By Joseph Hogue, CFA
Second quarter earnings season is approaching and investors need to assess the stocks in their portfolio for possible surprises. Corporate profits have trended down and first quarter GDP showed the first quarter-on-quarter drop in profits since 2008. Other financial trends and a moderation of economic data over the last few months suggest that earnings may not be as rosy as the street is expecting.
While longer-term investors may not sell positions ahead of a weak quarterly report, there still may be a strong reason to hedge some of the stocks in your portfolio. Even if your long-term assessment of a company's merits is sound, a 3-5% drop due to an earnings disappointment can send sentiment down and cause the shares to fall further on downward momentum. Selling calls or buying puts on the weakest holdings in your portfolio can be a good way of protecting your downside risk.
Looking through some of the shares I have covered or owned over the last year, Avon (AVP) emerged as the most likely to miss earnings expectations. The company is expected to post a gain of $0.22 per share for the second quarter, 55% lower than the same period last year. The shares trade for 11.2 times trailing earnings and pay a tempting 6.1% dividend yield. Despite the discount to valuation, the stock could be in for a strong miss on the second quarter. Avon has missed expectations for six of the last seven quarters on rising costs and falling sales growth and withdrew its yearly guidance last November after saying it was reviewing its operations.
Key Support Turned Weakness
Business in emerging markets, once key support for the company, could present some serious weakness this quarter on weak sales and currency effects. The company books more than four-fifths of its sales outside of North America with Latin America (44%); Western Europe, Middle East, and Africa (13%); Central and Eastern Europe (15%), Asia/Pacific (7%), and China (2%). Consumer spending, especially in larger markets like Brazil, has come down over the last quarter on the worldwide slowdown. Investors are getting used to the constant weakness in European sales but declines in Latin American revenues could hit sentiment drastically.
Beyond weakness in top-line sales, the company has yet to recognize possible losses on foreign exchange translation. Several companies recently warned that revenue would be affected by EM currency weakness.
Procter & Gamble (PG) lowered sales and profit estimates by about 6% on foreign exchange. The household products company derives the majority of its revenue from North America (41%) and Western Europe (20%) so the steep drop in emerging market currencies should not bite as much. Shares fell 3.4% on the day of the announcement and are down about another one percent since. The company announced a five-year, $10 billion cost reduction plan in February that could help to support margins even as consumers cut back due to weak global growth.
Philip Morris International (PMI) also warned and said that foreign exchange weakness could reduce full year EPS by $0.25, about 4.8% of the $5.20 expected gain for the year. The company is separate from U.S. operations so forex fluctuations are especially important, though some regulatory risk is removed. Revenues in 2011 are concentrated in the E.U. with 39%, followed by Asia (26%), EMEA (23%) and Latin America/Canada (12%).
Even with the hit to forex translation, the cigarette producer said profits should be up 10-12% over the year. Earnings are released on July 19th with expectations for $1.34 per share, flat from the same period last year. The company has beaten expectations for 9 of last 11 quarters and shares trade for 16.8 times trailing, about average for the industry.
Latin America was the only region that posted revenue growth for Avon in the first quarter though sales in Brazil, its largest market in the region, fell by 4%. The Brazilian Real has fallen by 13% over the quarter, with weakness seen in most currencies against the dollar. While currency effects are not the company's only problem, they could act to significantly depress earnings.
This contrasts my previously bullish stance on the company. In an article last November, I analyzed previous settlements of the Foreign Corrupt Practices Act (OTCPK:FCPA) and found that the shares were grossly oversold. I closed my position in the shares after Coty Incorporated made their initial bid for shares but did not necessarily have a bearish opinion on the company. While there is some upside potential from a resurface of the Coty bid or a recovery off of lows, I am changing my short-term outlook to negative.
Shares of Avon are down 10% year to date, underperforming competitors and coming 35% off highs for the year. Still, shares could continue downward leading up to and through the July 25th earnings release. Investors should hedge their position or may even take a short position on possible weakness, but may want to book profits on an earnings warning or other downside action. Significant upside risks exist including an acquisition offer by Coty that could resurface and some resolution in the FCPA case.