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Grease Is the Word
Looking beyond the short-term tyranny of the quarterly earnings report.
By John Buchanan
Every cautionary tale has its emblematic moment. In the case of quarterly earnings guidance, it was this: In early 2005, after eBay reported that it had missed its fourth-quarter 2004 consensus earnings estimate by just one cent, executives and shareholders watched in horror as the company's share price plummeted 22 percent—$17 billion in market cap lost in a single day.
True, missed estimates rarely result in investors inflicting such severe punishment. But the threat is always present, and regardless, no one wants to deliver uncomfortable news to the board, Wall Street, or Bloomberg. So no surprise that management does whatever it takes—within the law, if not reason or good judgment—to meet consensus estimates.
In order to accomplish that dubious and often difficult goal every ninety days, managers may deeply discount their products—thereby cannibalizing profit margins—or find other clever accounting tricks that, in effect, steal from the future to prop up the present. Sometimes managing expectations requires doing the opposite: For instance, within a few months of its (minor) setback, eBay regained momentum and saw revenues soar 37 percent in the third quarter of 2005—but this time management took pains to understate future expectations, and the company's roller-coaster stock ride smoothed out, to everyone's relief. Sure, everyone on the next analyst call understood that eBay was, just maybe, gaming the quarterly earnings system a little—but hey, the system is the system, right?
Except that it doesn't have to be. The majority of public companies strictly adhere to the practice, always looking ninety days ahead, but executives are increasingly grumbling and even balking. Many are openly asking to abolish—or at least seriously overhaul—the longstanding system, insisting that providing a quarterly report card does more harm than good.
The widespread use of quarterly earnings guidance began in the mid-1990s, when Congress moved to protect companies from liability for statements made about projected performance. For enthusiastic and clever practitioners, the new promotional fad promised a trio of enticing benefits: higher stock valuations, lower share-price volatility, and improved liquidity.
Over the ensuing decade, the use of quarterly guidance became a virtual obsession. The result has been a myopic focus on short-term results, says Matt Orsagh, director of capital-markets policy at the CFA Institute. "Each earnings season, it's about who made their penny and who didn't," he says. "It's not about long-term vision for and performance of the company. And the culture of earnings guidance we've gotten into has just reinforced that myopia."
"Did something really just happen that makes that company 10 percent less valuable, or is there an overreaction going on here?"
Jason Schloetzer, an assistant professor of accounting at Georgetown University's McDonough School of Business and a frequent contributor to The Conference Board's Governance and Corporate Values Center, agrees that the net effect of quarterly guidance has been more negative than positive. "The real effect," he says, "has been to create fabricated benchmarks that alter the decision-making of those corporate managers who allow themselves to be driven by the process."
A more readily apparent consequence has been the enormous cost in terms of time, money, and resources that the current system extracts. "Companies spend a lot of time preparing for what they think analysts are going to say and how the market is going to react," says Andrew Edson, a New York-based investor-relations consultant. "That is time and money that could be better spent actually running the company and planning for the long term. I think every company out there would agree with that." Some CFOs spend as much as 20 percent of their time managing earnings reporting and performing for Wall Street analysts to make sure they make their consensus earnings estimates, says Tom Kerr, portfolio manager at Rocky Peak Small Cap Value Fund in Calabasas, Calif.
And, Orsagh says, the often-frenzied dancing sometimes leads to unhappy endings. "To me, the problem is that when you see a company whose numbers have been going up, up, up, quarter after quarter for years and years, that says there is going to be a reckoning some day in the future—and that it is going to be ugly. It means the companies are borrowing from the future, and you can't do that."
In extreme cases, of course, borrowing from the future gives way to outright invention—and blaring headlines. Enron, WorldCom, and HealthSouth were once darlings of Wall Street.
"The Current System Makes No Sense"
Quarterly reports may be popular, but they're hardly universal. In a 2006 analysis, McKinsey & Co. found that of some four thousand companies with revenues greater than $500 million, about 1,600 had provided earnings guidance at least once between 1994 and 2004. And a number of high-profile companies—including Coca-Cola, Google, GE, Berkshire Hathaway, Citigroup, Ford Motor, and Unilever—had publicly sworn off the practice.
It should have been no surprise to see many established companies following their own timelines. In its report, The Misguided Practice of Earnings Guidance, McKinsey looked across all sectors and examined two mature representative industries—consumer packaged goods and pharmaceuticals—and found no evidence to support the promised benefits that had propagated the enthusiasm for quarterly guidance in the first place.
Indeed, McKinsey said, reporting quarterly earnings delivered more risk than reward. "The difficulty of predicting earnings accurately, for example, can lead to the often painful result of missing quarterly forecasts," the report authors noted. "That, in turn, can be a powerful incentive for management to focus excessive attention on the short term; to sacrifice longer-term, value-creating investments in favor of short-term results, and, in some cases, to manage earnings inappropriately from quarter to quarter to create the illusion of stability."
A few months ago, McKinsey released a new report, Avoiding the Consensus Earnings Trap, that raised even more doubts about quarterly guidance. "For example," says McKinsey partner Tim Koller, co-author of the report, "companies that do it are not valued differently from companies that don't."
Nevertheless, McKinsey found, the lingering myth that quarterly guidance delivers benefits has perpetuated its practice—often in ways that conflict with a company's genuine best interests. "Executives often go to some lengths to meet or beat consensus estimates—even acting in ways that could damage the longer-term health of the business," the report said.
Even more damning, Orsagh says, is anecdotal evidence that as many as three-quarters of executives admit they would, in effect, be willing to do things they knew were potentially detrimental to their employers' long-term interests in order to make their quarterly numbers.
As a result of such awkward self-realization and underlying reality, more and more senior executives have begun to question the practice. In the wake of the 2008 financial market meltdown—and further evidence of the things companies will do to satisfy Wall Street demands for results—enthusiasm for reporting every ninety days has diminished further.
"I think much of the decline in quarterly guidance given by companies since the financial crisis has been largely due to the awareness among those companies of their inability to accurately forecast quarterly performance," Schloetzer says. "And rather than providing a number that then becomes an external target that the company then misses—because of the volatility of their business or because of the general economic climate—more companies have just decided they prefer to go silent and not provide quarterly numbers."
Indeed, a startlingly high percentage of Fortune 500 CEOs and CFOs have increasingly concluded—based as much on common sense as research from McKinsey or CFA Institute—that the practice of quarterly guidance is more nuisance than salvation. Most informed observers agree that as many as 98 percent of top executives would admit privately, if not in public, that they would prefer to see quarterly guidance ended.
Koller and Orsagh agree that a vast majority of C-suite executives would personally like to see the present guidance system dismantled. "For example, we host a series of CFO roundtables," Koller says. "And that is often the strong consensus. So I think it is true that CFOs of big companies would be happier without the current system."
Kathleen Brush, a former public-company CEO who is now a management consultant, explains why: It's because they have seen the lunacy that goes on behind the scenes when their companies are scrambling to meet their quarterly earnings targets. They are finally realizing that the current system makes no sense.
The Conference Board
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