The Street Is Still Behind the Earnings Curve
By Margaret Popper
Seems like every day brings a new set of earnings warnings. And as the first quarter draws to a close, the warnings aren't just dribbling in, they're pouring in. On Mar. 5, LSI Logic (LSI ), Cypress Semiconductor (CY ), Vitesse Semiconductor (VTSS ), and Xilinx (XLNX ) all informed the market that first-quarter earnings and revenue growth will be disappointing.
We're not just talking little adjustments here. LSI Logic said first-quarter revenues would be 30% off the previous quarter, instead of the 12% initially predicted. Cypress announced they'd be 24% lower than fourth quarter of last year, vs. the 4% to 9% lower originally anticipated. Xilinx said its revenues would drop by 15% for the quarter, vs. a previous projection of no revenue growth.
It would be nice if this kind of "negative guidance," as it's called on the Street, was restricted to semiconductors, or at least to the hard-hit tech sector. Alas, techs represent only a third of the 406 companies that have made negative pre-earnings announcements so far this year.
And if it seems there are more skeletons flying out of the closets than ever before, well, it's true. More companies are giving guidance, in part because of the SEC's new Reg FD rules that require companies to give more warning about bad performance and in part because CEOs are concerned that investor expectations are still unrealistically high.
WORLD OF WOE.
Things have changed a lot since Alan Greenspan coined the term "irrational exuberance" to describe the giddy heights of the runaway markets of the late '90s. But even now, while it may not be "exuberance" exactly, analysts' forecasts still exhibit some irrational optimism.
That has left their 2001 projections even more out of sync. There has been a mad flurry of downward adjusting since January because analysts as a group still haven't caught on to the earnings reality of the slowdown. That's going to mean a further slide in stock prices as they absorb the repercussions of missed earnings projections and a lot of volatility, as CEOs continue to try to set the record straight. Woe unto investors in the short-term.
"One of the main reasons you're seeing all these earnings pre-announcements is that analysts really don't have a grip on their first-quarter projections," says Joe Kalinowski, equity strategist at Thomson Financial, which owns IBES and First Call, the respected aggregators of analyst opinion. "Corporate management is saying, 'You're ahead of yourselves.'"
If last quarter is anything to go by, a lot more companies are going to deliver bad news between now and the second week of April, when the actual numbers start getting published. There were 1,474 earnings pre-announcements in fourth-quarter 2000, of which 794 were to say earnings would be worse than expected.
While the percentage of negative vs. positive announcements wasn't out of the ordinary, the volume of pre-announcements was "huge," according to Kalinowski. Only 140 companies pre-announced last year at this time, 64 of them with bad news. That means CEOs are more concerned with making sure analysts are on the map. "Some of that is Reg FD, but most of it is because analysts are not in line with reality," observes Kalinowski. The wake-up call is blaring just as loudly this quarter. So far, 602 companies have made announcements, of which two-thirds were negative.
Unfortunately, it's still doubtful that analysts are chopping their estimates hard and fast enough to adjust for the whole of 2001. That's partly because they're still reacting to company news rather than taking into account the full macroeconomic impact of the slowdown on all companies. "Analysts are too used to being spoon-fed, because in the market we had in the 90s, you really didn't have to work too hard," says Chuck Hill, director of research at First Call and a former semiconductor analyst. "For the most part, last year, they were adjusting their numbers down a quarter at a time, and not adjusting them enough, and not doing anything until a company announced something."
To Hill's way of thinking, waiting for company announcements to readjust projections is sheer laziness. "It boggles the mind the way they didn't take into account the economic impact of Federal Reserve policy," he says. "There were a lot [of analysts] who would not react when a competitor of a company changed it's guidance." That's a logical time to review all companies in a particular sector to see whether there are bigger economic issues affecting the industry.
Still, Hill excuses analysts to some extent. "It's human nature to extrapolate the most recent trends," he allows. So after the soaring markets of 1999 and the first half of 2000, there was a bit of an excuse for not dropping projections far enough. But even Hill won't defend not adjusting them at all. "A lot of these guys spend too much time on the trees and not on the forest," he says. "They're very good at comparing Company A to Company B, and not so good at identifying the overall trends."
The big disconnect between analysts' projections and reality began last May, when Fed Chairman Greenspan made his last interest-rate hike. When the tightening stopped, it should have been a signal that the economy was slowing, as Greenspan wanted it to. A slowing economy will always translate into lower earnings. Instead, many analysts and investors alike took it as a positive sign that credit would loosen up.
From there, it got worse. Even as they scrambled to readjust their projections downward starting in the third quarter of last year, many analysts didn't change their 2001 numbers. "A company would give guidance, and they wouldn't change 2001, so the growth rate for 2001 rose," notes Milton Ezrati, senior economist and strategist for fund manager Lord, Abbett & Co. Slowly, the "top-down" consensus opinion for average 2001 S&P 500 earnings projections of strategists, as the economists who follow macroeconomic trends for brokerages are called, diverged from the so-called bottom-up consensus. The latter is the earnings-growth number you get if you average all of the estimates from analysts who cover individual companies and follow microeconomic trends.
MORE ROOM TO FALL.
Let's look at the numbers. At the end of 2000, the bottom-up consensus was predicting 9.2% earnings growth for the S&P 500 in 2001. The top-down consensus was 6%. In the last month, both have been revised downward to 4%, according to the most recent IBES numbers. Obviously, that meant more dramatic recalculations on the part of company analysts, rather than the strategists. Which helps explain why bad earnings news seemed to come out of the blue, increasing market volatility.
Strategists expect even these revised numbers to keep dropping, as companies continue to issue negative guidance. The real concern is that the bottom-up consensus of analysts for 5.3% growth in the third quarter is unrealistic. "The market usually bottoms three months after the Fed starts lowering rates, as it did on Jan. 3, and earnings usually bottom eight months after that," observes Charles Rheinhard, U.S. equity strategist at Lehman Brothers. GDP growth usually bottoms about five months after the market, so it will probably turn around before earnings do, according to Rheinhard.
Between now and the bottom, though, there'll be plenty more negative news. "The top tier of companies that are giving negative guidance are setting the stage," says Thomson's Kalinowski. "Now, I'm watching companies that haven't announced, like IBM (IBM ), Computer Associates (CA ), BMC Software (BMCS ), Citrix Systems (CTXS ), and Informix (IFMX ). These are companies with a history of negative pre-announcements last year, and there's a lot of analyst optimism surrounding them." The message: Investors should fasten their seatbelts. Further disappointing announcements could make for a white-knuckle ride.
Popper covers the markets for BW Online in our daily Street Wise column
Edited by Douglas Harbrecht