Managed Earnings, Tech Bubble Talk, and IPOs With No Earnings

By the Curmudgeon


Author's Note:  Victor has been out of the country for most of the past week and so was unable to contribute much to this article (see his "comment from the airport" at the end).  He will be back next week with his insightful comments and observations along with a few history lessons.




We examine several themes in this article:  1] Reported corporate earnings, sales and the weather, 2] Tech Bubble comments by hedge fund manager David Einhorn, and 3] IPOs without earnings nearing their all-time peak in February 2000.   The combination of these issues leads us to believe the stock market is living on "Fantasy Island," with a tremendous amount of risk that's not reflected in current stock prices.


The Earnings Mirage:

On the surface, the earnings season doesn't look too bad this quarter. According to FactSet, of the 240 companies that have reported earnings to date for Q1 2014, 73% have reported earnings above the mean estimate and 53% have reported sales above the mean estimate.    But looking beneath the surface reveals a very different picture. 


·         FactSet reports that the blended earnings growth rate for Q1 2014 is only 0.2%.  The blended growth rate combines actual results for companies that have reported with estimated results for companies that have yet to report.  This marks the first time that the earnings growth rate for Q1 has been in positive territory since the week ending on March 14 (also 0.2%).  Is that something to cheer about?


·         For Q2 2014, 36 companies have issued negative EPS guidance and 15 companies have issued positive EPS guidance.  This continues the trend of managed earnings (more on this topic below).


·         53% of companies have reported actual sales above estimated sales while 47% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is below both the 1-year (54%) average and the 4-year average (58%).   We maintain that after years of cost cutting to boost profits, companies must now show top line/sales growth to increase real earnings and thereby justify very high stock valuations.


·         In an article titled An Improving, But Still Weak Earnings Picture, Zacks Investment Research estimates that overall earnings will be down 0.9% for the quarter compared to last year and down 4.6% from last quarter. 


We have maintained for some time that reported "after tax earnings per share" are higher than "real earnings."  That's due to accounting tricks, untaxed overseas profits, and (for companies buying back shares) fewer shares outstanding.   Moreover, companies "manage earnings" by providing lower guidance which they know they can beat.  For example, the estimated earnings growth for Q1 2014 was negative at -1.2% on March 31st, according to FactSet.   That was then followed by upside earnings "surprises" and upward revisions to earnings estimates, led by the Utilities sector.  How could any serious analyst not realize this charade?


Zack's Sheraz Mian commented on corporate guidance and managed earnings: 


"There is still plenty that is disappointing about the Q1 earnings. The most notable disappointing aspect of the Q1 earning season thus far is the lack of any improvement on the guidance front. Management guidance has been on the weak side for almost two years now, keeping the revisions trend firmly in the negative direction. We haven’t seen any improvement on the guidance front thus far..."


“We’ve had some good earnings announcements, yes, but the expectations were very low. The broad picture is still weak.  Guidance for the second quarter and beyond remains tentative to the weak side,” Mian added.


Jim Reid, macro strategist at Deutsche Bank said, “Whilst earnings per share expectations were lowered as we entered earnings season, it’s still been a relief to the market that we’ve had a large number of ‘earnings beats.'”  Again, we ask:  who's kidding whom?


In a USA TODAY article titled Earnings are a Mirage, Matt Kranz wrote:


"Apple, Facebook and Gilead can’t do it alone. Just over 35 companies in the S&P 500 contribute more than a third of the index’ total profit, so how these companies fare as a group is what’s important."  Kranz says the reasons why investors aren’t ready to start celebrating a "miraculous turnaround" in corporate profit include:


* Low expectations. Companies love to temper expectations, so it’s easier to beat at reporting time. Apple was a classic example. Analysts had expected it Apple to report just 0.8% growth for the quarter, minuscule growth for a tech company. The fact Apple beat is simply a relief, not a point of victory, says Moshe Cohen, professor of finance at Columbia Business School. “Results were better than feared,” he says.


* Unique issues. Gilead Sciences’ results came in 62% ahead of expectations, getting and got the Wall Street’s attention. Shares of the biotech stock are up 4% this week. But much of its advance is due to its breakthrough hepatitis drug, not the economy, Mian says. Also, Apple’s stock is getting a bump largely due to financial maneuvers; it’s using, including a stock split, dividend hike and a stock buyback, Cohen says, not new products.


* Financial problems. One of the biggest anchors is financial firms, expected to report 9.3% lower first-quarter earnings, says S&P Capital IQ. Financial companies account for about 18% of expected earnings.


We've previously called attention to corporate profits growing much faster than the real economy and that stock prices were increasing even more than profits.  Please see: How Long Can Profits Continue to Outpace Sales, Productivity, and GDP Growth?   


That's clearly depicted in this chart from FactSet:



Bottom line:  We think that 2014 is yet another year of cost-cutting, accounting gimmicks, and share buy-backs to boost earnings per share, with no actual growth in real earnings over the previous year.  Yet the stock market is up (on average) over 30% from where it was last year on only a 2.9% overall growth in EPS!   Should anyone worry about that or is it already priced into the market? You be the judge!


Whither the Weather?

For two consecutive quarters, companies and analysts have been using bad weather as an excuse for the slow growth economy and lower earnings.  According to FactSet, 93 of the 154 companies that have reported Q1 earnings as of last Wednesday (April 23rd) mentioned the weather during their earnings conference calls. Talk of the elements dominated at FedEx, whose call was littered with 41 mentions of the weather, according to the firm. Railroads Union Pacific and Norfolk Southern tied for second place at 39 apiece.  UPS, McDonald's, Ford, Verizon and Dunkin' Donuts also cited the weather as a headwind in their Q1 earnings reports.


That extends the trend seen a quarter earlier, when companies blamed the weather for disappointing fourth-quarter results twice as much as they did a year earlier, according to FactSet. To us, this is yet another trick to fool shareholders into thinking things really are better than they seem. 


David Einhorn - Tech Bubble Redux:


The "Tech Stock Bubble" debate was renewed this week by Greenlight Capital’s David Einhorn. 


Note: We highly recommend you read the bottom of page 2 and all of page 3 of Einhorn's April 22nd letter to his hedge fund's limited partners.        


In that letter, Einhorn wrote that "there is a clear consensus we are witnessing our second tech bubble in 15 years.  What is uncertain is how much further the bubble may expand and what will pop it."  Einhorn said that this second tech bubble is "an echo of the previous tech bubble, but with fewer large capitalization stocks and much less public enthusiasm."    The Greenlight hedge fund went short a basket of high-flying momentum stocks. Einhorn wrote that "we estimate there to be at least a 90% downside for each stock (in his bubble basket of shorts) if and when the market applies traditional valuations to these stocks." 


The hedge fund manager also complains about companies counting stock option grants as an expense to artificially lower corporate taxes and thereby improve after tax profits.  That's yet another accounting gimmick we referred to in the managed earnings section (above) of this article. 


As expected, several analysts argued that while some pockets of tech are overvalued, that does not mean they are in a bubble.  We stand by our previous conclusion that Tech Bubble 2.0 Will End Badly.


High Flying IPOs Without Earnings:


On page 3 of his aforementioned letter to his fund's partners, Einhorn called attention to "Huge first day IPO pops for companies that have done little more than use the right buzzwords and attract the right venture capital."


With the imminent IPO of Chinese internet behemoth Alibaba, it is shocking to learn that more companies are going public with zero earnings than at any time since the all-time peak in February 2000!  Tyler Durden wrote: "Confirming everything U.S. "investors" already knew but were afraid to admit... earnings-less IPOs just hit peak greatest fool levels in the most uncomfortable deja vu moment of the 'recovery'..."


The following IPO tidbits are from an article titled, Hidden Danger Lurking Inside the IPO Market:   

·         The number of companies that IPO’d in Q1 was higher than any first quarter since 2000.

·         A total of 64 companies went public – double the number of IPOs in Q1 2013.

·         Nearly 70% of the companies had no earnings prior to their IPO.

·         The IPO pipeline now stands at 122 companies, based on data from Renaissance Capital.

·         An additional 103 firms have recently submitted filings, resulting in a 186% increase in IPOs quarter over quarter.

·         Of those companies, only 26% boast any profits at all.


"Don’t expect the trend to reverse course, either. In fact, it’s only getting worse," said author Richard Robinson.  The chart below shows how profitable companies that go public fare against firms with zero earnings.

As one observes from the above chart, unprofitable companies outperform in the first year of an IPO – due entirely to investor hype. By the third year, though, they’re only up 36% – compared to 153% for profitable companies.  But it's actually worse than that.


Analysis by SBA Research shows that fully one-third of unprofitable IPOs fail in three years. By year five, 55% hit the skids. And 61% are history by year 10.


Bottom line: The IPO market is clearly full of landmines right now.  It’s going to get dicey, as we could see a total of 320 IPOs this year – the highest number since 1999.  To the Curmudgeon, this is yet another dangerous sign of excess speculation in the market (along with record margin debt).  But it is only one of many signs of excess.


Philip Gotthelf of Commodities Futures Forecast wrote in his latest weekly report (subscribers only):  "Stocks are more of a Ponzi formula because the market is totally supported by liquidity and momentum. We all know that if investors head for the exit door at the same time, the system fails." 


"Concepts of price/earnings ratios, dividend yields, and prospective earnings have been augmented and, perhaps, offset by principles of anticipatory investing," Gotthelf said.



The list of other stock market negatives includes: that the economic growth (and profits) expected by the bulls is highly unlikely; that the market has yet to demonstrate that it can hold its own without the positive influence of the Fed's QE and ZIRP (which has been its main support throughout the 5+ year bull market); that stock prices are over-valued with the Shiller CAPE 10 P/E ratio at 25.3, which is 53.3% above its historic mean of 16.5; that we are in the 2nd year of the Four-Year Presidential Cycle, which since 1934 has seen an average decline of 21%; that the average length of the 11 bull markets since 1950 was 53 months; that only four bull markets lasted longer, including the current bull, which is now 62 months old.  There's also the potential that Russia's involvement in Ukraine will spread to other areas in Eastern Europe and might cause war, which is always bad for stocks.


Gotthelf said that an investment banker this week was explaining the foundations of the "acquisition value proposition." He was trying to explain that a small cap stock could gain traction if the company announced an acquisition regardless of any financial benefit associated with the purchase. By old standards, such a move would spell disaster. "But, now it's New Rules!"  In other words, "this time it's different." 


It is these kinds of "new rules" to justify sky high stock valuations that are yet another concern to us.  We saw that throughout the Internet stock bubble - right up till the time it burst.  In the world of investing, things are always great until they're not....We advise extreme caution and awareness of risk that most "investors" have ignored.


Victor's Comment (from the airport en route to Dallas, TX):


I see the greatest risks in the intermediate trend as geopolitical, especially Russia's involvement in Ukraine. There is also the failure of the U.S. and Japan to reach an agreement on a Pacific trade accord, China's territorial dispute with its Asian neighbors over islands in the South China Sea, the total collapse of Palestinian-Israeli peace talks due to the agreement between Hamas and Fatah, and the uncertainty of Iran giving up its nuclear weapons capabilities.  Also, the UKIP party -AKA the Tea Party of England- under Nigel Farage is gaining ground going into the U.K.'s upcoming elections, to be held the third week of May.  Any one of these could erupt into something that's very disruptive to the global economy and a threat to world peace.


Till next time........................


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies.  Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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