Our readers should have little doubt at this point about our view on the integrity of wall street and equity markets. In fact, we just spoke yesterday about all the little accounting games that companies play to "beat" earnings estimates in a post entitled "Mind The "GAAP" (Or How The Game Is Really 'Rigged')."
Well, CFOs can't bear the full burden of earnings management, they need complicit "independent" counterparts on wall street as well. A recent article in the Wall Street Journal points out how public companies use wall street analysts to manage quarterly earnings expectations and ultimately their stock prices. The article summarizes the quarterly dance played out between wall street analysts and investor relations teams to "manage" earnings down to a level that is ultimately "beatable" and thus produces a nice stock bounce on earnings day. Analysts, of course, are willing partners in the game because being a "team player" means better access to management teams, better attendance at bank-hosted conferences and the added benefit of very "accurate" forecasting for hedge fund clients that pay handsomely for their efforts. As the WSJ points out:
Analysts whose forecasts are far from what companies end up reporting risk losing credibility with clients and could get less access to company management. Those are reasons to listen if a company calls with a suggestion, according to analysts.
Roger Freeman, who left the stock-research industry in 2014 and now works at a technology startup, says: “If someone is trying to get your numbers down, they will highlight all the negatives and not positives, and you’ll come away thinking: ‘Gee, that sounds pretty bad,’ and sometimes take your numbers down.”
To prove the point, the WSJ reviewed over 6,000 earnings reports from 1Q13 through 1Q16 to see just how frequently companies manage to "beat" earnings estimates. "Shockingly" an overwhelming number of companies manage to report earnings that are exactly in-line or slightly above analyst expectations. But hey, maybe the analysts are just really good at modeling.
The WSJ went on to provide a couple of recent examples of "managed" earnings, with AT&T's 1Q16 numbers being the first, saying:
AT&T’s finance chief said last year’s fourth quarter included “a slowdown in the handset upgrade cycle.” He added that he “wouldn’t be surprised to see that continue.” Near the end of the first quarter, AT&T steered analysts back to Mr. Stephens’s comments at a Deutsche Bank AG conference on March 9, say five analysts who spoke to the telecom company.
Jeffrey Kvaal of Nomura Securities says AT&T’s investor-relations team “is very diligent” before earnings releases “about making sure that the comments from the executives are reflected in the commentary from the sell side.”
A week before the announcement, Mr. Kvaal cut his first-quarter sales estimate by $837 million to $40.54 billion, citing lower equipment sales. Two days before the results, the William Blair analysts cut their sales estimate by about $1 billion. With one day to go, Buckingham Research Group reduced its sales estimate by more than $1.1 billion, also noting the slower pace of upgrades.
Analyst James Breen of William Blair says he talks to investor-relations personnel at AT&T “all the time.” He adjusted his forecast because the previous estimate hadn’t taken into account the comments from AT&T’s management at several investor conferences. Mr. Breen says he also didn’t want to be an outlier compared with other analysts who follow AT&T.
Mr. Viola, AT&T’s investor-relations chief, says “companies can and do talk with analysts about their latest, publicly available information. That’s the job of investor relations, and it benefits the investing public.”
He adds: “Analysts change their estimates for many reasons, and do so throughout the quarter.” About half the changes in the first quarter were made a week or less before the April 26 earnings announcement.
We would agree with AT&T that providing earnings guidance could provide "benefits [to] the investing public." But that's not what's happening here because the "investing public" does not get access to research reports published by investment banks unless they happen to be clients which is a status reserved for hedge funds and super-wealthy individuals.
But we digress. To conclude the AT&T discussion, in the ~25 days leading up to AT&T's 1Q16 earnings release, the WSJ found that analysts cut AT&Ts revenue forecast by ~$1BN. And wouldn't you know it...when earnings were finally released AT&T managed to "beat" on revenue by 0.19%.
And, not to leave out our favorite investment banking operation, the WSJ also commented on Goldman Sachs' 1Q16 earnings:
This spring, many analysts were struggling to figure out how Goldman Sachs Group Inc. would fare amid the first quarter’s market turbulence. From mid-March to mid-April, 16 analysts cut their earnings estimates by an average of 41%.
Around the end of the first quarter, the bank’s investor-relations staff answered calls from analysts, many of whom routinely check in with the firm when updating their financial models and targets.
Some conversations included discussions about comments from rival executives at investor conferences during the first quarter, some analysts say.
Michael DuVally, a Goldman spokesman, says the discussions were appropriate, partly because analysts “are overloaded with data.” He adds: “Serving as a resource for public information is a sensible market practice.”
When Goldman released results April 19, it had $2.68 a share in earnings, more than 10% higher than the lowered target. The stock rose 2.3%.
The bottom line is that the game is rigged and retail investors are the losers. We fail to understand how companies can consistently work within the confines of the law yet still "manage" analysts' estimates to within fractions of a percent of a company's actual quarterly results. How is it possible that a call with investor relations of AT&T convinces an analyst to take down quarterly revenue estimates by $1BN (a reduction that puts the revised "forecast" within a small fraction of actual results) yet the contents of that call are not "material" under SEC guidelines? Why do investment banks and their clients deserve better access to management teams and information? Why can't all management presentations at conferences be open to the public? Why do wall street investors spend $1,000's of dollars attending investment bank conferences at remote beach destinations if they're not receiving something they deem valuable in return?
The fact is that a couple of small changes could be made to level the playing field. Corporate conferences are fine but why not require that all presentations and Q&A sessions be webcast with a transcript of discussions posted for public consumption? Same thing with quarterly update calls with analysts. If there is nothing nefarious in these discussions then why not make the process transparent and prove it? These issues are easy to solve but they never will be because the banks and corporations behind them are willing participants with economic interest in maintaining the status quo so we won't hold our breadth waiting for change.