Tuesday, April 22, 2008

What's Analyst Worth? Not Even Penny a Share as Estimates Miss

By Peter Robison

April 22 (Bloomberg) -- This earnings season may expose how much Wall Street analysts rely on guidance in making estimates, as the credit crunch and weakening economy make it harder for companies to meet or beat the numbers.

At least 27 companies have matched or topped Wall Street estimates in every quarter since 2000, including Coach Inc. and Starbucks Corp., according to data compiled by Bloomberg. General Electric Co. ended a 32-period winning streak on April 11. Goldman Sachs Group Inc. called GE and other early misses ``a sign of things to come,'' saying it expects more companies to fall short of first-quarter estimates.

In good times, companies often use the flexibility of accounting rules to choose when they book revenue and costs, creating an impression of predictable earnings, said Thomas Russo, a partner at Gardner Russo & Gardner. The economy's decline and the freeze in credit markets are making that harder.

``Companies are smooth and steady and growing, right up until the point they collapse,'' said Russo, who manages about $3.5 billion. His largest holding is Warren Buffett's Berkshire Hathaway Inc., famous for not providing quarterly forecasts.

The real puzzle is why GE hadn't missed estimates since at least 2000, said Shiva Rajgopal, an accounting professor at the University of Washington in Seattle. If analysts made their own judgments independent of company forecasts, the probability of compiling a record like GE's by sheer chance would be about 1 in 100 billion, based on a standard statistical equation, similar to a coin flip, he said.

`Silly' Game

``The whole game is silly,'' said former U.S. Securities and Exchange Commission Chairman William Donaldson, who led a group that recommended abolishing quarterly forecasts and reducing the amount of executive compensation tied to quarterly earnings per share. ``Earnings themselves are subject to interpretation.''

The so-called earnings game each quarter makes stock prices more volatile, wastes corporate resources and may encourage managers to use aggressive accounting or delay investments, according to a report Donaldson helped produce in June for the Committee for Economic Development, a Washington nonprofit policy group formed in 1942 to promote ``sustained economic growth.''

The earnings game costs anyone who invests in a mutual fund, by obscuring real corporate performance and through commissions from short-term, speculative trades, according to the report. Those extra fees may have cost $70 billion in 2005 alone, it found.

`Buy' Ratings

Most analysts missed the earnings shortfall for Fairfield, Connecticut-based GE, the world's biggest supplier of power- plant turbines, locomotives and medical imaging machines.

Sixteen of nineteen had ``buy'' ratings on the shares before the company said April 11 that profit from continuing operations fell 12 percent to $4.36 billion, or 44 cents a share, 7 cents less than the average Wall Street estimate. Its shares have fallen 12 percent since then to $32.46 yesterday. General Electric, which also sells financial services, said the seize-up in credit markets prevented it from closing some transactions.

``We're doing the best job forecasting that we know how,'' Chief Financial Officer Keith Sherin said the day General Electric reported earnings. ``I guess we could have forecast much lower earnings and just left an open category called unknown volatility, but that's not the way we do business.''

A 2000 SEC rule, the 2002 Sarbanes Oxley Act and a 2003 SEC settlement with securities firms all contained provisions intended to make Wall Street research more independent. By some measures, research has become less accurate.

Moving Target

In the fourth quarter, the almost 1,800 equity analysts overestimated final results by 33.5 percentage points, the biggest miss ever, based on data compiled by Bloomberg. Yet 62 percent of companies in the Standard & Poor's 500 Index beat average estimates -- because analysts lowered their forecasts as the quarter progressed. First-quarter numbers show a similar trend, with 55 percent of the 111 companies reporting so far exceeding the average estimate.

Until the recent quarter, GE and 27 other companies in the S&P 500 always met or exceeded Wall Street's average estimates dating back to 2000, Bloomberg data show.

While those companies' shares outperformed the S&P 500 during that span, seven of them -- including GE, Seattle-based Starbucks, the world's largest coffee retailer, and Atlanta- based Coca-Cola Co., the world's largest soft-drink maker -- lagged behind the benchmark index during the past five years.

GE, for instance, rose 36 percent from April 4, 2003, through April 4, 2008, compared with a 56 percent gain for the index. During the 32 quarters when its earnings met or beat estimates, GE's share price dropped 39 percent, while the S&P 500 was unchanged.

`Wrong Reasons'

``Quarterly earnings per share are at best a finger in the wind,'' said Nicholas Heymann, an analyst at Sterne, Agee & Leach Inc. who started his career as a General Electric auditor in 1977.

``People are obsessed for the wrong reasons.''

Other companies performed well for a time, only to stumble. KB Home exceeded profit estimates for 29 straight quarters, until the real estate market collapsed and the Los Angeles homebuilder lost $1.93 a share in the second quarter of 2007.

After rising fivefold from April 2003 to April 2007, New York-based Coach, the largest U.S. luxury-goods maker, fell 40 percent in the past year, compared with a 9 percent drop for the S&P 500. In one stretch from 2003 to 2005, Coach beat the average estimate by exactly 1 cent for 10 consecutive quarters.

Revenue growth and productivity gains are fueling the earnings streak, said Andrea Resnick, a Coach spokeswoman. The company is scheduled to report today.
Earnings Priority

Rajgopal, the University of Washington professor who has studied the earnings game, said pressure to meet quarterly targets can hurt investors. He helped survey 400 executives about management choices in 2005, and said he was surprised to find that 78 percent would sacrifice long-term investments for smoother earnings.

``Guidance serves a purpose,'' he said. ``It helps managers communicate a summary number that captures all the changes in the business. On the other hand, it can easily be abused.''

A 2006 paper by researchers at the University of Southern California in Los Angeles and New York's Columbia University, ``Earnings Management and Managerial Myopia,'' sought to document the costs of the earnings game.

The paper labeled 989 public U.S. companies as either dedicated guiders or occasional guiders, based on how often they gave quarterly direction. The study found that the value of dedicated guiders' assets declined 2.7 percent from 2000 to 2003, while occasional guiders achieved a 7.8 percent gain.

Less R&D

Frequent guiders spent about 25 percent less on research and development. The authors theorized that some companies scale back on R&D to meet earnings goals.

``Everyone is so focused on one number, forgetting that the much more important thing is the long-term growth of the company,'' said Yuan Zhang, who co-wrote the paper and teaches accounting at Columbia's Graduate School of Business.

Quarterly forecasts are an unintended consequence of the 1995 Private Securities Litigation Reform Act, which exempted companies from legal liability for making forward-looking statements. Investors had pressed for the law as a way to increase the information available.

Instead, it became a way for analysts to avoid doing their own legwork, said former Tupperware Corp. CEO Warren Batts, who said he was irritated by frequent requests for guidance in the 1990s.

`Hero to Bum'

``We went from hero to bum every three months,'' Batts said. ``It's such a ridiculous game.''

The SEC began regulating how companies communicate with analysts in 2000, when it passed Regulation FD, for fair disclosure. The rule barred officers from slipping market-moving news to favored investors before general dissemination.

Accounting scandals at Enron Corp. and WorldCom Inc. led to the 2002 Sarbanes Oxley Act, the most sweeping reform of U.S. financial laws since the 1930s. In addition to stiffening criminal penalties for financial fraud, the law forced analysts to disclose conflicts of interest and barred employers from retaliating against analysts who wrote negative reports.

In 2003, Citigroup Inc., Merrill Lynch & Co. and eight other securities firms paid a $1.4 billion fine to settle allegations of biased research and agreed to stop compensating analysts based on how much investment-banking business they helped generate.

Guidance in Statements

While Regulation FD prevented companies from making selective disclosures, they still can guide analysts to an estimate they know they can beat by forecasting in a public statement. Analysts still have incentives to avoid writing negative reports, because it might hurt their relationship with the company or their employer's goal of encouraging customers to buy shares.

Investors view analysts as ``a necessary evil,'' said Bryan Armstrong, who surveyed 30 portfolio managers in 2005 on how they use estimates. Many said they like to learn what others are saying about a company and compare with their own models, said Armstrong, a partner at Ashton Partners, a corporate advisory firm in Chicago.

Criticisms of analysts are overstated, said Paul Nisbet, an analyst with JSA Research Inc. in Newport, Rhode Island. Analysts stand to lose clients if their reports are inaccurate, he said.

``All of a sudden, the people you're selling the stock to try to find another analyst who didn't get caught,'' Nisbet said.

Analyst Uneasiness

In the months leading up to General Electric's results, analysts hinted at concern that the company was straining to meet its own growth forecasts. Credit Suisse analyst Nicole Parent wrote that she wanted GE to stop setting quarterly targets and focus instead on ``lower, higher-quality'' earnings.

Former GE auditor Heymann rated the stock ``hold'' when he began coverage Nov. 13 for Sterne Agee. He joined the Birmingham, Alabama, firm last year after 25 years as a Wall Street analyst. Now he looks at longer-term measures: research spending, internal growth, sales from emerging markets.

``Most guys, they're still carving wooden figurines: `Hey, this quarter's going to be 37, not 36, and the tax base is going to be low, so buy the stock,''' Heymann said, mimicking an analyst report. ``That stuff is so yesteryear.''

To contact the reporter on this story: Peter Robison in Seattle at Robison@bloomberg.net.

No comments: