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Tuesday, December 1, 1998

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

It's Earnings Warning Season

Achoo! A powerful market-moving event has emerged over the past few years that is now as common as the quarterly earnings season. It's called (as the creativity-o-meter goes berserk) the earnings warning season. During this period, companies that will not meet quarterly earnings estimates announce that a shortfall is imminent. This announcement is generally followed by a round of estimate and rating reductions by analysts and a plunging stock price.

Warning season usually starts about a month before the end of each calendar quarter, give or take a week. That means investors can start bracing for the warnings at the beginning of December, March, June, and September. The season tends to last for a month or so and is then followed by official earnings reports that are in line or ahead of street estimates.

Today's announcement by Twinlabs that its Q4 earnings will fall short of estimates threw the company's stock into a nose drive this morning. Based on past history, we can expect many more companies will be following suit over the next month. Given the dramatic fluctuations caused by these announcements, it might be helpful to see what happens afterward. I have gone back to the Fool News archives to look at three earnings warnings given during the first week of last December to see what has happened since.

First off is Pierce Leahy Corp. (Nasdaq: PLH), the acquirer and operator of document storage facilities. On December 5, 1997, the stock was hit for a loss of $6 9/16 to $15 7/16 after announcing that earnings would fall short of expectations due to increased spending on its sales staff to increase internal growth. In addition, the company noted that it may slow down its acquisition pace because of increasing prices being demanded by sellers.

The day after this announcement, the stock started an ascent that continued through May, when the stock approached $29 per share. The stock then began falling through October, hitting a low of $16 3/4 on September 1. Over the next month and a half, the stock did a round trip, hitting $22 1/2 before falling back below $18 in October. Since that time the stock has rallied with the market, with the stock now trading around $25. As it turns out, the company's investment in sales staff has helped maintain strong sales growth. Simultaneously, the acquisition pace has picked up as the company expended $187 million in the first nine months of 1998 compared to $92 million in the 1997 period. For a one-year Pierce Leahy price chart, click here.

Next is Moneygram Systems. There isn't any symbol for this company because it was taken over by Viad Corp. (NYSE: VVI) this past May. Last December 4th, Moneygram fell $2 13/16 to $10 1/4 after warning that it expected Q4 earnings to be $0.13-$0.15 per share, well below the $0.24 per share expected by analysts. The problem was that volume in the U.S.-to-Mexico money transfer market had declined because of price competition and because foreign currency spreads on those transactions were also reduced. The stock price drifted through late December and then started a rise to $14 in early April. The stock then jumped quickly above $16 when Viad announced the $17 per share acquisition (the deal actually closed in May at $17.35 per share). One advantage of our capitalist system is that predators will pounce on undervalued companies that can strategically enhance their long-term positioning.

Finally, let's look at Western Digital (NYSE: WDC). This major disk drive maker slipped $1 3/4 to $19 3/8 on December 2, 1997, after announcing that it would more than triple the size of a restructuring charge to $85-$95 million compared to previous expectations of $15-$30 million. It also stated that Q4 earnings were expected to be about breakeven, well below estimates of $0.25 per share. This estimate had already been reduced substantially in the prior month, and the stock continued the fall from $54 3/4 that had begun in August. In the month after the December earnings warning, Western Digital dropped even more. It then gyrated with an upward bias, hitting $22 1/16 in late April. From that point, the stock began a plunge down to $7 1/8 on October 15th as breakeven results turned into substantial losses. Since then, the stock has jumped up to $17 7/8 (including an unexplained gain of nearly $5 today). This link goes to a one-year price chart of Western Digital.

No magic formula can tell an investor what to do after an earnings warning. It really depends on the situation. Before deciding what to do, investors should ask themselves whether a company's long-term prospects are altered by the news. Learn about its business strategy, balance sheet strength, profitability drivers, and management adaptiveness. Decide if the news in the earnings warning will affect the long-term prospects. If you believe the company's stock has been knocked down to unfairly low levels, take advantage of the price decline that is brought on by the myopic Wall Street "pros." Don't invest blindly, though. Sometimes an earnings warning can be the start (or continuation) of a string of bad news that flows for years.


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