SEC Finally Exposes GE's Tricks for Beating Estimates

One of our pet peeves are companies that consistently "beat" analyst consensus estimates by a few pennies per share in nearly every quarter. We tend to view it as a big red flag, and we are pleased to see the SEC finally doing something about it. Many investors seem to fall for this "beating by a penny" practice and take this as a sign of a good company.

There are only two ways companies can consistently beat: (a) talk down the analysts by subtly rewarding those with lower estimates or stressing the downside risks (e.g. Microsoft (MSFT)) and (b) fiddling with the reported numbers, where management always has some discretion. Always being better-than-expected is simply not sustainable because expectations would adjust up over time.

To the extent there is a systematic bias in analyst’s earnings estimates, research has shown that they tend to be too high in projecting long-term growth rates. There is probably also a tendency for analysts to be too low on their near-term estimates because there is more of a penalty to analyst reputations from being too high than too low. These biases apply to analysts and companies across the board. Our pet peeve is about companies that stand out by consistently being slightly better than the consensus. [GE]] has been notorious for it, and the SEC, after years of digging, has discovered instances of fiddling with the numbers.

The SEC can and should be using statistics to spot probable perpetrators. Call it "corporate profiling." The Madoff fraud was apparently successfully detected by some investors (but not the SEC) because the returns were too consistent to be real. Let's watch and see (a) if the SEC catches some of the other "serial beaters,” (b) if GE stops consistently beating by a penny, and (c) if the practice at other companies becomes less common before the SEC steps in. We should not get our hopes up too high, however, because the underlying cause is human nature, and that is unchanging.

Comments

[ex GE'er:]

Immelt and Sherrin should be charged with crimes. Maybe that's the only way the board will act to get rid of these guys.

Aug 05 12:22 PM

[Avooch:]

The potential for a accounting scandal at GE was first discussed on this weblog 7 weeks ago. A few readers agreed.

gudovac1941.blogspot.com/

Also, note GE mentioned on 28.July Call that it might blow through Debt Covenants. Also discussed at Gudovac1941.

Aug 05 12:24 PM

[cswalker21:]

"the SEC, after years of digging, has discovered instances of fiddling with the numbers."

A post that contains a statement like this should back the statement up. Fiddling with the numbers means what, exactly? Perfectly legal changes in accounting practices that are disclosed in the footnotes to the financial statements? Or Enron-style fraud? If you're not offering details, at least mention your source. Otherwise you risk running into sensationalism.

Other than that, I agree with this post, but I'm sure markets are able to see through this pesky beating by a penny ever time.

Aug 05 12:55 PM

[cswalker21:]

OK, I'm a dope. Somehow I missed yesterday's headline about GE paying $50 million to settle claims of accounting irregularities. So that's what you are talking about here. Don't most bloggers put in links to help out attention-span-challenged guys like me?

Aug 05 12:59 PM

[BerkeleyBob:]

I took my long term loss in GE long ago, bought a small position this year and sold at about a 15% gain. The realized loss far exceeded the short term gain. The use of GE Financial to "smooth" out earnings is reminiscent of "Hammerin'" Hank Greenberg's resignation over manipulation of reinsurance and reserves to "smooth" AIG earnings. Greenberg's resignation came long before the credit default/financial crisis, I believe in 2006, when all seemed well in the financial world. The question is why should the SEC collect a fine from GE and there is no corresponding litigation to recover by shareholders.

Aug 05 01:51 PM

[User 466651:]

Cooking the books is nothing new at GE. Jack Welch mastered it! The only difference between Welch and the current idiots running GE is that he did it during times of prosperity. Where was the SEC then?

Aug 05 02:53 PM

[31October:]

Actually, it's amazing how irritating a mosquito can be.

*** Comic-Con, Cetin, Comic-Con:
There are girls there... Ones you might stand a chance with...
If you rent a Bentley and promise them candy...


On Aug 05 07:07 PM Darthmouth Economics wrote:
... good articles for a slow news day: www.iamned.com

Aug 05 08:07 PM

[Dan R/danrog:]

Thornton O'Glove discussed this GE "earnings issue" at some length in his 1987 classic, "Quality of Earnings."

Aug 05 11:49 PM

[Mrudula Shah:]

Mary Schapiro thinks $1B Congress approves for SEC is not enough!! She also thinks Congress doesn't ;et it do its job! Also, it gets its tincome through charging fees to the very corporations it regulates. If so, how can you expect it to be doing the job public wants it to do?


On Aug 05 02:53 PM User 466651 wrote:

> Cooking the books is nothing new at GE. Jack Welch mastered it! The
> only difference between Welch and the current idiots running GE is
> that he did it during times of prosperity. Where was the SEC then?

Aug 05 11:50 PM

[GSaad:]

GE the biggest farce.
When will SEC realize that GE fraud and deception is worth then
the Maddoff's story?
A penalty of fifty millions for a fraudulant entry of $995 millions is
a joke.Jack Welch and his mascott Immelt should be charged criminally for a fraud scheme that has gone on for ever.One should
wonder why they always beat by a penny?
The cost of the fraud was born by the shareholders,how comical!

Aug 06 05:01 AM

[TheRusty:]

It might help to put a few things in context. GE has a strict "follow the law first" policy that supercedes company objectives. GE has acknowledged that the errors that were made were not in compliance with company standards (i.e. this was not intentional). There is tremendous pressure on individual businesses to hit their numbers. The people who did the objectionable actions did so to hit their numbers, not to manage the corporate wide earnings per share numbers. The way that GE was supposed to have been managing EPS was by making discretionary transactions (e.g. selling businesses at a profit or loss, settling lawsuits). Having individual businesses hit their numbers got them in the neighborhood. Making one time decisions allowed them to fine tune the results. For example, a $200M loss could easily be offset by selling a piece of a business for a $200M gain. These kinds of actions were plainly visible in news reports, disclosed in the results announcements and well understood by analysts.

This article implies that GE's beating the numbers was like Madoff's Ponzi scheme in that the consistency was mainly a result of cheating. First, GE "beat or met" numbers from 95-04. The 4 instances cited by the SEC are only for 2002/2003 don't explain a decade of consistency. You can either believe that cheating is fundamental to the company and that the SEC only found the tip of the iceberg, or you can believe that these items were minor blips for a company that is too big to be perfect.

Aug 06 11:39 AM

[optionsgirl:]

GE ‘Buy American’ Water-Filter Shortage Strands Work (Update1)
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By Mark Drajem

Aug. 6 (Bloomberg) -- President Barack Obama’s stimulus spending has run into a problem: A shortage of General Electric Co. water filters.

GE makes them in Canada. Under the program’s ‘Buy American’ rules, that means the filters can’t be used for work paid for by the $787 billion fund.

Contractors are searching the U.S. in vain for filters as well as bolts and manhole covers needed to build wastewater plants, sewers and water pipes financed by the economic stimulus. As officials wait for federal waivers to buy those goods outside the U.S., water projects from Maine to Kansas have been delayed.

“It’s added a whole new level of difficulty,” said Kathy Emery, a senior engineer for the West Virginia Department of Environment. “We’re continually having changes and further guidance” from federal rule-makers, she said.

At stake are the president’s efforts to fuel an economic recovery in the U.S. by funneling stimulus funds to communities, including $6 billion for municipal water projects. Lawmakers mandated that the money be spent on U.S. products, with exceptions to meet international trade obligations.

Fairfield, Connecticut-based GE says it assembles high-tech filtration systems for North American markets at its plants in Toronto and Oakville, Ontario, with parts from Hungary and elsewhere.

Waiver Pleas

Those facilities are “fully integrated” with GE’s U.S. operations and play “a key role in the global distribution” of the filters, GE spokeswoman Kimberly Ramalho said in an e-mailed response to questions. “We believe that national preferences like ‘Buy American’ are protectionist and will invite counter- measures from trading partners.”

State agencies managing five U.S. water projects have requested waivers to buy filters made by GE and other companies, according to Emery, the West Virginia engineer.

Among them is a plea from Canaan Valley, West Virginia, which wants to buy a foreign-made membrane filtration system to prevent nitrogen and phosphorous from pouring into rivers. It’s made by companies such as GE and Japanese machinery maker Kubota Corp.

In all, the Environmental Protection Agency, which administers the water funding, has granted six waivers and has 29 petitions pending.

The purchasing rules are hurting the stimulus program, said U.S. Representative Kevin Brady, a Texas Republican. He has called for a congressional review of the Buy American plan.

Losing Jobs

“There are some real downsides to Buy American,” Brady said in an interview. “It delays projects. We have to look at what jobs we are losing.”

It’s appropriate to require that the stimulus funds be spent to help restore American jobs, said Leo Gerard, president of the United Steelworkers union. Justin Kitsch, a spokesman for North Dakota Senator Byron Dorgan, a Democrat who was a “Buy American” sponsor, also defended the measure.

“The recipients of economic recovery funds will work through the process as quickly as possible so more Americans can be put back to work,” Kitsch said. The “goal with the Buy American provision is to create jobs.”

The rules affect water projects most because highways and bridges have been constructed under Buy American regulations for the past 30 years, and not much stimulus money has been spent so far on public housing and schools, said Chris Braddock, the U.S. Chamber of Commerce’s associate director for procurement in Washington.

At Aquarius Technologies, which sells equipment to U.S. wastewater plants, domestic business has slowed to a trickle, said Tom Pokorsky, president of the closely held company in Port Washington, Wisconsin.

Manhole Covers

“Buy American has stopped U.S. wastewater work this year,” he said. “I’m surviving by selling to Canada.” Even that market won’t be safe if Buy American sparks a “Buy Canada” retaliatory initiative, he said.

After watching trucks send manhole covers flying, officials in Auburn, Maine, switched to hinged covers years ago. The ductile-iron ones they used were made across the border in Canada.

While they waited for weeks for a waiver to buy more covers for a new sewer project, Norm Lamie ordered steel plates placed over the exposed holes. “EPA did eventually give us the waiver,” and the manhole covers are in place, said Lamie, general manager of Auburn’s water and sewer district.

In Overland Park, Kansas, a $16 million project for a sludge plant hit delays once officials accepted federal stimulus funds, said Mike Welch, president of Topeka-based BRB Contractors Inc. Construction stalled because U.S. authorities had to authorize the use of Austrian-made equipment unavailable anywhere else, Welch said.

Make Exceptions

“I would think that with the economy the way it is, someone would make some exceptions and get things done,” Welch said in an interview.

Frederick, Maryland, is among communities waiting for permission to use the GE filters. Officials decided to go for stimulus money after learning they were eligible for more from that program than the $6 million in federal funds they had expected.

In the end Maryland pledged $76 million, including some from the state’s stimulus proceeds, to Frederick County. Now the project awaits resolution of another “Buy American” issue because contractors want to use South Korean blowers.

“The clock is ticking,” said Kevin Demosky, deputy director of the Frederick County Division of Utilities & Solid Waste. “How long are we going to wait to get these awards worked out?”

To contact the reporter on this story: Mark Drajem in Washington at

Aug 06 01:30 PM

[update:]

TheRusty:

It is well known in investment circles that GE is the original scoundrel when it comes to a lot of things, including cooking their books for over a decade.

Believe it.

Aug 06 03:28 PM