A Penny Shaved Is a Penny Earned


By Amey Stone As the second-quarter earnings season enters its final weeks, a lot of companies can boast of beating Wall Street earnings estimates -- even if it was by just a penny. Despite the weak economy and sliding corporate earnings, the list of one-cent beaters includes such widely held stocks as AT&T (T), Citigroup (C), Duke Energy (DKE), Juniper Networks (JNPR), Motorola (MOT), Pfizer (PFE), Siebel Systems (SEBL), Texas Instruments (TXN), and Yahoo! (YHOO) -- just to name some.

In a way, it was to be expected. "Companies keep updating analysts, so when the actual earnings come in, it is very close to estimates," says Robert Willens, a tax and accounting analyst at Lehman Bros. It falls under the general rubric of "managing expectations," which is hardly new in Corporate America.

It is, however, much more visible now, thanks to a securities law enacted in 2000 and known as Regulation FD (for "fair disclosure"). The law requires companies to release earnings guidance to the public at large -- not just to a few select analysts.

In the current weak economic environment, many companies have had to tell analysts -- sometimes more than once -- to ratchet back their expectations. A near-record 850 companies issued warnings prior to the second-quarter earnings season, according to Thomson Financial/First Call.

LOW EXPECTATIONS. More so than in the recent past, though, there is at least the appearance that companies may have intentionally low-balled estimates. If they are doing so, it is to make sure they hit their numbers (consider that coming in even a single cent below estimates can be mighty perilous to a fragile stock price). Beating estimates, even by as a little as a penny, creates an opposite impression -- a rosy one.

With 400 of the S&P 500 having reported, no fewer than 63 companies beat estimates by a penny a share, according to First Call. And while the percentage of companies besting Wall Street numbers is running similar to other quarters, at about 56%, companies are topping estimates by a smaller amount -- a mere 1.7% on average. Smart investors will take note of this phenomenon and do a little more homework as they scour the current market.

Not that there's anything untoward or illegal about finessing expectations. "It's always better to underpromise and overdeliver," says Rich Moroney, editor of Dow Theory Forecasts. "They may be allowing themselves a little bit of wiggle room, or they may be setting expectations to a level where they can beat them," he says.

NOT GOOD ENOUGH. In some cases, it may not be enough to merely meet analysts' earnings estimates. AOL Time Warner (AOL) essentially met estimates when it reported July 18, but because revenues were lower than expected, the stock that day plunged $4.80, or nearly 10%, to $44.65 a share. It has since climbed back to $47. Likewise, Colgate Palmolive (CL) met analysts' estimates on July 23, but the stock fell when analysts worried that earnings gains came mostly from cost cutting. At $53 a share, it is still down about 5% since reporting.

In more than a few instances, companies that had warned or announced they couldn't make analysts' numbers then turned around and bested the lowered estimates. For example, Check Point Software Technologies (CHKP), a leading security-software firm, announced preliminary results of 32 cents a share on July 3. Then, on July 23, it reported earnings of 33 cents a share. After the announcement, the stock quickly jumped $2, or about 6%, to $37.50 a share. Since then, it has climbed to $43.

Of course, no one knows which companies are doing this and which aren't. First Call's Director of Research Chuck Hill notes that in this environment, some outfits may be tempted to set the bar a little low, making it easier to reach. Hill frames the question this way: "Is where I want [analysts' consensus estimates] a penny below what I am going to do? Or the exact number?"

Wall Street itself has played a hand in the game of managing expectations. On June 8, Juniper Networks said it would earn 8 cents to 9 cents a share, on a pro forma basis. Analysts cut their estimates to 8 cents, then cheered the company when results came in at 9 cents on July 12. That scenario has played out more than a few times.

PRO FORMA FORMS. All this is a far cry from the height of the bull market and the economic boom, when quarterly results at most times seemed too good to be true to investors and corporate executives alike. These days, more companies are not only telling analysts what to expect, but how to calculate earnings. Many are devising their own pro forma measures of operating results. In essence, this means whatever basis happens to cast the company in the best light.

It should be the job of the analyst to calculate operating earnings in a way that makes the most sense, says Hill. But he says many are failing to do so: "I'm afraid that, in a lot of cases, the analysts have fallen down on the job and are blindly accepting what the companies put on the release."

Analysts bristle at such charges, arguing they are doing their job by acknowledging special factors that may be influencing a company's quarterly performance. Far more problematic, though, is the possibility that rather than just managing expectations, some companies may be managing earnings.

In order to meet or beat Wall Street's expectations, they might delay a major expense for a couple of days or speed up recording a sale near the end of a quarter in order to generate an extra penny a share. Says Willens: "In the current climate, there may be some added degree of pressure to do that, given the market environment and how badly stocks are punished for missing estimates."

GAMESMANSHIP. The danger comes in the following quarter, when earnings are lower or may seem less consistent because the expense is paid or the sale has already been registered. "What investors want to see is steady 10% growth without playing games," says Moroney, not earnings that grow 13% one quarter and then only 7% the next. In recent years, the Securities & Exchange Commission has vowed to crack down on companies that manage earnings. Getting caught can do major damage to a company's credibility.

As for the practice of beating estimates in hopes of giving the stock a bump, let's just say there's no lack of room for gamesmanship during earnings season in an economic downturn and a sluggish market. "As an investor, you just need to know that there is a wide degree of latitude in what these companies want to report," says Moroney. Sure, it is good news when a company can beat expectations. But maybe, just maybe, beating them by a nose shouldn't really count for much these days. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.

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