Hungry for some stocks that will satisfy your craving for portfolio growth? Darden Restaurants
When looking at earnings quality, we at The Motley Fool have two databases -- EQ Scan and EQ Score -- that help us uncover cash flow and revenue recognition issues. Smart financial officers can use several techniques to manipulate financial results, and manipulation of any of the three financial statements usually affects the other two. But a critical eye on these statements can often uncover trends that could be important to help investors protect against painful losses. The EQ Score database assigns an index rank to the company, from 1, for the lowest quality, to 5, for the highest. As the company's financial status changes over time, the database adjusts its rank and illuminates trends that will affect earnings quality going forward. The EQ Score ranks Darden, Ruby Tuesday, and Cracker Barrel all as a "5," equivalent to an "A" letter grade. Let's see why.
Darden operates approximately 1,900 restaurants in the U.S. and Canada under the Red Lobster, Olive Garden, LongHorn Steakhouse, Capital Grille, Bahama Breeze, and Seasons 52 brand names. The company has advanced from a "1" to a "5" ranking since January, and income-statement metrics look excellent, with revenue increasing 5.49% from 2010 to 2011 and 9.25% to $2.16 billion for 2012. The cost of sales has kept pace with revenue growth, but administrative costs have slowed to produce stable or slightly growing margins year over year. Net income has grown on average 11.1%, and earnings per share have increased 15% average since 2010.
Metrics affecting cash flows are also well managed. Operating cash flow increased 23.78% year over year, from $379.8 million to $470.1 million. Receivables, days sales outstanding, and payables are all low, and the company carries about $1.5 billion in long-term debt. Factors behind Darden's EQ score increase are improved operating cash flow to price, lower days sales outstanding, lower price to sales (currently 0.8x), and higher sales.
Darden's stock price has risen from $44.65 in January to $51.70 currently, or 15.79%.
Ruby Tuesday has 740 restaurants under the same name and franchises another 85 locations in the U.S., Puerto Rico, Guam, and elsewhere around the world. The company has retained its "5" EQ ranking since January, and its income-statement metrics look good, with revenue increasing an average of 2.86% since 2010 to $324.83 million for the quarter ending Feb. 29. Cost of sales is higher than Darden's, but selling and administrative costs are lower. Net income and earnings per share are both down for the period year over year, but operating cash flow is up 3.23% on a four-quarter average over last year.
The company carries minimal inventory and has reduced its long term debt exposure by 17.6%, from $344.12 million to $292.63 million. Working capital has been stubbornly negative, but it's a non-issue because Ruby carries deferred revenue on the books as current liabilities. Factors behind Ruby's EQ score are improved operating cash flow to price, low days sales outstanding, lower price to sales (currently 0.4), and higher sales.
Ruby's stock price has risen from $7.07 in January to $7.19 currently, or 1.7%.
Since January, Cracker Barrel has improved from a "2" to its current "5" ranking. It runs 608 stores in 42 states that combine a restaurant with a retail store in a general-store format. Revenue has grown steadily at a 3.21% average pace for the January-ending quarter over the past two years. A very low cost of sales provides excellent gross margins, but the selling and administrative costs associated with running the retail stores are unusually high, at around 61%. While operating and net profit margins are consistent, they could be improved through more efficient operations.
Operating cash flow has shown 24.55% average improvement year over year since 2010, and free cash flow is also positive and growing. The cash conversion cycle has decreased from 24 days to 15 over the past two years, and the company continues to pay down debt.
Since January, CB's stock price has increased 14.6% from $50.41 to $57.77 currently.
In the hierarchy of metrics affecting earnings quality, revenue is most important, and cash flow is more important than net income. In other words, Wall Street tends to focus on the wrong metric as the basis for its recommendations to buy, hold, or sell a stock. All three companies show steady improvement in earnings quality and could add to a portfolio of consistent long term growers. Darden also pays an annual dividend of $1.72 (3.40%), and Cracker Barrel pays $1.00 (1.70%). Prudent Fools should always make investment decisions based on consideration of earnings quality.
One of the great things about companies like Darden or Cracker Barrel is the great dividends they pay, but there are even better ones out there. You can read about them in our special free report: "Secure Your Future With 9 Rock-Solid Dividend Stocks." See which dividends make the grade.
John Del Vecchio is the co-advisor of Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter, where he goes by @johnfdelvecchio. He owns no shares in the companies mentioned in this article. The Motley Fool owns shares of Darden Restaurants and has a disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.