Agilent Technologies (NYS: A) will report earnings after the market closes on Monday, May 14. Agilent provides bioanalytical and electronic measurement solutions to communications, electronics, life sciences, and chemical analysis industries worldwide. Analysts expect the company to report $1.71 billion in revenue and $0.73 in EPS, which will be 1.37% lower than last year's reported $0.74 for the same quarter. If the company meets its revenue target, it will be a 1.79% increase from last year's $1.68 billion.
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 Agilent as a two, equivalent to a "D" letter grade. Danaher ranks as a one, and Teradyne scores a three. Let's see why.
The table below focuses on income statement metrics:
Jan. 31, 2012 (Qtr.)
Jan. 31, 2011 (Qtr.)
Jan. 31, 2010 (Qtr.)
Revenue +/- %
Cost of goods sold
Gross margin (R-COGS)
Selling, general and administrative costs
Net profit margin
Agilent's income statement provides no hints of issues that could affect earnings quality. Revenue is increasing year over year, cost of sales and gross margin trends are basically flat, and administrative costs are decreasing. The latter point is good news because it shows improved operational efficiency. Also good news is that margins are moving upward in the right direction.
Now let's look at metrics that affect cash flows:
The chart shows receivables, inventories, and days in inventory are all rising over the last two years. Unfortunately, this is not the preference because they affect cash flow and push up the cash conversion cycle (CCC). A higher CCC means a longer time between when cash is used to create the product and when money is received for the product sold.
These data by themselves would not be enough to earn an EQ score of two, so there must be other forces at work. Since 2009 Agilent has spent $1.57 billion on acquisitions, and carries $1.93 billion in long term debt. This means Agilent has been buying growth through acquisitions. In addition, the company spent $1.17 billion on share repurchases but issued new shares for $813 million, so a net $357 million was spent to buy back its stock. Also, Agilent showed $222 million in deferred tax assets at the end of 2011, down from $303 million a year earlier. Agilent does not actually have the cash but applies these prior losses to current taxes owed. This will affect cash flow as these reserves are used up.
Competitor No. 1 -- Danaher Corp
Danaher is a larger company than Agilent and exhibits similar income statement metrics. Revenue rose last quarter by 31% to $4.32 billion year over year. From the chart above, however, you can see that Danaher also has similar cash flow issues. Rex Moore's recent commentary notes that a ratio of intangible assets to total assets over 20% is worrisome. Danaher's intangible assets and goodwill comprise over 67% of total assets. Tangible book value is negative.
Competitor No. 2 -- Teradyne
Teradyne's income statement metrics look worse than either Agilent's or Danaher's. Revenue is only growing slightly, and costs are pressuring operating and profit margins. However, metrics affecting cash flow are better than its two rivals. The CCC is essentially flat; receivables are up; inventories are up by about 20% since 2010; and days inventory outstanding is actually down. Teradyne carries a small amount of long term debt, and made an acquisition in 2011 for $537 million, offset by sales of marketable securities totaling $1.195 billion.
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. Since last October, Agilent's stock price has increased from $29.40 to $40.27 currently, or nearly 37%. Agilent's trailing P/E is 13.60. Last year's earnings came in at $2.95, and analysts expect the company to earn $3.19 a share this year, an 8.14% increase but lower than expectations built into the stock price. Some fools may be tempted to buy ahead of the upcoming earnings announcement, but prudent Fools should make investment decisions based on consideration of earnings quality.
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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 has adisclosure policy.
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