by Ian Striplin
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

Here at Gradient Analytics, where we specialize in forensic accounting research and consulting, it may seem to the outsider that we are just a bunch of pessimistic short researchers, sniffing out aggressive accounting practices that might soon cause a given company to miss earnings expectations and reduce forward guidance, for the benefit of our clientele of long/short hedge funds. To be honest, we are jaded in our belief that most companies will, from time to time, take liberties with their accrual accounting in order to achieve short-term reporting objectives. But most only do it sparingly and temporarily, and only those that become overly extended in employing aggressive practices – while facing fundamental headwinds that make it likely certain metrics will persist or worsen – make good short candidates. But that doesn’t automatically make all the others good long candidates.

Thus, our expertise is also useful for identifying solid earnings quality for the vetting of long candidates. Earnings quality analysis can reveal accounting benefits to future earnings potential and help ensure that a quant model or fundamental analysis that created a positive equity profile for a given company is indeed based on the underlying economics of the business rather than an aberration of accrual accounting. In other words, it can serve to add conviction or a confirmation signal to a long thesis.

In this article, we will describe several positive earnings quality factors that can act as a tailwind to sustainable future earnings growth, with four real-life examples. In forming a stock universe for this article, we screened the output file of our proprietary Earnings Quality Rank (EQR), which assigns a quintile score of 1-5 (with 5 being the “best” earnings quality relative to peers), and limited the population to companies in the top quintile and a market capitalization greater than $500 million, to avoid liquidity constraints. (Note: On the other hand, when seeking short candidates, we look to the bottom quintile of the EQR model.)  Read on….

  by Rachel Bradley
  Equity Analyst, Gradient Analytics LLC (a Sabrient Systems company)

While the accrual method of accounting has its usefulness, it also opens the door for companies to “manage” and even overstate earnings through various tactics – some merely aggressive, others more nefarious. There are a variety of levers that management can pull to either book expected revenue sooner than normal or push current expenses farther out into the future. However, earnings growth sourced this way is unsustainable. Unless the firm expects a massive boost in sales in the near future (such as from the rollout of a highly anticipated new product), sustaining the growth story would require not only continuing to pull revenue forward but to do so at an accelerating rate.

Pulling sales forward or pushing expenses farther down the road both overstate the firm’s sustainable earnings power and result in a presentation of financials that obfuscate reality. There is also a myriad of other tools available to dress up financial statements to present a firm that appears financially healthier than it truly is. A common way to pad the balance sheet is through so-called “soft assets,” i.e., goodwill and other intangibles like brands, logos, trademarks, corporate reputation, client lists, and contracts.

At Gradient Analytics we have a saying, “With soft assets, come soft profits.” Put another way, when a firm has material intangible assets and most of its valuation is tied to the terminal value dependent on a set of unrealistic assumptions, then earnings have a higher risk of write-downs. As an example, we take a deeper look at the financials of The Kraft Heinz Company (KHC), specifically examining some overly optimistic assumptions management used in valuing its soft assets. Read on….