closely watched “core (recurring) earnings.” Is this earnings management or manipulation? Judging by the shared intent to deceive investors, who cares?
Chapter 3 is devoted to the follies of management or manipulation of financial information, showing that such practices are both ethically wrong and highly likely to be surfaced sooner or later by whistleblowers, auditors, or the SEC. Once disclosed, information manipulation is very detrimental to the company’s operations and reputation and often devastating to the perpetrating managers.28
RECOMMENDED COURSE: WARN, REPORT TRUTHFULLY, AND FIX THE FUNDAMENTALS. As soon as you realize you are going to disappoint investors—miss the consensus, or report an earnings or sales drop—preferably well before quarter-end, issue a public warning to this effect along with a detailed and credible plan of how you intend to fix the business fundamentals. Then, report the grim results truthfully and keep investors engaged, sharing with them the progress of the corrective moves, whether successful or not. A warning will not mollify investors, though; your stock will be hit on the announcement. Vodafone, the leading wireless communications company, lost almost 6 percent (S&P 500 dropped less than 1 percent) when it warned in February 27, 2006, of slowing revenues and a gross margin drop for the year ending March 31, 2007.29 Sometimes the price hit on the warning is temporary, as in Vodafone’s case. On March 3, 2006, a mere week after the warning, Vodafone’s stock price returned to its pre-warning level. Of course, if investors aren’t convinced of the efficacy of the corrective measures, the price drop will last longer. The main advantages of the warning are that it enhances managers’ credibility as straight shooters and as executives who are on top of things (they weren’t surprised by the shortfall), and that the warning often lessens the company’s exposure to shareholder litigation and the estimated damages to investors, as I show in chapter 6.
Most importantly, in financial reporting, honesty prevails. How do I know? In 2009, Sanjeev Bhojraj and colleagues examined empirically what happens to companies that miss the consensus estimate by a penny without managing earnings, compared with companies that beat the consensus by a penny with the help of earnings management.30 A few research particulars of this smart exercise: The study examined 1,390 companies that missed the consensus and 2,125 firms that beat it. The researchers assessed whether a company managed its earnings or not by tracking unusual changes in the major expense items that are susceptible to manipulation—accounting accruals (subjective reserves, provisions, estimates), R&D, and advertising expenses. Thus, for example, an unusual (relative to comparable firms) decrease in R&D, advertising expense, or in the bad-debt reserve (an accrual) at a company that beat the consensus by a penny leads to the presumption of earnings management.
The outcome of this analysis is both surprising and reassuring. First, the manipulators that beat the consensus received as a group a temporary 3 percent to 4 percent bump in stock price but lost it by year-end.31 This corroborates my earlier argument that beating the consensus by manipulation is a temporary fix, and sooner rather than later the true adverse fundamentals can no longer be masked. In sharp contrast, the one-penny missers that resisted the temptation to manage earnings didn’t suffer price decline, and from roughly a year after the consensus miss their share prices increased significantly. Thus, refusal to manipulate earnings prevails and will even be rewarded.
Operating Instructions
RISING STOCK PRICES CAN ALSO BITE. The mother of all stock hits on a consensus miss happens to growth companies whose share prices are stoked by inflated investor expectations (recall eBay’s 22 percent price drop upon a penny miss). Accordingly, resist the temptation of riding an inflated stock price tiger, and deflate investors’ overly optimistic expectations well before the inevitable disappointment.
AVOID QUICK FIXES. Unless the earnings shortfall is small and temporary, you should resist quick fixes—last-minute sales blitz, cost cuts, or shifts to future periods—for the sake of making the numbers. When such moves are not part of a carefully planned restructuring, they will only exacerbate future sales and earnings shortfalls.
THE ONE THING YOU SHOULDN’T MANAGE. You should avoid earnings manipulation or the better-sounding yet equally deleterious earnings management at all costs, on both ethical and practical grounds. Since most manipulation schemes “borrow from the future,” they soon spiral out of control and, when ultimately revealed, the consequences to the company and its managers are harsh.32
JUST DO THIS. The recommended course when facing a consensus miss is to warn investors of the impending shortfall as soon as practicable, share with them the corrective actions planned, report the financials honestly, and follow with detailed and credible progress reports.
Chapter 2
Do We Have a Story for You
How Soft Information Can Change Stock Prices
In This Chapter
How to overcome investors' “limited attention.”
What makes a conference call effective?
How the tone of managerial communications matters, not just the numbers.
How investor relations make a difference.
The Children's Place, a retailer of—what else?—children's apparel and accessories, opened the year 2003 with a quarter to forget: its EPS, at $.21, missed analysts' consensus estimate by $.04 and fell far short of the year-earlier EPS of $.56. If this was not enough, same-store sales, a key retailers' performance measure, fell 13 percent, and gross profit decreased to 38.6 percent of sales from 45.7 percent a year earlier. The May 15, 2003, conference call following this grim news opened with the CFO tersely pointing out several reasons for the financial results—a decrease in average transaction size, sales price decreases, increases in employee training and payroll costs, and severe winter weather. (Wouldn't you expect an increasing demand for children's clothes as the weather worsens?) The CFO went on to expand on the future: “Looking ahead, we remain confident that our business is moving in the right direction, as evidenced by our improved sales and transaction trends …” The CEO then joined the call and, abstracting from inconvenient details, had this to say on the quarter: “We are pleased with the progress we made in the first quarter … We made progress in our strategic initiatives and they remain on track yielding positive results in the following key performance indicators, as compared to last year.”
What followed was a litany of presumably positive indicators, such as increases in customer conversion rates and units per transaction. As for the large increase in inventory levels during the quarter—a frequent indicator of deteriorating business—the CEO said: “Inventory levels are now well positioned to support our business.” And, he concluded, “we are further streamlining our operations to leverage our infrastructure while at the same time supporting our growth. As we reflect on the challenges that we have been facing, we look forward to the many opportunities that lie ahead of us. Our early signs of progress encourage us and we remain confident about achieving our long-term objective of making the Children's Place the number-one brand in children's clothing. We believe we have the right formula and the right strategies to achieve this ambitious goal.”
All this optimism and progress notwithstanding, during the conference call, Children's Place executives adamantly refused to provide any quantitative earnings or expense guidelines for the next quarter. To an analyst's question about the main components of the deteriorating gross profit, an inquiry about past operations, not a request for prediction, the CFO replied: “John, on the gross profit breakdown, we don't specify the amounts, but we do list them in order.” All this, in reaction to an all-around disappointing quarter.1 No wonder that the cheerful, forward-looking message of Children's Place executives didn't do much to lift the spirits of investors: Children's stock price fell by over 5 percent during the call day and the following couple of days.2
While reading the transcripts of scores of conference calls I was occasionally reminded of the classic