Barron's(10/18)
The Trader: Oil Prices Have Allies In Pummeling Share Prices
(From BARRON'S)
Alan Greenspan didn't use the term "irrational exuberance" in characterizing
the heady rise in oil prices, the way he slandered a previous bull market -- in
stocks -- in late 1996. But the Federal Reserve chairman on Friday did cite
speculators as important drivers of the surge in crude, while attempting to
reassure the public that there's plenty of oil to quench demand and the economy
can still grow nicely given current energy costs. Greenspan, in effect,
raised the speed limit for economic growth above 55. That is, with crude futures
bumping against $55 a barrel, he said: "The risk of more serious negative
[economic] consequences would intensify if oil prices were to move materially
higher." Stocks caught a sudden bid midday Friday as these words were
uttered, providing the proximate motivation for the indexes to rise in mechanical
fashion, recouping a modest piece of the week's losses. The bulk of the market's
slippage during the week, though, couldn't be linked entirely to oil, which
has intermittently served as the stock market's script writer. A series of
not-so-great earnings reports and the eruption of scandal among huge insurers
were the collaborators. Possible causes aside, it's clear that the main indexes
were put back on the defensive. The Dow Jones Industrials slid 121 points,
or 1.2%, to retreat back under 10,000 and settle at 9933. The Standard &
Poor's 500 Index lost 13, or 1.2%, to reach 1108, returning to a slight loss
for the year to date. The Nasdaq Composite was steadier, surrendering just
8 to hit 1911, as Intel and Yahoo! reported earnings good enough for big-cap
tech to hold its own. The urgent question being aired constantly among investors
now is whether stocks have yet discounted the upward march in energy prices
and the somewhat-related economic slowdown. Traveling another link down the
chain, it's also not clear whether oil and the economic downshift have made
their way fully into investors' earnings expectations. In the past three
weeks, stocks have effectively made a quick round trip. The S&P jumped
3% to a recent high of 1142 as the fourth quarter began, and then rolled over
by the same amount to reach its current quote. In that time, with stocks
effectively flat, crude prices have climbed about 10% and forecasts for 2005
economic growth have been edging lower. It could be that stocks are attempting
to price in another reversal in oil and stabilization in economic outlook.
But that's not yet knowable. Stocks did find their footing with a little
39-point rise in the Dow Friday amid a mixed-to-negative set of economic numbers.
September retail sales surprised to the good. But industrial production, capacity
utilization and consumer sentiment fell short. So perhaps the slowdown story
has been absorbed to a degree. Also Friday, economist Ed Hyman of ISI
Group cut his forecast for 2005 real gross domestic product to 2.5%, citing
the lagged effects of the oil surge. Given the near-universal following Hyman
enjoys among fund managers, this tempered outlook must've been seen by a fair
number of those participating in the market's minor bounce. The coming
week will be the busiest of this earnings period, and ears will be particularly
tuned to any remarks about business conditions heading toward 2005, perhaps
even more than to clues about the fourth quarter. Overall earnings forecasts
for 2005 have held up even as those for the current quarter were trimmed in
many sectors. Citigroup economist Steven Wieting is among the number-crunchers
who believe the prevailing '05 projections remain too high and subject to
a painful reality check. He thinks S&P 500 companies' profits will
grow 6% next year, compared with a Thomson First Call consensus of 9.4%. Wieting's
work finds the greatest risk to '05 forecasts in consumer, financial, health-care
and basic-materials companies, with tech numbers looking achievable and energy
estimates poised for significant upside. If the market's recent sluggishness
-- along with the latest slide in the 10-year Treasury bond's yield to 4.05%
-- is telling investors to cut back their growth expectations, they don't
seem to be listening. There's now a broad sense of entitlement among frustrated
professional investors that a jaunty fourth-quarter rally is their due. That's
why most inquisitions into why stocks have stalled lately settle on a purportedly
fluky oil market, undifferentiated terrorism concerns and hesitancy ahead
of the election. Certainly, the idea of a fourth-quarter rally could
fulfill itself, especially once earnings season and the election pass to clear
the news slate. Bullish observers point, too, to additional one-time aids
to the year-end melt-up scenario, including the combined $70 billion in cash
soon to enter investors' pockets from Microsoft's special dividend and the
pending acquisition of AT&T Wireless. Other scenario spinners will
draw you a chart of the S&P 500 in 1984-'85 and 1994-'95, purporting to
show that around this time every decade stocks absorb the reality of a slowing
economy before taking off to the upside in the year ending in five. If
only life were so easy and neat. If, as in 1994, analysts have badly low-balled
the coming year's happy results, this script has a shot. Of course, oil spent
'95 in a harmless range of $17 to $21 a barrel, there was lots of room for
profit margins to grow and we hadn't yet weathered a historic bubble. But
now, anything could anything can happen. -- Fannie Mae has been accused,
in some sense, of being penny-wise and pound foolish. Regulators have alleged
that the company massaged its earnings to hit internal profit goals, smooth
its quarterly profit path and lock in executives' bonuses. (The company is
fighting the charges.) Now there is a growing curiosity among some investors
and analysts about the way other big financial companies manage to steer their
often-complex and volatile business to gently rising profits that nicely fit
with published forecasts. Without necessarily a suggestion of wrongdoing,
it does appear that the 'Nineties-era habit of earnings management has come
in for some close study, and is perhaps dampening the valuations of bank shares
and other financial stocks. Richard Bove, analyst with Punk Ziegel, says
it wouldn't be surprising if regulators begin poking around other financial
firms "to [bring to the] surface undesirable practices in reporting earnings."
Financial earnings, of course, always have a great deal of play in them.
These companies can freely borrow to buy securities, decide whether and when
to realize gains and losses, and take or release credit-loss reserves with
wide discretion. More often than not, financial companies pull these
levers in a way that lands quarterly results on or just above the consensus
forecasts. Michael Panzner, head of sales trading at Rabo Securities, screened
for the S&P Financial Index members with a history of tiny variations
between actual and forecast earnings. Among those with the slimmest deviation
from estimates over the past five quarters were AmSouth, American International
Group, Sovereign Bancorp, SunTrust, Marshall & Ilsley, SouthTrust, Torchmark
and Citigroup. Of course, some of the regional banks could have rather straightforward
spread-lending businesses that are easy to predict. What's interesting is
that, unlike in other sectors, predictability doesn't win the stocks high
valuations, given that these groups trade at steep discounts to the market.
This might suggest that the market infuses a measure of skepticism about the
quality or durability of these earnings. Sometimes, this posture becomes
explicit, as with Citi's results last week. Earnings came in at $1.02 a share,
above the 99-cent consensus. But several cents per share resulted from reversals
of loss reserves due to improved credit conditions. The stock sold off on
the news. Note, too, that at 10 times expected 2005 earnings, it's among the
cheapest-seeming stocks in the market. Bove suggests that this apparently
heightened skepticism toward financials' earnings could well reduce the multiples
on the stocks for a long time to come. That's not trivial, given that financials
represent more than 20% of the market's value, and a far greater portion of
its earnings. -- The opening salvos of earnings season prompted several
ad hoc meetings of the Falling Knife Catchers Club, made up of investors who
try to find plummeting stocks worth grabbing, without losing too many fingers.
Netflix -- an object of Barron's skepticism at various times on its way from
its $15 initial offering price to its high near 40 -- lost a third of its value
to about 10 following its profit report and an alarming forecast for the coming
year. Less dramatically, Novellus shares dropped nearly 10% on a saggy business
outlook, showing that there is still room for disappointment in the beaten-up
semiconductor-equipment sector. Away from the earnings slate, of course,
sits the smoldering pile of rubble that is the insurance-brokerage and property-casualty
group. Eliot Spitzer's stark charges of bid-rigging at Marsh & McLennan
and AIG have led these stocks to be disgorged in disgust. One earnings
offender that's a bit cooler to the touch and may recover the market's high
regard more readily is Accenture. The big technology-consulting and outsourcing
company, formerly known as Andersen Consulting, reported decent earnings with
the help of a lower tax rate but tempered its projected profit growth for
fiscal 2005, which just started Sept. 1. Accenture's new CEO, William Green,
penciled in 9% to 12% growth in earnings per share, down from 10% to 15%.
That suggests $1.34 to $1.39, up from the just-reported $1.24. New contract
bookings are projected at $18 billion to $20 billion, implying flat-to-down
performance, thanks in part to slowing outsourcing growth.
Investors griped that the latest quarter's bottom line was lightened by an
added $125 million in incentive compensation -- which some took to mean that the
former partnership is enriching employees at the expense of shareholders.
The stock was tagged for a 12% loss to around 23.50, which qualifies as a
harsh punishment for one of the steady segments of the tech galaxy. The shares
are now a touch lower than they were in late July, when Barron's Online profiled
the company favorably. The positive result of the sour market response is
that it has lowered expectations for a name that still enjoys excellent financial
trends and now appears more than reasonably priced. Accenture's outlook now
incorporates no acceleration in new business, and profit-margin expectations
have been eased as well. Although the outsourcing business has softened,
the decline in that business lately seems the result of AT&T's move to
exit the consumer long-distance game, says Legg Mason analyst William Loomis.
The consulting business -- which pays quicker returns in revenue and profits
-- appears solid, with bookings up more than 20% last quarter and retaining some
momentum. At root, Accenture is a story of recurring revenue and free cash
flow. The newly tempered guidance suggests the company will generate more
than $1.5 billion in free cash flow in the current fiscal year. Accenture
has a $23 billion market capitalization and no debt, making for a "free
cash flow yield" of 6.5%. The company also has $3 billion in cash
on hand, so the operating company is effectively capitalized at about $20
billion, making the valuation look that much better. Accenture announced a
$3-billion share buyback last week, giving shareholders some direct benefit
from its strong financial position. Accenture's price-earnings ratio of 17
on lowered fiscal 2005 forecasts represents a meaningful discount to the IT-consulting
sector average above 23. Stripping out the cash, Accenture's business carries
a P/E below 15. The caveat to this reassuring take on Accenture is that Wall
Street analysts continue to like the stock a bit too much, with a whopping
24 Buy ratings, three Holds and no one recommending it be sold. On the
buy side, too, it seems that plenty of money managers were "hiding"
in Accenture shares as a cautious way of participating in technology.
The question is whether last week's 12% drubbing sufficiently drained the
excess optimism from the market -- whether, in fact, this knife has yet landed.
If not, the numbers make it appear rather close to that point. -- In
addition to falling knives to catch, the market offers at least a few rockets
to chase. Apple Computer is one of the most hotly pursued lately. Subjected
to a cautious evaluation here last week, it was noted that Apple would need
to handily beat profit expectations to keep the stock aloft. The company
beat the numbers running away, with sales of its iPod music players coming
in more than 25% ahead of forecasts, and earnings of 26 cents a share versus
18 cents expected. The stock took off anew, rising from 39 to above 45 in
a blink. Never mind what still appears to be an aggressive valuation. The
stock will now trade as a consumer-product momentum story, with all eyes on
holiday-season iPod and iMac computer sales trends. The iPod, say tastemakers,
is the hot item on bid lists to Santa this year. For now, Apple's head start
over Dell and others has protected it from competition in the music devices.
Fans of the stock point out that there is enormous profit-margin leverage
in surging iPod sales. Others note that growth-fund investors are just now
discovering the story. The open question remains whether Apple's market share
is vulnerable here. A bigger untested assertion -- that the iPod will generate
a meaningful pickup in iMac sales -- looms. The responses will determine how
much fuel is left in a stock that has smoked its doubters until now.
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