Johnson & Johnson Earnings Quality: Good But Not Great

By Joseph Hogue, CFA

I have been a critic of Johnson & Johnson (JNJ) over the last month, writing in March that I didn't think the stock was worth the risk. While the dividend yield and fairly diversified business lines are attractive, there are just too many risks to poor management. The naming of Alex Gorsky as new CEO may help to resolve quality control issues but the company could have further signaled their commitment to change by seeking someone from outside the company's current culture.

Even if the company can turn around its poor quality control systems, it still has to face pressure from U.S. health care reform, a dated pipeline, and possible problems with its integration of Synthes operations.

One possible bright-spot for investors is a positive trend in the quality of the company's earnings over the last year. Aggregate accruals, a measure of the discretionary component of earnings, is down significantly signaling that current earnings are higher quality and probably persistent into coming quarters.

A quick review of how to measure earnings quality and why it matters should help to explain the circumstances. Firms report performance based on accrual accounting rather than on a cash-basis. The accrual method, matching expenses with revenues instead of just cash receipts and payments, better reflects the company's financial performance. The disadvantage to accrual-based accounting is that management has a great deal of discretion about what and when they classify as revenues, expenses, and other items.

This discretion can lead to manipulation of earnings and varies from minor to outright fraudulent. There are several incentives for management to cheat and manipulate earnings. There is a great deal of pressure to 'beat' market expectations for earnings. Management may speed up revenues or delay expenses to increase the current period's earnings. There are also often incentives derived from compensation contracts like stock options and performance-based pay.

Some of the areas where management can manipulate earnings are:

· Recognizing revenue too early or too late. If the current quarter is looking good but the next may be tough, management can delay revenue to smooth out earnings.

· Similarly, expenses can be taken in the current quarter or capitalized over time. The 'bathroom sink' strategy is where management expenses or writes down as much as possible in the current quarter (usually when it is going to be bad anyway) so future quarters look better.

· Management selects the depreciation method as well as the useful life of assets which is then used to calculate depreciation expense on the income statement.

· Management has several choices on how they account for inventory costs.

The problem with manipulation of earnings is that it must eventually be addressed. Revenue that is taken too early will still need to be earned in the future. Expenses that are deferred to future quarters will be taken against that quarter's revenues on top of the quarter's actual expenses.

Analysts use cash-flow based aggregate accruals to measure the amount of discretion, or possible manipulation, in a firm's earnings. Since cash transactions are much harder to manipulate, we can measure the amount of earnings from discretionary sources by removing cash earnings from the picture.

Aggregate accruals are basically the change in non-cash balance sheet items for the period. It excludes cash and debt because these accounts are subject to less manipulation.

Aggregate Accruals = NOAt - NOA t-1

Where Net Operating Assets (NOA) =
(Total Assets - Cash) - (Total Liabilities - Total Debt)

Do not let the math scare you. All items are easy to find on the company's balance sheet. Compare the NOA from the current period to the NOA from the prior period as shown in the formula above. Companies with high and increasing aggregate accruals are getting more of their earnings from discretionary accounts. While those with low or falling aggregate accruals have a higher amount of cash-based earnings.

To compare the aggregate accruals across companies, we need to standardize the net operating assets by taking the average over the period.

Accruals Ratio =
(NOAt - NOA t-1)/ ((NOAt + NOA t-1)/2)

Again, this is just taking the average of this period and last period's NOA for a denominator but it helps us compare companies of different sizes.

Looking at the trend in aggregate accruals for JNJ over the last four years we see that the company was getting an increasing amount of earnings from discretionary sources up until December of last year. Remember, the higher the aggregate accruals, the more earnings are based on discretionary items rather than cash-flow.

Comparing the accruals ratio for JNJ against other companies, we see that the company has improved its quality of earnings but still lags others like Pfizer (PFE). The graphic below shows that both Procter & Gamble (PG) and Colgate-Palmolive (CL) book more of their earnings from discretionary sources than JNJ. By itself, this may not be a warning sign for the two consumer staples companies but may lead to problems if the issue persists or becomes worse. For comparison, Groupon (GRPN) who revised its reported revenue and 4th quarter profit on Monday has a much higher accruals ratio. The revenue and profit restatement arose from management's need to increase the assumption it made for refunds, one of the often abused discretionary items.

Measuring aggregate accruals is only one tool that investors may use to judge earnings quality. The Management Discussion & Analysis and Footnotes sections of the financial statements will also need to be studied to find management's decisions on some important accounts. Besides the trend in aggregate accruals and the accruals ratio, investors need to understand the changes in the financial statements that led to the trends. Additionally, investors should not rely on the measure alone to pick investments but should use it in combination with other absolute and relative value metrics.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.