Raw earnings and valuation figures can sometimes be very misleading when taken face value. Not every company can feasibly operate on an earnings cycle that matches up neatly with our calendars and required earnings presentation periods. When evaluating a company, investors must be very careful to look beyond the short-term metrics and calculations to determine whether the earnings investors are seeing in the present are normalized, or represent a point on a longer curve. (To learn more about earnings, see Earnings: Quality Means Everything, Earnings Forecasts: A Primer and Surprising Earnings Results.)
Why Investors See Earnings Cyclicality
Every business model is unique and every industry has its own demand cycles. Investors are accustomed to reviewing earnings releases at the end of the four fiscal quarters of a company's fiscal year.
The Securities and Exchange Commission (SEC) requires that all publicly traded companies release earnings on a standard quarterly and annual schedule. A company can use any quarter end as the end of its fiscal year, which you've probably noticed if you have been reading annual reports for some time. (To continue reading on this subject, see Where can I find a company's annual report and its SEC filings?)
For industries such as consumer retail, a 12-month cycle is a good time period to capture what should be normal earnings for a retail firm. A twelve-month period captures all of the holidays and all of the seasons that occur in a company's business cycle. But for other companies and industries, the matter becomes trickier because earnings cycles can last anywhere from two to five years - and some may last even longer.
Cyclical companies often get a bad rap from the media and the analyst community because these companies can suffer through multi-year periods of market underperformance. This can turn a lot of people away from the stock, and that includes institutional money. But if investors just adjust the way they view and value the company, they can come to see the earnings in a new light, one that allows us to predict earnings growth in the same way investors can for other companies who follow a more normalized earnings schedule.
The Market's Choice
Most company CEOs, if you were to ask them, would definitely prefer to have their earnings cycles be as predictable as possible. Internally, this would make it that much easier to manage costs and cash flows, and also easier to communicate effectively with the analyst community regarding company performance.
Most stocks follow a pattern, especially in the mid- and large-cap categories, which tend to have a longer operating history. Armed with historical earnings and sales figures, industry reports, media publications and analyst reports, investors can see a more complete picture, allowing allow them to view current earnings strength in their historical context. Consider the following example of a market-dominating company that happens to operate in a very cyclical industry, Electronic Arts. (To continue reading on mid- and large-caps, see Market Capitalization Defined, Determining What Market Cap Suits Your Style and The Great Gap.)
Electronic Arts is the largest independent videogame publisher in the world. With a market cap of more than $15 billion, it is the official 800-pound gorilla in its industry and a member of the S&P 500. Consider the 10-year period of 1996 to 2006. The stock rose at a compounded annual return of more than 20% per year, whereas the S&P only grew at around 7% compounded annually during the same period. It is definitely a stock that, looking back, most investors would have to agree they would've liked to own.
However, if investors were to look at the valuation of the stock today, it would appear that the company isn't in great shape, and that investing in it wouldn't be the best decision. The current price-to-earnings ratio (P/E) on the stock is over 72, sales growth has been flat for the last couple of years and margins are depressed. What investors are actually witnessing today, however, is the trough of an earnings curve several years in the making.
Electronic Arts actually exhibits two types of cyclicality: the seasonal cyclicality that investors find with most, if not all, consumer retailers (where investors see a disproportionate amount of yearly earnings coming from the calendar fourth quarter (Q4), when gift buying is at its peak for the year). But ERTS also exhibits multi-year cycles of growth and decline in line with the release of console gaming systems from companies like Nintendo, Sony and Microsoft.
During the initial launch years of a new console, there tends to be a spike in sales and earnings as users purchase new games for their hardware systems. The sales growth after a new launch increases steadily, peaking at about 2.5 years after the initial launch. At this point, news begins to appear about the next generation console systems, and attention begins to turn toward the future. Growth in game sales begins to decline (however, there are still tens of millions of video games sold during these decline years). In terms of sales growth, the figures go from 20-40% year-over-year growth to no growth, or even a negative growth (see Figure 1 and Figure 2 below). Does this mean that during these cyclical decline years that ERTS is no longer a good company to own?
To determine the answer, investors will need to look at the past.
By looking at these charts investors can begin to discern the pattern. The last console cycle began in late 1999, peaked in late 2003 and investors are now in the "trough" portion of the cycle. As investors can see from the chart above, sales growth grew most sharply in the fiscal years of 2001 and 2002, roughly 2.5 years after the initial console launches. And due to the fact that the gross margins for ERTS's products are very high, the effect on net earnings of these sales spikes is even more dramatic.
|Fiscal Year||Sales||Sales Growth||EPS|
If investors look at the total growth in sales from peak to peak (1999 to 2003), it is clear that the cumulative sales growth during this period was just over 100%, which comes out to an average annual sales growth of just over 20%. Even more telling is the story on earnings per share (EPS) - EPS growth during this period quadrupled! The company exhibited the same patterned increase in net earnings during the previous cycle, from 1995-1999. (To learn more about EPS, read Types Of EPS, How To Evaluate The Quality Of EPS and Getting The Real Earnings.)
How do investors use this?
A bit of quick math would tell us that if ERTS were to show a similar percentage increase in EPS in the upcoming console cycle, the company could conceivably (in the best case scenario) earn more than $7 per share by the year 2008 or 2009. Based on today's price levels, that would give ERTS a forward P/E of around 7; even with inflation and other outside variables factored in, the stock would have to rise significantly to reflect the increased earnings. However, investors should always be conservative when making estimates on future earnings because of the inevitable swings the economy and stock market can go through.
For the sake of discussion, let's assume that ERTS only performs half as well in the upcoming cycle as it has in the past. That would bring net earnings up to the level of about $3.75 per share, and it would reflect the patterns of the past while giving us a nice moat of safety around our estimates. Based on the price at which ERTS is trading today, the forward P/E ratio would be roughly 13. By looking at a chart investors can see that in the past, ERTS has traded in a P/E range of 21-30 during periods of peak earnings. In this example, investors could expect the stock to appreciate more than 20% per year from now until peak earnings are reached, or about three years from now.
Cyclical companies essentially have to prove themselves to the market each time a new cycle begins. This creates an opportunity for the investor who is willing to take on greater risks in order to seek above-market returns. If investors just looked at the most current data, they might get turned off from many stocks that could make great additions to a diversified portfolio.
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