Winning Investors Over. Baruch Lev
In 2009, the SEC filed a suit against General Electric, alleging that it had misreported revenues and earnings during 2002 and 2003 in order to beat analysts’ consensus earnings estimates, partially explaining a “world record.” From 1995 through 2004, GE met or exceeded the consensus estimate in practically every quarter: forty consecutive hits! The SEC alleged several manipulations, some of which, while involving millions of dollars, require an advanced accounting degree to fully comprehend. One was a plain-vanilla accelerated revenue recognition scheme. In the fourth quarters of 2002 and 2003, GE purportedly sold locomotives to financial institutions (heavy users of locomotives) to the tune of $223 million and $158 million, respectively. These transactions, the SEC alleged, were not real sales and shouldn’t have been recorded as revenue, because they were structured in a way that didn’t transfer the risk of ownership to the institutions, a GAAP requirement for revenue recognition. The financial institutions were, of course, expected to subsequently deliver the locomotives to real customers, but GE needed immediate delivery to boost fourth-quarter sales and earnings to beat the consensus estimates. GE settled the SEC’s lawsuit by paying a $50 million penalty without, as is customary in such cases, admitting to wrongdoing.15
The major lesson learned is that many manipulative schemes cannibalize future revenues and earnings, necessitating an ever-increasing intensity of trickery, soon to spiral out of control. This was evident in 2007 when GE restated its 2002 and 2003 reports for the locomotives “sales,” stating that the 2002 fourth-quarter segment revenues and profits were overstated by 8.8 percent and 14.6 percent, respectively, while the corresponding 2003 overstatements were substantially higher: 22.6 percent and 16.7 percent, respectively. This cannibalization renders most reporting manipulations unsustainable.
How Gateway “Immunized Itself from the Vagaries of the Market”
In 1999, Gateway Inc., a direct marketer of personal computers and related products, embarked on a diversification strategy—dubbed venturing beyond the box—offering software, Internet access services, and training and support programs to customers. By the end of 1999, Gateway’s beyond-the-box income reached 20 percent of total earnings, seemingly demonstrating the success of the diversification program. Soon, however, things turned ugly. The tech bubble burst in 2000, the economy fell into a recession, and demand for computers and related products plummeted. Gateway, however, continued to present a happy face. While competitors reported a significant softening of demand and the consequent reduction in revenues and earnings, Gateway managers consistently claimed they were bucking the trend and reported increasing revenues and earnings to boot. How did Gateway manage, in the words of an analyst, to immunize itself from the vagaries of the market?
The SEC provides the answer.16 In late 1999, Gateway initiated a program to sell computers on credit to persons who were previously rejected because of poor-credit status. At first, management characterized the program “a test” and limited it to $10 million. Soon, however, as Gateway’s revenues declined and the specter of missing analyst estimates loomed large, it aggressively accelerated the program. In the second quarter of 2000, this high-risk sales drive—for which Gateway’s internal delinquencies estimates reached 40 percent—generated sales of $112 million (5 percent of second-quarter revenues). The SEC contends that Gateway violated securities regulations—the requirement to disclose known trends and uncertainties that could have an unfavorable impact on earnings—by failing to inform investors that a significant part of revenues came from a new, high-risk customer group. Nor did Gateway adequately provide for the expected loan losses for this program. But this wasn’t all.
The third quarter of 2000 saw further business deterioration, yet Gateway assured investors that its sales “remain robust” and the consensus revenue growth estimate of 16 percent would be achievable, despite a Gateway internal document, dubbed “Gap to Consensus,” to the contrary. How did Gateway close the gap? You guessed it. By accelerating sales to poor-credit customers, thereby adding $84 million to quarterly revenues.17 While the quality of Gateway’s receivables continued to deteriorate—poor-credit receivables reached 37 percent of total receivables at the end of the third quarter—management reduced the loan loss reserve by $34.5 million, inflating reported income by the same amount. This enabled the company to report $0.46 EPS, precisely meeting the consensus estimate. For good measure, Gateway improperly booked a gain of $4.3 million from receivables sales in the second quarter and shipped $21 million worth of PCs to warehouses at the end of the third quarter in 2000, improperly recording this channel stuffing as revenues.
Analysts celebrated Gateway’s third-quarter “performance”—meeting the consensus against all odds—leading one analyst to state that the company’s business model “gives them an advantage over everyone.” On October 13, 2000, the day following the third-quarter earnings release, Gateway’s stock followed suit, increasing 22 percent. So much for analysts’ prescience. Less than a couple of months later, however, Gateway’s manipulations ran out of steam, and its stock plummeted by two-thirds: from $53.11 in October 13, 2000, to $17.99 on December 31, 2000.
Note that Gateway engaged in a combination of accounting manipulations (cutting the bad-debt reserve) and real manipulative activities (increasing sales to poor-credit customers). The latter schemes, such as cutting R & D or maintenance to “make the numbers,” are particularly damaging because they exacerbate an already deteriorating business.18
Things Go Better with Coke (When Pushed a Bit)
From 1997 to 1999, Coca-Cola engaged in an elaborate program of “gallon pushing” in Japan, which made the difference, according to the SEC, “between Coca-Cola meeting or missing analysts’ consensus or modified consensus earnings estimates for 8 out of 12 quarters.”19 What was this innovative gallon-pushing strategy that was kept secret—as is the venerated Coke formula—from the public? In 1997 and onward, the Coca-Cola (Japan) Company substantially improved credit terms to Coke bottlers to induce them to purchase increased quantities of concentrates, beyond those required by customer demand. According to the SEC, these gallon-pushing efforts increased bottlers’ inventory of concentrates by 60 percent between 1997 and 1999, while sales rose by 11 percent only. The enhanced “pushed gallons” augmented Coca-Cola’s revenues and earnings from 1997 to 1999, a period of intensifying competition. The gallon-pushing program enabled Coca-Cola, according to the SEC, to “publicly maintain between 1996 and 1999 that it expected its earnings per share to continue to grow between 15 percent and 20 percent annually [despite the challenging competitive environment].”20
Typical to most revenue-enhancing schemes, borrowing from the future leads to deficits in subsequent quarters, requiring an acceleration of the manipulation. Unless business improves dramatically, this is bound to crash sooner rather than later. Indeed, by the end of 1999, as concentrate inventories at Coke bottlers reached exorbitant levels, it was no longer feasible to continue the gallon-pushing program, and, on January 26, 2000, Coca-Cola filed a Form 8-K with the SEC, announcing a worldwide concentrate-inventory-reduction plan, stating that “the management of Coca-Cola and its bottlers, specifically including bottlers in Japan, had jointly determined that opportunities exist to reduce concentrate inventory carried by bottlers.” This, artfully worded statement, says the SEC, was false and misleading, “describing the inventory reduction as a joint proactive efficiency measure between Coca-Cola and its bottlers,” while omitting any reference to the multiyear gallon-pushing program that created the urgent need to drastically reduce inventory levels.
The important lesson from this case is that when you cease mani-pulating, come out with a clear and complete mea culpa, rather than painting the pig with lipstick (i.e., “an inventory reduction plan”).
Charter Communications: No Customer Left Behind
Charter Communications is a provider of basic and digital cable, high-speed Internet, and telephone services. The SEC contends that in 2001, Charter inflated the number of its subscribers—a key performance and growth indicator for communications and Internet companies—to meet analyst growth expectations and portray itself as a reasonably successful enterprise.21 From 1999 to 2001,