Don't Ignore the Real Earnings Season

David Trainer  |

Source: Entegris

The financial press loves to hype up “earnings season”, but corporate earnings announcements often provide misleading data as empirically demonstrated by professors at Harvard Business School & MIT Sloan.

The real earnings season, 10-K filing season, happens from mid-February through March. It’s the time when companies publish 10-Ks or annual reports, the only filings where investors can find the financial footnotes and MD&A, which are required to get an accurate and complete measure of a firm’s true profits. Two companies from the beginning of filing season have core earnings trending in the opposite direction of GAAP earnings. Entegris Inc. and Power Integrations Inc. are in the Danger Zone this week.

Entegris Inc.– Very Unattractive Rating – Strong Miss Earnings Distortion Score

Entegris Inc. filed its 10-K with the SEC on February 7, 2020. Despite positive and rising GAAP net income, our research reveals deteriorating fundamentals.

Misleading Earnings: In 2019, GAAP net income grew by 6% year-over-year (YoY) while core earnings, a superior measure of profits[1], fell 22% per Figure 1.

Figure 1: Entegris' Misleading GAAP Net Income Hides Falling Core Earnings

Click to enlarge

Image Source: New Constructs, LLC

In 2019, Entegris had $60 million in net earnings distortion that caused earnings to be overstated. Notable unusual income in Entegris' filings include:

  • $122 million in non-recurring income related to the fee Versum paid to terminate a proposed merger

This non-recurring income was partially offset by:

  • $9 million in severance and restructuring costs included in SG&A – Page 36
  • $4 million in costs associated with the acquisition of MPD – Page F-15 (Page 75 total)
  • $2 million in severance and restructuring costs included in Engineering, Research & Development – Page 37

Only by removing these non-recurring gains and losses can we evaluate the core earnings of Entegris' operations. In total, we identified $0.44/share (24% of GAAP EPS) in net unusual income in Entegris' 2019 GAAP results. After removing this earnings distortion, Entegris' 2019 core earnings of $1.43/share are significantly less than GAAP EPS of $1.87.

With significantly overstated earnings, Entegris earns a “Strong Miss” Earnings Distortion Score, which means it is more likely to miss consensus expectations going forward.

We also adjust balance sheets to hold management accountable for all capital invested into a business; so we can calculate a more accurate return on invested capital (ROIC) and economic earnings, the true drivers of shareholder value.

Some notable adjustments to Entegris' 2019 balance sheet were:

  • $543 million in accumulated asset write-downs, including $11 million in 2019
  • $54 million in the present value of operating leases

After all adjustments, we find that Entegris' economic earnings fell 65% YoY in 2019. In addition to falling core and economic earnings, Entegris' ROIC fell from 13% in 2018 to 10% in 2019 while its net operating profit after-tax (NOPAT) margins fell from 18% to 15% over the same time.

Shares Are Now Overvalued: When we remove the accounting distortions and look at the expectations implied by the stock price, Entegris appears significantly overvalued.

To justify its current price, Entegris must achieve 18% NOPAT margins and grow NOPAT by 14% compounded annually for the next decade. See the math behind this reverse DCF scenario. An 18% NOPAT margin would equal the highest NOPAT margin in company history, compared to 15% in 2019. Markets and Markets, an industry research provider, expects the entire Semiconductor Equipment market to grow by 9% compounded annually from 2020-2025, which further highlights the optimism in this scenario.

Even if Entegris can maintain current NOPAT margins (15%) and grow NOPAT by 9% compounded annually (in-line with projected industry growth rate) for the next decade, the stock is worth just $37/share today – a 16% downside. See the math behind this reverse DCF scenario.

Power Integrations Inc. – Unattractive Rating – Strong Miss Earnings Distortion Score

Power Integrations Inc. also filed its 10-K with the SEC on February 7, 2020. We dug through its 10-K and, despite positive and rising GAAP net income, we found its GAAP earnings overstate core earnings.

Misleading Earnings: In 2019, GAAP net income grew by 176% year-over-year (YoY) while core earnings fell 19% per Figure 2. As demonstrated in “Core Earnings: New Data and Evidence,” corporate managers bury gains & losses in footnotes to help meet or beat earnings goals. Power Integrations beat consensus EPS expectations in each of the last eight quarters. Despite these beats, the firm’s core earnings have fallen in each of the past two years.

Figure 2: Power Integrations' GAAP Net Income Rises While Core Earnings Fall

Click to enlarge

Image Source: New Constructs, LLC

In 2019, Power Integrations had $148 million in net earnings distortion that cause GAAP earnings to be overstated. Specifically, Power Integrations profits were boosted by:

  • $169 million litigation settlement with ON Semiconductor Corporation
  • $5 million in other income consisting primarily of income earned on cash, securities, and other investments

We also identified $249,000 in non-recurring expenses related to the loss on disposal of property and equipment. While these unusual expenses may be considered immaterial by other firms, we collect them anyway because we collect all unusual expenses. Unless we collect all unusual items, we can never be completely sure that, when combined, these small unusual items add up to a material amount. Our Robo-Analyst technology allows us to do the diligence and adjust for all unusual items so our clients can trust the consistency and rigor of our models.

In total, we identified $4.97/share (77% of GAAP EPS) in net unusual income in Power Integrations' 2019 GAAP results. After removing this earnings distortion from GAAP net income, we see that Power Integrations' 2019 core earnings of $1.51/share are significantly less than GAAP EPS of $6.49.

With significantly overstated earnings, Power Integrations earns a “Strong Miss” Earnings Distortion Score, which means it is more likely to miss consensus expectations going forward.

We also made adjustments to Power Integrations' balance sheet and find that its invested capital increased 8% YoY in 2019. Meanwhile, its NOPAT fell by 21% over the same time. Not surprisingly, its ROIC fell from 15% in 2018 to 11% in 2019.

After all adjustments, we see that Power Integrations' fundamentals are deteriorating, despite its streak of earnings beats. In addition to the declines noted above, economic earnings fell 67% YoY in 2019 and NOPAT margin dropped from 14% in 2018 to 11% in 2019.

Shares Are Overvalued: When we analyze the cash flow expectations baked into the stock price using our reverse DCF model, we see that Power Integrations is significantly overvalued.

To justify its current price, Power Integrations must achieve a 15% NOPAT margin (company best in 2010, compared to 11% in 2019) and grow NOPAT by 16% compounded annually for the next 16 years. See the math behind this reverse DCF scenario. These expectations seem overly optimistic given that Power Integrations' NOPAT has grown by half this rate (8% compounded annually) over the past decade and the Power Management Integrated Circuit market is expected to grow by just 5% compounded annually through 2024.

Even if Power Integrations can achieve a 15% NOPAT margin and grow NOPAT by 13% compounded annually for the next decade, the stock is worth just $58/share today – a 33% downside. See the math behind this reverse DCF scenario.

This article originally published on February 24, 2020.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.

[1] In Core Earnings: New Data & Evidence, professors at Harvard Business School (HBS) & MIT Sloan empirically show that our “novel dataset” is superior to “Street Earnings” from Refinitiv’s IBES, owned by Blackstone (BX) and Thomson Reuters (TRI), and “Income Before Special Items” from Compustat, owned by S&P Global (SPGI).

_____

Equities Contributor: David Trainer

Source: Equities News

DISCLOSURE: Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, sector, style, or theme.


The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer. The author of this article, or a firm that employs the author, is a holder of the following securities mentioned in this article : none

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