With Its Stock Price in the Stratosphere, Will Stratasys' Earnings Be As Lofty?

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 manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important to 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. Let's see how Stratasys (Nasdaq: SSYS) stacks up.

Stratasys manufactures 3-D printers, rapid prototyping (RP) systems, and related consumable materials for office-based RP and direct digital manufacturing (DDM) markets, and it reports earnings before the market opens tomorrow. Analysts expect it to report $43.09 million in revenue and $0.27 in EPS, which will be an improvement of 29% over last year's reported $0.21 for the same quarter. If the company meets its revenue target, it will be a 26% increase from last year's $34.32 million.

Stratasys plays in a market niche with relatively few direct competitors, but two that compete are 3-D Systems (Nasdaq: DDD) and Parametric Technology (Nasdaq: PMTC).

Source: Yahoo! Finance.

The EQ Score ranks Stratasys as a "1," equivalent to an "F" letter grade, while 3-D also ranks as a "1" and Parametric gets a "3." Let's see why Stratasys ranks where it does by looking at its revenue, inventory, and operating cash flow.

Source: S&P Capital IQ.

First, notice that revenue is increasing nicely but the percentage increase year over year has slowed a bit. Deferred revenue -- or revenue that is collected before the product or service is delivered or performed -- has been increasing, but at a decreasing rate. Days deferred revenue reinforces the idea that orders are slowing with its downward trend, because you would expect backlogs to be increasing.

Next, inventory levels are growing, and at an increasing rate. I included raw materials and finished goods inventory numbers to show the divergence. Raw materials have increased year over year by only 4.6%, but finished goods -- product that can be delivered -- has mushroomed by 43.8%. Days in inventory is also high at 97 days, and the metric is trending higher.

Operating cash flow also shows signs of improvement, but the margins are deteriorating. The company spent $38.6 million in 2011 to acquire Solidscape, another rapid prototyping company. In April, Stratasys announced that it will merge with Objet, an Israeli company that offers access to untapped European markets. Investor enthusiasm has pushed Stratasys' stock price higher as a result.

Competitor No. 1 -- 3-D Systems
3-D Systems also shows excellent revenue growth but exhibits some of the same issues with inventory and cash flow as does Stratasys. For the quarter ended March 31, revenue increased 63% year over year to $77.92 million. Inventory continues to rise and most recently was at $34.94 million. Finished goods inventory is at $28.46 million versus raw materials inventory at $8.98 million, which highlights that 3-D has a lot of inventory ready to be sold. Days in inventory stands at a four-quarter average of 76 days. 3-D is taking a long time to pay its suppliers, as days payable outstanding is at 76 days average, and payables are at an average of 43% of revenue. This represents an artificial boost to cash flow.

Competitor No. 2 -- Parametric Technology
Because Parametric sells software, it doesn't have inventory or issues related to inventory. It's a much slower-growth company than either Stratasys or 3-D, and while it has decent cash flow, improved collections of receivables would drive its earnings quality score higher.

In the hierarchy of metrics affecting earnings quality, revenue is most important, 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. Since last October, Stratasys' stock price has increased from $18.00 to $51.61 currently, or 187%. Stratasys' trailing P/E is 54.33. Last year's earnings came in at $1.04, and analysts expect the company to earn $1.24 a share this year, a 19% increase but far lower than expectations built into the stock price. Some fools may be tempted to buy ahead of the upcoming earnings announcement, but prudent Fools should make investment decisions based on consideration of earnings quality.

To stay current on whether Stratasys' earnings report meets, misses, or beats expectations, be sure to add it to My Watchlist, a totally free service offered by The Motley Fool that keeps you current on your favorite stocks.