LEARN TO PLAY THE EARNINGS GAME (AND WALL STREET WILL

Plus: How the pros do it

[I]n January, for the 41st time in the 42 quarters

since it went public, Microsoft reported earnings

that met or beat Wall Street estimates. The 36

brokerage analysts who make the estimates were, as a

group, quite happy about this--the 57 cents per share

announced by the software giant was above their

consensus of 51 cents, but not so far above as to

make them look stupid. Investors were happy too,

bidding the already high-priced shares of the company

up 4% the first trading day after the announcement.

In short, for yet another quarter, Microsoft had kept

its comfortable spot in the innermost sphere of

corporate paradise. This is what chief executives and

chief financial officers dream of: quarter after

quarter after blessed quarter of not disappointing

Wall Street. Sure, they dream about other things

too--megamergers, blockbuster new products, global

domination. But the simplest, most visible, most

merciless measure of corporate success in the 1990s

has become this one: Did you make your earnings last

quarter?

This is new. Executives of public companies have

always strived to live up to investors' expectations,

and keeping earnings rising smoothly and predictably

has long been seen as the surest way to do that. But

it's only in the past decade, with the rise to

prominence of the consensus earnings estimates

compiled first in the early 1970s by I/B/E/S (it

stands for Institutional Brokers Estimate System) and

now also by competitors Zacks, First Call, and

Nelson's, that those expectations have become so

explicit. Possibly as a result, companies are doing a

better job of hitting their targets: For an

unprecedented 16 consecutive quarters, more S&P 500

companies have beat the consensus earnings estimates

than missed them.

Microsoft's prodigious record of beating expectations

is due in large part to the company's prodigious

growth, from annual revenues of $198 million at the

time of its IPO in 1986 to more than $9 billion now.

It also helps that it dominates its industry. But

even the Microsofts of the business world have a few

tricks up their sleeve. The most obvious is to manage

earnings. "Managing earnings" has a pejorative,

slightly sleazy ring to it, but even at the most

respected of companies, accounting and business

decisions are regularly made with smoothing or

temporarily boosting earnings in mind. Not all are as

up front about it as General Electric, where

executives say openly that they don't think their

company would be as popular with investors if its

profits weren't so consistent and predictable. But

neither can it be a complete coincidence that of the

top ten companies on FORTUNE's 1997 Most Admired

list, seven--Coca-Cola, Merck, Microsoft, Johnson &

Johnson, Intel, Pfizer, and Procter & Gamble--have

missed fewer than five quarters in the past five

years, according to I/B/E/S (and two of the other

three don't have any earnings estimates to meet).

Meeting the estimates is made easier by the fact that

they're not set in a vacuum--analysts rely heavily on

guidance from companies to form their forecasts, and

companies have in recent years figured out that it

pays to guide the analysts to a lower rather than a

higher number. At least partly as a result of this

expectational interplay, the price of missing a

quarter has risen sharply, particularly among

high-priced growth stocks. In the growth stock

fraternity, "missing by a penny" now implies the

height of corporate boneheadedness--that is, if you

couldn't find that extra penny to keep Wall Street

happy, then your company must really be in trouble,

and since missing by a penny is already going to send

your stock plummeting, you're better off missing by a

dime or two and saving those earnings for the next

quarter.

Microsoft missed by a penny

once--back in 1988, when such

behavior was not yet considered

unbearably gauche. Nowadays its executives treat

analysts to a constant patter of cautionary and even

downbeat words about the future that the analysts say

is a mix of genuine paranoia and astute expectations

management. After a typically grim presentation by

CEO Bill Gates and sales chief Steve Ballmer at an

analysts' meeting two years ago, Goldman Sachs

analyst Rick Sherlund ran into the pair outside and

said, "Congratulations. You guys scared the hell out

of people." Their response? "They gave each other a

high five," Sherlund recalls. But Microsoft, unlike

some companies less attuned to the rules of this

game, also lets analysts know when they're too

pessimistic. That's what CFO Mike Brown did, along

with the usual warnings about slower growth ahead,

during his regular quarterly conference call after

the January 17 earnings release. He told the hundreds

of analysts, money managers, and journalists

listening in that earnings would be "more than a

nickel, less than a dime" higher than predicted for

the current quarter, and another penny higher in the

next.

How did he know this? That involves something that

looks a lot like earnings management--although not of

the sort that provokes penalties from the Securities

and Exchange Commission or nasty newspaper articles

about inflated profits. Starting around the unveiling

of Windows 95 in August 1995, Microsoft has followed

a uniquely conservative method of accounting for the

software it ships--deferring recognition of large

chunks of revenue from a product until long after the

product is sold. The reasoning is that when somebody

buys software in 1996, they're also buying the right

to upgrades and customer support in 1997 and 1998. If

it hadn't been for the new accounting technique, the

company would have had to report a sharp rise in

profits in the latter half of 1995, then a sharp drop

in the first half of 1996--a turn of events that

might have sent its stock price reeling--instead of

the smoothly rising earnings that it did post. By the

end of 1996, Microsoft had taken in $1.1 billion in

"unearned revenue" that it had yet to recognize on

its income statements. "Because of this, they know

what they've got in the bag from one quarter to the

next," says Marshall Senk, a Robertson Stephens

analyst who follows the company. Which leads him to

conclude that "Microsoft does a better job of

leveraging accounting--I would almost say it's a

competitive weapon--than anybody else in the

industry."

Microsoft treasurer Greg Maffei doesn't like this

interpretation. "I'm a financial officer of this

company, and I would be in deep doo-doo with the SEC

if that was what was driving our revenue recognition

policies," he says. "Our revenue recognition policies

are driven by GAAP." Which isn't quite true. In fact,

GAAP--the Generally Accepted Accounting Principles

companies follow in preparing financial

statements--may in this area be driven by Microsoft.

Virtually no other software company does its

accounting the way Microsoft does, but standards

setters, egged on by the industry leader, are

starting to push in that direction.

That's how GAAP works. It's constantly changing and

evolving, particularly in businesses that haven't

been around for long. This is only natural, but it

can be maddening for people trying to understand what

a company's reported earnings really mean. "With

industries that haven't been in the market before,

you tend to see a lot of monkey business because

accountants, even if well intentioned, don't know

what the standards are," says Martin Fridson,

high-yield debt strategist at Merrill Lynch and a

financial statement analysis guru. "Underwriters of

small companies and people who make a living doing

IPOs are very conscious of the market's inability to

see what the correct measures are." Add that

confusion to the general cacophony of accounting

quirks and judgment calls in financial statements,

and you begin to realize that earnings are nothing

but a vague, approximate measure anyway.

One of modern accounting's guiding principles is that

of matching revenues and expenses over time. That's

why the cost of building a factory that will be

churning out cars for 20 years gets expensed over

those 20 years, not when the money is actually spent.

But such matching requires making all sorts of

guesses and estimates about the future. These

judgments--how much to set aside for potential loan

losses, what rate of return to expect on a pension

fund, over how many years to spread out the cost of a

factory--make earnings a better reflection of the

long-term economic health of a company. They also

provide ample room for managers to fudge. This is why

financial analysts and money managers are supposed to

know how to look beyond a company's bottom line to

find the true economic value in its balance sheet or

cash flow statement or, best of all, the footnotes to

its financial statements. In the bull market of the

past 15 years, however, analytic rigor hasn't always

been required to make good stock picks. "Nobody's

paying attention," says Robert Olstein, who in the

1970s co-authored an influential newsletter called

the Quality of Earnings Report and now runs the $140

million Olstein Financial Alert fund.

If Microsoft is the archetype of a hugely successful

company trying to tone its earnings down so people

don't get their expectations too high, Boston Chicken

bespeaks an altogether different and more common

phenomenon. It is a business that isn't successful

yet but has used accounting to help convince

investors that it already is, or at least will be

soon. This has enabled it to raise more than $800

million in stock and convertible debt offerings,

money which has been essential not only to the

company's rapid growth--from 175 Boston Chicken

restaurants when it went public in one of the

decade's hottest IPOs in November 1993 to 1,100

restaurants (rechristened Boston Markets) and 325

Einstein Brothers and Noah's bagel stores today--but

to its very survival. That's because, economically

speaking, Boston Chicken is still a big money loser,

as probably can be expected of a startup restaurant

chain. All the losses, however, have been incurred by

"financed area developers," or FADs, which is Boston

Chicken lingo for large-scale franchisees that act a

lot like subsidiaries but aren't. If they were, their

losses would have to be reported on Boston Chicken's

income statement (they are instead disclosed, on an

annual basis only, deep in the text of the company's

SEC filings). The FADs get 75% of their startup

capital in loans from Boston Chicken, and with that

money they pay the company the royalties, franchise

fees, and interest that allow it to report

ever-rising profits. Once the restaurants start

making money, Boston Chicken exercises its right to

convert the loans into equity, officially dubbing the

FADs subsidiaries and allowing their profits to flow

to its bottom line.

That's the plan, at least, as

outlined with somewhat more

delicacy in the company's 1993

annual report. And so far it has worked. Sure,

business publications have printed nasty articles

about the company, accounting professors have warned

their students about it, and shortsellers have lined

up in droves to place bets that its stock price will

crash. But Boston Chicken's stock price has more than

held its own. Part of investors' sanguinity has to do

with the track record of the two former Blockbuster

Entertainment bigwigs who run it, CEO Scott Beck and

President Saad Nadhir, and the belief that America

really is hungry for takeout chicken, ham, and meat

loaf. But it sure doesn't hurt, analysts and money

managers say, that not only is Boston Chicken able to

report earnings every quarter, but those earnings

have so far never failed to meet or surpass analysts'

expectations--even though those analysts all know

that the earnings in no significant way reflect how

the company is doing. "It's a very smart strategy,"

says Michael Moe, a growth stock strategist at

Montgomery Securities. "It has made enormous amounts

of capital available to them at an attractive price

that most companies can only dream of."

Boston Chicken CFO Mark Stephens says his company was

structured not to please Wall Street but to provide

flexibility and motivate its franchisees. But he

acknowledges that "a byproduct of where we are with

the structure is that we have a public entity with an

earnings complexion that is attractive." He adds:

"It's like sausage. I love the product; just don't

show me how it's made."

Another company that has used aggressive accounting

to raise money is America Online. AOL's practice of

capitalizing and writing off over two years the cost

of those ubiquitous free disks and ads it used to

lure members was highly controversial, and was

abandoned in October. But for years it allowed the

company to post earnings most of the time instead of

losses, which helped it to raise more than $350

million on the stock market. Says Wharton School

accounting professor Richard Sloan, referring to both

Boston Chicken and AOL: "They just view accounting as

another marketing tool that they should use to try

and promote their ideas."

Boston Chicken and America Online are extreme cases.

So is Microsoft. The mass of companies lead lives

somewhere in between. When they manage earnings, they

do it simply to smooth the ups and downs of business

life, and of course to meet those Wall Street

earnings estimates. Is there evidence of widespread

earnings management? You bet. Looking at 17 years of

I/B/E/S data on more than 1,000 companies, Jeff Payne

of the University of Mississippi and Sean Robb of

Canada's Wilfrid Laurier University found an

unmistakable pattern of using accruals (i.e.,

judgment calls) to manage earnings upward if they

were below the analysts' consensus and a somewhat

less pronounced trend of managing them downward if

they were above the consensus.

General Electric, a company whose name invariably

comes up when you ask Wall Streeters about earnings

management, says it does what it does because the

stock market demands it. "We think consistency of

earnings and no surprises is very important for us,"

says Dennis Dammerman, the company's CFO. "We're a

very complex, diverse company that no one from the

outside looking in can reasonably be expected to

understand in complete detail; so our story to the

investing world is, we have a lot of diverse

businesses, and when you put them all together they

produce consistent, reliable earnings growth." And if

something inconsistent comes along--say, a one-time

gain from selling off a factory--"we have a pretty

consistent record of saying, 'Okay, we're going to

take these large gains and offset them with

discretionary decisions, with restructurings.'"

These tactics have helped GE meet or beat

expectations every quarter but one in the past five

years, and they certainly haven't hurt it among

investors, even skeptical ones. "They are using all

sorts of techniques to smooth earnings," says Howard

Schilit, whose Center for Financial Research and

Analysis keeps institutional investors posted on

companies whose earnings numbers may be hiding

business troubles. "If I wrote that to my clients,

there would be a big yawn."

Another investor favorite that produces awfully

smooth earnings is Coca-Cola, which in the third

quarter of last year took advantage of $520 million

in one-time gains from a settlement with the IRS and

the sale of some bottling operations to recognize

$500 million in supposedly one-time hits to earnings.

One of those hits, $200 million used to reduce the

inventories of soft drink concentrate at bottling

companies, was explained as a move to free up

bottlers' capital but was seen by some as an

admission that Coke had been shipping concentrate

early to artificially boost earnings. That hurt the

company's stock price for a few months, but by taking

the charge Coke gave itself the option of using

inventory buildup at its bottlers to pad profits

later. "When they pull it out in 1998 or 1999 to keep

up their 19% or 20% earnings growth, everyone will

have forgotten," says Roy Burry, who follows Coke for

Oppenheimer & Co.

Will everyone really forget? If financial markets are

in fact efficient, economic reality will in the long

run win out over accounting games. But the long run

can seem awfully far away when you've got a posse of

analysts breathing down your neck every three months.

Many corporate executives also seem to think

investors take earnings numbers at face value; they

write outraged letters to the Financial Accounting

Standards Board, accounting's top rule-making body,

whenever it proposes a change that might reduce

reported earnings. "They obviously don't believe in

efficient markets," says Neel Foster, a FASB member

and former treasurer of Compaq Computer. "Academic

evidence shows that generally, accounting changes

don't result in changes in stock prices. But it also

shows that people that make greater disclosures

generally have a lower cost of capital. They don't

believe that either."

Even this doesn't explain why some companies seem to

persist in managing earnings in the face of Wall

Street disbelief. Food maker H.J. Heinz grew rapidly

during the 1980s but has since needed repeated asset

sales and other special items to keep earnings

steady--and its stock has lagged. Last June the

company announced quarterly earnings of 45 cents a

share but failed to mention that four of those cents

came from the sale of a magazine and two pet food

brands. It was "immaterial," a company spokesman says

now, but it nevertheless infuriated some analysts,

who found out only when they received the annual

report a month later. It didn't help the stock price

either, although the stock later bounced back on

rumors of a major restructuring.

What might motivate such corporate behavior? One

answer is money. High-level executives like to get

paid a lot, and it so happens that many bonus

plans--including the one at Heinz--are built around

meeting earnings targets. The rise of

performance-related bonuses has taken earnings

tweaking to new heights, say some market watchers.

There's no reliable measure of such activity, but one

rough gauge, comparing profits reported to the

Internal Revenue Service by U.S. corporations with

profits reported to shareholders (the measure that

counts for bonuses) by companies on the S&P 500,

gives a clue. It shows some wild relative swings in

S&P earnings in the late 1980s and early 1990s,

probably a result of big corporations using one-time

charges to pay for restructuring costs like plant

closures. This write-off binge ended in 1994, which

could mean either that earnings quality is getting

better or that companies are coasting to ever higher

earnings now because they hid ongoing costs back

then.

While there's no conclusive proof that managing

earnings is on the rise, it is undeniable that the

game is being played more aggressively than ever.

This isn't necessarily bad: "The good side of what a

lot of people call the game of managing expectations

is that companies realize that they have to give

better guidance to the market as to what their

prospects are," says Ed Keon, senior vice president

for marketing at I/B/E/S.

The downside of giving better guidance--apart from

the hours of valuable top management time that it

eats up--is that the investors most interested in the

estimates are not exactly the well-run corporation's

best friend. They are the momentum guys--mutual fund

managers and hedge fund jockeys and individual

investors--who jump on the bandwagon when a company's

earnings growth is accelerating and beating the

analysts' estimates, and jump off the second it

misses a quarter.

"When it stops, they sell--you cannot break this

algorithm," says a resigned Eric Benhamou, chief

executive of 3Com Corp., which lost $7 billion in

market value in a matter of weeks this year as it

became known that its earnings for the quarter ended

February 28 would not meet analysts' expectations.

The moral of the story: Unless you're a trader,

ignore the short-term kabuki that the companies and

the analysts perform for each other, but educate

yourself about the accounting games that companies

play. If enough investors did, it could mean that the

smartest earnings and expectations management

strategy of the 2000s will be--don't bother.

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HOW THE PROS DO IT

Plan ahead: Time store openings or asset sales to

keep earnings rising smoothly. In most cases, this is

earnings management at its least controversial. The

master of it is General Electric.

Call it a sale: Madly ship products during the final

days of a weak quarter, or hold off if the quarter's

already in the bag. There's leeway in revenue

recognition too: Tech companies often book sales

aggressively to boost profits, but Microsoft is now

demonstrating the virtues of belated recognition.

Capitalize it: Usually it's pretty clear which costs

you capitalize and which you expense. But there are

gray areas--software R&D is one--and you can get

creative about the length of time an asset should be

depreciated. America Online was, until it stopped in

October, a noted aggressive capitalizer.

Write it off: Take a "big bath" and charge a few

hundred million in restructuring costs, and meeting

future earnings targets will be easier. Among the

biggest restructurers of the 1990s: IBM.

Use your reserves: Build them up for product returns,

bad loans, and insurance losses; drain them down to

bolster earnings when business sags. Outsiders say

this is one of the secrets of GE's success, but the

company says that's just not true.

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