Earnings Hit, Sales Miss: When Momentum Models Go Astray

Earnings surprises are a signal in virtually all momentum systems. Unfortunately, earnings surprises give false signals when earnings quality is low, or when "surprises" are due to low-ball guidance. Both of these factors are at work in the second quarter, as the data below demonstrate.

EPS Hit, Sales Miss

Seeking Alpha contributor J. Clinton Hill has a very useful table on his Hillbent website: The Daily Earnings Surprise Summary. As you'd expect, it ranks the daily earnings surprises from best to worst, and it also shows reported sales vs. expectations. 62% of the 145 firms that reported results yesterday, for example, had positive earnings surprises. Only 32%, however, reported positive sales surprises (the data pool is smaller, since only 87 firms had sales estimates). Overall, earnings met expectations, but sales fell short.

Negative and Positive Sales Surprises

The list below shows firms that had double-digit sales shortfalls (revenues came in at least 10% below expectations):

1. -33% Sunoco Logistic (SXL)
2. -17% Commerical Vehicle (CVGI)
3. -17% Westell Tech (WSTL)
4. -16% Platinum Underwriters (PTP)
5. -13% CH Robinson Worldwide (CHRW)
6. -11% Peabody Energy (BTU)
7. -11% Cemex (CX)

The following firms had double-digit positive surprises (revenues beat expectations by 10% or more):

1. +41% Mueller Industries (MLI)
2. +32% Yahoo! (YHOO)
3. + 30% Jeffries Group (JEF)
4. + 19% Advanced Micro Devices (AMD)
5. + 14% Dr. Reddy's (RDY)

The Current Rally Reflects Naive Momentum Models

In March we had a reflation rally, as monetary and fiscal stimulus prevented a complete market meltdown, and as investors spotted some green shoots. Since July 13, positive earnings surprises have driven stocks higher. This has made it a frustrating earnings season for me: I've been right about the fundamentals (strong earnings, weak sales), but wrong about the market reaction (bullish, since investors focused on EPS, not sales). Positive earnings surprises are generating lots of bullish signals for momentum models, and this is driving stocks higher.

At this stage in the cycle, corporate earnings leverage is driven by cost-cutting, which generates "surprises," but makes for lousy earnings quality. (I guess positive earnings surprises are easy when you fire 10% of your work force.) Looking ahead, this rally sets us up for disappointment, since a company cannot "shrink its way to prosperity."

Disclosure: No positions in securities mentioned.

Comments

[Nick36]

When a company gets better than expected earnings while its sales are falling. Then this probably means that the company is stuck with a large inventory from previous production.

And that's where the company's better than expected earnings come from. The company can temporarily stop producing its stuff and continue to sell its excess inventory. Which results in a one-off positive earnings surprise. Because the excess inventory they are selling didn't cost anything to produce in the current quarter.

Cutting back on production in order to sell off excess inventory produced earlier creates an artificial earnings surprise. Because the cost of production is recorded in earlier quarters, while the sales proceeds are recorded in the latest quarter.

Excess inventories don't last indefinitely. Sooner or later the company has to start producing more of the stuff it sells. And when that happens. Then the true picture of the company's profitability emerges.

2009 Jul 22 10:12 PM

[Henry Buttal]

Nick36,

I think that is a little oversimplification of the accounting involved - LIFO, FIFO, Averaging, etc.

It is true there are some cost advantages, but they are in most cases not as straight forward as made it earlier, selling it now.

Most of the savings companies are recognizing are from reduced work hours, cut marketing and sales cost, and of course, layoffs.

2009 Jul 22 10:32 PM

[Nick36]

I suppose, I don't know that much about accounting. But the thing is that companies with excess inventories can temporarily lay off their workers in order to sell off their excess inventories. And then they will bring back these workers once the inventories are at more reasonable levels.

And such a temporary lay off of workers produces a one-off cost saving that won't be in play next time the company reports its earnings.


On Jul 22 10:32 PM Henry Buttal wrote:

> Nick36,
>
> I think that is a little oversimplification of the accounting involved
> - LIFO, FIFO, Averaging, etc.
>
> It is true there are some cost advantages, but they are in most cases
> not as straight forward as made it earlier, selling it now.
>
> Most of the savings companies are recognizing are from reduced work
> hours, cut marketing and sales cost, and of course, layoffs.

2009 Jul 22 10:43 PM

[sethmcs]

Reductions in inventory, accounts receivable result in improved cashflow. If sales fall accounts receivable and inventory should fall as well. Be very careful if sales fall and accounts receivable and inventory rises. Cash flow will be reduced. With tight credit markets reduced or negative cashflow can result in failure.

2009 Jul 23 12:29 AM

[Robert Martorana]

Henry, Nick, and Sethmcs:
Thanks for your comments. Inventory reductions might well be another temporary boost to earnings. Inventory reduction can give a one-time boost to earnings and cash flow (and the balance sheet, via receivables). I would love to see more info on inventory reductions during the second quarter, esp. the different impacts from LIFO/FIFO and cost averaging.

2009 Jul 23 06:52 AM

[Old Trader]

"And such a temporary lay off of workers produces a one-off cost saving that won't be in play next time the company reports its earnings."

Nick36,

That's exactly why I, as well as many others here on SA, aren't putting a lot of faith in the beats that have been announced over the last week, or so (to say nothing of numbers issued by financials reporting under revised, and MUCH looser guidelines).

2009 Jul 23 09:21 AM

[Robert Martorana]

Old Trader: I agree, and I think the media have missed the obvious conclusion about this rally: Momentum models are easily fooled.


On Jul 23 09:21 AM Old Trader wrote:

> "And such a temporary lay off of workers produces a one-off cost
> saving that won't be in play next time the company reports its earnings."
>
>
> Nick36,
>
> That's exactly why I, as well as many others here on SA, aren't putting
> a lot of faith in the beats that have been announced over the last
> week, or so (to say nothing of numbers issued by financials reporting
> under revised, and MUCH looser guidelines).

2009 Jul 23 09:39 AM