How to spot low-quality earnings

Not all earnings growth is created equal. Here's how to tell if profits are sustainable. 

It's easy to lie with numbers. More fiction is written in Excel than in Word, as the saying goes. Many types of accounting hocus-pocus can obscure what a company truly earns, so here we want to help you spot the difference between ‘high-quality earnings' and ‘low-quality earnings'. 

In broad terms, high-quality revenue and profits come from reliable, repeatable sources. Low-quality income, on the other hand, is from accounting changes, one-off items, and various short-term expenses and benefits – things that are unreliable or unsustainable. 

Let's use billing software maker Gentrack (ASX: GTK) as an example. In 2016, the company reported revenue growth of 25%. That looks good on paper but it means little until you understand the company's business model. 

Gentrack has three main streams of revenue: annual fees, support services, and one-off projects. Just over half of its income is from annual subscription fees and support services, which tend to repeat consistently year-to-year as customers update their software. This is the best kind of income due its predictability. In 2016, Gentrack's revenue from these sources grew 12%. 

However, Gentrack also earns money from one-off projects and special customer requests. These sources of revenue are unlikely to repeat – indeed, during a recession, they're likely to dry up completely as customers cut back on discretionary spending. In 2016, Gentrack was flooded with one-off orders, so project revenue grew 60%. That is, most of the growth in 2016 came from unrepeatable sources. It's cash in the bank all the same – shareholders can't complain – but it will distort your valuation if you assume this level of earnings and growth is sustainable.  

Acquisitions and currency

Other sources of low-quality revenue include acquisitions and foreign exchange movements. In 2017, Gentrack again posted excellent revenue growth of 43%. However, the company bought three smaller competitors during the year whose revenue was added to Gentrack's. After stripping out these acquisitions, organic revenue growth was a more subdued 18%. 

Gentrack earns revenue all around the world, so the company must translate earnings back to New Zealand dollars for reporting purposes. Depending on how the exchange rate moves throughout the year, revenue will either go up or down, even if the income earned in the local currency remained unchanged. In 2017, currency movements shaved around 4% from revenue. It's better to focus on ‘constant currency' revenue and earnings, which management typically discloses, as it gives you a better idea of how the underlying operations are going. 

As you move down the income statement, there's an increasing number of ways earnings can be distorted. Determining whether profits are high quality or low quality, however, still comes down to repeatability. Sources of low-quality profit growth include property sales, shifting expenses to a future period or recognising revenue early, the reversal of provisions, unrealised gains or losses on hedging contracts, and income from insurance claims. 

A less obvious contributor to low-quality profits is one-off cost cuts. We love companies focused on eliminating unnecessary expenses, but growth derived from cost cutting alone is usually unsustainable – you can fire 1,000 employees this year and, given stable revenue, it will show up as profit growth. However, there's a natural limit. You can't fire every last employee.

Furthermore, some managements will cut costs to boost short-term performance at the expense of long-term gains. That's the worst kind of earnings manipulation. For example, it's easy for a company to slash its marketing or research budget to temporarily boost profits, but that may erode its long-term profitability if the company falls behind competitors on the development of new products. It's a good idea to compare a company's marketing and research spending (as a proportion of revenue) to similar competitors and a multi-year average. If company XYZ spent 8% of revenue on marketing every year for the past decade, and now suddenly it's 4%, it may be a sign of management shenanigans. 

There are no rules of thumb when it comes to judging a company's earnings quality. Everything must be judged in context, but focusing on three questions usually gets to the heart of it: 1) Do current earnings accurately represent the company's financial health; 2) Is this level of earnings repeatable and sustainable; and 3) Does any change in earnings erode the company's long-term competitive advantage.  

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