Communications equipment for telecom businesses usually isn't a sexy sector, unless we're talking about fiber optics circa 2001. At a glance, ADC Telecommunications' (NASDAQ:ADCT) just-released earnings look like they would fit right in that glitzy fellowship, what with a 344% year-over-year EPS boost. But you gotta dig below the surface a bit. If something looks too good to be true, it usually is.
$44.7 million out of the $47.2 million in net profits came from a tax benefit, which usually qualifies as a one-time event. Hold that thought. Excluding that item, net margins would just barely break water at 0.8%. Operating margins were negative, and gross margins dropped by 7 percentage points.
Now, the good news: That tax benefit is unusually repeatable in this case. ADC has built up a substantial balance in deferred tax assets, a result of differing asset depreciation rates between GAAP standards and the U.S. tax code. The company expects to use that balance to reduce its income taxes for years to come, as it has done for the past few years.
That tool is available to many capital-heavy companies with substantial depreciation action on their cash flow statements. Look for deferred tax adjustments in the next report from Procter & Gamble (NYSE:PG) or Boeing (NYSE:BA), for example. They both have balances higher than $1.5 billion on that line. IBM (NYSE:IBM) and Sprint Nextel (NYSE:S) carry over a billion of deferred tax assets.
If you want numbers closer to operational reality, Fools like to look at free cash flow instead, which usually means operational cash flow minus capital expenditures. The cash flow statement cancels out unusual balance adjustments that showed up on the income statement, like this one. On that measure, ADC did worse this year than last, but FCF is still solidly positive.
You can also look at the simpler income from operations, also known as income before interest and taxes (EBIT). It's not as nuanced a measurement as free cash flow, but it can give you some insight into how much money the actual business operations of a company is making. In ADC's case, it's a $0.7 million loss for this quarter.
Regardless of how you slice it, ADC isn't exactly minting its own money here, first blush aside. But it's trading close to its 52-week lows while generating positive FCF and growing revenues, albeit slowly. Is the stock undervalued today? You'll have to make that call for yourself, after applying some elbow grease of your own. We Fools can't do all of your homework for you, and it's your money, after all.
Further Foolishness:
- The ABCs of ADC: Fool by Numbers
- Foolish Forecast: What's Bothering ADC?
- Foolish Fundamentals: The Balance Sheet
- Prepare for the Crash
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Fool contributor Anders Bylund holds no position in any of the companies discussed here. You can check out Anders' holdings if you like. Foolishdisclosureis well-rounded in and of itself.
