A Wall Street Witch's Brew

In a nearby post Jeff Snider makes a clean kill of the sell side hockey stick. Just 22 months ago (June 2014), Wall Street projected GAAP earnings of $144.60 per share for the S&P 500 in 2015.

Needless to say, that was off by a country mile. In fact, it was too high by 67%, but the instructive tale lies in the process of getting there.

Since 2013 actual results and 10K filings were long done by June 2014, you have to say that the street was virtually wallowing in hopium. To wit, the above 2015 estimates embodied a two-year gain of 45% from the actual figure of $100.20 per share for 2013.

And so it went. By March 2015 the consensus estimate had been lowered sharply to $111.34 per share because the fond hopes of the prior June had not quite worked out. In fact, GAAP results for 2014 had come in at only $102.31 per share, meaning a tiny gain of just 2.1% for the year and an impossible hole to fill with respect to the two-year gain of 45%.

Worse still, this December 2014 LTM reported figure was not just way short of the mark; it actually represented a reversal of direction. The post-crisis earnings recovery had already peaked at $106 per share in the September 2014 LTM period and was now down nearly 4%.

But no matter. The consensus estimate of $111.34 for 2015 made midway through the year represented a gain of nearly 9% over 2014. As per usual, of course, that was all back-loaded to the second half. The actual Q1 2015 GAAP profit of $25.81 was already in and represented a 6% decline from prior year.

But on Wall Street the hockey stick springs eternal. By the time of the September consensus estimate, first half earnings were already down by 17%. But the consensus assumed a stick save in the final quarter. Earnings per share were now projected.at $95.06, representing a full year drop of just 7%.

The stick save didn’t happen. GAAP profits for the year ended down 14% from the 2013 level, not up by 45%!

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Yet that’s not the half of it. In this age of Bubble Finance, Wall Street assumes that profit growth is definitional. So notwithstanding the total wipeout described above with respect to its 2015 hockey stick, the forward estimates are heading back toward the rafters. Even on a GAAP basis, the year end consensus estimates are $111.50 and  $126.50 for 2016 and 2017 respectively.

The point, however, is not just that the hockey stick is up by 29% for the current year when Q1 results/estimates are already down by 10% or that 2017 is up by 46%. The point is that the sell side stock peddlers are so intoxicated by life in the casino that they do not recognize that the jig is up. To wit, profit margins have been at an all-time high, but have visibly peaked, and the financial engineering boost to per share earnings is surely over and done.

As highlighted in another nearby post, profit margins for the S&P 500 peaked at an all-time high of nearly 10% in 2014 and have already dropped by one-fifth. And as we must repeat again, the business cycle has not been outlawed and this one is getting increasingly long in the tooth. The chart provides all the information necessary about what happens to profit margins when the next recession makes its inexorable appearance.

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At the same time, stock buybacks are certain to plunge as interest rates eventually normalize and borrowing to buy stock becomes less attractive. Financial engineering, therefore, has an inherent sell-by date.

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Indeed, the poster boy for financial engineering reported last night, and not only were IBM’s results another fiasco; they are actually just a leading indicator of where stock-option crazed C-suites are taking corporate America under the auspices of the Fed’s destructive regime of Bubble Finance.

Not surprisingly, IBM’s sales were down for the 16th straight quarter—-this time by 4.5%. Meanwhile, its pre-tax profits plunged by 67% from $3 billion in Q1 2015 to just $1 billion in the current quarter.

Perhaps fittingly, IBM’s bottom line results were saved from a total wipeout only by a final gasp of financial engineering. It posted a negative tax provision of $983 million or negative 95%. Save for that fig leaf, IBM posted the lowest quarterly pre-tax profit in two decades!

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Needless to say, more than a decade of extreme financial engineering does not have much to write home about. IBM has flooded the casino with share repurchases and dividends in order to levitate its stock price and keep its executives flush with stock option gains.

But even that short-sighted liquidation of its own seed corn is no longer working. After last night’s disaster, its stock is down by 6% from its recent dead cat bounce, and now dwells 33% below its early 2013 high of $215 per share.

That its hapless CEO and Board have not been sent packing long ago is undoubtedly due to the never ending gifts it showers on the casino and the brokers and fast money operators who ply their trade there. To wit, during the last decade, IBM has repurchased $100 billion worth of shares and paid $33 billion of dividends.

That happens to equal 100% of its cumulative net income——-so it is perhaps not surprising that its sales and profits continue to erode. At the same time, IBM made almost $30 billion of acquisitions and increased its outstanding debt from $10 billion to $31 billion.

In short, IBM has been a financial engineering dream. It is hard to imagine what Wall Street generated maneuver or gimmick it has overlooked.

But, alas, financial engineering does create value, and if practiced long enough, it destroys it.

That much is evident in the bank of charts below. During the last three years, IBMs sales have dropped by 21% or more than $20 billion. Likewise, its net income is down by 23% and its pre-tax profits by 37%.

That’s right. Its pre-tax profits of $14 billion for the March LTM period compared to $22.3 billion for the LTM period ending three years ago.

Stated differently, shrinking sales on top of steadily eroding operating margins, which dropped from 20.6% to 17.4% over the period, have wreaked havoc with IBM’s true profit. The only reason that its net income line does not fully reflect the financial shipwreck that IBM’s financial engineers have wrought is that they did make its tax provision virtually disappear.

As shown in the third panel, it’s effective tax rate was already a low 24.0% in the LTM period ending in March 2013. It is now 7.3% on an LTM basis. While it is undoubtedly heading slightly lower, that particular gimmicks is reaching its natural limits.

Indeed, not paying taxes is no particular vice. Even then, however, you can’t capitalize on a permanent basis one time gains in income that have been filched from the tax man.

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From time to time, Simple Janet has averred that there are no bubbles in the stock market and that she is puzzled as to why productivity has petered out and growth remains in the ultra-slow lane.

Perhaps she should contemplate the consequences of the massive central bank intrusion in financial markets that has supplanted honest price discovery and healthy financial discipline with hockey sticks and financial engineering.

As to the former, the market closed today at 24X actual S&P earnings. That is a meltdown waiting to happen, and one that is wholly attributable to the lunacy of 87 straight months of ZIRP and massive QE.

In the case of latter, IBM is no aberration, but the poster boy for the kind of financial engineering based liquidation of productive assets that is the inexorable result of Bubble Finance. On an inflation adjusted basis, Big Blue’s R&D spending is down 20% in the past four years and its CapEx by 40%.

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You could even call this a Wall Street witches brew of hockey sticks and financial engineering. But Simple Janet wouldn’t have a clue.

Regards,

David Stockman
for The Daily Reckoning

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