Corporate earnings announcements can prompt reactions in a company’s supply chain

9:55 am - December 16th, 2006

Shula Neuman
New research has confirmed the market’s link of suppliers and customers across industries. When good fortune smiles on a company, the stock market responds by valuing the firm more favorably. It’s well known that good news for one firm means other companies in the same industry will be affected as well. But according to new research from business professors at Washington University in St. Louis, The Ohio State University and University of Rochester, we can anticipate something else that isn’t as obvious: there’s also a predictable connection between news announcements of a company and its suppliers or customers.

“Efficient capital markets are sophisticated enough to uncover these types of relationships,” said Tzachi Zach, assistant professor of accounting at the Olin School of Business at Washington University.

For illustration, consider manufacturer Intel, and one of its major customers for computer chips, Dell Inc. One might observe information externalities affecting Intel when Dell makes its earnings announcements. Analysts who follow Dell probably ask questions about why the company reported lower operating income than expected. But other analysts-who don’t follow Dell-would still listen carefully because they want to pick up clues about what Dell’s news means to the companies they do follow.

What’s remarkable isn’t that humans can intuit these connections, but that the market behaves in a way that takes into account these finer relationships. Continuing the example, Zach said, consider what could happen to Intel after Dell makes its earnings statement.

“The supplier, in this case Intel, is likely to be affected when the customer announces increased revenues or decreased operating income. What’s more, the tighter the economic bond between customer and supplier, the stronger the impact,” Zach said. “Dell accounted for approximately 19 percent of Intel’s sales in 2005. If more people bought Dell computers in a given year, then Intel is going to benefit as well because Intel produces the chips for Dell’s computers.”
Not all announcements are good news, however.

“Consider the costs of the customer,” Zach said. “If Dell announces its costs have gone up, that’s obviously bad news for Dell. But it’s not necessarily bad news for Intel. Dell’s costs might have gone up because Intel was able to raise its prices. This could be a positive signal for Intel’s shareholders.”

Zach’s research examines various types of accounting announcements and evaluates whether the information-transfer flows consistently depending on the kind of news. In particular, Zach looked at earnings reports, management forecasts and conference callsâ€”whether those calls are related to earnings or not.

Investors aren’t the only ones that can benefit from understanding the connection of supplier and customer through what Zach calls “information externalities.” If there is a lot of competition in a supplier’s industry, then any relationship the supplier has with a major customer is going to be affected by announcements of the company’s well being.

More information on the study, co-written by Zach with accounting professor Shail Pandit at The Ohio State University and Charles Wasley, professor of business administration at the University of Rochester on the study is available through www.wustl.edu.