Beating the Street
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PAUL SOLMAN: The end of winter, and time for an American ritual.
The quarterly earnings report — and the quarterly pressure on corporations to please investors by showing growth: Higher profits than in the previous three months of the year.
The pressure to show rapid growth increased dramatically, it seems, during the boom 1990′s on Wall Street and seems to have influenced the accounting antics at Enron, Global Crossing, Qwest and the like that have made these firms infamous.
No one’s accusing all of corporate America, of course, but in recent years, more and more companies seem to have used more and more gimmicks to boost their reported profits….pushing the envelope of honest accounting.
Now please allow us a little poetic license, since we’re about to explain some of those gimmicks as they might be used by a fictional firm we’ve named, Tortillas Flat, in honor of writer John Steinbeck’s 100th birthday.
We’re doing this at a real tortilla factory — thus the hairnet legally required by the FDA.
The factory is run by the country’s top tortilla maker, Mission Foods, which was nice enough to lend us their facility in Pueblo, Colorado, for the occasion.
But before we demonstrate the gimmicks, a word about what drives them: the need to report ever higher earnings, to reassure investors about our company’s future.
PAUL SOLMAN: John Karns is a professional investor.
JOHN KARNS: So we’re looking at what’s happening currently to give us a window into what’s going to happen in the future. What we’re really looking at, we’re paying for is the future earnings potential of that company.
PAUL SOLMAN: Because that’s where the share of stock is worth.
JOHN KARNS: Sure, sure.
PAUL SOLMAN: Okay, a brief explanation. A company is worth no more or less than all the profits — the dough — it’s expected to earn in the future.
A share of Tortillas Flat, then, depends on how profitable we’re going to become: very — not very.
If investors think we’re a Mexican food Microsoft-in-the-making, that is, that our profits will keep expanding, a share today, our slice of the total will be worth more.
PAUL SOLMAN: But, if our profits look like they’ll be small, then our share — or cut of them, even if it’s the same percentage of the company — will be worth a lot less.
Thus, the question behind this story: How do we keep reporting higher profits… to keep investors hopes and our stock price up?
LYNN TURNER: What are some of the aggressive practices that you think are out there that we as auditors would have to keep our eyes on…
PAUL SOLMAN: The Securities & Exchange Commission’s former chief accountant, Lynn Turner, shared some of the most popular techniques with his college accounting class, and with us.
LYNN TURNER: There is a culture of gamesmanship going on where people really do try to game the number.
PAUL SOLMAN: One common way of hiking profits is called “stuffing the channels.”
Say Tortillas Flat’s top customer, a fast food chain we’ll call “The Big Enchilada,” cuts back on its tortilla orders — our sales will drop and profits will be flat.
But, if “The Big Enchilada” can be persuaded to take delivery of the tortillas it was expected to buy and stow them away for later use, the folks at Tortillas Flat can claim them as sales, even if they haven’t been paid for yet.
After all, they shipped them out the door.
On the other hand, it’s a short-term fix, according to Lynn Turner.
LYNN TURNER: What that means is if The Big Enchilada’s got so many tortillas sitting out there, they aren’t going to need as many next quarter and the chances are that sooner or later, you’re going to fall short and the investors are going to be surprised.
PAUL SOLMAN: Now if your customer won’t store your product, there’s an alternative: pay a warehouse to do it.
But says money manager John Karns, its the same short term fix, which comes with the same problem.
JOHN KARNS: They could just ship pallets and pallets of, of tortillas and recognize the revenues and have a great revenue quarter. The problem is they all sit somewhere in the warehouse, they go bad, they get returned…
PAUL SOLMAN: And you’re in deeper trouble next quarter. So maybe– for us here at Tortillas Flat, how about another widely used trick?
We sell something we own, like one of our factories and every piece of machinery in it. But instead of candidly reporting it as a one-time windfall, we use the proceeds to make ourselves seem more profitable.
Specifically, we deduct the sales price from our corporate overhead account. So reported overhead goes down, implying we’ve cut costs, and are therefore operating more efficiently, more profitably.
PAUL SOLMAN: Forbes Magazine explains how IBM has been doing this for years, again, to keep its profits growing, smoothly and regularly. And money manager John Karns says Coca-Cola has managed its reported profits by buying and selling it’s bottling companies.
Not that there’s anything wrong with it legally, but this technique has troubled the SEC enough to clamp down on it, suggesting that at Tortillas Flat we shouldn’t so asset sales as profits.
So how about copying yet another widely used practice: companies puffing up their bottom lines with — get this — stock gains from the pension money they’ve invested to pay their retired employees?
LYNN TURNER: They’ve invested heavily in the stock markets. And because the stock markets have done so well in recent years, 20, 25 percent returns, they’ve actually, instead of showing expense, shown an income from all the money that they’ve made on the stocks that are going to be used to pay off those pensions in the past.
PAUL SOLMAN: This form of financial flexibility — or manipulating the dough – was used in the old economy and in the new one, as Lynn Turner discovered when he was at the SEC, investigating Qwest, whose only profits, it turned out, came this way.
LYNN TURNER: All of the profit that the bottom line of Qwest, had come from the pension income.
PAUL SOLMAN: All of it?
LYNN TURNER: All of it.
PAUL SOLMAN: When the stock market sank, of course, the profits disappeared; the trick was useless.
Now at this point, you may have the same question we did: who comes up with all these techniques? Cunning consultants? Slippery CEO’s?
No, says Lynn Turner, the same folks who supposedly audit the company.
LYNN TURNER: All the Big Five accounting firms have a group of accountants within their organizations that do nothing, quite frankly, but work with Wall Street, trying to figure out how to get around the rules.
PAUL SOLMAN: Small wonder, then, that Enron’s auditor, for example, approved of Enron innovations like its so-called SPE’s – the “Special Purpose Entities” with the playful names — Raptor, Chewco, Hawaii 125-0 — partnerships Enron controlled, but treated, for reporting purposes, as independent companies, to boost its profits, hide its debts.
Arthur Andersen may actually have concocted many of them, to stay a step ahead of the rules being written to keep things on the up-and-up.
LYNN TURNER: Before the ink dries, they’ve got a new way to manufacture these financial transactions that really hide things from investors.
PAUL SOLMAN: We tried to come up with our own SPE, “Tomatoes of Wrath” salsa company, but decided in the wake of Enron it may be too dicey.
So here’s one last technique we might try: the swap.
PAUL SOLMAN: This is a trick practiced by the telecoms, Qwest and Global Crossing. They’d both laid miles of fiber optic cable that wasn’t being used. So they sold the idle lines to each other.
That’s right, it was really a swap, but both companies reported the sales as profits, the expense of buying the other guy’s cable would be written down slowly over years.
JOHN KARNS: So, I presume you plan to sell flour to somebody. They’re going to sell it back to you.
PAUL SOLMAN: Actually lard — a tub of lard.
That is, if we were stuck with some idle investment, say too much lard, one of the key ingredients in tortillas, we’d try to find another tortilla maker with too much lard, sell tubs of lard to each other, report the sales as profits, but amortize the cost over time as an investment.
And we could claim almost any price at all for selling lard….
JOHN KARNS: Which is, which is not a commodity that really is priced in the open market.
PAUL SOLMAN: Which is good for me.
JOHN KARNS: Yeah, absolutely it is good for you.
You know what? If you do that, it would probably be hard for me to discover it outright. But it will show over time — because it will have to unravel over time eventually. Either you’ve got a lot of lard on your books or something starts to show up.
PAUL SOLMAN: “Something starts to show up.” That is — once again the same problem looms — with channel stuffing, asset dumping, pension pinching, special purpose entities, swaps. You’re buying time by fudging this quarter’s results.
LYNN TURNER: But what do you do next quarter then when the business is still off? You start playing games with the numbers and you manage the numbers rather than managing the business.
And the very problems in the business that create those shortfalls in the numbers never get addressed.
PAUL SOLMAN: On the other hand, the pressure’s on to perform this quarter. It’s on the companies and on those who invest in them, like John Karns.
When he joined West Corp Funds a decade ago, mutual fund managers looked at earnings over a period of a year or two, he says.
JOHN KARNS: But it’s become such that it was half a year and it was quarterly and you can even press it down to weekly.
There are companies who give weekly indications on what their sales are doing or give weekly indications on their business. But what tends to happen with the market is the market is so focused on what are you going to make next quarter and then once you get there, what are you going to make the next quarter that it has a very hard time of saying, what’s going to happen over time?
PAUL SOLMAN: There’s a clear and present danger here. the value of our company depends on its cumulative, long-term profits.
But if Wall Street’s best indicator of long term profits is short term profits — rising every quarter — but in fact rather precariously — then the pressure on executives is to look good short term at a possible cost of the underlying, long term health of the company and thus the real value of its shares.
LYNN TURNER: It’s not just Enron. But it’s one after the other: Cendant, Rite-Aid, Xerox, Lucent, W.R. Grace. It goes on and on.
PAUL SOLMAN: Don’t you have any sympathy for the managements of these companies that have to report higher and higher numbers?
LYNN TURNER: I have a tremendous amount of sympathy for the executives.
It’s always, what have you done for me this quarter? And if the executives don’t make it next quarter, they’re gone. The average CEO today only has a three- or four- year life span as that before their turn around and, and gone. It’s phenomenal, phenomenal pressure on them.
PAUL SOLMAN: Phenomenal pressure on executives, which had caused some — perhaps more and more of them– to go over the line.
It may have been bad for American business. On the other hand, consider this: The U.S. has been criticized for short-term thinking since at least the 1970s. And yet, you could argue we’ve outperformed every economy on earth.
If you run an operation like Tortillas Flat, then, you could play it safe and never stretch the truth about your business, as so many others seem to — or you could keep investors happy by accentuating the positive, reporting ever higher earnings, and — please forgive us — letting the chips fall where they may.