This Season's Earnings Require More Scrutiny Than a Litmus Test

So much for sectorwide performance.

It's early in the earnings season, but so far, companies in the same sectors are reporting drastically different results. Indeed, this ugly third quarter -- bruised even more by the Sept. 11 terrorist attacks and the subsequent U.S. response -- will separate some winners from losers. Take the PC makers: Dell (DELL) has confirmed its earnings expectations, while rival Gateway (GTW) warned of an unexpected loss.

But before investors use litmus paper on third-quarter earnings reports, they should take a closer look behind the numbers. The result may not be a stark contrast of colors, but rather subtle differences in shades. In some cases, the companies are holding up because wider profit margins or recurring revenue streams are insulating them from shocks to their businesses. Indeed, when judging the longer-term viability of certain companies this quarter, there are many factors to consider, such as when a firm's fiscal quarter ends and the amount of exposure a company has to temporarily vulnerable markets.

Dell vs. Gateway

To illustrate this point, let's return to the Dell/Gateway example. Gateway has been struggling with a price war led by Dell, which has been able to offer its products at a discount because the company sells directly to customers rather than through retailers and distributors.

Dell announced that it would meet its earnings expectations of 15 cents to 16 cents a share, while Gateway warned that it would lose between 14 cents and 17 cents, far below the 4 cents analysts estimated, according to Thomson Financial/First Call, which tracks company earnings. Gateway said its wider-than-expected loss is partly due to a slowdown in demand after Sept. 11's terrorist attacks. On the news, investors bid up Dell's stock 8.1% to $22.32, while cautiously pushing Gateway shares up 3.2% to $4.85.

But Dell has more time to recover from any slowdown in demand due to the terrorist attacks. This is because its fiscal third quarter ends Oct. 31, while Dell's finished Sept. 30.

In addition, approximately 90% of Dell's revenue comes from the business market, whereas about 50%-55% of Gateway's revenue is from the consumer sector, which was hit harder by the attacks, according to Charles Wolf, analyst at Needham & Co. "Those businesses that had already started a deployment of machines wouldn't stop because of Sept. 11," says Wolf. "People talk about the lost business [in the consumer sector], but I anticipate that whatever sales Gateway lost will be recouped in December."

In fact, despite Gateway's current troubles, the company may see more growth than Dell in the long run, Wolf argues. "The home market is gaining share over the business sector, because in the U.S. and Western Europe, the business market is saturated," he says.

Because Gateway has storefronts, the company also has more success in selling added services such as Internet access -- for which the demand will only increase. In essence, in a store, Gateway sales representatives have a captive audience. "Gateway's beyond-the-box sales are 20% of total revenues and 40% of gross profits, whereas with Dell those percentages are much lower," Wolf says.

This is not to say, however, that Gateway is a better company than Dell. Gateway suffers from internal problems, in addition to the overall slack in consumer demand deepened by the terrorist attacks. Such difficulties have affected Gateway's revenue. During the second quarter, for instance, Dell logged $7.6 billion in revenue, while Gateway only brought in $1.5 billion. According to Wolf, the company's new CEO Theodore Waitt is a superb marketer but not a good manager. "Gateway's strategy and model is viable, but they need to execute," says Wolf. "If they can't do that, it doesn't matter what their demographics are."

But companies such as Gateway that have been hit harder by the Sept. 11 fallout could see a sharper recovery when their markets do come back, and such growth could translate into a stock increase.

IBM vs. Sun Microsystems

Let's take another example. IBM (IBM) is one of few hardware makers that hasn't ratcheted down its earnings this quarter, which ended Sept. 30. On the other hand, with its fiscal quarter finishing on the same date Sun Microsystems (SUNW) has warned twice of wider losses and weaker revenue. The company also announced plans to lay off 9% of its workforce. Sun now expects a quarterly loss of between 5 cents and 7 cents a share, compared with the 4 cents per share estimated by analysts. The company partly blamed the wider-than-expected loss on the Sept. 11 attacks.

It is true that analysts recently revised expectations for IBM, decreasing revenue to $20.76 billion from $20.81 billion and per-share profit from 90 cents to 89 cents, according to First Call. But such revisions aren't nearly as drastic as those for Sun.

This is partly due to IBM's business model. "Forty percent of the company's revenues and 60% of its operating profits are recurring," says Toni Sacconaghi, analyst at Sanford Bernstein. "During shocks like what happened on Sept. 11, a big portion of IBM's business remains unaffected because revenue is already locked in."

This compares with the less than 15% of Sun's recurring revenues and operating profits, Sacconaghi adds. "So the company is more vulnerable during downticks."

Such stability gives IBM the opportunity during rough markets to win customers through lower prices and financing deals. For example, on Oct. 4, IBM released its new server, Regatta, for about one-third the price of Sun's newest model, StarCat. In addition, a day before, the company announced a range of financing options that give customers the chance to buy IBM eServer iSeries and pSeries systems even when IT budgets at many companies continue to shrink.

But this doesn't mean that IBM is necessarily a better investment than Sun. It is just more stable. In a rocky market, such steadfastness is valued. "But stability in 1999 and early 2000 was bad," points out Sacconaghi.

More dependent on conditions during the quarter, Sun could see tremendous growth from a positive shock to its market. "In that case, IBM's stock would see the same growth, whereas Sun's shares would likely have higher growth," Sacconaghi says.

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