Show Me the Money, KVH Industries

Although business headlines still tout earnings numbers, many investors have moved past net earnings as a measure of a company's economic output. That's because earnings are very often less trustworthy than cash flow, since earnings are more open to manipulation based on dubious judgment calls.

Earnings' unreliability is one of the reasons Foolish investors often flip straight past the income statement to check the cash flow statement. In general, by taking a close look at the cash moving in and out of the business, you can better understand whether the last batch of earnings brought money into the company, or merely disguised a cash gusher with a pretty headline.

Calling all cash flows
When you are trying to buy the market's best stocks, it's worth checking up on your companies' free cash flow once a quarter or so, to see whether it bears any relationship to the net income in the headlines. That's what we do with this series. Today, we're checking in on KVH Industries (Nasdaq: KVHI  ) , whose recent revenue and earnings are plotted below.

Source: S&P Capital IQ. Data is current as of last fully reported fiscal quarter. Dollar values in millions. FCF = free cash flow. FY = fiscal year. TTM = trailing 12 months.

Over the past 12 months, KVH Industries generated $7.3 million cash while it booked net income of $6.9 million. That means it turned 4.8% of its revenue into FCF. That sounds OK.

All cash is not equal
Unfortunately, the cash flow statement isn't immune from nonsense, either. That's why it pays to take a close look at the components of cash flow from operations, to make sure that the cash flows are of high quality. What does that mean? To me, it means they need to be real and replicable in the upcoming quarters, rather than being offset by continual cash outflows that don't appear on the income statement (such as major capital expenditures).

For instance, cash flow based on cash net income and adjustments for non-cash income-statement expenses (like depreciation) is generally favorable. An increase in cash flow based on stiffing your suppliers (by increasing accounts payable for the short term) or shortchanging Uncle Sam on taxes will come back to bite investors later. The same goes for decreasing accounts receivable; this is good to see, but it's ordinary in recessionary times, and you can only increase collections so much. Finally, adding stock-based compensation expense back to cash flows is questionable when a company hands out a lot of equity to employees and uses cash in later periods to buy back those shares.

So how does the cash flow at KVH Industries look? Take a peek at the chart below, which flags questionable cash flow sources with a red bar.

Source: S&P Capital IQ. Data is current as of last fully reported fiscal quarter. Dollar values in millions. TTM = trailing 12 months.

When I say "questionable cash flow sources," I mean items such as changes in taxes payable, tax benefits from stock options, and asset sales, among others. That's not to say that companies booking these as sources of cash flow are weak, or are engaging in any sort of wrongdoing, or that everything that comes up questionable in my graph is automatically bad news. But whenever a company is getting more than, say, 10% of its cash from operations from these dubious sources, investors ought to make sure to refer to the filings and dig in.

With 57.5% of operating cash flow coming from questionable sources, KVH Industries investors should take a closer look at the underlying numbers. Within the questionable cash flow figure plotted in the TTM period above, stock-based compensation and related tax benefits provided the biggest boost, at 30.3% of cash flow from operations. Overall, the biggest drag on FCF came from changes in accounts receivable, which represented 94.4% of cash from operations. KVH Industries investors may also want to keep an eye on accounts receivable, because the TTM change is 3.6 times greater than the average swing over the past 5 fiscal years.

A Foolish final thought
Most investors don't keep tabs on their companies' cash flow. I think that's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. Better yet, you'll improve your odds of finding the underappreciated home-run stocks that provide the market's best returns.

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How Long Will Exelon Earnings Keep Falling?

Exelon (NYSE: EXC  ) will release its quarterly report on Wednesday, and investors are bracing themselves for what could be another disappointing report for the utility. Despite its promise as a major producer of nuclear power, Exelon earnings are likely to decline from their year-ago levels, continuing a troubling trend that has led to past dividend cuts and uncertainty about the company's future.

Historically, Exelon has benefited greatly from its diversified portfolio of electrical generation capacity, with its nuclear power plants helping to give it a major competitive advantage when fossil-fuel prices were high. Lately, though, low natural gas prices have taken away that advantage, creating problems for the utility's business model and depressing the price of the power it generates, hitting profits. Let's take an early look at what's been happening with Exelon over the past quarter and what we're likely to see in its quarterly report.

Stats on Exelon

Analyst EPS Estimate	$0.54
Change From Year-Ago EPS	(11.5%)
Revenue Estimate	$6.15 billion
Change From Year-Ago Revenue	(3.3%)
Earnings Beats in Past Four Quarters	2

Source: Yahoo! Finance.

When will Exelon earnings bottom out?
Analysts have largely kept their views on Exelon earnings stable in recent months, leaving June-quarter estimates unchanged though reining in their full-year 2013 views by $0.02 per share. The stock, though, has continued to pose problems for investors, having fallen 14% since late April.

A large part of that drop came in late May, following very poor results from power-grid operator PJM's auction of electrical capacity governing the 2016-2017 delivery year. With the grid operator managing to secure nearly 170 gigawatts of capacity at a price more than 55% below the previous year's auction, analysts downgraded Exelon and rival FirstEnergy (NYSE: FE  ) because of the adverse long-term implications on electricity demand. New natural-gas-fueled power plants were a major part of the capacity jump, and as gas prices continue to remain relatively low, producers like FirstEnergy and Exelon are facing profit squeezes well into the future.

But Exelon isn't giving up on the future prospects of nuclear energy. It filed renewal applications for two of its nuclear plants in May, seeking to get the multi-year process under way well before the 2024 to 2027 expiration dates of its current approval from the Nuclear Regulatory Commission. Industry rivals aren't committed to nuclear power given the current price environment, as Duke Energy (NYSE: DUK  ) decided to suspend its plans to build new nuclear plants in North Carolina, citing slowing growth in power demand as making the plants unnecessary as Duke turns its attention to modernizing its fossil-fuel plants.

Moreover, Exelon is looking at sources other than nuclear power for electricity generation. In its corporate sustainability report, the company not only touted safety and reliability but also more than 400 megawatts of wind power and 31 megawatts of solar generation it added in the past year.

In the Exelon earnings report, watch for signs of how the utility is handling the prospect of higher interest rates. The full brunt of higher financing costs won't hit the company immediately, but over time, rising interest expense could produce a further headwind to Exelon's profitability going forward.

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Here's What These Slow-and-Steady $3 Billion Investors Are Buying

Every quarter, many money managers have to disclose what they've bought and sold, via "13F" filings. Their latest moves can shine a bright light on smart stock picks.

Today let's look at money managers Douglas C. Lane & Associates, founded in 1994 and based in New York City. The firm devotes a high-profile section of its website to its unofficial mascot, the turtle, chosen for its willingness to stick its neck out and its perseverance, among other things. A profile in Barron's summarized its investment strategy by noting that "the firm invests long-only, aims for low portfolio turnover, and takes a long-term view -- typically three to five years -- of securities." Between 1994 and now, the money it manages for clients has grown from $300 million to about $3 billion, which suggests that the firm is doing something right.

The company's reportable stock portfolio totaled $2.6 billion  in value as of June 30.

Interesting developments
So what does Douglas C. Lane's latest quarterly 13F filing tell us? Here are a few interesting details.

The biggest new holdings are Visteon and Yahoo!. Other new holdings of interest include National Oilwell Varco (NYSE: NOV  ) , a top maker of oil and gas drilling and oilfield services equipment. Bulls like its big and growing backlog and its massive market share as a supplier of rig equipment. It recently doubled its dividend (now yielding 1.4%) and is poised to profit as recent shale oil finds lead to production growth. Analyst Stephen Gengaro of Stern, Agee & Leach reiterated his buy rating on the stock a few weeks ago, citing drillship orders received by Seadrill that can result in hundreds of millions of dollars for National Oilwell Varco.

Among holdings in which Douglas C. Lane increased its stake were VeriFone Systems (NYSE: PAY  ) and American Tower (NYSE: AMT  ) . VeriFone has seen its stock nearly halved over the past year, as it has repeatedly posted disappointing quarterly results and weak guidance. Indeed, results reported in June sent shares down some 20%. A board member recently bought about half a million dollars worth of shares though, signaling confidence, and bulls like a recent deal with China. With a single-digit forward P/E ratio, VerFone is seen as attractive by some, and as a possible acquisition target. Others, though, are wary, fearing that competitors will eat VeriFone's lunch.

With wireless communications facilitator American Tower's stock averaging 23% annual gains over the past decade and a forward P/E ratio near 30, you can argue that the real estate investment trust is overvalued. Some disagree, though, seeing opportunity and expecting growing demand for the company's towers. Another plus is the company's rising dividend, which yields 1.5%. The company's international growth has been particularly strong lately, too. American Tower stock took a hit recently when the activist short-selling firm Muddy Waters Research slapped a "sell" rating on it, citing questions about accounting and even questioning the company's viability. The company has rebutted the report.

Douglas C. Lane reduced its stake in lots of companies, including telecom company CenturyLink (NYSE: CTL  ) . The company sports a tempting 6% dividend yield, and that's after it cut its payout by about 25%, in part to focus more on share buybacks. The company landed a hefty Pentagon contract in April, with a possible 10-year value of $750 million and has been moving into promising arenas such as cloud computing (via its purchase of SAVVIS). CenturyLink carries more than $19 billion in debt, but it's also generating significant free cash flow, near $3 billion annually. Its revenue growth has been accelerating in recent years and has long been in double digits annually.

Finally, Douglas C. Lane's biggest closed positions included Western Union and bonds in General Motors. Other closed positions of interest include Annaly Capital Management (NYSE: NLY  ) . Annaly, a mortgage REIT, has many investors drooling over its 13.4% dividend yield. But it also has investors worried about rising interest rates and that the company might take on more risk by expanding beyond agency-backed securities. Some even worry about nepotism in the company and outsized compensation. Many are choosing to watch and wait. Annaly stock has sunk by more than 20% over the past year.

We should never blindly copy any investor's moves, no matter how talented the investor. But it can be useful to keep an eye on what smart folks are doing, and 13-F forms can be great places to find intriguing candidates for our portfolios.

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U.S. Stocks Slide to Start the Week

U.S. stock markets slid in late trading Monday ahead of another Fed meeting and more earnings reports. The only major economic news today was a 0.4% drop in pending home sales, which shouldn't be a huge shock given the rise in mortgage rates over the past three months. We should expect continued challenges in existing-home sales as rates rise, which will be a major reason the Fed will keep rates low for the foreseeable future. With 45 minutes left in trading, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) is down 0.2%, while the S&P 500 (SNPINDEX: ^GSPC  ) has fallen 0.27%.

The biggest mover on the Dow is Pfizer (NYSE: PFE  ) , up 1% after announcing a reorganization. The company will split its operations into three businesses -- two that make patent-protected products and one that makes generic drugs. This may prepare the company to eventually split into separate businesses focused on generic and branded drugs, respectively, but that's speculation for the time being. Plus, reorganizations are commonplace in corporate America, so unless the company splits into two or more pieces, I doubt it will make a big difference to shareholders.  

The other company gaining steam today is Verizon (NYSE: VZ  ) , also one of last week's big winners. Last week the company jumped on further speculation that it would buy out Vodafone's 45% stake in Verizon Wireless, and today investors are anticipating competitor Sprint's earnings. Sprint reports second-quarter results tomorrow and is expected to report a loss of 1.5 million customers, most of whom went to either Verizon or AT&T. 

The duopoly Verizon and AT&T have built in mobile is getting stronger every quarter, and both companies are providing great returns to shareholders. If Sprint does report big subscriber losses, it will make Verizon an even better buy, even if it doesn't get the 100% stake in Verizon Wireless it desires.

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Oil Surges on Economic Optimism

U.S. stock markets were closed yesterday to observe the Fourth of July holiday, but when they opened this morning, traders were in a buying mood. The addition of 195,000 jobs to the economy in June won't wow anyone, but it was better than expected and shows that the labor market is slowly growing. Investors cheered the news, and the Dow Jones Industrial Average (DJINDICES: ^DJI  ) is up 0.72% today, while the S&P 500 (SNPINDEX: ^GSPC  ) has gained 0.69%.  

Banking stocks are the biggest beneficiaries today, because this data will add to speculation that the Federal Reserve will slow its $85 billion-per-month bond-buying program, taking away the economy's crutch. The Fed's program has aimed to keep long-term interest rates low, and they will likely continue to rise now that the economy appears to be strong. There's no indication that short-term rates will rise, though, and that means banks can borrow at low short-term rates while borrowing at higher long-term rates, boosting profits.

JPMorgan Chase (NYSE: JPM  ) is up 1.9% today as investors speculate that interest rate spreads will rise and defaults will fall for the giant bank. But American Express (NYSE: AXP  ) is also up 2% because a stronger economy means fewer defaults on its credit cards, and the higher long-term interest rates could help boost profits as well. In short, it's good to be a bank investor today.

The other big mover is oil, which has jumped nearly $2 to pass $103 for the first time since early last year. A stronger economy should mean more demand for oil, which is good news for oil producers because demand has actually been dropping since 2005 in the U.S.

Chevron (NYSE: CVX  ) is the big beneficiary on the Dow today, climbing 0.9%. The company doesn't rely on the price of oil to make a profit, but a higher price can make exploration more lucrative.

The key for investors now is to identify the companies who will see a surge in profits now that oil is above $100 again and doesn't appear to be stopping there. For some currently intriguing energy plays, check out The Motley Fool's "3 Stocks for $100 Oil." For FREE access to this special report, simply click here now.

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