Wednesday, July 8, 2009

Profits Are Profits

When companies report earnings, analysts will often focus on how profit expectations were met, rather than what those numbers are. For example, even if a company beats earnings expectations, if revenues came in lower than expected, this is often viewed as a bearish sign. Similarly, earnings misses accompanied by higher revenues are often considered positive. However, this line of thinking sorely underestimates the value of a flexible cost structure.

After all, if profit expectations were beaten while revenue came in lower than expected, this means that costs were likely much lower than expected. A company that can control its costs is a company that can outlast its competitors when revenues unexpectedly fall, as they often do in recessions.

Furthermore, higher revenues and in-line earnings suggest that margins have degraded. This could be a sign that the company has had to offer incentives to customers in order to move products. Instead, investors should look for companies that have the ability to reduce or increase costs depending on revenues. This leads to higher predictability and therefore higher accuracy in determining whether a margin of safety exists.

As an example, consider Goodfellow (GDL), a stock we have discussed on this site as a potential value investment. In its most recent quarterly results ended May 31st, revenues dipped by about 15% from year-ago levels. Yet the company showed profits of 24 cents per share versus 20 cents one year ago. How did it do this? By paying down debt (and therefore reducing interest costs) and by slashing operating expenses: gross margin actually increased which is very rare when revenues decline, as fixed costs are spread out across fewer sold units.

One thing to keep in mind, however, is that revenues are more difficult (for managements) to manipulate than costs. However, manipulating revenues is far from unheard of, and as long as the assumptions used to calculate costs are reasonable, the arguments in this article still hold.

For a discussion on various points to consider when analyzing a company's cost structure, see here.


Anonymous said...

Granted that a cheap stock is a cheap stock, do you guys find that the Canadian stock market has more small cap value stocks than the US market? Or is it just that you are in Canada and have easy access to the market?

Saj Karsan said...

Canadian and US stocks tend to have some general/typical differences, but you can find value in each market. You probably see references to a lot of Canadian stocks on this site because being Canadian it limits our currency exposure, but I have no preference other than that.