Managers claim that restructuring increases the efficiency and profitability of companies, but the mixed findings of previous researchers paint a less compelling picture. The authors present new evidence supporting the contention that restructuring enhances firm performance over the subsequent three years.
What’s Inside?
Previous researchers have concluded that restructuring charges, or costs associated with such downsizings as closing plants or terminating employees, can be a device for manipulating future income by transferring expenses from future quarters into the current quarter, as demonstrated by the SEC cases against Borden (1994) and Sunbeam (2003). Other researchers have found that restructuring drives real improvements in future quarterly earnings and cash flows.
To address this conflict, the authors examine two related pairs of measures: (1) unexpected earnings and analysts’ earnings forecast meet/beat rates and (2) pre-managed earnings and operating cash flows.
How Is This Research Useful to Practitioners?
Empirical tests have shown that firms manage earnings to meet or beat consensus forecasts, which can lead to higher stock returns. Missing the forecast can be punishing. To reduce the incentive for firms to manage earnings by reversing portions of a prior year’s overestimated restructuring charge, the Financial Accounting Standards Board issued Statement 146 in 2002. This statement requires firms to record restructuring charges only after the assets and corresponding liabilities are identified and valued. The authors analyze restructured firms to determine whether the subsequent performance is real or managed.
Research analysts, portfolio managers, and regulators may benefit from the authors’ finding that the number and magnitude of unexpected earnings for restructuring firms increase between the pre- and post-restructuring periods. Specifically, quarterly analyst forecast meet/beat rates increase from around 74% prior to restructuring to 77.5% three years after restructuring. Furthermore, in terms of meet/beat rates, restructuring firms shift from falling significantly short of propensity-matched nonrestructuring firms in the pre-restructuring period to significantly exceeding them after the first one and a half years of the post-restructuring period.
The authors examine seasonally adjusted growth in both pretax earnings and operating cash flows for restructuring firms and find similar absolute and relative improvements between the pre- and post-restructuring periods.
The impact of restructuring on pretax earnings over the subsequent three years is between 245% and 730% of the original restructuring charge, depending on the controls applied. The authors arrive at their most conservative estimate (245%) using their measure of pre-managed earnings, which adjusts earnings for discretionary accruals, thereby reducing the possibility of earnings management. They also estimate that the corresponding three-year impact on operating cash flows is at least 275% of the restructuring charge.
Even though there is some evidence of managing earnings by all firms studied, the authors conclude that restructuring appears to lead to real efficiency gains—manifested by substantial improvements in pre-managed earnings and cash flows—which may allow restructuring firms to meet or beat analysts’ earnings forecasts with greater frequency.
How Did the Authors Conduct This Research?
The authors obtain quarterly earnings data from Compustat and analyst forecasts, earnings per share, and stock price data from the Thomson Reuters I/B/E/S database from 2002 to 2010. After applying data requirements and sample selection criteria, they are left with restructuring and matched nonrestructuring firm samples of 3,758 quarterly observations each (754 restructuring firms and 875 nonrestructuring firms).
Using propensity score matching, the authors match restructuring firms with nonrestructuring firms based on their probabilities of incurring a restructuring charge. They calculate those probabilities by feeding seven restructuring-related metrics (e.g., abnormal annual return, change in book-to-market ratio, change in CEO, repeat restructuring charges) into a probit regression model.
They then examine the impact of restructurings on unexpected earnings—defined as the difference between actual and consensus earnings, scaled by stock price—and the ability of firms to meet or beat analysts’ forecasts. The impact of restructurings on seasonally adjusted changes in pretax earnings and cash flows, scaled by the market value of equity, is also examined.
The authors use univariate temporal distributions—quarterly breakdowns of measures one year before restructuring, during the quarter of restructuring, and three years after restructuring—to reveal changes in the differences between restructuring and nonrestructuring firms over time. To examine the impact of restructuring alongside selected control variables, they also conduct multivariate cross-sectional regression analyses in conjunction with two-tailed t-tests.
Abstractor’s Viewpoint
By focusing on seasonally adjusted and control group–adjusted cash flows and pre-managed earnings, the authors aim to ensure that their measures of operational efficiency are as tamper proof as possible. They present convincing evidence showing that restructuring fosters real improvements in organizational efficiency and profitability for the three years following the restructuring.
Although they demonstrate how restructuring might help firms outperform analyst forecasts (forecasts that themselves are the subject of considerable variance and uncertainty), the authors leave unanswered the question of whether this restructuring-driven outperformance leads, in turn, to higher long-term investment returns. Further work in this area, including an assessment of how firms rank with their comparables over the long term, would make this research even more relevant to investment professionals.