Friday, January 13, 2006

Company Earnings Manipulation

Jeff Matthews, a hedge fund manager who blogs at Jeff Matthews Is Not Making This Up notes in a recent post that IBM dramatically lowered their Q1 earnings per share (EPS) estimate last April to 90 cents from $1.04. In actually, IBM earned 84 cents that quarter, net of 10 cents worth of options and stock-based compensation. Shortly, thereafter the stock fell ten dollars.

Because public company executives are trained to do everything to keep Wall St. happy, which typically means delivering ever higher earnings with no surprises, is it any wonder that the EPS number is ripe for manipulation? Since companies have the power to create and destroy stock pretty much at will through new stock and option issuances and buybacks of existing shares respectively, the PER SHARE earnings number does not necessarily accurately forecast the outlook for a company.

For example, if Company X with 100 million outstanding shares earned $100 million this past quarter, you can figure out that the firm earned $1.00 per share. If the company forecasts its EPS will rise year over year (YoY) to $1.25 it can meet this in two ways. The better way would be to earn an additional $25 million over the existing $100 million of current earnings to get to $125 million for the quarter or $1.25 of earnings per share. The worse way would be to buyback 20 million shares, "retire" them, and off a new 80 million share base report that while gross earnings were unchanged at $100 million, the EPS number still rose to $1.25.

While the two outcomes may be for accounting purposes similar, the second result clearly indicates a worse off situation than the first result. This is because not only did the company report in the latter example that gross earnings were unchanged YoY despite the higher EPS number, the company drained its cash reserves buying back stock to keep the EPS forecast on target. Current stockholders shouldn't shrug off this development just because their current shares now are worth more as a percent of the company (the stock base reduced from 100 million to 80 million) because as Jeff Matthews points out the granting of restricted stock and options is hardly a non-reoccurring expense to a major corporation like IBM. There is every likelihood of future dilution due to new stock being issued and 80 million shares can expand back to 100 million shares so that the EPS is no longer $1.25 but shrinks back to $1.00 EPS. What once was heralded as a sign of growth now becomes a realization of stagnation.