At The Motley Fool Big Short, we use our EQ score to filter stocks that might underperform the market, or better yet, make for worthy shorting candidates. The EQ score is a proprietary methodology that assesses the quality of a company's financials. "F" ranked stocks are demonstrating bad earnings quality, while "A" stocks show excellent earnings quality.
And here's the kicker: F-ranked stocks have under-performed A-ranked stocks by approximately 18% annually over the past 10 years. That's why our research for today's best shorting opportunities usually starts with the EQ score.
But not every F-ranked stock is a fraud or even a company with long-term business problems. In fact, many good -- even great -- companies are ranked F. Our beef is usually with the stock price. There is a difference between a good company and a good stock. Often, the stock prices of good companies fully reflect almost universally positive expectations, while heavily discounting or outright ignoring the potential for serious problems. As a result, they almost always offer subpar returns.
Good company, bad stock: Adobe Systems
Adobe is a great company with products that are not only admired by its users but are industry standards for creative design. That said, Adobe's earnings quality showed some chinks in its armor recently. In late September, Adobe issued a profit warning, which caused the stock to plunge by more than 25%.
One earnings quality measure we pay close attention to is the spread between the EBITDA margin (that's earnings before interest, taxes, depreciation, and amortization as a percentage of revenue) on a trailing 12 month basis relative to the operating cash flow margin. Many analysts incorrectly use EBITDA as a measure of cash flow. EBITDA does not take into account working capital investments such as inventory and receivables, or whether the company is financed with debt or taxes. Thus, it's a poor measure of cash flow.
When the spread between EBITDA margin and OCF margin widens, it indicates that EBITDA margins are expanding more than the cash coming into the company's coffers. In the case of Adobe, this spread widened from -3% (negative is good as more cash was coming in the door than profits on the income statement) to a positive 4%. That is a 7-point swing and the widest margin in at least eight quarters.
Had more investors focused on this powerful metric, they might have looked more closely at Adobe's financial picture and realized there was impending trouble in Adobe's earnings. That kind of analysis forces us to ask questions such as what was causing earnings growth at the expense of cash flow. Adobe's operating margin had expanded quite a bit. Was it sustainable? Was management creating earnings growth through artificial means?
Good company, bad stock: Green Mountain Coffee Roasters
Green Mountain Coffee Roasters has been a favorite of not only coffee drinkers for their convenient K-Cup technology but also for growth investors. The company was recently ranked No. 2 on Fortune's list of 100 fastest-growing companies. However, of the 100 companies on Fortune's list, it ranked last in terms of earnings quality according to our EQ score.
The spread between Green Mountain's EBITDA margin and OFC margin expanded from 6% to 10% last quarter, and is up three consecutive quarters year over year. Its operating cash flow to net income deficit has more than doubled. And thanks to acquisitions, intangible assets now account for 51% of Green Mountain's total asset base.
Given the deterioration in cash flow metrics, the big question is whether Green Mountain overpaid for Diedrich Coffee in an effort to buy growth. The spread between the EBITDA margin and OCF margin could indicate that management is pulling levers on the income statement to drive profits. But it is not translating into cash flow, and with Green Mountain's net debt up to $265 million (from $125 million a year ago), its financial strength is beginning to look a bit precarious.
And if all that wasn't bad enough, Green Mountain recently announced that it was the subject of a Securities and Exchange Commission investigation regarding its revenue recognition practices. For this once-hallowed growth star, trouble isn't just brewing, it's percolating.
Good company, bad stock: Kraft
Yes, it's a Buffett holding. It sports a dividend yield of almost 4%. It's a market-share leader in probably the most anti-recessionary industry of them all: food. So why do things look a bit ominous for Kraft?
First, Kraft's gross profit margins have gotten a big boost lately from price increases. As those inflationary pressures begin to bake themselves in to the rest of Kraft's cost structure, margins should come down and year-over-year comparisons will get tougher.
More worrisome is the deterioration in Kraft's cash flow metrics. The EBITDA to OCF margin is positive and ticking higher. Kraft's reported net income has exceeded its cash earnings over the last two quarters. This indicates that earnings are coming from accruals or from accounting levers, rather than activities that generate cash.
Moreover, the $19.5 billion acquisition of Cadbury earlier this year should have helped Kraft's cash flows as acquisition costs normally result in investing cash outflows, while selling acquired inventory and collecting accounts receivables results in operating cash inflows. Yet Kraft's cash flow metrics have weakened anyway.
The Foolish bottom line
Even good companies suffer the occasional earnings blunder. Digging deeper into a company's earnings quality can clue you in on when it's time to sell or, even better, when profit can be made through shorting.
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Matthew Argersinger doesn't own any of the stocks mentioned in this article. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers pick. Adobe Systems is a Motley Fool Stock Advisor recommendation. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.