Monthly Archives: July 2011

thinking about a US default

July 26, 2011 By in Current Market Thoughts, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , Leave a comment

a small boat out on the ocean

At the moment, the hardest investment task for me, as an American, is to distinguish between emotional involvement in the political struggle now going on in Washington, on the one hand, and the stock market consequences of apparent gridlock in Washington, on the other.

An equity portfolio manager, amateur or professional, is like a sailor in a small sailboat out in the middle of the ocean.  If you see a storm coming, you can spend your time cursing the wind and railing against the lightning–and achieve some emotional satisfaction.  But you’re better off taking in some sail, tying stuff down, putting on a raincoat, and doing whatever else prudent sailors do in circumstances you have basically no control over.

my assumptions

Two factors make the deficit situation hard for me to handicap.  The first is that, like most equity investors in the US, throughout my career I’ve regarded politics as a mild negative for stocks, but basically irrelevant.  So I don’t know much about the world inside the Beltway.  Also, today’s argument isn’t about who gets a larger relative share of an expanding pie to distribute as patronage to the people who voted for him.  It’s about everyone giving up something.  That’s a much harder discussion.  Nevertheless, you have to assume something.  For me,

1.  If S&P’s word is good, and I think it is, US Treasuries lose their AAA credit rating sometime soon.   This has two consequences that I can see:

–the US will have to offer a slightly higher interest rate to sell new debt, and

–depending on how their contracts are written, some bond managers will be unable to buy new Treasury debt, or to hold as much of it as they’ve done in the past.

2.  Washington may have to be forced into compromise.  This could happen in one (or both) of two ways:

–In early 2009, it took a large stock market drop immediately after Republicans voted against countercyclical fiscal stimulus to get them to change their minds.  That may happen again.  Maybe the Treasury refinancing scheduled for August 4th won’t go well.  Or maybe the stock market will drop.

–The government may stop sending out transfer payments, like Social Security, or checks to government employees.  The resulting tons of angry phone calls and emails to congressmen would likely focus their minds.

By the way, there’s been some discussion in the press as to whether government computers are flexible enough to make some payments, like Social Security or salary checks, but not others, say, payments to defense contractors.  It’s not clear that they can.  So the choice may be either to pay everyone or no one.  Federal government offices may have to shut down.  Not great for a sputtering economy.

In addition, money market funds are becoming more liquid–and withdrawing repo financing from EU banks–in preparation for possible redemptions of their own on a government debt downgrade.

Two conclusions:

–events will force Washington to raise the debt ceiling in short order;

–there could be a temporary, but possibly sharp, stock market selloff before that happens.

what I’m doing

Worries about domestic politics can play out in three ways, I think:

1.  through a weaker US dollar.  This is already starting to happen; look at the ¥/$ rate.  My guess dollar weakness continues.  My US holdings are selected to benefit from dollar weakness, however, so I don’t have to defend myself here.  In fact, I may even gain something.  A secondary concern is that investors in foreign markets will orient their holdings away from dollar earners, but I don’t have enough exposure to worry.

2.  through higher interest rates.  Since bonds are substitute investments for stocks, higher rates will likely put some downward pressure on stocks.  But US stocks already seem priced for much higher interest rates than we have at present, so I’m not too concerned.  Other than avoiding financials–and I own almost none–I don’t see anything I can do.

3.  through a stock market selloff–a mini-panic.  For an institutional equity manager, instructions from clients will likely not allow holding more than very small levels of cash.  So he just grits his teeth and rides out the storm.  A taxable private investor has to balance the certainty of triggering a capital gains tax vs. the possibility of selling today and buying back, say, 15% cheaper in a month.

My decision?

I’m looking through what I own to try to identify the clunkers hiding there so that I can get rid of them.  I’m also eyeing my biggest positions–both individual names and industry groups–to see what I should trim.  This is what I usually end up doing in times of stress–cleaning up my portfolio with the long term in mind.  I try to do this every day, but I find storm clouds on the horizon make me a more critical observer.


reason six why analysts mis-estimate company earnings

July 25, 2011 By in Casinos, earnings surprise, Entertainment, Industry Analysis, internet, reasons analysts mis-estimate company earnings, Technology, using research, Wireless Tags: , , , , , , , , , , Leave a comment

reason #6

In my post from yesterday, I titled this reason “making dumb mistakes.”  I’m not sure what else to call it.  Let me illustrate with two examples of recent huge misses by analysts who should have known better.  They’re the June quarter results from two high-profile companies with plenty of Wall Street coverage, WYNN and AAPL.

Let’s take WYNN first.

WYNN’s 1Q2011

In 1Q2011, WYNN earned $173.8 million, or $1.39 per fully-diluted share.  Look one line higher on the income statement, and you see that the $173.8 million figure is after deducting $52.5 million in “income attributable to non-controlling interests.”  That’s minority interest.  It’s income that belongs to the 27.7% of Wynn Macau that WYNN doesn’t own.  (Wynn prepares its financials as if it owned 100% of Wynn Macau, and then subtracts out the minority interest at the end.)

From the minority interest figure and the magic of long division, you can calculate ($52.5 /.277) that Wynn Macau’s total net income was $190 million. WYNN’s share was $137 million.  Therefore, WYNN, ex its interest in Wynn Macau, earned $36.8 million for the quarter.

One unusual feature of 1Q11:  gamblers at the WYNN tables in Las Vegas had bad luck by historic standards during the quarter.  They lost a bit over 30% of what they wagered vs. historical loss experience of 21%-24%.

Any analyst who follows the company could have found all this out in five minutes of studying the 1Q11 income statement.  Given that the analysts’ consensus for 1Q11 was wildly low at $.73, you’d assume they’d do so to try to figure out where they went so wrong.

turning to 2Q11

In 1Q11, 80% of WYNN’s income came from fast-growing Macau, 20% from slowly-recovering Las Vegas.

From figures the Macau government posts monthly on its Gambling Coordination and Inspection Bureau website, we knew on July 1st that gambling revenue for the market as a whole was 12% higher in 2Q11 than in 1Q11.  If we assume that Wynn Macau grew in line with the market, and that a 12% increase in revenues produced an 18% jump in income (basically, adjusting for normal operating leverage and the fact that Wynn Macau “adds” gambling capacity by raising table stakes), then Wynn Macau would have earned about $225 million in 2Q11.  Of that, WYNN’s share would be about $165 million.  That translates into around $1.35 a share for WYNN in eps during the quarter.

What about Las Vegas?  It chipped in $.25 a share to first quarter earnings.  “Luck” at table games returning to historical norms would probably push that figure back to zero.  On the other hand, room rates at both Wynn and the Encore are gradually rising, so zero might be too low.  But let’s stick with zero from Las Vegas is the most reasonable guess.

In other words, a sensible back-of-the-envelope guess for WYNN’s eps in 2Q11 would be $1.35 + $.00  =  $1.35.  This isn’t necessarily the most conservative forecast, but it is one based on factual data about the Macau gambling market and the assumption that nothing much goes wrong (or right) in Las Vegas.

What did the professional analysts say?

The median estimate was $1.01.  The highest was $1.25; one analyst had the dubious distinction of saying eps would be $.69.  For this last estimate to have come true, WYNN would have had to break even in Las Vegas (it earned about $.25/share) and to have revenues in Macau drop by 25% quarter on quarter, while the market was growing at 12%.

Given that WYNN’s results are so strongly influenced by Macau, even the median was predicting a relative disaster for the company there.  What were they thinking?

(True, they might have been assuming a disaster in Las Vegas, not Macau.  And, I’ll admit, I thought WYNN has done surprisingly well in Las Vegas so far this year.  But Las Vegas isn’t big enough to move the eps needle down to $1.  And the situation is a little more complicated than I sketched out above:  Wynn Macau pays a large management and royalty fee to the parent, almost $40 million in 2Q, so the better Macau does, the better ex Macau looks.)

APPLE

AAPL’s 2Q11 (ended in March)

During 2Q11, AAPL earned a profit of $6.40 a share.  Its business broke out as follows:

Macs     3.76 million units     $4.98 billion in revenue

iPod      9.02 million units     $3.23 billion (includes iTunes)

iPhone     18.6 million units     $12.3 billion

iPad     4.7 million units     $2.84 billion

Other                                         $1.3 billion

Total                   $24.7 billion

turning to 3Q11

Let’s try a back-of-the-envelope forecast for AAPL’s 3Q11.  To make things ultra-simple, we’ll ignore operating leverage, which will bias our estimate to the low side.

Macs  growing, but slowly in a developing world where overall PC sales are flattish.  Let’s say $5 billion in sales.

iPod  flat, $3.2 billion in sales

iPhone     industrywide smartphone unit sales are growing at 80% year on year.  All the growth is coming from half the market, Android and iPhone, with Android growing faster; Nokia and RIM are taking on water and sinking fast.  Let’s pencil in 19 million units at $660 each = $12.5 billion.

iPad  this is the tricky one.  We know that AAPL is capacity constrained, is adding manufacturing capacity as fast as it can, and sold 4.7 million units in 2Q11.  Let’s put in 6 million units at $600 each, the average price from 2Q11.   That’s $3.6 billion.

Other Leave it flat at $1.3 billion.

Add all these numbers up, and we get $25.6 billion.  If we assume constant margins–i.e., no operating leverage (which a really terrible example to set–working with margins instead of unit costs, but I’ll do it anyway), then earnings will come in at $6.60-$6.75 a share for the quarter.

As events turned out, my guess is way too low.    …oh well!   AAPL reported eps of $7.79.  The big difference?  The iPad sold 9.2 million units and brought in $6 billion in revenue.  That alone adds more than $.60 a share in earnings.  The rest is bits and pieces.

So I missed badly.  That’s not really the point.  The real question is how my ten-minute approach stacks up against the work of the 45 professional analysts who follow the company for a living–and for whom AAPL is probably their most important stock.  Check them out and I’m starting to look pretty good.

the analysts

The median estimate of the 45 was $5.82 a share.  The low was $5.10, the high $6.58.

How could they consensus be projecting an almost 10% quarter on quarter drop in earnings?

APPL’s main business, smartphones, which accounts for 50% of total company revenue, and a higher proportion of profit, is exploding. The category is growing by 80%.  Rivals NOK and RIMM are not only going nowhere, they’re getting worse by the day.   In fact, NOK’s smartphone sales in the June quarter fell year on year–probably by a third. So AAPL’s continually taking market share from them.  Quarter on quarter sales were likely up.

We don’t know what 2Q11 iPad revenues could have been, only that they flew off the shelves as fast as AAPL put them on.  So product sales had to be up, maybe substantially, in 3Q11.

If both iPhone and iPad were flat, quarter on quarter, the only way to get company results to be down 10% would be if Mac sales, which represent about a fifth of the company’s business, were cut in half.  Hard to fathom, given that the PC industry is growing, if only slightly, and Macs have been gaining significant market share from Windows-based PCs.

what did I do differently?

I think everybody ignored AAPL’s “guidance” of $5.03.  WYNN doesn’t give guidance.

I did five things:

I gathered industry information from the internet.

I read the prior-quarter results carefully.

I used a line of business table to make (very primitive) quarter on quarter projections.

I ignored macroeconomic forecasts of slow growth for the US, since both firms target the affluent here–AAPL more so than WYNN, I think.

I didn’t worry about missing on the high side.  I didn’t want an estimate that was deliberately too conservative.

What didn’t the analysts do?

I only have guesses.

It’s possible that they were influenced by downbeat general economic news.  Even so, I don’t see how you could have gotten to the consensus figures for either APPL or WYNN if you did a line of business table.  But that’s one of the first lessons in Security Analysis 101.  Maybe the analysts in question were out that day.

6 reasons why Wall Street analysts mis-estimate company earnings

July 24, 2011 By in FIFO and LIFO, Getting financial advice, Portfolio management, reasons analysts mis-estimate company earnings, whisper number Tags: , , , , , , , Leave a comment

companies continue to beat Wall Street estimates

It’s earnings season again.  As companies report their results for the quarter, investors watch carefully to see whether they match, surpass, or fall short of, the consensus estimates of Wall Street securities analysts.  As has been the case since the bull market began over two years ago, a majority of companies are beating the consensus figures–some by a mile .

Why don’t analysts do a better job of forecasting?   

I have six reasons (five of them today, the final one tomorrow):

1.  Some companies are very hard to forecast, because they’re so complex.  They may have a lot of divisions, many suppliers and a large variety of finished products that they sell.   

Alcoa, the first of the big publicly traded US corporations to report each quarter, is a case in point.  You’d think that the main variable for Alcoa would be the price of aluminum, which you can see every day in commodities trading.  …but no.

Alcoa can get its raw materials from many sources.   Some sources are joint ventures that Alcoa’s a part of, which often have complicated profit-sharing arrangements that are not publicly disclosed.

Miners deliberately change the grade of ore they mine, depending on price, to maximize the life of the ore body.  Ore can be processed in different locations, some company-owned, some not, depending on the price of electric power and other factors.  So expenses are hard to gauge.

On top of all that, differing accounting conventions at each step of the way can play a big role in what cost figures eventually appear on the income statement.

In a case like this, it’s hard to imagine anyone outside the company having a good handle on what reported earnings will be.

2.  Some companies demand that analysts stay close to “official” guidance.  CEOs understand that having earnings per share that exceed the consensus is a good thing for their company’s stock  (a positive earnings surprise), and that missing the consensus can be a very bad thing  (a negative surprise).  So most firms that issue next-quarter guidance to analysts give out numbers they believe they have an excellent chance of beating.

Some firms go further than that.  They make it clear they will punish any analyst who deviates from guidance more than a little bit.

What can a company do?

Lots of bad stuff.  From descending order from worst to not-as-bad, the company can:

–stop using the analyst’s firm for any investment banking services, like underwriting debt or equity offerings (which is likely to get the analyst fired),

–not appear at industry conferences the analyst’s firm may organize, or send the investor relations guy instead of the CEO or CFO,

–avoid using the analyst to organize the company’s visits to powerful investment management companies,

–refuse to give the analyst access to top company officers to ask questions about operations,

–delete the analyst from the queue to ask questions during earnings conference calls (petty, it’s true, but not unusual).

There have been cases of stubborn analysts who have stuck to their guns in print, against company wishes.  Their stories  usually end badly.  For most, they’ll show the number the company wants in their written reports and “whisper” their best guesses to clients.

3.  Some analysts aren’t good with numbers.  That’s not always a fatal flaw.  The analyst may have other pluses–a deep knowledge of the inner workings of an industry, an ability to  sense new trends quickly, or very good contacts with the companies, or customers and suppliers.  Or maybe they just know where to take clients to lunch.  After all, when you get down to it, sell-side analysts are paid for their ability to generate commission business  for their trading desks and to attract/keep investment banking clients–not necessarily for having the best numbers.

4.  Sometimes analysts don’t do the spreadsheets themselves.  An assistant does them instead.  Analysts may spend half their time on the road visiting companies and clients.  Much of the rest of the time, they’re doing the same thing on the phone.  And the analyst may not be so great with numbers, anyway.  So that task is relegated to an assistant.

An aside about assistants:  in my experience, many analysts pick assistants who are articulate, look good in a suit and are smart–but not too smart.  Why?  A sell-side analyst may earn 10x-20x what an assistant does, in an industry that suffers a severe downturn in profits about twice a decade.  The analyst may worry that having a top-notch assistant means the analyst becomes a cost-cutting victim during recession.

5.  Many experienced analysts have been laid off over the past few years.  Doing good estimates doesn’t require a genius, but it does require some training and experience.  A lot of that has been lost on the sell sidesince the Great Recession began.  In addition, as I suggested above, the assistants who have been promoted into the principal analyst jobs may not all be the brightest crayons.

That’s it for today.  I’ll write about #6, making really dumb mistakes, tomorrow.

Intel’s strong 2Q11

July 23, 2011 By in Current Market Thoughts, earnings conference calls, Industry Analysis, internet, Stock ideas, Technology, Wireless Tags: , , , Leave a comment

the results

INTC reported 2Q11 results after the close of trading in New York yesterday.  The company posted earnings per share of $.59, up 16% year on year, on revenue of $13.1 billion, a 22% gain vs. 2Q10.  The revenue number was an all-time high for INTC, thought it was helped along by the recent acquisitions of McAfee and of some chip businesses from Infineon.  Earnings handily beat the analyst consensus of $.51.

guidance

INTC typically doesn’t talk about future eps.  The company expects that 2H11 will show its normal seasonal strength vs. 1H, and that revenues over the period will likely be up by around 25% vs. 2H10.  This seems to me to suggest full-year 2011 eps of $2.50 or so.  INTC expects 2012 will be considerably better than 2011.

The mix of revenues will be different from what INTC thought three months ago, however.  More about this below.

details

Demand from emerging markets, which makes up the majority of INTC’s business, is booming.

Corporations around the world continue to spend heavily on new servers.  The development of cloud computing is adding to that.

The global consumer appetite for notebooks and desktops, with demand skewed toward the emerging world, is growing at double digits.

INTC saw some weakening of its business in Japan.

The corporate tax rate for the quarter was lower than anticipated, signalling that a greater proportion of its revenues than the company expected are coming from outside the US and EU.

The only fly in the ointment for INTC is netbooks.  Sales of the Atom chips which power them have swung from being up 4% year on year in 1Q11 to being down 15% year on year in 2Q11.

a lower PC unit growth forecast for 2011

Predictably, this is the one thing from the INTC earnings release and conference call that the press has seized on.

Third-party consultants have been saying for some time that they expect growth in global PC unit sales this year to by only about 5%.  INTC, in contrast, has been saying that it expects “low double digit” growth (10%-12%?).

The difference?  INTC says, in effect, that the consultants only have good information about the developed world.  They’re incorrectly extrapolating weakness there to the emerging markets, where conditions are far better.

None of that has changed.  What has taken INTC by surprise is a recent falloff in sales of Atom chips that go into netbooks.  It sounds to me that there’s worse in store for Atom than the 2Q11 sales drop cited above.  That’s  because Atom is the reason INTC is lowering its global PC unit growth forecast by about 2%, to up 8%-10%.

On the other hand, people still buying PCs are selecting higher priced ( and higher profit) chips than INTC thought.  The two factors are cancelling each other out on the revenue line.

my thoughts

They haven’t changed since my last post on INTC.  I was a little surprised, when I looked at a year to date chart a couple of minutes ago and saw that INTC has outperformed the S&P during 2011 (based on price action in July).  On a one year view, INTC is a substantial laggard, though.

The bearish case, as I understand it, is that INTC is a child of the PC generation.  That time is past; INTC has been displaced by ARMH in the new tablet/cellphone era.  Therefore, no matter how good earnings are today, they will inevitably decline.  And, as these situations typically develop, the falloff will be sooner than you think and very rapid.

An implicit assumption is that INTC will be unable to adjust.

The bullish case is a little more complicated.  It’s that:

–servers for general corporate needs and for cloud computing will remain booming businesses

–corporate users and consumers in the developing world will ensure that the traditional PC business will be at least stable, and won’t decline precipitously

–at 9x 2011 eps ( and 8x? 2012), and with a dividend yield higher than a ten-year Treasury, all but the most bearish outcome is already baked into the INTC stock price

–it’s possible that some combination of INTC’s chip innovation and the success of MSFT products in the cellphone and tablet markets will enable INTC to transition its consumer business in the developed world to the post-PC era.

I own INTC; I’m in the bullish camp; but I’m somewhat concerned that I’m simply tuning out the (negative) message that the stock price has been sending out for a long time.  I still think, however, that if the developed markets consumer business disappeared tonight and tomorrow INTC appeared as a fast-growing cloud computing and emerging markets play the stock would be a lot higher than it is now.  So for now I’m content to wait.

—

good news from Harley Davidson

July 22, 2011 By in earnings conference calls, Industry Analysis, Stock ideas, Strategy, Transport Tags: , , , , , , Leave a comment

the results

Harley Davidson (HOG) reported 2Q11 earnings before the New York market opened on July 19th.  EPS came in at $.81, a gain of 37% year on year, on revenues that were up by 18%, at $1339.7 million.  The Wall Street analyst consensus for HOG was $.71.

In contrast to most of the companies I’ve been watching, whose stocks have either shown little positive reaction–or gone down–after big positive earnings surprises (look at WYNN or AAPL), HOG shot up about 9% on this news, capping a run that has seen the stock rise 50% since mid-June.

the turnaround

HOG is an intriguing turnaround story, with three elements to new management’s plans:

–recovery from very serious damage done by the recession

–broadening the customer base beyond American males who watched Easy Rider as a first-run film, secretly love the Grateful Dead and need the extra stretch HOG puts in its tee shirts to accommodate seriously expanded waistlines, and

–overhauling inefficient manufacturing and distribution.

I’m not sure that at today’s price you’ll make a lot of near-term money in the stock.  I don’t own HOG now, though I owned it for years in a small-cap portfolio I once ran (despite the fact that I consider a US company having a ticker symbol that spells a word to be a serious red flag).  I did think about buying the stock after good 1Q11 results, but decided I had enough risk in my personal portfolio without it.

Anyway, what interests me most about HOG’s 2Q earnings report is what it says about the current state of the US economy.

a little history

Like a motor boat, or a two-seater sports car, a motorcycle–especially an expensive one like a Harley–is not a very practical purchase.  The riding season is short in many parts of the country and rainy weather turns a ride into an unpleasant experience for most people.  Sales of any of these vehicles are highly sensitive to the state of the economy.

During the boom years in the middle of the last decade, lots of people were feeling wealthy enough to buy Harleys.  Many got financing from HOG.  As the recession developed, a large number of these new owners couldn’t afford their payments any more and turned the keys back over to Harley.  This had two bad consequences for HOG:  demand for new bikes dried up; and dealers’ lots were flooded with tons of repossessed next-to-new used motorcycles that needed heavy discounting to be resold.  That depressed prices across the board.

Pretty ugly.

the sound of a corner turning

What caught my eye about HOG’s 2Q11 earnings report is that, for the first time since late 2006, retail sales of new motorcycles are up year on year in the US–by 7.5%.  Dealer inventories are below normal.  The credit experience in HOG’s financing arm has been improving for four quarters–although this is probably mostly a function of better underwriting.  And the company has raised its projected shipment numbers for the second half.

This is certainly welcome news for HOG.  More important to me, the increase in demand for new motorcycles seems to show that consumers are more confident, and that therefore the US economy is on a sounder footing, than the consensus realizes.