Jubak's Journal
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• Can earnings disappointment ever be good? Yes, 4/18/2003
• Tales from the 2 economies, 4/17/2003
• 8 stocks to watch in a wandering market, 4/15/2003
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Lies, damned lies and earnings reports
Don't read too much into overachieving first-quarter results. Most of the cheery numbers aren't sustainable or repeatable.
By Jim Jubak
Earning reports are flooding in, and good luck to investors trying to make sense of it all.
Dont get me wrong; Im not throwing a wet rag on all earnings reports. The size of some of the numbers is impressive. Ford Motor (F, news, msgs), for example, reported 45 cents a share for the first quarter. That was 104% better than the 22 cents a share Wall Street had projected.
Its not the quantity of the numbers, but their quality. Theyre full of huge swings in profitability from small (probably seasonal) changes in volume; lucky, unrepeatable profits; and unsustainable cost-cutting. Its just about impossible to tell if business is getting better or worse.
Add in an extraordinary confusion among Wall Street analysts about which numbers really count and the result is a minefield of misleading data. Think Im overstating the problem? Well, lets take a look at the biggest earnings success stories of this quarter.
3 big problems with earnings quality
Lockheed Martin (LMT, news, msgs) reported earnings of 55 cents a share, or 31% better than the 42 cents Wall Street analysts had predicted.
Paccar (PCAR, news, msgs) reported 95 cents a share, 34 cents a share better than projected.
Capital One (COF, news, msgs) reported $1.35 a share, or 32 cents a share better.
And General Motors (GM, news, msgs) reported $1.84 a share, 25 cents a share better.
Those numbers make the results from J.P. Morgan Chase (JPM, news, msgs), a mere 19 cents a share better than projected, Caterpillar (CAT, news, msgs), only 14 cents better, and Merrill Lynch (MER, news, msgs), 13 cents a share better, look downright piddling.
The size of the positive earnings surprises has been nothing less than stunning, especially when you remember the great fear of how terrible the earning results were going to be. With 25% of the companies in the Standard & Poors 500 ($INX) reporting, 27% of those reporting have announced earnings 5% or more above analyst expectations, according to First Call.
That percentage of companies reporting earnings 5% or more above expectations is not especially high. In fact, its close to the average of 28% for the period beginning in 1994.
What intrigues me, though, is how these companies produced these surprising results. The numbers Im looking at paint a picture of companies trading in earnings quality in order to produce earnings volume.
Earnings Quality Problem No. 1: Distortions from seasonality and the economic cycle. Take a look at Caterpillars surprisingly strong earnings showing this quarter. The company was expected to report 23 cents and actually announced earnings of 37 cents a share. Thats 61% better than projected.
What produced that gain? Operating leverage, for one thing. Were at that point in the business cycle where companies that have cut costs can show extraordinary increases in profitability from relatively smaller increases in sales volume. Caterpillars machinery segment, for example, showed a 79% jump in operating profit and an increase in operating profit margin to 7.4% from 4.5% on a 10% increase in revenue.
That leaves investors with two questions. First, does another modest 10% increase in revenue produce comparable increases in margins? And second, is this quarters increase in revenue a sign of a sustainable pickup in business?
That second question left more than one Wall Street analyst shaking his head in confusion. Machine revenue climbed almost 10% for the quarter, Merrill Lynch noted, driven by strong sales in China and a 3% increase in sales in North America over the same quarter in 2002. That increase in North America was the most difficult to understand, Merrill noted, given the weakness in non-residential construction spending in that market. In other words, Merrills analyst wondered why customers would be buying Caterpillars machinery when construction activity was showing no sign of an upswing.
CIBC World Markets argued that North American sales werent nearly as strong as they looked. Caterpillars dealers had built inventory in the quarter by 4%, a typical seasonal pattern in the construction machinery business. Another spike in demand came from the rental market as rental dealers opened new stores and replaced older rental equipment, again both seasonal events.
One possible conclusion with important implications for valuing Caterpillar: Take out the seasonal spike in sales and Caterpillars North American revenue increase becomes a revenue decrease. From these numbers, Id argue, an investor cant tell what the full-year sales trend will be at Caterpillar.
Earnings Quality Problem No. 2: Dumb luck isnt predictable or repeatable. J.P. Morgan Chase reported first-quarter earnings almost 40% above Wall Streets expected 50 cents a share. That amounts to quarterly earnings of about $380 million more than Wall Street expected.
Id put much of that $380 million down to luck. Even the bank said so, in a roundabout way. Investors should expect trading revenue at J.P. Morgan Chase to average somewhere between $1.2 billion and $1.5 billion a quarter, according to management. Trading revenue this quarter came to $1.9 billion. Thats $400 million in revenue above what management has called a repeatable level.
Profit on the companys own portfolio also kicked in big this quarter. The company posted $380 million in gains on its portfolio of Treasury bills and notes as the bond market continued to rally, thanks to the slow economy and the Iraq war. I think its reasonable to suppose that the bank will make a profit on its portfolio in most quarters, but I dont think the stars will line up in the banks favor in this way every quarter.
The issue here for an investor is how much of J.P. Morgan Chases earnings this quarter can be counted on for the next quarter and the quarter after that. Certainly no one wants to pay a multiple based on what turns out to be peak earnings in one of the companys business segments.
Earnings Quality Problem No. 3: Cost-cutting that provides only a one-time boost. Negotiate better prices from a supplier. Reorganize a factory floor to cut out a manufacturing step. Outsource part of production to a more efficient producer. These are all examples of cost-cutting that keep on contributing to a companys bottom line quarter after quarter.
Cut spending on research and development. Or on marketing. Or on customer service or sales. Those are examples of cost-cutting that can beef up a quarterly earnings statement but that do damage to a companys long-term business unless reversed in quick order.
Capital One (COF, news, msgs) delivered earnings of $1.35 this quarter, way above the $1.03 Wall Street expected. But much of the companys earnings surge came from cuts in reserves for bad credit-card loans and lower spending on marketing.
You can argue whether or not the cuts in reserves for bad debts were justified. The companys credit losses came in at 6.5% this quarter; thats up from the December quarter but below projections.
But its hard to argue that this kind of gain from lower bad debt reserves is a repeatable source of earnings growth. All credit card companies in all economic climates have to carry some reserve for card holders who dont pay. A.G. Edwards calculates that 22 cents of the companys earnings surprise this quarter came from reducing reserves.
The bulk of the remainder, 8 cents, came from cuts in spending on marketing. OK, money saved. But at what cost? Accounts at Capital One fell by 1 million this quarter, the third consecutive quarterly decline. And the company has trimmed its growth projections by 5 percent for 2003.
How much is an investor willing to pay for earnings that come from cost cuts that seem to hurt the growth of the business?
Harder to hit a moving target
The size of some of the surprises raises questions about why Wall Street analysts so badly missed these huge swings in earnings.
There are several possibilities. First, at this point in the economic cycle, small swings in the final revenue numbers can produce huge changes in earnings. And this quarter it was more difficult than usual for anyone, even company CEOs, to know what revenue would be until the quarter actually closed. Second, it looks like companies are more reluctant to share last-minute information with Wall Street analysts because they fear they will run afoul of the new Fair Disclosure regulations from the SEC. Some companies seem to have decided that the best way to meet the laws requirement that all material information be shared equally with all investors is not to distribute the information to anyone.
And last, and this is the most intriguing possibility to me, there seems to be genuine confusion and disagreement among analysts (and investors, Id guess) about which earnings numbers are the most accurate and the most important.
The earnings reporting standards are in flux, and the projections from individual analysts that are averaged into the Wall Street consensus arent necessarily all measures of earnings calculated in the same way. The size of the surprises this quarter is, I think, a reflection of the confused state of standards for earnings reporting right now.
Ill take a look at the state of the art in earnings reporting in my next column and tell you what this confusion means for investors trying to make sense of an already hard-to-understand stock market.
New developments on past columns
The only indicator that really matters
On Thursday morning, investors were left to debate which indicator gave a better picture of the economy. Weekly initial claims for unemployment climbed to 455,000, the highest level since March 2002. The four-week moving average, which smoothes out weekly swings, also hit a high for the year at 439,000. Economists had expected a drop of 12,000 in initial claims. So according to this indicator the economy is still weakening and faster than economists had projected. But the durables good numbers, announced the same morning, showed signs of a recovery. Sales of durable goods -- goods expected to last three years or more -- grew by 2% in March, after falling 1.5% in February. Even taking out defense orders, durable goods sales still climbed 1.3% in the month. And sales of non-defense capital goods -- the equipment to make things -- climbed 1.8% for the month. The conventional way to reconcile these numbers is to point out that the employment numbers look backward at where the economy has been and that a recovery in employment typically lags a recovery in the economy. On the other hand, orders of durable goods, especially of capital goods, are seen as a leading indicator because companies invest in anticipation of improvements in the economy.
8 stocks to watch in a wandering market
Score one for the technicians calling for this market to move higher in the near term. On Wednesday, the Nasdaq Composite ($COMPX) closed at 1,466, far enough above resistance at 1,423, 1,430 and 1,442 to make the move an indicator of further gains. The Dow Jones Industrial Average ($INDU) closed at 8,516, and the Standard & Poors 500 at 910. Both of those closing prices were above important resistance at 8,500 and 910, although the advance above those levels wasnt as impressive as the Nasdaq's. The consensus among bullish market timers is that this advance shows that the Nasdaq remains the strongest of the indexes, largely because technology and financial stocks have led the move. And that the climb has been strong enough to turn former resistance levels into support in any consolidation from these levels. Bearish market timers continue to point out that this climb has been accompanied by high levels of complacency -- relatively few investors are buying options as insurance against a fall and relatively few are shorting stocks. A market can keep climbing even at these levels of complacency, they point out, but these levels of complacency do signal a top.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak did not own or control shares of any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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