Wednesday, August 24, 2005

Earnings Games

August 24, 2005 -
I wrote this article after Minyans in the Mountains conference that took place in sunny Ojai. I was one of the panelists on fundamental panel where I was in the great company of Herb Greenberg, Fil Zucchi and Jeff Macke. JeffMacke© and I usually agree on things. (Though he recently mentioned that my four-year-old son will never meet his two and half old daughter.) However, in our fundamental panel discussion at MIM2, I discovered that Macke and I disagree on the issue of management's earnings guidance. I'll let Macke state his view, as my attempts would only bleach the colorful (psychedelic) way only Macke can express himself.
Here is my view: Wall Street's preoccupation with (public) corporate America meeting and beating its earnings forecasts has had a corrosive effect. In fact management's constant pursuit to appease a short-term minded Wall Street has spread to the ranks of the best of the breed.
This was the response of Costco's (COST) CEO to an analyst's question on what he loses sleep over...
"What I lose sleep over, and not a lot frankly, is more as it relates to the short-term stock price movements, because short-term stock price movement is impacted by expectations and the fact that at some point, and perhaps this quarter is a good example that we just announced, that if you look at quarters two, three and four last year we beat those by a little bit." (, Transcript of Costco's Q3 2004 earnings call.)
One would argue, what is the harm? How do a CEO's sleeping habits impact shareholders? A fair question. The apparent consequences of a CEO caving into the pressure to deliver the goods quarter after quarter came to light when the accounting scandals erupted at then unsuspecting places such as Enron, WorldCom, Bristol-Myers Squibb (BMY), HealthSouth, Fannie Mae (FNM) and many others. However, the hidden-to-the-naked-eye impact is morphed much deeper into the ranks of corporate America.
On a daily basis corporate management makes decisions that aim to benefit corporate performance in the short run versus the long run and vice versa. Though not all short-run and long-run decisions are mutually exclusive, to grow a tree (a long-term investment) seeds have to be planted (immediate expense). Management faces these decisions on a daily basis and unfortunately often destroys long-term value to please the short-run junkies.
A couple of years ago I had an informal breakfast meeting with the management of a wholesale club (not Costco). I asked why they did not open more pharmacies at their existing clubs, as the company had plenty of free cash flow and opening pharmacies seemed to improve traffic.
The response I received was: "Yes, pharmacies are a good investment, but it takes a while for them to reach profitability thus we'd be taking a short-term hit on earnings. Therefore, we are stretching the openings out."
Management has given up a good investment opportunity in favor of the short-term gratification of Wall Street.
During the break between the session at MIM2 (more in later posts), I had the pleasure of speaking with Professor Neal Dingmann (what a great, modest, sharp guy). Neil pointed out that in the oil industry, results choosing short run in lieu of the long run may have grave consequences on the company's long-term profitability. As companies strive to make the production numbers (and thus revenue) they may abuse the wells and potentially undermine their structural integrity and long-term profitability.
The pressure spills far beyond the retail and oil industries, for example, to a well-known beer maker. According to a CFA friend of mine, (an industry insider) often when the company feels the pressure to deliver the "expected" numbers, it sells beer to liquor stores at large discounts to its regular price. Beer has a limited shelf life (I try to explain this to my wife quite often), thus if it's not sold by the expiration date it must be returned back to the beer maker. By artificially stuffing inventory channels (demand did not warrant it) the beer company has cut into its next quarter's sales and increased its expenses as expired product will make it back to the warehouse.
As Macke mentioned in the panel discussion, Sarbanes-Oxley did not fix things because you cannot mandate ethical behavior.
However, it did enrich an army of consultants and imposed a great cost on public companies (especially smaller ones). The true cost of meeting the numbers game is truly impossible to measure, as we'll never know what projects companies have foregone to please the Street's crowd.
Over time the Street's obsession with short-term goals has shifted management focus from creating long-term value for shareholders to becoming Wall Street's lap dog trying to jump every quarter to the plank that was raised by its masters. I understand the pressure that companies face every quarter, as for many of them a declining stock price means an exodus of option-linked talent. However, there are creative ways to compensate their employees, where stock options and (short-term) stock performance are not the only solution to employee retention.
John Succo noted that Citigroup (C), the world's largest bank, has fiddled with its asset gains to make its numbers for the quarter. And he asked me, how do I deal with it? I tear a company's financials apart, trying to arrive to core operating performance--The Good, The Bad, and The Ugly series are a good example of that. In the case of Citigroup, I'd simply avoid the stock (Todd Harrison: not advice) as it'll consume the whole quarter for me to analyze the very complex financials of the giant conglomerate.
Every time I stumble on a company with complex financial statements, I remind myself that I want to only own companies whose financials (and business) I can understand. To make a rational decision one has to be able to analyze (in a timely manner) the information.
Vitaliy N. Katsenelson, CFA Copyright This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.

Monday, August 08, 2005

Nokia poised to ring investors' bells

Financial Times - August 8, 2005
Nokia is a perfect showcase for contrarian value investing. It is easy not to like Nokia stock, especially for US investors, as Nokia has not come up with a decent cell phone in the US for a while. Motorola has risen from the dead and offers a great portfolio. In addition, the latest quarter did little to provide comfort as margins in the mobile phone segment declined more than 3 per cent from 19.8 per cent to 16.2.
However, all these developments are widely known and more than priced into the stock, where many positive developments went unnoticed.
In the second quarter, Nokia's market share grew in the US sequentially, a miracle considering a below-average product range. Though 45 per cent of Nokia's shareholders live in the US and it is the single largest cell phone market, Nokia sales in the US represent only 8 per cent of its total sales - a considerable decline from 15 per cent last year. There is a lot more upside than downside in the US for Nokia.
Revenue in the second quarter grew 25 per cent and it was true organic growth, without acquisitions. An unfavourable product mix, a decline in the average selling price (ASP) of 5 per cent and intensified competition were responsible for margin erosion. The deterioration was due to explosive sales growth in emerging markets where sales are dominated by cheaper handsets.
The US situation is puzzling. Yogi Berra would describe it as Nokia making too many wrong mistakes. The company let Motorola take the lead in the US by missing the flip phone trend. Motorola deserves credit, as it did a wonderful job producing phones that US consumers wanted. Outside the US, Nokia is a dominant player owing to a strong brand and innovative products. Its problems in the US stemmed from its unwillingness to sacrifice manufacturing efficiency and to customise its phones to US carriers' specifications. Last year Nokia made needed modifications to its operating system that should have allowed customising phones on the software level without handicapping its manufacturing efficiencies.
Nokia is likely to approach the US market differently from the way it does the rest of the world. It will have to make phones just for the US - a significant shift in strategy. Nokia has all the ingredients to recapture the market, though I believe it will take some time. US will be the icing on the cake for Nokia as its overall success is not driven by its success in the US since it represents a small portion of its sales.
Nokia is by far the largest cell phone producer and it spends considerably more on research and development than its closest competitor Motorola. R&D is much needed to keep consumers in developed countries excited about new, feature-rich phones.
Nokia is also the low-cost producer, the Dell of cell phones, which is crucial as competition in the low end products is mostly price-driven. In the lower end phones in emerging markets, as long as features are comparable with other phones and the brand perceived to be of good quality, price is a deciding factor on a purchase. To put things in perspective, Nokia's record low operating margins are still much higher than Motorola's record high. The multimedia phone segment was a shining star for Nokia in the second quarter as it turned into a profitable (9.2 per cent margin) growth machine. Revenues were up 89 per cent. This segment was bleeding money in the past as it lacked much-needed scale. Nokia's portfolio in this segment is rich and it is likely to offset some margin compression in the mobile phone segment. Also, there is still room for margin expansion as its margins should be at least as high as - or higher than - mobile phone's 16.2 per cent. The company has virtually no debt and a $15bn cash stockpile in the bank (20 per cent of the market capitalisation) and has a great return on capital. The stock trades at 14.6 times 2004 free cash flows, and at 15 times - recently lowered but likely to be revised up - 2006 estimated earnings. The valuation is even more attractive if the cash stockpile is taken into consideration. In spite of falling ASPs and the difficulty in the US, Nokia's sales are likely to grow as the global market for cell phones is increasing rapidly.
The company expects to gain market share at the expense of the smaller players. Its margins are at record lows, thus their future movement is likely to be upward. Finally, Nokia pays a dividend yielding 2.4 per cent and is buying back stock (using its huge cash pile) as if it was going out of fashion.
The author is a portfolio manager with Denver-based Investment Management Associates and teaches equity research at the University of Colorado. His firm owns shares in Nokia.
Vitaliy N. Katsenelson, CFA Copyright Financial Times