Big (Black n') Blue

By: Chad Hudson | Wed, Apr 10, 2002
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The big earnings news this week was the pre-announcement from IBM. IBM announced revenue would be on the light side for the first quarter by more than $1 billion. But what's a billion among friends? The revenue shortfall will cause earnings to be off over 30% from year ago levels and 20% lower than analysts estimated. IBM attributed the shortfall on "customers chose to reduce or defer capital spending decisions until they see a sustained improvement in business." Since Gerstner just stepped down and this was Palmisano's first earnings announcement to preside over, there is speculation that Palmisano is trying to "clean the slate" or lower the expectations bar. Another scenario could be that increased investor scrutiny made it harder for IBM to engineer its earnings to the penny. IBM has been one of the poster childern for financial engineering. Between, pension accounting, share buybacks, asset write-downs, employee stock options, IBM did it all. Now IBM faces the very real possibility that all these factors that led to 20% EPS growth will not only stop contributing to EPS growth, but start being a drag on earnings. With investors' focus growing on accounting and financial engineering, it will be much harder for IBM to grow earnings over 20% while sales grow only 5%.

Also this week, Nortel announced that it expects first quarter revenue to be only $2.9 billion, down 50% from year ago levels. Nortel also announced it was drawing down a $1.75 billion line of credit, but that only turned out to be a good bluff as Nortel announced it came to an agreement to extend the credit line, albeit for $575 million less.

Wednesday, Tom Siebel added to technology woes. The CEO of Seibel Systems said that the first quarter may have been the worst quarter the computer industry has ever seen, and added that the contraction isn't over. Siebel predicts 100 to 200 IT companies will go out of business this year. Mark Murphy, an analyst with First Albany, noted that Seibel "was very bullish in his fourth-quarter conference call and now he doesn't sound bullish now." It sounds like business is not getting any better, and may actually be getting worse.

This continues a long string of negative outlooks among technology CEOs. Last week, Check Point Software announced its revenue would be lower than previously forecasted due to "weaker than anticipated revenues in the first quarter due to the continued depressed Information Technology (IT) spending environment." This announcement by Check Point is especially interesting since analysts, following September 11, expected a shift in IT budgets to security related products. If security products are getting a bigger piece of a shrinking pie, and that piece is even getting smaller, just think how much the rest of the pie is shrinking.

Last month Sybase's CEO, John Chen, said "People think it's going to pick up in the second half. I'm somewhat skeptical of that." I would bet that most companies have already set their IT budgets for the year, and unless there is a huge recovery in business those budgets will not be altered. In fact, for this year there is more risk of downside revisions if the economy does not continue to rebound.

There remains considerable weakness throughout the technology sector and it looks like it will persist. In a note today from Merrill Lynch discussing the Electronic Manufacturing Service Industry (EMS), Jerry Labowitz states that "Negative pre-announcements from IBM and Nortel Networks this week only reinforces our stance that a second half recovery is difficult to digest at this point in time." This does not bode well for a stock market that started discounting a second half recovery. Valuation ratios remain either very high or incalculable. According to Bloomberg, the NASDAQ 100 currently trades at 61 times estimated earnings, almost 80 times earnings from continuing operations, 63 times cash flow, and 3.7 times sales.

As tech companies continue to languish, cash registers are ringing at retailers. Maybe that is why technology is doing so poorly. Everyone is out buying stuff and not working? Retailers started releasing March sales this week and so far seem pretty strong. Part of the strength in retailing can be attributed to the $117 billion in rebates the IRS handed out during the first quarter, a 17% increase from last year. The average size of each refund grew 12% to almost $2,000. According to surveys tax refunds are generally spent, only 28% of those expecting a refund were planning to save or invest their refund.

Sears announced that its earnings will rise 17% due to aggressive cost cutting as same store sales fell by almost 5%. As I've discussed before, this will be how business will plan going forward. With more and more companies focusing on cutting cost it will be a very difficult environment for companies that sell equipment to other businesses. This is the area between the rock and the hard-place that technology finds itself.

The New York state attorney general obtained a court order to force Merrill Lynch to disclose conflicts of interests between its investment bankers and research analysts. The case is based on emails involving Internet analyst Henry Blodget. The attorney general stated Merrill issued "biased and distorted" stock picks. Merrill Lynch was quick to point out that the emails were "taken out of context."

Out of context? Here are a few quotes from Merrill Lynch emails that are quoted in the affidavit filed by the attorney general.

Regarding the ties between research and investment banking:
" The more I read of these, the less willing I am to cut companies any slack, regardless of predictable temper-tantrums, threats, and/or relationship damage that are likely to follow. If you believe that this stance is a bad business decision for Merrill Lynch, please raise this with [senior management]. We all had to spend (waste) an unbelievable amount of time on the latest situation....If there are no new email forthcoming from Andy [Melnick] on how the instructions below should be applied to sensitive banking clients/relations, we are going to just start calling the stocks (stocks, not companies), including AETH, like we see them, no matter what the ancillary business consequences are."
Regarding the ties between analyst compensation and investment banking:

"We are once again surveying your contributions to investment banking during the year....Please provide complete details on your involvement in the transaction, paying particular attention the degree that your research coverage played a role in origination, execution and follow-up. Please note, as well, your involvement in advisory work on mergers or acquisitions, especially where your coverage played a role in securing the assignment and your follow-up marketing to clients. Please indicate where your research coverage was pivotal in securing participation in high yield offering."

And Merrill giving advice to companies it covers:
" We need to talk about this. While I understand your genuine enthusiasm for the company and trust your "killer deal instinct", I am concerned that the market will not react favorable to any news that [InfoSpace] fund US Search. My BEST advice to you is to let Yahoo and Lycos win this one - there will be plenty of deals for you to do and [InfoSpace] cannot afford this kind of scrutiny right now - the stock is under a lot of pressure."

While most institutional investors were fully aware of the conflicts of interests and analysts were in fact banking salespeople, the investing public put their faith on these guys. This will not help Wall Street win back individual investors that have grown suspicious of Wall Street and have started throwing in the towel.

Here is the link if you are interested in reading the whole affidavit. There are some more egregious examples of the above conflicts, but could not be easily summarized. Warning - it is a 38 page PDF file. http://www.oag.state.ny.us/press/2002/apr/MerrillL.pdf


 

Chad Hudson

Author: Chad Hudson

Chad Hudson
Mid-Week Analysis
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