The dangers of earnings management

While we are on the subject of earnings management, let me highlight today’s Washington Post column by Steven Pearlstein — Leap of Illogic on Wall Street Leaves GE Flat-Footed — on the dangers:

Over time, this strategy has made GE the stock to own for long-term investors looking for “a safe and reliable growth company,” as [GE CEO Jeff] Immelt likes to put it. Unfortunately, under his predecessor, this wonderful reputation somehow got transformed into a solemn promise to deliver double-digit earnings growth every quarter, and to do so in a way that precisely matched the earnings guidance provided by the company. To meet those expectations, GE has become suspiciously adept at booking revenue and expenses and timing asset sales to meet earnings estimates with amazing precision and consistency.
The extent of this earnings management was revealed last month when an embarrassed Immelt explained that GE’s failure to hit its quarterly number was a result of the credit crisis, which in the past two weeks of the quarter had suddenly and unexpectedly reduced the market value of securities holdings and prevented it from completing anticipated real estate sales. But rather than acknowledging the folly of predicting quarterly results in the midst of a financial panic and worldwide economic downturn — particularly for a company reliant on financial services and “lumpy” industrial sales — Immelt prostrated himself before analysts and promised it would never happen again.

The problem Pearlstein notes, however, is that this strategy can come back to bite you:

Having decided that GE’s earnings surprise was the result of flawed corporate strategy, it was easy for Wall Street’s analysts to take the next leap of illogic and conclude that salvation could come only from buying and selling assets. That, by coincidence, just happens to be the only course that generates fees for Wall Street brokers and investment bankers. If Immelt had dared to tell them the truth — that he needs the cash generated from some of these maturing businesses to invest in new markets and new technologies for the long term — he would have sent GE shares into a tailspin.

Pearlstein is clearly frustrated with the way Wall Street treats such companies:

Immelt has the right strategy for General Electric, and he’s the right man to execute it. But he risks being frustrated in his efforts if he cannot transform his company’s relations with investors and opt out of the mindless earnings-expectation game. General Electric didn’t become a great company just by buying and selling assets — it did it by creating innovative products and continually finding better ways to produce them. It won’t remain a great company if it allows stock flippers and Wall Street analysts to distract it from its mission.

Right on: I have argued the same point in numerous posting on this blog. The problem is what to do about it. In part, it is a case of corporate relations. Watching a recent CNBC special on Warren Buffett, it was clear that he has done a masterful job of picking his stockholders by encouraging long term investors and discouraging short termers. Of course a Class A stock price of $100,000 helps in that regard – and it has not stop some from shorting the stock. It just means that Buffett doesn’t worry about the short term movement in the stock. But not everyone is a Buffett.
There is the United Technologies Corporation approach to highlight the company’s reputation and intangibles. UTC undertook a systematic effort to let Wall Street know about all the various aspects of their business and the strength of their intangibles.
Then there is the option of going private. Some have suggested that the best way to keep a company innovative to take the company away from Wall Street (for example, see The Gartner Fellows: Clayton Christensen’s Interview Part 1). This can be either through the existing private equity markets (at the risk of debt-overloading) or these new private trading markets.
Ultimately, there is the systemic issue of speculation. Speculation will always be a part of markets (a necessary part some would argue). But the issue is whether speculation or long term investment drives the market price. My preference is for long term investment. When speculators drive markets, markets fail — they turn into bubbles. But I would not ban speculation. My favorite solution is the sliding scale capital gains tax. Tax short term profits at a much higher rate than long term returns. That would help discourage the stock-flippers Pearlstein (and others) worry about.

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Changing nature of supplier relationship in IT

Is IT becoming just another supplier relationship? According to a story in today’s Wall Street Journal – Competitive Approach Taken to Outsourcing, that seems to be what is happening:

The shift marked one element in a broader transformation in the IT-services industry: Rather than simply handing over the keys to the tech department to one provider, businesses are increasingly signing shorter outsourcing deals with multiple firms that have employees around the globe. Often, they hire multiple firms to work on the same project.

Years ago, the business mantra was get close to your suppliers. Then came the “china price” — low cost sources from China in manufactured goods and India in IT services. Companies got close enough to their suppliers to say “match the price or I am out of here.” IT did the same, but still in the traditional way of large multi-year contracts. That appears to be changing. Is the result making IT services just another commodity (as Nicholas Carr argued a few years ago)?

Lessig on new orphan copyright bill

Larry Lessig on the pending “orphan works” copyright bill — Little Orphan Artworks – New York Times

The solution before Congress, however, is both unfair and unwise. The bill would excuse copyright infringers from significant damages if they can prove that they made a “diligent effort” to find the copyright owner. A “diligent effort” is defined as one that is “reasonable and appropriate,” as determined by a set of “best practices” maintained by the government.
But precisely what must be done by either the “infringer” or the copyright owner seeking to avoid infringement is not specified upfront. The bill instead would have us rely on a class of copyright experts who would advise or be employed by libraries. These experts would encourage copyright infringement by assuring that the costs of infringement are not too great. The bill makes no distinction between old and new works, or between foreign and domestic works. All work, whether old or new, whether created in America or Ukraine, is governed by the same slippery standard.

As a result, “The only beneficiaries would be the new class of ‘diligent effort’ searchers who would be a drain on library budgets.”
So, once again, is Washington about to create another Experts Full Employment Act?
Lessig does have a solution:

Congress could easily address the problem of orphan works in a manner that is efficient and not unfair to current or foreign copyright owners. Following the model of patent law, Congress should require a copyright owner to register a work after an initial and generous term of automatic and full protection.
For 14 years, a copyright owner would need to do nothing to receive the full protection of copyright law. But after 14 years, to receive full protection, the owner would have to take the minimal step of registering the work with an approved, privately managed and competitive registry, and of paying the copyright office $1.

Pattern copyright after patent law? Interesting. (And who says this guy is anti-IP?)

The valuation crisis

Apropos the last posting on “earnings management”, do we now need a new term for “asset valuation management”?
See this story from last weeks’ New York Times – A Values Debate (Not the Political Kind) –

But on Thursday, at conference hosted by Standard & Poor’s in New York, several bankers complained that they have felt pressured by accountants and regulators to undervalue assets in recent months.
Accountants countered that the bankers, like any investor or homeowner, simply do not like seeing their investments drop.
“People were saying, ‘We’ve got to face up to the fact that we are selling things we don’t know how to value,’ ” said Rebecca T. McEnally, senior analyst at the CFA Institute, a nonprofit organization for investors.

I think Ms. McEnally is exactly right. But it does not extend solely to existing exotic financial instruments. There are a number of hard-to-value assets which are traded every day — many of which fall under the classification of “intangibles”. Since the markets for these assets are thin, it is difficult for outside parties to understand the valuation — which is created in a private negotiation between the buyers and sellers. What new need is a system for better transparency in these hard-to-value assets. And a greater understand and appreciation for their volatility. Any system created to deal with the current hard-to-value financial instruments needs to also understand these other assets — and can be used for a more general model of asset valuation, including for intangibles.

Earnings manangement – on the downward side

Stories about companies’ “earnings management” are well known. But here is a study about using earnings management in a different way — not to manage the perception of Wall Street but to manage the perception of Washington — Accounting Information as Political Currency — HBS Working Knowledge:

Such “downward earnings management,” as it is known in accounting, seems to have been motivated by the desire of contributing firms to not taint preferred candidates with association to the political red flag of 2004—outsourcing—as well as to ensure future benefits and avoid future costs in regulatory matters.

Is “earnings management” a part of reputation management? And should we classify it as an intangible capability?

Entrepreneurship as the next American frontier

An interesting essay by Michael Malone in today’s Wall Street Journal (The Next American Frontier):

The entire world seems to be heading toward points of inflection. The developing world is embarking on the digital age. The developed world is entering the Internet era. And the United States, once again at the vanguard, is on the verge of becoming the world’s first Entrepreneurial Nation.
At the Chicago World’s Fair in 1893, Frederick Jackson Turner delivered a paper to the American Historical Association – the most famous ever by an American historian. In “The Significance of the Frontier in American History,” he noted that, according to the most recent U.S. census, so much of the nation had been settled that there was no longer an identifiable western migration. The very notion of a “frontier” was obsolete.
For three centuries the frontier had defined us, tantalized us with the perpetual chance to “light out for the territories” and start our lives over. It was the foundation of those very American notions of “federalism” and “rugged individualism.” But Americans had crossed an invisible line in history, entering a new world with a new set of rules.<br
What Turner couldn't guess was that the unexplored prairie would become the uninvented new product, the unexploited new market and the untried new business plan.

Malone highlights a number of changes taking place in the I-Cubed Economy, such as more innovation, more technology, more start-ups and more networked production. Not sure all this adds up to an “entrepreneurial” nation. But it does, as we have argued in this blog, mean major shifts. As Malone says:

The economy will be much more volatile and much more competitive. In the continuous fervor to create new institutions, it will become increasingly difficult to sustain old ones. New political parties, new social groupings, thousands of new manias and movements and millions of new companies will pop up over the next few decades. Large corporations that don’t figure out how to combine permanence with perpetual change will be swept away.

But, that could be said for a number of eras in history – including the relatively short period of American history. Things change and things remain the same. It will be interesting to see what part of the “permanence” remains as part of this latest upheaval.

Reviving an intangible

The Sunday New York Times magazine had a great story on Can a Dead Brand Live Again? — about reviving old brands. The story focuses on the brand management company of River West Brands:

Marketers like to talk about something called brand “equity,” a combination of familiarity and positive associations that clearly has some sort of value, even if it’s impossible to measure in a convincing empirical way. Exploiting the equity of dead or dying brands — sometimes called ghost brands, orphan brands or zombie brands — is a topic many consumer-products firms, large and small, have wrestled with for years. River West’s approach is interesting for two reasons.
One is that for the most part the equity — the idea — is the only thing the company is interested in owning. River West acquires brands when the products themselves are dead, not merely ailing. Aside from Brim, the brands it acquired in the last few years include Underalls, Salon Selectives, Nuprin and the game maker Coleco, among others. “In most cases we’re dealing with a brand that only exists as intellectual property,” says Paul Earle, River West’s founder. “There’s no retail presence, no product, no distribution, no trucks, no plants. Nothing. All that exists is memory. We’re taking consumers’ memories and starting entire businesses.”
The other interesting thing is that when Earle talks about consumer memory, he is factoring in something curious: the faultiness of consumer memory. There is opportunity, he says, not just in what we remember but also in what we misremember.

The trick, of course, is to find the right partners to make the products in such a way as to tap into those memories. For example, reviving Nuprin as a heartburn drug probably wouldn’t work. But creating a slightly different set of Eagle snacks (another River West brand) that the original probably would. As the story notes:

One of Paul Earle’s professors at Kellogg was John F. Sherry Jr. (now at Notre Dame), who has devoted some study to “retromarketing” and “the revival of brand meaning.” In 2003 he wrote an article (with Stephen Brown of the University of Ulster and Robert V. Kozinets of Kellogg) on the subject for The Journal of Customer Behavior. “Retromarketing is not merely a matter of reviving dormant brands and foisting them on softhearted, dewy-eyed, nostalgia-stricken consumers,” they asserted. “It involves working with consumers to co-create an oasis of authenticity for tired and thirsty travelers through the desert of mass-produced marketing dreck.”
I wasn’t entirely sure what that meant, but Sherry turned out to be more straightforward in conversation. “There’s no real reason that a brand needs to die,” he told me, unless it is attached to a product that “functionally doesn’t work.” That is, as long as a given product can change to meet contemporary performance standards, “your success is really dependent on how skillful you are in managing the brand’s story so that it resonates with meaning that consumers like.”

So brand and product are still inextricable tied together. Like many other (but not all) intangibles, the tangible is part and parcel of what makes up the I-Cubed Economy.