Hitting the Numbers
Are CEOs too busy managing the stock to effectively manage the company?
During his trial for fraud in 2005, former WorldCom CEO Bernie Ebbers told the jury he was under enormous pressure to "hit our numbers."
By the time the earnings-inflation scheme unraveled and WorldCom filed for bankruptcy protection, the accounting fraud totaled $11 billion. Ebbers, 63, was convicted of fraud, conspiracy and filing false statements with the SEC.
An extreme example? Sure. But it underscores what some see as an ongoing problem for CEOs and investors: Does the short-term outlook needed to achieve a company's quarterly earnings estimates damage its long-term growth prospects? If so -- and if many companies follow this practice -- is the short-term focus a drag on the US economy?
Some argue that a quarter-to-quarter view of corporate governance imposes high costs on stockholders. To meet quarterly earnings estimates, investments in product development or current equipment upgrades may be deferred, or assets may be liquidated to boost current revenue regardless of future profitability.
Constant churn at a company may mean institutional investors hold the stock for shorter periods of time. The result: Increased pressure on the company to goose its stock for immediate gains.
"It's a balancing act," says Tom Eggers, former CEO of Dreyfus and Scudder Investments. "I think good CEOs manage to find company, customer and shareholder attitudes that fit their budgets. You have to balance the need to run and grow your company with things that are nice to have. In a tough environment like we have now, the frills go first. You quickly focus on, say, 4 of the 8 things you thought you needed to grow and the 'nice-to-haves' go out the window. It's a matter of balance and perspective, but from time-to-time, things get out of whack."
Most of the complaints about quarterly earnings estimates come from management - not shareholders. The source of the gripes may illuminate the story.
Quarterly guidance is helpful for shareholders because it provides a quick gauge of how their investment is performing and avoids surprise horror tales at the end of the year. During the Jack Welch era, General Electric (GE) nimbly balanced long-term planning with the pressure to meet quarterly earnings estimates. It remains one of the world's top companies.
Problems arise when quarterly numbers become a goal and everything, including reason, is sacrificed to meet that goal. Used properly, quarterly earnings estimates can be a measure of current performance for top management and investors; in addition, it can be helpful in judging the current status of long-term plans. Current information also adds value to the stock.
The absence of information significantly increases any stock's uncertainty and risk, and may depress its value. This means any news -- even bad news -- is more valuable than no news.
Many companies have eliminated dividends. With greater reliance on capital gains to generate returns, value -- because it relies heavily on growth rates -- becomes highly volatile. An earnings miss, no matter how small, can produce manic swings in the stock price.
Strong quarterly earnings produce a chorus of "Halleluiah!" from the press, burnishing the CEO's image as a wizard. This boosts demand for the stock and gives the CEO a reason to seek a fatter bonus. Of course, that earnings growth may prove impossible to maintain in the long-term - but both investors and top management tend to disregard this fact.
Sarbanes-Oxley imposes a criminal penalty on misinformation. The law was intended to increase disclosure, but paradoxically, makes it prudent for top management to disclose as little as possible. The result: Bland boilerplate drafted with lawsuits in mind, often of little help to investors.
Critics of the emphasis on quarterly earnings say the pressure to meet or exceed analysts' estimates has shortened the average tenure of CEOs to 4.9 years, as compared with 8.9 in 1995. This, critics argue, may undercut a company's long-term prospects.
Shorter tenures may mean CEOs demand larger signing bonuses, plus more generous retirement and severance packages. These factors may erode shareholder value.
Volumes of academic research have been dedicated to this problem, and there's been endless chatter about how to resolve it. The Committee for Economic Development, an independent research and policy organization comprised of about 200 business leaders and professors, offers these suggestions:
- A company's board of directors should support strategic plans with long-range objectives. It should avoid micro-management by reviewing the plan, offering suggestions and holding top management accountable for achieving stated goals.
Executive pay should be linked to long-term performance. The board of directors should be responsible for aligning the pay of top executives with the company's strategic plan.
The board of directors should encourage succession planning in view of shortened CEO tenures. A well-run company should scout talent in house and develop top managers internally to avoid jarring changes in direction when top talent moves on or is forced out.
A company should develop more meaningful indicators of corporate value than quarterly earnings. These might include future opportunities, risks and strategies to help investors assess the quality and strength of the company's future earnings.
A company should consider refraining from issuing short-term earnings guidance. About half of publicly traded companies in the US now issue quarterly earnings estimates.
Clearly, the CEOs of many American companies are doing something right, because they run innovative, world-class companies that reward their shareholders. Think of ompanies such as Google (GOOG), the industry standard for search; Hewlett-Packard (HPQ), long the leader in printers and arguably the top PC maker; Intel (INTC), which in spite of stiff competition may soon find its low-power Silverthorne chip in the iPhone; and Genentech (DNA), perhaps best known for billion-dollar blockbusters Rituxan (non-Hodgkin's lymphoma), Avastin (colorectal and non-small cell lung cancers) and Herceptin (breast cancer.)
"The ability of corporate leaders to absorb new information about markets, technological change and other economic events, make quick decisions to capitalize on such information, and manage associated risks is a strength of the US economy that should not be underrated or lightly discarded," the Committee for Economic Development says in a report. "Ideally, however, decisions that address short-term issues should not sacrifice the achievement of longer-term goals."
When sentenced to 25 years in federal prison in July 2005 (effectively a life sentence), Ebbers said nothing. After all, what tale could he tell that wouldn't be demolished by his fraudulent numbers?
The need to "hit the numbers" may keep CEOs up at night (and force a few to make short-sighted decisions), but only the truly incompetent respond to pressure with criminal acts.
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