Now that once-benign jobs data has eroded in a hurry, validating the outlook for weaker U.S. economic growth, active investors need to turn their attention to another set of numbers that have held up remarkably well this year.
This is the first time in several years that the quality of a company’s profit merits as much attention as the growth rate of earnings per share. Like mortgages, company earnings are not created equal.
Second-quarter profits of the Standard & Poor’s 500 companies rose by nearly 9 percent from the 2006 second quarter, well above the 6 percent increase analysts expected when the quarter began April 1, according to Reuters Estimates.
For the three months ending Sept. 30, the rate of growth is forecast to drop to 3.7 percent, Reuters found in its weekly survey of analysts. Chances are good actual third-quarter reports, scheduled to emerge in early October, will beat that growth forecast.
But the stress of a sluggish economy will test the skill of company managements and provide useful clues for investors about those skills.
Two examples from recent headlines illustrate what is required to apply a credit-quality test to earnings quality.
In the last two trading sessions, shares of motorcycle-maker Harley-Davidson skidded 11 percent.
The sell-off was a typical Wall Street reaction to Friday’s company announcement that third-quarter bike shipments would be down about 6 percent from its previous estimate, and earnings per share would be down about 5 percent in the third quarter.
“This is a difficult time for the U.S. consumer,” Harley Chief Executive Jim Ziemer said as he cut shipments to retailers.
On Monday, shares of semiconductor-maker Intel slipped, despite a company statement increasing its forecast of third-quarter sales by about 3 percent and saying its gross profit margin would be in the upper half of its previous estimated range.
Intel cited “stronger than expected worldwide demand for its computing products.”
Setting aside the obvious differences between the companies, Intel is riding what it sees as a optimistic growth curve, while Harley-Davidson is protecting against a buildup of unsold inventory.
Using an analysis of earnings quality compiled by StarMine, you can make a case that the Harley-Davidson story is at least as bullish as Intel’s. On a scale of 1 to 100, Harley holds an earnings quality score of 89, compared with 56 for Intel.
In the last five years, Harley’s earnings quality has remained high, and stood well above its industry average in the second quarter. Beginning in early 2006, Intel’s earnings quality deteriorated sharply and stood below its industry average in the second quarter.
Looking at StarMine’s components of earnings quality, both companies rank high in cash flow. But Harley scores better in measures of business operating efficiency and balance-sheet strength.
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A wild card in this analysis is Harley’s practice of selling its customer finance accounts as marketable securities, a key to the company’s balance-sheet integrity. A surprise surge in payment delinquencies could disrupt this practice and potentially damage Harley’s earnings quality.
Still, Harley may be the better value, given the latest economic outlook.
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