1/11/2010
By Brian Sozzi, Research Analyst

Do fourth quarter earnings results matter as much as color provided by management teams regarding first quarter to date trends or outlooks for 2010?  How about the balance sheet, does that take on more importance than the income statement?  I would argue that fourth quarter earnings, though shedding light on the recovery likely taking place across corporate America, have but small importance in the grand scheme of things.  Now, if we receive a bunch of important companies (think Caterpillar (CAT), General Electric (GE), regional banks to name a few) missing consensus earnings estimates (which have been revised higher in recent months) than I might be wearing egg on my face.  I am assigning more weight this earnings season to comments made on the conference call as to how trends to start 2010 have unfolded.  How are bookings trending?  Are prices continuing to firm? What is the outlook for commodities in the second half of 2010?  On the topic of commodities, most companies experienced deflation from the middle of 2009 to the end of the year.  If pricing power is scant, and commodity price inflation flow through materializes strongly, then we could be setting ourselves up for some earnings disappointments later this year.

I digress, however.  Detailed below is your investor checklist for the coming earnings season.  One is reasonably assured to hear a bunch of spin from the Wall Street community, so having a guideline into what to look for in a company's financial results is of critical importance.  Personally, I delve into a deeper level of analysis than the checklist I have supplied, but the bullet points are general rules of thumb that are indeed of use in the current economic environment.

Sales
Year over sales comparisons are still skewed as demand dropped off a cliff in the first half of 2009.  Comparisons on a year over year basis do not become of greater use until second 2010 as companies began to experience signs of life in their businesses in second half 2009.  Rather, an investor must pay close attention to sequential sales trends.  Ideally, you want to see an acceleration in growth rates from the rates in the first half of 2009.  Every industry is different, keep this in mind.

Gross Margin
The profit remaining after cost of goods sold are subtracted, the percentage should be up sequentially on sustainable factors such as (1) pricing power, (2) new manufacturing processes, (3) closure of underperforming manufacturing plants, (4) improved sourcing capabilities, or (5) evolution of transportation methods.  The 8-K releases generally won't have the finer points of the business, meaning you need to listen into the conference call to hear how management is steering the company in still turbulent economic conditions.

Operating Expenses
While I was looking for lean expense bases from the companies I cover in 2009, I am shifting my focus ever so slightly.  Companies adding expenses, in the form of new workers, greater research capabilities, and matching 401k contributions are companies I perceive to be in good financial standing and have a solid outlook for the future.

Obscure Measures

* Net working capital: I still want to observe companies promptly collecting accounts receivable, staying disciplined on inventory, and squeezing their supplier base to keep cash in the business.  Combined with a tight cap ex requirement, the company should be able to generate strong free cash flow if working capital is well managed.  Free cash flow, in turn, could be returned to shareholders via dividends (I expect to see dividends stage a comeback in 2010, either through raises or reinstatements) and share repurchases (I also expect this to resume as companies have a ton of cash on the balance sheet and given valuations where they are, management teams may decide the best investment is in their own company's shares).
* Cash: It's no longer enough for a company to have a nice chunk of cash relative to capital.  At this point in the economic cycle (recovery), firms should be growing cash after a year plus of managing for the worst of times. 

Brian Sozzi
Wall Street Strategies