Never underestimate the power of diminished expectations.
Pretty much any way you look at it (but one), the third-quarter 2005 earnings results published by specialty printer maker Zebra Technologies (Nasdaq: ZBRA ) last week were disappointing. Sales increased 2.6% for the quarter, but profits per diluted share declined by 5% -- poor results on their face, which appear even worse when you consider that the company bought back 2.5% of its outstanding shares, and therefore it would have been easier to increase per-share earnings (as opposed to firmwide, net earnings) by divvying them up among fewer shares.
That bad news is expected to continue into the company's fourth quarter, with analysts now predicting $0.40 per share in profits, a figure no doubt derived from Zebra's own guidance of $0.36 to $0.41 per share. If you take the analysts at their word, that would result in Zebra's profits stumbling nearly twice as hard in the fourth quarter (they would be down 9% year over year). And if you take Zebra at its word, then the damage could be twice again as bad. A $0.36-per-share result would equate to an 18% decline against the $0.44 per diluted share that the firm earned in Q4 last year.
Which brings us to the diminished expectations part of this article. The reason that Zebra's shares are now fetching 5% more than they sold for before the earnings release is that the analysts' word proved pretty unreliable last Tuesday. Although analysts nailed their revenue prediction for the company ($175.6 million), the Street was expecting Zebra to report only $0.37 in per-share profits. So when Zebra reported $0.41, that 5% decline in year-over-year profitability was interpreted as being good news. Hence the jump in stock price.
To which this Fool replies: Hold your horse-resembling-mammals, pardner. Zebra may have "beaten expectations" on its income statement, but there's additional bad news to report on the balance sheet and cash flow statement. Down there, we see that the company's inventories grew a whopping 17% year over year -- considerably faster than sales. And with all that cash being tied up in unsold inventories, free cash flow (FCF) declined at nearly twice the pace of income. Year to date, net income has fallen 6% against the first nine months of 2004. Free cash flow, however, declined by 11% to $64.6 million. At its current pace of FCF production, Zebra should manage about $86 million this year, and at its current stock price, that means the firm is selling for 38 times free cash flow. In other words, this is one pricey piece of not-quite-horseflesh.
Interested in the concept, but perhaps a different player? Consider Zebra's rivals, discussed here:
Fool contributor Rich Smith owns no shares in any of the companies mentioned in this article.