reason six why analysts mis-estimate company earnings

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.

Is Wall Street’s “tactical” efficiency fading?

strategically inefficient…

Any student of Wall Street, or any other world stock market for that matter, knows that investors periodically fall under the sway of manias or panics.  In my professional life, I’ve lived through–among others–the mania for oil stocks in the early Eighties, for Japanese stocks in the late Eighties, for Asian stocks in the early Nineties, the Internet bubble of the late Nineties and the run-up to the recent meltdown of financial stocks, during which period commercial and investment banks could do no wrong.

In the aftermath of these episodes, markets can become quite depressed.  Occasionally, as in early 2003 and early 2009, stocks can temporarily fall so far in price that the dividend yield on the stock market of a country exceeds the coupon on its government debt.  Inevitably, a sharp rally follows.

Another way describing this behavior pattern is that in a strategic sense stock markets are very inefficient.  Investors have very little consciousness of the forest.

—but tactically efficient

On the other hand, in my experience, stock markets have always been very tactically efficient.  That is to say, publicly available information about specific companies is either anticipated by investors prior to public announcement–from, say, the results of private surveys or by inference from industry data–or at the very least, very quickly incorporated into stock prices.  In the Eighties, for example, Kyocera was the sole source for ceramic casings that Intel used to hold its newest microprocessor chips.  Kyocera’s production plans were publicly available in Japan.  So analysts soon learned to give a call to Kyocera’s investor relations department to find out this valuable leading indicator.  More recently, during the iPod boom, one could get a good handle on Apple’s production plans by looking at orders for the micro-motors that turned the small form factor hard disk drives that every iPod contained.  iPods were virtually the only users of these tiny drives, which were made almost entirely by a single company, Nidec.  No need to call Japan; Nidec had a New York investor relations office.

what about now?

I’m not sure I want to make a strong claim for Wall Street’s tactical efficiency any more.  Three recent occurrences that have really stock out to me:

–Fed Chairman Bernanke recently gave congressional testimony that caused Wall Street to drop sharply as it heard his words.  But he was just repeating what had been said in the minutes of the Fed’s Open Market Committee meeting, which had been released the week before.

–The New York Times Company reported results last week (I wrote briefly about this on July 23).  The company said that ad revenues were basically flat–for the first time in a long while–because online ad growth was big enough to offset the decline in print advertising.  Two days later, after this was flagged in the newspapers and by news services online, the stock reacted by rising 4% or so.

–In mid-June, FedEx was the first of a series of transportation companies to announce that its international business was booming.  It felt good enough about its prospects to begin restoring employee compensation cut during the downturn (I also wrote about this, on June 20).  The stock went down on the news–and stayed down amid a series of similar bullish announcements by other transport firms.  It rose sharply yesterday when it said (surprise, surprise) that the trends it spoke of in June were continuing in July.  As a result, near-term earnings would be higher than FDX’s original guidance.

why no discounting?

First of all, it may be that these are anomalous incidents.  It’s possible that what I see as the market not discounting important information is actually the discounting mechanism working in a much more sophisticated way than I perceive.  I don’t think so, but I’ve got to keep this in mind.

I think two factors are at work:

–large-scale layoffs of veteran researchers by investment banks has reduced the quality and quantity of research output by the sell side.  The same is likely true, to a lesser extent, of the buy side.

–the absence of individual investors in the stock market, either through direct stock purchases or through investment in actively managed mutual funds.  Computer-driven trading, an important factor in market movements since the Eighties, may have lost part of the counterbalance provided by stock-picking activity.

conclusions?

If my perceptions are right, the risk character of individual stock selection may be changing.  The rewards may be greater, but their timing may be less predictable.  The biggest practical result may be that you will either be way ahead of the market in buying a stock (and may need a lot of patience) or way behind it (and be playing an idea that’s long since discounted in today’s price).  More on this topic in later posts.

How to use brokerage research reports

The Business section of yesterday’s New York Times had an interesting article in it, pointing out that during the current stock market downturn the typical Wall Street analyst recommendation has been “buy” not “sell.”   A similar study of any other downturn would likely produce the same results.  Why is this?

There are lots of pragmatic, institutional reasons why it’s so difficult for an analyst to write “sell” (more about this below).  Also, as investor sentiment indicators–which are invariably most bullish near the top and most bearish at the bottom–illustrate, it’s psychologically much harder than it might seem to either buy low or to sell high. Ff there may not be much information in the analyst recommendation, then, what are the really useful parts of an analyst’s research report? Continue reading