Monday, December 18, 2006

And Beware CEOs Trying to “Hit the Numbers”



Tom Bender might be a great guy, for all I know.

And he might be a great CEO, too, although he does run The Cooper Companies, a contact lens maker whose news flow has been uniformly bad of late—so bad that its stock happens to be one of the only companies in the world trading closer to its 52 week low than its 52 week high.

But if the company’s recent conference call was any indication, the outside observer would not know how great he is.

I say this not because the word “decline” appears nine times in the earnings call transcript—bad things do happen to good people and good companies on occasion.

I say it because, after recounting the litany of woes resulting in the latest earnings miss, Bender says the following about the objectives he’s set for the upcoming year:

Let me talk a little bit about some of the objectives that we have for 2007. Number one, most important and most important to all of you is to hit our guidance.

I am not making that up.

Now, if Mr. Bender honestly thinks that the “number one” objective of his company should be “to hit our guidance” for the sake of Wall Street’s Finest and their precious earnings models, then he is about as far removed from what really makes a company great as a CEO can be.

Not only can the focus on hitting a meaningless, and often unsustainable, profit forecast result in stupid, short-term decision making; it can also, as in the case of Tyco, Fannie Mae, Enron, and a list of other companies large and small too lengthy to bother with, result in fraud.

As with morons writing blogs, beware a guy at the top whose chief goal is to “hit the numbers.”



Jeff Matthews
I Am Not Making This Up


© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.

1 comment:

Sam E. Antar said...

Jeff:

The issue here is known as “managing earnings.” Accounting is more art than science because of certain judgments on accounting principles management decides with the acceptance of its Audit Committee and external auditors. For example accounting principles relating to sales, leases, depreciation, accounts payable, and inventory all involve some amount of judgment or “leeway.”

In the Crazy Eddie fraud one technique used to manage earnings was the reserves against inventory. In fiscal year 1986, we inflated our earnings about $16 million due to fraudulent means. When the external auditors did their first computation of Crazy Eddie’s earnings our gross margins were over 40% for our last quarter when historically Crazy Eddie’s gross margins were about 20%.

Rather than investigate this issue, the auditors simply agreed to Crazy Eddie booking extra arbitrary “loss reserves” against our inventory valuations. They thought we were being “conservative” but in fact they unwittingly helped us reduce the excess fraud we committed.

The use of such reserves was known as “accountant’s legal liability insurance” since the rationale was that no one ever got sued for being too conservative for under reporting earnings. When I asked the auditors what to do with these “excessive” reserves in future years they replied to me that it is like “money in the bank” and such reserves can be reduced to make our future numbers.

The next fiscal year when Crazy Eddie started losing money and no amount of fraud could turn such losses into a profit we reduced the arbitrary reserves set up in the prior year with our auditors’ collusion.

While the external auditors were not involved in falsifying inventory they were unwitting accomplices to our fraud in they way they helped us “manage earnings” through the use of arbitrary reserves.

In many of my conversations with Wall Street analysts, underwriters, and other CFO’s I found this practice of “managing earnings” to be prevalent and an accepted norm.

Wall Street does not like surprises and the extra swing that management gets from applying so called judgment to accounting principles allows them to constantly make their earnings figure. In good years certain companies will save “unneeded excess earnings” through arbitrary reserves to save such earnings for the lean quarters or years when they do not make their earnings targets.

Respectfully,

Sam E. Antar
PS: To borrow your phrase, I am not making this up.