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Think Twice About IBM’s Earnings

By Greg Bartalos

When IBM reported earnings a couple of weeks ago, some analysts and investors hailed Big Blue for its strong showing amid the continuing gloom in technology.

The world’s largest computer company announced that income from operations rose by 8% and that revenue topped Wall Street’s estimates. It also reiterated its outlook for this year’s earnings.

And though first-quarter earnings per share came in a penny below Wall Street’s estimates, the stock hovers near a 52-week high.

But IBM, which under former chairman and chief executive officer Louis V. Gerstner, Jr., was dogged by accusations it used gimmicks and accounting tricks to dress up its earnings, still appears vulnerable to that criticism.

Examined more closely, IBM’s revenues actually declined during the quarter from the same period a year ago — and earnings again were pumped up by one-time gains.

So much for the clean sweep of new CEO Samuel J. Palmisano and a post-Enron environment where candor and transparency reign.

Itzhak Sharav, an accounting professor at Columbia Business School, notes that IBM discloses more than it used to (because of the Sarbanes-Oxley Act of 2002), but that it continues to omit key data, such as how much acquisitions contribute to revenue.

“You get the impression that they had to be dragged kicking and screaming to dole out more information,” he says.

According to IBM, first-quarter revenue rose 11% to $20.1 billion, topping the $19.85-billion Wall Street consensus. Great job, right?

Not so fast. IBM’s first-quarter revenue actually declined by 15% from the fourth quarter. In fact, revenue has fallen for three consecutive years.

And Morgan Stanley analyst Rebecca F. Runkle, in a recent research report that was critical of IBM’s quality of earnings, writes, “We believe organic revenue growth in the quarter (despite an easy comparison) was a decline of 1%.” (Organic growth excludes revenue from mergers or acquisitions.)

Analyst John Jones Jr. of SoundView Technology Group, also says he believes IBM’s organic revenue fell by 1% to 2%.

In fact, IBM’s first-quarter revenue gain was largely the result of a favorable currency exchange rate because of the weak dollar.

And then there were acquisitions. “A good part, if not all, of the increase” in IBM’s global services division in the first quarter was related to last year’s $3.5-billion purchase of PricewaterhouseCoopers’ (PwC) business consulting and technology services unit, says Sharav.

He also thinks that the first-quarter 8% revenue gain in IBM’s software division was tied to the company’s $2.1-billion purchase of Rational Software last year. IBM’s hardware business and global financing divisions both had first-quarter revenue declines, he observes.

“Several parts of services had a strong quarter,” replies IBM spokesman Joe Stunkard. He says that IBM does not break out results from the PwC consulting unit.

Runkle, who rates the stock Equal-Weight, also characterizes IBM’s cash flow as “disappointing” (though she did commend “the increased transparency over the last year”).

First-quarter cash flow from operations was $2.2 billion, down nearly 19% from last year.

But even that lower number was boosted by lower receivables and interest rate swaps, Runkle notes. Excluding those receivables and swaps, free cash flow in the first quarter was actually -$1.5 billion, nearly twice as much in the red as last year’s -$800 million, she writes.

Reduced free cash flow, which is cash from operations left over after paying out capital expenditures, can hurt a company’s ability to fund acquisitions and other ventures.

What’s more, Runkle doesn’t classify a $90-million payment to IBM for a research & development agreement and a $34-million payment from Sanmina-SCI as recurring events. Including them, she says, overstates IBM’s first-quarter net income by about a nickel per share.

IBM’s Stunkard says that the company did not include any of that money in revenue, but accounted for it instead as “intellectual property” income on its first-quarter income statement.

Nonetheless, if you strip out the weak dollar and these various accounting gimmicks, IBM would have had lower revenue in the first quarter and earnings that were as much as six cents a share below the Wall Street consensus — rather than the penny shortfall it reported.

IBM’s stock, which is up 58% from a 52-week low of 54.01 reached last October, looks rich, too.

Its shares change hands at almost six times book value. In contrast, Microsoft, Intel and Cisco Systems all trade for less than four to five times book.

And the stock is trading at a 10% premium to the Standard & Poor’s 500, based on projected earnings. It usually sells at a 9% discount to the market, according to Thomson Baseline.

The stock also fetches almost 20 times expected 2003 earnings, twice the company’s expected long-term earnings growth rate, according to Baseline.

John Rutledge, portfolio manager of the Evergreen Technology Fund, whose firm owns about a million IBM shares, defends the stock’s current valuation.

“IBM is a better company now than it was five years ago,” he says. He asserts that the services business gives it a more “predictable and consistent” earnings stream. (Services also has the lowest gross margin — 24.9% — of all IBM’s main businesses.)

And SoundView’s Jones, who rates the stock Outperform, says that during the first quarter IBM actually gained share in servers, storage and software.

Ultimately, however, the quality of IBM’s financial disclosure hasn’t kept pace with the quality of its products and services. And that may come back to bite Big Blue in the future.

Published April 28, 2003

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Lessons From Julian Robertson’s Folding Paper Tiger

By Greg Bartalos

So, legendary hedge fund manager Julian Robertson is closing his crumbling funds. Before heading off to retirement, he was last heard blaming an “irrational market” for his recent underperformance.

Instead of persevering or bowing out gracefully, Robertson, a self-styled value manager/opportunist chose to quit and blame the markets for his underperformance.

However, what is irrational is Robertson’s analysis of what went wrong. Here’s why.

Robertson earned his money manager maven status by deftly exploiting inefficiencies in the financial markets, buying low and selling high. Not an easy feat, given how few people consistently outperform the market over long periods of time.

For almost 18 years, he did a terrific job of making money for investors, returning a staggering 32% per year on a compounded annual basis. And this was after you deduct the 1% management fee and 20% performance fee. During the same period, the S&P 500 compounded at 18%.

One of Robertson’s great skills was his ability to read the markets and choose which ones offered the most value. Then he bet on it heavily.

U.S. stocks? Currencies? Commodities? Robertson considered all asset classes.

Sure, the last few years have been difficult for people like Robertson as value stocks were largely ignored by investors.

The reality is that an “irrational market” should have been an ideal environment for savvy investors like Robertson to exploit for his advantage. Instead, he let it confound him and frustrate him.

The spoils mainly went to those who bought large cap stocks, tech stocks and stocks with strong upward momentum. Money-losing companies were rewarded if they offered a romantic dream about the future.

A savvy investor doesn’t fight the tape, he rides the tape.

Yet Robertson fought it all the way up. As a result, in less than two years, the assets at Robertson’s Tiger Management plunged 70%, falling from $22 billion to $6.5 billion.

So, what caused this great, precipitous collapse? Certainly not “irrationality.” For irrationality is a natural part of the market’s landscape and will remain so because fear and greed factor largely in investment decisions. If markets were always rational, there would be no opportunities for managers like Robertson to way outperform the markets over a long period of time.

So, what caused Robertson’s collapse? Very simple.

Robertson was more of a victim of the same arrogance and stubbornness that probably played a large role in his long-term success.

For one thing, he stubbornly stuck with underperforming bets, like his long-time bet on US Airways Group.

He then arrogantly refused to admit he made a mistake and clung to it like an adolescent protects his security blanket he first cherished as a toddler.

Robertson also smugly eschewed tech stocks, the object of his “irrationality” post mortem. In other words, he fought the tape.

However, other value managers, like Bill Miller, who manages the wildly successful Legg Mason Value Trust Fund, learned how to live and thrive with this confounded sector. In addition to buying what most people would consider value stocks, he has embraced tech and Internet stalwarts like Amazon.com and America Online.

Miller didn’t throw up his hands and say “there is nothing to buy” just because most investors favored tech and dot-coms. He figured out how to mesh his view of the world with reality.

Even George Soros’ Quantum Fund diversified into tech, albeit a little late.

Sure, another investment icon, Warren Buffett shunned tech as well. But, he has at least showed humility in fessing up to his investment mistakes. Buffett wrote in Berkshire Hathaway’s 1999 annual report: “What most hurt us during the year was the inferior performance of Berkshire’s equity portfolio — and responsibility for that portfolio, leaving aside the small piece run by Lou Simpson of GEICO, is entirely mine.”

Wow! That’s candor. Robertson, on the other hand, refuses to take responsibility for his investment decisions, blaming an “irrational market.”

Perhaps if Robertson hadn’t lost so many top analysts and money managers in the past year alone, he might have been able to do a better job of taking advantage of this “irrational market.”

Several years ago, he lost a young, smart manager named Lee Ainslie III, who went over to Dallas-based Maverick Capital. In 1998 and 1999, Maverick climbed 22% and 25.9%, respectively, according to Antoine Bernheim, publisher of The U.S. Offshore Funds Directory, Hedge Fund News and Hedgefundnews.com. In the same period, Tiger’s funds fell 4% and 19%.

In short, Robertson’s blaming of the market’s “irrationality” is akin to a pitcher saying “curve balls always won me games in the past.” The truth is, hitters catch on and adjust. What worked yesterday won’t necessarily work tomorrow.

So, what lessons can be learned from Julian Robertson? Several.

First, you must be flexible, savvy and lucky to thrive in all market cycles.

Just think about the last decade. It started with a prediction from pundits that the 1990s’ returns would not match the large returns of the 1980s. We then headed into a recession fueled in large part by the downsizing of Corporate America.

Defensive stocks ruled the markets.

This was followed by the boom in multi-national, consumer nondurables, which were bid up to multiples that far exceeded the individual companies’ growth rates.

Just when investors became comfortable with these valuations, these stocks became passe, paving the way for the boom in tech stocks, but only the very largest. And then investors embraced Internet stocks, most of which didn’t make money.

Now, the markets are at a crossroads. Will tech come roaring back? Which Internet stocks are attractive?

Is it finally time to buy value stocks? Asset rich stocks like REITs?

Not confident with your own answer? Are you uncomfortable moving from one market environment to another totally different environment?

Afterall, even Julian Robertson couldn’t successfully make the transition in the past few years.

Then perhaps this is the opportunity to buy a fund that doesn’t have to worry about which investment style is in vogue — the Vanguard Total Stock Market Index Fund. The fund essentially invests in the whole stock market by tracking the Wilshire 5000 index. By investing in the whole market you will make money when tech rallies, just as you will make money when value stocks rally.

It’s tax efficient, highly diversified and sports a measly 0.20% expense ratio.

The Vanguard Total Stock Market Index Fund is a safe and boring investment that is virtually guaranteed to make you impressive gains over the long haul. For the last five years the fund has returned more than 23% on an annual basis and top holdings include Microsoft, General Electric and Cisco Systems.

And best of all: You won’t ever have to blame your underperformance on the market’s “irrationality.”

Published April 27, 2000

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This Bull May Start Running Again

By Greg Bartalos

After a stellar 2003, major U.S. stock indexes have stalled this year.

Investors are worried that oil prices are near a 20-year high, Iraq is in turmoil and interest rates are rising. Investors also fear that fast-growing China may fall into recession as it gradually tries to slow its economy. And concerns about terrorism will likely increase as we approach a presidential election whose outcome remains very much in doubt.

But the economy and corporate profits are both surging, employment is clearly growing and equity valuations are beginning to look attractive again.

“There are no signs from the stock market that the bull market is ending,” argues Hugh Johnson, chief investment strategist of First Albany Capital.

Since World War II, the average bull market has lasted nearly 50 months and the median lasted 39 months, says Johnson, noting that we are only in the 15th month of the current bull run.

The economy looks favorable, too.

“Real GDP [gross domestic product] grew 5% over the past four quarters, the fastest rate in 20 years,” says James W. Paulsen, chief investment strategist at Wells Capital Management.

Johnson adds that the Conference Board’s Index of Leading Economic Indicators has risen in 12 of the past 13 months.

“The index is very useful in forecasting turning points in the economy,” he says.

He expects the Standard & Poor’s 500 to be 11% higher by yearend and 27% higher by the end of 2005. It closed at 1125.26 Monday.

Meanwhile, oil prices have fallen by $4.53 a barrel since June 2 to a recent $37.85.

Johnson also believes that stock investors have discounted the effects of any increases in short-term interest rates by the Federal Reserve, which could begin as soon as this month.

“The early stages of an interest rate up cycle are usually not a problem [for the market],” says Tim Hayes, Global Equity Strategist for Ned Davis Research.

“I think we will have a period where both stocks and rates go up,” says Paulsen.

Dan Chung, president and chief investment officer of Fred Alger Management, argues that improving economic fundamentals, investors’ skepticism and enticing valuations should outweigh any fallout from rising rates.

He notes that the employment outlook has brightened significantly as the economy added almost a million jobs in just the past three months.

Chung also believes that investor sentiment is “appropriately cautious and risk averse,” ensuring that any market advance “should be rational.”

Chung says many investors remain on the sidelines after losing money in the recent scandal-ridden bear market and are mired in pessimism because of the media coverage of Iraq, high oil prices and geopolitical tensions.

And Chung says earnings are much more reliable today because corporate accounting is a lot cleaner than it was a few years ago, making already attractive valuations even more desirable.

Hayes says that in April, the S&P 500’s price-to-earnings multiple was 21.3x trailing-12-months earnings (using the more conservative generally accepted accounting principles), its lowest level in almost seven years.

And Chung argues that strong earnings growth will more than offset multiples that are slightly high by historically standards.

The S&P 500 trades at 17.3x expected 2004 operating earnings and at 16.3x projected 2005 earnings-above the average multiple of 15x forward earnings for the past half-century, Chung says.

He argues that these multiples are low considering that the S&P 500’s earnings are expected to grow by 17% this year and 10% next year, far above their 7% historical average.

“The stock market offers exceptional value,” says Chung, who believes stocks can rise through next year.

Not everyone’s bullish, of course.

Tobias Levkovich, chief U.S. strategist for Citigroup Smith Barney, expects the S&P 500 to finish the year almost 9% lower, at 1025.

The strategist says he has “deep concerns that analysts are raising earnings estimates very aggressively.”

And Levkovich is worried about the equity risk premium, which he describes as the “extra return needed for investors to buy stocks instead of bonds.”

He notes that the current equity risk premium is essentially in line with its long-term average since 1960.

“We are not in an average risk environment with high energy prices, current account deficits, and geopolitical and terrorism risks,” says Levkovich, arguing that these potential problems “may not be fully discounted in the stock market.”

And as the U.S. presidential election draws near, there is risk of the unknown, which makes investors nervous.

This uncertainty means that stocks could weaken this fall if investors conclude that Democratic Senator John Kerry will be elected president, especially because he is widely perceived to be less friendly to tax cuts than President George W. Bush is.

“If Kerry is elected, chances are that some of Bush’s tax cuts will be rolled back, especially the 15% dividend tax,” says Johnson.

But no matter who gets elected in November, a recovering economy and strong earnings suggest that the real winners will be stock market investors, be they Democrats or Republicans.

Published June 14, 2004

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Talk is Cheap Unless You’re John Major or George Bush

By Greg Bartalos

Former British Prime Minister John Major ought to skip skulking over his convincing defeat at the hands of the Labour Party’s Tony Blair and start rounding up his favorite home-spun tales, adages and nuggets of wisdom.

A report by the London Times said Major could demand at least 40,000 pounds (US$64,760) per speech on the “after-dinner speaking circuit.” Although Major’s best qualities do not shine through on television, his extemporaneous speeches at parties are impressive, said friends in the office, the Times reported.

“I strongly suspect there will be a lot of invitations for Major now,” said Brian Palmer, vice president of the National Speakers Bureau, based in Lake Forest, Illinois. He said that former heads of government “will always be in demand,” especially those important to the West, as Major is.

Margaret Thatcher, another former Prime Minister of England, enjoys high demand for giving speeches, Pamer said. “She’s strong and steady and gives very good speeches. She prepares.” Walters said Thatcher has charged at least as much as $60,000 for giving a speech.

Who’s Popular?

Microsoft Corp. Chairman and Chief Executive Bill Gates is by far the most requested person to deliver speeches, Palmer said. “It’s not even close. We get asked about Bill Gates two to three times a day,” Palmer said. Although the demands on his time are great, Gates does manage on occasion to give speeches, as he did on April 29 at the Executives’ Club of Chicago.

Dottie Walters, president of Walters International Speakers Bureau in Glendora, California, said among top-earning speakers, George Bush and motivating guru Anthony Robbins each demand more than $100,000 per one hour speech. “Read my lips: $100,000” could be Bush’s new slogan.

Colin Powell, a former chairman of the U.S. Joint Chiefs of Staff, is also very popular, Palmer said. He “always rated high in polls focusing on admiration and delivers a very good presentation,” Palmer said. Walters and Palmer said they believe that Powell commands in excess of $50,000 per speech.

Lee Iacocca, the former Chrysler Corp. chairman, receives more than $50,000 per speech, Walter said. Iacocca often talks about turning around businesses, a topic for which there great demand, Walters said. “The ‘been there, done that’ speaker tends to be most successful,” she said.

Also popular is Harvey MacKay, author of “Shark Proof” among other career-related books, who often gives speeches about the importance of customer service, Walter said.

Businesses Demand Technology Information

Speakers who can shed light on issues related to technology and how it can improve a company are always in demand, Palmer said. “The greatest sources of stress among people in business relates to technology,” he said. Walters concurred. “Oh my, that’s a real hot topic,” she said. Most of the speakers who are good at offersing such advice tend not to be celebrities, Palmer said.

Dan Burres, author of the book “Techno Trends,” is a prime example of someone who is generally not known, yet is very popular on the speech circuit, Palmer said. “Demand is amazing,” he said. The author’s book and speeches are aimed at helping businesses harness technology to their advantage, Palmer said.

Palmer said that these days, a big-name speaker isn’t necessarily enough to please people. “Audiences want to learn something, as time demands are more acute,” he said.

Published May 8, 1997

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