Earnings Season - A time to be very careful
When a company announces their earnings,
it usually affects the price of the company's stock, but not
always as one would expect. Earnings season takes place during the
weeks after the end of the quarter when companies announce
their most recent earnings performance. Earnings
announcements can have dramatic effect on the price of the
company's stock. Typically, if a
company's earnings exceed expectations the stock has an
excellent chance to go up. However, if it meets or worse,
misses expectations then the price of the company's stock
will drop precipitously. Also, what if a company tries to
lower expectations and then beats those lower expectations?
And do companies manipulate their earnings? What should an investor do during this turbulent time?
Before we answer these questions, let's look at an example.
I am using Intel, a large and well run company that has a
good reputation in the market and among investors for being
open and complete in their communications with investors and
analysts.
Intel's Earnings Punished Their Shareholders
As shown in the chart below Intel's
shareholders were punished on January 18, 2006 when the
company announced its Fourth Quarter Earnings Report.
Needless to say, many investors were caught off guard. Since
that date, those that are still holding Intel stock have
continued to experience further losses. Not a pleasant
experience.
The reason I choose Intel for this example
is it is widely held, a quality company with excellent
management and they had a very nice way to demonstrate the
problem that can take place during earnings season. Please
do not misconstrue my comments on Intel to mean that their
management was trying to hide information from investors and
analysts. They were not.
To facilitate this discussion I identified
the Revenue Announcement and Earnings Release dates on the
above chart. Intel releases their Revenue Announcements and
Earnings Releases after the market closes on the day
indicated. The market reacts to these
announcements the next day it is open (some after market
trading takes place, however, most of the volume is
experienced the next day).
On December 8, 2005 Intel provided
the following release regarding their revenue expectations
for the 4th quarter:
Intel Fourth-Quarter Business Consistent With
Expectations
SANTA CLARA, Calif., Dec. 8, 2005 – Intel Corporation
expects revenue for the fourth quarter to be between $10.4
billion and $10.6 billion, as compared to the previous range
of $10.2 billion to $10.8 billion.
The fourth-quarter gross margin percentage expectation
has been narrowed to 63 percent, plus or minus a point, and
is expected to be slightly above the midpoint of the new
range. The previous expectation was 63 percent, plus or
minus a couple of points. Capital spending is expected to be
below the midpoint of the previous expectation of $5.9
billion, plus or minus $200 million. All other expectations
are unchanged.
Now let's look at the part of the earnings release
after the market closed on January 17, 2006, keeping in mind
the revenue announcement above:
Intel Fourth–Quarter Revenue $10.2 Billion; EPS 40 Cents
- Record quarterly and annual revenue and operating
income
- Record quarterly unit shipments of mobile, desktop
and server microprocessors
SANTA CLARA, Calif., Jan. 17, 2006 - Intel Corporation
today announced fourth–quarter revenue of $10.2 billion,
operating income of $3.3 billion, net income of $2.5 billion
and earnings per share (EPS) of 40 cents. Revenue was below
the company’s updated expectation of $10.4 billion to $10.6
billion primarily due to lower than expected desktop
processor unit shipments and prices. . . .
Financial Review
Fourth–quarter gross margin was 61.8 percent, slightly below
the company’s updated expectation of 63 percent, plus or
minus a point, primarily due to lower than expected revenue,
a slight shift in the overall product mix to
non–microprocessor products, and some inventory valuation
adjustments to reflect lower unit costs.
First, note that the revenue Intel
reported for the fourth quarter was below the ranges they
had indicated in their Dec 8, 2005 announcement ($10.2
billion vs. a range of $10.4 to $10.6 billion). Also, their
gross margin was below what they indicated in their Dec 8,
2005 announcement (61.2% vs. 63%, plus or minus a point).
As shown by the chart the market reacted
positively to the revenue announcement on Dec 8, 2005. The
price of the stock rose for several days, then pulled back
before rising again. Each rise stopped short of the previous
high. If you believe in technical analysis, this indicates
weakness, at least short term.
On Jan 18, 2006 the price of Intel's stock
dropped 2.9 points of 11.4%. As shown the price continued to
fall for several days. Obviously, investors were not
satisfied with Intel's actual revenues and gross margin.
They were also concerned that the market for Intel's
products was weak and experiencing significant competition.
Advanced Micro Devices, a competitor of Intel's has been
able to capture some market share from Intel as well.
Next let's look at their revenue announcement for
first quarter 2006 on March 3, 2006:
Intel First-Quarter Revenue Below Expectations
SANTA CLARA, Calif., March 3, 2006 – Intel Corporation
today announced that first-quarter revenue is expected to be
between $8.7 billion and $9.1 billion, as compared to the
previous expectation of between $9.1 billion and $9.7
billion, primarily due to weaker than expected demand and a
slight market segment share loss.
The company expects the first-quarter gross margin
percentage to be adversely impacted by the change in
revenue. Expenses (R&D plus MG&A) are expected to be lower
than previously forecast due to lower revenue- and
profit-related spending.
And now Intel's first
quarter earnings release:
Intel First-Quarter Revenue $8.9 Billion
• Operating income $1.7 billion
($2.1 billion excluding share-based
compensation)
• EPS 23 cents
(27 cents excluding share-based
compensation)
• $585 million in cash dividends
• $2.9 billion used to repurchase 138.5
million shares
SANTA CLARA, Calif., April 19, 2006 –
Intel Corporation today announced
first-quarter revenue of $8.9 billion,
operating income of $1.7 billion, net income
of $1.3 billion and earnings per share (EPS)
of 23 cents. Excluding the effects of
share-based compensation, the company posted
operating income of $2.1 billion, net income
of $1.6 billion and EPS of 27 cents.
This time actual revenue was within the
pre-announced range. And notice that price of Intel's stock
did not react in any dramatic way. It did move lower in May
due to the overall market and the NASDAQ falling.
So what are we to make of this sample of
earnings releases?
Trading Online Markets' Approach
As a trader who holds a stock days or
weeks, I have a rule that I will not
hold a stock into its earnings announcement. To often the
price of stock falls immediately after earnings are
announced. This discipline
has protected me from incurring losses when a company announced
its earnings. It saved me substantial money a number of
times. If I am trading short term, I still follow this rule.
I document the next earnings date on my Watch List, just to
remind me to be aware of when earnings will be announced.
First, I recommend everyone read the article by Herb Greenberg,
Don't Get Blindsided, addresses some of the problems
that need to be explored. Herb always takes a critical look
at companies and presents a good perspective. In this
article he comments on what are some of the issues investors
should watch for before earnings are announced. Definitely
worth the read. The companies on the watch list
and in the portfolios are those that I believe the market
has undervalued and are fundamentally strong. These stocks
present buying opportunities at deflated prices.
Usually they have pulled back due to overall market
conditions, or the sector is out of favor. They may have
even experienced some bad news that is temporary.
So what are the rules for holding through
earnings? First, it depends on what stage we are in during
the business cycle. Please see the article on
Market Trends
that discusses how to understand the business cycle that
includes economic and market cycles. Basically, there are
four stages in the business cycle: Full Recession, Early
Recovery, Full Recovery, and Early Recession. First, I generally
tend not to hold these stocks through
their earnings announcements. There needs to be a good
reason for me to hold when a company releases their
earnings. Given that general guideline, I definitely will
not hold a position in a stock during the Full Recession and
the Early Recession stages. There tends to be to many
negative surprises when the economy is slowing down. During
the Early and Full Recovery stages, I may hold through
earnings, if I feel there is a good case to be made that the
announcement will positively impact the stock. In each case
I indicate my intentions on the
Premium Portfolio pages a couple of
days before earnings are to be released. As a member of the Trading Online Markets
community, you should monitor quarterly earnings
announcements to be sure the fundamentals are still intact.
Should the price pull back to a support level, then it might
be a good opportunity to make a strategic buy. If part of
the announcement changes your view of the fundamentals of
the company, then it is time to sell. If the news is worse
than you expected, then it is best to get of the stock,
since bad news seems to follow bad news. Every stock is
updated shortly before earnings are announced and then again
after they are released with my opinion of what to do
regarding the stock. Now if you are
a longer term investor, earnings
announcements may not present the same risk to the price of a
company's stock. As long as the fundamentals of the company
remain strong and the price has not reached or approached
the
target exit price, you may be willing to hold through earnings
announcement. It is important to review the fundamentals
of a company before they announce earnings, looking for
signs of potential problems.
Earnings Manipulation
So do companies manipulate their earnings?
Well, I found this study interesting. A University of Illinois
economist who analyzed thousands of forecasts of publicly
owned companies between 1989 and 1998 found that there was a
significantly higher probability for a company to beat the
consensus forecast if the forecast was lowered two weeks
prior to the announcement.
"We document empirically that many firms apparently have
ways of lowering the forecasts as the earnings announcement
date approaches," said Dan Bernhardt, the UI economist who
conducted the study with Murillo Campello, an economist at
Michigan State University.
Bernhardt theorized that
less experienced analysts were more likely to make late
forecasts and were more likely to revise their forecasts
than analysts who had covered a company for a longer period.
Also there is sometimes a legitimate reason for management
to lower expectations, or create "slack." Especially in
fast-growing companies, earnings may change dramatically in
the weeks or even days before a quarter ends.
Early in my career I worked
in the Finance department of a large bank preparing the
performance reports for senior management and the Board of
Directors. As you may know it is quite easy for banks to
manipulate their earnings in addition to estimating taxes
owed. Each quarter a bank estimates their loan losses that
they will write off as an expense. Estimating this expense
is part estimating what real losses and part what the CEO
wants the earnings to be. Usually the CEO sought to even out
earnings growth by increasing or decreasing the total amount
of loan losses written. This allowed the bank to meet and
usually beat expectations.
Is this earnings
manipulation? Possibly. Like so many things in life some
definitely do manipulate their earnings and some are quite
honest. Unfortunately accounting allows a fair amount of
leeway in the interpretation of rules. Also, management
tries to present the company in its best light. So, as
investors we need to read the earnings release with a
critical eye, looking for issues that may indicate problems.
All this tells me that
companies do adjust their earnings to try to exceed
expectations. Most also try to stay within the accounting
rules. However, I believe that the market is usually aware
these efforts. As a result when they finally announce
earnings that either meet or slightly exceed
expectations, the stock is punished. A company must
dramatically beat expectations before the price will jump up.
Conclusion
In conclusion, earnings season presents each
investor with new challenges. Do the earnings of the company
match up to expectations. Is the chart of the company
indicating any potential problems? Do I hold through earnings
announcements? Do I take advantage of any announcements and
buy? If you are a member of the Trading Online Markets
community the best way answer these questions is do your
homework and to follow the discipline. It will
keep you aligned with the best opportunities. |
