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Dale Jackson

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Great expectations

Dale Jackson

TORONTO (GlobeinvestorGOLD)—First, let's dispel any notion that the most recent earnings season blew past expectations and a robust profit recovery is at hand.

Earnings season is often referred to as a parade, but it's getting more and more like a circus and the most recent quarter was no different. Four times a year companies dress up their financial statements and put on a show, and each quarter many small investors are taken in by the sleight-of-hand, smoke and mirrors.

The most important stage prop is the earnings expectation: a bar the company will soar over, land upon or fall short of, and investors will typically buy, hold or sell shares of the company depending on the success or failure of its performance. What investors sometimes forget is that the company has set the bar's height itself and today's hurdle does not tell us how high or low it's been set in the past, or whether the company will hoist or drop the bar in coming months. And that makes all the difference.

Take Cisco Systems. In early November, the company said it swung to a third-quarter profit of $1-billion (U.S.) from a loss of $62-million a year earlier, beating analysts' average estimate by a penny. A few years ago euphoric investors might have ooed-and-awed, but an 80-per-cent slide by the stock has tempered enthusiasm somewhat. This time around, in a relatively rare earnings-season occurrence, the shares tumbled 5 per cent even though the company beat expectations.

The decline was not a reflection of Cisco's third quarter results but rather investors' increasing reluctance to take the average earnings expectation as the single-most important component of the company's report. Battered again and again by profit warning after profit warning, investors were on the lookout for more grim news in the telecom industry and dug hard to find it beneath the usual obfuscations of corporate double-talk and PR spin. Investors put Cisco's expectation-beating third quarter into context, and didn't like what they saw.

Behind the curtain

The key to analyzing earnings expectations is to look beyond the present-day numbers to the past and future. The authority on corporate earnings is Boston-based First Call/Thomson Financial. If an analyst covers a stock, First Call covers it too.

First Call simply takes the sum of all available estimates and divides by the number of estimates given. So when your broker or a reporter claims a company is expected to earn four cents a share, it's merely the average taken from a range of estimates. Two different analysts might see the company earning two cents a share and six cents respectively. The more analysts that cover a company, the more accurate the average estimate.

This can create a problem when a smaller company in your portfolio is only covered by two or three analysts, but that's why First Call benchmarks U.S. earnings growth against the S&P 500 index. The best benchmark for Canadian earnings is the S&P/TSX 60 but results are often skewed by that bull in the china shop, Nortel Networks.

In the most recent quarter, 59 per cent of S&P 500 companies beat expectations while 15 per cent came in lower. It sounds encouraging until you consider the number of companies that beat the Street over the past five years on average was 58 per cent, and the average number that disappointed was 15 percent. In other words, companies tend to beat or miss earnings expectations at about the same rate in good times and in bad. This time around, earnings were as bad as companies said they would be.

Revisionist history

All those percentages really tell us is that companies massaged their outlooks lower over the preceding months as many times as necessary for analysts to give an estimate that the company could likely beat. It's an old trick to jump start a stock, and it often works.


S&P 500 Third Quarter Earnings Performance
Most recent quarter 5-year average
Beat expectations 59% 58%
Met expectations 26% 24%
Below expectations 15% 15%

To get a more accurate earnings picture we need to determine the extent of revision activity. U.S. companies on average reported a 6.9-per-cent gain in earnings in the most recent quarter compared with a miserable quarter in the same period last year. Looking ahead, companies said they expect profit to jump about 16.7 per cent in the fourth quarter from last year, and full-year earnings to climb 2 per cent from last year's tally. Consensus calls for earnings to grow 14.9 per cent in 2003 from 2002.

While some equity strategists and market pundits may point to these numbers and trumpet a return to healthy earnings growth, be aware that at the beginning of the third quarter, average earnings for the S&P 500 were expected to grow 16.6 per cent while full-year profits were seen increasing by 6.8 per cent. Many companies clearly spent the intervening months warning and providing new "guidance" to analysts, who then lowered their profit forecasts.

Earnings Outlook Comparisons
November 15, 2002 July 1, 2002
Third quarter 2002 6.9% 16.6%
Fourth quarter 2002 16.7% 27.7%
Total 2002 2.0% 6.8%
First Quarter 2003 13.2% 25.3%

The downward revision trend indicates that the earnings recovery is much more fragile than many companies, investors and analysts had anticipated only a few months ago. Topping expectations is a good thing, but it does not necessarily mean earnings are growing.

Still, a fragile recovery is better than no recovery. First Call tracks revisions for all quarters on a one-week, 13-week and 52-week moving average. According to the 52-week moving average, 45 per cent of all revision activity in the current quarter is positive compared with 40 per cent on July first. That means a higher proportion of companies are telling investors that they will beat current expectations.

Granny Smith or MacIntosh?

Estimating earnings is by no means a science either. First Call is on a never-ending crusade to streamline company estimates to come up with what Research Director, Chuck Hill calls "apples to apples accounting practices."

"We still have the problem where companies aren't spelling out a clear trail," Mr. Hill said. "If they don't, they may be pushing the envelope on adjusted numbers."

A perfect example is the practice of amortizing goodwill. Goodwill is the price a company pays for an acquisition above its tangible assets, such as a customer base, a brand name or a good reputation. The practice leaves too much room for interpretation so on Jan. 1, 2002 companies were instructed under Generally Accepted Accounting Practices to stop. They were also told to provide restated numbers for previous quarters to allow for more accurate comparisons.

"Once we get through the transition investors will be better served," he says.

Earnings expectations taken alone are not enough to judge the health of a company, but should be part of every investor's due diligence. But even then, retail investors have to remember that it's the companies themselves that play the most influential part in determining analysts' estimates, and that headlines exclaiming "Better Than Expected" may be more accurately translated to read "As Bad as We Thought It Would Be."

Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.

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