April 14, 2004
Tracking the Numbers
Street Sleuth: Corner Office
Managers' Focus Is to Hit
Targets, Smooth Earnings,
Sacrificing Future Growth
By JUSTIN LAHART
Staff Reporter of THE WALL STREET
Given the choice between hitting earnings expectations and missing them
in order to improve their long-term financial health, most U.S. companies
would go for the short-term target.
So say the results of a survey by professors at Duke University's Fuqua
School of Business and the University of Washington.
In an effort to determine the degree to which companies will use legal
accounting actions to smooth earnings and meet analyst estimates,
professors Campbell Harvey and John Graham of Duke and Shiva Rajgopal of
the University of Washington surveyed financial executives at 401 firms
late last year and conducted extensive interviews with 20 senior
executives. To the professors' surprise, the financial officers were eager
to talk about how companies would forgo projects that would give them
economic gain in order to put a finer gloss on earnings.
"The thing that stunned us was that they were so up front about taking
these real economic decisions to manage earnings," Mr. Harvey says.
Targets vs. Health
What would you do to meet analysts' earnings expectations for your
company? See how 401 financial executives
responded to a scenario posed to them by professors at Duke University's
Fuqua School and the University of Washington.
In one of their survey questions, the researchers presented the
executives with a situation where earnings may come in below their
company's desired target and presented them with a choice of actions they
could take. Close to 80% said they would decrease discretionary spending on
items like research, advertising and maintenance to meet the target, while
more than half said they would put off starting a new project even if that
meant a small sacrifice in value.
Another question presented a situation wherein a new opportunity arose
late in the quarter that would generate a rate of return well in excess of
a company's cost of capital -- in other words, it would boost long-term
profitability -- but it would detract from earnings in the present quarter.
If taking on the project meant earnings would slip to just meeting, rather
than exceeding, analysts' consensus estimate, 80% of companies said they
would pursue it. Apparently, beating estimates -- not just meeting them --
is a priority at some firms. If taking on the project meant missing the
estimate, rather than meeting it, just 59% of respondents would go forward
In the interviews, conducted by Mr. Harvey and Mr. Graham, company
executives gave concrete examples of ways in which they had sacrificed the
long-term health of the company in order to meet analyst estimates. One
spoke of having the financing available for six valuable projects, but only
going forward with three in order to ensure that analyst earnings
expectations were met. Falling short of expectations, this executive said,
would put his job in jeopardy.
In another interview, an executive told of a situation where his company
had an unexpectedly large gain on an investment. Taking the gain, the
company surmised, might lead analysts to ratchet up future earnings
forecasts to the point where it would be difficult to meet them. Rather
than face that, the company went to an investment bank that designed
investment vehicles that allowed it to smooth the gain over the following
10 quarters, according to the executive. Such a move is costly, points out
Mr. Harvey. Traditional theory would hold that taking the gain up front
would be more valuable.
Along a similar vein, some executives spoke of how they would put off or
only do minimal maintenance in order to hit targets, even though this meant
that equipment would wear out more quickly, entailing costly replacements
down the road. A chief financial officer at a research-intensive firm spoke
of how research and development spending is curtailed when there's a danger
that earnings will come below what the company has indicated -- even if the
R&D was adding to the company's net-present value. Conversely, if
results were coming in ahead of expectations, R&D spending would get
ratcheted up. Such tactics create a smoother earnings stream, which many
investors equate with financial stability.
Such thinking is anathema to Mr. Harvey: "If something of value is on
the table, you should take it, because that's what's good for shareholders,
and that's what's good for the economy," he says.
In their forthcoming paper, Mr. Harvey and his co-authors point out that
many executives feel that they are unhappily locked into a situation where
the short-term focus of the market has affected their behavior. One CFO
talked of how "analysts viciously turn on you when you fail to come in line
with their projections." Mr. Harvey thinks that executives' frankness in
detailing how they would give up economic gain to hit short-term targets
may be tantamount to a cry for help -- that they're desperate for a change
in the status quo.
Many in the investing community, too, decry what they see as an
excessive focus on short-term factors within the stock market, even after a
rash of accounting scandals.
"It's a phenomenon that's gathered steam," says Steve Henningsen, a
financial adviser at the Wealth Conservancy in Boulder, Colo.
Mr. Henningsen believes that it's mostly professional investors, such as
fund managers, themselves increasingly guided by quarterly performance, who
are responsible for this. In the fight to keep up with their peers and
their benchmarks (not always the same thing as delivering consistent
returns), managers tend to sway with the crowd rather than think for the
But Jeff Bronchick, chief investment officer at Los Angeles
money-management firm Reed Conner Birdwell, believes that companies are
complicit in the market's short-termism and that it's their responsibility
to break the cycle.
"If companies get trapped in near-termism, they will attract
shareholders that are looking at the near term," he says. "Treat
shareholders like they were business partners. Who wants to run a business
where your business partner is going to dump you for missing [earnings] by
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