- There are generalities of what to look for in earnings reports that apply to most companies.
- A company’s executive team will do their best to put a positive spin on earnings, but profit margins may tell you a different story.
- Don’t look at the EBITDA figure, which some executives prefer you look at, but rather look at free cash flow.
On Tuesday, I had a triple serving of earnings reports. Two of the stocks I follow for AAII Dividend Investing, Travelers (NYSE:TRV) and AT&T (NYSE:T), announced their quarterly results. Skyworks Solutions (NASDAQ:SWKS), which I personally own, also released earnings. Compounding matters, the May issue of the AAII Journal was due to the printer. Needless to say, I had quite a bit on my plate.
Fortunately, I've learned techniques from years of analyzing earnings releases to streamline the process. It's not a completely formulaic process since every company has different divisions and statistics. Some even release different documents. AT&T particularly bogs down the process by issuing a press release, two sets of presentation slides and several spreadsheets. Still, there are generalities of what to look for that apply to most companies.
Hone in on Revenue, Earnings per Share and Net Income-The very first thing to do is to determine the rate at which revenues, earnings per share, (abbreviated as EPS) and net income have changed. Have they grown or decreased from the same period a year ago? How do the growth rates for each line item compare to the other two? If profits grew faster than sales, the company's margins widened. If sales grew faster, margins shrank. If EPS grew faster than net income, then EPS was boosted by a reduction in the share count. Depending on how the earnings release is formatted, it can be easier to simply calculate the growth rates yourself.
Compare EPS to Expectations-In any given quarter, about two-thirds of companies tracked by analysts beat the consensus earnings estimate. A miss should be explained by the company. If it's merely the timing of a key order or another temporary event, it may be justified to give the company a pass. If the company simply disappointed and you didn't intend for the stock to be a contrarian play when you bought it, consider whether or not your sell rules are being violated. (Earnings estimates can be found on most financial websites, including AAII.com.)
Examine Margins-A company's executive team will do their best to put a positive spin on earnings, but profit margins may tell you a different story. Look to see whether gross margins (gross profits divided by revenues) and operating margins (operating profits divided by revenues) increased or decreased. Then look through the narrative of the press release to find out why margins changed. If margins narrowed, determine if it is the result of competitive pressures, a change in the product mix or some other factor such as higher raw material costs.
Calculate Free Cash Flow-Not all companies release their cash flow statement with their earnings, but many do. If so, calculate how much free cash a company generated. Don't look at the EBITDA (earnings before interest, taxes, depreciation and amortization) figure, which some executives prefer you look at, but free cash flow. At AAII, we calculate free cash flow as cash flow from operating activities less capital expenditures and dividend payments. It should generally be positive unless the company had a big expenditure, such as a plant expansion, or the company has a seasonal business pattern.
Check Company-Specific Factors-There is no substitute for knowing the company you are analyzing, since key metrics will vary. I specifically looked for the number of postpaid (wireless customers under contract) additions in AT&T's report. (They were good last quarter.) Since Travelers is an insurance company, I was interested in the combined ratio, which measures what percentage of premiums are paid out as a claims. (It worsened because of the winter storms, which wasn't surprising.) I also scrutinized the numbers for the auto insurance segment, since this has been a weak spot for Travelers. (Still disappointing, but a new initiative, Quantum 2.0, was rolled out in many states.) The key here is to figure out what the key trends in a company's business are and then look for the data and commentary in the press release that show how those trends are evolving.
Look Over Other Information-I will read through the earnings press release and scan through the conference call transcript (which Seeking Alpha publishes transcripts of for most companies). I'm looking for color on what is happening with the business and within the industry. If there is guidance, I will compare it to the guidance given in the previous quarter. Some companies may also announce dividends or changes to their stock buyback programs in conjunction with announcing their results.
Keep Notes-Maintaining a log of how a company is performing will help you identify trends as they evolve. These notes do not have to be formal, or even in complete sentences. They only have to be in a form you understand and can quickly refer back to. To give you a tangible example, here are the notes I wrote down for Skyworks Solutions:
Q214 Earnings: Adjusted EPS = $0.62, +29% from $0.48, consensus was $0.590, above guidance; GAAP net income = $76.9 mil, +24.6%; Revenue = $481.0 mil, +13%; Gross margins = 44.1% vs. 41.6%; Operating margins = 21.3% vs. 16.2%; Declared dividend of $0.11, ex-dividend date is May 9.
Q314 Guidance: Revenues +23% to $535 mil, non-GAAP EPS +35% to $0.73; current EPS consensus is $0.628; credits emerging markets (LTE smartphones), key programs, 802.11ac broadband deployment and more opportunities in the Internet of things.
I'll admit that doing this type of analysis does require some time and effort, but less than you might think. I can often get through an earnings announcement in 15 to 20 minutes, including taking notes. By making the effort, I learn what is going on with the company and can better determine if the stock still matches my reasons for buying it.