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Posted 7/28/2003
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The Street still plays games with investors
Despite 'corporate reform,' companies and Wall Street still manage earnings and expectations. Investors still want desperately to believe -- just as the rally looks like it's unraveling.
By Bill Fleckenstein
On a baby's first birthday, parents can only marvel at the changes one year has brought. As the corporate-reform movement celebrates its first birthday (of the passage of the Sarbanes-Oxley Act), folks can only marvel at Wall Street's arrested state of development. Companies still manage their earnings, dead fish still churn out drivel packaged as "analysis," and once-bubble-burned investors stand ready to believe again. Anyone on the lookout for baby steps toward change had better know something about time-lapse photography.
Its still business as usual on the Street
Diving right into the glacial-change department, I'd like to spotlight the status quo on Wall Street, with respect to the beat-the-number game, overall hype by tech companies and the remarkably inaccurate track record of dead fish. An absolutely perfect example was illustrated in a Wall Street Journal story on page one last Tuesday: "Wall Street Plays Numbers Game with Earnings, Despite Reforms.
Never ever was a headline so true. Writer Ken Brown began: "Despite the bursting of the stock-market bubble, the discrediting of analysts' research and exposure of a slew of accounting tricks that companies use to make their financial figures look better, the earnings-management game is alive and well on Wall Street." Yes, it sure is.
Continuing, Ken Brown cited research by Lawrence Brown, an accounting professor at Georgia State University in Atlanta, who said he didnt think theres been a change since the passage of the Sarbanes-Oxley Act last year and other reforms. Lawrence Brown has been studying for 25 years how companies present their earnings. As an example, the story pointed to the recent action in Apple's (AAPL, news, msgs) shares after the company beat the number -- a modest rise of 5% the day following its news, to a 13-month high.
Apple's recipe for leavened 'bread'
"Never mind that Apple's net income had fallen 41%," the Journals Ken Brown wrote, "the computer maker had beaten Wall Street's all-important consensus earnings estimate, which is based on the predictions of research analysts who cover the company (who were led to the trough by the company). No one is saying that Apple is trying to manipulate its earnings. One reason for its success: Three months before, Apple told investors that it expected only a 'slight profit for the quarter,' leading analysts to predict that the company would earn a meager three cents a share."
And of course, it did better than that. This is the hobbyhorse I've been on lately -- the stupidity of the beat-the-number game. I mean, how can 6 cents or 8 cents a quarter justify a $20 stock, plus or minus? That's a hypothetical example somewhat relevant to a company I'll discuss below, Texas Instruments (TXN, news, msgs).
Back to the story. Brown said, "The game changed -- more in form than substance -- in 2000 when the Securities and Exchange Commission's Regulation Fair Disclosure rule went into effect. That rule (supposedly) prevented companies from calling individual investors and analysts and instead required the firms to release important information publicly. But companies adapted and began managing expectations using press releases instead of telephone calls." In addition, some companies have essentially flouted this rule during breakout sessions or one-on-one sessions at investment conferences. On this point, Brown concluded: "Corporate adaptation meant the new rule didn't change things."
Next, he observed how companies' "beating the number" has been equated with improvement in corporate America and the economy. To show that fallacy, he cited the finding of Merrill Lynch's Rich Bernstein that fewer and fewer companies have reported better earnings: "In the first quarter, 32.7% of companies in the S&P 500 reported lower profits than the year before, compared with an average of 28.5% going back to 1992. In other words, companies lowered expectations just enough to beat them."
Poor Richard's almanac of stock sales
That reality, of course, makes the need for hype all the more urgent, and that brings me to last week's hype fest in Techville. Starting in reverse order of absurdity, let's take a look at Novellus (NVLS, news, msgs), which I am neither short nor own puts. The company did not have a particularly difficult hurdle for the third quarter, though it did lower guidance slightly. But CEO Rick Hill allowed as how he was optimistic, because he's essentially looking for a PC recovery, demand for 3G phones, and enterprise systems strength. He also said that internally, Novellus would be switching to Windows XP in 2004, and therefore the PC market's going to rebound, etc.
In April 2002, Hill crowed about what the company expected its orders to be -- and then later proceeded to sell 337,500 shares of stock at $44 each, a price not seen again. (The stock is now at about $36.) Writing about this in my daily column at the time, I discussed how very kind it was of him to wax on so poetically, while simultaneously donating his shares at a cheap price to speculators.
Pseudo kudos to Texas Instruments' Q2
To set the stage properly on Texas Instruments, a couple of weeks before the quarter ended, the company pre-announced and lowered its Q2 earnings guidance. Then last Monday night, Texas Instruments managed to beat that new lowered number, which was supposed to be a victory. (Part of its better quarter came from a lowered tax rate.) In addition, the company announced that for its upcoming quarter, earnings would fall in the range of 6 cents to 10 cents, as opposed to the 11 cents it had been as of last Monday. But of course, it had been 12 cents as of a few weeks ago.
Further, finished-goods inventories were up 55%, and inventories overall were up 13%. With a straight face, the company tried to package that as intentional -- this, in a quarter where Nokia (NOK, news, msgs), its biggest customer, just announced horrible results. Texas Instruments even tried to say that demand unexpectedly surged in the last two days of the quarter. Of course, it was rather evasive when someone sought the particulars on how the last three weeks looked, in light of Nokia's comments a few days ago.
In short, the company pulled every lever in the book, played every little angle it could, and that was deemed to be good news the following day. The shares jumped to $19.25. It's beyond me how anybody can pay $19 for the stock, even if it can make 10 cents a quarter. Why pay, in essence, 40 times earnings for a company that's got no growth, has problems in its end markets and is run by folks who can see the first day of spring on Christmas Eve? It just goes to show how absolutely maniacally speculative the environment remains.
Dead-fish kahuna sings same tuna
Last Tuesday, to top that off, a dead fish whose name rhymes with "denial" and "guile" upped his opinion and targets for many of the stocks in the tech sector. He has been perennially wrong on his overall analysis, as he's been looking for the PC-upgrade cycle for years. He was famously positive on the whole sector in the summer of 2000, as he expected Microsofts (MSFT, news, msgs) Windows 2000 to drive demand. (Microsoft is the publisher of MSN Money.) He has been bullish on DRAM prices and Micron Technology (MU, news, msgs) nearly the whole way down. I say that not because I never make mistakes, but this guy's analysis has been chronically off the mark, and yet folks still leap at what is basically a second-half-of-the-decade story:
"Our industry call is not predicated on the belief that industry orders and revenues will be surprisingly good in the near term. Rather, we think the prospects for 2004-2006 are compelling, and we expect them to be reflected in the stocks early in the upcycle." Of course, even if the next up-cycle does occur in that timeframe, stock prices currently already reflect more than the companies can possibly deliver, which leaves today's stock buyers very little upside and a great deal of downside.
The price-to-emotion ratio: still growing
Segueing to the nosebleed valuations, the collective market cap of eBay (EBAY, news, msgs), Amazon.com (AMZN, news, msgs), Yahoo! (YHOO, news, msgs), and Priceline.com (PCLN, news, msgs) registers a modest $122 billion. With aggregate earnings of $25 million, that gets to a trailing P/E of a paltry 4,878. (Thank you to Joanie, who called this to my attention last week, via data from Bridgewater Associates.) Obviously, these stocks are about emotions, not earnings. I could give plenty more examples, but I think you get the point.
Meanwhile, as such speculative further continues, there's been no real improvement in the economy. Certainly, when you strip out hope and hype, most tech companies have had few positive things to say. With mortgage rates rising, the refinance game is now a thing of the past. So, it continues to look to me like the second half is going to be rather difficult. Folks are going to be forced to deal with that fact, even though right now, they're only too happy to talk about things getting better.
The relief rally is about to unravel
Last winter, when I was constructive on the market rallying (See "3 reasons to expect a war rally"), I laid out a group of reasons to support my case. The rally ensued, and then some.
Now it looks set to fall apart -- and from a height that I would not have thought possible at the time, given what little has changed. With stocks priced even more precariously, and given how excited folks have become, the stage is set for some pretty rough sledding. Folks are still willing to suspend disbelief and act like fools. I suppose it's largely due to the OPM factor. But I am still amazed by how this kind of insanity can exist -- and at such obscene valuations -- in a world with so many major problems. I continue to reiterate my view that this is a potent recipe for disaster.
Molten delight at silver's flight:
On a brighter note, I note that last Wednesday, silver ended the day up a SOX-like 6% to more than $5 a troy ounce. My sources in the silver market tell me that we may be nearing a move akin to what occurred in gold a couple of years ago when shares of Ghanaian mining company Ashanti Goldfields (ASL, news, msgs) blew up. It would appear that the silver market is short "vol," and an upside accident could be in the process of playing out. We'll just have to see. Meanwhile, folks interested in owning gold and silver should already have taken the opportunity to establish or add to their positions. We can now sit back and watch what the upside looks like.
Currency postscript: Finally, for those folks who've sent me e-mails asking how the "little guy" can get long foreign currencies, you might want to contact Everbank, which I read about in Grant's Interest Rate Observer. At Everbank, you can set up currency accounts and CDs denominated in all foreign currencies, and it's FDIC-insured. So, this sounds to me like the perfect place for folks who'd like to get involved in foreign exchange and don't know where to go. (See link at left under Related sites.)
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At the time of publication, he held a short position in Texas Instruments. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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