bizzXceleration: Performance, Value and Profit

 

The week started off with a dull thud of a Yin and Yang pair of earnings reports from AMD and Alcoa which should be taken as proxies for all the general forces, whatever their unique circumstances. In other words Tech and Basic Materials. We expect lowered outlooks across the board except for for companies where the downturn works somewhat in their favor (WMT) or who have gone both int'l AND focused on what the developing world needs (infrastructure, etc.) like GE. The collected prior posts will walk you thru the economic underpinnings of profits and earnings, the long-term trends and, most especially, point out how rising EPS have been non-organic. That is based more on buybacks and financial engineering than on revenue and profit growth. With all that out of the way we'd really urge you look at the excerpts in the assessments overview. A couple in particular.

That section starts with our counter-example talking about looking beyond the downturn. Since we don't think most are even looking at the downturn this is intended ironically at best. But it's the last three stories that deserve your attention because they dissect the flaws in the analysts thinking - especially "Asleep at the Wheel" which you should go read the whole of. In their and our opinion there are several things going on:

1) Analysts always lag actual earnings downturns with their estimate revisions.

2) Their estimates are built bottom-up based on company specifics and don't reflect broader trends, which in fact (as we've shown in the prior posts) are largely driven by overall economic conditions.

3) Analyst's estimates more often than not reflect the outlook of the companies they cover - NOT independent analysis of company performance, industry situation or economic outlook. While they're paid to be independent the result is that they generally aren't with some notable exceptions. A major part of the problem is that they lack the experience and tools to understand the businesses they cover as businesses and are forced to rely on numbers and managment guesstipulation = F(guesses, WAGs, stipulation, manipulation) :).

4) Management tends to both put the best face on things AND be focused on the current view in the rearview mirror and doesn't themselves examine the big picture until bad quarters and years sneak up on them. Now you do indeed have to run the company today but you should run with an eye to how to position it for the storms you can see coming. Again with notable exceptions that doesn't happen. GE and Cisco come to mind, especially Immelt who's been preparing for this for years.

So that's how we reach our bottomline but hopefully you can skim/read over the following and reach your own judgements and conclusions. Ours is very much that even a mild recession isn't factored to any great extent into earnings estimates. And we expect the recession to be somewhat deeper than generally thought and also much longer. Based on our own analysis and that of minor commentators (the usual suspects we keep citing, e.g. Summers/Feldstein/Krugman/Merrill/G-S).

As for the sentiment that one should be screening for good companies with a view to the upturn we wholeheartedly agree. With two major caveats. First, that uptick is a ways off. And second, good companies perform, that is they grow revenue and profits based on providing real products with real value. Those are the folks you need to start putting on your little list.

Earnings Outlook Assessments

Recession? Think Stocks for Recovery While Friday's weak employment report seems to confirm the economy is in the early stages of recession, investors looking at the longer term are thinking already about which stocks will work best in an eventual recovery. Many say the future might be brightest for one of the worst-performing sectors this year (technology) and one of the best (energy). And despite election-year uncertainty, they are finding things to like among health-care stocks. There is a common theme here: In a slow economy, investors are willing to pay for earnings growth, and they see it in these sectors. There still is a market for good technology, energy companies can benefit from the search for new supply and aging baby boomers will need health care, they say. The next month could be challenging for stocks as companies report first-quarter earnings and issue their expectations for the rest of the year. Many on Wall Street believe earnings expectations for the second half of 2008, with forecasts of double-digit percentage growth, are too high. While some were looking for shares of financial companies to lead the stock market out of its downturn, the earnings growth that powered big returns on financials in recent years now appears to have been driven by borrowing and moving certain assets off their balance sheets. It isn't likely to return soon.

Earnings: Bracing for bad news! The last time earnings suffered such a bad patch was during the last recession. Earnings fell for five straight quarters throughout 2001 and the the first quarter of 2002. To be sure, much of the earnings weakness is confined to one sector: financials. Earnings in this group are expected to plunge 61% from a year ago as many big mortgage lenders, banks and brokerages will be taking multi-billion dollar writedowns due to exposure to bad subprime loans. Excluding the financial arena, profits for the remaining nine sectors in the S&P 500 would be up 7.2%, according to Thomson. However, there is a caveat here as well. The only industry that you can truly say is doing well is energy. This should come as no surprise with oil prices at more than $100 per barrel. Earnings for energy companies are expected to soar 28%. So if you remove both the best and worst groups, you're left with a market and economy that is muddling along. Many consumer discretionary companies - retailers, homebuilders and auto manufacturers - are also facing a tough time as consumers pull back on spending.

Earnings Season Starts With a Thud When the year began, the consensus analyst forecast was that earnings among companies in the S&P 500-stock index would increase 5.7% from a year earlier. Now analysts see a 12.2% drop in earnings. Earnings for both the consumer-discretionary and consumer-staples sectors are expected to shrink. When the year began, profits for consumer-staples companies, such as food and drug makers, were forecast to rise 10%. Now they are expected to fall 1%. The consensus for consumer-discretionary, which includes home builders, has gone from an 8% profit increase to a 12% decline. The materials sector is expected to report no quarterly growth, and expected growth rates for every other sector but energy have been cut to single digits. If recent history is a guide, the Street still might be overly optimistic. S&P 500 profits fell short of analyst estimates in the third and fourth quarters of 2007, according to Thomson. Those were the first quarters since Thomson started keeping track in 1994 that reported earnings haven't beaten forecasts. That includes the earnings bust of 2001 and 2002. Expectations might be so low for financials that they don't have more room to disappoint. With the economy apparently in recession, the spread of weakness to other sectors still has the capacity to surprise.

Top-down vs. bottom-up  As Europe's first-quarter earnings season approaches, it's increasingly clear that analysts and strategists differ considerably on the prospects for company earnings and stock market performance this year.European stocks have shed around 20% of their value since June as investors priced in the effects of credit-market market turmoil. The pan-European Dow Jones Stoxx 600 index is currently trading at 318.88, a far cry from the all-time high of 400.75 reached in June, having just come through the worst quarter since 2002. The banking sector has led the decline, with share prices for lenders such as UBS falling sharply as asset write-downs mounted. UBS shares are currently trading down 55% from where they stood last June. Share prices have fallen for other companies, too, as investors try to extrapolate the effects of the market turmoil across to earnings for other sectors, particularly those exposed to consumer spending and economic growth, such as home builders. Such losses tie in with the view many strategists are taking on company earnings. Europe's corporate reporting season begins in earnest in the next week or two. But analysts are far more optimistic than strategists and are still penciling in moderately strong earnings growth this year. For 2008, analysts are expecting growth in European earnings of 9.6%, down from 10.4% three months ago, while earnings estimates for U.K. companies this year have been revised up and now stand at 7.3%, compared to 6.2% three months ago, according to IBES consensus estimates compiled by Nomura International. The main reason for the wide divergence between the forecasts made by strategists and analysts is that analysts usually wait for bad news to come from the companies before changing their models, Lawlor said. But some believe the worst of the bad news may have passed in the first-quarter, when the financial sector took more write-downs.

The Flawed Fed Valuation Model  We continue to see the Fed model used to rationalize a bullish stance in equities. However, given that it is based in large part on analysts consensus for future SPX earnings, investors need to be extremely cautious relying solely on the Fed model. Why? Analysts are unflaggingly inaccurate at turning points. Example: Q3 S&P500 earnings consensus were +8% -- S&P500 earnings came in at -8%. Q4 has been similarly lowered, undercutting the earlier forecasts of undervaluation. Now let's look at 2008. S&P 500 forward earnings over the next 4 quarters are as follows: Q1 = 3%; Q2 = 4%; Q3 = 20%; Q4 = 50%, according to UBS. So stocks, so we are confronted with two possibilities. Perhaps, equities are seriously undervalued (that assumes earnings  explode in 2H). An alternative explanation, and one I suspect is more likely: Analysts consensus earnings are wildly exuberant for the second half.  One last issue: Let's ignore the analysts, and merely  consider mean reversion: As the chart below shows, earnings have been unusually high relative to history. If they merely mean revert, they will come down another 25%. Even worse, most mean reversion blows right past historical averages to opposite extremes.

Asleep at the wheel, or, How I learned to stop worrying and love the bomb The chart makes is transparently obvious that analysts lag reality. They only change their minds when there is irrefutable proof they were wrong, and then only change their minds very slowly. The beginning of the downturn in earnings is clearly visible from this chart. However, analysts have hardly scratched their earnings numbers at all. I've had several conversations of late with both buy and sell side firms who have been busy trying to get their analysts to bring down their estimates. The response from the analysts has been exceedingly similar across the various institutions. The analysts all acknowledge the sense of lowering forecasts in aggregate. However, when they discuss such a move with the companies they cover, the companies. response is that it won't happen to them. This creates a fallacy of composition problem in which all the analysts think 'their' stocks are immune from the influence of the cycle! In general the evidence suggests that company management doesn't know any better than we do, especially when it comes to predicting the future. appear to be incapable of forming a view without the endorsement of company management. One must wonder why we pay legions of analysts if they are simply drip fed the management views like quasi IRs! One of the few surveys I keep an eye on is the Conference Board CEO survey. This survey has reasonable predictive power when it comes to earnings growth. It tells a very different story from the ones discussed above. These guys are most definitely not optimistic about the outlook. They are expecting growth to keep sliding away, and that isn't good news for profits! However, for this exercise I put aside my personal biases against this measure. I just take the current forward P/E and compare it with the historic average of the forward P/E. The extent to which the current forward P/E is below its average is presumably a measure of the expected earnings decline. As the table below shows, on this basis the US is pricing in an 8% decline in earnings, Europe a 24% decline and the UK a 23% decline. However, to my mind there is a problem with this process, and that is the historic forward P/E series is distorted by the experience of the bubble in the latter half of the 1990s. This was, of course, an incredibly unusual period, so one could argue that it should be excluded from the calculation of the average forward P/E. The table below shows the impact of excluding the bubble from our calculations. Now the US doesn't imply any drop in earnings, Europe implies an 11% fall in earnings, and the UK implies a 4% decline in earnings. Now how does this implied decline in earnings stack up against the empirical evidence on the scale of earnings declines in recessions? Well, the history of 'operating earnings' only goes back as far as the analysts. forecasts (i.e. the early to mid 1980s). This only gives two recessions to examine, and both of those have been exceptionally shallow. However, even in these shallow recessions earnings fell by 20% in the US, and 40% in Europe. Relative to this benchmark, the implied earnings declines are paltry. So the idea that the equity markets are anticipating a recession unfortunately looks to be yet another example of the triumph of hope over reality.

Earnings, Economy & Outlook: Prior Posts

Grading the Takehome: Bottoms, Earnings & Outlooks  We're going to sneak up on ours though our direction is pretty clear but before taking a look at some charts and graphs (follow-on post) we'd like to ask what's driving the Street's optimisms. The answer turns out to be very clear - the Street and the analyst community is expecting a major uptick in earnings growth (something else we've been ranting on about as well) but we thought we'd do a compare & contrast between Fortune (who's reporting what it's been told) and Jim Jubak (who's analyzing what he sees).The differences are large, understandable in view of their different responsiblities and the gap tells us what's driving the market sentiment right now. If you check out Fortune's chart from Thompson the rationale is pretty clear. In fact if we thought those were the numbers then now would be a good time to reverse direction from our current position.

Review the Bidding, Count the Cards: EPS Growth Rates Well after puzzling some more on the outlook for the economy, profits, earnings and EPS I may have stumbled across an explanation for why the prognosticators have such a sanguine view of things. Just to review, the economy is slowing and faces more and more headwinds. In fact recent polls show a majority expect a recession in '08 and feel that we may be in one now. In digging into earnings we found that EPS growth is not organic in the sense that it's based on growth in revenue, profits or earnings. And we found that to be consistent across three, no four, different and major data sources: GDP accounts, National Income accounts, WSJ reported earnings/profits by industry and S&P reported EPS by industry most recently. As they say - it's a puzzlement. BUT...but...but if you look at the accompanying table it starts to become clearer. EPS growth rates by sector from the most recent S&P numbers. Take a look and see what you think. EPS growth as reported actuals and estimates from Q106-Q407, based on YOY% growth, lines up with the other data. When you add the '08 numbers the averages show some uplift but not big jumps. In other words it's the going forward expectations for Q108-Q408 that make you shake your head.

Have You Seen the Elephant ?: More on Earnings Back to the Elephant and this time we'll go to the central cathedral of capitalism the Wall St. Journal - specifically it's recent reporting on quarterly profits and earnings. Which, BTW, they report as net operating income, NOT EPS ! If you take a look at the accompanying charts we have a third view, albeit on a shorter timeframe, of the shares of the various industries. Here we see quarterly profits from Q205 to Q207 in absolute and relative terms. Take a look for yourself and see what interpretations you come up with. For the life of me there doesn't appear to be any major acceleration in profit growth that would cause me to be wildly excited about business performance. Earlier (Models, Metaphors, Musical Chairs and Market Outlook) we'd looked at  the markets and even quoted BigPicture from last Fall about the range-boundedness thereof. Based on these charts we'd have to argue that was a pretty sound judgement by Mr. Market. On both absolute and relative basis we also don't see much to argue for a great outlook for any industry or sector. Energy and Materials looks pretty flat as do Consumer related industries (green-shaded) and Industrials/Utilities. Even Tech/Telecom, other than the spectacular performance of a few select (NDS, QQQQ) firms undergoing major innovation shifts (APPL, GOOG come to mind) indicate anything arguing for the runup over the other general or sector indices. Granted there was improvement in '06 and so far in '07 but an acceleration ? Nah.

Dr. Pangloss Treating Goldie: Markets, Profits & Earnings It was recently accounced that Goldilocks, who's rumored terminal illness brought world-wide panic to her many fans, was successfully treated by the famous French therapist Prof. V. Pangloss. He was pleased to announce that rumors of her death were greatly exaggerated and in fact treatment has been so complete and successful that a whole new Goldie is in the house. Dr. Pangloss was quoted as saying, "in your modern terms think of this as Goldie 2.0....a highly successful course of sentiment and psychology obviates any risks due to fundamentals, or even technicals". Yet Capex and Profit reached level plateaus in the 80s and 90s while wage share largely continued to shrink (excepting the lagged impact of the late-90s investment boom on labor demand). But, since early in this decade (have you thought about how odd that sounds for those of us still thrashing the Telecom bust and yearning for the good old days ?) Wages have returned to a deteriorating downtrend while Capex spending has remained relatively flat. In other words, as we kinda knew from other sources, businesses aren't hiring and they aren't spending. Not only was the Boom a very different thing than previous cycles the "recovery" is a very different recovery - no jobs, no equipment, not good. We can only conclude that with the lid screwed down on spending companies are making plenty of money, grabbing a growing share of the economy and, one guestimates, spend it on buybacks to keep the stock prices up and help out with EPS numbers. Which doesn't lead one to a great deal of confidence in organice growth of revenue, profits and earnings.

The Heart of the Matter: Profits vs Earnings ? If you look back over the last two Weekly Readers they both might be said to converge on key question - where will earnings go ? Or broken down a little more will businesses continue to generate profits and will those turn into reasonable earnings ? And earnings growth in particular ? Earlier (Dr. Pangloss Treating Goldie: Markets, Profits & Earnings) we'd taken a pretty hard look at that question and found that Profits were strongly correlated with GDP growth and Earnings (ala S&P reported earnings/EPS) were strongly correlated with Profits. It might be worth your time to re-vist those charts and arguments because they lay a foundation for this discussion. If you believe that argument, or at least think it raises some serious questions, then we thought it'd be worth looking into some more. Basically when we say growth is not organic what we're arguing is that EPS growth is NOT the result of growth in revenue or profits - rather it results more from throwing cash flow and borrowings at buybacks while screwing down the lid on expenses, hiring and capex spending.

Markets, Earnings and PE In the prior post we looked at the Grahm-Dodd PE valuation formula, built some useful tables and talked a bit about applying the approach to both company and market performance assessment. It seems like it might be a good idea to test it a little bit so let's walk thru SP500 quarterly earnings, PE's and compare the latter to what might be calculated using average earnings growth rates and AAA-rates. This will turn out to be a little rough and approximate but nonetheless be useful - at least in thinking about trends in valuations. Let's start with the following chart that looks at earnings from Q11990 to Q42006 and compares actual PE ratios to calculated ones.

Business Earnings

Alcoa Profit Drops 54%, Falls Short of Estimates on Rising Commodity Costs -- Alcoa Inc., the world's third-largest aluminum company, said first-quarter profit tumbled 54 percent because of surging energy costs, a weaker U.S. dollar and lower metals prices. Alcoa is the first company in the Standard & Poor's 500 Index to report results for the first three months of the year. Earnings at S&P 500 companies probably fell an average of 11 percent from the same period a year earlier, according to analyst estimates compiled by Bloomberg. Chief Executive Officer Alain Belda is selling less- profitable units to boost earnings after the company fell behind United Co. Rusal and Rio Tinto Group in aluminum production in the past year. Alcoa also is seeking to sign long-term electricity contracts and increase the amount of cheaper hydropower it uses to cut costs.

Advanced Micro Misses Its Revenue Forecast, Plans to Eliminate 10% of Jobs Advanced Micro Devices Inc., the chipmaker that's posting losses amid competition with Intel Corp., said first-quarter revenue missed its forecasts and announced plans to cut about 1,650 jobs. The revenue shortfall was caused by lower-than-expected sales ``across all business segments,'' Advanced Micro said in a statement today, without giving further details. Under Chief Executive Officer Hector Ruiz, Advanced Micro enjoyed its biggest ever sales gains against Intel, the world's largest semiconductor maker. Advanced Micro's market share rose to 25 percent in the fourth quarter of 2006. The company, Intel's only remaining rival among a group of competitors that once included Motorola Inc., gained ground by being the first to add designs and features such as building multiple processors into the same chip. Those wins were short-lived after Intel CEO Paul Otellini responded in late 2006 by speeding up the Santa Clara, California-based company's product development and new manufacturing advances. Advanced Micro cut prices to compete with Intel because it was late with a new chip design called Barcelona. The company then delayed mass manufacturing of the new processor when the chip caused errors in some computer programs.

Ackman paying a hefty price at Target  A foray into discount retailer Target has been no bargain for hedge fund manager William Ackman. The high-profile manager of Pershing Square Capital Management caught the market's eye in a big way last summer, when he announced that he had raised about $2 billion to funnel into the stock and options of Minneapolis-based Target (TGT, Fortune 500). Ackman's Pershing Square IV fund has since bought up nearly 10% of the company. But the trade has been a disaster for Pershing Square and for one of Pershing Square IV's biggest investors, insurer Leucadia National (LUK). The Pershing fund is down 43% since its June 1, 2007, launch, according to financials included in Leucadia's recently filed 10-K report. Pershing's suffering is not for want of ambition. In a Dec. 27 investor letter, Ackman argued that the stock could be worth $120 within 36 months. He also suggested selling off Target's credit-card portfolio, completing its previously announced $10 billion stock buy-back, and - in what has become something of Ackman's signature management demand - increasing cash-flows based on the value of Target's real estate holdings. He estimated that Target has some $42 billion worth of property value it can unlock. While it is tempting to scoff at the performance woes, it is important to recall that Ackman and his Pershing Square team have reaped some remarkable successes with an investing style that is patient and methodical.

UPS Cuts 1st-Quarter Profit Outlook The first quarter was rough for UPS Inc. amid higher fuel costs, a weakening U.S. economy and reduced domestic package volume, the world's largest shipping carrier said as it cut its earnings forecast for the January-March period. UPS warned at a New York investor conference last month that it might miss its earnings guidance for the quarter if the contraction that it saw in February continued. That prediction has become reality, Atlanta-based UPS said in a statement Tuesday. The company lowered its first-quarter earnings expectations to 86 or 87 cents per share, compared with a previously anticipated range of 94 to 98 cents a share. "The U.S. economy has continued to weaken, causing a reduction in domestic package volume and a shift away from premium products," UPS said. "Significantly increased fuel costs in the quarter also contributed to the lower-than-expected results." UPS has said the first three weeks of January saw strong volume growth, but that was later followed by six weeks of contraction. It suggested Tuesday that the negative trends continued into March.

Immelt's Push for Revenue Abroad Bolsters GE Profit as U.S. Economy Slows General Electric Co. Chief Executive Officer Jeffrey Immelt's strategy to sell power plant equipment overseas and shift more resources to commercial finance is helping the company weather a slowdown in the U.S. economy and likely led to higher first-quarter profit. GE Infrastructure, the largest of six main businesses at the world's third-biggest company by market value, fueled the increase in earnings, according to the company's forecast. Fairfield, Connecticut-based GE reports results tomorrow. Demand from developing regions including the Middle East to build utilities and water-treatment plants contributed to the surge at the unit, which also is the world's biggest provider of power plant turbines and jet engines. While profit probably fell at the GE Money finance unit, decisions Immelt's team made in the quarter to sell or swap some consumer-finance assets in favor of commercial lending set the groundwork for increased earnings later, even during an economic slowdown. GE's AAA credit rating, the highest available, should allow the segment to capture lending business from rivals ``and acquire financial assets at discount prices,'' wrote John Inch, an analyst with Merrill Lynch & Co., on March 20, when he raised his rating on the stock to ``buy'' from ``neutral.''

General Electric Profit Falls 12%, Missing Estimates; Annual Forecast Cut General Electric Co. said first- quarter profit fell 12 percent, missing analyst estimates, because it couldn't complete asset sales and had higher-than- expected losses at its finance businesses due to disruptions in global capital markets. GE cut its full-year forecast. Profit from continuing operations dropped to $4.36 billion, or 44 cents a share, from $4.93 billion, or 48 cents, a year ago, Fairfield, Connecticut-based GE said today in a statement, trailing the average analyst estimate of 51 cents. GE shares declined in Germany. GE missed its own forecasts for its commercial and consumer finance units because of an inability to complete planned asset sales and higher mark-to-market losses, the company said in its statement. That cut per-share profit by 5 cents a share, and resulted in a lowered forecast of $2.20 a share to $2.30 a share, down from the at least $2.42 previously forecast. GE Posts Lower 1Q Profit, Cuts Outlook

DuPont Profit Tops Estimates as Crop Prices Lift Corn, Soybean Seed Sales DuPont Co., the world's second- largest seed producer, posted first-quarter profit that topped analyst expectations because of demand from corn and soybean growers. The company's second-quarter forecast trailed estimates. Strong sales to farmers and customers outside of the U.S. more than compensated for slowing domestic construction and auto markets that hurt sales of products such as paint and insulation, Wilmington, Delaware-based DuPont said today in a statement. The reverse will occur in subsequent periods, with U.S. economic weakness detracting from gains elsewhere, DuPont said.
Chief Executive Officer Charles O. Holliday Jr. is investing in genetically modified seeds that resist bugs and weed killer to compete with larger rival Monsanto Co., which last week said quarterly profit doubled. Corn futures reached a record yesterday, and soybeans rose to an all-time high last month.