A past Foolish 8 stock was in the news last week, as information technology service management and customer relationship management products supplier Remedy Corp. (Nasdaq: RMDY) warned that it will report a first-quarter loss.
Earnings warnings from companies are a dime a dozen given how the general economic slowdown is affecting the business world these days, especially the small business world. "We have the same cold or flu as everyone else," Remedy's management noted on a conference call. But Remedy's shortfall is unique in that the company has never had a quarterly loss since coming public six years ago. The firm has been a model of small-cap consistency over the years, and last week's warning serves as a useful launching pad on what to look for in good small companies during this turbulent time.
At first glance, there doesn't seem to be anything particularly good about Remedy's warning. Postponed customer purchases led to lower-than-anticipated license revenue during a quarter when the company was incurring higher expenses, particularly to expand its sales force. Mashing these two factors together, the company is forecasting a loss between $1.6 million and $2.3 million, excluding goodwill amortization and a onetime charge related to a discontinued product line. On a per-share basis, Remedy's loss will be $0.05 to $0.07 per share, well below the prior First Call mean analyst estimate of earnings of $0.16 per share.
The warning is typical of the shortfalls that small company investors have been seeing lately. Customers are getting antsy with the slowing economy, producing top-line slowdowns at various small firms. Since a company such as Remedy only has a couple revenue streams available to it, any sales bump is going to cause some outsized effects, and that's exactly what is happening.
In Remedy's case, there are a few silver linings to the story. First, even though Q1 revenues will be lower than anticipated, total sales will still be up about 4% year-over-year. That's an accomplishment by itself, given the economic slowdown. Further, management indicated on the call that major business wasn't lost to competitors. Deals were deferred, but they didn't necessarily go away. If correct, this means the deferred deals will simply be booked farther down the line.
The big takeaway from the Remedy situation, however, has to do with how the accounting rules regarding reported earnings sometimes distort the economic realities of a business. This is a key issue for investors to focus on today, since we are being besieged by earnings warnings from small companies on almost a daily basis. A firm's reported earnings can paint one picture, while its cash flows can paint something very different. This is a big reason why positive cash flow from operations is a Foolish 8 screen, in conjunction with year-on-year earnings growth.
Remedy is a textbook example of earnings not accurately reflecting the underlying cash flows. Even though it will report a loss this quarter, the company will still generate positive operating cash flow. In fact, given the details provided in the press releases and call last week, the company generated enough operating cash flow to offset not only its quarterly loss, but to pay $3.5 million for an acquisition, repurchase $6.5 million of its stock, and increase cash and short-term investments on its balance sheet by $11 million from the end of last year.
With this information in hand, we can build a rough estimate of what the company's Q1 cash flow statement will look like, and then solve what Remedy's cash flow from operations will be (we'll highlight this figure in bold). For the purposes of this exercise, I've set depreciation equal to the firm's average quarterly depreciation last year, and assumed flat capital expenditures year-over-year. The actual numbers Remedy will report in a few weeks will assuredly be different than these estimates, but the idea is to be roughly right, not perfect. (All numbers in thousands of dollars.)
CASH FLOWS FROM OPERATING ACTIVITIES Net Income (Loss) (6,700) Adjustments to net income: Depreciation 2,200 Amortization of goodwill 2,400 Non-recurring charges 3,300 Net changes in assets and liabilities 21,800 Net cash from operations 23,000 CASH FLOWS FROM INVESTING ACTIVITIES Cash paid for acquisitions (3,500) Capital expenditures (2,000) Net cash used in investing (5,500) CASH FLOWS FROM FINANCING ACTIVITIES Purchase of treasury stock (6,500) Net cash used in financing (6,500) Net increase in cash 11,000 Cash at beginning of quarter 43,000 Cash at end of quarter $54,000
Based on these estimates, the company will record net cash from operations in the $23 million neighborhood, close to the $22.5 million reported in the previous Q1. To make the math work, the company will need large contributions from its main working capital inputs (referred to as "Net changes in assets and liabilities"), such as accounts receivable and deferred revenue. Again, this is just an estimate. But if it's in the right ballpark, then the company's operating cash flow and free cash flow (operating cash flow minus cap. ex.) might be flat year over year, despite a bottom-line loss on the income statement.
With that knowledge in mind, Remedy's current valuation can be viewed more objectively. Based on yesterday's closing price of $15.05 per share and an estimated Q1 diluted share count of 33 million shares, the company's market capitalization is $497 million. Subtracting $219 million in forecasted cash and short-term investments (about $7 per share) yields an enterprise value of $278 million, or 0.95x trailing sales. Based on 2000 numbers, the company is trading at a trailing price-to-earnings (P/E) ratio of 14.9x and a trailing price-to-free cash flow ratio of 8.2x. Based on all of these metrics, the stock is currently trading well below historical levels.
As earnings season kicks into high gear and small companies report lower results compared to a year ago, remember to focus on the cash flow statement along with the income statement and balance sheet. Quite often for a small company, the cash flow statement will tell a different story. And since stocks are valued in the market place based on their expected future cash flows -- which may or may not match their earnings -- investors should adopt a cash flow-centric view of business analysis early on and stick with it.
At the time of publishing, Brian Graney did not own shares of Remedy Corp. The Motley Fool is investors writing for investors.
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