Halloween Trick: Fossil

It's Halloween, and kids in costumes are embarking on their journey for free treats. But fiendish little scamps are also emerging to sate their tricky desires.

The best defense against Halloween tricks is to have your porch light on as long as possible and to pass out the best candy. But if you want to pixie-proof your portfolio, keep an eye on earnings quality.

Fossil (NASDAQ:FOSL) showed up on an earnings quality screen I put together. Typically, companies with cash flow from operations (CFFO) greater than net income (NI) have good earnings quality. It's not always a problem if NI is greater than CFFO. But when NI rises as CFFO falls, you should be alert for the possibility of ghoulish behavior.

Fossil is my case study for two reasons: It's a company I want to learn more about, and its price has declined by more than 50% since reaching new highs in October 2004. Here's some cash flow data from Capital IQ showing the latest rolling 12-month results on a quarter-by-quarter basis.

In aggregate, net income has risen steadily over the last eight quarters, while CFFO has been a bit lumpier. That lumpiness doesn't bother me, but the growing divergence between CFFO and NI since the October 2004 quarter does.

The culprits for the divergence are inventories and deferred tax liabilities. Although it's not always a problem when inventories rise faster than sales, you should always take notice. If those inventories pile up faster than sales, it may mean margins could suffer in the future, or worse, that inventories might have to be marked down. Investors need only consider the fates of Motley Fool Hidden Gems recommendations Columbia Sportswear (NASDAQ:COLM) and DeckersOutdoor (NASDAQ:DECK) to see how the market reacts to rising inventory issues.

The reduction in deferred tax liabilities is due to the American Jobs Creation Act of 2004, which gave companies a special one-year tax break when repatriating foreign earnings. This substantially reduced Fossil's tax rate during the April 2005 quarter (increasing net income) while reducing its deferred tax liability (decreasing CFFO). Confounding matters, the repatriation of foreign earnings came as SG&A expenses were on the rise, as seen from the data below.

Although Fossil is selling higher gross-margin products, SG&A expenses continue to rise, inventory turns are falling, and the cash conversion cycle is slowing. And notice that the start of the stock's price decline corresponds with the rise in SG&A and the slowing inventory turns. So, until there is evidence that those trends will start moving the other way, the market isn't going to reward Fossil with any sugary goodness.

The Foolish bottom line? If you want to keep the demons of stock-price declines out of your portfolio, keep an eye on the earnings quality of your companies. For more on earnings quality, read Thornton O'glove's fantastic book, Quality of Earnings, or read Tom Gardner's interview with Mr. O'glove on the Motley Fool Hidden Gems website. If you're not a member, you can access the interview and more via a 30-day free trial.

Good luck, and Happy Halloween, Fools!

David Meier owns shares of Deckers Outdoor but does not own shares in any of the other companies mentioned. The Fool has a disclosure policy.