My applause goes to
-- and thanks for stealing my thunder on this topic -- for being right on in his
column yesterday regarding the
new get-tough policy over the quality of corporate earnings.
While Herb's article mostly focused on the controversy regarding takeover-related charges, there is a lot more to the story than that. The whole issue of managing earnings to meet consensus earnings estimates has gotten completely out of hand and produced a number of financial discombobulations that should unnerve fundamental investors.
I am not sure where it started, but many companies seem to be intractably intertwined in a game of "meeting expectations" with the analysts who cover them. The game has gotten so ugly that insurance companies are now actually offering "earnings insurance" as a product line.
Obviously, a company that can deliver quarter after quarter of consistent earnings growth deserves a fat premium. The problem is that there are few companies out there like
Automatic Data Processing
, whose earnings have marched upward in a continuous and nearly flawless manner over the years. But, never fear, there remain plenty of analysts whose job it is to generate commissions in the search for the next ADP.
It is also obvious that every CEO wants to manage his or her company to deliver the same kind of flawless earnings consistency of an ADP and can easily convince himself or herself that the sheer brilliance of their management style can overcome some rough spots in their business model. This despite such minor peccadilloes as exposure to the economic cycle, capacity utilization issues and the inability to raise prices, just to name a few. Most have compensation packages designed to reward said executive brilliance with a pile of money if the stock price reflects it.
So I think it is clear that an awful lot rides on the ability of a company to generate results that meet the expectations of its investors. This pressure to "make the numbers" is felt throughout the organization, leading to what might be called uneconomic behavior or, at least, misleading behavior. If investors expect X this year and the business is producing 120% of X, might I spend a little of next year's money this year to give myself a little cushion? If I am running at 80% of X, might I defer some expenses until next year -- or push the salespeople to book sales before the end of the quarter?
Again, I am not sure who gave in first, the analysts or corporate America, but the one-time charge is the granddaddy of all earnings manipulation. I grew up analyzing
Dun and Bradstreet
in the 1980s and always marveled at how the company managed to find a one-time charge that was exactly the same amount as the gain it was about to report from the sale of a division. Essentially, what it was doing was capitalizing a number of software and development costs that kept income statement expenses low and profits high for a time being. When a gain materialized from the sale of a business, the company took all of the costs in one swoop and "preserved" its reported earnings per share. Eventually, investors caught on and penalized Dun and Bradstreet with a lousy multiple.
Here's a very annoying example of this from my own portfolio.
recently released fourth quarter was a complete mess as far as trying to judge apples-to-apples performance. The problem? A number of somewhat legitimate charges for the company's big merger with
. But Bank One thought it opportune to throw in a one-time charge of $102 million for a "valuation adjustment to auto lease residual values." In other words, the company overstated profit of about $102 million over the last four years because it made car leases on overly favorable terms by calculating overly high residual values. This year, the company realized the error and made up the costs in one swoop. Not a huge deal, but symptomatic of a bigger problem.
The key is that we let them do it. Many professional investors are overwhelmed by the blizzard of information and own hundreds of companies, leading them to conclude, quite erroneously, that all that counts is that they hit the bottom line number generated by the
machine. Investor relations at Bank One told me I was the only one who called to complain about whether the company's charge was a "one-time" one or just a part of everyday business. Just throw in the kitchen sink and don't worry -- we'll forget about it four months later.
Some of this is GAAP oriented, and since that is the accounting system we hang our hat on, some expenses can be properly "charged" as one-time issues. But needless to say, one time has become many times and fallen way over the line into abuse.
Corporate America and the analysts and investors who follow company moves are highly educated and highly paid people. A company's fiduciary responsibility should only be to report on the state of business in the most timely and thorough fashion as possible in order for outside investors to make intelligent decisions.
If their expectations are wrong, they have no one to blame but themselves. CEOs who play the quarterly game for its own sake will eventually pay the price via a shareholder base that thinks nothing of blowing them out as another number on a spreadsheet.
That the SEC is finally taking a look at these issues should be treated as a "Where the heck have they been?" issue. A good number of CEOs and their accountants should be congratulating themselves for pushing the accounting envelope while the getting was good rather than whining about the cold bucket of reality finally coming due. Enough of the whining -- on both sides.
Jeffrey Bronchick is the chief investment officer of Reed Conner & Birdwell (www.rcbinvest.com), a Los Angeles-based money manager with approximately $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value Fund. At the time of publication, RCB owned shares of Bank One, although these holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. His column, The Buysider, appears every Tuesday on TheStreet.com. He appreciates your feedback at firstname.lastname@example.org.
As originally published this story contained an error. Please see Corrections and Clarifications.