Tuesday, August 31, 2010

Managing Earnings or Managing The Business

Value investors are generally agreed that managements of going concerns should make their decisions based on long-term cash flow implications. Unfortunately, the pressures on managements to perform on a short-term earnings basis can push them to make decisions that are not in the best interests of shareholders. Consider Sterling Construction (STRL), a company that builds and repairs roads, highways and water infrastructure.

Due to the recession, the amount of work available for the company has declined, leaving it operating at a lower capacity. Idled equipment generates no revenue, but accrues charges for depreciation. This charge shows up on the income statement, but note that no actual cash charges occur (apart from any maintenance that is required).

However, if the company did sell this equipment, those depreciation charges would disappear, making the company's income statement look better! Considering the company is not hurting for cash, it would seem that Sterling is better off with the extra capacity, since the actual cash costs (as opposed to earnings costs) are minimal. The extra capacity could come in handy if competitors go under or if the government passes infrastructure stimulus bills.

Usually, minority public investors don't get to know what goes through a manager's mind when it makes a decision to reduce capacity. Sterling, however, illustrated on its last conference call how short-term earnings (as opposed to long-term cash flow) can influence decision-making. Here were management's comments on the topic of selling idled equipment that it believes it will eventually require:

"We're struggling with that issue. So far we are absorbing that extra cost...I have some on our management team that would prefer that we [sell idled equipment], mostly to enhance currently reported financial results. Most of us are of the opinion that that's shortsighted."

Warren Buffett has stated time again that managements must concentrate on long-term returns over short-term earnings management. He notes, "If a management makes bad decisions in order to hit short-term earnings targets...no amount of subsequent brilliance will overcome the damage that has been inflicted." All sorts of companies are busy trying to make earnings look better than they are; investors would be well served to find and stick with managements doing right by shareholders over the long term.

Disclosure: None

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