Could AOL's Earnings Mean "Away On Leave"?

AOL (NYSE: AOL  ) will report earnings before the market opens tomorrow. Many baby boomers remember AOL as one of the first Internet content providers, and the company is still offering subscription services to the Internet along with other, complementary services. Analysts expect the company to report $526.48 million in revenue and $0.07 in EPS, which will be an improvement of 75% over last year's reported EPS of $0.04 for the same quarter. If the company meets its revenue target, it will be a 4.5% decrease from last year's $551.4 million.

AOL competes with some of the world's largest and most powerful content providers, including none other than Google (Nasdaq: GOOG  ) and Yahoo! (Nasdaq: YHOO  ) , among others. Here are the estimates for their upcoming earnings:

Company

Reporting Date

Revenue Estimate

EPS Estimate

EQ Score

Google July 12 $8.46 billion $10.19 2
Yahoo! July 16 $1.09 billion $0.19 3

Source: Yahoo! Finance.

When looking at earnings quality, we at The Motley Fool have two databases -- EQ Scan and EQ Score -- that help us uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and changing any of the three financial statements usually affects the other two. But keeping a critical eye on these statements can often uncover trends that can help investors protect against losing their hard-earned money. The EQ Score database assigns an index rank to the company, from 1 -- for the lowest quality -- to 5 for the highest. As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward. The EQ Score ranks AOL as a "4," equivalent to a "B" letter grade. Google ranks as a "2," and Yahoo! is ranked a "3." Let's see why.

AOL stands for "away on leave"
Sorry, but this ship sails like an old scow rather than the battleships it's up against! AOL's financials are deteriorating, which makes it appear as if no one has the helm. The chart below explains why.

  Quarter Ended Dec. 31, 2011 Quarter Ended Dec. 31, 2010 Quarter Ended Dec. 31, 2009
Revenue (in millions) $576.8 $596.0 $835.0
Cost of Goods Sold 67% 62% 57%
Selling, General & Administrative 19% 19% 16%
Gross Margin 33% 38% 43%
Operating Margin 11% 20% 22%
Net Profit Margin 4% 11% 0%

Source: S&P Capital IQ.

You don't need to be a treasure hunter to understand the above map, I mean -- chart. Revenue needs some wind in its sails, the cost of sales is growing, and margins are sinking. If there is any lighthouse on the horizon for AOL, it is that the company generates positive cash flow and does not appear to be manipulating its financials -- thus it's "B" rating.

For some, Google stands for "mother ship"
Google does not report earnings until July, but let's compare the same metrics over the same time periods.

  Quarter Ended Dec. 31, 2011 Quarter Ended Dec. 31, 2010 Quarter Ended Dec. 31, 2009
Revenue (in billions) $10.58 $8.44 $6.67
Cost of Goods Sold 35% 35% 36%
Selling, General & Administrative 20% 17% 16%
Gross Margin 65% 65% 64%
Operating Margin 33% 35% 37%
Net Profit Margin 26% 30% 30%

Source: S&P Capital IQ.

Google's course shows much better sailing, although this "mother ship" has also been through some rough seas. First, Google's metrics are nearly the opposite of AOL's. Google's huge quarterly revenues are growing, its cost of sales is low and steady as she goes, and margins are excellent. A small barnacle on Google's hull is that administrative costs are increasing, and net profit margins are decreasing slightly.

So why does Google get a "D" earnings quality score? Over the past four quarters, the company has carried an average of 49% of its quarterly revenue as receivables. That's a lot of cash awaiting collection! Its days-sales-outstanding stands a bit too tall at 45 days.

Could Yahoo! be calling like a mythical siren?
The last company we'll set our sights on in depth (love those metaphors) is our friendly Yahoo!.

  Quarter Ended Dec. 31, 2011 Quarter Ended Dec. 31, 2010 Quarter Ended Dec. 31, 2009
Revenue (in billions) $1.32 $1.53 $1.73
Cost of Goods Sold 30% 37% 43%
Selling, General & Administrative 30% 28% 29%
Gross Margin 70% 63% 57%
Operating Margin 20% 17% 9%
Net Profit Margin 22% 20% 9%

Source: S&P Capital IQ.

Like a siren calling out to sailors and Web surfers alike, at first glance Yahoo!'s numbers appear harmless. Don't be lulled by the music to your senses because revenue is decreasing year-over-year. Tales from ancient mariners tell us there is a mutiny in the works at Yahoo!, resulting in a floundering stock price. A resolution could help this ship reverse course. Like Google, accounts receivable has grown to a loud and shrill 77% of quarterly revenue -- up from 56% two years ago -- and Yahoo!'s days sales outstanding has sailed higher, from 51 days to 74 days since the end of 2009. Still, Yahoo! has been lowering its cost structure, and margins are growing. Yahoo!'s business model provides decent cash flow. And that's how it got a "C."

In the hierarchy of metrics that affect earnings quality, revenue is at the top, and cash flow is more important than net income. In other words, Wall Street tends to focus on the wrong metric as the basis for its recommendations to buy, hold, or sell a stock.

AOL is the originator of the subscription model for accessing the Internet and for "you've got mail." Since Aug. 10, 2011, the company's stock price has ticked up nicely from $10.22 to $24.52 recently, a 133% jump. AOL has a trailing P/E of 204. Yikes! Last year's earnings came in at $0.14, and analysts expect the company to earn $0.41 a share this year, a lofty 193% bump up. The forward P/E would become 59.8, which is still high but a lot better than 204. As always, prudent Fools should make investment decisions based on consideration of earnings quality.

To stay current on whether AOL's earnings report meets, misses, or beats expectations, be sure to add it, or any of the other companies mentioned here, to My Watchlist, a totally free service offered by The Motley Fool that keeps you current on your favorite stocks. Get started with the links below.

  • Add Google to My Watchlist.
  • Add Yahoo! to My Watchlist.
  • Add AOL to My Watchlist.

Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article. The Motley Fool owns shares of Google and Yahoo!. Motley Fool newsletter services have recommended buying shares of Google and Yahoo!. The Motley Fool has a disclosure policy.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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  • Report this Comment On May 08, 2012, at 2:57 PM, elkwingcaddis wrote:

    Like the article. One note, its likely that AOL has scored well on the EQ scores because it remembers its days of booking revenues based on the number of those ubiquitous AOL CDs it distributed. This reeked havoc on the stock when the revenue and income numbers did not turn into increasing cash flows.

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