Sonoco (SON) has entered into a definitive agreement to sell its rigid plastics blow molding operations to Amcor for $280 million.
Asian companies will start reporting full-year earnings soon, so we decided to find some that are likely to have sustainable and strong results – as well as some that may suffer from poor earnings quality. The StarMine Earnings Quality model consists of three components: accruals, cash flow and operating efficiency. We chose an even half dozen – three that may be winners and three that may be also-rans. Poor Earnings Quality 000816.SZ : JiangSu Jianghuai Engine Co Ltd : Machinery : Earnings Quality Model Score : 1 With China taking a serious look at controlling air pollution, small engine manufacturers like JiangSu Jianghuai could face some pressures. The company manufactures diesel and gasoline engines and scored the poorest possible Earnings Quality model score of 1 indicating that earnings may not be coming from sustainable sources. One sign of poor earnings quality is negative free cash flows. JaingSu has seen negative free cash flow in six of the last seven quarters as it has spent more on capital expenditures than it has earned from operations. That is not sustainable in the long term. Another measure of earnings quality is operating efficiency: Jiangsu has seen trailing net operating assets at the lowest point in five years, a sign that the company may not be maximizing its assets’ potential. Source: Thomson Reuters Eikon/StarMine Inventory piling up JiangSu is also experiencing weakening inventory days. As you can see in the chart above, inventory days have been on the rise, and in the last quarter, inventory days was at 103 days, the highest level in more than five years. Rising inventory days could lead to obsolescence and could indicate poor inventory management. 1590.TW: Airtac International Group: Machinery : Earnings Quality Model Score : 9 This Taiwan-based valve and pump manufacturer is grappling with falling return on net operating assets and poor cash flows, both signs of poor earnings quality. Airtac has opened a new site in Taiwan and has seen operating expenses increase as a result. While that may help earnings in the future, for now the StarMine Earnings Quality Score of 9 puts it in the bottom decile of all companies in the region and leads us to believe that earnings are not coming from sustainable sources. Source: Thomson Reuters Eikon/StarMine Wealth erosion ahead? As you can see in the chart above, the company has had negative or weak free cash flows consistently over the past five years. When free cash flows lag net income and are negative, it is a sign of poor earnings quality. Part of the reason for the poor cash flows could be the new plant opening in Taiwan, but studies have shown that spending on capital expenditures when return on net operating assets are falling could lead to wealth erosion. For Airtac, RNOA is at 18.7%, almost half of what it was just four years ago. That weakness is driven by weak asset turnover, which has also been falling in the same period. It’s a sign that the company may not be using assets efficiently. LTG PM: Lt Group Inc: Beverages : Earnings Quality Model Score : 1 LT Group is a Philippines-based beverage company that recently forayed into banking. The company seems to have poor earnings quality based on rising inventory, falling margins, poor free cash flows, and large non-operating income, all contributing to the worst possible Earnings Quality (EQ) model score of 1. LT Group is also in the business of selling cigarettes, which were under scrutiny by the taxman. In addition, a new tax code on cigarette sales is likely to be a drag on future earnings. The company’s new banking arm also seems to be a drag on earnings and analysts continue to lower earnings estimates. Source: Thomson Reuters Eikon/StarMine Smoking and drinking As the cigarette and beverage businesses have become more competitive and price wars have broken out, operating profit margins have fallen over the last three years to 9.7% from 12.8%, and over the last four quarters that trend has continued. In the last quarter, trailing 4Q operating margins was just 0.1% and that trend is not sustainable. It’s a big reason why LT Group scores so poorly on the operating efficiency component of the EQ model. The foray into banking has not yet panned out for LT Group as can be seen by analyst pessimism. Strong Earnings Quality AMC.AX: Amcor Limited : Container & Packaging : Earnings Quality Model Score : 98 This Australia-based packaging company has been firing on all cylinders. As oil prices fall, the consumer has more disposable income to spend on food and drink, and Amcor is in the business of packaging that food, which means a potential increase in business. The company already is displaying signs of good earnings quality with strong cash flows and improving margins, and the StarMine Earnings Quality model score of 96 leads us to believe that these earnings are likely to be sustainable going forward. Let’s look at the signs of strong earnings quality. Source: Thomson Reuters Eikon/StarMine Arrows pointing upward Not only has net income been increasing in each of the last three years but free cash flow has also been rising. In the fiscal year ending June 2014, Amcor reported record free cash flow of A$829 million, far exceeding the net income of A$565 million. In the last semiannual period, free cash flow was the highest in four years at A$730 million. Earnings supported by strong cash flows tend to be more sustainable in the future. Operating profit margins reached a 10 year high of 10.1%, and falling oil prices (a key material input) is likely to improve those margins. Consequently, return on net operating assets, which measures the company’s operating efficiency, is also at a five-year high at 16.7%, much higher than the 6.5% it was in June 2007. All these factors lead to a high StarMine Earnings Quality model score of 98, a sign that these strong earnings are coming from sustainable sources. HROM.NS: Hero Motocorp Ltd: Automobiles : Earnings Quality Model Score : 99 Hero Motocorp was recently in the news for a big endorsement deal with Tiger Woods worth millions, and it seems like it can afford that. The company is one of the largest motorcycle manufacturers in India. Until recently it had a joint venture with Honda and demand for bikes continues to be strong. Revenues and earnings have more than doubled in the last seven years, and those earnings seem likely to remain sustainable based on a strong Earnings Quality score of 99. Source: Thomson Reuters Eikon/StarMine Look for sustainable earnings As you can see in the chart above, as net income has increased over the last five years, so has cash flow from operations. In fact, in the last year ending March 2014, net income was an impressive Rs. 21 billion, but even more impressive is that cash flow from operating was even higher at Rs. 30 billion. Earnings backed by strong cash flows tend to be sustainable going forward. Return on net operating assets is at an impressive 97%, close to all time highs, and that efficiency is being driven by asset turnover which is at a record high. That means that Hero Motocorp is using its assets efficiently to generate returns and is another sign of strong earnings quality. Now if only Tiger could get back to his old glory days and justify the group’s faith in him! 047810 KS: Korea Aerospace Industries Ltd : Aerospace & Defense : Earnings Quality Model Score : 91 This Korean military and civilian aircraft manufacturer is seeing a surge in new orders and especially strong demand for its next generation KFX fighter jet. Already the company is showing signs of strong earnings quality with improving operating efficiency and strong cash flows. On the domestic front, the company has an 11-year backlog for its aerospace unit, which exceeds even Airbus and Boeing and could lead to strong profits. Source: Thomson Reuters Eikon/StarMine Good order pace Despite the growing order book, the KAI has done a good job of managing inventories. The latest inventory days were at 76, the lowest level in the company’s history. That reduces the risk of obsolescence in this fast-paced industry. Another positive for KAI is improved efficiency over the past four quarters. At 14.9%, trailing 4Q RNOA is at an all time high. With a new partnership to develop helicopters, the management team is doing all it can to diversify its product offerings while at the same time ensuring efficiency. With earnings coming from sustainable source, it looks like KAI earnings may be on an upward trajectory. Receive stories like this to your inbox as they are published. Subscribe here and follow us @Alpha_Now on Twitter or check out the Thomson Reuters Eikon blog. If you are looking to access Thomson Reuters data or analytics, register for a free trial.