Stock Market Reactions to Earnings Announcements:
Eastman Kodak and Intel (Medium)
For its September quarter of 1998, Eastman Kodak, the imaging products manufacturer, reported a net profit of $398 million, up 72 per cent from one year earlier and in line with analysts’ expectations. However, when it was also revealed that its sales had fallen 10 per cent to $3.4 billion, its stock price dropped 13 per cent.
For the same quarter, Intel, the world’s biggest computer chip manufacturer, reported that its net income of $1.6 billion was much the same as a year earlier, but sales rose 9 percent to $6.7 billion. Its stock price increased by 8 percent after the announcement.
a. Calculate the changes in the net profit margins in the September 1999 quarter over the quarter for the year earlier for both firms. Why would the price reaction be so different to the two earnings announcements?
b. Below is the cash flow from the operations section of Eastman Kodak’s cash flow statements for the first three quarters of 1998 and 1997. Sales were $9.843 billion for the first three quarters of 1998 and $10.759 billion for the corresponding period for 1997. Do these statements provide any information about earnings quality?
Stock Market announcements are regular events in the life of the company. The company needs to align itself with Company Law and SEC requirements by disclosing the required transactions and events as and when they occur to stock exchanges in which they are listed. Various events have various reactions. Share repurchases draw positive reaction while the bad quarterly result draws a negative reaction in the market. This is observed in the price movements of the stock.
a. Net profit margin is the amount of profit generated as a percentage of revenue. A healthy growth over the year is perceived as positive market announcement.
Compute net profit margin for EK as:
Compute net profit margin for I Corp as:
The profit and profit margin of Eastman Kodak has increased on declining sales. The increment in earnings on such declining sales raises red flags and is subject to manipulation as to whether expenses were under-reported. This certainly raises red flag as opposed to Intel corporation and reaction would be negative by market.
Intel corporation is high quality company. It is observed that sales increased and net income has not increased proportionately. It can be due to additional expenses incurred to capture these sales.
Hence, the reaction to this would be positive in the market.
b. The following observations can be made after scrutinizing the cash flow statements which certainly raises red flag:
i. Earnings in 1998 includes one-time gain on sale of business of $107 million which is a big amount.
ii. The cash flow from operations has decreased while the earnings has increased. Hence, the accruals may involve manipulation.
iii. Even though sales decreased, accounts receivable has increased by big amount of $216 million. The receivables need to be checked for quality and ageing analysis.
iv. In 1998, inventory build-up is seen by $334 million. There is also the observation of declining sales. This raises the question as to whether the inventory cycle has increased meaning the firm has difficulty in selling the inventory.