The Earnings Waltz: Is the Music Stopping?
nytimes.com
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New York Times
October 24, 1999
MARKET WATCH
The Earnings Waltz: Is the Music Stopping?
By GRETCHEN MORGENSON
NEW YORK -- Almost two out of three companies in the Standard & Poor's 500-stock index have reported earnings that exceeded analysts' expectations for the third quarter. So why is the index itself up only 1.47 percent since the quarter ended?
Fears that rising interest rates will cut corporate profitability have contributed to the S&P's malaise in October. And warnings that fourth-quarter earnings might disappoint are keeping a lid on some stocks.
But here's another theory for why great earnings are not translating into ever higher stock prices today. Investors may be realizing that positive earnings news is less an indication of a company's financial health than it is evidence that the company is good at playing the earnings management game.
Quarterly earnings announcements have been a well-choreographed waltz for some time. As investors relied more on short-term earnings forecasts to help them value shares, astute executives learned to manage expectations for their companies' performance down to a level that they could then breeze past.
Evidence of how well companies have managed earnings can be seen in the number of reports that beat Wall Street estimates by a single penny a share. According to Thomson/First Call, of the 311 S&P companies that have reported earnings for the third quarter, 21.5 percent beat their estimates by one cent. In each of the last six quarters, 18 percent of companies, on average, beat their estimates by a penny.
Paired with management in the earnings waltz were security analysts who are supposed to conduct independent research on companies they follow. As quarterly earnings numbers became paramount, analysts grew more dependent upon company management for "guidance" to the correct earnings forecast. The more help they received, the less work they did.
This dance went smoothly for awhile. Companies met or beat the analysts' estimates and their stocks went up.
Now, however, many companies who had been great at managing earnings are caught in a vise of rising expectations: A company that merely matches Wall Street's forecasts in a given quarter may see its stock price tank on the news.
Tony Crooks, a research analyst at Thomson/First Call, explained it this way: For a company that has beaten Wall Street's forecast by a penny a share over the last eight quarters, beating the number by a penny soon becomes the equivalent of matching expectations. As a result, he said: "Now you have to beat by two pennies to get a positive surprise." Managers have to run faster to stay in place.
If they don't, they are taken to the woodshed. Louis V. Gerstner Jr., chairman of IBM, had been a master of the earnings game until last Thursday when he stunned investors with a 1 percent drop in hardware sales in the third quarter and forecast weakness in coming quarters. IBM shares fell 15 percent.
Such is the dark side of earnings management. After years of watching executives achieve more than expected, investors punish those that no longer can. With the market trading near its record highs, there is less margin for error than ever.
"If a penny a share is that critical to the value of the company, then the stock is overvalued," said Robert A. Olstein, manager of the Olstein Financial Alert fund. "Investors are starting to see the ridiculousness of the situation. It's starting to unravel and that's why you're seeing these tremendous corrections."
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-Eric |
