Quitting the Guidance Game
June 1 2005 by Chief Executive
Damned if we do, and damned if we don’t” fairly sums up the way CEOs and their financial deputies feel these days when it comes to giving future earnings guidance.
On the one hand, investors and analysts pressure executives for a specific, regular profit estimate, and unless the company meets or beats that number, millions of dollars’ worth of market capitalization can vaporize in minutes. On the other hand, intense scrutiny of corporate auditing and accounting procedures has made some time-honored methods of bolstering current earnings statements dicey at best. Scrambling to make short-term numbers, managers make short-term decisions that delay important investments in R&D or marketing. And in today’s regulatory environment, CEOs and CFOs get punished if they don’t announce every bit of news€¦quot;even the good news€¦quot;as soon as they know it and as publicly as possible.
Caught between the proverbial rock and hard place, CEOs are hunkering down with their boards and advisors to figure out the new rules to the earnings guidance game€¦quot;if, indeed, there are any clear rules. In fact, the issue of how best to share critical information with the public is such a hot button that when Chief Executive asked to speak with corporate officers, auditors and investor relations pros, nearly all declined. “People are lying low on this issue because they’re not sure what to do,” says Louis M. Thompson, president of the National Investor Relations Institute (NIRI) in Vienna, Va., who has attended long, tense conclaves on the subject with his association’s beleaguered members.
The fear and confusion surrounding earnings predictions speaks volumes about a corporate climate that’s full of uncertainty. Haunting every decision about what the market needs to know is the still-amorphous specter of Sarbanes-Oxley, which makes CEOs and CFOs personally accountable for the veracity of financial statements. Then there’s the Securities and Exchange Commission’s Regulation FD (for “fair disclosure”), which states that companies can’t share “material news” selectively€¦quot;that is, with a small group of analysts or institutional investors. Yet the pressure to deliver smooth earnings, and to minimize stock-price volatility, hasn’t let up.
No matter what a CEO does, it doesn’t seem to be right. Look at General Motors. In mid-April, the company announced its biggest quarterly loss in 13 years. The $1.1 billion hit, due mainly to a steep drop in the carmaker’s North American business, worked out to $1.48 per share. That was actually a couple of cents better than what the company had estimated when giving guidance to Wall Street the previous month; by the time the audited numbers were announced, investors had already priced them into GM’s shares. So, what did CEO Rick Wagoner do to spark April’s stock dump? He decided to hold off on giving guidance for full-year 2005 results, pending the outcome of a United Automobile Workers’ union negotiation over health care benefits. Investors figured that could only mean more bad news.
In another cautionary tale, the SEC recently fined Flowserve, a global pump and valve maker based in Irving, Tex., $350,000 for affirming its earnings guidance at a private meeting with analysts, just one month after the company had issued the same affirmation publicly via a Form 10-Q. Flowserve’s CEO was personally fined $50,000 for answering an analyst’s question at the meeting, and its IR director got a cease-and-desist order. The case marked the first time the SEC had ruled that simply confirming, rather than revising, earnings guidance amounted to “material news”€¦quot;the CEO ran afoul of Reg FD by saying nothing had changed€¦quot;and the first time an IR professional was included in the enforcement action, for not stepping in.
Two recent studies suggest that, thanks to nervousness over compliance, more companies are backing off from giving any guidance at all, or giving it less frequently. In an annual survey of finance executives at major U.S. corporations by Greenwich Associates, 55 percent of the 385 respondents said they had issued some form of earnings guidance during 2004, down from 72 percent in 2003.
And when the National Investor Relations Institute questioned 527 of its corporate members on their guidance practices, two results jumped out. The number of companies providing only annualized guidance nearly doubled, from 16 percent in 2003 to 28 percent last year. Those giving quarterly guidance (either exclusively or in addition to annual estimates) fell sharply, from 75 percent to 61 percent. “Everybody’s afraid,” says Frank Redican, a veteran of brokerage house Josephthal & Co. in New York who now runs his own investment firm. “Sarbanes-Oxley changed something, but I’m not sure what.”
From Nothing to Everything
Theoretically, the point of all the new regulation is twofold: to protect investors from behind-the-scenes activities that could affect the value of their holdings, and to encourage companies to manage for long-term growth rather than short-term profitability. How to accomplish these worthy goals has been debated for decades. In the early days of securities regulation, the SEC didn’t permit companies to make earnings forecasts at all. Management released audited and unaudited financial statements as they were compiled. While analysts could publish whatever predictive opinions they liked, estimates from management were considered confusing and counterproductive.
Regulators did a U-turn in the late ’70s, allowing companies to make their own forecasts, and earnings guidance became the norm. The Private Securities Litigation Reform Act of 1995 let companies issue forward-looking, speculative financial reports, with a “safe harbor” provision protecting them from lawsuits if the numbers were wrong. Now, investors who got burned during the tech boom want more regulatory guarantees that companies can’t present their earnings through rose-colored guidance. “We swing back and forth every 10, 20, 30 years,” says Shyam Sunder, professor at the Yale School of Management. “Should we give corporations freedom to give unverifiable information to the public or not? Transparency is good, but if the numbers are wrong, information turns into disinformation.”
He and other academicians are examining earnings guidance patterns to see how companies try to balance investor hunger for information with regulators’ demand for prudence. A study by professors at MIT’s Sloan School of Management last year showed that on average, corporate estimates for earnings 12 months or more in advance tend to be optimistic; as the calendar ticks forward, the numbers are revised gradually downward. And as the actual statement date approaches, guidance leads analysts to lowball predictions. Those data suggest companies spend an inordinate amount of energy managing expectations, Sunder says. Another study, from the International Center for Financial Asset Management and Engineering, goes further, linking the downward-revision trend to executive compensation. With stock options accounting for much of CEO pay, the authors argue, their incentive to beat Wall Street estimates is stronger than ever.
Even before stock options became common, though, executives often felt that analysts had a gun to their heads to give frequent guidance, and many still feel it. Some observers chalk it up to the “lazy analyst syndrome.” “Most Wall Street analysts never ran a company, never ran a payroll and never met a reporting deadline,” says asset manager Redican. “There’s an impatience on the part of these young bucks on Wall Street€¦quot;€˜give me a number!’ But sometimes life is more complicated.” Adds NIRI president Thompson: “What’s behind the drive to annualized guidance is to get analysts away from the quarter-to-quarter mentality. I think there’s hope that it will work.”
Regular guidance also helps analysts minimize the negative surprises that cause stock dumps; they can type up a quick report to warn investors. Without that guidance, and with sell sides so overtaxed, companies fear analysts might dump them. Nearly a third of the CFOs, treasurers and IR officers in the NIRI survey said they are worried they might lose coverage if they cut back on guidance.
So, even CEOs who dislike the practice are finding it hard to break away from quarterly guidance. “If you didn’t have to give it, who would want to?” says Ernst Volgenau, chief executive of SRA International, a technology service and consulting firm in Fairfax, Va., that relies heavily on government contracts. “We want to resist the pressure to be driven on a quarterly basis. Our dilemma is that if we don’t provide guidance every quarter, investors will draw their own conclusions, and we’ll be criticized anyway.” SRA has issued quarterly guidance ever since the company went public in 2002 and, Volgenau says, has always met its numbers. Nevertheless, he adds, “I tell our people not to look at our stock price, but to concentrate on building the value of the company, and the stock will take care of itself in the long term.”
NOT ONLY are accounting firms doing more fraud detection in the wake of Enron and other scandals, there is also a movement afoot to replace the current pass/fail audit with a more detailed grading system.
The idea was first suggested by Samuel DiPiazza, CEO of PricewaterhouseCoopers. Its proponents say accounting firms should adopt a grading system similar to the one used by credit-rating companies such as Moody’s and Standard and Poor’s.
DiPiazza has proposed that auditors grade their clients on what he calls the “six C’s” of financial reporting: completeness, compliance, consistency, commentary, clarity and communication.
In the case of Enron, the argument goes, there was no way that the company’s auditor, Arthur Andersen, would have dared give the energy giant a failing grade under the present pass/fail system. But Anderson might have given, say, a grade of “B” or worse to Enron’s financial statement transparency. That could have sent a signal to the financial markets, prompting analysts to more carefully scrutinize the company.
It’s unlikely, though, that if the nature of the audit ever undergoes such a radical change it will happen anytime soon. The profession has already been buffeted a great deal over the past three years, and the new standard-setter, the Public Company Accounting Oversight Board, is expected to let things settle for a while.
Top CEOs Just Say No
Berkshire Hathaway CEO Warren Buffett was ahead of the pack in backing away from the craze for providing a constant stream of forecasts. In his 2000 letter to shareholders, he said that giving quarterly earnings guidance was a waste of management’s time; CEOs should worry more about long-term strategy. Subsequently, Gillette, Coca-Cola and Washington Post Co.€¦quot;all of which enjoy Buffett’s presence on their boards€¦quot;ceased the practice, giving annual guidance instead. Many other major companies have followed suit. “We changed from quarterly to annual because we decided long-term guidance was better for investors,” says Pepsi spokesman Mark Dollans. “Yes, it’s a tough place to be, but it’s about judgment€¦quot;determining what’s material to investors and what isn’t.”
Executives have discovered, though, that erring on the side of discretion can backfire. After vowing to give up quarterly guidance, Coca-Cola “fell off the wagon,” as one observer puts it, at the end of third-quarter 2004 when management realized that second-half results were going to drag down its annual numbers. Analysts and investors had already reacted poorly to the new lack of hand-holding by management, and executives feared that a major negative earnings surprise would be disastrous. “They had to bring the Street back,” the source says.
Indeed, the tyranny of meeting estimates plays a large part in the corporate accounting scandals of the past several years. To be sure, in some cases, raw greed was at the heart of the wrongdoing. Yet the new spotlight on audit procedures, and on the basic rules of corporate bookkeeping, is forcing some chief executives to rethink routine practices. The most recent example is the investigation into AIG’s method of accounting for its reinsurance transactions, which cost former CEO Maurice “Hank” Greenberg his job. It will be many months before the evidence is sifted and wrongdoing, if any, is established. But new CEO Martin Sullivan is struggling with the market’s reaction to his decision to delay AIG’s annual report. As the company’s officers are questioned, it’s likely that the issue of avoiding negative earnings surprises will come up. In one accounting investigation after another, NIRI’s Thompson says, “all the testimony says, €˜We were trying to make the number.’ And Sarbanes-Oxley didn’t cure that.”
What will? It’s easy to demonize Wall Street, but weaning analysts from the comfortable bosom of guidance may just address the symptom rather than the disease. In fairness, Wall Street is only one link in the daisy chain of short-term thinking. Merrill Lynch conducts an annual survey in which it asks money managers what factors they use when picking stocks to buy. In the latest study, 47 percent of the 201 respondents said they look for companies that beat earnings estimates, up from 30 percent in 2003. That makes positive earnings surprises by far the most popular consideration among stock-pickers€¦quot;way ahead of factors such as return on equity and dividend yield.
Merrill believes the trend is the result of pressure from money managers’ clients clamoring for consistent, high returns. “What was once an annual portfolio review has become a quarterly review, and what was once a quarterly review has become a monthly review,” the study concluded. “As a result, institutional investors have been forced to seek out shorter-term data.”
Individual investors, too, still smarting from the tech boom and bust, have gotten addicted to a steady stream of data. “The public thinks earnings per share is a real number,” scoffs asset manager Redican. “I don’t think you can expect financial data to be all that good for comparison purposes€¦quot;only in a rough, general way. To look at pennies per share per quarter is nonsensical.”
Redican also believes the upheaval in the accounting and audit professions spells more trouble ahead for companies. “Up until now,” he says, “CEOs were charged with keeping the books under GAAP. But what’s €˜generally accepted’? Getting accountants to agree on one method is difficult. Management is sitting between the accounting profession and the public.”
Perhaps nothing short of a prolonged bear market will break investors’ addiction to frequent guidance, and nothing short of a rewritten GAAP will clarify how companies can and should present their earnings. Meanwhile, CEOs trying to break the cycle of earnings guidance and earnings management can expect Wall Street to keep breathing down their necks, regulators to keep watching their every statement and investors to get mad at them no matter how they handle it.