The Earnings Warning Hiding in Your Mailbox

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If my mailbox is any indication, profits will be pretty slim in the fourth quarter. Call it the junk mail-to-earnings ratio, but the proliferation of ads, coupons, and promos stuffing my mailbox these days means that retailer advertising will be consuming a larger portion of their budgets -- and narrowing their earnings.

Sure, as the Christmas shopping season approaches, we can expect to see an increase in the amount of junk mail flooding our mailboxes. For some companies, it seems that every month is Christmas. Bed Bath & Beyond (Nasdaq: BBBY) has lifted the art of coupon distribution to a new level; sometimes two or three postcards are hitting the mails in a single day.

This ad blitz has shown up in Bed Bath's financial statements. Even as the number of "events" in the latest quarter were the same as in prior years, increases in postage, paper, and productions costs caused selling, general, and administrative expense to rise to nearly 30% of revenue, a 90-basis-point increase over the prior period. With the retailer's same-store sales declining in the quarter, it was spending more, but not getting the same return for the effort.

That influx of direct mail is a direct response to how companies are spending their ad dollars. While Google (Nasdaq: GOOG) and Yahoo! (Nasdaq: YHOO) are enjoying double-digit growth rates in online advertising, traditional media outlets like The New York Times (NYSE: NYT), Gannett (NYSE: GCI), and McClatchy are suffering from a reduction in ad spends. Conde Nast's articulate Portfolio magazine just reported that it was reducing the number of issues it published each year to 10, because of a lack of advertising.

According to media analyst Jack Meyers, while media-based advertising has shrunk to 30.6%, direct marketing has more than doubled its share of advertising expenditures, to 22.8% of communications spending over the past 10 years.

An investor reading a company's financial statements, when they're read at all, may be forgiven if they gloss over the advertising budgets. Ad expenses are generally lumped in with other discretionary items like R&D and SG&A on the income statement. Yet at least one study has found that it may be worthwhile for investors to pay a little closer attention to how advertising dollars are actually being spent.

Companies have long been tempted to use ad budgets to their earnings benefit. There's apparently a large enticement to manage earnings through ad resources -- a maneuver that won't crop up on an auditor's radar as prominently as other, more direct, earnings manipulation tactics will. Moreover, companies that are attempting to massage their earnings will do so in the fourth quarter. Perhaps they feel it will get lost in the Christmas crush.

Even where there's no dubious manipulation, you'll see companies putting greater emphasis on discounts and sales. Look for managers to use euphemisms like "promotional environment" to highlight how much they've been giving away to prop up revenue. Zumiez (Nasdaq: ZUMZ), for example, cut its earnings forecast yesterday, reporting that comps dropped 13% in November as a result of a "highly promotional retail atmosphere." OfficeMax (NYSE: OMX) noted that it tried to protect its margins despite the ongoing discounting.

So as you take in your daily mail and sort between the "read" and "trash" piles (no, your bills don't go in the latter), keep in mind that all those flyers you're getting today may just be typical holiday advertising fare -- or  symptom of a more sinister plan by a company to massage its earnings.