Chickens, Eggs and Analyst Opinion

When Hewlett-Packard announced, just recently, that it was combining the headquarters operations of its PC and printing divisions, but would continue to report their results separately, I assumed they were doing it to provide legal cover for the transfer of costs from the PC side to the printing side.

The core argument at the time of HP’s takeover of Compaq was, as you might recall, between those who wanted to continue HP’s long history as an engineering innovator and those who wanted to align HP more closely with Intel and Microsoft.

Thus, the nearly simultaneous announcement of the “HP Invent” slogan and the laying-off of most of the company’s innovators signaled the victory of the pro-Microsoft side and the defeat of Walter Hewlett’s last-ditch proposal that the printing business be spun off to give Carly Fiorina et al. a clear field in which to demonstrate their PC marketing expertise.

Marketplace Loss

Since then, HP’s senior management, which won the merger battles, lost the fight in the marketplace as Microsoft lost interest in the Itanium and HP’s bigger customers were left with nowhere to go but IBM first and Sun later.

The printing business, meanwhile, continues to prove Mr. Hewlett right by minting money faster than the PC people can lose it — leading to the present reorganization and, I’m sure, some interesting internal tensions.

The surprising thing about this, however, isn’t the effect it’s having in setting HP up for dismemberment — that was fully predictable given Digital Equipment Corporation’s experience with the same strategy — but the apparent total lack of reaction in the professional analyst community. This kind of self-serving behavior in the HP executive suite signals impending catastrophe, yet HP’s stock barely wavered with the announcement, and I could find no obvious public record of any analyst or commentator who publicly saw the reorganization as a response to disclosure requirements.

So maybe it wasn’t? Or maybe the analysts follow each other’s opinions and one of the leaders has another agenda? Analyst opinion isn’t open source and doesn’t come with explanatory footnotes or explication of alternative views, so there’s no immediate way for an outsider to know which came first: the opinion or the research.

Earnings Forecasts

We can, however, look back at other analyst pronouncements and see whether history sheds light on analysts’ current behavior.

The most common expression of analyst opinion is in the form of an earnings forecast for some company. There have been hundreds of thousands of such forecasts and thousands of academic studies of their contents. In general, these studies either conclude that earnings forecasts are reasonably good or divide forecasts into predictions and targets to conclude that targets have predictive value but predictions do not.

What’s going on here is that most earnings forecasts aren’t forecasts at all: They are announcements under the analyst’s name of consensus opinion arrived at in consultation with company management. As a result, they represent targets to which company management commits, not forecasts, and are correspondingly likely to be about as right as management works to achieve them.

There are cases, however, where an analyst will issue an earnings forecast unblessed by management. Such predictions are generally wrong but inherit credibility from the target form of forecast because the two kinds of forecast can be hard to distinguish and most of the press tends not to. As a result headlines like: Sun Meets Earnings Forecast, Misses on Revenue incorrectly blame the company, instead of the analyst, for the forecasting error.

Mover and Shaker

Earnings forecasts, whether real or not, have the power to move the market and are therefore open to abuse. For example, an influential analyst can usually guarantee a disproportionate share price dip simply by issuing an overly optimistic forecast a week or so before the actual earnings report — and there’s simply no immediate way for an outsider to know whether the analyst was mistaken or covering someone’s short position.

More subtly, ill-conceived negative analyst comments can become self-fulfilling prophecies in part because they will predictably be quoted in ways that further damage the target company’s competitive prospects.

In September of 2003, for example, Sun brought a lot of their heavyweights, including chairman and CEO Scott McNealy, to Ottawa to pitch Java-engineered security to some senior players in Canada’s federal bureaucracy.

The resulting meetings were reported, somewhat differently (although both operations are owned by Transcontinental Media), as “SUN Talks Smart Cards with Feds” in the Ottawa Business Journal and as “Sun Courts Canadian Government with Smart Card Plan” on itbusiness.ca.

The Ottawa Business Journal piece (bylined Ottawa Business Journal Staff) concludes with this paragraph:

Also on Thursday, Steven Milunovich, a prominent analyst at Merril Lynch & Co., sent an open letter to Sun’s board, as well as McNealy, saying the CEO needs “a makeover” and the company needs to cut up to 7,000 more workers and drop out of some businesses. Otherwise, Milunovich predicted Sun’s ultimate value will only be its customer list for another tech company that buys it.

The ITBusiness.ca article (bylined Scott Foster) concludes with this paragraph:

Also last week, Steven Milunovich, a prominent analyst at Merril Lynch & Co., sent an open letter to Sun’s board and McNealy himself which said the CEO needs “a makeover” and the company needs to cut up to 7,000 more workers and drop out of some businesses. Otherwise, Milunovich predicted Sun’s ultimate value will only be its customer list for another tech company that buys it.

The quotation from Milunovich relates to Sun, not the story being reported, and has no more business here than an alternative paragraph puffing Sun’s R&D capabilities would have had — but both stories would have been widely read among Ottawa’s extremely risk averse civil service decision makers and influencers.

An Example

Among analysts, Milunovich, in particular, is an interesting case in this context because his apparent success within Merrill Lynch bears no obvious positive relationship to the quality of his comments about Sun — a company whose products I use and greatly admire.

Here’s an excerpt from thestreet.com’s Report Card: Steven Milunovich (Alison Zombs 09/12/00) in which he gets three of a possible three stars under the criterion: “makes money for me”:

As Milunovich explains, “We’ve argued that the profits in the computer industry are going above and below the personal computer: above, into enterprise computing and, below, into information appliances.” The first positive trend he sees is renewed demand for large servers — particularly UNIX servers. While demand for “big iron” declined significantly in the first half of the ’90s, the requirements of current applications necessitate a return to powerful processors. Milunovich sees Sun Microsystems as the primary beneficiary.

At the time, Sun shares sold for about US$120; three months later and after a two-for-one split, they sold for $34; now they’re around $4.20.

By October of 2003, he had direct advice for Sun as reported by Paul Krill for infoworld:

In his letter, dated Oct. 2, Merrill Lynch’s Steven Milunovich recommends Sun de-emphasize its Sparc hardware architecture and focus on the Intel x86 platform, spin off its crown jewel Java programming language, and pass on battling Microsoft on the desktop with the newly announced Java Desktop System, formerly known as “Mad Hatter.”

Right now, of course, SPARC/Solaris is pretty much set to be IBM’s only competitor as x86 gets replaced by either, or both, cell and throughput computing while Milunovich’s much hyped “industry standard architecture” (the Itanium) has been all but abandoned.

No Sense

In June of 2004, Martin LaMonica writing for zdnet, reports that:

Milunovich said that overall, it appears that HP made a smart move in acquiring Compaq Computer, which improved the company’s market share in servers, PCs and storage. To better compete, Milunovich said, HP should continue making acquisitions of other companies. He noted that HP would be the most likely acquirer of Sun Microsystems.

About a month ago he issued a proclamation that Sun should buy either Red Hat or Novell, presumably as part of its commitment to open source.

I don’t think his pronouncements make any sense, but you don’t get to be a Merrill Lynch vice president as well as their Global Technology Strategist by being an idiot, so I have to assume that this man’s opinions have consistently earned that three-star rating by making money for someone. But who? Not, I think, Sun shareholders.

And his advice on HP’s re-organization? CBSmarketwatch quoted him as saying: “that there is a strategic rationale to HP’s move,” and that it’s “a slight positive given the possibility of improved management of PCs, both tactically and strategically.”

But not a word about Walter Hewlett, the SEC or GAAP compliance.