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Posted 4/4/2005
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Dear CEOs: Stop fudging your numbers
Note to Corporate America: Cheating to meet an earnings estimate hurts more than an honest miss. Note to SEC: Make them stop.
By Bill Fleckenstein
It used to be that highly respected corporate chieftains were focused on building their businesses with an eye toward the future, and weren't overly concerned with the next 90 days' results. However, since the stock-options era of the mid-1990s, what has often appeared to matter most to those in charge is the business of managing their companies' stock price. Not surprisingly, there is ultimately a consequence to getting one's priorities wrong.
Beat the number, damage the business
Throughout the mania and since, I have written about how companies generically, in an attempt to beat the number -- i.e., the analysts' earnings estimates -- frequently wind up damaging their businesses, sometimes disastrously, as Enron and WorldCom did.
I think that Fannie Mae (FNM, news, msgs) will probably emerge as a classic example of this, as might American International Group (AIG, news, msgs), to cite two financial companies recently in the news. Just last week, AIG was forced to admit that certain transactions "appear to have been structured for the sole purpose or primary purpose of accomplishing a desired accounting effect," that is, to beat its number.
Financial institutions are perfect for managing earnings because they are essentially black boxes. Their accounting is specifically set up so that they can report whatever numbers they want. They can choose to hold an asset for sale or hold it to maturity. Then they can buy or write derivatives against them, and they can change their mind on the accounting for both.
This is why I do not like financial stocks as investments -- though many people have made fortunes on these much-loved black boxes during Greenspan's tenure at the Fed. It's also why I tend to avoid them as shorts, because the accounting is what it is -- making it very difficult to find a catalyst that will cause people to re-evaluate their opinions.
A flogging in financial-stocks' future?
Now, however, it seems to me that there is no shortage of catalysts:- Interest rates are rising.
- There is a black cloud hanging over Fannie Mae, forcing it to be less aggressive in feeding the housing ATM.
- Corporate spreads are widening, thanks to General Motors' (GM, news, msgs) problems. (Ford Motor Co. (F, news, msgs) should probably be included here as well.)
- There is also a black cloud over AIG, which may potentially impact the derivatives industry, since AIG is the big cog in the derivatives wheel.
If additional problems are revealed at AIG, GM or Fannie Mae and if the psychology changes, it will exert a negative influence on how these stocks are valued beyond whatever damage is done to the businesses themselves. Of course, due to the size and influence of the trio, the financial system itself might be negatively impacted.
Related news and commentary on MSN Money
Meanwhile, I'm sure anyone with a pulse realizes that the ability to report whatever number a company chooses is not confined to financial institutions. In the technology arena, I think that lots of companies have also hurt themselves by trying to improve their short-term financial performances in order to keep their stock prices up.
I have discussed this many times vis-a-vis Intel (INTC, news, msgs), as in my Oct. 18, 2004, column, "Intel: All risk, no reward." The chipmaker has attempted to keep margins and average selling prices up -- and therefore prop up the stock price -- as opposed to really focusing on how to innovate and incite end-market growth as best it could. (As an aside, this misplaced focus is what has allowed Advanced Micro Devices (AMD, news, msgs) to swoop past Intel with its Athlon and Opteron processors, a development Intel will pay dearly for one of these days.)
They all fudge, don't they?
Of course, financial and tech companies have no monopoly on the beat-the-number game. This is a gambit beloved of corporate chieftains at large. Indeed, a former HealthSouth (HLSH, news, msgs) CFO testified recently that company founder Richard Scrushy once told him: "All public companies fudge" their numbers.
While Scrushy's credibility is in question, given that he is on trial for accounting fraud, he is correct on this subject, and the fudging has been obvious for a long time. Complex businesses with multifaceted parts do not work in such a way as to constantly arrive at a predictable, prescribed number. For example, why is it that Berkshire Hathaway (BRK.A, news, msgs), unlike its peers, doesn't make its number each quarter? The answer: Berkshire Hathaway isn't reverse-engineering its results to hit precise targets, as so many others do.
Wake up and smell the chicanery, SEC
My belief is that any company that "makes the number" more than twice in a row is probably cooking the books. What I want to know is: Why hasn't the SEC done more to uncover the management of earnings that has gone on? Fannie Mae was found out, in essence, by the Office of Federal Housing Enterprise Oversight. Nearly all of the other chicanery that we have learned about was discovered by New York Attorney General Eliot Spitzer. If the SEC needs more money to get to the bottom of all this, then it should get it. If the SEC doesn't need more money, the regulator should give us an explanation of why it can't seem to expose any of these fraudulent acts until well after they have occurred. If short-sellers can figure it out, why can't the SEC, when it has subpoena power?
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money. At the time of publication, Bill Fleckenstein was Long Fannie Mae puts and Intel puts and short Intel.
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