Tuesday, August 14, 2007

Saying too much

It's hard to believe it. Companies just cannot get away from the supposed "protocol" of giving specific guidance about future earnings. It's pervasive and it's not smart.

Today Wal-Mart, as part of its second quarter earnings report, said that third quarter earnings would be "as much as 65 cents a share", less than the 68 cents estimated by analysts and that full year profit will be "from $3.05 to $3.13", less than the previously forecast $3.15 to $3.13. Home Depot, reporting as well, gave specific guidance a different way by saying that earnings per share from continuing operations "will decline 12 to 15 %". That just takes a couple of seconds on a calculator to turn into an EPS projection.

It seems that most companies these days think that this is what they need to do to communicate to investors. What they are doing under legal and regulatory guidelines is obligating themselves to ongoing disclosure anytime that their guidance falls outside of the projected range, and they are also setting themselves up to get asked to refine their guidance at any public meeting, conference call, or investor event. This raises a few questions:

---What is the role of securities analysts? Don't they look at trends, financial structure, market events, management, and comps to come up with their estimates, or are they now just there to opine on what management constantly gives them. This basically levels the playing field as the few capable analysts that actually add valuable insight and understand the dynamics of a business can barely show their stuff before the company hands over the goods to the entire insight challenged analyst community.

---Is management at all of the firms that give specific guidance, most firms, expected to have a crystal ball or a trusted psychic? For example, look at what's going on now. The interest rate environment is up in the air, consumer spending has some big questions around it, the dollars impact on export and import prices has some significant variability, and corporate investments of cash and securities(for rainy days, pension funding etc.) is faced with the same challenges as the overall equity and credit markets. Yet, these managements are projecting earnings six months out to with around a 2 to 3 % margin of error. Damn smart they are, I'd say. The fact is that they are giving "all things being equal, or as they are now" projections and that's generally not the way the world works.

---Is the focus on constant updating that this guidance practice requires productive for American companies? The lament once was that investors and analysts force companies to focus constantly on quarterly earnings and not on longer term investment, planning, and financial health. Now it's real time earnings that the companies have caved in to.

It doesn't need to be this way. No rule requires companies to give specific guidance on earnings. Google doesn't do it, not at all, because of all of the issues above. They have the power to ignore the requests of many analysts and investors. All companies can choose and there is no evidence that it has an impact on stock price to not play this game. Here's an example.

In 1990, as today, most companies played the game but without Reg FD it was done on an informal basis constantly and securities analysts were the conduit to investors. In the banking industry companies almost uniformly gave guidance to the penny on quarterly earnings and in tight ranges for the year. To my knowledge only four banks did not follow the practice---Manufacturers Hanover, Chemical, Citibank, and J.P. Morgan. ManHan and Chemical combined and the new Chemical continued the approach, and when Chemical bought Chase and became the new Chase the approach continued. From 1990 to 2000 this company, Chase as the combination of MHC, CHL, and CMB, had over a 600% gain from its legal entity stock basis of Chemical. J.P. Morgan's stock price was flat as a pancake until mid-'99 when the market began to price in the possibility that its excellent franchise but woeful financial performance would lead to a takeout(it did in August 2000). Citibank was up over 700% from its beleaguered position in 1990. The point is that choosing to not kowtow to the securities analysts had no discernable impact on stock price. Performance was the issue.

Why do companies give in:
---Everyone else does it so we have to as well(if a few more were brave others would follow)
---Our investment bankers say we need to(investment bankers are experts at making money--clients are their second priority and apart from that they have no interest in rocking the boat)
---The securities analysts say that they can't defend us without the updates(find another line of work if you can't do it)
---Our institutional investors want it(talk to the ones that matter and really move the market and find out the truth)

Open communication to and a dialogue with the investment community is a good practice and is healthy for both the companies and investors. That is generally and correctly presumed to be good for a company's share price over the short and long term. Handing over the keys to internal projections does not need to be a part of this and arguably leads to a lot of wasted time, misdirected priorities, and greater stock price volatility.

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