Engineering Earnings

By: Chad Hudson | Thu, Aug 7, 2003
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This week's economic data continued to depict an economy gaining strength. However, the stock market has not been impressed as the S&P 500 closed at a two-month low on Tuesday. The bond market has been where the action is and it is amazing how contained the stock market has been given the historic increase in long-term interest rates. Corporate earnings have been in the spotlight for the past month. While corporate earnings managed to beat analyst's estimates, results were not as high quality as was priced into the market. Investors realized that second quarter earnings growth was more a function of cost cutting and favorable currency gains than quality earnings growth.

Monday's release of the ISM non-manufacturing survey revealed that the service sector continued to expand. The survey of service sector business activity jumped 4.5 points to 65.1; this was the highest level since the index was created in July 1997. Strength was led by new orders, which soared 9.4 points to 66.9, which was also a record. Employment registered the second consecutive month over 50 since the first two months of 2001 when the component was trending down. Economic strength has started seeping into the manufacturing sector. Last week, the manufacturing ISM showed expansion in July for the first time since February. New orders jumped 4.4 points to 56.6, a level not seen since January.

Vehicle sales in July jumped 5% from June to a 17.3 million annual rate. Not only was this higher than economists expected, but the highest rate of the year. The Big Three lost 2.2% market share in July from last year. Every month this year, the Big Three have lost market share on a year-over-year basis. Market share has continued to fall even as the Big Three have piled on the incentives. General Motors still offers the largest average incentive, $3,994, but Ford and Chrysler are catching up. Ford's average incentive jumped 7.4% in the last month to $3,986 and Chrysler's soared 12% to $3,958. Even the Japanese automakers have increased their incentives, but still remain substantially below the US manufacturers. Toyota's average incentive increased 15% to $1,132, while Honda's jumped 44% to $805. Nissan only increased its incentive by 6% to $1,492.

Most retailers will report July sales on Thursday, but a few have already reported. While it is an extremely limited sample, so far it appears retail activity in July mirrored auto sales, which indicates the consumer has yet to slow down. Even sales at Costco, which has seen its stock decline over 20% this week, said July same store sales increased 8.0%. Bank of Tokyo-Mitsubishi estimates that July same store sales will be 3% ahead of last July.

With earnings season nearing completion, Ryan wanted to analyze how the weaker dollar helped revenue growth. He also dug into the quality of Cisco's earnings, so without further ado:

We started with the 30 Dow Jones Industrials and looked for the effect of currency gains on top-line growth. Out of the 30 Dow companies only eleven separated revenue growth and currency-adjusted revenue growth. Understandably, this is not a statistically significant sample, but it still proves useful in witnessing how a weak dollar benefits the multinational companies. The results are difficult to ignore. A remarkable 4.8% of the 7.6% (63%) average revenue growth of the eleven companies that reported revenue growth was due to currency gains. Joe Basset of Banc One Investment Advisors summed up the current business climate, "A lot of the top-line growth is still anemic, especially if you consider foreign exchange."

"What components were the biggest beneficiaries of the dollar decline?" one might reasonably ask. IBM achieved 70% of its 10% revenue growth due to currency gains from a weaker dollar. Eastman Kodak would have shown second quarter revenue growth of negative 5% instead of the 1% it did show had currency not been an issue. And of the double digit revenue increase (10%) from McDonald's in the most recent quarter, a full 60% of that was due to foreign currency gains.

Dow Jones: Currency Impact on Q2 Revenue

Component Name Q2 Revenue with Currency Gain Q2 Revenue without Currency Gain Difference
3M 11.0% 5.4% 5.6%
Altria -1.3% -5.7% 4.4%
American Express 6.9% 4.9% 2.0%
Caterpillar 12.1% 7.9% 4.2%
Du Pont 10.0% 5.0% 5.0%
Eastman Kodak 0.5% -5.5% 6.0%
Honeywell 2.0% -2.0% 4.0%
IBM 10.0% 3.0% 7.0%
Johnson & Johnson 13.9% 8.9% 5.0%
McDonald's 10.0% 4.0% 6.0%
Procter & Gamble 8.0% 4.0% 4.0%
AVERAGE 7.6% 2.7% 4.8%

Since many firms hedge their foreign exchange exposure and the accounting data does not require division by division results in home currencies, it is difficult to analyze how currency translation affects the bottom line. Revenue data is all that we have to analyze, at least until 10-Qs and 10-Ks are filed. The results show that companies benefited from outside forces during the second quarter. In order for investors to maintain comfort with second half earnings estimates, companies will have to do a better job at growing revenues.

Last night after the market close, networking solutions provider Cisco Systems released their fourth quarter and fiscal year 2003 financial results. Investors were duly unimpressed, as the stock has declined 6% since yesterday's close. Cisco reported that it had no fiscal year revenue growth and fourth quarter revenue fell by 2.6%. Note these growth numbers are inclusive of currency gains and the incremental revenue from the Linksys acquisition. Revenue guidance for the tech bellweather was equally benign, as CEO John Chambers said that revenues are expected to increase roughly 2% in the first quarter of fiscal 2004.

Cisco's fourth quarter income statement was filled with examples of one-time tricks that are often only lesson in text books. There were several line items that helped boost net income during the fourth quarter that cannot be relied upon for continued growth. Differences in amortization of purchased intangible assets accounted for $178 million of the increase, a decline in research and development accounted for $27 million. Furthermore, allowance for doubtful accounts declined substantially (45%) from $335 million in Q4 2002 to $183 million in Q4 2003 despite accounts receivables jumped by $246 million. Adding all these factors together Cisco's pre-tax income actually declined by 11.1% instead of the 25.2% growth Cisco reported. Furthermore, the repurchase of shares added a cent to Cisco's net income per share.

Cisco Systems

Q4 2003 and 2002 Comparisons in $ millions
    Q4 2003
Income before tax  $     1,373
  less: difference in amortization of  
  purchased intangible assets  $      (178)
     
  less: difference in process  
  research and development  $        (27)
     
  less: difference in interest income  $         62
     
  less: difference in other income  $        (81)
  less: difference in allowance  
  for doubtful accounts  $      (174)
Revised Income before tax  $       975
  Change over Q4 2002 -11.1%

Cisco currently trades at 30 times trailing earnings. This is a company that had declining quarterly year-over-year revenue and used earnings management to achieve Wall Street estimates.


 

Chad Hudson

Author: Chad Hudson

Chad Hudson
Mid-Week Analysis
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