Can You Trust Aphria’s Reported Earnings?

From an investment perspective, the short answer is no.

From an accounting perspective, the earnings are what they are. And in the case of Aphria (APR:TSX), one of Canada’s largest and lower cost Cannabis producers, earnings appear accurate. Once the accountants have gotten a hold of numbers, checked and rechecked and provided a full audit, we should be able to “trust” the stated earnings are correct.

But, from an investment perspective, the question of whether headline reported earnings figure be used for valuation purposes is a very different one.

High Quality vs. Low Quality Earnings

When a company releases a quarterly or year-end financial report, they provide investors and analysts a plethora of information that can be used to value returns of the company’s stock. Possibly the most widely used and important piece of information provided by the company in their reports is their quarterly or annual net income and earnings per share (EPS). EPS is the most easily understood and universal term to use when examining a company’s profitability, representing the portion of the overall company profit that would be hypothetically allocated to an individual share of a company. However, these reported earnings are far from the whole picture, and this is where the concept of high quality vs. low quality earnings comes in.

A company with high-quality earnings operates exactly as you would hope that it would. It performs its primary business operations, receives cash compensation for its operations, pays for its expenses followed by any applicable taxes, and reports the remainder of its income as earnings. The earnings the company receives literally translates to cash the company can distribute to shareholders, invest in future operations, or hold on to for a future date. Additionally, assuming the company’s operations continue at a similar level, we can reasonably expect similar earnings to continue in the future.

A company with low-quality earnings, has less of a clear line between its reported “earnings” and cash that the company has actually acquired or is likely to continue to acquire in the future. This can occur due to a variety of reasons.

Reason 1: No Cash Flow

One of the most common causes of low-quality earnings is when a business sells its product through credit and financing. Instead of receiving cash for a product or service, the company receives what is essentially an “IOU” from a customer. This is often recorded on the company’s financial statements as an “accounts receivable” asset. While these are considered “earnings” for reporting purposes, consider an extreme case where a company exclusively makes credit sales and never ends up collecting on its accounts receivable. The reported earnings could be extremely high without the company ever receiving a single dollar. In other words, the company could have Low Cash Flow Relative to Earnings.

Reason 2: Non-Recurring Earnings

In another extreme example, a company that consistently earns $1 per share might decide to sell off a portion of the business. Proceeds from these sales may amount to $100 per share which could then be included in the company’s earnings. It is unrealistic to say that the company’s total earnings of $101 per share are high-quality, as it can hardly be expected that earnings will continue at this level. In other words, the company has experienced High Earnings but Low Recurrence of Earnings.

Tying it Together

In each of these examples, while the reported earnings do have meaning, they do not represent money the company has received and can expect to continue to receive. A company not receiving cash for their services has no way of investing in future operations or distributing money to shareholders. While a company that receives non-recurring cash earnings can put it to use, it has more in common with a payout than as a metric to value the business.

It is important to note that low-quality earnings do not equate to poor earnings. Many low-quality earnings can still be realized fully in the future. It is just an indicator that the company’s net earnings as they are reported do not directly align with the cash the company receives.

Back to the Aphria Case

Aphria reported $54.8 million in net income in the most recent quarter, translating to $0.22 per share. This is up from $7.0 million or $0.04 per share last year. This seems good, right?

A closer look shows its cash flow generated from operating activities was in fact a loss of $1.9 million compared to $4.2 million last year, signalling low cash flow relative to earnings. Additionally, over $70 million of their earnings in the most recent quarter came from their own investments unrelated to actual operations, which are unlikely to continue to support the company in the future, signalling low recurrence of earnings.

If you were wondering whether you could trust or use Aphria’s reported earnings to value the stock, the short answer is no. At least, not without the bigger picture of where the company’s earnings come from.

At KeyStone, we value companies that not only have consistently strong high-quality earnings but are able to grow high-quality earnings as well. This creates long-term value for investors based on a foundation of solid cash flow.

One company that fits this profile is U.S.-based, software engineering firm, EPAM Systems (EPAM: NASDAQ) which has grown revenues and earnings in all 7 of the years that it has been a public company. Not only have earnings per share growth consistently at a double-digit rate but those earnings have been fundamentally high-quality as evidenced by the solid operating cash flow generated over that period. Real earnings and cash flow has allowed the company to grow without reliance on debt or share issues and to build up a net cash balance of $745 million. The success of this strategy is evident in the company’s return to shareholders as EPAM has been one of the top performing stocks on the NASDAQ since it became public in 2012.

We favour companies with clean balance sheets, relatively easy to understand businesses, reasonable valuations and near to long-term growth prospects. A recent example of this was our SPEC BUY rating on Questor Technology Inc. (QST:TSX-V), Cleantech business which designs, manufactures and services high efficiency waste gas combustion systems for the oil and gas industry.

At our Fall 2018 DIY seminars, we recommended Questor at $2.22. The stock has jumped over 120% to just under $5.00 since the buy recommendation. Powering the gains was record financial results for the nine-month period.

Earnings doubled to $5.62 million or $0.21 from $2.8 million or $0.11 per share in the first nine-months of 2017.

Questor, a company recommended by Keystone, reports strong streamlined earnings with even stronger growing cash flows. The company is relatively unknown in Canadian markets and has very few analysts covering the stock.

Stocks like Questor and EPAM are excellent examples of the unique and highly selective research present to our clients each year.

Attend one of our upcoming DIY Stock Seminars and learn about 5 great new growth and dividend growth stocks we think you should buy today. Our analysts will show you how to take control of your portfolio, simplify and pay less fees in the process. Our goal is to help you create a simple 10-20 stock portfolio consisting of ubique quality stocks.

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