No time in the markets is as confusing to investors as earnings season. The program-generated headlines that have replaced actual reporting are bad enough. But even many live stories are written to draw attention to the author or publication, rather than inform.
What analysts say in private to their firms’ best clients is another matter. But they’re certainly not immune to headline-grabbing hyperbole when it comes to making public statements, the kind that are repeated again and again as a company’s numbers are digested.
Then there’s the immediate market reaction to earnings releases. Depending on the mood of certain key investors, a seemingly dazzling set of numbers can set off a cascade of selling. Conversely, what appears logically to be bad news can bring out buyers.
As for getting a read on the numbers themselves, the length of financial filings themselves is daunting even for the most aggressive statistician. The First Quarter 2011 Form 10-Q filed by Virginia-based power and energy infrastructure company Dominion Resources (NYSE: D) on April 29, for example, is 62 pages long, not including references.
The company’s Form 10-K for 2010 filed Feb. 28, meanwhile, is 167 densely packed pages. And those are just two of the 73 financial and other disclosure documents the company has filed with the US Securities and Exchange Commission (SEC) since the beginning of the year.
Such complexities and incongruities have led many investors to simply throw up their hands. After absorbing grievous wounds from the 2000-02 and 2008-09 bear markets, many have abandoned stocks altogether. Others have stayed in the stock market, but only by through large mutual funds or exchange-traded funds (ETF), which basically eliminate the need for them to pick stocks.
Given a choice, I strongly favor option two. And for those interested in ETFs, I strongly recommend checking out the excellent Global ETF Profits advisory, penned by my long-time colleagues Ben Shepherd and Yiannis Mostrous.
Fortunately, for income-focused investors at least, making sense of the numbers isn’t nearly as complicated it appears. The key is focusing on the handful of critical factors that put everything else in context.
Front and center is how well profits cover dividends paid out. We’re now nearly two years into the recovery from the 2008-09 credit crunch/market meltdown. Companies that are still stressed to be paying their current dividends should mostly be avoided, except as special situations that will generate big capital gains if they can hang in there.
If you have access to a decent quote service, it shouldn’t be much problem to figure out what a company’s current dividend rate is. Finding the relevant measure of profits, however, can get complicated, particularly when you’re talking about higher-yielding equities.
The first lesson most investors have to unlearn is that earnings per share (EPS) aren’t always the best measure of profits. That’s particularly true of the “headline” variety automatically pulled by computer programs when a company releases numbers.
These programs are set up to pluck out the EPS number using Generally Accepted Accounting Principles (GAAP). Unfortunately, GAAP numbers include one-time items such as gains and/or losses from asset sales, accounting changes and writedowns. These have nothing whatsoever to do with a company’s ability to pay dividends. But they do routinely inflate and deflate headline EPS, and therefore often present a misleading picture of company profitability and therefore dividend safety.
Consequently, my first advice when it comes to earnings season is to skip the short stories and go right to the company’s own earnings release. These are posted on company websites, as well as on popular quote/information services such as Google Finance and Yahoo Finance.
Once you’re there, the next step is to find the relevant measure of profitability. Most of the time, that’s going to be EPS after factoring out the items that can make the official GAAP measure misleading. For some companies, there are no items to knock the GAAP measure off kilter. For others, it’s “operating earnings per share” or “adjusted earnings per share.”
Dominion Resources, for example, posted GAAP earnings of 82 cents per share in the first quarter, but operating earnings of 93 cents. The difference was $62 million in non-cash writeoffs of certain unregulated power plant assets. As these are not items that affect the company’s ability to pay its current dividend–or increase it as it by 7.7 percent a few weeks before releasing first quarter numbers–operating earnings is clearly the better measure of profits. And the same goes for other companies.
On the other hand, it should be noted that “adjusted” or “operating” earnings are not a formally sanctioned measure of profits as GAAP EPS is. And I do recommend a healthy dose of skepticism when it comes to the way some companies calculate them.
For example, Otter Tail Corp (NSDQ: OTTR) has run into major problems with the raft of businesses it’s built up outside the power business. And as these are now roughly 70 percent of revenue, it’s hard to claim adverse developments in these businesses are somehow one-time items. Mainly, a loss in their plastics or food ingredient processing businesses must be considered an impairment to their ability to pay dividends.
If you own a master limited partnership (MLP), you’re hopefully already aware that GAAP EPS is a hopelessly misleading number when it comes to assessing profitability and dividend safety. MLPs are set up specifically to avoid generating taxable earnings per share at the corporate level and instead pass everything through to the investor level. That’s how they’re able to pay such high yields.
Rather, the key measure of profits is again a non-GAAP measurement, called alternately distributable cash flow (DCF) or funds from operations (FFO). DCF and FFO are basically operating cash flow as it appears in the company’s “statement of cash flows,” less any cash taxes or interest and “maintenance capital expenditures.” The latter is what’s needed to sustain the business, as opposed to “growth capital,” which is money to grow it that can be pulled back.
DCF is also the relevant measure of profits for most of the former Canadian income trusts, which have now largely converted to corporations. Some also refer to the figure as FFO or free cash flow. Most of the former trusts elected to be big dividend payers after converting by taking advantage of their ability to avoid taxes. In fact, more than a third converted without cutting their dividends from what they paid as trusts, and several have actually boosted payouts since converting.
The ex-trusts do calculate earnings per share. But the best way to get a read on dividends is again through the non-GAAP measure of profits. Note the Conservative Party of Canada now has its long-coveted majority and so is free to execute its long-term plans to push Canadian corporate tax rates into the teens, which will further improve Canadian companies’ ability to pay outsized dividends going forward.
Finally, communications service providers are also increasingly using free cash flow as their gauge for how much they can pay out in dividends. That’s thanks in large part to having massive asset pools to write down as non-cash expenses, and therefore avoid paying taxes.
Again, they do publish earnings per share numbers. But good luck to anyone trying to make rhyme or reason out of them. Government regulations make it necessary to calculate them. But they’re basically a waste of space.
A conventional payout ratio is simply dividends as a percentage of profits, though MLPs usually calculate the inverse as a “dividend coverage ratio.” A 50 percent payout ratio, for example, equates to a dividend coverage ratio of 2-to-1, or 2.00.
The general rule of thumb is the more reliable the profit side of the equation, the higher the payout ratio can be–the lower a coverage ratio–and still have the dividend be considered “safe.” Kinder Morgan Energy Partners LP (NYSE: KMP), for example, derives its distributable cash flow almost entirely from fees collected for running assets that are always in demand by major energy companies.
That’s an extremely reliable source of revenue and it allows management to basically pay out almost all of its DCF every quarter. In fact, Kinder Morgan routinely ratchets up its distribution whenever it adds a new asset.
In contrast, producing energy is an extremely volatile business, even if companies basically lock in prices in advance for their output well in advance. Paying out all DCF would be foolish. That doesn’t mean you should automatically sell a high payout producer. In fact, you can realize big gains from buying one. But only producers with payout ratios of 50 percent or less of profit (coverage ratios of 2.00 or more) should be considered safe, and even then only with an eye on energy prices.
Just having a handle on true profits and dividend coverage will put you light years ahead of the average investor when it comes to anticipating dividend safety and growth. Knowing how results are measuring up to management guidance will largely complete the picture.
Obviously, the reason financial documents are so long is that there are so many factors that shape the bottom line. Dominion’s profit report, for example, is a data-lover’s dream, featuring extensive information on all of its operations, as well as the health of its pension plans and investments, developments in regulation, the inevitable lawsuits that plague virtually every major company in America today and a host of other factors.
I synthesize and present the most relevant of this information on some 215 different companies for Utility Forecaster readers every month in a feature called “How They Rate”–you can try it out risk-free here.
But one item more or less captures them all: management guidance for profits.
In setting its guidance, a company’s executives take all of the relevant factors about its business into account. Unlike Wall Street estimates–which are basically set to determine a stock’s day-to-day value in the market place and are ephemeral to companies–management estimates actually determine dividend policy and investment.
If a company meets or beats its own guidance for profitability, its dividend is secure and set to grow. If it fails, that doesn’t necessarily mean curtains right away. But there’s no more clear sign of trouble. We may not run right away. But I’m going to be a lot more interested in what happens next.
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