Tuesday, April 30, 1996
The Games that Analysts Play, Part One
by TBEllis1

MF Yakko's Fribble, "Flying under Radar" (4/8/96) confirms the view I've long held about so-called "analyst projections." Since no investor ever complains if an analyst's crystal ball undershoots a company's EPS, the incentives encourage "conservative" projections, particularly with small cap stocks. After all, when the actual EPS comes in higher than forecast, the stock usually enjoys a nice jump.

I actually have an even more cynical view of "sell-side" analysts. (Sell side analysts are those who work for underwriters, like investment banks, that *sell* stock to the public; "buy-side" analysts work for institutions that *buy* stock for their portfolios.)

In a nutshell, I think that many small-cap sell-side analysts are little more than sales tools that banks use to land lucrative investment banking business. An investment bank will often offer to initiate coverage of a company *if* the company chooses the bank as its underwriter. The bank benefits because it gets millions of dollars in fees for having a $50K a year junior analyst write a five page report on the company---the research for which has to be done by the due diligence team anyhow. What's more, the report will help the bank actually sell the issue they're underwriting in the first place.

The company benefits, because all the major financial news services will print a story saying Bank XYZ initiated coverage with a BUY recommendation. There's nothing a young small-cap loves more than free publicity.

Datastream Systems is a great example. It's covered by analysts from H&Q, Raymond James, and Robinson-Humphrey. Lo' and behold, DSTM's IPO was underwritten by Robinson-Humphrey and Raymond James, and the secondary was underwritten by Raymond James and H&Q. Notice a pattern?

Consider, too, that the underwriters were paid $1.5 million for the IPO, and $2.7 million for the secondary. Issuing an analyst report is a small price to pay for these kinds of fees, no?

But just how good are the reports?

H&Q's projection for the 4th Quarter of last year clearly undershot the mark. They had estimated $0.15 EPS, and DSTM actually came in at $0.17- -a twelve percent difference. But even worse, H&Q's revenue estimate was more than $300 MILLION on the low side---ouch!

Realizing their mistake, H&Q raised *all* of their estimates for DSTM for the next two years, but look closely at these revenue growth rates:

1992 - 1993 -- 43.2% (actual)

1993 - 1994 -- 76.5% (actual)

1994 - 1995 -- 96.1% (actual)

1995 - 1996 -- 59.8% (projected)

1996 - 1997 -- 49.2% (projected)

Why is it that consistently increasing growth rates should precipitously drop off in '96 and '97? There's absolutely no reference in H&Q's report about slowing growth. And they never justify why they picked 59.8% as opposed to, say, 55.7 or 65.2%.

On the EPS side, the lunacy is even more apparent:

1992 - 1993 -- 73.0% (actual)

1993 - 1994 -- 206.1% (actual)

1994 - 1995 -- 105.5% (actual)

1995 - 1996 -- 32.5% (projected)

1996 - 1997 -- 45.8% (projected)

Again, no justification is given as to why EPS growth should drop 67.5% in 1996, only to rebound 50% in '97. Where's the logic?!?

Then there's the fact that DSTM made an announcement in early March that they would be increasing R&D expenses. That would clearly impact EPS, right? But did any of the analysts change their projections? NO. Did any of them comment on the announcement? NO. Were any of them even aware of it? Uh, well, apparently not.

As frustrating as this is, there are alternatives to relying on sell-side analysts for information. Just by reading this Fribble you're already warm. And tomorrow, in Part Two, we'll see how to turn the tables back in your favor.

[Editor's note: more information on Datastream Systems (DSTM) can be found on the Motley Fool Stock Boards.]

Transmitted: 4/30/96