If the stock market is as efficient as it's supposed to be, then why would CFOs bother to cook up a few pennies of earnings each quarter to meet analysts' estimates? The answer they frequently give off the record, of course--is that many investors care more about those earnings estimates than about whether those extra pennies have anything to do with a company's operations.
Judging from recent market activity, however, investors may be wising up. For example, as Q3 2000 came to an end, shares in Eastman Kodak Co., Intel, and Oracle Corp. all took it on the chin, not just because those companies' earnings were falling short of expectations, but also because sales were disappointing. Shares in IBM Corp. and Motorola Inc. fell even though earnings met estimates, because sales did not. In other words, investors were at least partly discounting earnings management--even if it stayed well within the boundaries of generally accepted accounting principles (GAAP)--and looking hard at both the top and the bottom lines. Their collective expectation, says William Aylesworth, CFO of Texas Instruments Inc., "is more balanced than it used to be."
So long as that balance persists, CFOs will increasingly find themselves in a new and not entirely comfortable role: They will be called on to help sustain their companies' revenue growth as well as expansion of earnings. Those who fail to meet the call will find their talents and experience less and less relevant to the creation of shareholder value. "Failing to generate enough top-line growth to meet sales estimates is even worse than not making your earnings numbers," declares Chuck Hill, director of research for First Call/Thomson Financial Research, a Boston-based firm that tracks analysts' estimates. The logic is unassailable, says Hill: "That much less is making it to the bottom line."
For some CFOs, to be sure, the challenge isn't new (see "Birth of a Salesman," CFO, June 1997). But in the face of greater expectations, sustaining profitable top-line growth will become a more urgent challenge than ever. And as more investors become more sophisticated in their appraisal of company performance, capital will surely fly from those companies with consistently large gaps between reported earnings and operating results.
Recently, we set out to determine whether it was feasible to identify which companies, and thus which CFOs, currently have the greatest gaps to contend with. There's no foolproof standard for tracking how revenue growth is consistently translating into earnings. But one yardstick clearly comes closest: cash flow from operations, that is, the amount of money that the ongoing business throws off. Why? Because that measure is least subject to accounting distortions.
"Net income and cash flow from operations should track pretty closely," said Howard Schilit, an accounting expert who heads the Center for Financial Research and Analysis Inc., in Rockville, Maryland, at a gathering late last year of the New York Society of Security Analysts. "If cash flow from operations lags behind net income, usually the results are going to be very bad."
Accordingly, we asked the data-retrieval firm Standard & Poor's Compustat to compare the growth in cash flow from operations for the companies in the S&P 500 Composite Index with the growth of their net income for the past three years. We list the 100 companies with the greatest growth gaps. More than 50 companies experienced growth in net income that exceeded that of their operating cash flow by at least 100 percent. And of those companies with at least $100 million in quarterly net income as of the end of the three-year period, earnings growth in 29 cases exceeded operating cash flow growth by at least 25 percent.
Noteworthy Chasms
Consider, for example, Eastman Kodak's yawning gap of 45 percent, which placed it at #90 in the S&P's Compustat study. Analysts say this reflects the company's inability to match cost cuts with top-line growth in any of its most promising business segments. In much-vaunted digital cameras, for instance, the company is losing market share to such competitors as Canon Inc. and Sony Corp., according to Benjamin Reitzes, an analyst for PaineWebber Inc. At the same time, says Reitzes, what sales Kodak is generating there could threaten sales of its basic film business.
While Eastman Kodak declined to comment, its lagging cash flow growth is far from the worst among the S&P 500, according to the S&P's Compustat study. That dubious distinction goes to Ryder System Inc., a Miami-based logistics and transportation firm, whose operating cash flow growth trailed that of its net income during the period in question by an astronomical 67,000 percent. The problem is a legacy of Ryder's history as a diversified transportation services firm.
"We were almost a holding company" as recently as 1996, notes Ryder CFO C. J. "Corky" Nelson. And while the company exited most of its poorly performing businesses, including consumer truck rentals and school bus services, that cost the company almost 60 percent of its revenues. Meanwhile, the company has had to spend heavily to exploit opportunities in its fastest-growing business segment--corporate supply-chain logistics--and that has held back the stock's performance. Similarly costly business-model transitions explain lagging cash flow from operations at such companies as PepsiCo Inc. (#61) and Texas Instruments (#6). And high-tech start-ups such as Xilinx Inc. (#14) find their way onto the list because they've upped their spending to boost growth (see "Capital Exceptions," below).
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