Don't Get Blindsided By Earnings

SAN DIEGO – From the "don't get blindsided" file: With yet another earnings season about to blow through, it's time for investors to figure out if what they see is really what they get. This is where understanding nuance can help spot unexpected surprises before they happen.

There is no simple crib sheet on what to watch for. But with the benefit of hindsight from some recently reported results, and a peek at a few on tap, here are four situations that should get your attention if they show up at any company whose stock you own:

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What goes in, doesn't come out. Sounds simple enough, but it's actually quite complicated, especially for a company like Palm Inc. (PALM) , maker of the popular Treo phones. Rather than book revenues when products sell through to consumers, Palm does what many consumer product manufacturers do: It records a sale when its phones ship to retailers or, in this case, wireless carriers like Verizon Wireless.

That policy works well when retail sales are brisk but can backfire when they're not as robust as expected. That appears to be what in part happened in Palm's recently reported fourth fiscal quarter -- the first full quarter for sales of its new Treo 700 series. The phones generated good press, with Palm experiencing the strongest unit shipments ever. But sell-through actually slipped slightly from the prior quarter. Palm executives cited several reasons for the lack of sell-through, and (not surprisingly) guided to a fiscal first quarter that is below expectations. "The guidance we gave is based on the velocity as we see it," a spokeswoman says.

Melting margins. This should be the worry of investors in every semiconductor stock, especially if the company in question has lots of competition, which means its customers have a choice of suppliers. "Falling average selling prices are not necessarily a bad sign," says Paul McWilliams, editor of nextinning.com, a newsletter that tracks tech stocks. "A trend of falling operating margins is."

Witness the 20%-plus slide in the rocket-like stock of OmniVision (OVTI) after the company recently reported an across-the-board sequential fourth-quarter slip in gross, operating and net margins. The company, which makes image sensors so cell phones can take pictures, attributed the change to "a shift" toward lower-margin chips. McWilliams adds, "We are going to see consolidation in the image sensor space and the largest companies will likely have competitive advantages." That might mean more tough news for OmniVision. An OmniVision spokesman didn't respond to written and telephone inquiries.

Signing up customers at any cost. With Internet companies, one of the toughest decisions is how much earnings growth to sacrifice for the sake of acquiring customers. Netflix (NFLX) has bragged that it'll have 20 million customers by 2012; that's about four times the number it had at the end of its first quarter. The company has been equally brash in saying that "if we are running ahead on full year's earnings guidance," it'll spend aggressively to drive faster subscription growth.

Therein lay the possible surprise: Analyst consensus expects 2007 earnings-per-share growth of more than 80 percent. But to reach the company's subscription goals, Thomas Weisel Partners analyst Gordon Hodge raised his estimate of marketing expenses, in turn prompting him to slice his 2007 earnings estimate to 65 cents a share from 90 cents. Netflix itself hasn't provided 2007 guidance.

While that would still represent impressive annual earnings growth of 44% over 2006 consensus, Mr. Hodge told clients he believes a shortfall of that magnitude "may surprise investors somewhat." A spokesman for Netflix, which reports second-quarter results on July 24, says the company didn't provide any special insight or comment to Hodge and doesn't offering any guidance on the subscriber acquisition costs.

Quarter-end announcements. Last-minute deals that somehow puff up some part of a company's performance are always worthy of suspicion. Take, for example, Biolase Technology (BLTI) , which makes dental lasers. On June 29 -- just before quarter's end -- it announced a strategic relationship with Procter & Gamble (PG) . Biolase offered scant detail, though it did disclose that it immediately received an initial payment of $3 million in return for granting P&G rights to some of its intellectual property.

The company said the timing of the deal wasn't tied to any cash needs. Good thing, because there's a catch: According to a regulatory filing, this is merely a binding letter of agreement, and the license is "provisional." The two sides still need to hammer out a definitive agreement. If the binding agreement is breached or terminated, the filing says, Biolase will have to return the $3 million.

All of which is a long-winded way to say: When it comes to earnings, it's quality, not quantity, that counts.

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