Have big earnings season moves made way for opportunities?

We’ve reached the end of earnings season. It’s a half yearly occurrence where self-proclaimed long-term investors are given the opportunity to overreact to short-term results while traders try and profit from guessing the direction of this overreaction.

Earnings season is a time where business results create the clearest connection that stocks represent ownership stakes in a business and not just a nebulous concept. Morningstar’s equity analysts pay close attention to earnings, but the focus is on how they inform our view of long-term outcomes and the valuations of the companies in our coverage universe.

A single earnings report usually doesn’t lead to a change in the long-term assumptions behind our assessment of a share’s fair value. Exceptions are material information that changes our long-term assumptions. For example, new data on a drug that raises the probability of approval, or signs of pricing powering a key product line that could impact our assessment of long-term margins.

The paradox of being an investor is that the only thing that matters is what a company achieves in the future. Yet, all the information we have is historic. Many investors place outsized importance on earnings season as it shows how companies, and their investments, performed. Although interesting, it defeats the purpose of investing as we should not place undo emphasis on what happened in the past. Our focus should remain on the future.

Ultimately, successful long-term investing can be simplified to buying shares in great businesses at compelling prices. At Morningstar we believe that the real opportunities for investors occur when the short-term reaction to an earnings announcement is not in line with the long-term value of a company. Changes to our fair value estimates for a company can provide context to price movements.

Here are four stocks with the largest price movements during earnings season, and our analysts’ thoughts on whether these market reactions were justified.

FINEOS Corp Holdings PLC Chess Depository Interest FCL

Earnings summary: Drop of 20% over the month, 58% undervalued.

Figure: FINEOS Corp share price history. Source: Morningstar Investor

FINEOS Corp announced their earnings on the 21^st, resulting in a sharp drop in the share price. The stock is down over 20% over the last month (at 3 September 2024). This recent drop has placed it firmly in five-star territory, last priced at $1.30 against a $3.10 Fair Value – 58% undervalued.

In saying that, drops like this aren’t unusual for FINEOS. In the first two weeks of January, FINEOS shares were up almost 20%. By the end of February, they had lost 25% from that peak. The shares rallied 30% from February to May, lost 20% between May and June, rallied 25% from June to mid-July and dumped 30% from mid-July until now.

Our analyst, Shaun Ler, believes that the trajectory of FINEOS’ business does not seem to be changing enough to justify these market prices.

FINEOS is an insurance software provider that was founded in Dublin in 1993. Customers are primarily large multinationals and midmarket insurers, and they generate their revenue mainly from subscriptions and product implementation services.

Their products help insurers by automating the work, centralising data and reducing the time to market for new products, and assisting new business wins and client retention. In other words, they provide a lot of value for businesses by automating administrative work that saves money, and wins new business. 

FINEOS is in the process of migrating customers to a cloud-based offering from a desktop program. This means that they can rollout new features and support their current offerings at a lower marginal cost. Following the migration FINEOS will transition to a recurring subscription revenue model.

These features are key to their wide economic stemming from switching costs. A wide economic moat is awarded to companies that our analysts believe can sustain their competitive advantage for at least the next 20 years. FINEOS has a comprehensive product suite that is a one stop shop for their customers. The suite performs mission critical functions for life, accident and health insurance carriers which means that they are central to the business operations.

This makes their customers extremely hesitant to switch software providers. They need to run a seamless and uninterrupted insurance business, and the friction that comes from switching software providers is just not a risk that they want to take on.

FINEOS' first-half 2024 results met Ler’s expectations with revenue growth, a positive mix shift, and cost controls driving improvements in gross profit and EBITDA by around 7% and 60%, respectively from the previous corresponding period.

According to Ler, investor reactions stem mostly from markets misunderstanding the company’s story. Thin disclosures from management are doing little to help them do so.

Sticking points in the recent results included slow sales growth last year (up just 1.5%), client losses in non-core businesses and management saying that revenue in 2025 would likely be at the lower end of previous guidance.

Longer term Ler sees FINEOS as a market leader with a sticky customer base, long-term growth opportunities and a clear path to higher profitability. 

 FINEOS is currently the cheapest wide moat stock in our global equity coverage.

Figure: FINEOS Corp Price vs. Fair Value. Source: Morningstar Investor

SiteMinder Ltd SDR

Earnings summary: Drop of 12.75% over the month, 51% undervalued

Figure: Siteminder share price history. Source: Morningstar Investor

SiteMinder’s software lets hotels and other accommodation providers accept and manage bookings from several internal and external channels at once. By driving better room utilisation, rates and profitability Siteminder has become a mission critical supplier to over 40,000 accommodation businesses worldwide.

As is the case with many other software-as-a-service companies, SiteMinder’s products benefit from switching costs. These mostly arise from its mission-critical nature and the risks related to switching vendors. The process of switching providers could lead to downtime in important demand channels or a reduction in performance.  There are also direct costs in the form of money and time to setting up a new channel manager.

Siteminder offers several secondary tools including software for direct bookings, search engine optimisation, corporate travel channel management, payments, and analytics. As customers adopt more products from SiteMinder’s suite, it becomes more embedded in the customer’s workflows and switching costs increase further.

Switching costs aren’t the whole story. Our analyst Roy Van Keulen also sees Siteminder’s relative size as a source of competitive advantage.

Building the infrastructure to connect demand channels and property management systems entails large upfront investments for each compatible demand channel, as well as additional costs for maintenance and updates. Bigger players can spread these costs over a larger revenue base and avoid sacrificing sales and marketing spend.

As Siteminder is at least twice the size of its closest competitors, Van Keulen believes it is in a strong position to gain share from sub-scale players as the industry consolidates. Van Keulen also sees the growing number of integrations already offered by existing providers as a rising barrier to entry for new competitors.

Van Keulen’s Fair Value estimate of $10 per share is almost 100% higher than Siteminder’s current share price of around $5. 

Figure: Siteminder Price vs. Fair Value Source: Morningstar Investor

Pro Medicus PME

Earnings summary: Up 6.90% over the month, 307% overvalued.

Figure: Pro Medicus share price history. Source: Morningstar Investor

Mark LaMonica and I recently covered Pro Medicus in an Investing Compass podcast. It received top billing because it was the best performing ASX share in our coverage universe over the past decade. Pro Medicus shares returned an average of 63% per year over the past ten years – enough to turn every $10 invested into over $1300. The magic formula? Rapidly growing revenue and profits combined with sky-high – and growing - valuation multiples for the shares.

That trifecta continued to work its magic after Pro Medicus announced its full-year results this week. The shares are now up over 50% this calendar year and more than 100% over the past twelve months.

Pro Medicus is a healthcare IT company specialising in radiology imaging software. Its main product is called Visage 7 and it’s a clinical desktop application that radiologists use to view, enhance, and manipulate images from any device and make a diagnosis. Its main customers are U.S. private academic hospitals.

Currently, Visage 7 is limited to radiology departments, but Pro Medicus is aiming to extend the product set to other specialty departments including cardiology and ophthalmology. On top of Visage 7the firm has other products that they cross sell to clients.

Pro Medicus reported 34% growth in underlying earnings before interest and tax (EBIT) to $112 million. This came from a 26% increase in revenues and an improvement in EBIT margins (the amount of revenues kept as pre-tax profits) to 70%.

This improvement in margins defied analyst Shane Ponraj’s expectations that some of Pro Medicus’s expenses like travel and marketing would bounce back after the pandemic. He increased his Fair Value estimate for the shares by 7%. However, his estimate is still far below the levels that Pro Medicus shares currently trade.

Pro Medicus shares currently trade at almost 150 times Ponraj’s forecast for earnings per share in 2025. A high valuation can give a company less room for error when it comes to their results. If the company stumbles – or simply reports good as opposed to great results – it can lead to weakness in the shares.

Pro Medicus reported strong results this time but looks vulnerable in this regard.

Ponraj feels that investor expectations baked into the current share price are too high. To reach the market’s valuation of Pro Medicus, he estimates that he would need to assume midcycle profit margins of almost 90% and a 10-year average revenue growth rate of above 25%. This is worlds away from his forecast for profits of around 70% and 11% annual growth.

Overall, Ponraj has a positive view on the outlook for Pro Medicus’s business. He just thinks the shares look too expensive. His Fair Value estimate of $37 per share is roughly four times lower than the current price of $150.

Figure: Pro Medicus Price vs. Fair Value. Source: Morningstar Investor

Guzman y Gomez GYG

Earnings summary: Up 23% for the month, 141% overvalued.

Figure: Guzman y Gomez share price history. Source: Morningstar Investor

Guzman y Gomez came to the public markets with a bang in June. At the time, our analysts said there was plenty to like about Guzman’s business model and its growth prospects. They just couldn’t get on board with the share price.

The company’s first earnings report since the IPO held little in the way of surprises. After all, Guzman provided a lot of information in the run up to their debut just days before the financial year ended. A good start to the new financial year saw the shares continue to rise.

Our analyst Johannes Faul said the results were impressive.

This was especially true in regard to GYG’s like-for-like sales growth of 8% for fiscal 2024 and 7% for the first few weeks of the new financial year. Crucially, this was enough to secure strong profitability and high returns on capital for Guzman’s franchises, who GYG claim enjoyed a cash-on-cash return of over 53% on their invested capital during fiscal 2024.

Happy franchisees and strong store economics underpin a healthy near-term outlook for store openings, which in turn are the key driver for revenue and earnings.

While GYG’s same-store sales growth has been impressive, Faul thinks it would be brave to forecast that they can continue to grow at a similar rate. His reasoning? A lot of the low-hanging fruit – like the introduction of breakfast items and longer opening hours – has already been picked. As a result, he thinks like-for-like sales growth is more likely to slow to around 5%.

Where Faul and the market seem to differ is on the expectations for Guzman’s long-term store rollout. At current price levels, Faul thinks the market is taking a big chunk of management’s long-term target of 1000 Australian stores as a given – and is maybe even baking in some international success.

Faul maintained his Fair Value estimate of $15 per Guzman y Gomez share.

This reflects his assumption that the company can open 40 new Australian stores per year for the next decade and grow its revenue and profits at a yearly clip of 18% and 40% respectively.

Those numbers are nothing to sniff at – but at a current share price of over $35 markets seem to be expecting even more. The shares screen as materially overvalued versus our Fair Value estimate.

Figure: Guzman y Gomez Price vs. Fair Value. Source: Morningstar Investor.

All share prices and Fair Values are at 3 September unless otherwise stated.

If you would like Morningstar’s insights into your inbox, sign up for the free newsletter.

Articles mentioned:

• Pro Medicus had a 63% annualised return over the last decade. What lessons can we take from this top performer?