Fool.com: What Season Is It? Warning Season[Fool on the Hill] June 9, 2000

FOOL ON THE HILL
An Investment Opinion

What Season Is It? Warning Season

By Bill Mann (TMF Otter)
June 9, 2000

The critics are out in force these days -- ready to chop a transgressing company down at the knees. The majority of all public companies have their fiscal years coincide with the calendar year, which means that they are currently about three weeks short of the end of the second quarter. Now is the time when companies are getting some idea of where they are going to fall in regard to revenues and earnings. And some of them are not going to like what they see.

This has led to a phenomenon that has been granted a really clever name: Earnings Warning Season. Geez, that's almost as inventive as "The White House." My favorite financial calendar term: "Triple Witching." (Named as such because all three classes of options expire on the same day. I don't have much use for options, nor does my investing strategy call for me to take such events into account. But it's a pretty cool name, no?) Companies that have to pre-announce that they will not meet expected earnings are said to be "warning" investors. This is often followed up by a slew of analyst downgrades and a suddenly unloved stock.

Warning season comes each December, March, June, and September. Strangely, warning season is often followed by the official earnings reports that are "in line or ahead of expectations." Well, the lowered expectations, at least.

Today's transgressor, for example, is EDS (NYSE: EDS), which announced overnight that it would miss forecasted earnings this quarter. The reaction was swift and harsh, with the stock plunging 25% today, shaving a cool $5 billion off of the company's market capitalization. The company cited its sales force's difficulty adjusting to a reorganization as the culprit. The company issued a statement saying that the "softness" was temporary and that sales are still strong. The public market seems to disagree, as evidenced by the sharp and immediate drop. One covering analyst called the revenue shortfall inexplicable, given the company's seemingly strong sales.

After a slow start this year, the last few days have seen some significant warning activity: H&R Block (NYSE: HRB), Great Plains (Nasdaq: GPSI), Procter & Gamble (NYSE: PG), and Land's End (NYSE: LE) have all piped up to tell us not to expect what we previously expected. Predictably, each of these companies were knocked down pretty hard in the marketplace, shedding billions in capitalization between them (concentrated in P&G, of course, but nonetheless shareholders in each company have felt the wrath). Why do companies do this? After all, the earnings warning takes on the same gravity as an actual earnings shortfall, and the market reacts just as quickly.

First is liability. In the age of rapid-fire, cookie-cutter class action suits, companies feel compelled to get the information, or the implied information, out as soon as possible. Many a company has faced the music from a plaintiff because they knew, or are believed to have known, that analyst expectations were too optimistic and chose to delay the pain.

Second is one of perception, sort of the myopic "what have you done for me lately" syndrome. If a company warns of an earnings shortfall to guide analysts lower, and then beats those lowered earnings, it may seem like the company is "back on track." This happened with Lucent (NYSE: LU) last quarter, when it warned that earnings would be lower well ahead of the quarter's end. By the time its earnings came out several weeks later, it had already regained almost all of the market losses incurred directly as a result of the warning. (It has since drifted back lower, but that is a different story.)

There are as many reasons for earnings warnings as there are different types of businesses. Still, there are certain environments in which higher numbers of warnings can be expected. It just so happens that this past quarter has many of those attributes. A primary culprit is rising interest rates, as companies that use varying levels of debt suffer from rising cost of capital. Inflation, particularly in raw materials, can wreak havoc upon manufacturers. I've been surprised, frankly, at the lack of earnings warnings from companies that rely heavily on transportation, since energy prices have skyrocketed. Cyclical businesses can be hurt by sudden slowdowns of economic expansion.

But the question is how do we react when companies issue warnings. There is no magic bullet here, unfortunately. Some companies, such as Legato (Nasdaq: LGTOE) or Abercrombie & Fitch (NYSE: ANF), show the first signs of impending and long-term trouble when they issue warnings. The best course of action is also the one that requires some mental gymnastics from investors. If you own or are interested in owning a company that comes out with an earnings warning, the standard rules of thumb apply. Earnings, by their very nature, rarely move in a straight line. If the warnings seem to you to trumpet a change in the underlying business of the company, it may be time to re-evaluate your position. However, if the company still shows balance sheet strength, profitability, and the potential for significant future growth, your position should be secure. And if the market overreacts, as it is wont to do, you can even consider taking advantage of a short-term inefficiency.

But make sure you know what you're doing here. Buying a company "on dips," particularly ones brought about specifically due to earnings warnings, should be done only after significant consideration of the reasons for the shortfall. One should act according to a plan only after taking the time to consider the consequences.

Fool on!

Bill Mann, TMF Otter on the Fool discussion boards

Related Links:

  • H&R Block Gets Squeezed, Fool News, 6/9/00
  • Procter & (Failed) Gamble, Fool Plate Special, 6/8/00
  • Great Plains: Gone With the Wind, Fool News, 6/8/00