Next week is the start of the second quarter earnings season on Wall Street. It’s perhaps the most consequential quarter of financial guidance we’ve had since the Great Depression.
During the last few weeks, companies have been pulling their previous earning guidance left and right, because the information is quickly becoming obsolete and stale, due to the economic impact of COVID-19.
However, there’s a deeper question to examine: was the ritual of quarterly earning guidance ever a useful indicator to predict the future? Was it ever not stale?
Earning Guidance Kabuki Dance
The most generous interpretation of the usefulness of quarterly guidance is that it helps investors prepare for changes in either the market conditions or the company. In reality, it’s a kabuki dance between the company management slash investor relations office and the analysts who cover the company. They both manipulate and coordinate with each other in subtle ways, so most, if not all, of the time, the company’s earnings exceed the analysts’ expectations.
The class of Wall Street analysts is an essential element of the financial media industry. Just like the media, they like to fuel a storyline and pick winners and losers. However, they seem to never be held accountable for being wrong. I’ve yet to see an analyst get fired for being wrong on his or her price target prediction. Since there’s no deadline on when a prediction expires, you can always argue that given enough time, a prediction will be right eventually, thus you are never “wrong”.
As long as analysts play along, there are three types of levers that company management can pull to “control” the earnings it reports -- real, accrual, and expectation management -- according to this paper written by Professor Thomas King of Case Western University.
In plain terms, “real” is an operational lever to control or cut costs in R&D, marketing budget, headcount, etc. which can all be done, more or less, with the snap of a finger by upper management. When the amount and/or growth of your expenses become a relevant factor in your guidance, controlling them can help the company score consistent earnings beats. For example, see how from 2013-2018 Facebook has used its guidance to have its expenses always come under or in-line with expectations:
“Accrual” is basically accounting tricks applied to increase earnings by changing some underlying assumptions about either the asset or liability portion of the company’s balance sheet, so it gets valued differently enough to make earnings look good.
“Expectation management” is more or less “sandbagging” the Wall Street analysts. By chatting via private conversations, the CEOs and other executives can get into the analysts’ heads, so whatever is the consensus expected earnings these analysts come up with, the company management has a good idea of what they are and figure out ways to beat them.
(An aside: this type of “expectation management” is quite common in political campaigns, where a campaign’s spokesperson (“investor relations”) constantly massages the expectations of the news media (“analysts”) heading into a big debate, so the candidate always “wins” the debate by exceeding those expectations (“an earnings beat”). Not surprisingly, the best political communications talent often ends up working in corporate communications of big companies when they leave politics.)
One common method that’s been in vogue is stock buyback programs to boost earnings-per-share (EPS) -- one of the two most important numbers to beat in guidance; the other being revenue.
Perhaps the most expensive example of stock buyback in the last decade was IBM’s, which amounted to nearly $40 billion USD between 2010-2015, for the purpose of achieving its highly-public pledge to shareholders of achieving $20 operating EPS over those five years. Consequently, its share price during the same period increased quite a bit for some time, but eventually ended up where it started:
Were those billions of dollars in cash well spent? I don’t think so. I’ve been skeptical of stock buyback programs, especially for companies that need growth drivers and product innovation, like Dropbox. IBM falls in that category too, as it tries to catch up to AWS, Azure, and others in the cloud market.
This earning guidance kabuki dance is both laborious and expensive for company management. So why go through with it every quarter?
CEO Compensation and Credibility
The obvious answer, which happens to be by-and-large the right answer, is the CEO’s equity-based compensation. Positive future predictability, as demonstrated by consistent earnings beats, is rewarded with a higher valuation and stock prices. It’s partially why SaaS companies, with their supposedly predictable business model of recurring subscription revenue, have been rewarded with high valuations relative to their revenue. And higher stock prices lead to more compensation for the CEO, because more and more of CEO compensation is tied to some form of equity, either stock or options.
Based on research by Stanford’s Graduate School of Business, more than half of a CEO’s compensation package is equity-based -- a trend that is growing rather quickly during the last couple of decades.
Combining this trend with a steady decline in median CEO tenure from six years in 2013 to five years in 2017, as shown in this Harvard Law School research, it’s not surprising that earning guidance is being used and abused to maximize share price increase in the short-term.
To be clear: this is not just another one of the many articles out there railing on CEO pay. CEOs are not completely to blame for this phenomenon. There are two other dimensions at play here.
One dimension is the lack of oversight from independent directors on the Board. These directors are supposed to keep the CEO accountable, and stop him or her from doing things that would harm the long-term prospect of the company. Yet, many of these directors are paid purely or mostly in cash, meaning they have little vested interest in shaping the company but every interest to not be a pain in the neck to the CEO, in order to keep the directorship. From a compensation perspective, these independent directors are about as invested as the hourly worker or part-time contractor; they just want to get paid and go home. Checking how a public company’s directors are paid by reading their SEC 14A filings is a good way to evaluate their incentives. This observation is not new. Warren Buffett has criticized this phenomenon publicly, to no avail.
The other dimension is the strange logic that consistent quarterly earnings beat is how a company shows managerial competency and credibility. In fact, of the CEOs and CFOs interviewed in Thomas King’s paper mentioned above, quite a few expressed that being able to deliver on a guidance’s promise directly impacts the CEO’s credibility and trustworthiness, even on a personal level. This is strange because each guidance is supposed to be an honest attempt at predicting the business’s future. We all intellectually know that it’s impossible to consistently predict the future. A company that can always predict its own future ought to seem fishy and less credible, not more. A company whose future forecasts sometimes hit and sometimes miss should be deemed more credible, if only because its prediction track record is more reflective of reality. Judging from this dimension, it’s no wonder controlling operational costs, applying accounting tricks, buying back shares, and other methods are used to make the future seem more “predictable”; they are all under the CEO’s control and out of the realm of natural future uncertainty.
As an operator, I’m sympathetic to the CEO position, no matter how big or small the company is. It’s the toughest job, the loneliest job, and the buck must stop with whoever has that job. The problem is not that we have a bunch of terrible short-term thinking CEOs and need to be replaced with better long-term thinking CEOs. The problem is the CEO’s current incentives, situated in a complex web of actors with their own incentives, that are all out of whack. Every person, no matter how intelligent, capable, or honest, is a prisoner of his or her incentives.
While COVID-19’s economic impact is still unfolding in real-time, it’s likely that the American economy will never return to its former self. Nor should it. One silver lining of the coronavirus pandemic is that it ruthlessly exposes the corporate excess, income inequality, government ineptness, and structural fragility in our society.
There’s no good reason to hold on to any of that and yearn for the good ol’ days. Certainly not a ritual as stale and counterproductive as the quarterly guidance. Corporate Europe has already mostly gotten rid of it. Maybe it’s time for Corporate America to do the same, reset, look inward, and, as Charlie Munger’s timeless wisdom suggests, “get the incentives right.”
Thank you to a good investor friend of mine whose newsletter inspired this topic and discussion.
Chinese Version Below
Case Western大学的Thomas King教授的一篇论文指出，只要分析师配合，公司管理层就可以利用三种方法来“控制”每季度报告的收益：运维管理、财务管理和预期管理。