Wednesday, July 25, 2007

Earnings Guidance: Contrasting Perspectives

In a recent post (here), I discussed the recent work of two blue-ribbon groups focused on eliminating “short-termism” and recommending, among other things, the elimination of quarterly earnings guidance. The results of the National Investor Relations Institute’s 2007 Earnings Guidance Practices Survey (press release here, survey results here) suggest that more companies are shifting away from quarterly earnings per share guidance. The survey results also appear to refute the suggestion that companies that eliminate guidance suffer adverse effects, as discussed further below.

The NIRI survey’s results appear somewhat contrary to some recent academic research on related topics. An April 2007 paper by Joel Houston and Jenny Tucker of the University of Florida and Baruch Lev of New York University entitled “To Guide or Not to Guide? Causes and Consequences of Stopping Quarterly Earnings Guidance” (here) takes a look at a sample of 222 companies that ceased to provide quarterly earnings guidance during 2002 through the first quarter of 2005. The authors found that the “stoppers” ceased guidance for a variety of reasons, all suggesting operating weakness or other concerns, such as poor earning performance, poor record beating estimates, change in management, or difficulty in predicting earnings. The authors also found that “stoppers” experienced a relative decrease in analyst coverage and a relative increase in analyst forecast dispersion.

In summarizing their findings, the authors state:

In a nutshell, guidance cessation follows a poor operating performance and causes a deterioration in the information environment about the company. The major benefits claimed from stopping quarterly guidance – enhanced investment in the long-term and increased strategic disclosures – do not appear to materialize. Moreover, 31% of the stoppers in our sample subsequently resumed quarterly guidance, suggesting that it is rather difficult for firms to buck the trend and abstain from quarterly earnings guidance. Thus, we conclude that, consistent with economic theory, decreasing disclosure – stopping guidance in our case –does not seem to benefit investors or firms.
The 2007 NIRI survey report paints a different picture, perhaps because its survey reflects a later time period than the period the academics studied. The NIRI survey group also includes companies that never provided earnings guidance, as well as “stoppers,” which may account for some of the differences in findings.

The NIRI survey found that only 51% of 2007 survey respondents provide earnings guidance of some kind, compared to 60% of 2006 survey respondents, and that only 47% of 2007 survey respondents provide revenue guidance, compared to 56% of 2006 survey respondents. Of the survey respondents that provide guidance of some kind, only 27% provide quarterly guidance. The 133 responding companies that provide quarterly guidance represents only 17.68% of the 752 survey respondents.

The NIRI survey’s findings about the impact on “stoppers” who ceased providing earnings guidance in the last 24 months contrasts significantly from the findings in the academics’ research. The NIRI survey results reflect an indifferent reaction from both the buy-side and the sell-side to the elimination of quarterly earnings guidance. The NIRI survey respondents reported that discontinued guidance had a neutral effect on their company’s stock’s valuation and volatility, and that their companies had not experienced unusual shareholder turnover. Moreover, only 11% of the companies that do not provide guidance were even considering providing guidance in the future.

Perhaps the later time period reflected in the NIRI survey compared to the time period reflected in the academics’ research explains some of the differences between the two reports. A more cynical view might be that the NIRI study is a survey that depends on respondents’ views, whereas the academics’ analysis was based on the companies’ actual performance.

In any event, the presence or absence of guidance may make less of a difference for companies’ goals than is generally assumed. A July 23, 2007 Wall Street Journal article entitled “Numbers Game: Why ‘Guidance’ May Not Matter” (here, subscription required) reported on a recent study by Thomson Financial that took a look at company performance relative to guidance. Conventional wisdom holds that company executives use guidance to “manage expectations” by keeping analysts’ estimates low ahead of earnings announcements, so that the reported numbers look better. But the Thomson Financial study found that between 2001 and 2006, the S & P 500 companies that issued guidance beat analysts’ estimates 65% of the time, while companies that didn’t issue guidance beat analysts’ estimates 63% of the time.

But whatever companies’ motivations may be for providing guidance, the NIRI survey suggests that fewer and fewer companies are doing it. I don’t think the academics’ research can be disregarded, but I think it may need to be updated. For example, if the class of “stoppers” were brought up to date and the early part of the academics’ data set eliminated (say, data from years 2002 and 2003), the academics’ research might well more closely resemble the NIRI survey’s results.

In any event, the academics’ analysis also represents a particular point of view. The academics expressly advocate the view that it is better if companies provide guidance, on their generalized economic theory that more information is better for the marketplace. But whatever the merits of this analysis in its own context, it is divorced from the practical effect that a public earnings prediction has on the behavior of company officials. Specifically, companies that have established a target will strain to meet it. As I have previously noted (most recently here), a short term orientation driven by earning estimates is frequently at the heart of problems that lead to shareholder claims. I am all in favor of complete disclosure about past performance. But whatever the arguable economic benefits from trying to make public predictions about the future, from a risk standpoint, companies will always be better off keeping their projections to themselves, particularly on quarterly projections.
A July 24, 2007 article discussing the NIRI survey results and the academics' reserach can be found here.

Deeper Dive: In an earlier post (here), I took a look at the 2007 year-to-date securities lawsuits, and I also took a look (here) at the question whether the downturn in securities lawsuits may be temporary or is permanent. In the latest issue of InSights (here), I take a deeper look at both of these topics.

D & O Litigation Update Teleconference: On August 15, 2007, from 2:00 pm to 3:45 pm Eastern, I will be participating in a Mealey’s sponsored D & O Litigation Update teleconference (here). My co-panelists are Marialuisa Gallozzi of the Covington & Burling law firm and Joe Monteleone of the Tressler, Soderstrom law firm. Topics to be discussed include the impact of global warming legal and regulatory issues on the board room and on D & O exposure; the impact of recent Supreme Court decisions, including Tellabs; D & O coverage issues arising from the subprime lending lawsuits; and problems with insurability of Section 11 settlements.


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