Cisco (Nasdaq: CSCO ) fell 12% after hours yesterday, despite reporting earnings that beat expectations. Now, I don't follow the company at all -- couldn't even tell you what it really does -- but this caught my attention. How can a company beat expectations and still be an epic disappointment?
Most who follow the company blamed a dire outlook. I'd like to believe them. But I found this line, quoted from an analyst we'll leave unnamed, both candid and amusing: "The Street was expecting a bigger beat."
Gah. If there's a bigger oxymoron than expecting earnings to beat expectations, I'm stumped. Quick sanity check: If you're expecting a surprise, it's not a surprise.
What's scary about this form of Wall Street stupidity is the effect it has on companies. If management's job is to please shareholders, and shareholders play silly games, then games are what management will deliver. Roger Lowenstein explains in the book Origins of the Crash how the relentless pressure to beat expectations can make otherwise good companies bend:
Number games were becoming a pervasive part of the culture [in the '90s]. The total of companies forced to restate earnings because of accounting errors rose from a handful a year in the early '80s to more than 150 a year by the late '90s. And restatements only scraped the surface; most companies, including IBM (NYSE: IBM ) , were clever enough to manipulate the numbers without running awry of the rules. Microsoft (Nasdaq: MSFT ) flatlined results by deferring (until, presumably, a rainy day) billions of dollars in revenue. PepsiCo (NYSE: PEP ) resorted to the well-known artifice of a "big bath" -- a one-time charge that would enable it to report higher quarterly earnings in the future. According to an intriguing study, the number of companies that either met or just topped their previous quarter's earnings far surpassed the number that fell just a penny short -- a result inconsistent with mathematical chance.
Sad. Warren Buffett, whose honesty has made Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) one of the world's most successful corporations, once said, "We won't 'smooth' quarterly or annual results. If earnings figures are lumpy when they reach headquarters, they will be lumpy when they reach you."
That's how you beat shareholders' expectations.