The Idea in Brief
What made Cisco System’s stock value plunge 13% overnight? A one-cent difference between reported and expected quarterly earnings. Welcome to the earnings game.
Quarterly-earnings reports say little about a company’s financial health. Yet this number dominates—and distorts—executives’, analysts’, investors’, and auditors’ decisions. An example: SmithKline Beecham’s venture-capital unit missed millions of dollars of profit when it refused to sell its hot biotech holdings. Why the refusal? Selling would have boosted quarterly earnings beyond analysts’ expectations—imperiling the company’s ability to meet expectations next year.
As players in this game increasingly view quarterly earnings as collective fiction, they also lose faith in the stock prices these numbers influence. When the connection between stock price and a company’s intrinsic value dissolves, the earnings game can ruin companies and shareholders alike.
Understand these players’ motivations—and this game’s perils—and you just might refuse to play.
The Idea in Practice
Why Quarterly Earnings?
All earnings-game players have reasons for focusing on quarterly numbers:
Analysts: Their pay and reputations hinge on their furnishing constant and correct quarterly-earnings estimates.
Corporate executives: They feel they have no choice—disappointing Wall Street is just too costly for their companies and themselves. Most executives’ compensation packages are tied to stock prices and earnings targets.
Investors: Intense media coverage exaggerates quarterly earnings’ significance and creates a false sense of urgency, compelling investors to act on artificial earnings news.
Accounting firms: Helping clients meet their quarterly numbers nets lucrative auditing and consulting gigs.
Devious Deeds
This collective emphasis on quarterly earnings spawns sleazy practices that can destroy companies. Many of these practices entail “borrowing” sales and profits from the next quarter to cover the current quarter’s shortfall:
Channel stuffing—selling goods to customers who aren’t ready to buy yet. Example:
To inflate earnings, appliance maker Sunbeam sold millions of dollars of backyard grills to Sears and Wal-Mart in midwinter, booking the sales but allowing deferment of payment until spring. By summertime, the retailers already had enough grills, so Sunbeam had no fresh revenue to cover its “borrowed sales.” Humiliated, Sunbeam had to restate several quarters of revenue and earnings. Its CEO was ousted; its customers and investors felt betrayed. Sunbeam filed for bankruptcy protection in February 2001.
Premature revenue recognition—recording a highly contingent transaction as a definite sale. Example:
During 1998–99, Web software developer MicroStrategy inflated revenue measures by booking money it expected to collect from future software upgrades. The impressive figures made MicroStrategy a Wall Street darling; its share price galloped to $333. When the press and SEC discovered the truth, MicroStrategy’s $12.6 million profit reverted to a $34 million loss. Its stock price shriveled to $4.
Hope for Redemption?
To stop earnings-game abuses, executives must take action. One possibility: Introduce a range of quantifiable value measures in addition to quarterly earnings—e.g., training investments, patent-royalty income, new-product introductions. And forbid managers from making “stupid business decisions for the sake of steady earnings.”
Last fall, S.R. One, The In-House venture capital unit of what was then known as SmithKline Beecham, was showing some very impressive paper gains on its biotechnology holdings. Figuring—rightly, as it turned out—that prices for biotech assets were at or near a cyclical peak, S.R. One president Brenda Gavin planned to sell the holdings and realize a tidy windfall for SmithKline, or rather, for its shareholders. Those plans, however, lasted only until Gavin’s corporate masters heard about them. At that point, says Gavin, “The message came down from headquarters: ‘Not another dollar of profit.’”