Never underestimate the power of diminished expectations, or the value of being able to exceed them.
Whether you're talking presidential election debates or earnings releases from Motley Fool HiddenGems recommendation Select Comfort (NASDAQ:SCSS), beating expectations can be a powerful tool. In politics, it can help turn a weak debater into a president. In the stock market, it can turn a less-than-stellar earnings report into an 11% gain.
After a series of earnings warnings that shook the confidence of investors, Select Comfort finally delivered the goods yesterday with its earnings report for the first fiscal quarter of 2005. How good was it? Not perfect, but good enough.
The good news was that the company grew its profits by 18% over the year-ago quarter. The bad news was that it grew sales by 23%. Now, as a general rule, growing earnings at a double-digit clip should merit applause. But also as a general rule, a well-run company should be able to grow its earnings at least as fast as it grows its sales -- and preferably faster. Select Comfort failed to do that this quarter, and even if you look at its results from the perspective of diluted earnings per share (as the company did in the headline for its announcement), share buybacks plus the rounding effect of distilling net earnings into per-share earnings were able to boost per-share profits growth to only 22% (i.e., still short of sales growth).
The profits lag arose from margin deterioration, as the company spent significant sums to grow sales this quarter. Gross margins increased to 69.2%, 640 basis points more than Q1 2004 margins. But increased sales, as well as general and administrative expenses, quickly ate up those gains, bringing operating margins down 40 basis points to 7.9%. By the time profits had reached the bottom line, net margins had contracted 20 basis points to 5%.
The news was better on the cash flow statement, however. There, we saw that GAAP profits for the quarter understated the company's true cash profitability. Whereas GAAP accounting gave the company $8.6 million in profits, Select Comfort actually generated $11.4 million in cash in Q1 -- a $5.5 million, or 93%, increase from the company's performance one year ago.
Now, one quarter's results do not a trend make. Still, the solidity of the free cash flow results, plus the company's declining to give specific short-term earnings guidance for next quarter, give reason to hope that the earnings warnings of past quarters may finally be behind Select Comfort.
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Fool contributor Rich Smith has no position, short or long, in Select Comfort.
