Income Statement Analysis PROFITS
Alexander Motola, CFA
Alexander Motola, 2013
1
Quality of Earnings, Ch. 4
“Differential Disclosure”
Differential Disclosure is when a company
paints a different picture in its SEC filings
compared with other informational
releases
 Large deltas in disclosure can point to
poor management quality
 (pg. 45) – if SEC filings are “more
accurate” why read anything else? There is
a lot of qualitative information in press
releases (as well as better timeliness) and
shareholder reports

Alexander Motola, 2013
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Quality of Earnings, Ch. 4
“Differential Disclosure”
Case Study of P&G (pg. 45)
 From 1983 to 1984, operating income
declined, which is NOT mentioned in the
annual
◦ Tax rate changes and special items drove a
modest increase in Earnings per Share (EPS)

Pgs. 45-46 give a excellent example of how
qualitative research can verify and
illuminated issued raised quantitatively
(through financial/forensic analysis)
Alexander Motola, 2013
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Quality of Earnings, Ch. 4
“Differential Disclosure”
Case Study of CVGT (pgs. 46-49)
 Big earnings (+25%) and revenue
increases (+70%), but EPS was -5% ($0.40
vs. $0.42)
 Let’s examine these in order:
◦ Big revenue increase is good, clearly.
 However, 46% of sales were to 1 customer
(Burroughs) who also had other incentives to buy
stuff (owned warrants) and who was private
labeling it (likely lower margin for CVGT)
Alexander Motola, 2013
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Quality of Earnings, Ch. 4
“Differential Disclosure”
 Some inputs were on allocation because CVGT was
dependent on a sole provider for 2 important items
 Could severely impact future revenue growth
 Could be good: imagine if they could have made as many as
they wanted
 The AMEX thing is weird, it feels like advertising or even
channel stuffing (also something to check with Burroughs on
as well). Would like to know how much of revenue came
from this (pg. 47)?
Alexander Motola, 2013
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Quality of Earnings, Ch. 4
“Differential Disclosure”
 When revenues grow rapidly, you normally expect
margins to expand – why?
 Hiring usually lags growth (lower opex/cogs)
 Advertising leverage
 Manufacturing efficiencies, procurement efficiencies
 Sometimes this doesn’t happen
 Extreme discounting
 Like with the iDevices, airfreight to meet demand ate up a lot
of margin
 Large customer discounts or other low margin distribution
changes (getting into Wal-Mart)
 I can’t find the SEC filings for CVGT, so we don’t know
exactly what happened with margins
Alexander Motola, 2013
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Quality of Earnings, Ch. 4
“Differential Disclosure”
 If revenues grew 70%, but net income only grew
+25%, then we know margins went down (but not
necessarily which ones or how much); this is
another way of saying expenses grew faster than
70% Year over Year (YoY)
◦ The biggest problem is obviously the shares
outstanding. o’Glove doesn’t give us a ton of
information, but we can figure this out, based
on the formula for EPS [EPS = (net
income/shares outstanding)]
Alexander Motola, 2013
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Quality of Earnings, Ch. 4
“Differential Disclosure”
[EPS = (net income/shares outstanding)]
◦ For 1982, we know that net income was
$11.9mm with EPS of $0.42 (pg. 47)
◦ For 1983, we know that net income was
$14.9, with EPS of $0.40 (pg. 47)
◦ We also learn that CVGT has 36mm shares
outstanding in 1983, +1.5mm warrants, for a
total of 37.5mm
◦ 1983 EPS of $0.40 = ($14.9mm/37.5mm)
◦ 1982 EPS was $0.42, Net Income was
$11.9mm, so SO must equal 28.33mm
Alexander Motola, 2013
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Quality of Earnings, Ch. 4
“Differential Disclosure”

1982 EPS was $0.42, Net Income was
$11.9mm, so SO must equal 28.33mm
◦ That means Shares Outstanding increased
32% yoy, or each share you own is now worth
25% less than it was worth (you were diluted)
◦ Presumably, the company got a lot of money
for an offering, but there’s other ways to grow
share count which are bad for investors
Alexander Motola, 2013
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Quality of Earnings, Ch. 4
“Differential Disclosure”
The qualitative work covered on pg. 48-49 shows
that CVGT made a “deal with the devil” to grow
revenues in 1983 from Burroughs, but ultimately
gave the technology to them.
 CVGT was ultimately bought by Unisys (which
was Burroughs after they changed their name),
but CVGT investors didn’t do well
 UIS had one of the worst returns on equity of
any company in US history (poorly managed)

Alexander Motola, 2013
10
More on Margins
Margins are a % of revenue (common
sized income statement)
 The most important margins (we covered
this earlier) are: Gross Margin, Operating
Margin, and Net Margin.
 GM and OM can be used to compare
within and across industries
 These 3 margins are what is being
referred to when the “profitability” of a
company is being discussed

Alexander Motola, 2013
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More on Margins
Negative GM is rare, but it means that a
company is selling goods in total for less
than it costs to make or buy them; this is
unsustainable
 Companies with high fixed costs generally
have volatile GM and companies with
variable GM usually have more stable GM

Alexander Motola, 2013
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More on Margins

If GM improves, then – all else being equal
– OM improves, and NM improves
◦ Be sure to understand where the
improvement or deterioration is coming from
◦ If you calculate growth rates (YoY, or even
QoQ) for all line items (revenue and each
expense), then these will literally “jump off the
page” at you, and the margin % can help
understand the magnitude
Alexander Motola, 2013
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More on Margins

For investors, rising margins are great (assuming they are rising for the
right reasons)
◦ Company grows (+ve) (business is good and/or well managed)
◦ Margins expand (+ve) (growth and mgmt leverage and control expenses)
◦ Earnings grow faster than revenue (+ve) (direct result of margin expansion)
◦ Often equals earnings surprises (+ve) (analysts underestimate margin exp)
◦ Earnings estimates get revised higher (+ve) (analysts try to correct)
◦ P/E multiples (discussed later) expand (+ve) (investors value the stock more)

This creates a situation where the stock price grows much faster than
revenues/earnings, and translates into huge investor profits
Alexander Motola, 2013
14
Shares Outstanding

Shares Outstanding = how many pieces the
ownership pie is divided into
◦ Fully Diluted – includes options, warrants, converts, etc.
Used to calculate EPS if Net Income is >= 0
◦ Basic – only issued shares, used to calculate EPS is Net
Income is < 0
◦ Most companies grow SO by 1.5%-2% due to options
issuance to employees
◦ Equity offerings trade more shares outstanding for cash,
which can be used to growth the company
◦ If SO shrinks, then each share is worth more
Alexander Motola, 2013
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Quality of Earnings, Ch. 5
Non-Operating/Non-Recurring Income
 It’s pretty easy to do a basic model
(income statement) of a company – you
just copy the income statement into
Excel, and divide net income by shares
outstanding, get EPS
 Where does the model add value?
◦ Incremental information
◦ Analyzing routine information in a different
way
◦ Marrying the qualitative to the quantitative for
additional insight
Alexander Motola, 2013
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Quality of Earnings, Ch. 5
Non-Operating/Non-Recurring Income

Incremental information
“If you believe Standard & Poor’s Stocks Reports and Moody’s Handbook of Common
Stocks, those two reference bellwethers, in 1982 Pepsico (PEP) reported $2.40 per
share which rose to $3.01 the following year, for an increase of 25 percent. But
subscribers to The Value Line Investment Survey, an equally reputable publication,
were informed that the 1982 earnings did not come to $2.40, but rather to $3.24
and 1983’s to $3.01, for a decline of 7% percent” (QoE, pg. 55)

Analysts make choices; this difference was driven by choices in how to handle
“charges” – unusual and supposedly non-recurring expenses related to write
downs, mergers, and other “one time events”
Alexander Motola, 2013
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Quality of Earnings, Ch. 5
Non-Operating/Non-Recurring Income

There is no “right or wrong” answer to handling this, it’s the analyst’s
judgment based on their research

It is important to be consistent in how you handle modeling items or
comparability gets disrupt and the value of your model becomes less

PEP did grow EPS 25% and decline 7% in the same year, in accounting
terms; the key is to understand why

Even if the “Street” choses one method, you might not agree – which is
fine, just be prepared to provide your rationale.

Some companies have a long history (UIS – Unisys, mentioned in the
earlier chapter) of taking “non-recurring charges” every single or nearly
every quarter – is that truly “non-recurring”?
Alexander Motola, 2013
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Quality of Earnings, Ch. 5
Non-Operating/Non-Recurring Income

What’s the attraction of “charging off”
expenses?
◦ Wall Street usually ignores the charges, resulting in a higher pro
forma EPS, which would normally – over time – translate into a
higher stock price
◦ Being overly aggressive with charges (“The Big Bath”) creates a
“cookie jar” where expenses charged off can be reversed in
future period to increase earnings (confused – ask the question)
◦ Tiny amounts can matter
Alexander Motola, 2013
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Quality of Earnings, Ch. 5
Non-Operating/Non-Recurring Income

Let’s use CVGT’s #s as an example

1982 EPS was $0.42, Net Income was $11.9mm, SO equal 28.33mm

How much “accounting” needs to be done to get the 1982 EPS
from 42c to 43c per share?
◦ $0.425 will be rounded to $0.43
◦ 0.425 (necessary EPS) * 28.33 (SO) = $12.040mm in Net Income
◦ 1983 Net Income was $11.9mm, so if the CVGT CFO can find ($12.040 –
11.9 = ) $140,000 (after tax), he just earned another penny per share,
perhaps meeting or beating expectations…
Alexander Motola, 2013
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Quality of Earnings, Ch. 5
Other Thoughts

As covered last lecture, revenue recognition and
expense recognition matter a lot
◦ Most any number can be manipulated
 DSOs can be factored, and this is often not disclosed. Factoring creates the appearance
of high collections but at a cost (but one not obvious to investors)
◦ Channel stuffing happens… a lot
◦ Think about the motivations (proxy, meeting expectations, pride, etc.) –
how much stock do the C-levels own?
◦ % of completion allows a huge range of possible revenue and expense
recognition; companies that use this for a material part of their revenues
often sell at a multiple discount for this reason
Alexander Motola, 2013
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