Worry About the Quality of EDS' Earnings, Too

Should you buy shares of Electronic Data Systems (EDS - commentary - Cramer's Take) now that the stock trades at its lowest level since 1992?

The answer is an emphatic no. Here's why. First, the company has low-quality earnings, and second, its credit risk is increasing.

Low-Quality Earnings

The first chart shows that the company has defensive losses going back to March 2001, while enterprising profits have averaged 45% of accrual profits, that is, net income as defined by generally accepted accounting principles, during this period.

The second chart ignores accrual profits due to four substantive limitations and instead focuses solely on the relationship between defensive and enterprising profits (or losses). As I've written before, the best companies to own, especially for the buy-and-hold investor, are those situated in the upper right, the earnings power box. These companies possess authentic earnings power. They can self-fund and create value -- the two are not the same, and both are hallmarks of blue-chip companies.

The worst firms, on the other hand, are in the lower left box. In the case of EDS, it's been bobbing around in the lower right box for the last six quarters.

I concede that EDS' alternate profits are improving. Still, there are 10,000 stocks you can buy, so if you have your heart set on this one, why not wait until management demonstrates that it can stay in the earnings power box consistently?

Higher Credit Risk

What really makes me nervous about EDS, however, is its increasing credit risk. Here are three red flags:

For starters, net debt as a percentage of revenue is rising. This is a bad trend, because every dollar that goes to pay interest expense on debt capital is a dollar less that can pay dividends, repurchase stock, fund a new marketing campaign, etc.

Also, goodwill and other intangibles as a percentage of assets is increasing. Bankers don't like to finance things they can't touch.

Lastly, cash as a percentage of debt is declining. If a company had bona fide earnings power, the balance sheet would become more liquid, not less liquid.

The scariest thing about EDS right now is the number of years needed to repay debt and equivalents based on its normalized enterprise defensive profits, the latter defined as average free cash flow to owners and lenders over the last four years. If the recent past is prologue, the company won't be able to fully repay its $5.5 billion of borrowed money until 2055. (Amounts in millions.)

That's 53 years (I avoid companies with debt repayment periods over five years). Egad. Britney Spears will be in her 70s by then. No thanks. Let the other guy buy EDS. There are better risk-adjusted opportunities for you elsewhere on Wall Street.

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].