yakush wrote:

    Following a 3-page recommendation of PriceSmart (PSMT) by Motely Fools I rushed in and bought a chunk of this dog 2 days ago at $69.55.

    You can imagine how pleasantly surprised I was when I opened my 'puter to find out they are down today by 20%(!). Apparently they missed their earnings big time!

    So much fun to follow an advice to buy the "The Motley Fool's Top Stock for 2012" and get chopped by 20% in two days!! :(

  • Report this Comment On January 06, 2012, at 3:31 PM, fogworks wrote:

    Interesting that the number 1 stock recommendation for 2012 is not among the 'buy' or 'core' for Tom or David.

  • Report this Comment On January 06, 2012, at 4:56 PM, Domeyrock wrote:

    If you looked closely, they missed on earnings but beat on revenue by about $5 million. That's not too bad. I think it's only taking a hit because it did run up a lot last year and the p/e is a little high, but they are expanding without going into debt.

  • Report this Comment On January 06, 2012, at 5:13 PM, gmc0652 wrote:

    Teradata's not doing very well either. Another foolish recommendation

  • Report this Comment On January 06, 2012, at 5:42 PM, WikiCPA wrote:

    Yakush,

    Not sure which recommendation you are speaking of, but I read an article back in June 2011 that gave PSMT a thumbs up. I opened a small position back then and until yesterday, it was up 20%. I agree with the other commenters that this is a overreaction and looks pretty bright for the rest of 2012.

  • Report this Comment On January 06, 2012, at 9:35 PM, dustbyn wrote:

    Nice job on the analysis, Seth. SO, where the hell was this "cash flow" analysis when TMF named PSMT "The One Stock to Buy in 2012" . All the more annoying after going through a maze of come-ons and offers, we got this bag of coal post-Christmas. I just renewed my TMF subscription and I'm starting to feel remorse. It's fine to recommend a stock and then it underperforms, but when you pay the fee to TMF you expect this analysis UPFRONT. But, for TMF to say this ONE COMPANY was the place to put your money on in 2012 and then a surprise comes of this magnitude .... well, there are holes in TMF model and this is an example. After stating it's TMF's #1 Stock, it's obvious that people will be laying down some serious cash on this stock. But, apparently you didn't do your due dilegence and further - you need to get some marketplace intelligence on your top recommendations. Another misfire like this and I'll be taking you up on your cancellation policy.

  • Report this Comment On January 06, 2012, at 10:17 PM, rodnog wrote:

    I don't know; after the drop, i'm seriously considering buying this one in 2012... And if it falls further, i'll take it on the chin because the money i invest is my responsibility.

    14% drop or not, where do you think it'll be in 5 years?

  • Report this Comment On January 06, 2012, at 11:03 PM, dustbyn wrote:

    not the point, rodnog, not about accepting responsibility - in a market that is in reality a more formalized casino environment. It IS about selling investment advice and saying this is the best pick of EVERYTHING out there. Serious miss.

  • Report this Comment On January 07, 2012, at 3:08 PM, Saintramus wrote:

    Seeing this stock down $14 and change on the CNBC ticker yesterday before I went off to work, well, caught my attention. jjs90405, nice point about accounts payable. My take-away is while this year's FCF is too low relative to earnings, revenues, last year's FCF, it's not because PSMT's management is doing anything egregious. And if a lot of that low FCF figure is tied up in inventories and cap ex, that could bode well for the future. If they start paying their bills, haha.Yakush, sorry and I know it sucks when something you buy takes a dive right away, but the '3-page recommendation' did recommend buying below $65. OK, I'm not sure if there was a price point given in the "One Stock to Buy in 2012" pitch. rodnog, I want to watch this stock, too. If you look at say a 3-year chart, PSMT's been on quite an upswing over the past year. A $50-55 range might be nice.

  • Report this Comment On January 29, 2012, at 12:36 PM, mountain8 wrote:

    This is not the firse TMF recommendation that has taken a dive shortly after. I would like to see stats on that, say three month performance after recommendation.

    I don't understand why that would happen but I see a lot of news, recommendations etc that sound good to me, but the stock immediately drops. Anybody else see this? Can you explain?

  • Report this Comment On January 29, 2012, at 12:51 PM, mountain8 wrote:

    As I understand this, 1.7% FCF is "really bad", however, only 4.5% of that is questionable which is good. So only 95.5% of this FCF is legitimately "really bad". So "unquestionable really bad", FCF is about 1.62% . I'd say thats "really bad". On this info alone, I would have to say this doesn't look good based on this information..

    Or have I just misunderstood?

    Sure wish you'd summarize your articles. Is it a buy or not? How does one stat balance against the other? Why is poor but accurate FCF good?

  • Report this Comment On January 29, 2012, at 1:10 PM, mountain8 wrote:

    From a non-numbers, non-chartest, regular kinda investor, here's all I see with your charts.

    Cash from operations went down and FCF also decreased while they reported better net income.

    Net income looks to have increased 25-20% while accounts receivable increased by 35-40% and inventory more than doubled. Aren't those sometimes negative indicators. To me this says, "they reported an increase in income but a good chunk of it is in inventory or accounts receivable."

    I'm not an accountant and still learning as I go but 1) am I reading this right and 2) aren't these usually negative results? Somebody please explain.

  • Report this Comment On February 01, 2012, at 4:14 PM, mountain8 wrote:

    Thanks for your rapid response.

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