Tuesday, July 24, 2012

"Beat the Estimate" Grows Old

Companies, securities analysts, and the media are again colluding in a favorite activity, "beat the quarterly earnings consensus estimates."  It's pretty simple.  Corporate managements guide analysts during the quarter to lower their earnings estimates for the company.  Or, if business is better than expected, managements lowball their earnings guidance.  Either way, when the company actually reports its profits for the latest quarter, the results are better than the consensus forecast, and the stock jumps.  Collectively, the media reports on the percentage of companies that "beat" the consensus estimates and typically, it is about two thirds of companies.  "Positive earnings surprises" are indeed looked upon favorably.

A related phenomenon is occurring again this quarter--earnings growth with little or no growth in revenues.  IBM has been a foremost example of this puzzling phenomenon, as it has continued to generate double-digit growth while revenues rise much less.  Several tactics are commonly used to drive earnings per share.  Switching to more lucrative business activities could provide a boost to profit margins and earnings.  Savvy tax strategies can lower the company's corporate tax rate (and increase reported profits).  Or buying in shares to reduce the number of shares outstanding increases earnings per share.  

There must be a limit to such tactics to boost reported earnings.  And since profit margins are at historic high levels, further significant growth in profits will need a comparable growth in revenues.

On this measure, the latest quarter is not encouraging.  Verizon, for example, reported 13% profit growth in its latest quarter while revenues grew only 3.7%.  GE and Microsoft had soft results in both earnings and revenues.  GE  profit and revenues each grew only 2.5%, while Microsoft had a slight decline in earnings while revenues grew 4%.

The media are reporting that the percentage of companies that "beat" the consensus earnings expectations is again running at close to 70%, but the number "beating" revenue expectations is only about 40%.  I remain concerned about earnings risks in the quarters ahead.

Steve Lehman

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