The U in FUD:
October 3, 2001
Heard on the Street
With Forecasts in Disarray,
Analysts Turn to New, Old
By STEVE LIESMAN
Staff Reporter of THE WALL STREET JOURNAL
If people say this stock market is cheap relative to earnings, don't believe them.
They probably don't know.
Like few events before it, the terrorist attacks of Sept. 11 have created unprecedented turmoil in the earnings outlook. Thomson Financial/First Call can't say with any certainty what the consensus of stock analysts is for operating earnings of companies in the Standard & Poor's 500-stock index in the most recently completed quarter or in the coming quarters. S&P has been running a disclaimer recently on its earnings-outlook Web page, warning that many company earnings forecasts "are still under review." Without corporate guidance and reliable analyst estimates for individual companies, First Call's much-followed aggregate earnings figure for the S&P 500 lacks any particular meaning.
The difficulties are multiple, forcing stock analysts and investors to find new ways -- some of them actually old -- of evaluating stocks.
Among the problems, companies haven't had time to separate the temporary impacts of the disaster from the permanent. Some warnings so far have been unusually vague, such as Ford Motor Co.'s announcement that it wouldn't make its previous earnings target, but its failure to provide new forecasts. And there's concern that a variety of companies will attribute unrelated costs and expenses to the disaster.
Three weeks and a day after the terrorist attacks, analysts have yet to digest all the warnings being dispatched. For example, Hartford Financial Services Group Inc. has suggested that its third-quarter operating loss could be around 70 cents a share. But the consensus remains at a loss of 15 cents a share, because three of 13 analysts covering the insurance company have yet to change their previous estimates. Of those who have updated their estimates, the consensus is a 75 cent loss, reflecting a trend of greater bearishness on the part of analysts, compared with company statements. (Operating earnings typically exclude certain expenses that are considered normal business costs under generally accepted accounting principles; in the insurance industry, they typically exclude realized investment-portfolio capital gains and losses.)
"Certainly, analysts have brought the numbers down," says Chuck Hill, director of research at First Call. "But they haven't brought them down enough."
One problem is that many analysts, such as those at Merrill Lynch & Co., have been displaced by the collapse of the World Trade Center and have had trouble updating forecasts. "We're making do," says Satya Pradhuman, director of small-stock research at Merrill Lynch. "It's kind of like working with rubber bands and gum right now."
The uncertainty finds stock analysts grasping for ways to do what they are paid to do: evaluate companies even -- and, some say, especially -- when things are unclear.
To be sure, earnings decline every time the economy sours, and so the most popular corporate gauge, a price-to-earnings ratio, loses its value for many companies and industries. But the shock of the terrorist attacks has forced analysts to rethink how they value companies. For example, where once they followed growth rates, analysts are now focused more keenly then ever on whether a company has enough cash for its interest payments.
Their absence from regular offices has given Merrill analysts time to think about the sharply changed economic landscape. They have come up with new ways of thinking about companies that would have seemed strange just a few weeks ago. "In some ways, we've used this displacement to our advantage," Mr. Pradhuman says. "We all have this nervous energy, thanks to this chaotic situation, and that forces us to dig in."
Mr. Pradhuman believes investors are becoming more conservative and so will pay a higher price for visibility and stability of earnings. But how to find such things in today's market?
Merrill is zeroing in, curiously enough, on the otherwise cacophonous message being sent by the earnings forecasts. It's looking for companies with the narrowest range of earnings forecasts from analysts, suggesting that there is some measure of certainty there. It also is screening the universe of companies for the most stable earnings growth in the past five years. Finally, analysts are looking at an old-fashioned metric -- return on equity, which looks at trailing net income as a percentage of book value. Mr. Pradhuman says this helps identify companies that can grow by using their own resources.
"Sector for sector, we think the market will pay a premium for that which is more predictable," he says.
Companies that make the grade so far include Advanced PCS, Cracker Barrel and Universal Health Services.
For analysts at Salomon Smith Barney, the first preoccupation is more basic: assessing the potential for liquidity problems.
That was always important, but never so much as now, especially among the highly leveraged industries such as telecommunications and broadcasting. So analysts are busy simulating various revenue and cost projections, using worst- and best-case scenarios, to determine in the first order if cash flow will cover interest payments. Salomon is assessing whether companies will have the cash flow in a recessionary environment to pursue growth objectives, or in some cases, just to survive.
In their models, Salomon analysts usually aren't reducing expenses as fast as revenue, because it is typically difficult for a company to cut costs in line with declining sales, says Tim Tucker, who oversees U.S. research policy and quality at Salomon.
But to figure out whether a given stock is relatively cheap or expensive, in cases where earnings fall sharply, Salomon analysts have to find something other than price-to-earnings ratios to value companies. "In recessionary times, earnings can become meaningless," Mr. Tucker says.
Salomon instead is focusing on total enterprise value, which is a company's market capitalization plus its net debt, and comparing that with earnings before interest, depreciation and amortization, or Ebitda. That isn't the end of the analysis. Salomon then takes the ratio of enterprise value to Ebitda and compares that to ratios found during previous recessions, either for the individual company or its industry group.
But the analysis can go only so far without good information. And so, Salomon's semiconductor analyst warned Tuesday, "While valuations are interesting after significant price declines, we caution investors to wait until near-term bad news is out before looking to establish positions in the group."
While acknowledging that much has changed, auto analyst Saul Rubin at UBS Warburg thinks a lot remains the same. Even before the attacks on Sept. 11, Mr. Rubin was concerned about U.S. auto makers maintaining market share and about declining sales. The attacks have only exacerbated those problems. As before, Mr. Rubin is keeping a close eye on consumer confidence as the most significant factor affecting sales.
"Even before, my view was that there was a distinct possibility that consumers would retrench, and auto sales would come down heavily," he says. What is different, he says, is that there is now more interest in the worst-case scenarios that he has always generated, but that investors have overlooked. "The 'what-if' has become more a base case." |
