Friday, April 18, 2008
Posted by Jeff Lipshaw I had a flashback to 1996 or so when I saw the Wall Street Journal's front page story on Jack Welch's criticism of General Electric's earnings miss, and his attribution to his successor and current CEO, Jeffrey Immelt, of a "credibiity problem." The next day, Welch apologized for sounding like a buttinski, and a retired one at that, coming across, as he did, like somebody (Greenspan? Weill?) who just can't let go. What follows is not for the faint of heart, but it's the academic in me. My intended audience here is educated, thoughtful, but not financial or corporate, people. And understand that I have tremendous respect and admiration for Jack Welch's leadership philosophy and rhetoric. A bit of context may be necessary for those not familiar with the reporting of financial results by public companies in the United States. Under SEC regulations, companies release their results shortly after the end of each fiscal quarter, and just after the end of each fiscal year. In companies like GE, this is an almost inconceivably complex process, involving hundreds of thousands of inputs and outputs into what is known as enterprise resource planning (ERP) software, the most famous of which is SAP, and other financial consolidation programs. But the millions of transactions undertaken by a company like GE get boiled down to what the company earned per share of stock (earnings per share or EPS), and that's what you hear about at times like this. What does it mean to "miss"? Who sets the target? Well, that's an interesting question. The target is set by a group of people who serve as proxies for the market, called analysts. (These are "sell-side analysts" but we'll leave that to another time.) The analysts work for brokers and investment banks, and they do research on the companies, which the brokers and banks provide to their clients. The analysts construct financial models, and the trick is (a) to have a good model, and (b) to put really good data into it, so as to predict the company's earnings in the succeeding quarters and years. Sometimes companies help out by actually saying what their EPS target is! In fact, in 1996 or so, that was standard practice. GE would say in January of a year that its expected EPS per quarter was X, Y, and Z, and its expected EPS for the year would be Q. You can imagine the pressure that this put on GE managers to make sure that they achieved their budgets so as not to make a liar out of Jack Welch. Indeed, in this very context, here's a quote from the Journal's article a few days ago on the GE miss:
In 1994, Immelt’s GE Plastics unit missed net income expectations by $50 million, spurring a tough-love speech from his boss, Jack Welch, who told him that if his unit missed its results again, Immelt would be out. Immelt’s observation in a great, frank interview with Fast Company magazine: “Failures are great learning tools — but they must be kept to a minimum.” (In a wry — or “Doh!” — moment, Immelt said of his future ambitions, “I’d love to say I could teach math, but I can’t even help my daughter with that.”)Now, of course, the question was how GE managed to hit EXACTLY that number every single quarter, year after year. Well, certainly the portfolio is diversified and some businesses will be up while others are down. But I'm afraid you don't get that consistent to the penny without some financial engineering. And that was the world of Jack Welch and the CEOs of the other mega-corporations of the 1980s and 1990s. As you can imagine, what analysts REALLY don't like is to be surprised. They don't particularly like bad news, but they don't get paid according to the fortunes of the stocks they cover. They make money according to their ability to predict the fortunes of the stocks they cover. So the biggest sin, and the credibility problem if there is one, is the failure to be reasonably transparent. (Note: there is largely no legal duty of transparency. That is, unless you've done something to create a duty to disclose result before the normal reporting dates, there is no duty to disclose.) What has people flummoxed is that Mr. Immelt reaffirmed that GE would come in as expected for the first quarter of 2008 only seventeen days before the end of the quarter. Now we get into some real subtleties of earnings reporting and earnings management. The stock price is, in theory, the earning power of the company over the long run reduced to present value. In that vein, one doesn't even worry about the difference between earnings and cash flow, because in the long run, they are the same. So a good analyst discounts the hurt of one-time bad events and discounts the help of one-time good events. What she really wants to see is that the ongoing operating engine of the company is robust. But, of course, it's not that simple, because all the one-time stuff has to be accounted for, and the financial statements don't conform to generally accepted accounting principles if they don't. So companies and analysts do pro forma statements to peel away the one-time stuff, unless of course you want to obscure the fact that the ongoing business is having problems, in which case you highlight the GAAP stuff. Why did GE miss? As I read the reports, for three reasons: - all of the underlying businesses in GE's portfolio underperformed expectations on an ongoing basis. I can't tell offhand if the credit market problem, which occurred in the last two weeks of March, were accounted for at the underlying business level, but it doesn't make sense that they would be. No, there are economy-related issues, I would think. - GE had to recognize unusual losses because of the markdown of financial assets because of the credit market problems in the last two weeks of March. This is interesting, because the markdown of assets is not something on which you just pull a switch. It involves an extended analysis and discussion between the company and its auditors. For all I know, GE had not figured out how much it had to report as the loss until thirty minutes before it released its earnings, and that would have been well after March 31. - GE didn't close some real estate sales, which would have given one-time gains that would have sheltered losses in the two other categories I just listed. So finally, what's the credibility issue, and why do I think Jack Welch sounded out of touch? It's a real credibility issue not to at least appear to be transparent with your analysts. Personally, were I a public company CEO, I wouldn't give earnings guidance, and I would certainly not give it seventeen days before the books close for the quarter. But analysts predict, even if the company doesn't give guidance, and the tough call is whether to "pre-announce" a miss, so that at least the analysts don't feel unduly sandbagged. It's also a real credibility issue if the earnings engine of the underlying business is flawed, and you are using the smoke and mirrors of one-time events to make it seem otherwise. But that's not why I think Welch sounded out of touch. No, to him, the credibility issue goes to EVERYTHING, including all of the macroeconomic forces that touch upon a business. Because part of the GE management myth was that a great leader-manager could indeed stand in front of and hold back the tsunami. And if [s]he didn't, there was always somebody else who could. Which is why Welch could say "I'd be shocked beyond belief and I'd get a gun out and shoot him if he doesn't make what he promised now." As though, along with everything else, and as talented as he is, Jeff Immelt can personally impact the price of oil, the buy-out of Bear Stearns, consumer confidence, and the restructuring of the housing market. It's a different world now. In the 1990s, Jack Welch was a visionary, preaching the rhetoric (and damn good rhetoric at that!) about learning, and boundarylessness, and values, but it was millennial rhetoric coming out of guys who came to business maturity in the 1950s and 1960s. Yes, CEOs still need credibility, but it's no longer credible to impute the powers of the Imperial CEO even to Jeffrey Immelt.