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. . . .
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.
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.
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.