Forensics Reveal a Healthier Target than Wal-Mart
Palwasha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Dow Jones Consumer Services Index opened yesterday 14 basis points above the previous day's close of 401.44. The index has returned 14% year to date and the companies that make up part of the index have generally performed well over the years, returning a sound dividend stream.
I picked out the General Retailers sector that takes the biggest percentage of the index. The four general retailers I’ve chosen are amongst the stocks with the largest holdings in the iShares Dow Jones Consumer Services Index Fund. Wal-Mart Stores Inc. (NYSE: WMT) takes the first place over all with 6.62%, Costco Wholesale Corp. (NASDAQ: COST) bags the 10th place with 2.2%, Target Corp. (NYSE: TGT) lands at the 13th place with 1.91% and finally Best Buy Co. Inc. (NYSE: BBY) goes a little further down the list having a holding of 0.3% in the index fund.
In order to check whether these retail sector big guns can live up to analysts’ forward estimates and investors’ expectations of future earnings, I ran a simple forensic test of earnings health on each. The metric I used is the Cash Flows Accruals Ratio and to verify my results I compared it with revenue growth.
To give the non-finance folks an early heads up so that they don’t get lost somewhere in the middle, an accruals ratio is a metric used to gauge the earnings health of a company. By earnings health I mean the sustainability of earnings and not its conservatism. The accruals ratio is calculated as a ratio of net income less cash flows from operating and investing activities in the numerator and the average of beginning and ending net operating assets in the denominator. The rule of thumb is - the smaller the ratio, the healthier and more sustainable the earnings. The greater the ratio is, the more the company posts accrual based revenue and the greater the chances that these revenues will not persist in the future. The explanation of the accruals ratio doesn’t get any simpler than this!
Table 1 below shows the Cash Flows Accruals Ratio for the four companies over the past three years and this year up until the latest reported quarterly earnings. Table 2 shows revenue growth over the same period.
|Table: 1 Cash Flows Accruals Ratio|
|Table 2: Revenue Growth|
Wal-Mart saw its revenue growth slump in FY2010 after which it picked up the pace. However, its earnings quality improved in FY09-FY10. After FY10, you can witness the deterioration in its earnings health. Notice how accruals increase from a ratio of only 0.96% to over 6.81% by the first quarter of 2012. I wonder whether Buffett ever put that into perspective or is it all about the dividends?
The same years were good news for Target. Target’s revenue growth consistently peaked from 0.63% in FY09 to over 6.1% by the first quarter of 2012. Although its earnings quality has slightly weakened over the same period, yet Target has the lowest accruals ratio amongst all its peers, depicting the healthiest and most promising revenue prospects.
Costco's revenues have seen the greatest growth over the four years. However, the pattern that its accruals ratio appears to follow is highly questionable. The earnings quality weakened in FY10 and then monumentally improved in FY11, finally deteriorating again in 2012. Not a good sign! Changes this irregular are a sign of potentially unstable earnings.
Best Buy has shown the worst revenue growth performance taking a toll on the company each year. The biggest decline came in FY11 and Best Buy reported a net loss for FY12. Earnings quality appeared to have a mammoth improvement from FY09 to FY10 and then degenerated again but with a slower momentum. The noticeable improvement in the accruals ratio during 2012 comes from revenues which, although slowed, are cash based and thus of better quality. Despite that the overall irregularity cannot be overlooked.
In a nut shell, Target appears to me as having the best earnings quality with a stable past and expected revenue growth. Closely keeping pace is Wal-Mart that has a good potential of future earnings, though the earnings health is weakening. Costco has brow-raising revenue growth with doubtful accruals. Best Buy is the worst buy right now with weakening growth and its accruals not following a stable pattern.
PalwashaS does not hold any positions in the stocks mentioned above. The data used for calculations for each company in Table 1 & Table 2 has been taken from the respective company's annual reports and is correct to the best of my knowledge. The Motley Fool owns shares of Best Buy and Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.