February 2, 2004

Explaining poor financial performance to analysts

By Diana Drake

It was Sept. 25, 2001, and the nation was still reeling from the 9/11 terrorist attacks of a few weeks earlier. That day, grocery store chain Winn-Dixie revised its earnings estimate downward, blaming economic uncertainties arising from the tragic events of Sept. 11 as one of the primary reasons for its expected earnings shortfall.

Market watchers immediately began to question the tactics of Winn-Dixie and some 100 other firms that pointed to 9/11 as a reason for their bad results. "There's an interesting trend emerging in the stream of corporate profit warnings coming out since the Sept. 11 attacks," said David Brancaccio, host of National Public Radio's (NPR) "Marketplace," on Sept. 25 of that year. "Many companies are blaming their crummy results at least in part on the terrorist strike. But analysts are starting to look askance at some of these claims."

The final message in NPR's report: Analysts and investors, beware.

Managers often provide self-serving disclosures that blame poor corporate financial performance on temporary, external factors, according to Molly Mercer, assistant professor of accounting in the Goizueta Business School. Winn-Dixie, WebMD and others blamed Sept. 11 for their poor results; Callaway Golf has accused the winds of El Niño for blowing in subpar financial performance; and Hershey Foods pointed to economic problems in its relatively tiny Asian market to account for performance woes.

But little is known, Mercer said, about how financial analysts respond to such disclosures. Mercer and colleague Jan Barton, also a Goizueta assistant professor of accounting, explored the topic further in their paper, "To Blame or Not to Blame: Analysts' Reactions to External Explana-tions for Poor Financial Performance."

"We got interested in this subject after Sept. 11," Mercer said. "For some companies [blaming 9/11] was credible because it had a huge impact on them, like anybody in the tourism industry and obviously airlines. But we also noticed that there were some companies where it didn't really make sense. We were interested in the general phenomena, the dog-ate-my-homework kind of excuses, when you try to blame it on something else. Is that an effective strategy for a firm? And when is that an effective strategy?"

Mercer and Barton set out to develop a model of how analysts respond to external explanations for poor performance. Their basic proposition was that analysts' reactions to such a disclosure depend on their perceptions of its plausibility.

The authors tested their hypothesis by conducting an experiment with 94 experienced financial analysts. The analysts were randomly assigned to one of three conditions: a control condition, a plausible explanation condition and in implausible explanation condition.

"[The control group] got a company with bad results with no explanation for the results," Mercer said. "The second group was shown the same bad results and given an explanation where management blamed it on an external event, an earthquake set in Turkey. The earthquake epicenter was right by the company stores.

"We also had a cell where they got the same explanation, same bad results, and were also told an earthquake caused those bad results," Mercer continued. "But in this case we shifted the epicenter of the earthquake really far away from the company's stores."

The pair then asked their subjects to assess three main variables about the company: what the earnings would be the next period, the stock price and their opinions about management credibility. What they found should be a warning for managers: Self-serving disclosures can backfire.

"In the plausible condition where the epicenter is by the stores, people are gentler when predicting the future because they think the bad results could be due to this earthquake," said Mercer, adding that the most interesting results involve the implausible test group.

"We find that this sort of backfires," she said. "When managers try to float these implausible, blame-the-dog type explanations, it doesn't just cancel out. They're actually worse off than if they hadn't given any excuse. When investors try to predict earnings, they reason, 'Things must be really bad if this is the best explanation the company can come up with.' The earnings forecasts and stock valuations are actually lower than they are in our condition where there is no explanation."

Mercer and Barton also found that self-serving disclosures had a substantial negative effect on management credibility, which could damage a company's stock price in the long-term.

Future studies, the pair said, could examine factors analysts use to assess an explanation's plausibility. Researchers also may want to consider the type of external explanation; earthquakes are a one-time event, whereas an explanation like unfavorable weather conditions may persist over time.

This story first appeared in the Goizueta Business School's online newsletter, Knowledge@Emory (http://knowledge.emory.edu), and is reprinted with permission.