How Did You Manage That, Brocade Communications?

In 2000, General Electric posted its 100th consecutive quarter of growth in continuing operations. That's 25 years. Raise your hand if that sounds just a bit suspicious. Whatever business you're in, that feat just isn't possible unless your company's managing its reported earnings.

According to a 1998 survey, 78% of CFOs attending a given conference said they'd been asked to "cast financial results in a better light" without running afoul of GAAP. Half said they'd done it. Nearly half said they'd been asked to misrepresent their company's numbers, and 38% admitted they'd done so. Another survey at a different conference found that more than half of the CFOs attending had been asked to juice their numbers, and 17% had agreed to do so.

It's easy to understand why companies succumb to the incredible pressure to make it look like they've met or beaten targets or Wall Street expectations. Consistent growth is a feather in any CEO's cap, and a rising stock price often increases many executives' compensation, especially from stock options. But when companies stray from merely managing their numbers within GAAP into outright fudging them -- Enron, Sunbeam, we're looking at you here -- they can ruin themselves and their shareholders.

How can we spot suspicious earnings patterns soon enough to save ourselves? We can track how closely a company meets earnings expectations, monitor its frequency of year-over-year growth, and compare those stats to numbers from a few competitors, which should be affected similarly by changes in the business cycle. Any company that lands eerily close to earnings-per-share expectations, and grows earnings year over year with unusual reliability, should raise a yellow flag and invite us to look closer.

Here's a look at what Brocade Communications Systems (Nasdaq: BRCD), the networking company, has done over the past few years. I've also included a couple of other businesses playing in the same space for comparison.

Source: earnings.com and author's calculations. Difference in number of quarters counted due to data source.

In my view, these three companies are, at the very least, good at managing analysts. That's especially true for Brocade, which has hit estimates within $0.02 an astounding 21 times out of the last 27 quarters, even through the recession. For 15 of the past 23 quarters, it's also managed to report yearly growth. When you consider that its biggest estimates miss was a mere $0.05, Foolish investors should probably look a bit more closely to ensure that Brocade is only controlling analyst expectations.

Cisco and QLogic also hit earnings estimates fairly consistently (missing by a max of $0.05 and $0.06, respectively), but they differed a bit on how often they reported growth. QLogic probably gets off the hook with its mere 11 times out of 21, but Cisco grew four of every five times over the past five years. That raises a bit of a yellow flag, at least in my mind.

Note that I'm not concentrating on managing estimates here -- though management does that, too. However, if a management team always seems to deliver on estimates time and time again, you should probably dig a bit deeper, to see whether its interpretation of GAAP is getting a bit too fast and loose.

Investors crave consistency. That's one reason why GE's string of reliable results spurred its stock price to rise so much in the 1980s and 1990s. But the real world isn't consistent, and Foolish investors should account for that. If a company's results seem too steady to be true, Fools should proceed with caution.

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