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, Charter reported annual customer growth rates of 3.1 percent, 2.5 percent, and 1.1 percent, respectively. The meager 2001 growth, however, was enabled by a process dubbed internally as “holding disconnects.” This original “growth strategy” was surprisingly simple. Facing an increasing number of customers switching to satellite television and otherwise delinquent or terminating customers, Charter responded by—doing nothing, that is, retaining the deserting customers. This, says the SEC, enabled Charter to pretend that, in 2001, “it was meeting and, at times, exceeding analysts’ expectations for subscriber growth when, in fact, Charter actually experienced flat to negative growth.”22 Whereas the “holding the disconnects” policy took care of the pretense of subscriber growth, Charter also needed to show revenue growth—“show me the money.” This was facilitated by fictitious barter transactions. Charter entered into agreements with set-top box providers adding $20 to the price of a box, and in return the box providers purchased $20 in advertising from Charter, which was duly recorded as revenues to the tune of $17 million in the fourth quarter of 2000. In fact, says the SEC, “no real revenue was generated by these transactions.”23
This scheme highlights yet another aspect of manipulations that makes them unsustainable: manipulating one performance indicator—in this case, subscriber growth—generally requires doctoring other indicators, such as revenue growth.
CMS Energy: Brag-a-Watts
CMS Energy, an integrated energy company, overstated its revenues in 2000 and 2001 by $1.0 billion (10 percent of revenues) and $4.2 billion (36 percent of revenues), respectively.24 This manipulation, however, didn’t affect earnings because it entailed round-trip trades with counterparties, simultaneously purchasing and selling electric power or natural gas in identical volumes and prices, with no deliveries in sight. The purpose of these sham transactions, which were quite popular in the late 1990s and early 2000s in the energy sector, was, according to the SEC, “to elevate MS & T [CMS’s trading division] into the top-20 tier (“top 20”) of the industry publication volume ranking,” expecting that the top-tier status would enhance CMS’s business. As in the Coca-Cola case, the end-of-day contrition was halfhearted. When CMS’s revenues were restated downward on March 29, 2002, to eliminate the effect of the round-trip trades, the explanation CMS gave investors was materially misleading, according to the SEC, because it did not state that the transactions causing the restatement—dubbed in the industry as “brag-a-watts”—lacked economic substance. Nor was the full magnitude of the round-trip transactions—$5.2 billion—properly disclosed.
Both the Charter and CMS cases demonstrate the wide range of manipulated items in addition to earnings and sales, like subscriber growth or oil reserves,25 and the varied target audiences, like customers and suppliers, in addition to investors.
Daisytek International: Driving Miss Daisy to Bankruptcy
Daisytek,
