We plan to continue our "barbell strategy" discussion on Friday. In the meantime, it's timely to take a quick look at some stocks that had disappointing earnings this past quarter that could be buys.
Over the short term, investors will typically have more success buying upside surprises rather than starting a position in an earnings disappointment. The vast majority of our stock recommendations to date fall into the "solid earnings" category.
However, on occasion, it can pay to buy into an earnings disappointment.
When looking to buy into a disappointment, one or more of three factors should be present:
- The conditions that caused the earnings disappointment are transitory and should be resolved in a quarter or two.
- The stock is just too cheap, and the company is a great franchise with very favorable long-term prospects.
- The earnings miss has resulted in such a depressed stock price that it might attract a buyer or force the board to change the company's direction with a focus on enhancing shareholder value.
Here are three companies that fall into one of those categories. All have solid outlooks, and are well-run business but reported first-quarter downside earnings surprises. We are recommending buying into the subsequent stock selloff of each.
Devon Energy (DVN), a leading and highly entrepreneurial independent oil and gas producer, reported disappointing results for the quarter, because of lower realization prices for Canadian crude oil and U.S./Canadian liquid natural gas prices. Core earnings were $1.05 a share, compared with a $1.38 estimate. Very importantly, the company commented that the spreads on Canadian crude oils have returned to more normal levels, so it is very likely that the reason for the earnings miss is behind it.
Nevertheless, analysts are reducing their 2012 EPS estimates by $0.49 a share. At the recent price of $64.35, Devon trades for 11.3x 2012's EPS of $5.72. On the basis of aggressive oil liquids production growth of 7% to 8% per year and an eventual rebound in North American natural gas prices, we believe Devon should earn more than $8.50 per share in the next few years. The firm has a safe North American asset footprint, an industry-leading balance sheet and a shareholder-friendly management team.
Devon has historically traded for 1.6x book value, compared with the current 1.15x price-to-book level. Growing oil liquids production and firming natural gas prices should lead to a solid rebound in company fundamentals and stock price over the next two years. Furthermore, Devon is also at the top of the acquisition list for major oil companies that want safe geographic assets in the rapidly growing North American shale fields.
Emerson Electric (EMR), a major global manufacturer of process controls and industrial automation equipment, reported disappointing operating results for the quarter of $0.74 a share, compared with estimates of $0.80. The miss was due to weak demand from Europe and Asia and increased competitive pressures in network power systems.
Analysts are reducing the 2012 EPS estimates by $0.15. Atypically, the company has missed frequently in recent quarters. It appears that management is very frustrated with this and is committed to doing better sooner rather than later.
At the recent price of $48.70, Emerson Electric trades for just 14.5x 2012's EPS of $3.35. It has historically traded at a premium to the group at 16x to 18x earnings, since it has consistently generated high operating margins and return on invested capital and a more consistent earnings stream. The firm's strong business franchises should see robust revenue and earnings growth over the next several years as emerging markets continue to build out their basic infrastructures.
Lastly, Procter & Gamble (PG), a leading global consumer products company, reported better quarterly results but provided disappointing earnings guidance for the balance of the year because of increased competitive pricing, volume pressures and one-time international charges.
Management lowered 2012's earnings per share guidance to $3.87 from $3.98. At the recent price of $64.25, Procter & Gamble trades at 16.6x 2012's EPS of $3.87, compared with its historical range of 17x to 19x earnings. It also pays a healthy 3.3% and growing dividend. Emerging pressure from frustrated shareholders should lead to further cost-reduction actions.
With Procter, investor disappointment and stock price weakness will probably be catalysts to better things for the company and for the stock.
Again, we like these companies because of their fundamentals and their business prospects over the intermediate and longer term. In the very short term, the disappointments they experienced should be short-lived.
In retrospect, these earnings disappointments will likely prove to be buying opportunities.