Four Tips for Understanding Earnings Reports

The Finance Professor breaks down a few key ways to cut through the noise of quarterly data.
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With Alcoa's (AA) - Get Report earnings report on Monday, April 7, the latest quarterly earnings season has officially kicked off. (To listen to Alcoa's April 7 conference call, click here.)

So as an investor, how prepared are you for the ensuing cycle of company reports and conference calls?

Following up "

Beginner's Guide to Earnings Calls

," "

Five Missteps to Avoid in Earning Season

" and "

Conference Calls: The Good, the Bad, the In-Between

," this installment of The Finance Professor will focus on how to identify deceptive and confusing aspects of corporate earnings reports and conference calls.

1. Understand Time Frame Comparisons

When companies present data for comparative purposes in reports and on conference calls, they will refer to two different time relationships. The first one is a comparison of results for the current period to the same period a year ago. This is referred to as "year-on-year (or "YOY") growth or changes. So if a company is reporting fourth quarter results for 2007 ("4Q '07") the YOY growth would be

relative

to their "4Q '06" results.

The second time frame comparison relates back-to-back quarters. This is referred to as "sequential" or "linked" quarters. So sequential growth for 4Q '07 would be

relative

to 3Q '07.

The issue here is relevance. For some companies, YOY comparisons are applicable while for others, sequential evaluations are germane. How do we know which one to focus on? It all boils down to the type of industry or business that the company is engaged in.

For example, say we are listening to a conference call of a retailer such as

Macy's

(M) - Get Report

, which is reporting fourth quarter results. The fourth quarter spans the winter holiday shopping season of November through January. For Macy's, YOY comparisons are not just relevant, they're vital in digging into the company's results. Why? With Macy's (and most retailers), the fourth quarter is the largest contributor to the company's full-year results. So a comparison of 4Q to 3Q provides far less substance to the analysis of this retailer's results.

Recently, some homebuilders (like

Toll Brothers

(TOL) - Get Report

,

Lennar

(LEN) - Get Report

and

Hovnanian

(HOV) - Get Report

) tried to inject and emphasize sequential data points in the reporting of their quarterly results. This was an attempt to obfuscate the poor state of the housing market and provide an appearance of improvement, when little or no improvement was really evident.

On the other hand, a sequential growth figure can be an important metric for some companies and industries. This is especially true for non-seasonal and/or growth companies.

For example,

Google

(GOOG) - Get Report

is considered a fast-growing company. That said,

analysts and investors are less focused on YOY growth, as sequential growth figures are more indicative of the velocity of growth of the company's business model. Hence, in Google's case, there is great interest in and speculation about the amount of "paid clicks" and "click-throughs" (important metrics for online advertisers) that Google may have generated in the first quarter of 2008 relative to that of the fourth quarter of 2007.

2. Get a Handle on Taxes

Taxes are recorded as "accruals" based on calculations by the company and its tax advisors. Sounds simple enough, but that's just the beginning.

Certain expenses may not be deductible for tax purposes. And some taxes are recurring, while others are one-time in nature. Companies may benefit from tax credits, tax loss carry forwards or settlements with taxing authorities. Plus, from time-to-time, tax authorities may audit a company's tax returns and require the payment of additional taxes that were not previously recorded by the company.

As you can see, there is nothing straightforward about corporate taxation.

When a company reports its results in a quarterly press release or during a conference call, you will be able to ascertain the "effective" tax rate that the company has recorded. Some companies will provide that information, while with others, you must perform that calculation yourself. Here's how: the effective tax rate

equals

income tax

divided by

income before taxes.

While the effect tax rate will vary by the location where the company is based and operates, in general, most companies will have an effective tax which will be fairly static from quarter-to-quarter and year-to-year. However, once in a while, there are two tax-related red flags that you should be aware of when companies report earnings:

If a company reports an EPS number that is much greater than expected, while the company's sales remain level or dropped and expenses remain level or increased, it may indicate that the company benefited from "one-time tax items." For example, Ruby Tuesday reported EPS that was greater than expected by 5 cents, while revenues missed estimates by 4.5%. On closer inspection, Ruby Tuesday reported a "net tax benefit" of 24.6% versus a "real tax expense rate" of 30.9% in the prior year's quarter. What looked like a "big beat" for Ruby Tuesday was, in fact, a miss.

A company that suddenly turns its history of generating "operating losses" to "operating gains" will report a low effective tax rate, generating earnings results that seem better than expected. The reason for this anomaly is that accumulated prior years' losses (for which taxes were not due) can be carried forward as a deduction against current year's income for tax purposes. As a result, the EPS for the current year is deceptively higher than if the company were operating and paying taxes over longer periods of time. For example, over many years Amazon.com generated and accumulated large operating losses that Amazon was not able to deduct. However, in future years, when the company began to generate profits, these old losses were used to offset current gains. Thus, lowering the effective tax rate and inflating EPS.

3. Make Sense of Managing Expenses

Expense accruals are defined as the recording of expenses incurred in the current period, which are

not

payable until future periods. While some expenses such as rent and utilities are straightforward, other expenses have more

subjective

criteria in determination of the accrual.

For example, in the financial services industry where bonuses are paid annually but are recorded quarterly, management has a great amount of discretion as the amount of bonus that will be accrued and paid.

Sometimes these expenses will be "managed" to help the company meet or exceed its

earnings guidance

or consensus estimates. What you should look for is consistency in such accruals and if necessary question why those accruals may vary from historical norms.

4. Keep an Eye on Calendar Shifts, Schedules and Deadlines

Notwithstanding what I previously covered about time frame comparisons, we need to be aware of the vagaries of the calendar.

There are several scenarios of how a company's income flows can be affected by calendar. Here are two:

In the retail sector there are shifts in financial data based on when certain holidays fall on the calendar. The most notorious shift is the one which is caused by Easter. Some years, Easter falls in March, while other years, it may fall in April. Quite frequently, it seems that the Easter holiday flip-flops from one month to another in back to back years (though this is not always the case). Why is this important? Most stores are closed on Easter, so a day's worth of sales may be lost and hence shift from month-to-month.

New product introductions can cause blips in income flows. Often, this is most noticeable in the technology sector. For example, when Microsoft introduced its Vista operating system or when Apple was introducing a new version of the iPod. Why this is important: consumers delayed purchases until the new products hit the shelves. This is often referred to as a "product upgrade cycle."

As you can see there are many aspects of a company's quarterly earnings press release or conference call that may give rise to inconsistent or confusing data and "stories."

As always, ignore the headlines and read the details before you draw any conclusions. You are likely to come across many of the situations above. The trick now is to be able to identify those issues when they first occur and incorporate them into your analysis.

Homework Time

To prepare yourself for the current earnings season or the next earnings season, look back at the prior quarter's earnings of your stock holdings, or refer to some of the earnings that I referred to in this lesson.

To stay up to date on earnings news, bookmark and visit TheStreet.com's Earnings section. And to listen to an upcoming (or archived) conference call for a specific company, check out TheStreet.com's Earnings Calendar: Conference Calls page.

At the time of publication, Rothbort was long AAPL and GOOG, although positions can change at any time. Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University. For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.