Given that Gradient Analytics’ research is primarily focused on forensic accounting, this common client question falls into our sweet spot. However, the link between earnings quality concerns and share price underperformance can be difficult to assess for two reasons:

1. Investors and sell-side analysts tend to focus their attention on the income statement, but there is not always a predictable correlation between the highlighted balance sheet trends and the income statement impact.
2.  Because management has a huge amount of discretion over how accounting entries are handled (including when to recognize built-up expenses, impairments, non-cash gains, etc.), earnings quality concerns often have ambiguous timing.

Thus, investors often are left wondering just how and when eroding earnings quality in their portfolio holdings – whether long or short – will ultimately impact their fund’s performance.

Nevertheless, to illustrate how such red flags may indeed lead to notable share price decline, I will describe three real-life examples. For compliance reasons, I won’t disclose their names, but will simply refer to them as Company A, B, and C. Read on....

The Retailer:

For Company A, we had concerns that the firm's transition from a brick-and-mortar retailer to an "omni-channel" retailer would soon begin to weigh on its gross margins. In fact, its expansion into this new online sales channel would soon bring it into direct competition with Amazon. In addition to the fundamental challenges, the firm’s inventory metrics were trending in the wrong direction. For example, elevated inventory levels were expected to weigh heavily on future margins such that markdowns (or impairments) would be required to ultimately sell the merchandise. Moreover, this buildup of inventory was a negative signal in and of itself.  Because management had clearly overestimated demand in recent months, we felt that there was an increased chance that future sales also would be disappointing.

As is typical, management didn’t share our inventory concerns. During the earnings call, management stated, “Retail inventories continue to be tailored to meet the anticipated demands of our customers and are in good condition.” Despite this assertion, our concerns ultimately did indeed impact the firm. Top-line sales remained soft, missing the consensus revenue forecast in two of the next three quarters. Gross margins also came under pressure, as we expected, falling to the lowest level in five years. While this wasn’t solely due to inventory impairments, the bloated balance sheet was an early signal that the business was underperforming.

The Scientific Instruments Maker:

Regarding Company B, which is headquartered in Europe but listed in the US, our initial concerns focused on a decline in organic revenue. Although reported sales were up a robust 36% YOY, it was mostly due to a recent acquisition. Once we backed out the impact of the acquisition, it became clear that the company’s inventories and receivables were rising on an organic basis. Furthermore, our equity incentives model indicated unusual insider sales activity by two high-ranking executives who appeared to be exercising their options early.

Over the ensuing three quarterly reports, the company beat analyst consensus non-GAAP EPS estimates by $0.01, $0.01, and $0.02, which seemed impressive on the surface. However, the last beat of $0.02 appeared to us to be due to an unsustainable boost to earnings from a delay in realizing certain expenses. These expenses were being stored on the balance sheet in the form of prepaid expenses, deferring the inevitable reduction to the income statement to a later date. Although organic sales were down 1% YOY, organic prepaid expenses (absent another recent acquisition) grew a whopping 30% YOY, while total prepaid expenses also grew 53% YOY. Even if we gave management the benefit of the doubt that there was no storing of current period expenses, we still felt that an inevitable reversion-to-the-mean would soon bring the prepaids category back to historical levels. When its prepaids eventually normalize, this will spike current expenses on the income statement and negatively impact earnings.

In addition to the spike in prepaids, we also identified a jump in inventories. We calculated that organic inventory grew approximately 39% YOY, significantly higher than the tepid organic revenue growth of 2% YOY. Three months later, during the quarterly earnings call, the CEO stated that inventory “continues to run high from historical, although not growing. And so our current perspective is that it seems to be adjusting to a new normal [and] we're at the point now where those high levels are becoming the historical.”

Despite management’s contention that current elevated levels of inventory were the “new normal,” management also mentioned that its end markets were destocking (i.e., when a firm’s customers start to manage their own inventory levels by slowing or halting orders). These fundamental cracks began to show in the next quarter, and the CEO commented, “When we updated full year financial guidance in July, we expected a quick inventory adjustment ... Given where we stand today, end markets look worse than our prior assumptions.” Then, in the following quarter, after backing out the impact of yet another acquisition, the firm’s organic sales actually fell 1% YOY, and its share price continued to fall.

The Industrial Equipment Rental Company:

As for Company C, which is headquartered and listed in Europe, we had reservations about the company’s future prospects. Fundamentally, the firm appeared to be dealing with several segments that were under pressure. Prior to the release of our initial Alert, its largest segment (58% of total revenue) was struggling with difficult conditions in Latin America, where sales fell 17% YOY, while sales in its second largest segment (42% of total revenue) also fell 5% YOY.

In addition, inventory appeared elevated. In H2 2015, inventory increased 16% YOY, while six-month revenue declined 4%. As a result, inventory to six-month revenue ratio climbed to 24%, the highest level over the prior five years. Similarly, 6M DSI increased 16% YOY to 100 days, the highest seasonal level in the prior five years.

While management appeared to attribute the inventory rise to a temporary increase (i.e., timing) in one product line – repeating comments that they had made six months earlier – we remained skeptical. The persistence of this trend, coupled with the low-demand environment, heightened our concern that the inventory build couldn’t be solely attributable to a timing issue. Rather, like we discussed with Company A above, we felt that the inventory rise was signaling the presence of larger fundamental concerns.

Subsequently, Company C missed both revenue and earnings estimates in both of the next fiscal halves (note that filings are semiannual in Europe, rather than quarterly as in the US). In fact, our earnings quality concerns came to roost when the company recognized an impairment to the carrying value of certain equipment in inventory. This inventory impairment was highly material as it represented 58% of the operating profit of the associated business segment, or 12% of its total operating profit.

Hopefully, these examples help illustrate how earnings quality issues can foreshadow future fundamental weakness in a company. While the link between the quality of a firm’s earnings and the share price may be tenuous at times, a focus on sustainable growth in earnings often can provide astute investors with an important early warning sign if something is amiss.