How to Crack Wall Street's Earnings Code
07/06/2012| 10:36am US/Eastern
By Matt Andrejczak
Executives at Research In Motion Ltd. (>> Research In Motion Limited) were "extremely excited" in March 2011 about prospects for the Blackberry smartphone and PlayBook tablet, according to the company's quarterly earnings release.
Their tone changed over the short course of a year. In subsequent earnings releases, RIM used phrases like "challenging start," "slightly below our forecast," and "market challenges" to describe the pace of its business.
As its struggles mounted, RIM eventually stopped providing financial targets to the investment community.
By now, investors know RIM's predicament. The Canadian company is selling fewer Blackberrys, and losses are piling up. Its shares have plunged 72% over the past 12 months. And recently, RIM delayed its much-anticipated Blackberry 10--again.
Let RIM be a lesson for decoding corporate earnings-speak as investors gear up for this year's second-quarter earnings updates, which are slated to kick off Monday with aluminum maker Alcoa Inc. (>> Alcoa Inc.).
This time, more companies are likely to dispense disappointing news, or worse, reveal dim second-half prospects. Blue-chip companies such as Ford Motor Co. (F), Procter & Gamble Co. (>> The Procter & Gamble Company) and United Technologies Corp. (>> United Technologies Corporation) have already issued financial warnings.
So far, 94 of the companies in the Standard & Poor's 500-stock index have made negative earnings announcements for the second quarter. That compares with 26 positive announcements, according to Thomson Reuters data as of June 29.
With growth for the rest of 2012 looking suspect, investors need to be mindful of corporate management trying to sugarcoat business conditions. To help, MarketWatch asked money managers and market analysts which key phrases perk their antennae when reading an earnings statement or listening to a conference call.
"We get suspicious when corporations talk about a 'strong' or 'solid' quarter but revenues disappoint," said Oliver Pursche, co-portfolio manager of the GMG Defensive Beta Fund (MPDAX).
Here's a sampling of what management might say -- and what they really mean:
1) Conditions were challenging
Translation: We're getting killed by the competition is another way to interpret this statement, according to Dallas-based money-manager Charles Sizemore.
2) Sales and earnings are poised to reaccelerate
Translation: Forget the bad quarter we just announced and maybe even our current business period, said Brian Sozzi, chief equities analyst at New York's NBG Productions.
3) Weather affected sales
Translation: The company sells a product or service no one really wants or they are losing market share, said Tim Gramatovich, chief investment officer at Santa Barbara, Calif.-based Peritus Asset Management, which runs AdvisorShares Peritus High Yield ETF (HYLD).
4) Right-sizing inventory
Translation: Sales are slipping or falling off a cliff, said Sandy Villere III, a portfolio manager for New Orleans-based Villere & Co., which runs Villere Balanced Fund (VILLX) .
5) Macro-environment was weak
Translation: Our market share is under pressure.
Blaming the economy could obscure market share losses or the company's decision to step up discounts, NBG's Sozzi said. This is often heard when profits are less than a company's internal projections.
6) We face uncertainty
Translation: We lost sales this quarter. In this case, companies are certain business is slowing, Gramatovich said.
7) Seasonality affected sales
Translation: Business is weaker than usual.
Companies are prone to doing more business at certain times of the year. But if a company's sales typically slip 10% in the fourth quarter and the company reports a 25% decline, then beware if management tries to spin this as nothing out of the ordinary, said Dan Mahoney of CFRA Research, which does forensic accounting and quality of earnings research.
Anatomy of a Conference Call
In the Journal of Accounting Research, Stanford University's David Larcker and Anastasia Zakolyukina found that when it comes to language, deceptive CEOs and CFOs use more references to general knowledge and fewer references to shareholder value.
In addition, deceptive CEOs use significantly more extreme positive emotion and fewer anxiety words, their research concluded. Watch for excessive use of words like "strong" and "great."
Quarterly conference calls are a highly planned event, in which top executives read from a script of carefully chosen words. CEOs usually start with an executive overview, followed by the CFO summarizing the company's profit or loss, sales, and performance by business unit.
Then they offer an outlook before opening the call to analyst questions.
During the call, it's important to listen to how executives are communicating their message, said Chris Terry, a senior analyst at Hodges Capital Management in Dallas. For instance, is management emphasizing something different than three or six months ago?
Moreover, listen closely to detect if management's tone has changed about sales growth or product pricing. This could impact profit margins. Do they sound less aggressive? Better yet: Match their comments against a rival company. If there's a disconnect, there might be a problem.
Also, determine if management ducks questions.
"At the end of the day, it's about managing expectations and the best teams provide as much information and explanation as possible to assist analysis," Terry said. "Others lose credibility fast and the stock suffers as a result."
Take luxury goods retailer Tiffany & Co (>> Tiffany & Co.), whose shares are trading near a 52-week low after its guidance seesawed in a span of six months. Tiffany on Nov. 29 raised its 2011 outlook, only to cut its forecast Jan. 10.
Then on March 20, the retailer said demand had picked up. In late May, Tiffany brought down those expectations. Shares have stumbled 19% year-to-date.
"We and everyone else like companies which underpromise and overdeliver," said investment chief Bill Smead of Smead Value Fund (SMVLX) in Seattle. His fund doesn't own Tiffany shares.
Earnings Meets, Beats or Misses
An earnings miss may be a prelude of things to come.
"A miss usually leads to another miss," said John Del Vecchio, co-portfolio manager of the AdvisorShares Active Bear ETF (HDGE), which bets on company share prices to decline.
"Very rarely does a business have a one-quarter bump in the road," he added.
Research in Motion is a good example. Dating back to June 2011, the company missed the consensus profit estimate of analysts in four of those quarters, FactSet data shows. Another example was Juniper Networks Inc. (>> Juniper Networks, Inc.), according to Mr. Del Vecchio, who profited from shorting the stock last year.
Juniper, a maker of telecommunications networking equipment, missed sales expectations from the second quarter of 2011 through the fourth quarter. Juniper later cut its quarterly financial projections and also issued a below consensus sales outlook for its 2012 first quarter.
Watch inventory, especially at consumer-products makers. In the past, companies have been known to speak optimistically about future sales even as current inventories are growing much faster than revenue.
Inventory tripped up Deckers Outdoor Corp. (>> Deckers Outdoor Corp), maker of Ugg boots and Teva sandals.
The company's fourth-quarter report Feb. 23 showed sales up 40% while inventories had ballooned 103%. Yet Deckers's brass spoke of "compelling growth prospects across our entire business." Come April 26, the company cut its outlook after missing first-quarter estimates. During the quarter, sales growth had slowed to 20% while inventories rose 95%.
No surprise, Deckers shares have been squashed.
A string of profit or sales misses is never good. To money-manager Sizemore, it can mean "management has underestimated how bad the company's situation is. Industry or market conditions are changing faster than management believed and their firm is getting left behind."
Write to Matt Andrejczak at AskNewswires@dowjones.com