Credibility Gap Still a Challenge for Analysts
Clark Westmont, a semiconductor-industry analyst for brokerage Salomon Smith Barney, decided last week that Irvine-based chip maker Broadcom Corp. was highly unlikely to earn 29 cents a share in 2003, which had been Westmont’s estimate.
In fact, the analyst’s view of Broadcom’s profit outlook became far darker than those of the two dozen other brokerage researchers who follow the company. Westmont told clients Wednesday that he now expects Broadcom to earn just 3 cents a share next year.
At a time when the credibility of Wall Street analysts has been severely undermined by a torrent of conflict-of-interest allegations, investors’ reaction to Westmont’s slashed profit estimate showed the power that analysts still have over share prices: Broadcom stock plunged $2.04, or 15%, to $11.86 on Thursday, the lowest price since the shares began trading in 1998.
The price continued to slide Friday, ending at $10.95 on Nasdaq.
Yet Westmont didn’t lower his official recommendation on Broadcom. He kept his rating at “2S,” which under Salomon’s grading system means he expects the stock to perform “in line” with others in its industry over the next 12 to 18 months. That’s analogous to a “hold” rating at other brokerages.
At the same time, the “S” warns that Westmont considers the stock to be speculative, meaning it has “exceptionally low predictability of financial results and highest risk and volatility,” Salomon says.
Confused? This is the new, and supposedly improving, world of analyst recommendations.
By Friday, some of Westmont’s clients may well have been asking a question that has been repeatedly asked of analysts since the bear market began 30 months ago: Why didn’t he just say “sell”?
An investor who got out of Broadcom at Wednesday’s closing price of $13.90 a share left with 27% more money than someone who mulled over Westmont’s report, then sold on Friday at $10.95.
Westmont, who has been covering the chip industry for eight years, says he didn’t cut his rating on Broadcom to “3,” or “underperform”--the closest Salomon’s grading system gets to “sell”--because by his estimation Broadcom still is a stock worth keeping long term.
He may well be shown to be right about that. If so, he’ll have plenty of company: Of 25 analysts who follow Broadcom, 14 now rate the stock “buy” or “strong buy,” and 11 rate it “hold” or the equivalent, according to data-tracker Thomson First Call in Boston.
None of the analysts recommends selling Broadcom at this point, despite--or perhaps, because of--the record-low share price. Since it peaked at about $270 in August 2000, the stock has lost more than 95% of its value.
Investors who are angry with brokerage analysts and their recommendations probably have more issues with the past than with the present. In retrospect, the best time to have sold Broadcom was in or around August 2000. But few, if any, analysts wanted to pull the plug then, despite the stock’s stratospheric valuations.
Analysts’ reluctance to say “sell” during the technology-stock mania of 1998 to 2000 is one basis for the numerous investigations state and national regulators have launched into Wall Street’s practices.
Regulators’ investigations have turned up plenty of evidence suggesting that some analysts stayed optimistic about stocks not because they believed in the companies, but mainly to keep their investment bankers happy.
If a brokerage’s bankers were trying to lure fee-rich underwriting business from a particular company, it helped if the analyst following the company maintained a bullish rating on the stock.
The investigation by New York Atty. Gen. Eliot Spitzer into Merrill Lynch & Co.’s practices, which resulted in Merrill agreeing in May to pay a $100 million fine, turned up internal e-mails showing some of the brokerage’s analysts privately slamming Internet stocks in 2000 and 2001 while continuing to advise the public to buy them.
A similar pattern occurred at brokerage CS First Boston, according to Massachusetts regulators, who have asked Spitzer to consider bringing criminal charges against the company.
Analyst practices at Salomon Smith Barney, meanwhile, are under investigation by Spitzer’s office and by the Securities and Exchange Commission and the National Assn. of Securities Dealers.
Wall Street, fearing for its livelihood if not its image, has taken a number of steps to change its ways since spring. Major brokerages have pledged that analysts won’t report directly to investment banking departments, and that analysts’ compensation won’t be linked directly to specific banking work received from a client company.
But that may not be enough. Last week, sources told The Times that Salomon and other major firms are trying to reach an overall settlement of the various probes by agreeing to build a much more substantial wall between analysts and bankers, to reduce the potential for bankers to influence analysts’ opinions of stocks.
Exactly how that wall would be strengthened isn’t yet clear. But the SEC and other regulators know that individual and institutional investors alike are disgusted by the revelations of tainted stock touts, and that the only chance brokerages have to rebuild confidence in their advice is to present a meaningful plan for reform.
For many brokerage clients, one element of reform already visible is in stock rating systems. Regulators in the spring ordered Wall Street to be clearer in its stock recommendations and to include with every research report much more disclosure about how ratings work and whether a firm faces any potential conflicts of interest in following a particular stock.
At Salomon Smith Barney, that resulted in a change from a five-level rating system to a three-level system: a 1 rating for “outperform,” indicating that the stock, over 12 to 18 months, is expected to perform better than others in its industry that are followed by the analyst; a 2 rating for “in line,” meaning the stock should perform in line with its peers; and a 3 rating for “underperform,” meaning the performance is expected to be worse than the average peer stock.
Salomon also includes letter ratings indicating whether a stock is considered low risk, medium risk, high risk or speculative.
Some brokerages, such as Prudential Securities, have opted for simpler ratings. Prudential labels stocks either buy, hold or sell.
Salomon and other firms with more convoluted grading systems have argued that fairly rating stocks isn’t always as simple as black, white and one shade of gray.
Here’s how Salomon’s Westmont explains his decision to keep Broadcom rated a 2, even while reducing his earnings estimate for 2003 by 90%: The expected earnings shortfall reflects Westmont’s belief that demand for Broadcom’s chips will slow because of weaker sales of devices such as set-top cable TV boxes. Broadcom is big supplier of chips to the cable and telecommunications industries.
Nonetheless, Westmont said he expects Broadcom--which isn’t a banking client of Salomon--to be a survivor of the horrendous shakeout still going on in the telecom sector. He said the company has relatively low debt, and expects that Broadcom’s sales will continue to grow, albeit at a slower pace. He forecasts sales of $1.1 billion this year and $1.3 billion in 2003.
In the absence of material earnings per share in 2003, Westmont said, the only logical way to judge the value of Broadcom’s shares is to compare the price with estimated sales per share. And by that measure, he said, the stock already is cheaper than shares of many of its peers. To Westmont, that makes Broadcom an “in line” performer by Salomon’s official terminology--a “hold” in other brokerages’ parlance.
Is Wall Street still far too optimistic on stocks like Broadcom? Thomson First Call’s tally of 25,000 stock recommendations shows 93% now are “buys” or “holds.” Just 7% are “sells.” Still, the “sells” are up from 2% of the total a year ago.
The real test of analysts’ objectivity, however, won’t come in the midst of a bear market. It will be during the next bull market, when everyone senses that stock valuations have become overextended, but saying so wins no friends.
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Tom Petruno can be reached at [email protected]
