Live by the Sword! Fall on Your Sword!

If you listen to a lot of financial conference calls or news reports, you’ve probably heard analysts questioning the "earnings quality" of a particular company’s quarterly results.

The phrase can mean a lot of things but is actually akin to your mechanic telling you the car engine doesn’t sound right. It is a nebulous statement that tells you virtually nothing.

Earnings quality issues can come from bloated inventories; changes to allowances for doubtful accounts or bad debts; unusual changes in tax rates; or a disproportionate amount of your "earnings" coming from non-operating sources. The term really alludes to anything that’s out of the ordinary from past practices or industry norms. Moreover, it is all in the eye of the beholder, as there is no standard definition of what are and are not "quality earnings."

The wireless world had one of its top dogs demonstrate the downside of earnings quality issues just the other day. Things are bad enough in the handset business, but when Qualcomm Inc. (Nasdaq: QCOM) reported, it managed to surprise even some of its most ardent supporters.

It’s fair to say that most investors have been expecting bad news from the handset supply chain for most of the last three months. As the economy headed south, nearly all of the major players reduced expectations for December quarter results. For the most part, as those results have been announced in January, they have cast an even darker pall on the state of the industry and its near-term outlook. (See The Cellphone Slide.)

Qualcomm joined that band the other day. While its overall revenue was actually up 3 percent from last year – an anomaly in the current environment but most likely due to the resumption of Nokia Corp. (NYSE: NOK) royalties – its chipset operations were woeful. Chipset revenues fell 15 percent from last year, and unit shipments were down 20 percent year-on-year. Worse still, the group’s operating profits plummeted 63 percent versus last’s year’s level. Tough times at Qualcomm right now! (See Qualcomm Reports Q1.)

Despite the difficulties in operations, it is the non-operating income that provided the biggest shock for investors. To understand that, we have to take a look at some history...

Page 2: Mind the GAAP

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paolo.franzoi 12/5/2012 | 4:12:45 PM
re: Live by the Sword! Fall on Your Sword!
I like the discussion of balance sheet cash. However, I would like to extend the discussion. You mention the risk versus reward issues. What you fail to mention is the "Who is making the decision?" issue?.

Firms with huge amounts of cash are running cash investment operations. The alternative is to return this spare cash to investors to allow them to invest it as they see fit. There are 2 basic ways of doing this: Share Buybacks and Dividends (including 1 time special dividends). One might debate whether using this cash for additional investments - like buying companies - could count as well. I would generally say yes. But why the heck are companies sitting on barrels of cash that they are not using? I can think of several good answers, but I think we are way beyond the need for the cash to run the business in many of these cases.

Really - if you are an investor - do you want Qualcomm (as this example has) investing your money?

renkluaf 12/5/2012 | 4:12:40 PM
re: Live by the Sword! Fall on Your Sword! Brookseven,

Generally the CEO & CFO set the strategy for cash investments and that is executed by the Treasurer. Traditionally, tech firms have hoarded cash to support their higher growth rates but that has changed somewhat in the last 5-10 years as the growth has mitigated. Cash management is also a very emotional issue just like it is with individuals. In a downturn, as now, we want to hold as much as possible out of fear of the unknown and the reverse is true during up turns. It's always tough to know how much cash is enough because, as you suggest, you can't know when an acquisition opportunity may become available nor can you predict when events may send a positive cash flow into the red.
paolo.franzoi 12/5/2012 | 4:12:39 PM
re: Live by the Sword! Fall on Your Sword!

I am quite aware of how cash management works in companies. However, it is still not the place of a company to become an investor - except to manage its needed cash.

Companies like Microsoft, Cisco - heck all the listed ones in this article - have much more cash than they require to execute their businesses. Most of their acquisitions are stock based and do not require cash at all. So, I stand by my statement that they should give a significant amount of their cash back to shareholders. These shareholders can then choose what to do with their cash - bonds, CDs, invest in other firms, etc. But I don't pay a CFO or a treasurer to be an investor. That is MY job not theirs.

So, either use it or give it back. It is not yours to keep and invest in low return safe securities. If I want to do that, it is my prerogative. If I want to take more risk, that is my choice as well.

lrmobile_Ziggy 12/5/2012 | 4:12:33 PM
re: Live by the Sword! Fall on Your Sword! I'm not sure if this is the right forum to discuss investments, but I generally agree with Mr. Seven. When I invest in a company like Qualcomm, I invest in the chip vendor / patent licensing company, not in a mutual fund trying to diversify its investments. Having enough cash to acquire companies allowing them to grow their business is desirable. Having so much cash that their short-term investments have a mterial impact on their financials is not.

If I want to diversify my protfolio, I'd rather do it myself. Imho, publicly-traded companies should concentrate on growing their core businesses, rather than trying to reduce thei risks at all costs.
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