- The Washington Times - Friday, April 30, 2010

While many investors kept one eye on the Greek financial crisis and what might have been done by Germany, the European Central Bank and the International Monetary Fund to stave off any meltdown, the other eye was on the plethora of corporate earnings both this week and last.

Assembling and understanding what so many companies report can be daunting even for the professional investor and money managers, particularly when trying to gauge the underlying strength of the domestic economy. Based on company earnings, the majority of which have beaten Wall Street expectations, it would appear that things are getting better. I can say the majority because as of the end of last week 172 of the 500 companies that make up the S&P; 500 had reported their earnings and, according to Thomson Reuters, a record 83 percent of those 172 had beaten Wall Street expectations (typically 61 percent of firms exceed expectations).

What that may or may not mean about analyst expectations is fodder for another day. The real question is whether or not companies beating Wall Street expectations means that things - the economy in general, the industry in which a company competes, or that company’s position - are getting better.

The quick answer is “maybe; maybe not.”

To say a company beat its earnings makes for a good headline but, as we know, we have to dig deeper to understand how a company gets such a “beat.” There are several items we as investors need to watch out for - a gain or loss that is nonrecurring in nature, like the sale of a business or product line; an unexpectedly low tax rate that is not sustainable; ongoing cost containment that masks tepid revenue growth, and so on.

What it comes down to is breaking down a company’s income statement and understanding the moving parts that compose its revenue line, cost structure above the operating income line as well as those parts between the operating income line and net earnings. Understanding these parts lets us understand the quality of a company’s earnings.

A company that does better than expected with revenue and profit generation, with few one-time shenanigans to generate better than expected earnings per share is generally considered to be a solid “beat” with high-quality earnings. Companies that miss on the revenue line, artificially reduce operating expenses, benefit from an unsustainably low tax rate, tend to eke out performances in line with or slightly better than was forecast by Wall Street - they are viewed as having low-quality earnings.

As one can imagine, investors prefer companies with high-quality earnings and improving business over those with low-quality earnings and rocky prospects.

Back to all of those companies that have beaten expectations over the past few weeks. While I can’t listen to all the earnings calls and review all the transcripts for all the companies that have so far delivered their March quarter results, of the ones I have, the vast majority have delivered good revenue performance and good cost containment.

That cost containment has largely been on operating-expense items, though predominantly through head count reduction over the last several quarters. I mention “head count” here because the question of jobs and job growth is rather important. As I type this, initial jobless claims for this week of 448,000 were modestly higher than economists were expecting, but the fresh weekly claims remain at elevated levels.

With regard to head-count reductions and company earnings, the question I ask as an investor is “how much more cost cutting can be done?” As the popular expression goes, past a certain point you stop cutting the fat and start cutting into the muscle.

There is a larger concern that I have surrounding the risk of a rising-cost structure and what it means not only for earnings but also for a company’s ability to beat earnings expectations in the coming quarters. On the one hand, the domestic economy is improving, as recent commentary from the Federal Reserve underscores. Eventually this should drive some job growth, which would add to a company’s cost structure incrementally, particularly when we consider the full cost of employing a person for salary and benefits.

At the same time, there are growing data that show input costs are rising as well. Oil, gas and other commodities. Rising meat prices as pork, beef and chicken prices have all moved higher with several food economists calling for record prices in the coming months. These and other inputs are likely to have a ripple effect, especially given the wide reach of petroleum in the factory as well as in and around the home, car and elsewhere on both a direct and indirect basis. Already inflation in producer prices is being reported in Australia and there is growing concern that China’s economy may be overstimulated.

How long until the talk of inflation rears it head again? Mix that with lingering high unemployment and stir. My advice - focus on companies with those high-quality earnings because those low-quality earnings companies might be in for a tougher ride going forward. All that and we did not touch on what rising input costs may mean amid high unemployment and tepid consumer spending in our current economic recovery. More as it develops.

Chris Versace is director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston, Va. He can be reached at cversace@washington times.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.

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