Harry Domash

The Basics

How to spot trouble in earnings reports

Don't just read the press release. Here are some easy ways to look for warning signs when earnings season rolls around.

By Harry Domash

Earnings season is here, and the stakes are high.

The markets already are nervous about the threat of inflation and rising interest rates. So any disappointment, either in reported results or forecasts for next quarter, will likely sink a stock big time.

Even for companies that meet Wall Street's expectations, the worry's not over. One of your stock's reports could contain hidden clues warning of future disaster.

These "red flags" are easy to spot if you know where to look. I'll show you how.

The nuts 'n' bolts

Most companies issue press releases summarizing their quarterly results prior to filing their required reports with the Securities and Exchange Commission. It's the press releases that make headlines and move stock prices. Relatively few investors read the more complete SEC reports.

The press releases include commentaries that usually make things sound hunky-dory, no matter how dismal the financial results.

The SEC requires three financial statements in its reports: an income statement, balance sheet and statement of cash flows. But the SEC doesn't require companies to include any financial statements in their press release.

In practice, most do include a reasonably complete income statement, which lists sales and itemizes expenses for the recent quarter. They also include at least some balance-sheet items, but not many provide a statement of cash flows. Most companies also display the year-ago numbers for any current data that they provide. If not, you can easily get the year-ago figures from MSN Money's financial statements.

Looking for red flags

I'll demonstrate the report analysis process using two examples: manufacturer 3M Company (MMM, news, msgs) and personal-care product maker Helen of Troy (HELE, news, msgs).

Helen of Troy missed analysts' estimates in the quarter that ended in August, but the stock didn't drop much. That may be because shares were already down 26% from July 11, when the company released results for the quarter ended in May.

But investors could have avoided that 26% haircut. We'll examine Helen of Troy's May quarter report, as we could have on July 11, to see how investors could have spotted Helen of Troy's warning signals before it was too late to get out. You can find the July 11 press release here.

And we'll look at 3M's most recent report, issued this month, to see if there are any similar problems to be found.

Sales growth

The first check is easy.

Find the companies' recent quarter's year-over-year sales growth figures mentioned in their introductory summaries and compare them to the 5-year average annual sales growth numbers found in the MSN Money Company Reports section.

In the best case, the recent quarter's year-over-year sales growth would exceed the long-term growth rate, signaling accelerating sales growth. If not, the two growth rates should be in the same ballpark. A 25% growth-rate slowdown (e.g., from 20% long-term to 15% quarter-over-quarter) is cause for concern, and a 50% slowdown (e.g. from 30% to 15%) is a red flag.

3M reported 8% September quarter year-over year sales growth, greater than the 5% five-year annual growth shown on MSN's Company Report.

Helen of Troy's May quarter report showed 19% year-over-year growth, also above its 11% long-term growth rate, as shown on its Company Report page.

So, both 3M and Troy passed the sales growth test. Next, look past the commentary on the press release to the income statement.

A peek at the future

First, for review: Net income is the company's bottom-line profit, which is sales minus all expenses, including income taxes.

Operating income is similar to net income, except it doesn't subtract income taxes and interest expenses not related to the firm's main operations. Because income tax rates can vary from quarter to quarter, operating income is a more accurate profitability measure than net income.

Operating margin is operating income divided by sales. It's easy to understand. A 10% operating margin means that, before paying income taxes, a company earned $10 for every $100 of sales.

Rising margins may signal that the company is operating more efficiently or that is gaining on the competition, enabling it to increase prices. Conversely, declining margins may warn that something is going wrong.

Thus, operating margin trends are a good predictor of things to come.

You'll need your calculator, but it's an easy calculation. Find the operating income line in the income statement and divide the operating income by net sales.

Looking at 3M's September 2005 numbers, net sales were $5.382 billion and operating income was $1.29 billion. Dividing $1.29 by $5.382 gives 0.240 or 24%, compared to 23.8% for the year-ago quarter. So 3M's operating margin increased slightly from year-ago.

But Helen of Troy's May quarterly report told a different story. Operating margins were 12%, down from the year-ago 17.7% figure.

Small operating-margin variations (say from 20% to 19.5%) are normal. Only changes amounting to 15% or more (17% down from 20%, for example) are significant. Falling margins warn of future earnings shortfalls, while rising margins signal the possibility of positive earnings surprises.

3M's operating-margin change was insignificant, but Helen of Troy's 32% drop (12% vs. 17.7%) was a red flag warning of future shortfalls.

Matching what you sell to what you're owed

When one company sells to another company, the selling company usually bills the customer and adds the owed amount to its accounts receivables. When the customer pays, the seller subtracts the payment from its receivables.

Normally, a company's receivables would track sales. For instance, if sales double, you'd expect the monies owed by its customers to double also. Research studies have found that when receivables rise faster than sales, there's an increased likelihood of future earnings disappointments.

The easiest way to detect that ominous trend is by comparing receivables to sales for the most recent and year-ago quarters. If accounts receivable increased faster than sales, that ratio would also rise.

The math to detect a problem is straightforward: You divide accounts receivable by sales. You'll find receivables near the top of the balance sheet.

Doing the calculation for 3M yields an answer of 56.9% ($3,061/$5,382) for its September quarter and 57.4% for the year-earlier quarter. Since 3M's receivables-to-sales ratio dropped slightly, there's no cause for concern.

Again, Helen of Troy's May quarter figures told a different story. Troy's May 2005 quarter receivables-to-sales came in at 87.7%, up from 77.2% in May 2004, a difference of about 14%.

As a rule of thumb, consider a jump of 10% or more in sales-to-receivables as cause for concern and gains of 20% as red flags. Changes of 5% or less are normal. Troy's was certainly a cause for concern, but not necessarily a red flag.

Identifying clear and present dangers

My analysis of 3M's September quarter results found no red flags. However, Helen of Troy's operating margin drop by itself was a clear warning of future problems, and a look at its receivables reinforced that conclusion. Those simple calculations could have saved alert investors a lot of money.

Finding no red flags in an earnings report doesn't necessarily mean a stock is headed up. But it does make it easier to save yourself from a big loss.

At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article. Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being "Fire Your Stock Analyst," published by Financial Times Prentice Hall.

Rate this Article

Click on one of the stars below to rate this article from 1 (lowest) to 5 (highest). LowHigh