3 red flags signal a troubled stock

By Harry Domash

Plantronics shareholders recently saw its stock sink more than 30% after the headset maker warned that its results for the June quarter would fall short of analysts' forecasts.

But the bad news needn't have been a surprise. Anyone who checked Plantronics' (PLT, news, msgs) December quarterly report for three easily detected "red flags" would have known that continuing to hold the stock was risky business.

Those checks are vital because, in this market, such shortfalls spell big trouble for shareholders. And while they may seem to come out of the blue, in many cases, earlier earnings reports contained telltale signs warning that something was amiss.

Here's how to identify three of those telltale signs, which I call red flags, warning of future bad news. You can easily check for these red flags using the financial statements on MSN Money. You'll need a calculator, but the calculations are easy. Once you get the hang of it, you'll be able to do the analysis in less than five minutes. You'll find it well worth the effort.

No margin for error

I'll start with gross margins, which are most useful for detecting deteriorating competitive conditions.

Gross margins measure the profit a company makes on each widget it sells before accounting for overhead, marketing, research and development cost, interest and taxes. Gross margins tell you a lot about a firm's competitive position. Rising gross margins tell you that a firm is either reducing production costs or raising prices. Whatever the reason, margins tend to move in trends and rising margins point to future positive earnings surprises.

Conversely, deteriorating margins say that either production costs are increasing and the firm can't raise prices proportionally, or that it is cutting prices in an attempt to maintain market share. Since either condition portends future earnings shortfalls, declining gross margins is a red flag.

Calculate gross margins by dividing gross operating profit by sales for the same period. You can find both on MSN Money by looking at quarterly income statements.

To rule out seasonal variations, always compare the most-recent quarter's gross margin to the same quarter one year ago.

I'll use Plantronics to illustrate the process. After you get a price quote, you can find the financial statements on the Plantronics highlights page by selecting Financial Results (on the left-hand column) and then Statements (under Financial Results). The default is an annual income statement. To analyze gross margins, use the dropdown menu to select the quarterly income statement, which lists data for the last five quarters.

For Plantronics' December 2005 quarter, the chart listed sales of $222.5 million and gross operating profit of $101.2 million. So the gross margin was 45.5% (101.2 divided by 222.5). Doing the same calculation for December 2004 yielded a 53.1% gross margin.

(Note: Since the statement only lists the five most recent quarters, the December 2004 quarter disappeared when the March 2006 results were posted. So you won't be able to check my math for December 2004.)

Red flag 1: Deteriorating gross margins

Plantronics' March 2005 gross margin dropped. Small changes in gross margins translate to big changes in reported earnings. Consider a year-over-year gross-margin drop of two percentage points or more (e.g. from 20% to 18%) as a red flag.

'Tis better to receive

Corporations usually don't pay cash when they buy from another company. Instead, they have a predetermined time, say 90 days, to pay for the goods. The amounts owed to a company by its customers for goods received are termed "accounts receivables."

Usually, receivables track sales. For instance, if a company sells twice as much as it did the year before, you would expect its receivables to double. Sometimes sales grow faster than receivables, which signals that the firm is doing better at collecting its bills, which is good.

But beware when receivables increase faster than sales. That means customers are taking longer to pay their bills. Here are three reasons why that could happen:

• The company is slow in billing its customers.

• Customers don't have the cash to pay.

• The firm is giving its customers longer payment terms to encourage them to order products that they really don't need, a practice known as "channel stuffing."

While No. 1 is fixable, reasons No. 2 and No. 3 will likely result in sales and earnings shortfalls in the not-too-distant future.

To analyze receivables, compare the ratio of receivables (found on the quarterly balance sheet) to sales (income statement) for the most recent quarter to the same ratio for the year-ago quarter.

Video-lottery machine maker WMS Industries' (WMS, news, msgs) share price dropped around 15% after the company reported March quarterly revenues below analysts' forecasts and cut its revenue guidance (forecasts) for the balance of the year. Here's what you would have found if you had analyzed WMS' receivables after it released its December 2005 quarterly results.

For the December 2005 quarter, WMS sales totaled $113.4 million and its receivables came in at $140 million. So, the ratio of accounts receivable to sales, or AR/S, was 123% (140.0 divided by 113.4). The same calculation for the December 2004 quarter would have yielded a 98% figure for AR/S. WMS Industries' receivables increased to 123% of sales in December 2005, up from 98% in December 2004.

Red flag 2: Accounts receivables vs. sales

Consider a 20% increase in AR/S (e.g. from 50% to 60% or from 10% to 12%) as an accounts-receivables red flag. WMS Industries' ratio increased 26% (123 vs. 98), which more than qualified for red-flag status.

Count the Cash

Cash flow measures the cash that moved in or out of a company's bank accounts during a reporting period. Since cash flow must be reconciled to actual bank balances, it is a more-reliable measure of a company's results than reported earnings, which are subject to a variety of arbitrary accounting decisions.

Operating cash flow measures the change in bank balances resulting from a firm's main business. When a firm calculates its net income, it deducts a variety of non-cash accounting entries such as depreciation and amortization (If you're rusty on your accounting terms, earnings per share is net income divided by the number of shares outstanding).

Operating cash flow is mainly net income with those non-cash accounting entries added back in. So, generally, operating cash flow should exceed net income. But in fact, many firms find ways to report positive net income when they are actually losing money when you count the cash.

Recent academic research found that comparing reported net income to operating cash flow is a good way to spot future problems. Specifically, the researchers found that the combination of rising net income and declining operating cash flow is a red flag pointing to future earnings shortfalls.

Jos. A. Bank Clothiers (JOSB, news, msgs) share price recently took a 29% drubbing after it reported disappointing April quarter results. I'll use the men's clothing retailer's January quarter cash-flow statement to show you how to look for cash-flow red flags.

Doing the analysis doesn't even require a calculator, but interpreting a cash-flow statement is a little tricky. The quarterly statements show the cumulative year-to-date totals for each quarter instead of each quarter's individual figures. For instance, if a firm's fiscal year starts with January, its June quarter figures include the total of the March and June quarters. To get the June quarter's operating cash flow, you would have to subtract the March totals from the June totals.

However, there's no particular advantage to analyzing the quarters separately. So, I take the easy way and compare the most-recent quarter numbers to the year-ago figures, regardless of whether they represent single or multiple quarters. To do the analysis, simply compare the change in net income to the change in operating cash flow from the year-ago quarter to the most recent quarter.

Here are the numbers you would have found had you checked Jos. A. Bank's cash-flow statement after it reported its January 2006 quarter results (Since the company's fiscal year ends with its January quarter, the cash-flow statement figures for January actually represent the entire fiscal year).

Jos. A. Bank's cash flow

Quarter	Net income	Operating cash flow
January ’06	$35.3 million	$37 million
January ’05	$24.5 million	$51.4 million

Red flag 3: Rising net income combined with a decline in operating cash flow

In Bank's January 2006 quarter, net income rose to $35.3 million from the year-ago $24.5 million figure, but operating cash flow sank to $37 million in January 2006 from $51.4 million in the year-ago quarter.

It's a red flag if net income increased from a year ago but operating cash flow dropped.

Better safe than sorry

Nothing always works in the stock market and these three red flags are no exception. Sometimes cash flow drops because a company loads up on inventory for a new product introduction, or gross margins drop due to short-term conditions.

Nevertheless, successful investing is more about avoiding disastrous losses than it is about riding hot stocks. Paying attention to these red flags will help you do that.

Fortunately, Harry Domash did not own or control any of the stocks mentioned in this column at the time of publication. Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.