Monday Morning Musings:  Working Towards Conservative Numbers

Analyst: Tobias M. Levkovich

Institutional Equity Strategy                                                  

Monday Morning Musings:  Working Towards Conservative Numbers

(Le immagini non le posso inserire, scusate)

August 12, 2002           SUMMARY                                             

                * Earnings are far more critical for the market's   

Tobias M. Levkovich         performance than GDP due to much higher statistical

..............              correlation                                       

......................... * Operating EPS up slightly in 2Q02, but up nearly  

30% on reported EPS                                 

* Even if we had to trim fiscal 2003 EPS estimates  

by 20%, the median P/E (ex-tech) would be something

like 16.5x, which does not seem very expensive at 

all                                               

* Options expensing likely to be less of an issue   

for the overall market than it is likely to be for

technology firms                                  

* Iraq remains a wild card but seems priced into the

oil markets, in our view.                           

OPINION

All referenced figures can only be seen in the PDF version of this document.

Over the past two years, the investment community has been compelled to

struggle through some very difficult times in terms of revenues, earnings and

stock prices as it has attempted to decipher various reporting methodologies.

The now well-known abuses of revenue recognition practices as well as pro forma

numbers have left a bitter taste in investors' mouths, only to be further

soured by concerns over stock options expensing and the contribution of pension

income to EPS.  Thus, with the August 14 deadline for swearing by the numbers

looming within the next two days, the potential for some major restatements

arguably hangs over the markets like the Sword of Damocles.  Indeed, in our

opinion, this issue seems more important than the FOMC meeting this week, since

it is still unclear if the Fed will be reactive this soon to the latest

economic data in terms of cutting the fed funds rate.

Investors are also likely to focus on the upcoming economic conference being

held by the President in Texas later this week, with some hope that there is

some meaningful outcome that might jump start the economy from the lackluster

advance 2Q02 GDP figures (that we think most likely will be revised higher at a

later date).  Nonetheless, investors seem pre-occupied with the economic data,

with even currency traders focused on the Fed's actions and its anticipated

economic impact determining the short term trading patterns of the U.S. dollar

vis-a-vis the Yen and the Euro.

Unfortunately, investors need to understand that the R^2 correlation between

earnings and the stock market is 0.85, while the R^2 relationship between GDP

and the stock market is only 0.06 (given that the market has led, lagged or

moved coincidentally with economic trends as seen in Figure 1).  Thus, while we

would not suggest that the economy is irrelevant to stock market performance,

we would argue more aggressively that earnings are radically more critical.

Thus, understanding earnings and their impact is crucial for stock market

participants and the veracity of those numbers cannot be overlooked.  Hence, we

think that the combination of the new accounting oversight legislation recently

signed by President Bush, the new earnings certification rule and the recent

adoption of the New York Stock Exchange's guidelines for corporate governance

are all fairly important items to restore confidence in the equity markets.

Figure 1

Source:  Economy.com, FactSet and Salomon Smith Barney

We should stress, however, that simply certifying results will not change

investors' attitudes overnight and should not be viewed as a panacea.  The new

SEC rule is not a magic wand that can be waved over the market and remove all

vestiges of corrupt numbers.  For example, almost 240 of the 947 companies

required to certify do not have to meet the August 14 deadline due to different

fiscal year-ends.  Moreover, the fact that a company's principal executive and

financial officers have signed off on the numbers "to the best of (their)

knowledge" does not ensure that a fraudulent transaction will not surface some

time in the future, since it is hard to ban dishonesty.  On the other hand, we

continue to believe that the vast majority of companies do not have problem

accounting to begin with, as about 100 companies already have certified their

numbers according to the SEC web site.

But Which Numbers Should We Believe?

The definition of earnings has become somewhat of a mishmash of late, with some

companies using EBITDA, some utilizing pro forma EPS, others offering up

operating income excluding one-time charges, Standard and Poor's wanting us all

to shift to "core earnings" and still others (generally, bears) arguing

vehemently for the lowest of all numbers -- reported earnings.

We have noted in the past that the spread (or difference) between reported and

operating earnings has been in the 5%-15% range over time (see Figure 2), with

2001's 45% difference reflecting both recession-related restructuring charges

as well as the adoption of FAS 142, which requires companies to write off

"impaired" goodwill (of which there was a bunch, following the collapse of the

New Economy bubble).  Hence, just like in 1992, when accounting changes led to

nonrecurring charges, reported earnings plunged even though operating earnings

did not.

Figure 2

Source:  Salomon Smith Barney

Fascinatingly, outright bears want it both ways -- reported earnings should be

used for valuing the market, in order to argue that stocks are still quite

expensive in a blatantly biased approach of "conservative" accounting, while,

at the same time, ignoring the fact that reported S&P 500 EPS probably jumped

something close to 30% year over year in 2Q02; arguably something that should

be reflected in the stock market's directional activity.  On the other hand,

more realistic operating earnings grew only about 1% year over year in the

second quarter and is likely to jump in the teens for 2H02 -- therefore, we

think that operating earnings are probably a more conservative method for

determining EPS currently.  Nevertheless, either the market is still richly

valued and earnings are soaring, or the market is reasonably valued (Figure 3)

and earnings are just beginning to gather some steam.  Actually,  even if we

had to trim fiscal 2003 consensus (bottom-up) EPS estimates by 20%, the median

S&P 500 P/E ex-tech might be in the 16.5x area, which is far from expensive.

Either way suggests that the stock market is probably not headed lower quickly

unless there was to be some unexpected shock to the system.

Investors remain concerned about the pace of economic growth and the potential

for consumer "failure," which we deem unlikely as we discussed this issue twice

last week in research call notes.  Furthermore, from this writer's vantage

point after a weekend at the Newport Jazz Festival, consumerism still seemed

pretty much "in" as measured by sold-out hotel rooms, busy nightclubs and large

crowds on the festival's grounds.

Figure 3

Source: FactSet and Salomon Smith Barney

Optional Expensing

The subject of stock options continues to dominate the financial pages, with

companies like Coca Cola, The Washington Post, General Electric, AIG and

Procter & Gamble all succumbing to pressure to expense options, while Intel is

looking for alternative reporting mechanisms and Cisco's chairman essentially

dodged the issue, in our view,  when questioned about it last week on CNBC.

The differences in reporting options expense could make the S&P 500 earnings

figures even more confusing, but we should be careful in making rash judgments.

While options accounted for an estimated 18%-20% of 2001 S&P 500 reported EPS,

it may have accounted for only 9%-10% of operating EPS, with the tech sector

comprising the greatest contributor (approximately 45% of reported EPS and

probably something like 25% of operating EPS last year).  Accordingly, it is

not too hard to understand the opposition of information technology firms

towards expensing options, as many management teams see options as a meaningful

motivator for innovation that could hurt the ultimate valuation of their

businesses (if EPS is lowered by the expense).

However, if one realizes that most strike prices are well above the current

outstanding options, the impact to future EPS is likely to come down sharply.

Plus, even if the options are not expensed, they are going to be scrutinized by

investors and there will be a market discount applied to earnings that are not

trimmed for assumed options expense.  Thus, those who think this issue is going

away are likely to be severely disappointed and that means that publicly traded

IT companies could still face downward stock price pressure over time due to

the options factor.  While expensing options may not become law or a new

standard as applied by the Financial Accounting Standards Board, it most likely

will become part of the way in which companies are valued, such that a 10x P/E

may actually be a 30x P/E when options expenses are included and investors will

react accordingly.  As a result, it is quite likely that the issuance of

options will come down dramatically in the next few years and the impact on S&P

500 will become fairly minor.  Thus, as we look out over time, options may end

up costing the S&P 500 only 2%-3% of operating EPS, although we suspect that it

will still be a factor for tech firms.

Is America Stuck Between Iraq And A Hard Place?

One large unknown to the economy, earnings and the market is the potential for

a war with Iraq.  Many traditional U.S. allies seem opposed to such a war and

there is concern about its impact on oil prices and thereby economic trends,

since, in the past, oil shocks have crushed the U.S. consumers' ability to

continue spending.  While the timing of any military moves versus Saddam is

unclear, the determination to foster a regime change does not seem to be at all

fuzzy, with this well-advertised war being at the forefront of the Bush

administration's foreign policy.

In fact, some oil industry watchers believe that there already is a $5-

$6/barrel war premium built into the world energy markets, given that weak OPEC

quota compliance and a desire by some oil exporters to raise production in the

face of a soft global economy does not support the current $26-$27 price.

Hence, open warfare may not cause a spike in energy prices as is feared; as a

reminder, Operation Desert Storm in 1991 caused oil prices to come down sharply

despite a war with Iraq.  And, while the Saudis have voiced opposition to an

American attack on Iraq, it is doubtful that they would institute an oil

embargo against the U.S.  Note that, in the past, war has not been a restraint

for stock market gains.

To be fair, probably the most critical test for the U.S. consumer may come from

Wal-Mart's earnings release later this week since WMT accounts for roughly 10%

of non-auto U.S. retail sales, and, arguably, WMT's sales are less affected by

stock market trends than is, say, Tiffany's revenues.  Our sense is that the

American consumer is not as stretched as some believe, but, at some point in

time, job and wage growth will be needed to reaccelerate in order to sustain

growth -- fortunately, that time is likely to be late 2002 and into 2003 when

corporate profits should be showing more impressive year over year growth,

helped along by industrial production (Figure 4).

Figure 4

Source:  Economy.com and Salomon Smith Barney

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