Quarterly results can be very misleading. As value investors, we must think long-term and avoid over-emphasizing recent events. Negative quarters for otherwise healthy companies can occur for a variety of economic reasons, including temporary dips in demand or competitor actions. For growing companies, another cause of seemingly poor quarters is expenses that precede new revenues. This appears to be the case for value stock Parlux Fragrances, which saw a drop in price last week following its quarterly earnings release.
Even though accounting principles dictate that revenues and expenses should be matched where possible (i.e. revenues and expenses that are related should be booked in the same period), an accounting principal of conservatism also requires that a number of expenses with uncertain payoffs be booked immediately, even if the revenues are forthcoming.
Advertising is a category of expense that generally falls under this purview, as it would become rather problematic if companies capitalized (and then later depreciated, as if a building) advertising spend, as some management groups would deliberately use this to hide actual expenses.
So when Parlux reported last week that it saw a loss in its first quarter of $2.9 million, the market was unimpressed. Importantly, however, the reason for the loss was a $3.8 million increase in advertising spend to support its new Rihanna fragrance. Management stated that it anticipates recouping all of this quarter's losses in the current quarter. Since we're almost half-way through the current quarter already, management likely has pretty good visibility about what the period is going to look like.
For the full-year, the company anticipates sales of $145 million with a 7% operating margin. If successful at hitting these targets, management will have generated a return on invested capital of almost 8%. This in itself does not represent an extraordinary return for investors, except for the fact that the company's equity can be purchased at a 40% discount to book!
Since the results were published, Parlux came out with a statement that it is in talks to be acquired. Shares rallied 30% on this news, giving investors who took advantage of the quarterly weakness a ridiculously high annualized return not even worth calculating.
Quarterly results can sway markets, but ordinarily they shouldn't sway valuations much. Investors should be sure to understand that expenses are sometimes booked in anticipation of future revenues. Recognizing when this is occurring will save investors from making valuation errors.
Disclosure: Author has long positions in PARL