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Bill Fleckenstein

Contrarian Chronicles7/27/2009 12:01 AM ET

Earnings game: Don't take the spin

Companies would rather play 'beat the number' than come clean about how they're actually doing. Don't get sucked in. Play 'the price is right' instead.

By Bill Fleckenstein
MSN Money

Because it's let's-play-beat-the-number season (i.e., when corporate earnings are reported), let's look at what a game it is. First of all, some months ago, General Electric (GE, news, msgs) said it would abandon the practice of giving guidance in the game of beat-the-number. And GE reaffirmed that when it recently released its second-quarter results.

I think that is potentially an important development -- at least if one would like to see the investment business become more about thought, research and managing risk, rather than hype, momentum and gamesmanship (which reduces the stock market to some sort of video game). Perhaps as an early practitioner, GE's abstinence will cause other companies to rethink what they do and stop playing games. (After all, GE -- led by Jack Welch -- played and perfected that game as well as anyone, though it ultimately blew up in the company's face.)

IBM: The new GE?

In terms of financial maneuvers, we can look at IBM (IBM, news, msgs), which reported a day before GE. IBM saw its revenues do worse than expected again. That would not be particularly surprising, given the environment, except for the fact that IBM was (again) able to do far better than folks had expected on the earnings front.

Thus, even though it saw revenues fall 13% year-over-year (paced by hardware sales dropping 26% year-over-year), earnings per share somehow miraculously rose 18% from the same period a year before. Of course, a variation of this happens repeatedly at IBM. (How exactly, other than some help from intercontinental employee arbitrage, I really can't say.)

Let's take a look at the current allure of sizzle (aka tech) stocks, via Texas Instruments (TXN, news, msgs) and Caterpillar (CAT, news, msgs), both of which reported last week. Texas Instruments won at beat-the-number, aided by a stock buyback. And, next quarter's guidance was deemed to be a victory. (Though Texas Instruments sank July 21, it subsequently rallied.)

Texas Instruments' revenues are running at about the levels they did in 2003, and the company is making around the same amount of money. Meaning that if you annualized last quarter -- which I'm not so sure you should, but if you did -- Texas Instruments would be earning around $1 a share. Texas Instruments is not a growth stock, but it's priced like one. Texas Instruments is a cyclical stock (sort of like Caterpillar), so, it isn't deserving of any kind of giant multiple, in my opinion. Nonetheless, it's valued at 23 to 24 times what the company might earn.

Caterpillar, on the other hand, supplied the biggest "wow" factor that day by reporting a huge earnings (though not revenues) win. Based on the same loose methodology as I used for Texas Instruments, Caterpillar is priced at about 14 times EPS. Is Texas Instruments really that much more valuable than Caterpillar? I don't think so.

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Is tech about to tumble? © CNBC
Is tech about to tumble?
Insight on whether the tech rally will continue, with CNBC's Jim Goldman. (July 23)

Turning to another company that reported last week (whose products tend to elicit "wow" from the faithful), Apple (AAPL, news, msgs) won at its own special version of beat-the-number -- whereby Apple beats the number and lowers its (previously set) guidance for the upcoming quarter, whereby it plans to then beat the number and lower the guidance once again, and then plans to repeat the process.

Continued: Iconic iPod just plodded along

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Monday, July 27, 2009 6:54:28 AM
The accounting standards that the government allows are nothing but a joke. If companies were not allowed to write off so many ludicrous items all these companies would look much worse than they currently appear!
Monday, July 27, 2009 7:18:22 AM

RUNFORYOURLIFE, companies stocks are in the tank ,shareholders are revolting and most companies need to show great financial numbers. Where did this rally come from the Dow up almost nine hundred points in two weeks? You hit it right Mr. Fleckenstein.

Monday, July 27, 2009 8:50:20 AM

What has the government ever done right? As for this report and the info on banks. Did you know what the reason the banks aren't lending money is? Our wonderful government is paying them interest on their "bail-out money" and other funds NOT TO LEND!! So the huge profits they are reporting is actually "interest earned" from our tax dollars.

 

Trying to trick the markets and consumers into thinking that everything is wonderful. And we need more of Geitner's leadership and more of Nobama government?

Monday, July 27, 2009 9:19:40 AM
Basically, this recent rally was a farce once investors look at how these profits came to be.  Companies have slashed costs like crazy.  They haven't made any progress on the revenue part and personally, I don't think they will for a while.  Prior to the recession 70% of the economy was driven by consumer spending.  Now, take away about 6.5% (the percentage that is now being saved by consumers) and roughly another 5% (due to the rise in unemployment from aprox. 5% to 10%) and you have 58.5% of the economy now being driven by consumer spending.  A drop of 11.5%.  And does anyone actually believe that we're going to stop saving now and that the unemployment is going to suddenly drop back down to pre-recession levels?  We are in this mess for a while.  Wait about 2-4 weeks for stocks to drop and then buy. 
Monday, July 27, 2009 10:40:39 AM

Right on the mark Bill!  Great article.

 

Accounting tricks and cutting expenditures are short-term gimmicks with no long-term benefits. 

 

Companies must realize that long-term profitibility is more important than playing with the numbers to get that quarterly bonus.

Monday, July 27, 2009 11:28:38 AM

The lack of depth in this article is disappointing. This seems to be a recent trend for Bill's articles.

 

As a recent long-term IBMer who still has friends working at IBM Global Services, employee arbitrage IS a big piece of IBM's strategy to lower costs, and thus improve earnings.  They are also commoditizing their service offerings to garner labor savings in a MAJOR way.

 

IMO, there are significant issues with this in the longer term and the sustainability of the strategy, but any analyst with a just a LITTLE real insight into IBM's workings should be able to offer commentary on points like this. Bill offers nothing of substance.  

 

The IBM issues, as I see (and experienced) them:

 

1).  How long can they continue to grow net earnings by moving labor to India, China, Brazil, Russia, etc?  5 more years? Then what? 

 

2).  I know for a fact that MUCH of the work done when the computer software service jobs move offshore in IBM Global Services has a SIGNIFICANT decline in both productivity and quality.  Yes, the labor is much cheaper, but due to communication, skill, and (apparently) work ethic deficiencies of the new cheap labor - the real dollar savings are causing real customer problems - problems that I believe will grow a lot over time (you can delay software maintenance only so long until it bites you).  Customers have been leaving in droves, in an accelerating trend.  Google the state of Indiana and the IBM welfare contract for a current example.

 

3).  By commoditizing the service offerings (unless the customer pays a lot more, which most customers won't) - the personalized service, the quality of customer interaction, the loyalty/incentive of the IBM employees to excel are all significantly undermined.  Again - short term the numbers look great, but longer term I have to wonder if there is a meaningful gain to be had.  (That shift was the final straw that caused me to quit the company.  They showed they no longer had ANY respect for their employees at that point, the way they handled it).

 

. . .

 

In general, we WANT to see companies become more efficient and thus improve earnings, especially in a recession -- it reflects well on their earnings when a recovery finally rolls around.  The question is whether the changes are real and are viable long term without severe consequences to the business/customers.

 

With IBM, as a long time insider to the service business, I have reasons to have serious doubts about their actions.  With the information from Bill, aside from knowing he is skeptical, we learn nothing meaningful or specific from this article.  (So why are people paying Bill for his insights to his for-pay newsletter?  He's a permabear -- not too tough to get that message. Not too profitable except when he's lucky enough to be right.)

Monday, July 27, 2009 11:28:39 AM
The Joblessness Threat (by Nouriel Roubini)
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European Union With Turkey

Monday, 27 July 2009

Recent data suggest that job market conditions are not improving in the United States and other advanced economies. In the US, the unemployment rate, currently at 9.5%, is poised to rise above 10% by the fall. It should peak at 11% some time in 2010 and remain well above 10% for a long time. The unemployment rate will peak above 10% in most other advanced economies, too.

These raw figures on job losses, bad as they are, actually understate the weakness in world labor markets. If you include partially employed workers and discouraged workers who left the US labor force, for example, the unemployment rate is already 16.5%. Monetary and fiscal stimulus in most countries has done little to slow down the rate of job losses. As a result, total labor income - the product of jobs times hours worked times average hourly wages - has fallen dramatically.

Moreover, many employers, seeking to share the pain of recession and slow down layoffs, are now asking workers to accept cuts in both hours and hourly wages. British Airways, for example, has asked workers to work for an entire month without pay. Thus, the total effect of the recession on labor income of jobs, hours and wage reductions is much larger.

A sharp contraction in jobs and labor income has many negative consequences on both the economy and financial markets. First, falling labor income implies falling consumption for households, which have already been hard hit by a massive loss of wealth (as the value of equities and homes has fallen) and a sharp rise in their debt ratios. With consumption accounting for 70% of US GDP in the US, and a similarly high percent in other advanced economies, this implies that the recession will last longer, and that economic recovery next year will be anemic (less than 1% growth in the US and even lower growth rates in Europe and Japan).

Second, job losses will lead to a more protracted and severe housing recession, as joblessness and falling income are key factors in determining delinquencies on mortgages and foreclosure. By the end of this year about 8.4 million US individuals with mortgages will be unemployed and unable to service their mortgages.

Third, if you plug an unemployment rate of 10% to 11% into any model of loan defaults, you get ugly figures not just for residential mortgages (both prime and subprime), but also for commercial real estate, credit cards, student loans, auto loans, etc. Thus, banks losses on their toxic assets and their capital needs will be much larger than recently estimated, which will worsen the credit crunch.

Fourth, rising job losses lead to greater demands for protectionist measures, as governments are pressured to save domestic jobs. This threatens to aggravate the damaging contraction of global trade.

Fifth, the higher the unemployment rate goes, the wider budget deficits will become, as automatic stabilizers reduce revenue and increase spending (for example, on unemployment benefits). Thus, an already unsustainable US fiscal path, with budget deficits above 10% of GDP and public debt expected to double as a share of GDP by 2014, becomes even worse.

This leads to a policy dilemma: rising unemployment rates are forcing politicians in the US and other countries to consider additional fiscal stimulus programs to boost sagging demand and falling employment. But, despite persistent deflationary pressure through 2010, rising budget deficits, high financial-sector bailout costs, continued monetization of deficits, and eventually unsustainable levels of public debt will ultimately lead to higher expected inflation - and thus to higher interest rates, which would stifle the recovery of private demand.

So, while further fiscal stimulus seems necessary to avoid a more protracted recession, governments around the world can
Monday, July 27, 2009 11:51:26 AM

Bill! Get back to the basics. Spell out the necessary changes to return to the historical requirements for mortgages, and for transparent valuation of invented security bundles. The door was deliberately eased open for the

post WW2 generations to boom and bust without actually working!!  

 

 

 

Monday, July 27, 2009 12:43:20 PM
A shell game with nothing under any of the shells.
Monday, July 27, 2009 5:37:26 PM

Well, I like Mr. Fleckenstein and I also believe that there is so much BS in the numbers from the Government and Corporations …. I also followed him when he was writing all the columns about the economy during the housing boom. Here is my problem; he always misses the run up in stocks. Yes, companies are doing everything they can to cut cost and outsourcing jobs (I was outsourced more than once). Yes, Government numbers on the economy don't reflect the current problems with the economy and the numbers are often skied to be positive. Yes, we have turned largely into a service economy and so much less is actually made in the USA. Yes, this is a huge problem and there is very little value added to products. Yes, yes, yes, yes. Everything he says and everything I have seen as an engineer that has happened to this economy would suggest that there should not have been a 1000 point run up in the Dow and that the bull market from 2003 to 2006 should never have happened …. BUT … nothing Bill says ever pans out. If you listened to Bill you would have missed the 2003 to 2007 Bull market. If you listen to Bill, you just missed a 1000 point rally. Well, why? How can Bill (and I) see all the nonsense that should make most rational investors pause, yet persons like Bill and myself are always missing the rallies? What is wrong here? What are better indicators to allow persons such as Bill and myself to better understand where the markets are going? Anyone have a clue? Does this rally, the stock markets and the economy have nothing to with logic and understanding? Is it all just one great big guess? Bill, I really like all your articles. But why is truth about the market so far from the truth in making money in this market?

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