The Trifecta

There are some investors who will contend that the market obsesses and frets way too much over quarterly earnings reports, and that true investors should pay less attention to the parade of financial results every three months and focus instead on a company's fundamentals and long-term prospects. I strongly disagree with that view, for two basic reasons. First, investors should pay attention to anything that moves a stock's price. If we were to discover a meaningful correlation between a stock's price and lunar eclipses, hemlines, or the performance of the Ole Miss Rebels football team, we should pay attention to those things, too. Second, the two approaches are not by any means mutually exclusive. Investing is all about what is going to happen in the future, and stock prices represent a particular assessment of that future. The quarterly reports cards are a vital source of feedback for whether those assessments are too optimistic or too pessimistic. If a company's sales, earnings, and margins are growing faster than expected, the stock is likely to move up--and vice-versa. While we do not want to make immediate buy or sell decisions based only on the earnings report, we do need to factor that information into our overall investment thesis for the company, at least as a way of squaring our own assessments with reality. Remember that hubris can be an investor's worst enemy, so don't start thinking that you are smarter and cuter than everybody else, or that you are right and the market is wrong. That's a sure way to get your head handed to you.

As we will see in the examples that follow, a company has to hit a virtual trifecta with its earnings report in order for its stock to react favorably. First, the so-called "headline number," or the actual earnings per share result, needs to exceed expectations. Second, the sales and margin results need to strike the right balance. If too much of earnings growth is coming from profit margin expansion, that can be a red flag because the company can reduce costs only so far--true growth companies need impressive top-line growth. If margins are slipping, though, that can be a sign that the company cannot pass along higher input costs or that it is not being managed efficiently. Third, and back to the future, what a company has to say about its prospects going forward, what is known as "guidance," needs to reflect a positive outlook. Here are some recent results from companies on our Radar Screen.

Tempur Pedic (TPX, $57) reported earnings of $.86 versus an estimate of $.84, but first quarter revenue was below forecasts. The stock has fallen more than 25% since the report. Furthermore, the company committed the unpardonable sin of forecasting a full fiscal year outlook of $3.80 to $3.95 per share compared with a consensus view of $3.97, with the report lacking any upward revision to guidance. Why such a dramatic decline in the stock? Well, TPX, like many other high-growth stocks, has been on a tear since the beginning of the year, rising more than 60%. As we have noted before, an expectation develops that such stocks will exceed the earnings estimates by a wide margin, and this is known as the "whisper number" of expected earnings. The stock advances strongly as this true expectation is built into the price of the stock, and even the slightest disappointment can send shares tumbling. Also, we need to consider the nature of the company's business. If your son or daughter has just graduated from college and you are being the proud and generous parent who is going to help him or her furnish that first apartment, a Tempur Pedic mattress is probably not on your shopping list. No, you are likely to shop for that first mattress at one of the discount warehouses. Such high-end bedding is usually purchased by people who are upgrading from their old box-spring product. This is why TPX is not as dependent on the housing cycle as would be the case for a maker of mass market appliances or furniture. That distinction is what has allowed TPX to be a growth, rather than a cyclical, stock. TPX, though, is not the only maker of nicer mattresses (Select Comfort is another), so the modest outlook that the company offered just fed those fears about competition. TPX is also bringing out a new line of lower-priced mattresses, and that has some investors concerned about cannibalization of the company's signature offerings.

Stanley Black and Decker (SWK,$72) reported first quarter earnings of $1.09 per share, shy of the $1.13 estimate; revenues actually came in ahead of estimates. The stock began the year at around $67, rallied up to around $81 in March, and was trading at $78.49 going into the earnings report. The earnings miss sent the shares down to the $72 range. The decline in the share price was less severe than what we saw with TPX, which is more of a momentum stock that had shown major gains prior to its report. The investment thesis for SWK appears to be essentially intact, with the company noting that it now sees annualized cost synergies at $485 million versus the previous forecast of $350 million.

QUALCOMM (QCOM, $62) reported earnings per share of $1.01, ahead of the $.96 estimate, and revenues were also above forecasts. The company noted, however, that it is having some issues with supply constraints, as its foundry partners are having trouble manufacturing enough chips to meet demand. That is actually one of those "good" problems to have, and it reflects the continuing strong demand for smartphones. However, this may mean some weakness in results for the current quarter, although the company actually raised its full-year earnings outlook to $3.61 to $3.76 from $3.55 to $3.75. Goldman maintains its Conviction Buy rating and price target of $76.

Yum! Brands (YUM, $71) reported earnings per share of $.76, beating the consensus of $.73, with revenues also exceeding expectations. Investors have been focusing on the company's growth in China, which has been making up for weakness in its domestic Taco Bell segment. Now there are concerns that China growth may be moderating, but that is being offset now by a rebound in the U.S.

Cerner (CERN, $81), whose products and services bring technological integration to the healthcare sector, reported earnings of  $.54 per share, compared with an estimate of $.50; revenues came in at $641.2 million versus an estimate of $578. 39 million. The company also raised their full-year view for earnings.

GNC Holdings (GNC, $38), the retailer of nutritional supplements once known as General Nutrition Centers, reported eps of $.60 versus an estimate of $.52; revenues were $624 million compared with the forecast of $589 million. The company raised their full-year earnings projection to $2.05, compared with a consensus of $1.93. The stock pulled back when the FDA issued a safety warning about dietary supplements containing dimethylamylamine (DMAA). GNC contends that the product is safe, but even in a worst case scenario where the product is removed from shelves, consumers are likely to substitute another performance-enhancing offering. The supplement in question does not make up a meaningful amount of the company's sales.

Titan International (TWI, $28), a maker of wheels and tires for the agricultural, earthmoving/construction, and consumer sectors reported earnings of $.78 per share versus an estimate of $.52; revenues were $463 million versus a forecast of $429 million.

Chipotle Mexican Grill (CMG, $409) reported quarterly earnings of $1.97 per share, versus an estimate of $1.92; revenues were $640.6 million compared with a forecast of  $630.92 million.

Las Vegas Sands (LVS, $55) reported earnings of $.70 per share versus an estimate of $.60; revenues came in at $2.76 billion versus the $2.62 billion forecast. The story here is all about the continuing strong growth in the Macau market, plus the company's other planned expansions internationally.

What are some "take-aways" from these earnings reports? First of all, stocks have had an incredible run since the end of last year, and those gains have left shares especially vulnerable to profit-taking. When there is the slightest whiff of something even remotely negative--when an earnings report does not hit a perfect trifecta--we can expect a sell-off. Companies that are best positioned to bounce back are those with exposure to solid long-term growth trends that may be suffering through some sort of temporary challenge or setback. QUALCOMM would be an example here. Of course, the company has to demonstrate that it is growing sales and managing that growth effectively. As for valuations, a company that is growing at 25% per year can trade at a price/earnings ratio of 50 (Chipotle, for example; a good rule of thumb is that the p/e ratio should not be more than twice the growth rate), but if anything is perceived to put that growth in jeopardy, look out below.

Investors are conditioned to "buy low and sell high," so it is tempting to think that a dramatic decline in a stock's price is an automatic buying opportunity. That is not always the case, so we have to evaluate stocks on a case-by-case basis to understand what exactly is causing the stock to go lower. Of the stocks mentioned above, I would have the most concern about Tempur Pedic. Yes, the stock has fallen significantly since the earnings report, but the issue here may have more to do with investor perceptions. Investors became accustomed to the company reporting exceptional results, and expectations of this pattern were built into the stock. If any of that is indeed broken, the stock may not return to its glory days. We see a very different case with Cerner, which did hit the trifecta with its report. The stock had been trading around $78, rallied to $84 following the earnings report, and is down to around $80 in Friday's broad market sell-off. The investment thesis for Cerner is still very much intact, so the stock's decline in a bad market is a case of the "baby being thrown out with the bathwater"--good stocks get taken down along with the not-so-good ones, and that makes for one of my favorite buying opportunities. The important distinction to make is between a decline that is company-specific, which can constitute a red flag, and a decline that is just the result of an overall market sell-off.

Finally, all of this serves to underscore the importance of diversification. If we do our homework and apply a disciplined investment methodology, we can find stocks that have the potential to outperform the market over long periods of time. Those stocks can compensate for the occasional disappointments and negative surprises, but in order for that to hold true we have to own stocks in a variety of companies across different sectors. In other words, never bet the farm on your favorite horse.

We'll look at more earnings reports next time as part of our ongoing reality check.

Life is short. Get busy.

Jim

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The photo at the top of this post is from A Day At The Races, my favorite Marx Brothers movie that is still one of the funniest films I have ever seen. If you want a good laugh, give it another viewing.

Disclosure/Disclaimer: My family members and/or I own shares of SWK, QCOM, YUM, CERN, GNC, TWI, CMG, and LVS. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.