Another earnings season is upon us, and it's a make-or-break time for most publicly held companies. If a company exceeds Wall Street's expectations for revenue and earnings, its stock price could be off to the races. On the other hand, any shortfall could spell disaster. Up Monday: Mattel (NAS: MAT) .
Analysts expect the world's largest toy manufacturer to report $990.92 million in revenue and $0.07 in EPS, which is a 40% improvement over last year's $0.05 a share. If the company meets its revenue target, it'll mark a 4.1% increase from last year's $951.90 million.
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 losing their hard-earned money. 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 Mattel as a 4, equivalent to a 'B' letter grade.
As you would expect, Mattel relies heavily on retailers in its primary markets -- the U.S., Europe, and Latin America -- to sell toys and related merchandise to children around the globe. The chart above shows the seasonal trends typical of retailers, as well as the relationship between accounts receivable and days sales outstanding (DSO); note the lag between the two metrics. However, since the end of the recession in 2009, both AR and DSO are trending upward. DSO over the past two years on a four-quarter basis has risen from 63 to 70 days. Days sales in inventory has also increased from 74 to 86 days on a four-quarter average basis. Average inventory as a percentage of revenue is increasing year over year from 39% in 2009 to 48% in 2011. The cash conversion cycle has increased over the same periods from 89 to 111 days.
All of these metrics are rising faster than revenue and suggest sluggishness among consumers who have been hard-pressed to decide between buying staples and discretionary items like toys for their kids. Retailers are taking longer to pay Mattel, and stock on hand is not moving to retailers as quickly. This story has implications for cash flow.
The second chart shows that Mattel's cash from operations spikes between positive and negative numbers. The trend in free cash flow looks almost identical. Operating cash flow has been negative in six of the last eight quarters. The free cash flow margin during this same time period has dropped from 36% to 24%.
The third chart reflects trends in EPS, shares outstanding, and long-term debt. Cash has been used to repurchase shares, and we have already determined that cash flow is frequently in negative territory. No problem -- just borrow at low interest rates to repurchase shares. This is a common tactic used by management to artificially boost net income and EPS. By reducing the float (total shares outstanding) through shares repurchases, net income and EPS increase. To be fair, some of the cash has been returned to shareholders in the form of dividends, and Mattel increased its dividend last year by 35%. But clearly management is incentivized to boost NI and EPS.
Let's review briefly: Borrow money to buy back shares and pay later with money not yet earned. Hmm...
In the hierarchy of metrics that affect earnings quality, revenue is at the top of the chart, and cash flow is more important that 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. Mattel's revenue trend has been relatively flat over the past five years, while inventories and receivables have trended higher. While Mattel's earnings quality has trended higher since the start of 2012, cash management remains as a nagging issue. As always, prudent Fools should make investment decisions based on consideration of earnings quality.
At the time thisarticle was published Fool contributorJohn Del Vecchiois co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article.Motley Fool newsletter serviceshave recommended buying shares of Hasbro and Mattel.Motley Fool newsletter serviceshave recommended creating a bear put spread position in Mattel. The Motley Fool has adisclosure policy.
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