Stocking Up

Through much of the year 2000, stock market analysts at leading brokerage houses were wildly bullish on Priceline.com, the Internet firm that sells discounted airline tickets, groceries, and other goods. True, the company was hemorrhaging money--operating losses for 1999 ran to $63 million--but the analysts boldly predicted that Priceline would soon move into the black. In January 2000, Mark Rowen and Susan Hawkins of Prudential Securities rated the company a "strong buy," saying, "Without a doubt, consumers have adopted Priceline as a great new way to buy."

A host of other analysts joined in with their own upbeat assessments, including Credit Suisse First Boston, Jefferies and Company, PaineWebber, and Robertson Stephens. The analyst at Robertson Stephens, Lauren Cooks Levitan, gave Priceline her highest possible rating on September 8. The company was poised to take off, she informed investors in a turgid research report, thanks to "organic growth in existing businesses, the launch of new verticals employing the name-your-price model and international expansion." Buoyed by such optimistic predictions, investors poured money into Priceline. The share price soared from $45 at the start of the year to a high of $104 in March, at which time the company had a market capitalization of $16 billion--slightly higher than the gross domestic product of Senegal.

Three weeks after Cooks Levitan weighed in--and at a time that 16 of the 20 Wall Street analysts covering the company rated its stock as a "buy" or a "strong buy"--Priceline tanked. On one particularly brutal day, after the company warned that third-quarter sales would be far lower than expected, Priceline's stock plunged in value by 42 percent. As of mid-January, the stock was selling for about $3 a share--98 percent off its peak.

Priceline is just one of countless Wall Street darlings to implode during the Nasdaq meltdown that began last spring. MicroStrategy, an Internet software company, was trading at $313 in early March, and virtually every analyst covering the firm assured investors that its stock price would keep rising. As of this writing, shares of the company--which lost about $33 million last year--can be had for about $15. In July analyst Paul Merenbloom of Prudential Securities rated "Internet incubator" CMGI a strong buy and predicted its price would rise from about $45 to $155 within 12 months. Merenbloom's hunch about an impending explosion involving the company's shares was deadly accurate. Unfortunately for investors who followed his advice, CMGI's shares went through the floor instead of the ceiling; they now sell for about $6. The stock price of Qualcomm, a cell phone and telecommunications company, rose 30-fold in 1999, hitting $164 on December 31. Shortly before its peak, PaineWebber analyst Walter Piecyk predicted that Qualcomm would rise by another 65 percent by New Year's Day 2001. Instead, Qualcomm shares have sunk like a stone. They currently trade at $70.

The term stock analyst conjures up the image of a tough-minded bean counter who diligently investigates a company's balance sheet before crunching the numbers and gauging the prospects. But in fact, most analysts are little more than cheerleaders for the firms they cover. Chuck Hill--research director for First Call/Thomson Financial, a company that tracks stock recommendations--says that as of November 1 of last year, fewer than 1 percent of roughly 27,000 ratings issued by analysts were "sells" or "strong sells"; nearly three-quarters were "strong buys" or "buys"; and almost all the rest were "holds."

To put an end to the incestuous relationship between analysts and corporations, the U.S. Securities and Exchange Commission (SEC) last October issued Rule FD ( for "fair disclosure"). The rule prohibits companies from providing analysts with inside information about earnings or any other news--for example, upcoming layoffs or the resignation of a CEO--that is likely to affect share price. The SEC dubbed that heretofore common practice "selective disclosure" and said it allowed analysts (and their private clients, largely big institutional investors) to "make a profit or avoid a loss at the expense of those kept in the dark." From now on, analysts will get market-moving news at the same time the public does, through postings on corporate Web sites, press conferences simulcast on the Internet, and earnings reports that are open to small investors via conference call. Top officers of firms that violate the rules will face criminal sanctions.

But it's not clear what exactly this will change. At best, analysts will have to do more independent research. Yet there's still going to be a huge bias to recommend buys because nothing in the new SEC rule alters the deeper conflicts of interest--the link between research and investment banking, the merger consulting fees, and the fact that the brokerage firm that employs the analyst is still basically there to sell stocks.

Analysts have long maintained close ties to the companies they monitor. Corporate executives court them with inside information, not to mention invitations to lavish dinners and weekends at plush resorts. Because they fear losing their access, analysts are loath to speak ill of companies they rate. Many even allow corporations to review their research reports before making them public. "Most analysts are simply putting out promotional literature," says Scott Black, president of Delphi Management, an investment management firm in Boston. "They're there to sell stocks and drum up other business."

The mutual back scratching has become particularly flagrant in recent years. Traditionally, brokerage firms made huge profits from commissions they charged customers for buying and selling stocks. After discount brokers (and now online brokers) picked up a good chunk of that market, brokerage houses compensated by moving into the booming fields of underwriting new stock offerings and consulting on corporate mergers. (Their fees can run as high as 5 percent of a given deal.) According to Bloomberg News, the top 25 investment banks--led by Goldman Sachs and Morgan Stanley Dean Witter and Company--handled $68.9 billion in initial public offerings (IPOs) during 1999, up from $4.5 billion a decade earlier. During that same period, the value of mergers and acquisitions rose by a factor of 11, to $1.6 trillion.

In theory there's a Chinese Wall between a brokerage house's research wing and its investment banking departments. In practice, analysts--who are paid as much as $25 million annually--know that companies that suffer stock downgrades or are otherwise offended by their comments will withhold business from their employer. "Analysts make their living by being friendly and supportive," says Chris Whalen, a New York-based investment banker. "People on Wall Street understand that. The problem is that individual investors don't."

Chase H&Q underwrote MicroStrategy's IPO in 1999, and Chase analyst James Pickrel subsequently became one of the company's primary hawkers. He reiterated a buy rating on MicroStrategy even after the stock plunged by 70 percent in a single day last March. Since then, the company's shares have dropped from $86 to $15. Goldman Sachs made millions by underwriting the 1996 IPO for Open Market, another Internet software firm. On February 3, 2000, Goldman analyst Richard Sherlund raised his rating on the firm to "market outperform." Open Market's share price later plummeted from about $60 to under $3 today.

Brokerage firms insist that all of this is mere coincidence. Occasionally, though, a smoking gun surfaces. In early 1999, Bear Stearns underwrote $307 million worth of stock and debt sales for NetBank, a firm based in Alpharetta, Georgia. Sean Ryan, then an analyst for Bear Stearns, says the brokerage house pressured him to recommend NetBank even though he thought the company was a dog. "I put a 'buy' on it because they paid for it," Ryan told Bloomberg. After topping out at $78 in April of 1999, NetBank began a bloodcurdling decline to its current level of about $9.

The old method of determining a stock's fair price is simple: Divide share price by the following year's estimated earnings to determine a company's price-to-earnings (P/E) ratio. Thus, a company expected to earn $2 per share had, at a share price of $20, a P/E ratio of 10. The average P/E ratio for the Standard and Poor's 500 over the past 50 years is 15. Even after the brutal downturn of recent months, the S&P 500 currently is trading at a P/E ratio of about 25. At the tech-heavy Nasdaq, the P/E ratio remains at 100 and many big-name stocks are far higher. For example, eBay's P/E ratio sits at a stratospheric 308 while Yahoo!'s still tops 175--and that following the latter's nearly 80 percent decline from a peak share price of $250.

But what about the many Internet stocks with no earnings and therefore no E to calculate a P/E ratio? Here, analysts were forced to innovate. Many began to divide a company's stock price by its projected revenues instead of earnings, and looked 5 to 10 years down the road instead of at the following year. The beauty of this arrangement was that e-commerce was just getting off the ground and revenues for new companies were starting from zero. Hence, growth rates were phenomenal--Priceline's sales grew by 1,270 percent in 1999, even as its losses soared--and led to wildly optimistic projections about future revenues. To further grease the wheels, analysts factored into their estimates such intangibles as "eyeballs" (the number of visitors to a company's Web site) and brand names. They also started judging stock prices based on "relative multiples," or how similar stocks were valued. Ergo, if one company's stock climbed to an astronomical level--normally in response to analysts' rave reviews--estimates for its competitors' share prices were upgraded on that basis alone.

Consider the case of Amazon.com, the best-known Internet firm and the bellwether for the entire sector. While some observers expressed skepticism about Amazon's potential--Barron's famously called the company "Amazon-dot-bomb"--many predicted that the company would soon supplant bricks-and-mortar bookstores. In 1998 Amazon lost about $100 million, but analysts, citing revenue growth of more than 400 percent, helped push its share price up fourfold.

Losses continued to mount during 1998 and 1999, eventually totaling $800 million for those two years, but analysts still recommended that investors buy the firm's shares. Jamie Kiggen of Donaldson, Lufkin and Jenrette--which in February 2000 helped manage Amazon's sale of $600 million in bonds--was one of the biggest bulls. Last June he gave Amazon shares a price target of $140, a value he derived by calculating that each Amazon customer would buy $2,400 worth of goods. That figure was ludicrously high, but even if it had been accurate, it would have meant no profit for the company until the year 2030. Amazon's shares entered a free-fall soon after Kiggen recommended them, and they now sell for about $30.

The bursting of the Nasdaq bubble has been especially cruel to the analysts who came to prominence on the rising tide of high-tech euphoria. Mary Meeker of Morgan Stanley Dean Witter became known as the Net Queen after she predicted the dawn of the Internet age in 1995. An inveterate bull--even today she has positive ratings on all but two of 20 companies she covers--Meeker was one of Amazon's biggest boosters. Her glowing reports about the company--"grow, grow, grow, spend, spend, spend, expand, grow, spend more, grow more, and then suddenly reap the financial benefits," she wrote in 1998--led the online bookseller to move its investment banking business from Deutsche Bank to Morgan Stanley.

Meeker's early backing of Amazon prompted many new Net firms to seek her support. As a result, Morgan Stanley underwrote IPOs for companies such as Priceline, Ask Jeeves, and Drugstore.com. Meeker subsequently recommended that investors buy all those stocks--advice that if followed would have led investors straight into personal bankruptcy. Drugstore.com rose to $54 after Meeker first recommended it in September 1999, then began a relentless plunge to its current level of about $3. Morgan Stanley was the lead underwriter for Priceline's March 1999 IPO and another offering later that year. Meeker had a "buy" recommendation on its stock when it cost $104; alone among major analysts, she maintains one even today. Ask Jeeves soared to $190 after Meeker recommended it but has since fallen to about $14.

Jack Grubman of Salomon Smith Barney, who reportedly is paid $20 million annually, has helped broker some of the biggest telecommunications mergers of recent times, including deals between Bell Atlantic and GTE, and SBC and Ameritech. Grubman is also a friend and adviser to a number of leading industry CEOs, including Bernie Ebbers at WorldCom and Ivan Seidenberg at Verizon. In late 1999, Grubman said that C. Michael Armstrong, AT&T's CEO, had the company heading in the right direction, and predicted its share price would hit $75 by the end of 2000. Soon after, AT&T made Salomon one of the underwriters on the $10.6 billion IPO of its new wireless stock. A few months later, AT&T issued a profit warning that sent its shares into a tailspin. Today, AT&T stock goes for $20 a share.

In May, when Salomon was co-managing a $5-billion sale of bonds for WorldCom, Grubman issued a glowing report about the firm's prospects. A few months later, he called the firm's shares "dirt cheap" and said they'd rise to $90 a year out. Since then, WorldCom's dirt-cheap shares have fallen from from $46 to $16. Like many telecommunications analysts, Grubman confidently foresaw government approval for WorldCom and Sprint's planned $129-billion merger. Since Salomon serves as WorldCom's investment banker, that deal would have brought the brokerage house billions of dollars in fees.

Soon after the two firms announced their union in October of 1999, Federal Communications Commission Chairman William Kennard declared that the companies would "bear a heavy burden to show how consumers would be better off." Two months later, a leaked memo from one of Kennard's chief legal advisers described the deal--which would have united the nation's number-two and number-three long-distance providers--as "intolerable."

Grubman dismissed these and other signs of trouble. Last February he assured investors that the merger would close by midyear and said that "the regulatory process is far less onerous than investors think." He even attacked a fellow analyst, Scott Cleland of the Precursor Group, who predicted that the govern ment would block the deal. But it was Cleland who looked smart in the end. The merger collapsed in July 2000 after the Justice Department vowed in June to go to court to block it.

The SEC's recent fair-disclosure rule marks an important change in the relationship between analysts and companies. Law-abiding analysts can no longer receive the inside scoop, so they will be forced to do a bit of real research instead of relying on the self-serving handouts offered by company officials. At the same time, though, fair disclosure won't help patch the wall between the brokerage houses' research departments and investment banking operations. "There's a built-in conflict and that's not going to be affected," says Neil Barsky, a Manhattan-based hedge fund manager and former analyst. "There's still no reward in being negative."

Hence, small investors should remember that any analyst downgrade, even from a "strong buy" to a "buy," should be immediately translated as "unload the turkey." ?

Ken Silverstein is a Washington, D.C.-based writer and a contributing editor to Harper's magazine. His new book, Private Warriors, investigates the post-Cold War arms trade.

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