CHAPTER 8: INCOME STATEMENT – MEASUREMENT OF PROFITABILITY

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The Seasonality Factor in Earnings
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The chase for “consistent growth” among the investment community has caused them to lose their rationality to recognise that companies don’t continue to grow their earnings every quarter. I have yet to see a company that can sustainably pull off such a stunt.

In business, there will be seasonality factor in earnings. For retail businesses, the quarters that capture festive seasons will have better performance compared with the quarters without. Locally, retail sales in the first quarter of the calendar year, i.e., January to March (capturing the Chinese New Year period), will definitely be better than sales in the second quarter, i.e., April to June. In this case, a more rational measurement of the retail company’s performance will be to compare the current year’s January to March sales with January to March sales in the previous year. Otherwise, we will be comparing Chinese New Year sales performance with Christmas sales performance.

 Figure 1 shows the quarterly revenue for AEON Co (M) Bhd, the operator of the AEON retail chain, which obviously shows a seasonal trend in sales.

Tomei Consolidated Bhd (“Tomei”), a retailer of gold jewelleries, also suffered the same fate of being tracked on a quarter-on-quarter basis. On 17 August 2017, Tomei released its second quarter result for 2017, which showed higher profits of RM5.64 million compared to RM0.49 million for the second quarter of 2016. Tomei’s share price reacted strongly after the announcement.

Subsequently, on 16 November 2017, Tomei released its third quarter result. Again, Tomei reported positive growth in terms of year-on-year profit – RM1.84 million for the third quarter of 2017 compared to RM0.58 million for the third quarter of 2016. However, its share price reacted negatively. The main reason is that the market viewed the result as “disappointing” when compared with the second quarter of 2017 (profit of RM5.64 million), which really doesn’t make much sense as discussed previously.

Figure 2 shows the movement of Tomei’s share price and the date of the release of its quarterly results.

The sharp observer may notice that in Tomei’s case, in the year 2016, profit still improved from the second quarter to the third quarter; but in 2017, profit actually dropped from the second quarter to the third quarter. Recall that Hari Raya fell on 6 July in 2016 (third quarter of 2016), whilst in 2017, Hari Raya fell on 25 June, which is in the second quarter. This difference resulted in the seasonality effect on Tomei’s quarterly earnings.

The semiconductor industry is another example. New mobile handsets will usually be launched in the months of September and October, to capture sales for the Christmas season. Companies involved in assembling the handsets will start ramping up production from May to June. The component suppliers will be busy at the beginning of the year, while the suppliers of manufacturing equipment to the components makers will start delivering the equipment in the second half of the previous year.

Thus, understanding which part of the value chain a company is sitting at is also crucial for investors to understand the seasonality of the earnings. When earnings improve, share prices tend to rise in tandem.

In the course of writing this book, I was asked this question:

Say a company does badly unexpectedly in a particular quarter (say, the second quarter), which has historically always been the stronger quarter of the year. Would it then be correct to look at the subsequent quarters to see if their business has recovered first before investing?

All businesses will have cycles. The only difference is whether the cycle is a short cycle or a long cycle. No business will grow or perform consistently in a straight line. The answer for this question boils down to how well the investor knows the business. Is the poor result due to temporary setback or is it due to a change in industry dynamics? The former’s effects would be felt in the short- term, whereas the latter would be more worrying.

This concludes Chapter 8. Next posting will be on Chapter 9: Balance Sheet – Measurement of Financial Health. Do not miss it.