The Earnings Deception

Investors should look at earnings with a skeptical eye. A company's management has considerable leeway in determining its reported bottom-line performance. While growth investors focus on revenue and earnings, they often fail to look deeper into a company's financials to assess the quality of its business. Here are some tools to help you assess the quality of a company's earnings.

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By John Del Vecchio (TMF Fuz)
April 3, 2001

Not all earnings reports are created equally. A company's management has considerable leeway in determining its reported bottom-line performance. Investors should therefore look at earnings with a bit of skepticism and dig deeper into a company's financials to determine the underlying strength or weakness of its business.

Last week, I wrote about Cisco Systems (Nasdaq: CSCO) and provided some tools for assessing the quality of Cisco's operations. Many of the same problems, such as a buildup in inventories, plagued Lucent Technologies (NYSE: LU). The stocks of both Lucent and Cisco have been hammered, so many investors feel it is too late to worry about the warning signs. Well, CSG Systems International (Nasdaq: CSGS) is an example of a stock that's not down 80%, but exhibits many of the same warning signs that faced Cisco and Lucent.

At first blush, CSG looks like a growth investor's dream. CSG is a provider of customer care and billing software solutions and services for the communications industry, including cable television, online services, and broadcast satellite systems. For the year, CSG's net income was up 51% and revenue grew 24%. It also trades at about 26 times earnings, which appears reasonable compared with many technology stocks. Finally, shares of CSG have held up relatively well in the tech slaughter, down about 40% from their 52-week high compared with many stocks down 80% or more. The fun, however, ends there.

You need only read the press release from the fourth quarter to know things might get ugly. While the company primarily highlights the positives of its operating results, the CFO also slips in a quote or two about accounts receivable, which increased more than 75% for the year -- three times as much as sales. According to CFO Peter Kalan, "The increase in accounts receivable was primarily related to our willingness to accommodate requests to extend scheduled payment terms two or three weeks across year end." The company anticipates the trend for increased credit from customers to continue for another couple of quarters.

Rising accounts receivable are a red flag, especially when they are growing three times faster than sales. The company has booked the revenue, but has yet to collect the cash from the sale. An increase in receivables is indicative of trouble collecting from customers or extending credit to customers of poor credit quality, which may be the case in a weak economy.

Management is confident in its ability to collect cash from its customers. However, the historical levels for CSG's days billed outstanding (DBO) is 55 to 60 days, compared with 118 at the end of 2000.

DBO = Billed receivables / (Sales/365)

As a result of CSG's significant rise in DBOs above historical levels and its weakening operating environment, the company may be at risk to write-down some of its billed receivables as uncollectible. Assuming CSG reverts to its historical DBO of 60 as a reasonable collection period, a reduction of 58 days would be necessary based on CSG's annual DBO of 118. As a result, this translates into nearly $63.3 million in billed receivables at risk for a write-down. The problems with receivables alone should be enough to scare away most investors. But, wait, there's more!

Let's see what's behind curtain number two.

Tucked away within CSG's press release is a significant deterioration in its cash flow from operations (CFFO) to net income in fiscal 2000. CSG's ratio of CFFO to net income -- which should approximate 100% -- has declined from 170% in fiscal year 1999 to 74% in fiscal year 2000. Net income grew 51% while CFFO declined by 35%, creating a CFFO deficit relative to net income of $23.8 million at year-end.

The importance of the relationship between CFFO and net income is outlined in Financial Shenanigans, a great book by Howard Schilit. Net income is based on accrual accounting whereby revenue is recognized when it is earned and expenses recognized when they are incurred rather than when cash is received or paid. So, using the cash flow statement in conjunction with the income statement can alert an investor to differences between accrual accounting and the cash flow of the business.

Besides problems with its receivables and cash flow, CSG used investment and interest income to bolster its bottom line. CSG's pre-tax income increased 51% during fiscal 2000 while interest and investment income increased approximately 94% over the same time period. As a percent of pre-tax income, interest and investment income increased from 3% in 1999 to 4% in 2000 and accounted for $0.063 earnings per share on an after-tax basis. The increasing reliance on non-operating income to enhance net income may provide further evidence of operational deterioration -- particularly slowing sales growth.

Finally, sales to AT&T (NYSE: T) represent approximately 50% of CSG's business. When a significant amount of revenue comes from one customer, investors should be concerned. Should anything sour the relationship between the customer/vendor relationship, you can bet on a big blow to shareholders of the vendor. 

How can I do this at home?
After writing about Cisco and its financials, I received a lot of feedback from people inquiring about resources that help investors analyze financial statements so they can possibly avoid companies on the brink of trouble. In addition to Financial Shenanigans mentioned above, Quality of Earnings by Thornton O'Glove is another great resource.

Both are very readable books -- and possibly the only books you may need. They provide simple as well as complex tools to determine the quality of a company's operating results. Every investor should use them when evaluating a stock.

John Del Vecchio has kept his own receivables and inventory under control. At the time of publication, the writer did not own shares of any company mentioned in this article. The Motley Fool is investors writing for investors.

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