This week's guest is Chuck Hill, director of research at Thomson Financial/First Call, Boston-based provider of real-time, broker-sourced research, earnings estimates, equity and fixed income ownership information, insider trading information, and corporate news releases.
Since Hill joined the company in 1991, his primary responsibility has been to serve as the chief financial analyst for Thomson Financial/First Call earnings data. He is featured regularly on many radio and television newscasts and is frequently quoted in leading financial print media.
Hill has more than 25 years of experience in the field of financial analysis. His introduction to the technology industry came as an
salesman. Prior to joining Thomson Financial/First Call, he was a technology analyst at Scudder, Stevens & Clark; Kidder, Peabody, Bache (now Prudential); and Quantum Associates.
Hill will answer questions from moderator
Personal Finance Editor Lisa Meyer.
LM: A year ago, corporate earnings began to deteriorate, pushing the U.S. toward a recession. Now profit warnings are beginning to slow. Negative preannouncements are running only 2% ahead of those for the fourth quarter of 2000, and more than 20% below those of first quarter of 2001, second quarter of 2001 and third quarter of 2001, according to First Call. Will we see signs of recovery during this quarter's earnings season?
CH: The fourth quarter will be much worse than the third. The year-over-year will look similar, about a 22%-21.6% decline in the third quarter being something like that in the fourth quarter. But since the comparison gets much easier to the year-ago quarter for the fourth quarter, that in effect means that on a seasonally adjusted sequential quarter basis, the fourth quarter earnings will be much worse than the third. That will also be true for the first quarter of 2002. It won't be to as big a degree and it might only be down slightly from the fourth quarter, but we won't see any improvement until the second quarter. But that's what we've been saying all along. When people have been predicting that earnings are going to turn one or two quarters out, we've said, "Wait a minute!" You've got to first start seeing some slowing in the rate of the warnings and downward estimate revisions before you can talk about an earnings recovery being imminent. But that's fallen into place now. We stand a very good chance of seeing an earnings recovery in the second quarter, barring any type of unforeseen event like a terrorist attack or what have you.
LM: Do you think such expected poor earnings reports for the fourth quarter and the first quarter of 2002 are already priced into stocks, or will we see a market reaction?
CH: They are already priced in. You are going to see better comments accompanying those reports in terms of the outlook going forward. So even though the results for the fourth quarter will be horrible, the market reaction should be favorable in that the comments will be better.
LM: Do you think that companies have taken advantage of Sept. 11 by lumping all their current poor news onto their third- and fourth-quarter earnings -- and maybe the first quarter -- that they would normally have spread across several quarters because investors expect the third and fourth quarters to be bad? By doing so, have companies artificially inflated earnings in the following quarters? Might such a sharp increase make companies appear to be doing better than they really are?
CH: Yes, to some degree. They'll take restructuring charges and so forth, but they tend to do that in the fourth quarter anyway. I don't know if the attack changed it much, but if you are in a downturn like we already were, it's common practice to see a lot of restructuring charges and inventory writedowns and so forth in the final quarter of a company's fiscal year. Since most of them are on a December year, there's nothing particularly unusual about seeing that happen. Obviously, the restructuring charges get ignored by the analysts. They back those out of the reported earnings to get to the earnings segment used to value the stock. It does, to some extent, inflate the numbers a bit going forward. Theoretically, it shouldn't, because it should be reflecting charges that they actually took, but a lot of stuff gets shoved into that restructuring charge that probably should have been an operating charge in the next few quarters. There is a little bit of that "clearing the decks" type of thing that does help the numbers going forward. It's not a major thing.
LM: What about multiples, especially for tech stocks? Prices have come down, but so have earnings. Are multiples still too high?
CH: I think they are, but not for the reasons people are citing. It doesn't mean much to look at 2002 earnings and talk about the multiples. Those are trough earnings in the bottom of the business cycle. To say that XYZ is selling at 50 times or 100 times its 2002 earnings doesn't prove a whole lot. If you go out and look at 2003 earnings for tech companies, you'll see that even using those earnings to value the stock, which you normally wouldn't be doing until a year from now, they nevertheless already look overvalued. Those are earnings, at least for most of the tech companies, where you're back to normal type earnings, not the inflated ones like we had in 1999 or early 2000, but not the trough ones, either. When you see what the valuations are on those 2003 numbers, you have to wonder about how much they have run these technology stocks. That's worrisome not only for the tech sector, but also for the market overall. It says that investors really didn't learn the lessons they should have from the excesses of the late '90s and the correction that followed. That's one of the things that worries us here about the market going forward down the road, not in the immediate term. We never saw the kind of capitulation that you usually have at the bottom of a recession, where for example, instead of discounting the current quarter and next quarter like they've been doing all through this downturn, analysts say, "Things are really bad; I'm going to cut my numbers for the next 4 quarters." That never really happened, so we didn't see the same kind of capitulation that you typically have in a bottom. That has to worry. Over the near term, the market is probably going to do well because there's going to be a lot of good news, but when we hear comments such as "earnings don't matter," that's the kind of stuff we heard in the late '90s. Those kinds of comments are starting to appear again. I'm afraid that the market will continue to move up, but we will be back to the excesses of the late '90s. Maybe not quite as bad, but certainly you can't justify buying a lot of these stocks on the earnings outlook for 2003 and beyond.
LM: The current recession is different than past recessions in that it was led by earnings shortfalls rather than a dropoff in consumer spending. How did that factor shape this recession?
CH: The reason this recession was different from other recessions since WWII was instead of it being caused, as you mentioned, by too much demand chasing too much capacity -- consumers spending too much relative to what could be produced -- it was caused this time by too much capacity. The easy money of the late '90s resulted in too many projects being built that either shouldn't have been built at all in some cases, or at least not at the time they were built. I'm a little worried again on the technology sector in particular. A lot of analysts and investors are looking back at the more recent recessions at how fast technology earnings ramped up in the recovery and expecting that again, but because this is a different kind of recession, that may not happen. If there is too much capacity out there, no matter what interest rates are, you're really not too interested in adding more until there is some visibility that that capacity is going to be used up in the relative near term. It's going to take a little time to work through that. Therefore, the ramp-up in tech stocks may not be as steep as it has been in prior recoveries. Earnings for tech will probably start to turn at about the same time as they did in prior recoveries, but they won't recover as fast.
LM: Which sectors will lead the earnings recovery, and why?
CH: Some of the traditional cyclicals will lead. There's not a lot of room for a sharp upturn in the consumer cyclicals for the reasons you've stated. Consumers have pretty much continued to spend. It's hard to see much of a rebound in homebuilding when it's never really gone down to any extent. Autos have held up much better than expected with the incentives. Retail didn't get hit as hard as in traditional recessions, but there is some room for a bounce up there. There will be some improvement in the consumer cyclicals earnings. You'll see improvements in the basic materials areas, the papers, metals, chemicals -- the traditional ones, and with tech, but not at the rate that expectations are at.
LM: Let's talk about expectations. What can we expect for earnings during the rebound? Slower growth?
CH: Earnings in the last hundred years have grown at about the rate of 7% for the
. That was true even if you include the '90s in there. The only difference in that period was that it was a longer stretch of staying above the trend line, but there were actually periods in the past when we got more above trend line in terms of earnings growth than we did in the '90s. That's a trend line that I think is pretty much cast in stone at 7%. We've spent some time below it now, and we'll probably start moving back up again, but not at some short ramp-up. We're likely talking mid-single-digit earnings growth for this year. The industry analysts are expecting growth of 16%. I don't think that's realistic. Certainly the first quarter will be below what they are expecting. If you're starting from a low point in the first quarter, it's going to be hard to get the estimates that they have for the fourth quarter. That would require a pretty rapid ramp-up, so I don't think we'll achieve the 16%, but we'll have earnings growth in the mid-single-digits.
LM: How will increased productivity levels change P/E ratios? According to recent productivity data, Internet technology appears to be starting to make companies more productive. They can spend less and produce the same amount of product. Will this create higher earnings going forward, with smaller overhead subtracted from revenue?
CH: We've heard this new era stuff through the '90s, and it didn't materialize. The productivity numbers in the '90s were lower than in the '60s. All this productivity hoopla is a result of the '90s being better than what we saw in the late '70s and the early '80s, but it was more getting back to normal type numbers rather than some new era. I don't agree with that at all. We heard in the late '60s and early '70s about how things were going to be different this time because of the technology advances that were going on then. Technology is still cyclical, always will be, but with a higher growth rate. The idea that we are in some accelerated growth rate -- I just don't believe that.
LM: In the wake of
, there has been a lot of discussion about how companies account for earnings. How powerful is the
warning that companies could be liable for fraud if they misrepresent earnings by using pro forma?
CH: It's powerful because the SEC can speak softly and carry a big stick, and they've said with this warning that they are going to use that stick. Unfortunately, I think it needs to be a little more specific. It leaves a couple of loopholes where the companies can say their earnings were $1.50 on a GAAP basis, but pro forma was $1.75, for the following reasons. Then they give you a bunch of reasons as to what they were, but they don't explain each one and break out the amount of each. That means you are left either excluding all of those items or excluding none of them. It may be that if it was a restructuring charge, an asset sale gain and an inventory writedown, you might want to exclude the first two but not the third. They have a duty to provide the tools to let the investor adjust the GAAP earnings to whatever basis they feel is appropriate. The companies have a right to put out a number that they believe is the one you should use for earnings to value the stock, but they have to provide all the tools. That means quantifying and explaining not only each item, but also items that might be normally excluded in the adjusted earnings, but that the company is including. For example, the venture capital gains that companies were having in the tech area a few years ago -- normally asset sale gains like that are excluded from the GAAP earnings to get to the adjusted earnings. The case was made that these were not just for investment, but because they wanted to have a strategic relationship with these companies and therefore should be included in operating earnings. That's an interesting argument, but I don't think everyone would necessarily agree with it. Therefore, you should provide information about what this item is all about and how much it added to your earnings. If someone wanted to back that up, they can. They need to fine-tune that warning, but it's a very important first step.
LM: Because of Enron,
-- just to name a few of the companies that journalists and analysts have caught abusing pro forma -- is the term useful any more because it has been so discredited?
CH: Well, the term pro forma had a different meaning prior to the last few years. Pro forma means you are providing earnings on some basis other than the normal one. If a company went out and acquired somebody with a purchase acquisition, where you only include the purchase in the GAAP earnings from the time it was acquired onward, you want to compare how this company is doing to what it did a year ago if the combination had taken effect back then. Otherwise, it's an apples-and-oranges comparison. Pro forma meant restating the year-ago numbers for an acquisition or an accounting change or what have you. Right now we're in this transition period to a new accounting basis where you won't include amortization or goodwill anymore. Well, if I compare last year's to 2001's numbers where amortization was included, that's going to inflate the growth rate that I have in 2002 since I won't be taking that charge for amortization anymore. FASB says you have to provide a pro forma number for the prior periods. That's legitimate, and that's what pro forma originally was all about. It got twisted around by the Internet and later by other technology companies where they were backing out the amortization of goodwill before this took effect and even before the FASB came out with this proposal. That was accepted by the investment community, but once some companies saw that, they then started shoving all sorts of other junk in there. That's what's given pro forma a bad name. It's certainly legitimate to adjust the GAAP numbers in many cases to some other basis, which I would prefer to call valuation earnings. What you are doing is adjusting the reported earnings to a number you would want to use to value the stock. Most people in the investment community would agree that you want to look at earnings from continuing operations after excluding nonrecurring and/or nonoperating items. The problem is that what one person considers nonrecurring or nonoperating, another might not. There is no right answer for this. That's why companies need to spell out what all the items are that might be controversial about whether they should be excluded or included, and to explain and quantify each one.
LM: How important is it for the economy that companies report their earnings accurately? Does sound financial reporting lead to a sound economy with correct allocation of capital? As we saw in the dot-com bust, both companies and investors misallocated their resources, partly due to companies hiding what's going on with their bottom lines through pro forma reporting and other accounting tricks.
CH: Yes, but again, the answer is not just to look at GAAP earnings alone because that would mean for the venture capital example that you would be including large gains that aren't necessarily sustainable, something that's not really part of your ongoing business. It's not just the charges, but it's also the gains sometimes that need to be excluded. You have to have some reasonable basis here. The companies have to put releases out that spell things out clearly so people can make their own judgments, and the analysts have to do a better job of being the gatekeepers. That's part of their job. One of the reasons they get the big bucks is that they have to ascertain what the reasonable valuation basis is for earnings and at times take issue with the basis that the company may be promoting. But I don't think the analysts have done that to the degree that they should have in recent years.
LM: How important is it to the health of a company itself? Wasn't Enron's fall caused by loss of investor trust through misrepresentation of earnings? Isn't shareholder trust crucial for the longevity of a company?
CH: Yes, in Enron's case, it wasn't so much pro forma as much as playing games with accounting itself. The off-balance sheet stuff was a problem. Enron is probably a poor example in terms of what most of the companies out there are doing to push the envelope. Enron did a lot of other things that were certainly egregious and probably caused their downfall. Yes, the accounting has to be sound, and that means that the SEC and the auditors have to be looking over the company's shoulder and questioning a lot of things. The SEC has done a better job lately, in the last several years or so since Arthur Levitt came in, and it seems like the new chairman will carry on with that. The auditors need a wake-up call, and Enron may be that. Congress has gotten into the act and is pushing for better performance by the industry in doing proper accounting and proper releasing of earnings. They don't want to be in the regulation business. They've made it clear that they would prefer to see the industry set up self-regulation, but if they don't do it, Congress will step in. They are not done with their hearings yet. There could be some interesting things to come out of that. It's terribly important, not just for the economy, but the general public's support of our capitalist system that the accounting be fair and accurate in portraying the outlook for a company, and it's the same with the releases they put out.
LM: In the wake of the recent sell-side analyst research controversy that highlighted the conflict of interests between investment banking divisions of full service financial firms and their research divisions, new guidelines have been set by industry groups and Congress has held hearings, but has anything really changed? Can we trust the stock ratings coming from full service financial firms?
CH: No, unfortunately, the SIA (the Security Industries Association) proposals didn't have many teeth in them. You had no penalties, and Congress basically said, "Go back to the drawing board and come back with something that has more teeth in it, or we're going to step in." Whether the SIA will do that or not remains to be seen. But as I said earlier, I think Congress is not going to let this issue die. If the sell-side firms don't get the message, then Congress is going to step in.