Earnings: A season of hollow victories

Summary:A lot of companies are beating earnings estimates--but only after delivering profit warnings. A peek behind the numbers, however, shows not all is as rosy as they would like us to believe.

Topping earnings estimates just isn't what it used to be.

Judging from earnings tracking firm First Call's running tally of better-than-expected earnings, a lot of technology companies are busy ringing up hollow victories--earnings that beat consensus estimates, but only after profit warnings.

According to First Call, topping previously lowered expectations still counts as an "upside surprise," which occurs when a company's earnings pleasantly surprise Wall Street. "As long as the earnings top the consensus estimates at the time they report, it counts," a First Call spokesman said.

Here's how it works in practice: Company A issues a profit warning, and Wall Street analysts adjust their financial models to reflect the new outlook. These estimates wind up in First Call's database. Company A reports earnings of a few pennies better than the lowered estimates and looks good. The press runs with "beats estimates" headlines, and some traders forget that the company was expected to do a lot better just a few weeks ago.

So far this earnings season, technology companies on the Standard & Poor's 500 have at least hit their earnings targets 94 percent of the time, according to Morgan Stanley. That kind of statistic would normally cheer investors, but there's a big caveat in 2001.

"Earnings reports by S&P technology companies have generally exceeded consensus estimates, but largely because preannouncements had beaten expectations down," Merrill Lynch strategist Christine Callies said in a note to clients.

Toss in pro forma earnings, which exclude charges that could cut into the bottom line, as well as other subtle accounting changes, and the whole concept of what constitutes an upside surprise gets murky, analysts said.

In fact, many analysts are toning down the focus on whether companies meet or beat estimates. "If a company lowers the bar and earnings are down from a year ago, you're not a hero if you top estimates," said Brent Bracelin, an analyst with Pacific Crest Securities.

Examples of hollow earnings victories in the tech sector aren't hard to find. Intel's second-quarter earnings were 12 cents a share, topping estimates by 2 cents a share, but sales were down sharply from a year ago. But in First Call's running tally of positive surprises, the chipmaker was among the top technology companies impressing Wall Street.

A peek behind the numbers, however, had a lot of analysts pooh-poohing Intel's bottom line, excluding charges.

Analysts said Intel gained a penny a share from a lower tax rate. Most analysts calculated Intel's estimates assuming a 30 percent tax rate. Intel actually had a 20 percent tax rate.

"New-age EPS (earnings per share) of 12 cents beat our 11 cents forecast because the implied tax rate of 20 percent was far below our 30 percent model," said SG Cowen Securities analyst Drew Peck.

On its recent midquarter conference call, Intel stuck with its outlook for the second quarter but had already cut targets when it reported first-quarter results. Because of the fluid nature of beating estimates these days, analysts tended to focus on Intel's outlook to report revenue between $6.2 billion to $6.8 billion in the third quarter.

Peck said Intel's on-the-mark earnings might "be a relief to nervous investors" but noted that the chipmaker's wide revenue target indicates the company is unsure of how things will turn out.

Tellabs was another company that issued a profit warning only to top lowered estimates when it reported its second-quarter results. Tellabs reported a pro forma profit of 2 cents a share when Wall Street was expecting break-even results.

Were analysts impressed? Hardly. Analysts dutifully noted that Tellabs beat estimates, but they also highlighted that the company couldn't provide much of an outlook. The "lack of visibility should spook investors," said Dresdner Kleinwort Wasserstein analyst Eric C. Buck, who maintains that Tellabs is a good investment in the long run.

EMC was another company in the hollow victory club, analysts said. There weren't many surprises in EMC's second quarter--largely because it surprised investors June 6 with a profit warning. The company reported earnings excluding charges of 5 cents a share, matching estimates.

EMC executives were mum on the outlook for the future, largely because the information technology market is moving too fast to get a read.

The current economic outlook and the fact that few companies can predict their earnings and sales have forced analysts to focus on more than how a company compares to First Call estimates.

"We're looking at trend lines and less at earnings expectations," said Bracelin, who covers RealNetworks, a company that missed estimates. "You could say it's a forced exercise, but we're moving away from the hypersensitivity to estimates and focusing on the health of a company."

Topics: Intel, EMC

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