Driving Through Earnings Season

The average investor should watch out for detours and roadblocks in earnings releases.
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Earnings season is a lot like putting an ugly person in a hot car.

The initial presentation is dynamite. But once you open the door and meet the driver, you may be a tad disappointed.

That's because there's a lot of sugar-coating during earnings season. Companies can opt to report only their sexiest numbers. So expect to see Lamborghinis and Lotuses leading the way. The ugly driver is in there somewhere, but he'll definitely be behind tinted windows.

Does that mean the average investor should just ignore earnings releases altogether?

Hardly. If you ignore them, you're essentially saying you can't trust management. And if that's true, you shouldn't have the stock in your portfolio to begin with.

But the long-term investor should just use these releases as information updates, fully understanding the motivation behind them.

Figure Out the Rules of the Road

The biggest reason you shouldn't put too much weight on these releases is that they aren't heavily policed. A company's auditors and the

Securities and Exchange Commission

are not required to review them before they go to print. Even worse, there are no guidelines as to what should be included in an earnings release, so companies have the freedom to include only the most appealing numbers.

Granted, most of the larger companies will ask their auditors to review their press releases, some with more scrutiny than others. But you won't see a note from the auditors saying they've reviewed it and the numbers look good.

So be skeptical. Watch for purposeful detours. If sales are down but the company has two new products in the pipeline, don't be surprised if the release focuses on those two new products.

Also, be on the look out for "pro forma" numbers vs. generally accepted accounting principles (or GAAP) numbers in the release. The pro formas are the numbers a company reports using its own set of assumptions. Often the pro forma numbers are different (read: prettier) than the GAAP numbers. A stand-up company will hold your hand and explain the difference to you.

How Do I Drive This Thing?

"Man, this baby must corner like it's on rails!"

-- Julia Roberts,

Pretty Woman

Just use these releases to further educate yourself. Ideally, you'd like to see increasing revenue, increasing operating cash flows and new products coming down the road.

In the past, investors could look for long-term guidance during earnings season, but that's becoming less prevalent, notes Brad Sorenson, the head sector analyst at Schwab's Center for Investment Research. That's mainly because these days, if the company doesn't live up to its promise, disgruntled shareholders will proffer up a big lawsuit. So, many companies believe they're better off saying nothing.

Still, pull out last quarter's earnings release and see if the company made promises for this quarter. Then check to see if it followed through. If not, are the reasons acceptable to you? Were there fundamental changes in the business that caused the company to report negatively (which could mean more bad news) or did it just hit a bump in the road?

Then look for some trends.

Thus far, this earnings season is turning out to be pretty neutral. No one is reporting anything stellar, yet no one is disappointing too terribly.

"One trend we are seeing is that energy costs are starting to affect the bottom line more than in the past," says Sorenson. "Even in less obvious sectors like consumer staples, energy costs are starting to eat into profit margins." So that's a type of trend to be on the lookout for.

I'll Take the Convertible, Please

All is not lost. There are still some companies out there that are not afraid to take the topdown. Companies such as stalwart

IBM

(IBM) - Get Report

gave the whole story this quarter. So did smaller companies like

Schnitzer Steel Industries

(SCHN) - Get Report

and laser-optics component maker

II-VI

(IIVI)

, says 2nd Opinion Research analyst Albert Meyer.

A good earnings release should include numbers from the income statement, the cash flow statement and the balance sheet. That means revenue, income, operating cash flow, receivables and inventory should all be reported. Otherwise you'll have to wait for the company's 10-Q -- quarterly financial statements reported to the SEC -- to become available to get the true meat of the story. And that could mean your company many have something to hide.

So be skeptical. And read these releases with the proverbial grain of salt.

Just because Julia Roberts sauntered up to that fabulous Lotus Esprit andfound Richard Gere, doesn't mean you'll be that lucky.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

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