Earnings Season Progress: Perception vs. Reality

The lunatics are back in charge. First we had Meredith Whitney upgrade Goldman Sachs. She was rather cautious on the fundamental prospects of the banking sector, but did anyone care? No.

Next, we learned that Meredith has a pretty good contact at Goldman as they reported a blowout quarter. Of course, they're benefiting from the "unfortunate" demise of a few of their key competitors which has resulted in widening spreads and terrific near-term trading profits. How many other large "banks" will benefit from this? A couple. Commercial and residential loans continue to deteriorate. Does anyone care? Not really.

Intel followed. Nice quarter. Revenue was better than expected which helped boost gross margin. Of course, Intel is at the back end of the supply chain and not the best company to listen to when it comes to tech industry guidance (I'd happily wager that they guide down revenue before their next report). We also just learned that AMD posted a fairly poor quarter, so Intel clearly benefited at the expense of a key competitor. That's a different story than a general tech rebound. Does anyone care? Doesn't look like it.

Apple was next to release. Not surprisingly (they always guide low), the company posted a strong quarter with particular strength coming from iPhones. Despite the recession, this is clearly the hottest consumer gadget on the market. Does this have any bearing on technology consumption in general? Not much. In fact, it could easily be argued that the money that cash-strapped consumers are spending on iPhones and monthly calling plans is money not being spent on other products. Does anyone care? Not much.

Plenty of companies have already reported. In general, we're seeing continued weakness on the top line (revenue) with pretty good cost cutting. With analysts having low-balled estimates (at times without company guidance), we're seeing plenty of headlines heralding a slew of earnings beats. With each beat from a high-profile company, the market charges higher.

The bulls contend that corporate America will be nice and lean when the imminent rebound occurs thanks to aggressive cost cutting. Margins will rebound strongly as will earnings. We've also seen a few of the quieter bulls pop up in the media recently. Bill Miller and Mario Gabelli have just sounded the all-clear. In addition, plenty of analysts have been upgrading stocks to "Buy" on the heels of these "wondrous" earnings. Interestingly, these folks were awfully quiet earlier this year. Now that the market has jumped 35% and many stocks have more than doubled, they're telling us that it's safe to wade back in. Different business cycle, same self-serving lemming behavior.

Yes. A few large well-known companies have reported decent earnings, but these companies are not at all indicative of the earnings prospect of the S&P 500. There are unique and one-time explanations for these results, and the weaker reports of many lesser-known companies confirm this. Even the almighty Google reported nearly flat revenue growth. Where was the concern? The market barely budged.

For those of us with a less sanguine view of our economic prospects in the next few years, the continued weakness in revenue is a serious concern. Costs can only be cut so far before margins are impacted.

We've been steadily reducing our exposure to equities during this rally. We were getting paid well to incur risk back in February and March. That's no longer the case.

Does anyone care? Not at the moment. At some point, they will. Sentiment can drive the market in the near-term, but the fundamentals will eventually reassert themselves. Until then, be wary of the lunatics.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Intel Lowering Guidance - A Good Thing

What a difference a month makes. One month after releasing its third quarter earnings report, Intel has issued a press release guiding down revenue and margins for the fourth quarter. As recently as October 14th, the company was expecting Q4 revenue to come in between $10.1 and $10.9 billion with gross margin at or near 59%. The company is now looking for revenue of $9 billion with gross margin in the vicinity of 55%. In just under one month, Intel's business has deteriorated by 14%. This is a huge miss.

There will be plenty of negative commentary over the next day about this miss, but I actually think this may perversely turn out to be positive for the market in the near-term. Despite the earnings misses and the cautious guidance from virtually every company this earnings season, Q4 and 2009 earnings expectations still remain too high. Now that bellwethers Intel and Cisco have both put a serious ding in expectations, it's hard to imagine that investors and analysts will be able to ignore the poor near-term earnings reality that nearly all companies face.

I suspect this will soon lead to yet another near-term bottom (though not necessarily THE bottom) in the market, as investors (particularly the pros) start to think that a more realistically poor earnings outlook is finally being discounted.

As I wrote in my November 6th post:

As we stand now, I plan to continue fading strong moves in the market. I'll be looking to cover the current shorts and rebuild the long side should we head back to recent lows. If we turn around and start heading back up, I anticipate adding short exposure in the S&P 500 and the Russell 2000 as well as in the consumer, alternative energy, and financial spaces.

With the market now down about 15% from its most recent peak on November 4th, my bias has again shifted to the long side. Today I covered 2 of my outstanding (alternative energy) shorts, leaving one financial short. I've also begun to add some long exposure (Russell 2000 and QQQQ). I plan to keep building the long portion of the portfolio at lower levels and will be a bit more aggressive if we see a sharp Intel-inspired sell-off tomorrow morning.

Disclosure: The Rubbernecker is getting longer again but is still short slothful, Panglossian, sell-side analysts.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

3Q08 Earnings Season and Valuation

What a week. We wrap up the worst month in the market since the 1987 crash by enjoying the best week in the market in 34 years. This neurotic bi-polar market continues to redefine everyone's view of volatility. It feels like we've had 3 years worth of action in just the past few weeks. The news flow has been incredible as well as the financial crisis continues to unfold at the same time as earnings season is in full swing.


Now that I've had a chance to catch my breath, there are a few thoughts about this earnings season that I thought I'd share as we enter the last heavy week of reporting. First of all, it isn't surprising that most of the news on the earnings front has been rather disappointing this quarter. It's looking like earnings for the quarter may end up falling 9-10%. Few firms in any industry are very upbeat about the near future although most firms claim to be very well-positioned for the long-term. This is just how things are done during a "slowdown." Mangements are typically of the optimistic sort, so when the near-term outlook is terrible, the conversation begins to focus more on the long-term, for which their enthusiasm knows no bounds. Of course, when the near-term starts to improve, we can expect the conversation to quickly shift back to their more typical, "long-term", three-month outlook.

Another point that I'd like to stress is that it gets a little more difficult during an economic downturn to assess the performance and prospects of a firm. Whatever the true reason for a slowdown in sales, a fall in margins, or a lower earnings forecast, virtually all companies will blame any shortfall on the economy. Thus, differentiating between company-specific and economy-specific reasons for a firm's poor performance gets a little tricky. No CEO really wants to say, "Hey. Not only does the economy stink, but we've been really making a mess of things around here ourselves." So, instead, blame gets shifted solely to the economy. For this reason, paying attention to a company's industry peers takes on even more importance during a recession (yes, this is a recession). If all of the companies in an industry are hurting fairly equally, it's probably the economy. The larger the differences in performance, the less likely it is that the economy is the only factor impacting the laggards.

Finally, let's take a look at earnings expectations for the fourth quarter and 2009. A report from Thomson Reuters Research came out in the middle of last week that showed that analysts were expecting earnings for the fourth quarter to increase by 32.2% and for 2009 to show growth of 15.7%. I suppose anything is possible, but these figures strike me as a touch absurd.

Let's look at earnings estimates a little closer, using Standard & Poor's data. For the fourth quarter of 2008, the estimate for S&P 500 earnings based on analyst projections (bottom-up) is calling for a 15.2% sequential increase over Q3 and a 36.8% increase year-over-year. These are operating earnings, which leave out all of the "one-time" items. Unfortunately, there isn't a comparable top-down operating number. The top-down estimates that we have come from strategists (as opposed to analysts) and are for reported earnings, which do include those "one-time" items. It's interesting to note the difference in these figures. The bottom-up (analyst) operating estimate for the fourth quarter stands at $20.82 while the top down (strategist) reported figure comes in at $12.12, 42% lower. For 2009 those numbers are $94.25 and $48.52, respectively. That's a huge difference of 48.5%. By way of comparison, the difference between the reported and operating numbers for 2007 and 2006 were 19.8% and 7.1%, respectively. The difference for 2008 is forecast to be 25% currently.

What does this mean for valuation? The S&P 500 index closed last week at 968.75. Put a 15 multiple (arbitrary) on the $94.25 figure for 2009, and you get a level for the S&P 500 of 1413, implying that the market is undervalued by 45% currently. Put that 15 P/E on the $48.52 figure, however, and we find fair value at 727, implying the market is overvalued still by 25%.

There are two points to this analysis. First of all, the bottom-up estimates from the analysts are almost always too optimistic, particularly during a downturn. The analysts are being spoon-fed by optimistic managements and are therefore very slow to bring their numbers down to better reflect reality.

The other point is that we have to be very careful when trying to value the market using P/E analysis. There are a number of different earnings measures and time frames that can be used. The use of a particular P/E multiple is also highly subjective. Care must be taken not to mix a forward (2009) earnings estimate with a P/E based on historical trailing earnings. Forward P/Es must be applied to forward earnings, and trailing P/Es must be applied to trailing earnings. Better yet, these inputs should be normalized for the business cycle. Unfortunately, rather than approach valuation objectively, many people tend to use the combination of earnings and multiple that best helps them justify the bullish or bearish view they already hold. This is called data mining, and it's a dangerous substitute for objective analysis.

Disclosure: The Rubbernecker is long mining, but not data mining.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Trading Around Earnings

With earnings season in full swing and beautiful bike riding weather tempting me, I haven't been writing too much lately. Furthermore, my wife and I are expecting our first baby (a daughter) in about 7 weeks, so I've been hunkered down conducting intensive research on girls-only day care, nunnery applications, and state gun permitting laws.

But earnings season is finally winding down, and I'm sufficiently recharged to once again form complete sentences. With earnings still fresh on the mind, I thought I'd share a few thoughts about earnings season. First of all, I think the idea of quarterly earnings reports is ridiculous. Company management is supposed to be focused on building long-term value, and quarterly reporting only encourages an emphasis on short-term results. It's a tremendous distraction. Twice-a-year reporting would make much more sense -- and not just because it would interfere only half as much with my bike riding.

I've been asked a number of times about my opinion on trading in anticipation of an earnings miss or beat. This isn't surprising since there are plenty of bloggers/gurus/charlatans/hucksters/frauds/Street.com personalities and Wall Street analysts offering their opinions about which stocks you should trade heading into earnings season. I'm not a big fan of placing these trades. The difficulty lies in the fact that the stock may not rise or fall just because it met or missed earnings expectations. Here are a few of the possibilities:

• The company could report a great quarter, and the stock goes up.
  
• The company could report a great quarter, but it might not be as strong as the market was expecting so the stock gets hit.
  
• The company could report a great quarter but guide the next quarter down, so the stock gets hit.
• The company could report a great quarter and an SEC investigation, so the stock gets hit.
• The company could report a great number, but the quality of those earnings could be poor, and the stock gets hit.
• The company could report a great number and a stock offering, so the stock gets hit.
• The company could report a great number, but the stock had run up in anticipation of the great number, so investors take profits on the news (buy on the rumor and sell on the news).
  
• The company could report a bad quarter, and the stock gets hammered.
• The company could report a bad quarter, but it might not be as bad as feared, so the stock goes up.
• The company could report a bad quarter but announce that it's pursuing "strategic alternatives" so the stock goes up.
• The company could report a bad quarter but offer strong guidance, and the stock goes up.
• The company could report a bad quarter and a stock buyback, and the stock goes up.
• The company could report a bad quarter, but the Street might believe that the worst is over, and the stock goes up.
  

I'm sure I missed a few, but the point is hopefully clear. Placing a short-term trade based only on whether you think a company will beat or miss earnings expectations can be treacherous since that's only part of the picture. Still, from time to time I will buy or short a stock shortly before it announces its earnings (such as shorting GOOG before last quarter's earnings release), but there are a few requirements.

First of all, if I'm buying, then I must feel very confident that the company will beat expectations AND/OR raise its guidance. If I'm shorting, then I must believe that the company will miss expectations AND/OR guide lower. The trade also has to be consistent with my view of the company's valuation and fundamentals. I'm not likely to short the stock of an inexpensive company with great fundamentals, and I'm not likely to buy the stock of an expensive company with poor fundamentals, regardless of the time frame.

Rather than take a new position just before an earnings announcement, I usually prefer to see the market reaction following the earnings release and possibly the conference call. Especially in volatile times like these, investors tend (in my opinion) to be prone to overreacting to news. Of course, the stock reaction has to be out of proportion to the news. These overreactions are more likely to occur during after hours trading when liquidity is relatively thin. I only placed one of these trades this earnings season, and it was a purchase of MEMC Electronic Materials (WFR) after hours on July 23rd following a poor earnings release. The stock was purchased at the mid-$38 level when it was briefly down about 30%. The position was sold the following morning just shy of $45.

So what should you do? Place a trade in anticipation of some earnings outcome, or look for over-reactions following earnings releases? You probably shouldn't be doing either. It's very difficult to make money consistently with any short-term trading strategy, and you're up against pros with far more experience and far better contacts. Stick with the long-term, focus on valuation and the fundamentals, and go for a bike ride.

Disclosure: The Rubbernecker is long post-earnings season lobotomies but short earnings season.

Tis The Season

It's been a slow week posting-wise thanks to a busy week earnings season-wise. Earnings season is always a bit of a mind-numbing experience. Every day is met with a barrage of press releases, numerous analyst rating changes, and back-to-back conference calls with management explaining how their quarterly earnings would have been an all-time record if you just ignore the write-offs, higher commodity costs, lawsuits, accounting system transition issues, margin shortfall, higher tax rate, options expense, weather impact, goodwill amortization, order push-outs, and poor feng shui. It makes for some long days.

Of course, there are companies reporting good earnings -- mostly commodity-related companies, those benefiting from international growth and the weak dollar, and those that operate pawn shops. Those with the most excuses are the financials. The typical bank conference call this quarter can be summed up as follows:

We’re disappointed to report a record loss of 12 kajillion dollars, but our core business is performing strongly as you can see if you strip out the mark-to-market losses and the charge-offs.

Well, if I ignore my lack of buoyancy and my inability to breathe in the water, then I'm a world-class swimmer. They’re a bank! The purpose for their existence is to attract deposits/funds and invest the proceeds in securities and loans. It’s like Microsoft saying, “We had a great quarter aside from terrible software sales.”

Let’s be very clear. When a bank has to charge-off a good chunk of its loans, it's an admission that prior period earnings were overstated. Prior earnings benefited from these loans back when borrowers were actually making their payments and the bank wasn’t adding to reserves. These guys want the benefit of the overinflated prior period earnings but no penalty for the current period charge-offs. It would be genius if it weren't so ridiculous.

Despite some truly poor earnings in general from the financial sector this quarter, we did witness a very robust rally in the group. This wasn't terribly surprising. As I wrote on July 15^th in my Trader VIX post,

...the VIX has had an uncanny ability to predict short-term rallies (lasting between 2 weeks to 3 months) in the S&P 500 (top chart) each time it has exceeded 30 in the past year. As the VIX has approached this level, I've been less inclined to initiate new short positions and more inclined to cover existing shorts. Note that the intraday high for the VIX today was 30.81.

It seems I wasn’t the only one watching the VIX. Almost as soon as the VIX crossed 30, the market made its most recent low and began its latest bounce. With financials having been sold-off so brutally over the prior 2 ½ months, it was no surprise that they benefited the most from the rally.

Also from the Trader VIX post,

In general, I'm expecting plenty of earnings misses and fairly restrained (to put it mildly) earnings guidance over the next month. But, with cash on the sidelines and a pervasive sense of gloom in the market, an earnings season short of cataclysmic may be just enough to spur the next bear market rally.

This also turned out to be the case. Prior to Thursday, the S&P 500 rallied more than 6% over a mere 6 trading days. Generally speaking, the earnings results from the financials were awful, but since they turned out to be less terrible than feared, the group enjoyed a powerful rally.

The other strong move of note this month has been the sell-off in practically every commodity and commodity-related company. I’ve been cautioning that this would happen at some point and that this is normal bull market activity. I had pared back exposure to the group and have been keeping some dry powder ready for just such a pullback.

In recent days, I’ve been gradually putting some of that dry powder back to work, adding to some energy, metals, and agriculture names. I anticipate adding further should investors continue to bail out. As for the financials, I've had no interest in chasing the latest rally. For now, I'm on the sidelines, but should the group rally further, I'll be looking to rebuild a short position in the sector.

My writing is likely to continue to be a little thin over the next couple of weeks since we're in the meat of earnings season. I'm not as effective or coherent a writer when I'm in an earnings release-induced state of catatonia.

Disclosure: The Rubbernecker is long commodities and caffeine and very short sleep.

Sallie Mae I? No, You May Not.

I noticed SLM popped 9% this morning after their earnings release and conference call. You've got to be kidding me.

The student loan market is in disarray.

• Cuts made to the federally guaranteed loan program have hurt.
  
• The credit crisis has resulted in less funding being made available to the student loan companies.
• The lack of liquidity in the market has made it difficult for lenders to package and sell (securitize) their loans in the asset-backed market. The securitizations that they can sell are being done at very high spreads (they're very expensive to the lender). As a result, new loans are being made at a loss.
  
• Fifty-seven lenders have dropped out of the program, and 19 lenders have suspended private student loans.

With that, let's take a quick look at Sallie Mae's (SLM) press release from last night. To their credit, in the first paragraph they state that, "Under current conditions, however, loans can only be made at an economic loss. Reflecting this environment, the company is assessing how best to balance its resources and its mission to provide access for higher education."

In the next 4 paragraphs they go on to discuss "core earnings" and explain how according to "core earnings" they registered a nice $0.48 in EPS for the quarter. Finally, in the 8th paragraph, they get around to discussing GAAP earnings. Turns out they managed to LOSE $0.28 share according to GAAP.

Basically, they tell us that we should ignore the markdown they took on their derivatives position and forget about their intangible assets. Leave out the bad stuff and things don't look so bad.

Some other points. The loss provision they took didn't look overly conservative given the environment. The company admitted that they can't write new business at a profit. The company isn't sure whether any legislation coming out of Washington would help or hurt them. The company's reliance on forbearance continues to increase. Their access to reasonably priced capital continues to deteriorate. Equity is a whopping 2% (that's sarcasm) of assets. Even "core earnings" are expected to be at the low end of their range (I'd be surprised if they even hit that.).

With all that, the stock is up 9%, north of $17.50. Apparently, the market feared something worse than what the company reported, and this is some sort of relief rally.

Given the risks and uncertainties surrounding this company and its business, this would not be a good investment for your kid's education fund given what we know today.

IBM - The Falling Dollar Ain't All Bad

If you want to see the benefit of the falling value of the U.S. dollar just take a peek at IBM's earnings release today. The headline is that they destroyed the analyst estimate of $1.45 by reporting $1.65. True enough, but lets look at the details and the quality of those earnings.

First off, revenue reportedly increased 11%, but if you take out the currency gain that growth shrinks to 4%. So, of the reported $2.5 billion increase in revenue, $1.6 billion of that came from currency.

Next, relative to the same quarter last year the company benefitted from a 1.0% lower tax rate.

If you take out the currency and tax benefit the company would have reported EPS of $1.29 instead of $1.65, barely ahead of last year's $1.23.

The other part of this is that the company has been a steady purchaser of its own stock. The purchases over this past year benefitted the company by another dime.

So, tonight and tomorrow when you're reading all of the glowing reports about how IBM knocked the cover off the ball, just remember that a minority of the strength really came from improved operations. This isn't a high quality beat.

JP Morgan - Will the Real EPS Please Stand Up

I just finished going over the JP Morgan earnings release and listening to the conference call. Here's a summary of what stood out to me:

• The company reported EPS this quarter of $0.68 versus expectations of $0.64. This is down from $1.34 for the same quarter last year. That's a 49% decline. Furthermore, $0.27 of this quarter's earnings came from a one-time gain from the sale of Visa shares in its IPO, so operating EPS was more like $0.41.
  

• This next part is a little tricky. According to fair-market accounting rules, firms get to report a gain when the debt that they've issued weakens. According to a recent Barrons article, "Here's how the accounting works: When a company's credit weakens and the yield on its debt rises relative to risk-free Treasuries, the debt becomes worth less to the holder. The financial company, which is the debt issuer, then takes a gain, because theoretically it could buy back its debt below face value." This quarter, JPM recorded a $949 million benefit from this accounting treatment in its investment banking treatment. Management stated that there was an offsetting amount in several other business lines to the tune of "several hundred million dollars." No one followed up on this during the call, so we don't know the exact figure, but let's assume that the company's net benefit from this was $500 million. That works out to about $0.10 of EPS.

• Any financial company has a bit of latitude in massaging its earnings due to their control over the amount of money they set aside for loan losses. This is as much an art as a science. Overall, JPM added $2.5 billion to its credit reserves which isn't terribly surprising. When you look a little closer at the pieces, however, there are a couple surprises.
• The Card Services division actually had a lower provision for losses (by $112 million) this quarter than last quarter even though net charge-offs increased from 3.89% to 4.37% and the 30-day managed delinquency rate was 3.66% vs 3.48% last quarter. Given the stress on the consumer in the current economic environment and the fact that the company's loss experience is deteriorating, I would think the loss provision should be increasing. The managed portfolio did shrink by 4% over this period, but the reserving here could have been much more conservative.
• The allowance for loan losses in the Commercial Bank segment was essentially flat with last quarter at $101 million even though nonperforming loans increased by $300 million. The net charge-off rate rose sharply from .21% last quarter to .48% this quarter.
  
• Every $100 million in loss provision works out to about a $0.02 swing in EPS.

• The Commercial business is growing nicely. This could be a bit concerning given the deterioration in the economy. The company stated that they're not doing much real-estate related business, and they specifically mentioned government and non-profit business as areas of recent focus. The charge-offs in this division have started rising, so this needs to be watched closely. The company claims this recent increase is just a normalization from very low levels of losses. We'll see.

• Their page on Prime Mortgages was very disconcerting. The 30-day delinquencies have been moving up strongly from just under 1.00% last June to over 3.00% this quarter. The company has obviously been tightening underwriting standards, but this is troubling.
  

• The Bear Stearns acquisition remains a big question mark. It's expected to close June 30, 2008. Time will tell whether this turns out to be a terrific buy or an albatross.

JP Morgan management made it clear on the call that they're open for business, and they're using the current financial turmoil to opportunistically expand their business. Should the financial markets and economy not suffer a severe recession, JPM stands to be a big winner. However, if we do suffer a severe recession and credit deterioration continues to expand, their purchase of Bear and continued balance sheet growth could do some serious damage. This is ignoring the potential ramifications of their huge derivatives book. Either way, JPM is clearly too big too fail.

I expect this stock to move with the financials which will continue to be subject to violent swings in sentiment. We seem to alternate between "The worst is behind us. It's time to buy!" and "Run for cover! Here comes another wave of write-downs!" At some point, the financial sector in general will again be a buy, but for the time being I'm comfortable opportunistically adding to my net short position.