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 before the market opens on Tuesday, April 17: Coca-Cola (NYS: KO) .
Analysts expect the beverage giant to report $10.83 billion in revenue and $0.88 in EPS, which is a modest 2.33% improvement over last year's reported $0.86 a share for the same quarter. If the company meets its revenue target, it'll mark a 2.7% increase from last year's $10.54 billion.
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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 one, for the lowest quality, to five, 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 Coca-Cola as a two, equivalent to a D letter grade. Let's see why.
Coca-Cola is sold throughout the world, and in some countries Coke serves as a substitute for water due to water quality and safety issues. A significant amount of annual sales come from overseas. The first chart illustrates the company's revenues through the recession and then a steep climb during the last two years. The revenue trend is up but the last two quarters show declining revenue. Remember that the expectation is for revenue to be $10.83 billion, which is less than the last quarter's $11.04 billion. The stock price appears to trend fairly well with revenues. The net profit margin spiked in the beginning of 2011, but then fell off the cliff. The spike in earnings was due to $4.551 billion of investments sold along with $597 million in assets sold. After smoothing the trend data, net profit is trending downward. The company's gross margin has also trended down from 65% in 2009 to 60% in 2011. This reflects the increased cost of goods sold -- the prices of the ingredients needed to make Coca-Cola's products have been rising. Declining margins are never a good thing.
The second chart shows Coca-Cola's cash from operations and accounts receivables. The trend in operating cash is relatively flat, but the receivables trend is upward. The operating cash flow margin on a trailing-12-month basis for the last eight quarters has fallen from 28% two years ago to 20%. Average receivables have increased from $3.964 billion to $5.053 billion since 2009.
The third chart shows that the company took on almost $10 billion more in long-term debt near the end of 2010 and very likely used this to repurchase shares while interest rates are low. This is a common tactic used by management to artificially boost net income and EPS. By reducing the float (total shares outstanding) through share repurchases, net income and EPS increase. EPS in 2010 totaled $5.05 due to the investments and assets sales, while 2011's earnings per share totaled $3.69. Analysts estimate EPS of $4.00 this year, which would represent a 10.57% increase.
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. Coca-Cola's markets are mature throughout the world and the company's margins are under pressure. To keep stockholders satisfied, debt likely was used to artific ially boost EPS. 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. The Motley Fool owns shares of PepsiCo and Coca-Cola.Motley Fool newsletter serviceshave recommended buying shares of Coca-Cola and PepsiCo.Motley Fool newsletter serviceshave recommended creating a diagonal call position in PepsiCo. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.