Opinion ID: 653198
Heading Depth: 2
Heading Rank: 3

Heading: Nakao's $2.10 Estimate

Text: 15 On March 20th, Adobe announced the results of the first quarter of fiscal 1990 (Q1). That day, Warnock, Nakao and other Adobe officers had a telephone conference with more than fifty financial analysts. The following is an excerpt from the conversation with Nakao: Mr. Burdell of Venture Growth: 16 Bruce, I'm wondering with the first quarter coming in at the high end of the range on earnings, and the new product momentum you discussed, how comfortable you are with the $2.25 estimates out there? Mr. Nakao: 17 Well, Jim, I think you know that most of those estimates are clustering around $2.10 or so, and I guess obviously we'd feel more comfortable with that, and I'm not saying $2.25 is not doable, but I think we just need to wait and see a little bit longer, it's kind of early in the year yet. 18 The context of Nakao's $2.10 estimate, following as it did the public release of actual Q1 results, and Nakao's comfort with a definite number without qualifying language of consensus estimates or possibilities, makes the $2.10 estimate the crux of the case. The projection is actionable if it violates any of the three Apple Computer conditions.
19 The plaintiff concedes the statement was genuinely believed, so the first Apple Computer condition is satisfied.
20 As to the second Apple Computer condition, the plaintiff contends Nakao had no reasonable basis for the $2.10 per share earnings estimate. 21 In Apple Computer, we held that no reasonable basis existed for the speaker to believe the truth of a prediction if the source of the optimism was unrealistic, and not merely uncertain. Apple Computer, 886 F.2d at 1117. The question, therefore, is whether there was a realistic basis for Nakao's $2.10 prediction. 22 Historically, Adobe's earnings had increased incrementally each quarter after the first quarter in a fiscal year. The first had always been Adobe's weakest quarter. In 1987, the year-end earnings were 5.4 times greater than the first quarter; in 1988 they were 5.8 times greater; in 1989 they were 4.8 times greater. Based on these growth patterns, the year-end earnings for fiscal 1990 would have been, respectively, $2.59, $2.78 and $2.30 per share--all higher than Nakao's projection of $2.10. 2 23 The plaintiff contends that Nakao and the defendants had no reason to believe that the historical pattern would hold in 1990. The defendants, however, present four facts which show they had reason to believe that earnings in subsequent quarters would increase and, therefore, Nakao's $2.10 figure was not unrealistic. 24
25 Adobe's 1990 Q1 results were its best ever. Based on quarterly earnings patterns, it was realistic for Nakao to believe that Q2 earnings would be higher than the results for Q1, and that the last two quarters would be even higher. The plaintiff challenges this on the basis that increased costs for the fiscal year would undercut earnings. He points out that Adobe expected to hire new employees during the year, anticipated higher marketing and advertising expenses, and knew there would be higher costs associated with anticipated growth in direct sales revenues. 26 We reject these contentions. They do not demonstrate that Nakao's $2.10 projection was unrealistic. Costs associated with Q1 results were not abnormally low compared to the actual costs of the previous six quarters--all came to about 56% of total revenue. The expected increased hiring did not occur, deferred marketing expenses amounted to only $.02 a share, and it was not unrealistic to assume that expenses attributable to increased direct sales would have the increased sales to offset the higher costs. 27 Even assuming, however, that Adobe was aware higher than usual costs would be incurred for the fiscal year ending November 1990, the following three bases for the belief that the $2.10 projection was reasonable establish, beyond any genuine dispute of a material fact, that the projection was realistic. 28
29 Adobe had reason to believe the Q1 figure of $0.48 would increase in the following quarters because HP became a new customer in Q1. The undisputed facts reveal that there was a major untapped market for HP printers, and the PostScript interpreter performed many more functions than HP's own interpreter. Adobe's optimism about HP was borne out: HP generated additional revenue of over $7 million for fiscal 1990, and one year later Apple and HP were Adobe's largest customers. Nakao could realistically expect higher revenues for Adobe given the new relationship with HP. 3 30
31 It was reasonable for the defendants to believe that IBM's announcement that Adobe's PostScript would be standard in all IBM systems would cause Adobe's product to be increasingly viewed as the industry standard. Given this circumstance, it was not unrealistic to believe that fiscal 1990 earnings would increase as Adobe's product was adopted by more OEMs. The reasonableness of this belief was supported by an analyst's report from Shearson Lehman Hutton and the market's response to IBM's announcement--the six-point surge in the stock price the following day, at the outset of the class period. 32 The plaintiff argues that the failure to quantify expressly the effect of IBM's announcement on revenues rendered the use of the IBM endorsement in a specific earnings projection unreasonable, or at least requires a trial to resolve the question. We reject this argument. There is no authority requiring such quantification. Indeed, Apple Computer holds that the basis for the prediction need not be certain, but only realistic. Apple Computer, 886 F.2d at 1117. 33
34 Adobe had launched four new products that would produce additional revenues in the last three quarters of fiscal 1990. No evidence in the record shows that Adobe did not reasonably believe its new products would generate higher earnings. See Hanon, 976 F.2d at 501. Optimism for the earning potential of these new products was later substantiated by the profits they generated in fiscal 1990. Adobe Photoshop generated $6.5 million; Adobe Type Manager Windows Version generated $1.5 million; Adobe Illustrator 1990 Revision generated $5 million; and a PostScript cartridge available to consumers owning the HP LaserJet II printer generated $3 million. 35 In sum, any one of the three undisputed facts showing Adobe's revenues would increase in fiscal 1990 provide a reasonable and realistic basis for Nakao's $2.10 earnings estimate. These facts render any factual dispute about the alleged understatement of Adobe's costs in Q1 immaterial. Adobe's implied factual assertion that there was a reasonable basis for the $2.10 estimate was not inaccurate. See Hanon, 976 F.2d at 501. 36 We conclude that the plaintiff has failed to present a genuine issue of a material fact to dispute that there was a reasonable basis for Nakao's belief in his $2.10 per share earnings estimate.
37 As to Apple Computer 's third condition, the plaintiff contends that Nakao was aware of five undisclosed facts which tended to seriously undermine the accuracy of his $2.10 per share estimate. 38 a. The plaintiff first contends Adobe's 1990 Financial Plan included an estimate of fiscal 1990 earnings of only $1.47. This estimate, however, was an internal projection. It was designed as a basis for calculating employee bonuses and internal operating expenditures. Financial Plan projections in previous years had never been publicly released and were intended solely for internal use. 39 A corporation may be called upon to make confidential projections for a variety of sound purposes where public disclosure would be harmful. In re Lyondell Petrochemical Co. Seq. Litig., 984 F.2d 1050, 1052-53 (9th Cir.1993). Indeed, in Vaughn v. Teledyne Inc., 628 F.2d 1214, 1221 (9th Cir.1980), we observed: It is just good general business practice to make such projections for internal corporate use. There is no evidence, however, that the estimates were made with such reasonable certainty even to allow them to be disclosed to the public. Vaughn, 628 F.2d at 1221 (emphasis in original). 40 There is no evidence from which a reasonable jury could infer that disclosure of the $1.47 projection in the Financial Plan would have seriously undermined Nakao's $2.10 projection and reduced Adobe's stock price. The facts show the Plan estimate was completely uncertain: it had been historically inaccurate by 50%, it was 50% off by the end of the first quarter, and ended up 25% off by the end of fiscal 1990. 41 Attempting to rebut the uncertainty argument, the plaintiff points to evidence showing that the 1990 Financial Plan was carefully prepared, had been approved by the Board of Directors, had a relatively small contingency reserve compared to previous years, and was the first annual plan under Adobe's new management team. The defendants dispute the meaning of some of this evidence, but this dispute does not create a genuine issue of material fact. The evidence proffered by the plaintiff only shows that the 1990 plan was not as conservative as previous years, not that the market would have used it to discount Nakao's $2.10 projection per share estimate. 42 b. As his next challenge to the $2.10 projection, the plaintiff contends that at the time it was made, Adobe's largest customer, Apple, was demanding lower royalty rates, thereby rendering revenue amounts from Apple highly uncertain. We have consistently rejected similar arguments. In Apple Computer, we held that the defendants' knowledge of facts showing that the company's prospects were uncertain ... [was] insufficient to support liability as a matter of law. 886 F.2d at 1117 (emphasis added). In Hanon, we held that [d]iscussion among management staff regarding potential action to be taken sometime in the distant future is not an item appropriately made a part of public disclosure because of its speculativeness. Hanon, 976 F.2d at 506. Within the constraints imposed by Basic Inc. v. Levinson, 485 U.S. 224 (1988) (disclosure of merger negotiations), highly speculative discussions among companies are also not appropriate for disclosure. Cf. id. at 232 n. 9 (declining to address other kinds of contingent or speculative information, such as earnings forecasts or predictions.) 43 The fact that Apple was demanding lower royalty rates does not necessarily mean that Adobe's earnings would be lower. For example, a royalty reduction might be offset by increased sales. Further, there is no evidence that either Adobe or Apple believed the royalty reduction would actually happen, either in fiscal 1990, in which Apple was contractually bound to continue to pay the rate prevailing on March 20, 1990, or thereafter. This undisclosed fact at most shows some uncertainty of future revenues, which is insufficient to meet the third Apple condition. See 886 F.2d at 1117. 44 c. The plaintiff's third challenge to the $2.10 per share estimate is that the defendants knew that Q2 revenues from two of Adobe's OEMs would be significantly under the 1990 Financial Plan projections, and failed to disclose these projections or the shortfall. The evidence shows that Adobe knew in November that NEC was replacing its old PostScript laser printer with a new model in March and that there were serious concerns about the market competitiveness of the new model. Further, Adobe knew by February 26, 1990 that NEC laser printer sales had declined 22% from Q1. Adobe also knew when it prepared its 1990 Plan that sales of IBM's PostScript laser printers would be lower in Q2 because IBM was introducing a new PostScript laser printer in the spring of 1990. 45 None of these facts seriously undermines the accuracy of the $2.10 prediction. They only pertain to a shortfall in Q2. Even given the undisclosed Q2 shortfall, Adobe's annual revenues from IBM and NEC could still have reached the necessary level to support the predicted $2.10 figure. Further, Adobe's overall revenues would not have suffered had competitors of IBM and NEC sold more PostScript-based products in Q2 or later. Sales by other OEMs had covered shortfalls in predicted revenue in prior years. On March 20, Adobe had no way of knowing that this wouldn't happen again. Lower than anticipated sales in a small percentage of Adobe's business in one quarter does not tend to seriously undermine the accuracy of a prediction that pertains to earnings from all revenue sources for the entire fiscal year. 46 d. The plaintiff's fourth challenge to the $2.10 estimate is that HP's shipments of PostScript products were delayed. This contention lacks merit. Although Adobe knew and did not disclose that Q2 revenues from HP would be lower than expected because introduction of HP's new PostScript cartridge had been delayed, the strong possibility that the revenues would come later in the year means that this undisclosed fact did not tend to seriously undermine the Nakao $2.10 estimate. 47 e. In support of his fifth challenge to the $2.10 estimate, the plaintiff contends that the fact top executives of Adobe were selling huge blocks of stock during the class period tends seriously to undermine the accuracy of Nakao's prediction. 48 This contention conflates the false representation and scienter elements of the plaintiff's case. The undisclosed fact that insiders were selling large blocks of stock is material evidence of scienter. [I]nsider trading in suspicious amounts or at suspicious times is probative of bad faith and scienter. Apple Computer, 886 F.2d at 1117. However, before the element of scienter becomes relevant, the plaitniff must establish that the defendant made an untrue statement of a material fact or [omitted] to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading. 17 C.F.R. Sec. 240.10(b)-5. As we have previously stated, the defendants did not make or omit such a statement.