Thread: Great piece on how the big boyz play the game:
(Part 1)
Technology News
Sun, 02 Jul 2000, 7:08am EDT
Wall Street Conflicts Make Analysts' Calls Suspect (Correct)
By Faith Keenan
Wall Street Conflicts Make Analysts' Calls Suspect (Correct)
(Corrects company name to First Call/Thomson Financial in 11th paragraph.
Published in the July issue of Bloomberg magazine.)
New York, June 30 (Bloomberg) -- Stock trader Marty Fiascone says he's not
normally a sore sport. Yet one trade continues to irk him.
In March, he lost $70,000 of his own money when the shares of MicroStrategy
Inc., an Internet software company, tanked. Fiascone, a managing director at
Stafford Trading in Chicago, insists securities analysts knew MicroStrategy
would restate its books to conform with standard accounting practices and that
its earnings and stock price would suffer.
Rather than alert him, the analysts kept urging him to buy shares, he says. On
March 20, MicroStrategy did announce the accounting change. The stock
plummeted 62 percent to 86 3/4 that day. Yesterday, it closed at 32 5/8.
``They have no credibility,'' Fiascone says, getting angrier at the analyst corps
with each breath. ``They should be exposed for what they are. They're used-car
salesmen.''
Fiascone isn't alone. Many investors these days complain that stocks they own
fall precipitously without a warning from the analysts who persuaded them to
buy the shares in the first place.
Palley-Needelman Asset Management, a San Diego money manager, says it
lost almost $10 million on its UnumProvident Corp. shares last year because it
believed analysts who kept recommending the company in the face of evidence
that its disability insurance business was deteriorating. Palley-Needelman sold
the stock in December.
P&G Falls
Molly Guenther, who oversees $220 million in investments at SunTrust Banks in
Atlanta, had about 4 percent of her customers' money in Procter & Gamble Co.
stock on March 7. That day, the consumer-products giant said its earnings would
fall short of analysts' estimates. The shares tumbled 30 percent.
Guenther says she had no idea something was awry. Many of her clients were
unaware of P&G's problems until they got their quarterly reports -- and then
started calling her. ``It's one thing to lose money in an aggressive, speculative
investment, but for a company like P&G to have a drop like that is very upsetting
to them,'' she says.
Why didn't Wall Street pros issue warnings before the routs? Well, why would
they? Analysts are more rainmakers than researchers these days. They're paid
to be positive: Their fawning research reports help their firms win and keep
investment-banking clients -- and keep the brokerage machine oiled.
The Skinny
``An analyst is just a banker who writes reports,'' says Stephen Balog, former
research director at Lehman Brothers and Furman Selz, who left the latter firm
after ING Groep bought it in 1997. ``No one makes a pretense that it's
independent.''
Analysts would sooner stop covering a company than recommend selling its
stock. Of 28,000 analyst recommendations on 6,700 companies in the U.S. and
Canada, less than 1 percent are ``sells'' or ``strong sells,'' according to First
Call/Thomson Financial, which tracks ratings. By contrast, one-third of the
ratings are ``strong buys,'' another third are ``buys'' and almost all the rest are
``holds.''
The ratio hasn't changed since First Call started to keep count five years ago. It's
not likely to change as long as analysts' pay -- $2 million to $3 million annually
for the top- ranked names and as much as $15 million for the superstars -- is
linked to how much business they bring to their firms.
At Donaldson, Lufkin & Jenrette Inc., for instance, analysts get quarterly
bonuses from the investment-banking budget. Tom Brown, chief executive of
Second Curve Capital, a hedge fund, says that when he was a banking analyst at
DLJ, an analyst who brought in, say, a midsize bank with assets of about $10
billion as a potential merger candidate could earn a $250,000 bonus if the merger
came about. A DLJ spokesperson says the bank doesn't comment on
compensation.
Small Print
Analysts must disclose their firm's relationship with companies covered, and
they usually do it at the end of a report, in tiny type that's easily overlooked.
The pressure from the top of the firm for buy recommendations can put analysts
through the wringer. Sean Ryan, a former banking analyst at Bear Stearns Cos.,
says he recommended Net.Bank Inc., an Internet bank based in Alpharetta, Ga.,
even though he thought it was a crummy company. ``I put a `buy' on it because
they paid for it,'' says Ryan.
Bear Stearns underwrote two stock offerings and one subordinated debt sale for
the company in the first half of 1999, helping it raise $307 million. Morgan
Keegan, an investment bank in Memphis, Tennessee, that managed the bank's
initial public offering in 1997, had downgraded the stock a year earlier.
Ryan then called a few customers -- some who paid Bear Stearns a lot in trading
commissions -- and told them what he really thought. ``I said, `We just launched
coverage on Net.Bank because they bought it fair and square with two offerings,'''
he says. ```Unless money is burning a hole in your pocket, there isn't any reason
to own it.''' Net.Bank traded at 12 3/16 yesterday, down from a high of 83 in April
1999.
Censored?
The analyst says he left Bear Stearns in January to form Byrne Ryan & Co., a
brokerage that promised unbiased research. (It closed in May, and Ryan joined
Banc of America Securities in June.) Ryan alleges that Bear Stearns censored
his tough reports on First Union Corp., then refused to let him write about the
bank.
Bear Stearns disputes Ryan's version of events. ``Bear Stearns stands by the
quality and integrity of our research,'' the firm said in a written statement. ``Our
analysts are encouraged and expected to maintain their independence and
provide the best possible research product to our clients. Since his departure
from Bear Stearns, Sean Ryan has made disparaging comments about the Bear
Stearns research department in an effort to generate publicity for his latest
business venture. The comments are the same ones he has made before and, as
in the past, are totally inaccurate.''
Comment, Please
Many analysts routinely send drafts of their research reports to the companies
being covered for comment and tweaking. ``The way the game is played is that
we want to make money for our clients,'' Richard Leggett, head of research at
Friedman, Billings, Ramsey & Co., a small investment bank in Arlington, Va.,
said at a conference in late March. ``So if a company guides us lower in our
earnings estimates and then the company blows out the estimate, I look good,
the company looks good,'' he said. ``We all win.'' Except, of course, for the
investors who took the analysts' advice at face value.
Headhunters know the game. The first question they ask about an analyst they
might hire is whether the analyst is investment- banker friendly, says Balog. That
is, does the researcher bring in deals, or if a bank does a mediocre deal, will the
researcher look the other way?
Today's star analysts are Jack Grubman, 46, of Salomon Smith Barney and
Mary Meeker, 40, of Morgan Stanley Dean Witter & Co. These people are much
more than stock pickers.
In February 1998 executives at SBC Communications Inc., pondering an
acquisition, invited Grubman to a strategy session in Arizona and asked for his
overview of the industry and his opinion of where it was heading.
``He confirmed the strategy we were working on,'' says James Kahan, SBC's
senior executive vice president of corporate development, who adds that the
company didn't specifically discuss possible acquisition targets. ``We valued his
judgment because of his experience and knowledge.''
Salomon on Board
In April 1998 San Antonio-based SBC hired Salomon to advise it on its plans to
acquire Ameritech Corp., another former Baby Bell, based in Chicago. Kahan
says SBC's decision to retain Salomon for the Ameritech acquisition, which it
announced that May, was not connected to Grubman's comments. Salomon
earned $33 million on the SBC/Ameritech deal, which closed in October 1999.
Grubman, who did not return phone calls seeking comment for this story, covers
34 companies. He has ``buy'' recommendations on all but three. Last November,
Grubman raised his rating on AT&T Corp. to ``buy'' from ``neutral.'' Rival analysts
suggested that Grubman had to be nice to AT&T so that Salomon could win a
role in the largest U.S. IPO ever: the $10.6-billion sale in April of a so- called
tracking stock in AT&T's wireless unit. AT&T did, in fact, name Salomon,
Goldman, Sachs & Co. and Merrill Lynch & Co. to manage the underwriting.
In May, Grubman praised WorldCom Inc. for first-quarter results that put the
company far and away at the top of the industry. The glowing report came just at
the time Salomon was comanaging a $5 billion sale of bonds for the
telecommunications company. Asked to comment on these developments, a
Salomon spokesperson said, ``We as a firm do objective research.''
Analyst Marketers
It can't be easy for analysts with such extensive access to keep their dual duties
separate. ``They're trying to be analysts, but at the same time they're marketers
for the company,'' says Kent Womack, a finance professor at Dartmouth College.
Because of that, opinions generally are more biased than they used to be,
Womack says.
Meeker made her name with a 300-page report in 1995 that hailed the dawn of
the Internet age. She has since turned corporate finance on its head by valuing
companies on their potential rather than their past. The upshot: start-ups now
routinely seek her backing. Morgan Stanley has underwritten such IPOs as
Priceline.com Inc., HomeGrocer.com Inc., Martha Stewart Living Omnimedia
Inc., Ask Jeeves Inc. and Drugstore.com. Inc.
Forever Bullish
Dubbed Queen of the Internet, Meeker has been consistently bullish about her
subjects. She has recommendations of ``outperform'' (read ``buy'') on all but two
of 20 companies she covers; she's ``neutral'' on VeriSign Inc., a maker of Internet
security software, and Electronic Arts Inc., a designer of interactive
entertainment software.
Morgan Stanley managed underwritings on 14 of the IPOs for these companies
and comanaged another. Says a Morgan Stanley spokesperson, ``Long before
the IPO boom, we erected a strict system of Chinese wall separations between
the research and banking functions, and it still serves us well today.''
The schmoozing and selling an analyst must do these days takes time away
from doing research. That, in turn, reinforces a researcher's dependence on
spoon-fed information from the companies. Junior analysts right out of college or
business school often crunch the numbers. ``It's private-label research,'' says
Ryan, the former Bear Stearns analyst. ``You just slap your name on it. Even I
did that.''
Ryan says Bear Stearns expects analysts to make 150 calls per month to
clients, mostly institutional investors, to update them on companies they follow
and to pitch stocks. A survey of 2,181 analysts at 102 securities firms by
Tempest Consultants found analysts spent 40 percent of their time doing
fundamental research in 1999. The analysts expect to spend less time this year
-- 36 percent -- on research and more time on selling stocks.
SEC Concern
Analysts' conflicts of interest have worried Securities and Exchange Commission
chairman Arthur Levitt Jr. for some time. In speeches in April and October of
1999, the stock market's top regulator complained that analysts all seem to have
graduated from the Lake Woebegone School of Securities Analysis: the one that
boasts that all stocks are above average.
Levitt warned that analysts were protecting business relationships at the cost of
fair analysis. ``I worry that investors hear from too many analysts who may be
just a bit too eager to report that what looks like a frog is really a prince,'' he said
in April. ``Sometimes a frog is just a frog.''
Analyst conflicts aren't new. Wall Street is for bulls, and nobody in a firm likes to
hear an analyst say sell. Investors have learned that a ``hold'' recommendation is
really a warning to sell the stock. Still, researchers used to be thought of as
people who visited companies, kicked some tires and drew independent
conclusions.
That started to change after 1975, when brokerage firms could no longer fix
commissions and Wall Street started to make more money from new stock and
bond sales and mergers. The stakes have soared since: The top 25 investment
banks handled $68.9 billion in U.S. initial public offerings during 1999, up from
$4.5 billion a decade earlier. The value of mergers and acquisitions stood at $1.6
trillion, 11 times the amount for 1990.
Campaigning
Big-name analysts always have been a magnet for new business. That's why
securities firms campaign each year to get money managers to vote for their
analysts when Institutional Investor magazine picks the top research talent. Now
the stars are even more important as the returns from investment banking and
mergers businesses increase.
Consider the case of Regeneron Pharmaceuticals Inc., based in Tarrytown, New
York. The company shifted its business to Merrill Lynch, largely because
biotechnology analyst Eric Hecht had moved there three years ago from Morgan
Stanley Dean Witter. Morgan Stanley handled the company's last stock sale in
1995. Regeneron's chief financial officer, Murray Goldberg, says: ``A bank is
basically selling a company's stock to its customers. It can only do that if the
analyst supports it. You need an analyst who understands your industry and
your company and who has enthusiasm for the company.''
Biotech Booster
Hecht, 40, filled the bill. A medical doctor who ranked third in his category in
Institutional Investor's latest poll published in October, he had long been a
biotech booster. Better yet, he liked Regeneron even though it hasn't made a
cent in the 12 years it's been developing drugs to treat obesity, arthritis, cancer
and other diseases.
On Feb. 23, when he recommended Regeneron shares as a ``long- term buy,''
Hecht was the only analyst covering the company. One was enough:
Regeneron's stock price, which had crawled along the floor at less than 10 for
most of 1999, jumped 75 percent the day Hecht's report came out and reached
an all-time high of 57 3/8 six days later.
No Precondition
Regeneron moved quickly to take advantage. Goldberg says that a week after the
report came out, Regeneron met with underwriters and hired Merrill to lead the
deal. On March 6, it registered the sale with the SEC. The company sold 2.6
million shares on March 29 to raise $77.4 million. Goldberg says the bullish
coverage was not a precondition for Merrill to win the business.
The preponderance of glowing research reports coming from Wall Street has
made it increasingly difficult for investors to discern the truth. Stock trader
Fiascone, for one, relied on favorable reports on MicroStrategy from firms like
Friedman, Billings, Ramsey. That firm had helped take MicroStrategy public in
June 1998 and comanaged a $54 million secondary issue in February 1999. FBR
was also in on another sale of 4 million shares being planned for March.
Michael Saylor, who started MicroStrategy in 1989, was never shy about his
company's mission. He boasted that his firm would purge ignorance from the
planet with data-mining software that could tell companies who was buying what
where. Managerial and personal quirks like a mandatory annual Caribbean cruise
for the staff (no spouses allowed) and lavish parties at places like Washington's
Corcoran Gallery lifted the company's profile.
After MicroStrategy went public at 12, its prospects looked good. The company's
client roster included big names like General Electric Co. and Est,e Lauder Cos.
Analysts loved the stock, which rose to 150 in late November 1999. If anyone
saw trouble, they didn't admit it.
`Monstrous Deal'
From month to month, FBR analyst David Hilal was unrelentingly bullish on the
company's prospects. ``Vision becoming a reality,'' he wrote on July 28, 1999.
``E-business just starting to take off,'' said an Aug. 16 note. ``MSTR Rings the
Cash Register-Monstrous Deal With NCR,'' he wrote on Oct. 5. On Jan. 28, he
predicted the by-then split-adjusted stock would reach 200.
MicroStrategy topped Hilal's price target of 200 on March 6 and shot up to 313
by March 10. Ten days later the company announced that it was restating its
earnings and would report a loss of 43 cents to 51 cents a share for 1999 instead
of a profit of 15 cents a share. The stock plummeted.
Analysts like Hilal apparently missed an obvious problem. MicroStrategy had
explained in its 1998 annual report that it booked product-license revenues after it
signed a contract and shipped the software. Service fees were deferred over the
life of the contract. Wrong, say accountants.
Waiting Period
``The revenues should not be booked until the seller has completed providing the
services that are required under the agreement,'' says Howard Schilit, an
accountant and president of the Center for Financial Research & Analysis in
Rockville, Md. ``It appeared that those services had yet to be performed.''
The company's accountants -- and the analysts -- didn't seem to understand this.
``The evidence is pretty persuasive that the original financial reports were wrong,''
says Schilit. MicroStrategy said in April the SEC was investigating the
accounting change.
Hilal, 29, who has been an analyst for three years, says he trusted
MicroStrategy's accountants. He even noted in a Jan. 6 report that the company
planned to book $10 million in revenue for the fourth quarter of 1999 for a $65
million deal it had just announced that day.
He says that if the company had been superaggressive, it would have recorded
the entire amount of these megadeals up front. ``We did extensive work,'' says
Hilal. ``We always thought it was probably slightly aggressive, but when the
auditors sign off, at some point you defer to them.''
Denying Pressure
Hilal says FBR's investment bankers were not pressuring him to favor
MicroStrategy. ``We have complete autonomy; we can do what we want,'' he
says. Sort of, anyway. It was, after all, the firm's research director, Richard
Leggett, who publicly stated at a conference in March that the firm works closely
with its clients to fashion earnings estimates to get the biggest bang out of a
stock price.
The Monday-morning quarterbacking doesn't console Fiascone. ``It's one thing if
you're just wrong,'' he says. ``But they overlooked a basic accounting principle
that's taught freshman year in college and in business school.'' Hilal continues to
recommend MicroStrategy's stock.
An even more basic principle -- that the bottom line is the bottom line -- seemed
to elude some analysts covering insurer Unum Corp. (The company merged with
Provident Cos. in June 1999 to become UnumProvident Corp., America's largest
seller of disability insurance.) In Unum's case, the tendency of companies and
analysts to focus on the top line, or sales growth, to gauge the strength of an
insurance company's core business became a distraction.
Expenses Rising
The sales numbers for 1998 were impressive enough: Premiums collected for the
year increased 13.4 percent to $4 billion, and total revenue was up 11.9 percent
to $4.6 billion. Expenses, though, were rising slightly faster: up 14.2 percent to
$4.1 billion. Net income dropped 2 percent to $363 million.
Then, in the first quarter of 1999, net income plummeted 83.4 percent to $15.5
million after the company took a $101-million charge for a money-losing
reinsurance unit. (The company's 1999 annual report would later put the total
charge for the debacle at $328 million.)
The disastrous quarterly results didn't faze Vanessa Wilson, an analyst at DLJ
who had covered the company since 1991. In April 1999 she even upgraded the
stock to a ``top pick'' from a ``buy.'' The merger with Provident fueled her
optimism. ``Good news was not in short supply,'' she wrote in a May 10 report.
Wilson emphasized revenue growth and described the $101- million charge as a
way to box in the reinsurance problem. Also on May 10, Wilson raised her
12-month price target to 70 from 62.
Billion-Dollar Pool
Bad news would soon be in abundant supply. In August, the new UnumProvident
announced a $191 million loss for the second quarter, blaming merger-related
expenses. The stock declined 30 percent to 36 3/8. Total charges related to the
merger would eventually run to more than $1 billion -- largely to fill Unum's
reserve pool against future claims, which were growing.
Wilson maintained her ``top-pick'' rating on the stock and predicted earnings
were bottoming out. ``By `setting the dials right' with accounting and pricing
changes in 1999, UnumProvident is marking the bottom of the 1999 trough,'' she
wrote in a Sept. 7 report. It continued, ``The Unum/Provident merger provides a
dose of humility, new management, and the potential for a clean slate.''
At the same time, though, Wilson acknowledged a slow, continuous deterioration
in the prospects for disability insurers. People collecting on disability claims
were living longer and becoming more sophisticated about how to fight insurance
companies, she noted. And they had been for some time.
Suspicion
Wilson also wrote that Unum had loosened its underwriting standards to write
policies for higher-risk customers to boost revenue growth. ``Investors are
suspicious about whether disability was ever a good business, the integrity of
Unum's recent financial statements is in question, and the credibility of
management has taken a pounding,'' her Sept. 7 report stated. Wilson still rated
the stock a top pick.
If this were a steady trend, why hadn't the analyst noticed it earlier? ``In
retrospect, I asked most of the right questions, kept asking, and got sucked in
by fairly credible answers from management,'' Wilson says. Unum insisted its
rising prices would offset worsening risk. When Wilson presented Unum with a
specific customer who seemed to get an unreasonably low price, Unum would
say its competitors charged even less.
``The company lied to themselves,'' she says. ``There's no way any outsider
could figure this out. They always had a reasonable explanation about why it was
temporary and that it would get better.'' |
