Earnings: The Ugly Hour Is Just Beginning


By Amey Stone Earnings season has barely started, and already it's clear that fourth-quarter 2000 results for Corporate America are downright dismal. Every day now, a major company either posts disappointing numbers or warns that it won't be able to meet Wall Street's expectations. On Jan. 9, Nokia (NOK) said it sold fewer cell-phone handsets than expected in 2000. On Jan. 10, Yahoo! (YHOO) reined in 2001 forecasts because of weak advertising spending. And on Jan. 11, Gateway (GTW) announced layoffs and disappointing fourth-quarter earnings.

The bad news isn't confined to technology companies. International Paper (IP), online broker Ameritrade (AMTD), and aerospace giant Martin Marietta (MLM) have all told Wall Street recently they wouldn't be able to meet forecasts.

Only about 10% of companies have reported actual results so far, but 2000's last quarter is already a record-setter in terms of the most companies warning about earnings ahead of time -- "pre-announcing" they call it. As of Jan. 11, 624 companies had issued warnings, up from 331 at the same time last year, an increase of 89%, says Chuck Hill, director of research at earnings tracker First Call. The prior high was 554 warnings for the fourth quarter of 1998.

"WE'RE IN FREE FALL."All this isn't to say that investors should start selling out their portfolios. But you may want to wait until all the fourth-quarter reports are available before deciding whether to start buying again. It may seem like all the bad news from Corporate America must be out, but analysts believe there's a lot more to come. "It is still early in the game," says S&P sector strategist Sam Stovall.

Not surprisingly, the scaleback is most dramatic in technology. At the start of the fourth quarter, analysts were expecting tech companies to post 29% earnings growth. Now they're looking for only 3% growth. For the Standard & Poor's 500, growth was expected at 16% at the beginning of the quarter, but now analysts expect only 4% growth. Even though analysts' estimates have come down dramatically, some companies are still asking analysts to reduce their expectations, as Hewlett-Packard did on Jan. 11. "We're in free fall here," says First Call's Hill.

Explanations abound as to why so many companies are coming out with earnings warnings. One is mainly cosmetic: A new Securities & Exchange Commission (SEC) regulation, known as "Reg FD" (for "fair disclosure"), requires companies to release to the public at large any news that could affect their stock prices -- and not give it just to a few select analysts. Prior to the rule change, if a company found its numbers were looking a little wobbly, it probably would have just called up a few Wall Street analysts and told them to reduce their estimates. Analysts then would have warned their firm's customers in waves rather than all at once, which generally helped cushion the blow of weak numbers.

FAULTY FUNDAMENTALS. The SEC didn't like the selective disclosure, and it's no longer allowed. "Now, you are sort of forced to use that blunt instrument of a press release," says Richard Moroney, editor of newsletter Dow Theory Forecasts and a portfolio manager for Horizon Investments.

But analysts say Reg FD doesn't explain away the flood of bad news. As President Clinton's campaign team was fond of saying in 1992, "It's the economy, stupid." The fact is that business fundamentals have deteriorated much faster than anyone anticipated when earnings estimates were calculated last fall. That warp-speed slowdown is showing up in earnings numbers now. In their announcements, companies have pointed to rising energy prices, higher interest rates, and a strong U.S. dollar as factors. Hill believes a slowdown in PC sales may have gotten the ball rolling -- both fundamentally and psychologically.

The result has been a broad slowdown in demand across many industries. Companies that were busy bringing on more supply to meet expected increases in demand got caught with excess capacity and had to cut prices. "It only takes a little excess capacity for pricing to deteriorate," says Moroney, especially in a relatively low-inflation environment. This is true of technology sectors, most notably semiconductors, but it's also true of Old Economy industries like forest products and chemicals. "People think that companies and analysts can really fine-tune this stuff and accurately predict 15% growth," says Moroney. But when conditions change, "They can't," he says.

"NEW TERRITORY." Investors have known for some time now that the economic boom was faltering. Stock market selling began to pick up steam in 2000 when the government's economic growth measures were revised down for the third quarter. Gross domestic product (GDP) growth fell from 5.6% in the second quarter to 2.2% in the third quarter. Lower stock prices in turn may have exacerbated the curtailing of consumer spending, leading to the weakest holiday shopping season since 1990. Preliminary numbers for fourth-quarter GDP growth are due from the Commerce Dept. in late January. Most analysts expect positive numbers, but some are more pessimistic.

"I wouldn't be surprised to see when the numbers are revised later that we actually slipped into recession in October and November," says Guy Scott, chief investment officer at EGM Capital, a hedge fund in San Francisco. "Most investors have never been in a recessionary environment. For a lot of people, this is new territory."

Scott may be onto something. Although the stock market plummeted last fall, it has taken a while for companies and stock analysts to readjust their thinking to a inhospitable environment for stocks. Both investors and business executives probably have continued to hope for the best until the books were closed on 2000. "People want to take baby steps on the way down," says Scott. "It really would be best if we went right to the worst case."

DELAYED IMPACT. Indeed, despite the sharp sell-offs in the broad market, Wall Street still may be too optimistic about what will happen in 2001, analysts say. Thanks to the Fed's surprise half-point rate cut on Jan. 3, investors are hoping the economy will quickly turn up in the second half of the year. "They heard the tone from the Fed that it will be aggressive if it needs to," says Stovall. In the futures markets, investors have already priced in another half-point rate cut from the central bank in late January, when Fed policymakers gather in Washington for the first meeting of 2001, he says. Investors have even begun to sell defensive plays in utilities, health care, energy, and consumer staples, and begun buying technology stocks again, points out Stovall.

But hold off a minute before you phone your broker. Hill warns that the rate cut won't even begin to have an impact on the economy until the fourth quarter of this year. Sure, for many sectors, consensus estimates are that corporate results will bottom in the first and second quarters, and then turn up in the third. But even then, the rate cut may not be as effective at reversing things expected, depending on how serious the slowdown becomes.

Consumer and investor psychology is tantamount. That's why it's crucial for investors to listen closely to companies' projections when they release fourth-quarter 2000 reports. "It may be wishful thinking that the worst is out of the way," Hill says. Scott, who began his investing career in 1965, wants to see a more pessimistic outlook before he'll be confident that the worst of the selling is over. "We have to stare into the abyss, and we're not staring into it yet," he says.

To be sure, many investors and companies are still hoping that Fed Chairman Alan Greenspan can work his magic one more time and avert a crash landing for the economy. But even his most ardent admirers admit this landing will be bumpier than what has come before. That doesn't mean investors need to rush for the exits. But strapping on your seat belt is probably the best way to make it through this earnings season. Stone is an associate editor of Business Week Online and covers the markets in our daily Street Wise column.

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