Why CECO Environmental's Earnings Are Outstanding

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 CECO Environmental (Nasdaq: CECE  ) , 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, CECO Environmental generated $17.0 million cash while it booked net income of $11.0 million. That means it turned 12.5% of its revenue into FCF. That sounds pretty impressive.

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 CECO Environmental 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 questionable cash flows amounting to only 7.3% of operating cash flow, CECO Environmental's cash flows look clean. Within the questionable cash flow figure plotted in the TTM period above, stock-based compensation and related tax benefits provided the biggest boost, at 3.9% of cash flow from operations. Overall, the biggest drag on FCF came from changes in accounts receivable, which represented 15.3% of cash from operations.

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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Is Microsoft Stock a Buy?

For more than a decade, Microsoft (NASDAQ: MSFT  ) has been playing catch-up with Apple's (NASDAQ: AAPL  ) market-defining products. The iPhone and iPad defined categories that Microsoft had no answer to and the popularity of the tablet has rendered the PC a dinosaur in computing.

Yet Microsoft has continued to grow revenue and income, despite these challenges, something that often goes overlooked.

MSFT Net Income TTM data by YCharts.

Now that Microsoft has released Windows 8 and Xbox One, I think the company's strategy is coming into focus and it's time to consider whether Microsoft stock is worth buying.

Xbox One brings Microsoft into the living room
Windows Phone 8 and the mobile versions of Windows 8 look like catch-up products for Microsoft, but Xbox One has the opportunity to define the future of television and gaming. In theory, the new console will bring gaming, television, and streaming media onto one device. For years, this has been the goal of Apple, Sony, Google (NASDAQ: GOOG  ) , and even Nintendo, who hoped to create the living room hub that connected people to the world. 

Steve Jobs said he "cracked" the TV in 2011 and Apple could create a device that could seamlessly sync with all of your iDevices and the iCloud. Apple TV is a step in that direction, but nearly two years after Jobs' proclamation, we're still waiting to see a game-changing product from Apple. The long-rumored iTV isn't even on the horizon yet. 

Google gave it a shot with Google TV, but the product lacked functionality and never gained traction with consumers. But Google TV is pre-installed on many new TVs, so it has a solid installed base if functionality improves. 

For both Apple and Google, the living room is a vast untapped market that could provide growth and momentum for other devices. Apple's AirPlay allows its devices to sync with Apple TV, and with app development and more accommodation from media companies, Apple could change the way we look at TV. Google isn't as far along in its TV development, but with the largest share of smartphone operating systems and a growing presence in tablets, it should look at the living room as a growth avenue. 

But while Apple and Google have made limited progress with their TV products, Microsoft hopes it has learned from their mistakes and has given consumers a compelling product with Xbox One. It may not have perfected its integration in the first iteration, but it's a step in the right direction. The Smartglass capabilities that allow Google Android, iOS, and Windows mobile devices to interact with Xbox One make it a more friendly device than a closed system like Apple TV.

The importance of Xbox One can't be understated. What Microsoft is trying to do is create an ecosystem that rivals Apple or Google's, drawing consumers in and making it more appealing to buy other Microsoft products. Xbox One will be the center of that sales pitch and should help mobile device and cloud sales in the process.

At the very least, Xbox One has a chance to be the consumer product home run Microsoft is looking for.

Behind the scenes, Microsoft is king
Microsoft may be getting a lot of heat because Windows 8 hasn't been a smashing success, but the company's behind-the-scenes businesses are thriving. In the first quarter, the server and tools division grew 11.2% and the Microsoft business division grew 8.2%. Even if the company isn't selling many new copies of Windows 8, Microsoft Office is still a vital tool for and the server business plays a key role in making companies run.  

These aren't sexy businesses like Xbox or Windows 8, but they're vitally important to the future of Microsoft and a key the company's continued growth.

Microsoft stock is a great value
I like Microsoft's strategic position, and the stock's value is very appealing as well. The company has a market cap of $285 billion, has $60 billion of net cash, and has generated $16.4 billion in net income over the past year, including a $6.2 billion charge for writing down aQuantive. Adjusted for cash and the writedown, the stock has a trailing P/E of about 10, a great value for a company growing in the high single digits.  

Microsoft will continue to grow its behind-the-scenes businesses, which really drive the company's results, and if it can gain share in mobile and generate buzz from Xbox One, the stock should continue its strong run this year. Microsoft stock is still one of the best buys in tech.

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3 Reasons It Might Be a Good Idea to Ignore the Dow Today

This week is a big one for investors who have been looking for some economic data points to direct their investing. But with so much news coming later in the week, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) may not be a reliable guide today as traders wait for more substantial news throughout the remainder of the week. As of 11:45 a.m. EDT, the index is down slightly with a 71-point loss. With more substantial data points yet to come, there are plenty of reasons to just let today's Dow moves go by the wayside.

Reason 1: Pending home sales
This morning's report of signed contracts for existing homes during the month of June showed a 0.4% decline. Though analysts had anticipated a 1% drop, the actual results still mark a fall from May's six-year high and could signal the impact of rising interest rates on sales. One of the more likely culprits, however, is the continued lack of inventory for buyers to choose from. As last week's existing homes sales report noted, the current inventory of existing homes stands at a  5.2-month supply -- well below the level that economists view as a good balance between supply and demand.

Both of the Dow bank component stocks are down this morning, with Bank of America (NYSE: BAC  ) and JPMorgan (NYSE: JPM  ) down more than 1% so far in trading. Though the losses may not be tied directly to this morning's sales report, housing data has been extremely important for bank investors lately. JPMorgan is the second-largest mortgage originator in the country, and B of A has been fervently trying to gain more ground in the market, so a decline in potential sales (read: loans) is a problem for the banks, which rely on interest revenue heavily.

Reason 2: More from Bernanke
Tomorrow, the Federal Open Market Committee will begin its two-day meeting to discuss the current monetary policy and any changes that they will make. Since the markets pay very close attention to these meetings and Ben Bernanke's announcement on Wednesday afternoon, there's sure to be a lot of movement in the coming days. The current speculation features a cutback in the Fed's bond purchasing by $20 billion starting in September -- though investors will have to wait till Wednesday to see if there's any merit to that plan.

As the Fed's stimulus policy changes, there will be an impact on firms with large investments, particularly in bonds. For insurers, this could pose a problem going forward since investment income is an essential part of their business operations. During its first-quarter earnings call, Allstate (NYSE: ALL  ) disclosed that it had altered its investing plan in order to acclimate to the current low-interest-rate environment, though it would be a sacrifice of higher returns later on. This type of change was not widely used, as insurers would have to make a series of adjustments should interest rates rise at a later time. Either way, investors should be aware of such adjustments as the environment transitions.

Reason 3: Employment data
Friday is the big day for labor market data, with the release of the Labor Department's Employment Situation report. Since labor market conditions are a huge part of the Fed's calculations for when to pull back on stimulus policies, Mr. Market has been keen to move dramatically when such reports are released. 

Companies that are dependent on consumer spending also pay close attention to labor statistics, since more employed people could result in higher spending. Dow component American Express (NYSE: AXP  ) has been highly successful in large part because it caters to spenders in the high-income demographics. But as people within all segments of the population begin spending at higher rates, the credit card company and its peers will benefit from a broader revenue stream.

Today's not the day
If there was ever a day to take a break from watching the Dow, it's today. With so much information to come later in the week, any big decisions today may be wasted once investors start reacting to the news items listed above. And as a long-term investor, you know that any single day isn't worth sweating over, so you might want to consider taking the day off!

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Will These Numbers from AT&T Be Good Enough for You?

AT&T (NYSE: T  ) is expected to report Q2 earnings on July 23. Here's what Wall Street wants to see:

The 10-second takeaway
Comparing the upcoming quarter to the prior-year quarter, average analyst estimates predict AT&T's revenues will expand 0.8% and EPS will increase 3.0%.

The average estimate for revenue is $31.84 billion. On the bottom line, the average EPS estimate is $0.68.

Revenue details
Last quarter, AT&T booked revenue of $31.36 billion. GAAP reported sales were 1.5% lower than the prior-year quarter's $31.82 billion.

Source: S&P Capital IQ. Quarterly periods. Dollar amounts in millions. Non-GAAP figures may vary to maintain comparability with estimates.

EPS details
Last quarter, non-GAAP EPS came in at $0.64. GAAP EPS of $0.67 for Q1 were 12% higher than the prior-year quarter's $0.60 per share.

Source: S&P Capital IQ. Quarterly periods. Non-GAAP figures may vary to maintain comparability with estimates.

Recent performance
For the preceding quarter, gross margin was 60.0%, 30 basis points better than the prior-year quarter. Operating margin was 18.9%, 30 basis points worse than the prior-year quarter. Net margin was 11.8%, 50 basis points better than the prior-year quarter.

Looking ahead

Best Stocks For 2014

The full year's average estimate for revenue is $128.32 billion. The average EPS estimate is $2.50.

Investor sentiment
The stock has a three-star rating (out of five) at Motley Fool CAPS, with 5,429 members out of 5,888 rating the stock outperform, and 459 members rating it underperform. Among 1,213 CAPS All-Star picks (recommendations by the highest-ranked CAPS members), 1,145 give AT&T a green thumbs-up, and 68 give it a red thumbs-down.

Of Wall Street recommendations tracked by S&P Capital IQ, the average opinion on AT&T is hold, with an average price target of $36.39.

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