An Earnings Primer

It's time for a refresher course in what the "big money" is looking for out of earnings. Let's make this as simple as possible. You professionals out there will be yawning away, so go click on something else please. This piece is for the hundreds of thousands of you who get confused by all of this "better than expected," "worse than expected" gibberish.

When companies are reporting, people are looking for clues about how fast the company is growing (revenue) and how profitable the company might be (earnings). Younger companies are supposed to show outsized revenue growth. Older companies are supposed to have been able to figure out how to monetize that growing revenue into earnings. Old-line, boring companies are trying to maximize the cash flow to reward shareholders. Maybe they do it buying back stock or by raising the dividend.

If a company does "better than expected" revenue, that's a big deal, provided it is much better than expected. Too often we see the term "blowout" when we don't really have one, so be suspicious if a broker or a commentator uses that phrase. There was a time when companies used to get nailed for using that term "blowout" if they didn't do 20% better than expected. Now guys use it with in-line numbers, so scrutinize this lingo closely.

I care more about revenue than earnings these days because of all the obfuscations some of these once great growth companies seem to pull each quarter. For example, for the life of me, I can't see how Coke (KO) is a growth company. It seems like it is a single-digit grower at best these days. But it always reports double-digit earnings, because the company is very good at maximizing its cash flow and very clever at off-loading costs.

That's why when I hear that so-and-so company reported "a penny better" I don't get too jazzed.

To drill down further, after revenue we care about gross-margin guidance. Take Compaq (CPQ). On the conference call yesterday Compaq said gross margins might decline a bit next quarter but that they would improve in the second half. I was worried that analysts would see that as a negative, but two firms upgraded the stock saying that you had to look through near-term margin problems. If gross margins go up, that revenue will obviously get translated into much higher earnings.

So it is right to focus on gross margins, even to the possible exclusion of the final printed number, the earnings-per-share number, because of concerns like tax rate and charges that might impact that final number. That's why I always urge caution to the cowboys out there who trade only on the "number," the earnings per share, because it doesn't tell you enough.

Remember, Intel (INTC) traded up when the earnings-per-share number came out, and then down when the revenue number came out because even though the earnings seemed OK, the revenue number missed a couple of the recently raised estimates.

So, to beat a dead horse, Exodus (EXDS) reported a much smaller loss than expected but it didn't blow away revenue. To me, that's amazing, because this company has repeatedly blown away revenue estimates. I still haven't heard why it didn't and I probably never will because companies don't like to be pinned down on why they didn't do a number that was more than they were supposed to. The dialogue would go like this: "Why didn't you do more revenue than you were supposed to do?" "We did the amount of revenue that we forecasted we would do, isn't that enough?"

Of course, it should be, but in this bizarre world where doing what you are supposed to do takes out a third of your corporate value, you have to expect the worse if you meet any expectation.

Should any of this matter? Report cards do matter short term. But if a company is doing well, over the long term that should be reflected in the stock. I have found -- and I am not being facetious -- a very high correlation between companies that beat expectations of both revenue and earnings and higher stock prices. Until that correlation is repealed, we will always have to pay close attention to quarterly earnings.

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