If earnings really do drive the stock market (and who are we to argue with Peter Lynch?), small wonder Chuck Hill is so popular these days. At least four times a year, the director of research at First Call is one of the most celebrated guests on financial television. With the first-quarter earnings season winding down, Hill made a pilgrimage to TheStreet.com's Manhattan headquarters Tuesday. His views on the outlook for technology earnings were reported in the Market Roundup Tuesday. Prior to joining First Call in 1992, Hill analyzed technology companies at Scudder, Stevens & Clark, so he knows of which he speaks. As with technology, Hill is outspoken about a number of issues. What follows is an edited transcript of the interview, including a follow-up discussion today.
The sense on the Street is first-quarter earnings have been overwhelmingly positive. Are they?
: No matter how you slice it, it's a very good quarter and better than expected. Through
Wednesday morning, 79% of
companies have reported and 66% have reported better-than-expected earnings vs. an average of 56% in the past five years; 21% of companies have come in on target vs. 19% normally; and only 13% are below vs. an average of 26%.
But aren't companies mainly beating lowered estimates?
: We always beat
estimates in the aggregate but we're clearly doing better than for some time. The average we're beating the numbers by is 4.8% vs. 2.5% for the last five years. If we stay at that level, it would be the highest since First Call started doing this in 1990.
Have you been as surprised as the Street?
: At the beginning of the year I thought the first quarter would probably end up about 6%, about the same as the fourth quarter or maybe a hair better. Ten percent didn't seem like it was on the radar screen.
What made you cautious was behind the numbers in the fourth quarter, 3%
of the gains were from five companies that had severely depressed fourth quarters in 1997 from one-shot deals. There's nobody in that category this quarter on the up or downside. No matter how you look at it, the first quarter is good. We missed it to some extent, but not as much as industry analysts. They were still in a downward revision mind-set that persisted even as things were starting to get a little better.
What got better? It is a turn in the world economy?
: I'm not sure we're having a recovery yet, but the impact has maybe bottomed for U.S. companies. Put that together with continuing good growth in things driven by U.S. consumer spending and you don't have as much of a drag as you did before.
Japan is getting better but it's not put to bed. Latin America will probably get a little worse before it gets better, but not as bad as people thought. I think you still have to worry about some disturbing signs in the European economy in recent months. Do interest-rate cuts mean that's not a worry going forward? But put all these things together, 1999 is shaping up better than we thought at the beginning of the year.
Back to the first-quarter results. Any insights on how different sectors are performing?
: One of the places where we've gotten positive surprises is in commodity cyclicals. In the fourth quarter, analysts lowered numbers even though they beat estimates. This time, they're raising numbers for metals, paper and -- to some extent -- chemicals. Oil is a mixed bag. But that would support the rotation; they may be early, but there's a change in the mind-set of the analysts.
It's clear in the last week or so there's an upward trend underway. It's a good sign for how the second quarter is going to shape up. I think we're looking for 12% to 13% in
earnings growth vs. probably 9% to 10% for this quarter, probably closer to 10%.
You mentioned some unusual situations affecting fourth-quarter results. What do you think of accusations that some companies use financial shenanigans to artificially inflate earnings? Are they doing it more than in the past?
: I don't know if I'd call it artificial. There are some legitimate ways you can try to manage earnings. You take something on the shipping dock that's ready to go and they said 'next week,' but get them out this week before the quarter is over. Those kind of games have always been played
and I don't think it's happening more than in the past. Even the illegal stuff -- there's always some going on -- always will be.
But I do think there is so much pressure now on making expectations and keeping earnings growth going that some of these mergers are really driven by that. 'Hey we're in for a tough period, let's go out and make some acquisition where we can do some cost-cutting and get a little kick out of that.'
What about stuff like
buying puts against its own stock? (The company had an investment gain of more than $350 million in the latest quarter.)
: That's a good point. Now people are talking about insurance. I don't know, maybe people would get so disgusted with this kind of thing they will start to pay more attention to the long term.
What do you think about the
Securities & Exchange Commission's
newly implemented rules about write-downs of research and development costs?
: Let's examine that: When
reported fourth-quarter results, they had to restate second- and third-quarter earnings because of an acquisition and the SEC came in and said 'you can't write all that down. That's going to leave you with some goodwill you're going to have to amortize from the second quarter on. By the way, with the other acquisition you're making in the fourth quarter, don't try that. You're going to have some goodwill from that going forward.'
So the 10Q and 10K looked different, but the analysts said, 'We're going to exclude this amortization of the goodwill.' So on a practical basis, it was a non-event. But it clearly sent some signals: Don't push the envelope too far.
What other regulatory developments do you see coming down the pike?
: The whole goodwill thing is still fluid.
Financial Accounting Standards Board
is discussing maybe this won't flow through the income statement. Either it goes directly to the balance sheet or you take a one-time write-down at the time of acquisition for goodwill, which obviously analysts would exclude. It's going to be an issue for the next year or so until it's clarified. Obviously if they end up not flowing it through income statements, it's a moot point. But if we get this somewhere-in-between stuff, does it get to the point where the Street says: 'We need some kind of consistency. Forget what the majority of Internet analysts want to do, let's include goodwill across the board like we used to.' I foresee a mess, particularly if FASBi drags its heel on clarifying it and particularly if it ends up continuing to flow through the income statement.
How do you think it will be resolved?
: If practical logic prevails, I think they'll get it out of the income statement. There's clearly a goal of moving more toward a cash flow number rather than a earnings number, so get this non-cash charge out of the income statement. Part of it also is trying to harmonize international accounting standards.
Isn't there already a move toward cash flow per share?
: Cash/EPS as they call it, has a specific definition -- earnings from continuing operations where you're excluding restructuring and also excluding amortization of this short-life goodwill. But three years is longer than anything we've ever excluded before. We have pushed the envelope further.
The Wall Street Journal
article made it seem like we were sprinkling holy water on cash EPS and we were doing business differently than in the past. It's just an extension of what we've done. We're not taking a position one way or the other. We want to have numbers in there on the basis of what the investment community would want to use to judge to value of a stock. The point I'm getting to is, whatever FASBi moves to, we'll be there.
As long as the analysts follow along, right?
: We do cash flow now for the oil industry. We are doing more revenue
estimates for Internet companies. Our policy is we'll do anything where you can clearly define the basis, where analysts make estimates on the number and where it has an impact on stock prices.
One thing I 'd love to do, and we don't have the software now, is the monthly same-store retail sales. Analyst make estimates, it's clearly defined how you report, and it moves stocks. We ought to be providing those estimates. Hopefully, before long, we will be.