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Earnings releases often act as a major catalyst for share price movement up or down, which is the primary reason reporting season is big news in the trading world. 

Some newcomers to investing are shocked when they see a favored stock drop dramatically after an earnings release that seemed reasonable to them.  They soon learn that, in truth market, reaction to an earnings release is as much about expectations as it is about objective reality.  Objective reality may exist in the natural sciences, but in the wonderful world of equities even the most positive of results can be subjected to negative interpretation.  Similarly, seemingly horrible numbers can drive a share price up if they are less horrible than the market expected.

Most investors who have been at the game for a while will tell you not to trade earnings.  If you believe in the fundamentals of a company and an earnings release does nothing to change your investment thesis – the rational for buying the stock in the first place – there is no reason to sell out in the face of a market sell-off.  Conversely, it is risky to add to your holdings in anticipation of positive numbers that should in theory drive the share price up.  Short term predictions in the share market are the stuff of market-timers, which is a fool’s game. 

As a case in point, let us look at the most recently available ASX earnings release from 31 July 2012.  On that date ALE Property Group (LEP), with a market cap of $334 Million, reported 2012 Full Year Results.  The company owns pubs throughout Australia but does not operate them.  Their 90 Pub Properties are leased out to a Woolworth’s subsidiary, the Australian Leisure and Hospitality Group Limited (ALH).  If you have never heard of ALE property and are wondering why anyone would want to invest in a Pub owner, a 7.6% dividend yield would be your first clue.  To see what happened to the LEP share price going into earnings and in the immediate aftermath, let’s look at a 5 Day price movement chart:

LEP has long term leases, making their revenue stream more secure than other AREITs (Australian Real Estate Investment Trusts).  They reported a revenue increase spearheaded by a 3.4% increase in rental income, but higher debt costs led to a 14% decline in profit; hence the immediate drop in share price.  However, as is often the case, on sober reflection, share market participants came back and the share price is now about where it was before the earnings release. 

Apparently investors were satisfied the debt and gearing situation would be rectified in the longer term and the revenue increase was enough to justify a halt to the share price decline.

If expectations are more important than reality, what should you be looking for in an earnings release?

Many investors watch for irrational reactions to earnings releases that in the long run are not as bad; these times can present good buying opportunities.  Right now most investors seem more concerned about revenues than they are about earnings.

Since the point of revenues is to generate earnings this doesn’t make a lot of sense.  In theory, yearly increases in top line revenue should yield roughly corresponding increases in earnings.  However, right now we live in a dreary world where expectations of a global slowdown or even a global recession are running wild.  In the long run earnings are what share markets are all about, but in poor economic conditions – cost-cutting and other measures can lead to respectable earnings despite soft revenues. 

Today declining revenues are looked to as evidence supporting the global slowdown or recession scenario.  Historically bottom line profitability is the ultimate measure of success but even in the face of a negative bottom line, investors look to top line revenue for evidence of an upward trend.  If revenue continues to increase, even an unprofitable company will eventually turn the corner.  For instance, many Aussie punters were well rewarded investing in junior iron ore miners at the height of the mining boom despite the fact most juniors had yet to return so much as a nickel in earnings. 

There are other important facts in an earnings release, but top line revenue and bottom line profitability get the most attention.  Many investors limit their reading of earnings reports to press releases which never contain everything you can glean from the release itself.  The press headlines and the revenue, earnings, and earnings per share they include do not even begin to scratch the surface of the tale of what is going on inside a company.

First, all the numbers need to be taken in historical context.  Is a big earnings per share miss a one time event or is this the third consecutive reporting period that has missed estimates?  Which way is revenue trending?  Are there one off charges that can explain declining profitability?  Numbers in isolation may be impressive but it is performance over time that matters.

Then there is the narrative behind the numbers.  All full year releases are accompanied by some kind of statement from management explaining the results.  Of course, you need to be skeptical as all earnings releases are put forward to show the company in the best possible light.  However, if management says flooding in Queensland gave them trouble, it doesn’t take a degree in finance to verify there was flooding in Queensland impacting their operations.

The best way to prepare for an upcoming earnings release is to look at the last release.  If revenue slipped, market participants will be casting a watchful eye on improving revenue.  If the company cited weather as an explanation for decreased revenue and profit and the weather has been fine since, expect to see a change. 

In a few short days, three of Australia’s top companies will be reporting earnings.  Here they are along with their Year over Year share price performance and three years of reported revenue:

Company

Code

Share Price

52 Wk Hi

52 Wk Low

Revenue ($M)

2008

Revenue ($M)

2009

Revenue ($M)

2010

Revenue ($M)

2011

Rio Tinto

RIO

$54.41

$80.49

$50.22

$78,326

$46,633

$55,669

$59,607

Telstra

TLS

$3.99

$4.09

$2.69

$24,834

$25,514

$24,967

$25,129

Cochlear

COH

$64.70

$77.50

$45.11

$580.4

$711.8

$696.2

$738.4

 

From the table you can see the GFC hit RIO the hardest but they have been recovering a bit in each successive year.  Their revenue for FY 2011 was actually higher than in 2007 immediately preceding the GFC when they reported $33,689.  Telstra’s revenue shows little variation and Cochlear’s revenues have also risen substantially above their 2007 number of $543.  Telstra is strictly Australian but the other two companies operate internationally and revenue as a measure of economic conditions will be important this reporting period.  Let’s take a look at each of the three companies.

Rio Tinto (RIO) is down 30% Year over Year, as depicted in its one year share price performance chart:

You can see a little spike in the chart when Rio released its most recent quarterly production report with solid numbers.  But sentiment surrounding the mining sector has hit a low.  Economists at Deloitte Access claim the boom has just two years left to run.

News that Rio is axing 270 staff from its Sydney and Melbourne offices is certainly not helping sentiment improve either.

The market is expecting the worst from Rio; anticipating they could follow the biggest iron ore producer on the planet, Vale, which reported its worst results in two years.

Nevertheless, a recent recommendation from Deutsche Bank reiterated its BUY call on Rio and praised the company’s decision to proceed with production expansion plans while rivals BHP and Vale “are still trying to figure out what to do.”

The consensus estimate for Rio’s earnings before one-off charges is – US$4.94 billion for the six months through June, down from a record US$7.78 billion a year earlier.

You can watch for that number but the truth is even if Rio comes in above estimates, it is unlikely to move sentiment.  A better “tell” will be what management has to say about conditions going forward.  Even though investors seem bearish on Rio, major analyst recommendations for Rio (as at July) are all BUYs, OVERWEIGHT, and OUTPERFORM.

Telstra (TLS) is up 35% year over year and some analysts are warning the share price may be overheated.  Here is their chart:

They have dominant market share in all major telecommunication segments and although there’s the worry that NBN will allow smaller competitors to nip away at market share, Telstra has the expertise and now the cash to expand in services on a large scale.  Although their customer pricing is not our lowest, their internal costs make them the lowest cost producer in the industry, which is a key competitive advantage.  Telstra recently sold some New Zealand assets to raise cash for future operations. 

Although no one can say for sure, Telstra’s year long ride from dog to darling is probably due to lessening concerns about the NBN impact and certainty regarding the company’s outstanding dividend.  On 03 August an analyst at Citi expressed the opinion that shares of TLS may have become “sort of a bond proxy.”  In the earnings release watch for what management has to say about dividend payments going forward as well as expansion plans for their cash on hand war chest – $4 billion.

By now the Cochlear (COH) story is well known.  The global leader in hearing implants shocked investors with the news of a product recall in early September 2011.  The share price plummeted from $74.88 on 01 September 2011 to $45.51 by the end of the month.

Initially the company was lauded for its handling of the recall but concerns over the actual rate of failure came into play as well as possible loss of market share to US competitor Advanced Bionics.  The share price has moved from $45 to about $65 today, down only about 5% as their one year chart shows:

In their Half Year reporting back in February the company claimed the costs of the recall had been fully expensed in the first half.  Watch for any change.  Also, management assured investors of no significant loss of market share, although analysts at Deutsche bank disagree and see loss of market share going forward.  Deutsche have a SELL rating on the company with a $56 price target. 

Deutsche conducted a survey of implant centres and, from that they conclude, market share has dropped to 61%, down from a high of 68% in 2010. Finally, there is still concern about the rate of failure.  In Cochlear’s case, the aftermath of the recall is still the thing to watch.  Although analysts are decidedly bearish on Cochlear going forward, their upward trending share price since the recall suggests market participants remain unconvinced.

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