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How investors should read the numbers in earnings season

As first-quarter reports pour out, look past the earnings to see what really counts, says this Canadian analyst. She has three case studies.

Yesterday, we heard from an expert who warned against the ways and means companies use to fluff up their earnings reports, often at the expense of their balance sheets.

Yet earnings reports, like death and taxes, come around like clockwork. But they have taken on a different character this spring.

There’s not much that can be done to fluff up these numbers. In a word, they’re bad.

So how do you judge? How can you tell which stocks may be perking up and which look like they’ve still got a long uphill climb ahead of them?

Don’t get hung up on the earnings, says Ms. Jennifer Dowty. Look at the company’s guidance, at the goals it has set for itself. And look at the hard economic facts, case by case.

Writing in Investor's Digest of Canada, this portfolio manager studies several specific cases — and she tells her readers that behind all the upheaval in the market, opportunity is waiting.

We’ll look at three companies. Two of them reported their first quarter results just after Ms. Dowty’s report went to press. The other will report next week.

The report card

For the seventh consecutive quarter, U.S. markets will show year-over-year negative earnings growth. Canada’s bad report card doesn’t stretch back quite as far, but it’s nothing to write home about either.

“In both the U.S. and Canadian markets,” reports Ms. Dowty, “the largest declines are expected in the financials, materials and consumer discretionary sectors.”

The number of negative “pre-announcements” from companies is at its highest level in eight years. These early announcements may soften the blow somewhat so that the market doesn’t trash the share price when the actual numbers are released, but they’re still bad news.

This earnings season is sure to increase market volatility, this expert tells us, but that will create opportunities for investors. “Economic data will be increasingly important as a leading indicator to corporate profitability resuming.”

But the economic data that counts most may vary from stock to stock. Let’s get down to cases.

The key issue is debt

Teck Cominco is no more. Canada’s largest mining company is now known as Teck Resources Ltd. (TSX-TCK.B). Perhaps the name change was a way of shrugging off the bad numbers of the past year.

Ms. Dowty traces the bumpy trail of the share price — from $40 in September to $3.42 in early March, and then up to $8 a month later.

“The key issue for investors here is not earnings, but debt,” she states firmly. “Continued news of asset sales and debt restructuring will continue to revive the stock price.”

Sure enough, when Teck’s first quarter report came out shortly after Ms. Dowty penned her report, the emphasis was on a flurry of asset sales.

Revenues were up from the first quarter last year, but net earnings were down. And Moody’s lowered Teck’s credit rating, so it’s certainly not out of the debt woods yet.

But the market appears to believe that Teck’s asset housecleaning is on the right track. From just under $8, the shares have risen to $12.43.

“The bottom line,” wrote the analyst, “I would accumulate shares of Teck at these levels.” And investors are apparently doing just that.

Chinese and Indian contracts

Canadian investors don’t need to be reminded of the wild swings that occur in the shares of Potash Corp. of Saskatchewan (TSX-POT). But it would be handy to know what to expect.

It’s the long-term contracts that count, Ms. Dowty told her readers in Investor's Digest of Canada. This spring, farmers have been delaying fertilizer purchases as long as possible, betting on lower prices.

“Soon-to-be-negotiated Chinese and Indian potash are key drivers for the stock price,” explains the analyst. “If potash contracts are signed at $700 per metric tonne, the stock will soar.” But if they come in at less than $600, the stock will be vulnerable.

When Potash reported, it showed a mixed bag of results. Last year the company had its highest first-quarter earnings per share ever. This year’s earnings were down by more than $250 million, but they were hailed as Potash’s second-highest first quarter ever!

So don’t get caught up in the numbers game, Ms. Dowty suggests, but look for those contracts to come down. The share price continues to hover around $100.

For long-term investors, “Potash represents a must-own core holding,” concludes the analyst. “Shorter-term investors would be well advised to stay on the sidelines.”

Bums in seats

We end up at the movies. Cineplex Galaxy Income Fund (TSX-CGX.UN) has an interest in 130 theatres across the country. During tough financial times, Ms. Dowty observes, people tend to escape to the movies.

“I like this trust,” she adds, “not only because of its valuation, but because the upcoming quarter looks impressive.”

Lots of blockbuster movies are hitting the screens between now and mid-July (including a flood of action movie sequels and a new Harry Potter). Here you’re looking for revenues to climb as more bums go into more seats.

Cineplex reports its first-quarter results just over a week from now, on May 8. Even before then, it gets a thumbs-up review in Investor's Digest of Canada. Ms. Dowty recommends that you accumulate the units of this fund. They are just under $15.

In troubled times, the onset of earnings reports can seem like a plague of locusts sent to spread disarray among investors. But take them one a time, and the sky can look a little bit brighter.