Corporate Earnings Focus on the Real Numbers
Companies / Corporate Earnings Nov 03, 2007 - 03:25 AM GMTBy: Roger_Conrad
Does it really matter whether or not a company makes Wall Street estimates? What about employment or GDP growth numbers coming in above or below consensus? Is there a magic number for crude oil inventories that will trigger a higher or lower price?
At no time in the markets are numbers more widely watched than earnings season. First come the pre-announcements and handicapping, as analysts put every company with a half-decent following under the microscope.
Then come the actual announcements, followed by the conference calls—always worth tuning in for. Finally, just as in politics, we have the spin cycle, as companies try to put their results in the best light and analysts use them to justify past positions and build future outlooks.
In a best case, management would first hint at a solid result when a quarter closes. That will create interest in the stock and probably push it up a few points. Some analysts may then adjust their estimates upward.
Next, earnings would come out above even those expectations, and the stock would take a further bounce. Best of all is if the conference call and further analysis by Wall Street leave the impression that even better times lie ahead. The company may increase its earnings guidance. That in turn will send the stock up a third time.
In a worst case, a company's management first warns that earnings won't be up to par for the concluded quarter. Next, it becomes clear that management was trying to let everyone down easy, as actual results come in even worse.
Finally, the inside numbers are shown to be worse than the headline figures. Guidance is ratcheted down, both by the company and the Street, and the result is a bloodbath in the stock.
In reality, the impact of most companies' earnings seasons is far less dramatic. The headline numbers will tend to mirror expectations, as will those inside the report. As a result, there will be little change in outlook and share prices will be relatively steady.
The upshot: Earnings seasons are full of a lot more sound and fury than anything significant to long-term investors. In fact, the biggest challenge is often getting past the volatility that results from lazy journalism—i.e., overfocusing on a single number to the exclusion of everything else—and anxious trading.
Last week, for example, I spotlighted the knee-jerk selling that accompanied Comcast Corp's third quarter results. The consensus focused on an unexpectedly high loss of basic cable customers and lower-than-expected growth rates for advanced services, ignoring the fact that growth remained extremely robust.
This week, investors continued to treat the company as though it was practically moribund, even though it's clear from rivals' results that it's holding market share while it adds sales and boosts profit margins.
Comcast's example illustrates the first way earnings numbers are important for investors: They shape the perceptions that largely determine where a stock will trade in the near term.
The reaction to Comcast's third quarter earnings is a pretty clear sign Wall Street is going to stay negative on the stock for a while or at least until the company manages to post some result that changes the mood. This is especially important for money managers, who dominate stock trading more than ever.
Whether they run major mutual funds, hedge funds or individual accounts, money managers are evaluated on a quarterly basis or, at the longest, an annual basis. As a result, with very few exceptions, they don't have the luxury of placing their bets on the next three to five years. Rather, they have to think about what's going to work in the next few months.
In the case of Comcast, money managers have access to the same information I have, and some may well have agreed with my analysis of the selling as way overdone. Even if they did, however, they simply can't afford to get stuck with an underperforming stock for an appreciable length of time. That's why so many have piled on over the past two weeks, even as Comcast shares have slipped to just 1.5 times book value, their lowest level on that gauge ever.
Although the stock market is a popularity contest in the near term, it's a weighing machine long term. The second way earnings reports are important is how they measure companies' progress on that score.
Here it's not the headline number that counts. Rather, it's the numbers within that number that reflect the underlying health of the business and whether or not it's becoming more valuable over time.
My point with Comcast's numbers last week was that the balance of these gauges were still pointing to a company that's becoming increasingly valuable, building out its network and attracting customers for its advanced services. All of these areas continued to show robust growth, leading to the inescapable conclusion that the company is building wealth and remains a strong long-term investment.
WHAT'S IMPORTANT
For long-term investors, it's the inside numbers that are the most important. These numbers determine whether a company's business is becoming more valuable over time and whether its stock is worth holding as a long-term investment.
However, numbers' impact on perception—and vice versa—is also important, even for those whose motive is sticking around for a while. It's always better, for example, to buy low and sell high. And there's no better combination than a company that's low on perception but is still putting up numbers indicating business is growing.
Comcast is one of the best examples in the current market. And its common stock, preferred shares and bonds are strong buys. But it's hardly the only example.
Two others are the cable giant's chief rivals, AT&T and VERIZON COMMUNICATIONS. Both announced very solid third quarter earnings, and both remain plagued by the continuing myopic view on Wall Street that Big Cable and Big Telecom are somehow locked in a death match, from which none will emerge profitable.
Wireless operations were at the core of the strong results for both companies. VERIZON WIRELESS revenue grew 14.4 percent as it boosted customer count and profit per customer, while reducing turnover or “churn.” AT&T actually added more customers than Verizon for the first time in quite a while, as its iPhone deal began to produce results.
Both companies also announced solid progress on the wireline front, as gains in broadband more than offset the continued erosion of the local phone base. Interesting, Wall Street no longer seems concerned about the drop in copper phone connections at either company.
It's finally sunk in that both companies are gaining communications market share; it's just taking a different form. Moreover, advanced services are more profitable and advanced networks are cheaper to run, so profit margins are higher as well.
Given how negative the Street was on Comcast's earnings this time around, you may have expected a more positive reception to the two telecom giants' results. Again, this is symptomatic of money managers' unwillingness to bet on the long term in a world where they're judged on the short term.
When perception does change for this sector, we're going to see an upside explosion for AT&T and Verizon, as well as for Comcast. Until then, however, these stocks will be cheap and their owners will have to be patient for the ultimate payoff.
Note that these companies are moving in a whole opposite direction from what used to be a key rival, SPRINTNEXTEL CORP. In contrast to AT&T, Verizon and Comcast, that company reported horrific third quarter earnings clearly indicative of a business in fast retreat.
The headline number was sorry enough: A 77 percent drop in earnings per share from year-earlier levels that was even worse than management had let on. But it was the underlying numbers that really told the tale, as postpaid subscribers dropped at a 337,000 clip. Meanwhile, revenue per customer actually dropped 3 percent, while churn was flat but near industry highs at 2.3 percent.
Even worse, the company revealed a deeply troubling exposure to Americas' subprime mortgage crisis, a consequence of too much bottom-feeding—i.e., relying on less creditworthy customers to beef up growth numbers. That's a strategy that had Wall Street salivating for years, and it's come back to haunt the company with more bad debt.
Still without a permanent CEO after the board basically forced out Gary Forsee, Sprint has announced an aggressive plan to reduce future credit exposure. The inevitable consequence of that, however, is going to be slower new customer additions at a time when Verizon and AT&T are increasingly poaching its better clients.
All that also casts a very dark cloud on what many have considered Sprint's one big chance to challenge its larger, more profitable rivals: WiMax. The company is now allegedly considering a spinoff of this unit and its formidable capital cost obligations.
In utility-quality industries—including telecom—even the most battered weaklings eventually become recovery plays. That will ultimately happen with Sprint. Interestingly, however, Wall Street hasn't punished its shares anywhere close to the extent it has much stronger Comcast.
To me, that indicates there are still too many optimists who are expecting some kind of turnaround and possibly a takeover. The shares are trading under book value, so it's hard to argue there's much of a premium built into the shares.
But with more tough earnings comparisons likely ahead—as well as customer losses to rivals—there's a lot more downside risk. And a declining business means a falling book value.
The upshot: If you're looking for a comeback bet in telecom, Comcast is a much better deal than Sprint. Note, however, that the perception is still negative for the entire sector, despite strong growth numbers. And as long as that's the case, it's a place for long-term investors only.
Turning to the power sector, most results came in on the plus side for US companies. One big reason is wholesale power prices have turned decidedly to the upside in most regions, as the supply glut left by the late 1990s gas plant build has been soaked up.
Nuclear and wind companies have been especially profitable. But as Edison International's solid third quarter results illustrate, even coal power producers are sharing in the spoils, as prices for electricity rise and the cost of inputs like gas and coal moderate.
Edison's results also highlight another industry trend: rising regulated utility investment and its recovery through rate increases. As I've pointed out in Utility & Income, this is a particularly important factor to watch for companies going forward, particularly in states with a history of regulatory turmoil.
This week, for example, EMPIRE DISTRICT saw its rate hike in Missouri revoked by the state Supreme Court. The judges stated that regulators hadn't given consumer advocates enough time to prepare a case before approving the 5 percent increase.
The state commission has stated it will rehear the case per the court's specifications and is likely to approve it then, despite the consumer advocate's opposition. But the case will delay the needed money for Empire.
Moreover, it demonstrates the continued knee-jerk opposition of some to rate increases needed to pay for infrastructure. That's a particularly grave risk in some states, notably the Show Me State, where utilities face considerable capital spending for growth and environmental expenditures.
In Edison's case, California under Gov. Arnold Schwarzenegger has established a very cooperative relationship with utilities. As a result, the company was able to add some $1 billion in regulated utility assets on its books over the past year.
Over the next several years, Edison will continue to spend heavily on conservation, renewable energy and system reliability. As a result, it will remain very dependent on the positive environment continuing in California.
On the plus side, the Gubernator remains very popular, as does his focus on green energy, and that should play to the company's benefit. On the minus side, the stock now yields only 2 percent, so it isn't pricing in much risk for a downside surprise.
In my view, the sector suffering under the worst Wall Street perceptions but with the most promising numbers is Canadian income trusts. Bargains include trusts inside the energy producer patch and outside in other sectors, from Yellow Pages to real estate.
The energy producers caught a potentially big break in late October, as the provincial government of Alberta reduced royalty rates on the mature reserves that are most trusts' bread and butter. Those reduced levies promise to boost cash flow and enterprise value for the likes of ENERPLUS RESOURCES and PENN WEST ENERGY TRUST, both of which continue to yield well in the double digits and trade at sharp book value discounts to non-trust producers.
The negative perception for Canadian trusts is still mostly due to the Conservative Party government's surprise decision a year ago Halloween to tax them as corporations beginning in 2011. But although many investors can't get past the fallout from that move, those that still own strong trusts have realized gains of 20 percent and more since Jan. 1. Takeover activity and solid results have lifted many, while the 18 percent jump in the Canadian dollar year-to-date has lifted all boats.
Those are all trends that show every sign of continuing for the rest of 2007 and beyond. That ultimately means a shift in the market's perception of trusts—even if there's no change in the 2011 taxation picture—and strong profits for these still very cheap investments. For more on trusts, see U&I's companion, complimentary e-zine http://www.mapleleafmemo.com .
MARKET WATCH
As for the overall market, Wall Street's obsession remains with the economy and the Federal Reserve, with little real conviction either way. Early in the week, we saw stocks rally in anticipation of a fed rate cut. That gave way to selling later in the week because the rate cut was only a quarter point and the Fed indicated it may not cut again any time soon.
Today's news that employment was considerably more robust than expected reinforced this later point. And the perception that the Fed is now even less likely to cut rates has set off another wave of selling stocks.
On the plus side, the drop in stocks has set off a corresponding rally in the bond market. The benchmark 10-year Treasury note yield, for example, has now fallen to barely 4.3 percent, and a continued selloff in stocks would likely take it lower still.
Lower rates are logically a plus for the economy, which at least according to today's data is healthier than the consensus has given it credit for. That would seem to further diminish the risk of a recession.
In the case of utilities and other income stocks, lower rates are also a plus. At one point this week, for example, utilities actually broke out to a new all-time high during the trading day before closing only slightly below the last. That's an extraordinary recovery over the past year and points to another strong fourth quarter, the 34th time that's happened since 1969.
If we do start to see more signs of inflation, we're likely to see the 10-year yield head higher and utilities go the opposite direction. That may start to happen early next year, particularly if oil prices wind up breaking above $100 a barrel.
That's a good reason to not buy anything over my target buy prices. For now, however, there's little risk to holding good, quality companies, whether we see a recession or not.
The question of whether and how much growth slows is of considerably greater importance for natural resource producer companies. As I've noted before, natural gas prices remain in the doldrums and gas producers are still cheap. Oil stocks too haven't run nearly as far as oil prices, so there's a good case to be made for buying the likes of CHEVRON CORP and other Super Oils, despite disappointing results because of falling refining margins.
As for producers of copper, nickel, gold, platinum group metals and other vital resources, their profitability is inexorably tied to the infrastructure growth of the world's developing economies, from China to Central Europe. A recession could slow demand for a short time.
Ultimately, however, producers that successfully navigate the challenges of rising costs, resource nationalism and reserve replenishment are headed for huge returns. And they make a nice portfolio balance and inflation hedge for income-weighted portfolios as well.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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