There are various "tricks" or actions that some public companies will use or set in motion to pull the wool over the investment community's eyes come earnings season—particularly when a company misses estimates or otherwise disappoints investors. Analysts and managers typically set their guidelines and estimates based on the results reported by firms during earnings season, and they often have a significant role in the performance of their stocks.
Let's take a look at five of the most common shenanigans that management and communications teams use in their companies' releases.
1. Strategic Release Timing
Communication teams looking to "bury" a bad earnings report (or bad news in general) will sometimes seek to disseminate the release when it suspects the least number of people are watching. One trick that was frequently used in the mid- to late-nineties was to release information after the close of the market on a Friday afternoon. Sometimes the release was issued heading into a holiday weekend, or on a day when a variety of economic data was due for release and the spotlight wasn't on the company.
In today's markets, it comes down more to the general timing of a release rather than a specific day of the week. A company might plan to announce their earnings after hours when there is typically a lower level of investor attention being paid. Conversely, in order to minimize scrutiny on a bad report, the numbers can be scheduled for release on a day where there are already hundreds of other companies reporting, and markets are distracted.
Some companies might announce a positive development during times of bad news. They might announce a major new customer, large order, store opening, product launch, or new hire around the same time that bad news is released. Again, the idea is to convey the image that things aren't that bad.
Don't be fooled: Reading the small print in a company's footnotes and the hidden news stories can help you uncover a stock's real story.
2. Cloaking Their Communication
In the interest of full and fair disclosure, companies are required to disclose both the good information and the bad information about a given quarter in their earnings reports. Their communications teams, however, may attempt to bury the bad news by using phrases and words that mask what's really going on.
Language like "challenging, "pressured," "slipping," and "stressed" should not be taken lightly and could even be red flags.
For example, rather than say in a release that the company's gross margins have been declining and that as a result the company's earnings may get pinched in the future, management may simply say that it "sees a great deal of pricing pressure." Meanwhile, the investor is left to calculate gross margin percentages from the provided income statement, something that few retail investors have time to do.
You'll also note that the information a company doesn't want you to see tends to be located somewhere near the bottom of the release, and could be coupled with other information as well. As an example, some company teams may talk about all of the new products they anticipate releasing in the coming year (in the announcement) or other upbeat, forward-looking news, and then say what investors can expect in terms of earnings in the future period.
Since the earnings expectations are not a standalone item (but are bunched with other information) and the average investor may have nothing handy to compare the company's forecasts to (such as the current consensus number), the communications team wins by burying the news and distracting the public.
3. Enhancing Preferred Information
Some companies' investor relations teams will bold or italicize headlines and information in an earnings release that they want the investment community to focus on instead of the actual results. This isn't a trick designed to fool you, but it can take advantage of reader laziness. Investors should try not to be mesmerized by the highlighted data and should read the entire release, as well as look for future guidance if provided.
Investors should also not be so consumed with a bolded headline that says (for example), "Q3 EPS Increases 30 Percent" that they forget to read between the lines. Play detective and read into what management is saying and forecasting about future periods.
4. Use of Non-GAAP Measures
A company's executive management can also cite non-GAAP accounting measures designed to strip out or add in certain items. GAAP is an acronym for generally accepted accounting principles (GAAP) and is a set of accounting standards, principles, and procedures. Publicly-traded companies must adhere to GAAP when compiling their financial statements.
However, non-GAAP financial measures also can be included in an earnings presentation. These financial metrics might show a company's revenue based on its core operations by excluding one-time costs. Companies might exclude the costs of their employee-stock program, for example. Again, these measures are not deceptive, but they can show the company's numbers in a more positive light. Examples of non-GAAP measures include:
EBIT or earnings before interest and taxes is a non-GAAP measure of earnings. A management team might highlight their growing EBIT over several quarters. However, if the company has a lot of debt, its interest expense might be significant. As a result, EBIT would look far more favorable than net income, which includes interest expense in its calculation.
Cash Flow and Free Cash Flow
Cash flow and free cash flow are two popular metrics that investors, analysts, and company executives monitor closely. Cash flow is the net amount of cash that has been transferred in and out during a period. A company with positive cash flow has enough liquid assets–meaning they can be easily converted to cash–to cover debts and financial obligations. Cash flow is reported on a company's cash flow statement and broken down into three sections; operating, investing, and financing activities.
Companies can cite positive cash flow figures during an earnings presentation. However, if the company sold an asset, such as a division or piece of equipment, it would show a positive cash entry, inflating the cash reported for the period. Selling assets is common by companies that need cash to meet their dividend obligations. It's important that investors also examine free cash flow, which is a company's cash flow without capital expenditures, such as buying and selling of fixed assets.
5. Increasing Stock Buybacks
While stock buybacks are often a good thing, some boards will authorize a buyback as part of an effort to make their stock appear more attractive to the investment community. These boards and their companies may have every intention of completing such a repurchase. Still, you might notice that companies tend to announce such repurchases in conjunction with or just after bad news is released. It's important that investors monitor the timing of such announcements to ensure that the company's boards and executives are not trying to bolster the stock price during times of poor performance.
Although investors typically cheer when stock buybacks are announced, an analysis is warranted to break down the buybacks to determine whether the company has the cash and revenue generation to fund the repurchases.
Buybacks and EPS
Earnings per share (EPS) is a company's profit or net income minus dividends paid to preferred shareholders and divided by the number of shares outstanding. Companies can use buybacks to inflate EPS. For example, let's assume a company has no preferred dividends and reported earnings of $18 million. If a company has 10 million shares outstanding, the EPS was $1.80 for the period ($18 million /10 million shares).
Let's assume that the company's earnings haven't changed in the next period and reported $18 million in earnings. However, the company's management decided to buy back 3 million shares. The company's EPS would be $2.57 for the period ($18 million / 7 million shares). All else being equal and without generating any additional profit, the company posted a higher earnings per share in the second period.
Investors need to be aware of how companies can improve their earnings and financial ratios reported during earnings season. There are many tricks and financial transactions that companies can employ to help improve their reported earnings during a period when the company was performing poorly. It's important for investors to develop a strategy or approach when it comes to analyzing a company's earnings and whether the company hit or missed its target.