Understanding Earnings Surprises: What To Look For & Their Meaning For Investors

There have been many earnings announcements lately that have surprised investors and analysts. And this has resulted in some significant gains in stock prices.

But don’t take these quarterly results at face value.

Earnings and guidance are very conservative this year, so it shouldn’t come as a shock when a company beats its projections. Just because a company like Caterpillar crushes its estimates, it doesn’t mean the business is humming along. It just means they beat the estimate.

That said, at a time like this, it’s important to figure out why the earnings come in better than expected. Were sales higher than forecasted? Did margins improve? Was it due to a lower tax rate? Lower general and administrative costs (layoffs)?

There are a number of reasons why a company might spring a surprise. Let’s take a look at a few that recently reported earnings surprises to see the real reasons why it happened…

Three Reasons Why Company Earnings Can Surprise

• Employee Layoffs

On Tuesday, Yahoo! (NASDAQ:YHOO) doubled up on analysts’ estimates, notching earnings per share of 16 cents, versus expectations of eight cents. That was on a non-GAAP (Generally Accepted Accounting Practices) basis, though. Using GAAP, the company earned 10 cents per share - a penny more than in the same period last year.

Behind the flashy headline numbers, Yahoo! actually experienced a 13% decline in sales. It offset that with a $120 million decrease in sales and marketing expenses and $50 million less in general and administrative expenses (most likely due to layoffs).

In addition, the company’s gross and operating margins were both lower than the corresponding earnings period in 2008. So while Yahoo! did beat its estimates - and even earned more per share than it did last year - it was all due to cost-cutting and firing employees.

• Cost Cutting

Despite a revenue decline of 6.6% during its fiscal third quarter, as all-important same store sales dropped by 5%, Starbucks (NASDAQ:SBUX) was still able to post a profit of $151 million (20 cents per share). That beat EPS by a penny and compared to a net loss of $6.7 million during the same period a year ago.

To its credit, management was able to shave operating costs at company-owned stores from 42.1% of revenue to 41.9%. But the big change to this quarter’s income statement was the roughly $175 million in cost-savings, mainly by closing stores.

It took $51.6 million in restructuring charges this quarter, versus $167.7 million a year ago.

Starbucks also had an additional $33 million benefit, due to lower interest expenses, higher interest income and other items, when compared to last year.

But even though the company swung to profitability, a quick comparison of this quarter’s numbers versus the same data from a year earlier shows that the real story behind the profitability was because of savings from closed stores.

Still, that’s not necessarily a bad thing. Starbucks did need to cut back (as long as they don’t cut the one by my office!).And if the company can show increased profitability from existing (and any new) stores in the future, then its cost-cutting moves will prove fruitful.

Right now, though, a look at Starbucks’ numbers tells us that its recovery is still early in its development. Too early, in my opinion, to make for an attractive investment.

• Operating Expenses

Here’s another example of how the mainstream media can mislead.

Some outlets reported that Delta Air Lines’ (NYSE:DAL) revenue shot up by 27%. But some journalists didn’t take the company’s acquisition of Northwest into account. Their combined revenue actually fell by 23%.

In addition, while Delta did report better than expected numbers, losing 24 cents per share, five cents better than consensus estimates, it would have turned a profit if not for losses suffered when trying to hedge fuel costs.

So in Delta’s case, the airline was actually operating in the black, despite lower revenues. That was until some traders got involved and bet the wrong way on fuel prices. Had it managed to cut its expenses, the earning surprise could have gone the other way.

I don’t love the airline business, but if Delta can show me another quarter where it manages its business efficiently, it could be an interesting recovery play. Assuming some oil traders don’t mess things up, of course.

Clearly, this is just a quick look at these companies’ earnings reports. But even then, it reveals more information than the headline numbers you see reported in the press. Unless you drill into those numbers, they’re pretty meaningless.

Earnings increases on favorable tax treatment, layoffs and accounting slight of hand isn’t sustainable. Whereas earnings increases on increasing sales and decreasing costs are something that investors like to see in well-run companies that make good long-term investments.

Understanding earnings surprises and why a company beat its numbers is incredibly important to making good investment choices.

Hoping your longs go up and your shorts go down.

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