Guidance – Part 1, Can’t Live With It, Can’t Live Without It

Back in the sexist days of yore, men had a saying: “Women – Can’t live with ‘em, can’t live without ‘em.” That’s sort of the way I feel about guidance, especially earnings guidance. Personally, I don’t like it, but I recognize there are times when it’s necessary. It seems to me that if you give guidance, and you hit your projected numbers, then you get no credit for it. On the other hand, if you miss the numbers you guided to, investors really penalizes you because they expect that you have better insight into the business than they do. And if you beat guidance, then you were sandbagging the numbers and analysts raise their future estimates so high that you are sure to miss in the near future.

Yet lots of companies give guidance, so they must feel they need to. According to a 2010 NIRI survey on guidance practices, of the 269 responding companies, 90% provide some form of guidance, 58% provide guidance on earnings/EPS and 62% on revenue or sales. Baruch Lev, in his book “Winning Investors Over” uses data from First Call and comes up with around 800 companies that provided quarterly guidance and 1,400 that provided annual guidance in 2007. Companies must feel compelled to issue guidance because no sane businessman is going to want to make a public forecast unless he is forced to do so.

So I went looking for some data to see if guidance was a good thing or not. Not surprisingly, the data is mixed. In his book Baruch Lev cites a number of academic studies in support of giving guidance. First, there is a study that shows that companies are more accurate at quarterly guidance than analysts. (This, of course, is not evidence that company guidance is necessarily very accurate, just that it’s more accurate than analysts’.) Second, he cites studies that indicate that guidance enriches the information environment in the capital markets. By this I think he means that the very act of giving guidance is another piece of information, which helps improve transparency. And academic studies show that transparency leads to higher stock prices, lower stock volatility and reduced cost of capital.

On the other hand, the consulting firm McKinsey, in a study published in the Spring of 2006, concludes “Our analysis of the perceived benefits of issuing frequent earnings guidance found no evidence that it affects valuation multiples, improves shareholder returns, or reduces share price volatility. The only significant effect we observed is an increase in trading volumes when companies start issuing guidance…”

So there you have it: dueling experts that lead you to exactly opposite conclusions. Given that it is not totally clear that guidance is for every company, I thought I would try to lay out some of the thinking that might lead a company to make an informed decision regarding guidance. My next post will take the opposite side, citing the reasons not to issue guidance and discuss some of the alternatives that I think are better.

You should engage in guidance if:

1. You are a small cap company and have low sell side analyst coverage. One of the big issues for small cap stocks is getting on the radar screen of analysts and getting coverage. Anything a company can do to improve their chance of coverage, including issuing guidance, should come into play in order to gain the increased trading volumes, liquidity and visibility that come with increased sell side coverage.

2.  You are in a predictable business with good insight into near term revenues and profits. Companies with recurring revenue streams or large backlogs of orders to be fulfilled in the near future are an example here. Businesses with wide swings in revenues dependent upon one-time orders are not good candidates.

3.  You don’t want to give continuous updates on your business in between quarters. The more transparent you can be on a continuing basis, the less you need to help the street by giving guidance. (More on this next week.)

4.  Management has the intestinal fortitude to run the business to plan and not manage the earning to hit guidance. Accounting is full of subjective judgments and timing issues. It is possible to move revenues into the current quarter or fiddle with loss reserves to make earnings look better in the quarter so you hit your guidance. This is almost never a good thing, but the pressure to “hit the numbers” can be overwhelming at times. Don’t issue guidance if it is going to warp the way you run your business.

5.  You figure that the market is going to make a forecast anyway, so why not take control of the process.

I suspect there are many companies that give guidance that do not fit any of the above reasons, but instead do it because all of their peer companies give guidance. This is probably the worst reason to do it, and for support, I cite motherly wisdom about all your friends jumping off a cliff.

Sell Side Coverage, Part 2

A couple of weeks ago, I wrote about the relationship between Sell Side Coverage and a company’s ability to generate commissions. The long and the short of the article was that the sell side is paid via commissions and therefore, the more trading volume your stock has, the greater the likelihood a sell side analyst will cover your company. This is bad news if you are a small capitalization company, as the volume of commissions generated by your average daily trading volume will not make you a high probability candidate for coverage.

So if you are a small cap company, the question becomes, can you achieve any meaningful sell side coverage? The answer to this is yes, but like so much in life, in order to achieve your goal, you must be willing to spend a good deal of time and effort in order to get where you want to be.

There are a number of approaches to this, but in the end, they all come down to doing things that make you more attractive to the sell side. First, you can institute a marketing campaign to make your company more known to the sell side. This means reviewing who covers your peers and others in your industry and contacting them regarding your company’s investment thesis. While this alone is unlikely to result in sell side coverage, it does get you on the radar screen and raises your profile with the sell side. It also helps if you can present the sell side with a compelling reason to follow your company, such as a unique market niche, product or approach your company has that will enable the sell side analyst to be more knowledgeable about the industry than his competitors.

Second, you can make yourself more known to the sell side’s clients, the buy side. This involves the somewhat labor-intensive task of segmenting, targeting and positioning the company’s message to the buy side community followed by lots and lots of mostly fruitless phone calls. The result of this can be two things that will get the sell side’s interest: more trading in the stock and more questions about the company from the buy side. In this process it is wise not to ignore the IR officer’s anathema, hedge funds, as that is where a significant portion of today’s stock trading volume resides.

Next, you can make your management more accessible to the sell side. This may help sell side analysts fill in gaps in their knowledge about the industry and your company’s position in it, or may give them more product knowledge. As the sell side is expected to be experts in all aspects of the industry they cover, helping them gain more knowledge will put you on their radar screen. Additionally, doing a sell side analyst’s conference or using them to help arrange non-deal road shows allows them to show the buy side that they have management access, something they do get compensated for by the buy side.

One thing to keep in mind about this process is that it takes time and commitment from company management to raise the profile with the sell side. If a company has a dedicated investor relations officer and that person has a good working knowledge of how the Street operates, and the willingness to spend the time, then it can be done in-house. If, however, like many small cap companies, the CFO is filling the role of principle spokesperson to the Street, then it makes a lot of sense to hire an outside IR advisory firm to do the heavy lifting described above.

(Full and fair disclosure: the author is a consultant for Three Part Advisors, an investor relations strategic communications and consulting firm.)