Financial Review

Earnings Gimmicks

Sinclair Noe — May 4, 2016

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DOW – 99 = 17,651
SPX – 12 = 2051
NAS – 37 = 4725
10 Y – .02 = 1.78%
OIL + .24 = 43.89
GOLD – 7.30 = 1279.40

Private-sector employment gains slowed in April. According to Automatic Data Processing employers added 156,000 new jobs in April; it was the lowest level in 3 years. The ADP report is an early indicator of Friday’s non-farm payroll report from the Labor Department. The Friday jobs report is expected to show about 200,000 new jobs in April, but that’s before the weak report from ADP.

The productivity of U.S. businesses and workers fell by a 1% annual rate in the first quarter, marking the fourth decline in the past six quarters. Over the past year productivity has risen at a 0.6% pace, well below the historic 2.2% U.S. average. In the first quarter, output of the goods and services businesses sell edged up 0.4%. Yet the amount of time employees worked rose a much faster 1.5%. As a result, unit labor costs climbed 4.1% in the first quarter, the biggest increase since the end of 2014. Still, unit labor costs have risen just 2.3% in the past year, little changed from the prior quarter. Higher productivity is the key to better pay and an improved standard of living.

The U.S. trade deficit shrank in March by almost 14% to $40.4 billion — the lowest level in more than a year — but the plunge reflected a tough climate for American exporters and more caution on the part of consumers. U.S. exports fell 0.9% to $176.6 billion in March. Imports fell an even steeper 3.6% to $217.1 billion and touched a five-year low. The decline in imports offers more evidence that consumers are cautious and reluctant to spend.

The Institute for Supply Management said its non-manufacturing index rose to 55.7% in April from 54.5%, marking the highest level of 2016. The index surveys executives in industries such as retail, health care, hospitality, finance and technology that employ the vast majority of American workers. In April, the new orders index climbed 3.2 points to 59.9%. The employment gauge rose 2.7 points to 53% — the highest reading of the year. Readings over 50% signal more businesses are expanding instead of contracting.

The drop in crude prices is snowballing into one of the biggest avalanches in the history of corporate America, with 59 oil and gas companies now bankrupt following this week’s Chapter 11 filings by Midstates Petroleum and Ultra Petroleum. According to Reuters data, the number of U.S. energy bankruptcies is closing in on the 68 filings seen during the depths of the telecom bust of 2002 and 2003. A 60 percent slide in oil prices since mid-2014 erased as much as $1 trillion from the valuations of U.S. energy companies, according to the Dow Jones U.S. Oil and Gas Index, which tracks about 80 stocks. This has already surpassed the $882 billion peak-to-trough loss in market capitalization from the Dow Jones U.S. Telecommunications Sector Index in the early 2000s.

Some oil producers appear to be holding on, hoping the price of crude stabilizes at a higher level. Until recently, banks had been willing to offer leeway to borrowers in the shale sector, but lately some lenders have tightened their purse strings. A widely predicted wave of mergers in the shale space has yet to materialize as oil price volatility makes valuations difficult, and buyers balk at taking on debt loads until target companies exit bankruptcy. In the debt market, there are signs that lots of money could be lost this time around, especially in high-yield bonds. U.S. oil and gas companies sold about $350 billion in debt between 2010 and 2014, the peak years of the oil-and-gas boom, with junk bonds making up more than 50 percent of all issuance.

Worldwide merger deals have declined sharply from the intense pace that pushed them to record levels in 2015, a sign that could reflect broader weakness in the American economy and vulnerability for U.S. stocks. So far in 2016, the dollar value of completed deals is 22% below the same period last year, while the number of transactions is down 13%, as expectations of higher interest rates and more government regulation is making mergers seem more expensive and risky.

Brazilian prosecutors have filed a civil claim against iron miner Samarco and its owners BHP Billiton and Vale, demanding damages over the deadly collapse of a dam last November. The $44 billion lawsuit is the result of a six-month investigation into the catastrophe, which led to the pollution of a major river and killed 19 people.

Target is cracking down on suppliers as part of a multi billion-dollar overhaul to speed up its supply chain and better compete with rivals. The retailer plans to tighten deadlines for deliveries to its warehouses, hike fines for late shipments, and could institute penalties of up to $10K for inaccuracies in product information. The moves, effective May 30, are the first major steps Target has taken to fix supply problems that emerged after it expanded offerings, including fresh food, several years ago.

This is a busy week for earnings reports. For many traders, earnings reports don’t mean a hill of beans but many investors like to pore over the numbers. Stocks can be affected by central bank policies, macro-global events, and existential crises. But in spite of, and especially in the absence of those “big-picture” market impactors, it’s earnings that drive stock prices in the longer term.

And because there is so much riding on earnings, there is a concerted effort by companies and Wall Street analysts and the media to make the earnings look a lot better than they really are. Headline earnings numbers fed to us by companies, analysts, and the media are more often than not jacked-up by means of creative accounting tricks.

The headline earnings reports investors take as gospel every quarter when the dog and pony shows start up, are non-GAAP, pro-forma, “Street” earnings, not bona fide earnings based on Generally Accepted Accounting Principles. As you know, the difference between non-GAAP and GAAP earnings can be huge and can trap investors.

Last year is just another example of the disparity between real and unreal earnings numbers. According to the Wall Street Journal, headline or pro-forma earnings for companies in the S&P 500 in 2015 were 25% higher than GAAP earnings. That’s the biggest disparity since 2008. A CNBC.com analysis found a similar gap in 2015 earnings.

In February 2016, regarding 2015 earnings, FactSet reported that: 67 percent of the companies in the Dow Jones Industrial Average reported non-GAAP earnings per share and, on average, that the difference between the GAAP and non-GAAP earnings per share for these companies was approximately 30 percent, representing a significant increase from approximately 12 percent in 2014.

The first quarter earnings season has crossed the midway point with more and more companies coming out with positive earnings surprises. According to Zack’s Earnings Trend report, out of the 310 S&P 500 members that have reported as of last Friday, 71.9% of them have beaten earnings estimates with 57.1% beating on the revenue front.

However, total earnings for these companies are down 7.2% year over year on a 2.4% decline in sales. First-quarter earnings for S&P 500 companies are now expected to dip 7.3% year over year on 1.1% lower revenues with the Energy sector being a major drag.

That’s really quite amazing; earnings are down but companies still beat estimates; not just a few but 71.9%. That’s a lot of beats. Analysts have been furiously ratcheting down their earnings estimates since January, while company accountants, with executives standing tall over them, have been making “adjustments” right and left in their earnings and expense columns.

The regulators have noticed because you would have to be blind not to notice. The SEC is worried about how investors are being misled. SEC chief accountant James Schnurr criticized the rampant use of non-GAAP measures in a recent speech, saying, “SEC staff has observed a significant and, in some respects, troubling increase… in the use of, and nature of adjustments within, non-GAAP measures.” So, the next question is – what will the regulators do about this non-GAAP gimmickry? And we all know the answer is that the regulators will do nothing.

What can you do? Well, if earnings really matter to your analysis, then be sure to pay attention to the numbers they aren’t talking about on the earnings calls. Compare Non-GAAP and GAAP numbers side by side. Make sure there is a reasonable explanation for the adjustments represented by Non-GAAP numbers. Look at all numbers sequentially.

For example, look at changes in top-line revenue sequentially over the past four quarters to a year ago, because how a company is doing in sales and generating revenue is hard to mess with. If you look at earnings numbers sequentially, it’s easier to spot anomalies that you might miss if you just compare this quarter’s numbers to the same quarter a year ago.

Here’s what you can learn from Non-GAAP numbers: they can show you how often a business will resort to bending the rules in their reporting; they have a use when comparing extraordinary items, like gains or losses from sales of major production assets; they have a use if the types of events keep getting repeated; and the recurring use of Non-GAAP might be valuable in letting you know the report is full of garbage. In other words, it makes it easier to identify the stinkers.

Financial Review

A Go Figure Bounce

Sinclair Noe — February 24, 2016

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DOW + 53 = 16,484
SPX + 8 = 1929
NAS + 39 = 4542
10 Y – .01 = 1.74%
OIL + .36 = 32.23
GOLD + 3.00 = 1229.40

Stock markets closed down in Asia and European shares dropped the most in two weeks. Investors continue to use oil prices as a gauge of the global economy. At an event in Houston on Tuesday, Saudi oil minister ruled out production cuts anytime soon, sending crude sharply lower despite talk of a mid-March oil producer meeting. New API figures showing a further build in U.S. stockpiles are also weighing on oil. Oil’s retreat, together with slowing growth in China, has dragged down global stocks about 8% since the start of the year.

Miners fell again, with Glencore and BHP Billiton losing more than 8% on the day. Statoil and Royal Dutch Shell were leading energy-related companies lower. Iran said the plan to freeze oil production was “ridiculous.”  Every member of the Stoxx 600 Banks Index declined.

For most of the session today, Wall Street was down. The Dow Industrial average started the morning with a 250-point drop, and was down about 150 points for most of the session, until the final hour of trade when suddenly and without much reason, stocks turned higher, oil turned higher, treasuries turned lower, and gold tanked. I wish I could offer some clear reason for the turnaround, but I haven’t really seen anything to explain the move. About 3 weeks ago we saw a turnaround that erased a 1.5% loss in the S&P; over the following week the index lost 3%. Go figure.

How low could the pound go? The British pound is worth less than $1.40 for the first time since 2007. While currencies move for a variety of different reasons, most speculate the drop this week is to do with uncertainty over the Brexit referendum in June. The pound fell hard on Monday after London Mayor Boris Johnson decided to support the UK leaving the European Union. Britons get to vote on whether the UK should stay in or leave the European Union in the EU referendum on June 23.

The dollar index is at 97.5, and trading in a range between 95.5 and 100. If the dollar can just hold steady at these levels. A stable dollar would be a boost to multi-nationals, commodity traders across the board, and almost everybody except American tourists. The strength of the dollar might well be determined by the direction of the Fed.

It is “still too early” to assess the implications of recent volatility in financial markets for the U.S. economy, so says Fed Vice Chairman Stanley Fischer. With regards to the FOMC’s upcoming policy meeting in March, Fischer said he couldn’t predict what officials are going to do “because, as I’ve emphasized in the past, we simply do not know.” Still, Fischer thinks there is a chance the recent sell-off on Wall Street may not damage the economy.

Meanwhile, Richmond Fed President Jeffrey Lacker said there is more room for the Federal Reserve to raise interest rates because the current level remains below the economy’s so-called natural real rate of interest. And Kansas City Fed President Esther George says it’s too soon to say whether the stock market selloff had “fundamentally” altered the outlook, and a rate hike should “absolutely” be on the table for mid-March. She even suggests that the Fed could surprise markets with a hike.

Investors currently view the probability of a single rate rise in 2016 at around 45 percent, according to trading in federal funds futures contracts. The FOMC next meets on March 15-16, and the best bet is that the Fed will hit the pause button.

For evidence, we look to the Fed minutes from the January FOMC meeting: “Almost all participants cited a number of recent events as indicative of tighter financial conditions in the United States; these events included declines in equity prices, a widening in credit spreads, a further rise in the exchange value of the dollar, and an increase in financial market volatility. Some participants also pointed to significantly tighter financing conditions for speculative-grade firms and small businesses, and to reports of tighter standards at banks.”

Purchases of new homes dropped more than forecast in January. Sales declined 9.2 percent to a 494,000 annualized pace after a 544,000 rate in December that was the strongest in 10 months. The supply of homes increased to 5.8 months from 5.1 months in December. There were 238,000 new houses on the market at the end of January, the most since October 2009. The median sales price of a new house declined 4.5 percent from January 2015 to $278,800.

Markit Economics’ monthly flash services purchasing manager’s index, a preliminary reading on the sector, fell into contraction for the first time in over two years. The tentative February index was reported Wednesday at 49.8. That’s below 50, the border between expansion and contraction. The services sector, which covers about two-thirds of the economy, is essentially having its worst month since the recession. The only exception is when the government shutdown disrupted business activity in October 2013.

The US is exporting liquefied natural gas. The first shipload is pulling out of port in Louisiana right about now. The United States expects to transition from a net importer of gas to a net exporter by 2017 as the nation’s shale gas production continues to grow. For now, prices remain low, around $2.61 per million British thermal units in 2015, the lowest annual average since 1999; and there is a glut. The first shipment is headed to Petrobras in Brazil.

Sugar futures on the Intercontinental Exchange staged their biggest daily gain in nearly 23 years, jumping 8.9% to settle at $0.139 a pound, after forecasts suggested supply may fall short of demand due to bad weather conditions. This year’s supply loss will be the first deficit in five years as harvests are hit by the El Nino weather phenomenon and heavy rain in Brazil, the world’s largest producer.

Brazilian police have charged the chief executive of Samarco – a joint venture between BHP Billiton and Vale – and six others with criminal homicide following the collapse of the miner’s dam last November that killed at least 19 people. The report concluded that the accident was caused by excess water in the dam, lack of proper monitoring, faulty equipment and failure in the drainage system. The police report also said that Samarco’s emergency plan to warn nearby villagers was insufficient.

New York State’s comptroller and four Exxon Mobil shareholders have asked the SEC to force the company to include a climate change resolution in its annual shareholder proxy. The move, the first since the Paris climate accord, ratchets up the tension between the oil producer and investors concerned that climate change or legislation designed to curb it will harm the business’s ability to operate profitably. It also comes as Exxon fights an inquiry by NY’s attorney general into whether it misled the public and shareholders about climate change risks.

Sharp’s board has begun a two-day meeting to decide if it should accept a $5.9 billion takeover by Taiwan’s Foxconn Technology. That figure is more than double the offer by the Innovation Network Corp of Japan, which was previously considered the more likely suitor for Sharp due to its government backing.

Viacom has launched a process to explore a strategic minority investment in Paramount Pictures, after being ranked last among Hollywood “majors” at the box office for four straight years. The news comes as the company faces pressure to consider spinning off assets from its core TV business.

Target posted a fourth-quarter profit of $1.4 billion, helped by a gain on the sale of its pharmacy and clinic businesses and lower overhead expenses.

Lowe’s said profit dropped in its latest quarter following its decision to exit an Australian joint venture, though adjusted earnings rose and the company offered upbeat guidance for the year. Last month, the home-improvement retailer said it would sell its 33.3% stake in an unprofitable Australian home-improvement store venture to Woolworths.

Chesapeake Energy reported its fourth-quarter loss widened and it unveiled further capex cuts and asset sales. The company said it had a net loss of $2.23 billion.

Airbus Group posted a 15% rise in profit for 2015 and reported sales grew 6%. Airbus and Boeing have enjoyed a prolonged period of high aircraft order bookings as airlines renew aging fleets and add planes to deliver growth. Investors have increasingly become concerned, though, the boom period may be nearing an end. Despite those worries, Airbus said it would lift production next year of the A330 wide body to seven planes a month from six.

The pharmaceutical group GlaxoSmithKline has been fined $3 billion after admitting bribing doctors and encouraging the prescription of unsuitable antidepressants to children. Glaxo is also expected to admit failing to report safety problems with the diabetes drug Avandia in a district court in Boston on Thursday.

The company encouraged sales reps in the US to misrepresent three drugs to doctors and lavished hospitality and kickbacks on those who agreed to write extra prescriptions, including trips to resorts in Bermuda, Jamaica and California. The company admitted corporate misconduct over the antidepressants Paxil and Wellbutrin and asthma drug Advair. GSK also paid for articles on its drugs to appear in medical journals and supposedly “independent” doctors were hired by the company to promote the treatments.

German luxury automaker Audi has topped the annual ranking of new vehicles by Consumer Reports despite the brand’s emissions-cheating scandal. In November, Audi admitted using separate software that allowed its diesel U.S. SUVs and larger cars to emit excess emissions.

Tesla’s Model S electric car was named Consumer Reports’ best overall car in 2014 and 2015, but this year the magazine opted not to name any best overall vehicle.