March quarter earnings (3Q16) for Microsoft(MSFT)

MSFT reported earnings for its fiscal third (=March) quarter after the close yesterday.

My takeaways:

–the company had a good quarter for its future-oriented cloud and mobility businesses during a period where the legacy PC business was unusually weak.  In the latter arena, MSFT did substantially better than the market.

–the strength of the dollar continues to be a drag

–income tax.  Geographically, the US has been stronger than expected, emerging markets weaker.  One result of this development is that MSFT has adjusted its estimate for the corporate tax rate for the full year from 19% to 21%.  The full revision for the first nine months was made in the 3Q income statement, boosting the March quarter tax rate to 24% (this is normal accounting procedure).  That clipped $.04 from what eps would otherwise have been.

–company guidance for upcoming quarters is being revised down somewhat, in a justifiably cautious way.  The dollar is one issue.  But the bigger headache seems to me to be weakness in Latin America, the Middle East and Africa, where lots of transactional (as opposed to long-term contract) business takes place and where tax rates are lower.

–today’s selloff appears overdone to me.  That’s partly the way markets move nowadays, reacting violently to headline news.  It’s also partly because MSFT had been up by 35% over the past year in a market that has been basically flat over the same time span.

–I’m not tempted to transact.  I see no reason to sell the shares I own.  If anything, I’d be a buyer below $50.  But I see no reason to rush.

 

a great academic paper: “Playing Favorites: How Firms Prevent the Revelation of Bad News”

A sidebar next to the “Heard on the Street” column of yesterday’s Wall Street Journal highlighted a research study by Profs. Lauren Cohen and Christopher Malloy of Harvard and Prof. Dong Lou of the London School of Economics titled “Playing Favorites…”.  I found the study itself on Prof. Cohen’s web page (along with a lot of other neat stuff that I’ll be writing about soon).  It’s well worth reading at least the summary at the beginning.

information manipulation

Mssrs. Cohen, Lou and Malloy studied the way in which companies choreograph conference calls by selecting the analysts who are allowed to ask questions.  Their finding:  companies that routinely call only on the analysts who are the most favorably disposed toward them–as measured by how bullish their official buy/sell recommendations are–may have a temporary positive bounce right after the call.  But they end up being significant subsequent stock market underperformers.

how so?

The authors suggest three motivations for companies to engage in this type of information manipulation.  It may want only softball questions because (in my words, not necessarily theirs):

–a company may be trying to “smooth” earnings by making more or less arbitrary changes in its accruals for, say, inventories or tax rates, and doesen’t want these devices subjected to scrutiny, or

–a company may have made its earnings guidance only by the skin of its teeth–and maybe even then only by making dubious accounting choices, which they may not want exposed to the light of day, or

–a company may want to present a glowing, somewhat bookkeeping PED-assisted, quarter because it’s going to soon sell new equity and wants the most favorable price.

why do analysts play ball?

After all, it’s embarrassing to be seen as a sycophant.

CL&M point out that the analysts called on may get to fill the holes in their earnings forecast spreadsheets, and therefore improve their future profit forecasts.  Colleagues who can only listen to the call may have different holes but can’t get them filled, so their forecasts may gain nothing.  In any event, CL&M demonstrate the favored analysts do indeed have better numbers.

As far as “why,” my experience is that the brokers the favored analysts work for garner more investment banking business from the firm in question.  Management returns the follow-up calls of the favored analysts faster, so they have better answers for their money management clients.  And when the CEO or CFO visits institutional holders of the stock, the softball-tossing analysts most often get to arrange the itinerary.   All this means more money for the brokerage houses they work for–and because of this for the analysts themselves.

the best earnings estimates?

How do the CEO’s pets end up with the best earnings estimates?  It may be the way CL&M suggest.

I don’t believe it, though.  Personally, I think selective disclosure still happens, despite its prohibition by Regulation FD.  At the very least, more frequent contact with management gives the favored analyst a greater chance to understand and decipher body language, intonation and word choice–all of which can provide valuable hints about how business is going.

why do these firms subsequently crash and burn?

CL&M observe that the analyst selection behavior is designed to prevent bad news from reaching the market.  But there are limits to how long negative information can be suppressed.  Eventually the companies have to come clean–if for no other reason than the auditors have arrived.  This results in negative earnings revisions and stock underperformance.

Maybe so.  Personally, I have a simpler, though non-verifiable view.  I think the conference call manipulation stems from–and reveals–a character flaw in a firm’s CEO.  The boss doesn’t want to have his ideas questioned and never wants to hear bad news.  Because he always shoots the messenger, subordinates hide unpleasant realities until they’re so big they’ve done serious damage to the firm.

one complaint, sort of

The study has a lot of statistics but no names of offending companies.  They would be worth knowing.  A shrewd investor, however, would keep that information for himself.  He’d also thereby avoid a firestorm of protest from egomaniacal CEOs.

“Great quarter, guys!”–the smarmy analyst refrain

Bob

A few days ago, my friend Bob emailed me a link to a recent Wall Street Journal article commenting on the omega-dog behavior of brokerage house securities analysts on company conference calls.  The ultimate acknowledgment of this inferior status is the obsequious “Great quarter” comment.

A distant cousin is “Thank you for taking my question,”  which typically means “I know you control who gets to be heard on the call and I appreciate the status you’re granting me.”  It can also convey an undertone of irritation that the analyst has been denied this opportunity on previous calls, despite his obvious stature in the industry.  If so, the analyst is also implying (sometimes, to his regret) that management isn’t clever enough to pick this up.

my take on the sell side, and on earnings calls

Anyway, Bob’s email prompted me to write down these thoughts.

1.  The earnings release and conference call are, in the first instance, the straightforward way that publicly traded companies feel they meet disclosure requirements mandated by regulators.

At the same time, companies understand these are marketing opportunities as well.

Of course, management controls who gets to speak on the call–and it’s virtually always favorably inclined analysts who get the air time.  If you don’t believe this, read anything Mike Mayo has written about the securities industry.  For the better part of two decades he was blackballed by the major banks, not because he was an incompetent (he’s quite the opposite) but because he pointed out banks’ weaknesses and recommended selling their stocks.  Not only was he denied access to managements, but he was repeatedly fired from brokerage houses when firms he covered directed investment banking business elsewhere and when institutional investors who had large bank stock positions shifted their trading away.

No, being seen as the CEO’s boot-licking lapdog isn’t pretty.  Looking on the bright side, though, a lapdog has unparalleled access to his master–and that access is something institutional investors are willing to pay for.

2.  Securities analysts are deeply dependent on the managements of the companies they cover.  Investment banking business is only part of the story.  Will the CEO help an analyst burnish his reputation by attending a conference the analyst organizes or will he dispatch an IR person who will give a canned presentation that’s months old.  When the CEO or CFO travels to meet large institutional investors, will they let the analyst arrange the agenda and travel with them?  If the analyst has a question, will the CEO return his call?  How fast?  These are all factors an institutional investor considers in deciding how much he’s willing to pay an analyst for services.

Companies are also the primary source of industry information for almost every analyst.  Cutting off access to management is like taking away your internet connection.  That’s doubly true today when brokerage house research budgets have been pared to to bone and many laid-off analysts have been forced to open up shop on their own.

3.  The traditional communication system, of which many earnings conference calls are still a part, is broken.  When I was a rookie analyst, publicly listed firms would feed financial information to shareholders and interested investors through “tame” brokerage house securities analysts.  Many companies regarded analysts as quasi-employees whose job was to relay the info–untouched–to shareholders.  After all, everyone had to have a brokerage account.

Lots has changed since then:

–investors under the age of, say, 60 have spurned traditional brokers in favor of a do-it-yourself approach through discounters like Fidelity.  Two reasons:  much lower costs, and a fundamental distrust of the motives of traditional brokers.  Sell side analysts still have contact with institutions, but will almost no individual investors

–Regulation FH (Fair Disclosure, August 2000) has clearly specified that the practice of selective disclosure is illegal

–many of the analysts companies communicate with no longer work for brokers.  They’re in independent research boutiques that repackage the information they receive and sell it.  They talk to some institutions, but not all.  And they have no content whatsoever with individual investors.

The upshot of the traditional practice is that individual shareholders are cut out of the information loop altogether.  Ironically, CEOs can end up giving corporate information (which is the property of shareholders) for free to professional analysts, who are typically not shareholders, while denying it to owners.  To add insult to injury, these middlemen then sell the information to shareholders, who are forced to pay thousands of dollars a pop.

Yes, the “tame” analysts kowtow–but they’re laughing all the way to the bank.

The current system is so broken, I think it’s only a matter of time before there’s wholesale change.  That day can’t come too soon for me.