Sunday, December 02, 2007

P&L: Sustainable earnings 1 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
For the fundamentals analyst, the financial statements provide a wealth of information. I am busiest during the months of February, May, August and November when most quarterly/interim/final results are released. The P&L statement is often the one most people focus on, because it's used to calculate the most popular metric, the PE ratio. However, it is important to recognise the components that make up the denominator E (earnings).

The most important factor is sustainability of earnings. And the key component to watch is extraordinary, or non-recurring, income, which are one-offs that should be isolated and eliminated from earnings calculations. Often, it is not difficult to identify these components, because P&L statements typically recognise these as "Other income" and further confirmation can be obtained by checking the footnotes on "Other income". The most common extraordinary profit is gains on asset sales, where sales price is substantially higher than that recorded on book, hence constituting a profit. Other non-recurring items (might also be expenditures, in which case they should be reversed) are forex gains and asset revaluations (increasingly common among property companies under new accounting rules).

Case in point: Many offshore support companies have been padding their earnings in recent years by selling vessels at huge profits over book value eg. Ezra, Swissco. Others have booked huge profits selling their stakes in other offshore companies eg. KS Energy selling its stake in Ezra on the market. All this can be considered non-recurring.

Sometimes things are not so simple. The non-recurring characteristic of the earnings is embedded in the numbers and the nature of the business. Cyclical companies, especially, enjoy huge profits at cycle upturns but the high margins cannot be forever because of business cyclicality. Sometimes, companies might also enjoy high margins because their inventory has appreciated considerably in price. But since their inventory constitutes their raw materials, the huge profit is embedded in the higher revenue, the manifestation of higher selling prices.

Case in point: Tai Sin, which sells electric cables, benefitted tremendously from high copper prices which enabled them to raise their selling prices of their electric cables. As cost of inventory was low (purchased sometime back), the gross margin was fantastic. This enabled them to have a superb 1H07 where profits trebled. However, the non-sustainability of the margin manifested in 2H07 when margin slumped significantly (though still very high).

And sometimes, what appears to be non-recurring earnings might turn out to be quite sustainable. This might form the basis for a good buy, especially if the market doesn't recognise this insight but the individual investor captures its essence.

Case in point: Boustead has been disposing its logistics assets (warehouses, customised high-tech buildings) to various buyers (mostly REITs) for the last few years, all at substantial gains. But this has been taking place so often that it seems almost sustainable. And perhaps it is. After all, when one builds the assets, and then sells them later, does this not constitute a recurring business? Does it matter whether it holds them as fixed assets/investments (in which case it is classically considered as extraordinary gains) or as inventory/development properties (in which case it is normally booked as core revenue)?

And so discerning the sustainable components of earnings can sometimes be a matter of judgment, though often it is as simple as stripping away the "Other income". Taking this step of determining earnings sustainability often improves the accuracy of future projections substantially, and one will be able to determine the general trend of profit margins with much less distortion.




Anonymous Penny Stock Newsletter said...

Earnings are not predictable for many stocks whose business may change unexpectly.

11/24/2012 7:47 PM  

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