Coke, Quarterly Estimates and 'The Numbers Game'Published: January 29, 2003 in Knowledge@Wharton
When Coca-Cola announced in mid-December that it would end its long practice of making quarterly earnings forecasts, it looked like heresy. Practically all public companies participate in the ritual of earnings guidance. And in the post-Enron-WorldCom-Tyco era, regulators and investors are pressing for more financial disclosure, not less.
What was behind Coke’s decision? Is it one that other companies should emulate?
According to Coke, quarterly estimates were drawing attention away from its emphasis on long-term strategy. Though the company will not make per-share earnings projections down to the penny, as it has in the past, it will continue to discuss its strategy and factors that affect earnings.
“We are quite comfortable measuring our progress as we achieve it, instead of focusing on the establishment and attainment of public forecasts,” Coke chairman and CEO Douglas Daft said in a statement. “Our share owners are best served by this because we should not run our business based on short-term ‘expectations.’ We are managing this business for the long-term.”
Some analysts note that Coke has been criticized for questionable accounting and forecasts that turned out wrong, and the announcement seemed a little like the company was taking its ball and going home. Coke also has good reason to ask investors to focus on the long term, given that its total returns for the past five years are about minus 30%, far worse than the 6% loss of the Standard & Poor’s 500.
Yet some analysts point out that Coke was among the first companies to respond to investors’ post-Enron concerns by announcing last year that it would begin expensing stock options grants. Curtailing earnings forecasts is another way to reduce puffery and distortion in financial disclosure, say these admirers. Dozens of companies followed Coke’s example on options accounting, but the earnings-forecast announcement has so far not inspired copycats.
By most accounts, the immediate impetus probably came from Warren Buffett, a big Coke shareholder and director who has long avoided the guidance game at his own company, Berkshire Hathaway. As an investor, Buffett looks to the long term, and investors of this type have long complained that managers trying to meet their own quarterly earnings predictions focus on short-term results at the expense of the more important long-term strategy.
Even worse, the quarterly forecast practice gives corporate managers incentives to “manage” or manipulate earnings. During the quarter, the CEO may first talk up his company’s prospects, then issue a warning late in the quarter to get analysts to settle on modest predictions the company can beat, causing a positive surprise that boosts the stock price.
Former Securities and Exchange Commission chairman Arthur Levitt warned in a well-known 1998 speech titled “The Numbers Game” that earnings management was becoming a serious problem as CEOs struggled to meet Wall Street expectations. “This process has evolved over the years into what can be characterized as a game among market participants – a game that if not addressed soon will have adverse consequences,” Levitt said. Indeed, the Enron and other scandals of the past year all involved accounting gimmicks to make short-term results look better than they were.
“We know that they can get whatever they want in the next quarter,” says Wharton finance professor Andrew Metrick. “There are millions and millions of accounting tricks, such as accelerating earnings or decelerating costs.”
While just about everyone agrees earnings management is bad, experts are far from unanimous on whether quarterly forecasts inevitably lead to this practice. Metrick suggests it would be fine if all companies followed Coke’s lead. “We’ve learned that it’s not that informative to make these quarterly estimates, and it would be nice if companies could get away from doing it.”
But he and others note the issue really boils down to what managers say. “If guidance is used to pump up estimates artificially, that’s bad,” points out Wharton finance professor Jeremy Siegel. “But if they do have something to say, I have no trouble with guidance.”
According to accounting professor David Larcker, the problem is aggravated by U.S. accounting standards, which give companies many alternatives as they compile their numbers. Auditing tends to be based on a kind of checklist system, making it possible for a company to pass muster while in fact giving a misleading picture of its results. “There’s tremendous discretion in the way you do accounting,” he says. “It can be as simple as, do you choose a long time or a short time to depreciate assets … Some of it can get pretty ugly,” such as what happened at WorldCom. In Europe, he adds, companies are held to a somewhat different standard that emphasizes the accuracy of the whole picture.
Accounting professor Brian Bushee agrees that the attention surrounding forecasts gives CEOs a short-term incentive to manipulate results, and he notes that the Safe Harbor Act of 1995 protects executives from legal liability if forward-looking statements are off. On the other hand, he says, most executives realize they have a long-term stake in their own reputations.
Bushee’s research suggests Coke may have had another motive for curtailing quarterly forecasts – to change the profile of its own owners, the shareholders. Companies that make lots of financial disclosures tend to attract “transient investors” who trade frequently as corporate news is released. In addition to the obvious candidates, day traders, transient investors include institutional investors such as mutual fund managers with high turnover rates, highly diversified portfolios and momentum investing strategies that call for buying stocks with positive earnings surprises.
“The problem is that once a company attracts more transient investors through greater disclosure, the transient investors tend to destabilize the company’s stock price through their frequent trading and their overreaction to news events,” he says.
Transient investors tend to focus on short-term results and not to care about long-term strategy. When a company has lots of transient owners, the CEO comes under pressure to deliver short-term earnings gains, even if that means long-term performance will suffer. In fact, Bushee says, one of his studies found that companies with high degrees of transient ownership are more likely than other managers to reduce research and development spending to shore up short-term earnings. “Reducing long-term investment to meet short-term goals is unequivocally bad, so if Coke’s decision removes this pressure and allows them to better focus on maximizing long-run value, then shareholders are indeed better off.”
By curtailing quarterly earnings forecasts, Coke may make itself less appealing to transient investors, leaving more of its ownership in the hands of investors who share Coke’s view that it’s the long-term, not the short-term, that matters. And these may be the kind of investors who will wait patiently while Coke managers come up with a way to drag the company out of its slump.