Earnings-Estimate Revisions Put an End to the Rating Game

Instead of issuing a downgrade when trouble is brewing for a company, analysts are lowering earnings estimates.
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On Wall Street, the rating-change game is gradually becoming a thing of the past.

A top analyst's rating change was once big news for a company's stock price. It now seems, especially among technology companies, that analysts change ratings en masse only

after

a company announces bad news. Instead, earnings-estimate revisions are becoming the new game to watch on the Street.

Analysts at securities firms, perhaps concerned about their relationships with the companies they cover, often tend to maintain their ratings on a company, but change their earnings estimates. So instead of issuing a downgrade when trouble is brewing for a company, the analyst will only lower its earnings estimate by a penny or two to alert clients to potential problems. But the average individual investor, looking for the big rating change, will often miss that company's subsequent stock-price fall.

Take the case of

3Com

(COMS)

. Over the past two months, analysts have lowered by almost half their earnings estimates for the struggling networker's third quarter ended in February, to 23 cents a share from 42 cents. During this span, however, only nine of the 52 analysts who cover the stock lowered their 3Com ratings, according to data tracker

Baseline

.

Needman & Co.

analyst Peter Lieu, for example, lowered his earnings estimate Feb. 4, but maintained his strong buy rating on 3Com until March 3, when he lowered it to a buy after the stock had already fallen to 27. Lieu wasn't available for comment. Today, 3Com's stock price of 23 is less than half of what it was on Feb. 1.

In general, however, analysts do not like to issue sell ratings, which are used only 3% of the time, according to a recent

First Call

survey. By keeping the buy rating while lowering the earnings estimate, the analyst can please both his or her clients and the company. Of course, if analysts already rate a stock a buy or a strong buy, a raised estimate will not be accompanied by a rating change. The same goes for when they have a neutral rating on a stock that they don't favor.

Piper Jaffray's

bombastic analyst Ashok Kumar recently raised his quarterly earnings estimate on

Gateway

(GTW)

to 90 cents a share from 59 cents and lowered

Compaq's

(CPQ)

first-quarter estimate to 20 cents from 35 cents. Yet Kumar did not alter his ratings on the two stocks -- a buy for Compaq and a strong buy for Gateway. His firm has done no underwriting for either company.

Kumar says in his defense that Compaq already is trading at a 40% discount to the rest of the industry and that there "would be no point in doing a rating change at this point."

"Whether or not he's right, the move was like a rating change and is now priced into Compaq's stock," says Jeff Matthews, a money manager at

Ram Partners

. On the same day Kumar lowered his Compaq numbers, the stock fell 4%, or 1 3/8, to 31 7/8 on no other news.

Sending such subtle signals is a skill. Wendell Laidley, enterprise software analyst at

Credit Suisse First Boston

, had an inkling that software giant

Oracle

(ORCL) - Get Report

was not likely to show gangbusting revenue numbers when it reported third-quarter results in March. Laidley did not lower his outperform rating on Oracle, but he did warn the CS First Boston sales force and sent a research note to clients about his misgivings. Oracle missed its growth projections, and the stock fell 20% the day after the results were announced.

Even in the volatile PC hardware industry, where both

Dell

(DELL) - Get Report

and Compaq have run into problems this year, there have been 375 earnings-estimate revisions from Jan. 1 to March 31 compared with 84 rating changes, according to a study done by market researchers at

Zacks Research Service

.

Now analysts are adding estimate revisions to their repertoire, as if "they were trying to maneuver the stocks up and down," says Craig Johnson, principal of consulting firm

Pita Group

and a close follower of analyst activity.

"If you based your investing decisions on just what these analysts are saying, you would be out of business in a month," says an institutional money manager who requested anonymity. "If you knew how to make money, you wouldn't be on the sell side."

Blame the Internet, say analysts. "The Web changed everything," says Amit Chopra, enterprise systems analyst for Credit Suisse First Boston. "Everyone is keeping their long-term buy ratings in place until they can figure out how the companies they cover will benefit from this new space."

Investors, in the meantime, had better learn to pay attention to the nuances of the ratings game.

The Ax is a regular feature in which TSC analyzes the analysts tracking important stocks. Eric Moskowitz keeps the Ax sharp, so if you have any comments or suggestions, please email him at

emoskowitz@thestreet.com.