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Weighing On The Market

Pundits have been asking why the market is not perking up with the increasingly optimistic economic data that has been coming out recently. The usual answer is fear of terrorism or war between India and Pakistan. Unfortunately, this misses what investors are focusing on. Granted, the increased tension around the world is adding to the uncertainty, but the fact is companies have yet to prove they will be able to grow earnings. While the economic data is looking better, these data points are based on month-to-month changes. Investors care about year-over-year growth, and year-over-year results are still down dramatically. The upturn in the economic data is really only indicating that the economy is stabilizing, but at a lower level of activity. And this runs a significant risk of further deterioration as we have discussed. Even if the economy plateaus here, companies will have a hard time achieving the earnings growth investors have priced into stocks. Jobless claims provide a good example. The week-to-week tally of new jobless claims has been declining, but the number of continuing claims keeps rising and now stands around 19-year highs.

Capital spending plans continue to get pushed back. The latest survey of U.S. and European information officers conducted by Merrill Lynch revealed that IT budgets for 2003 have contracted. IT managers expect budgets to fall 0.5% this year compared to the anticipated 2% growth forecasted at the beginning of the year. 80% of the respondents do not expect a fourth quarter surge this year. Software sales seem to be one of the biggest areas of weakness. Companies have purchased licenses that are not being used. 40% of CIO's have more licenses than they need and estimate that on average it will take 12 months to work off the additional licenses. Also, the PC upgrade cycle is lengthening. More than half said their upgrade cycle lengthened to an average of 40 months. Additionally, 64% said they plan to upgrade in 2003 or 2004, with 10% not having any upgrade plans. These findings certainly do not bode well for technology companies.

This week, Manugistics, the supply chain management software company, announced it would miss Wall Street earnings estimates. I apologize for including such a long quote, but I think the following three paragraphs from its press release point to the heart of the weakness in technology spending:

"Manugistics financial performance this quarter was adversely impacted by the continuing global economic downturn," said Greg Owens, Manugistics' chairman and chief executive officer. "The current economic environment negatively impacted the purchasing of information technology, especially in the enterprise application software sector which worsened late in our first quarter."

"As we exited our strong fourth quarter, we were encouraged by the level of sales activities we were seeing. Throughout our first quarter we were winning the selection process and beating our competition. Unfortunately in the last month of our quarter, we saw our customers and prospects become increasingly unwilling to commit to large capital expenditures, which adversely affected our performance," continued Owens. "We started the quarter strongly with several significant client wins, but we were unable to attain expected closure rates as we ended the quarter."

"We continue to be confident in our solutions and products, our business strategy and our people," said Owens. "However, because it is unclear when the capital spending will improve, we will further align the Company's organization, resources, and expenses with current financial and market realities. Manugistics is beginning to implement a range of measures to reduce costs and further improve our operational efficiencies, which will include a reduction in our workforce."

Flextronics was another company that warned this week. The leading contract manufacturer said, "an upturn is coming, but we don't know when." Cisco's CEO, John Chambers, added that the economy is in the "show me" state. With the Show Me State (Missouri) withholding tax refunds, there seems to be a lack of items to show.

The recovery is hinging on an increase in capital spending, which does not appear imminent, and consumers maintaining their spending. The weaker than anticipated auto sales for May might be signaling that the consumer is finally slowing down. Auto sales in May surprised analysts as industry auto sales fell 6% and GM sales fell 12%. GM attributes the decline partly to a lack of inventory, however the very next day GM announced it was increasing its incentives on trucks.

Accounting issues continue to weigh on the market, and rightly so. Earnings have been manipulated by such a wide range of companies it is difficult to know what to believe. A recent academic study found the use of "cookie jar" reserves is the most common method of managing earnings, accounting for 25% of the earnings management techniques studied. These reserves are usually created by taking excessive acquisition related charges that can be reversed in later years to boost earnings when business conditions and earnings deteriorate. The next two popular methods of massaging earnings were revenue recognition (15%) and business combination transactions (14%).

For those who think cash flow is king and offers a "true measure" of financial performance, the SEC announced it is concerned about companies' use of accounting tricks to inflate cash flow. While cash flow from operations is more difficult to fudge, the standard for accounting for cash flow, FAS 95, does allow companies discretion in classifying some items such as operating, investing or financing, to their liking. The most common method used to inflate cash flows is the practice of not expensing employee options. Cash flow is inflated due to the tax treatment of employee options. Since the employees pay the tax on the exercise, the company gets to take a tax deduction on the same amount. This lowers the taxes paid by the company, thus increasing the cash flow. During the bull market of the late 90s this accounting treatment accounted for a major portion of cash flow for several technology companies. NVIDIA, the graphic chip maker, benefited greatly from this tax treatment. Of the $68 million NVIDIA reported in cash flow from operations, $63.3, or 93%, was attributed to the option-related tax benefit.

These past accounting indiscretions led bankers to accept "enterprise value" as security for loans. A recent FT story discussed how regulators are finding large losses on loans that were secured by "enterprise value." Unfortunately, these enterprise values were based on inflated merger prices of the bubble era. This was the cause of "a lot of the loan losses you have seen banks take - and they are on the rise," according to David Gibbons, who is in charge of credit issues for the Treasury agency conducting the review. These losses were being found during a joint review by regulators that focused on syndicated loans. The regulators look thought the syndicated loans to ensure that banks holding different pieces of the same loan are accounting for it the same way and acknowledge credit problems if need be. Mr. Gibbons said that problem loans would probably increase this year and "There's not a lot of enterprise value left and that's the reality…you have to say there is nothing there - nothing but air."

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