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.

One Tweet Over the Line - Social Media, Investor Relations and Common Sense

Occasionally a sacrifice must be made to the gods of new technology. That is why innovation is sometimes referred to as “the bleeding edge”.  The latest cautionary tale about the brave new world of social media just happens to be about Gene Morphis, the now former CFO of Francesca’s Holdings, a public company, who used Facebook and Twitter to make comments about company and board activities and got fired for his comments.

We have been living with social media for a number of years now, so perhaps it’s not exactly leading edge, but in areas touching upon investor relations, companies have been late adopters, so there is not a lot of precedence to guide people. However, there are two touchstones people should use when putting out blogs, tweets and other social media postings.

First, consider what the Securities and Exchange Commission has said on the subject. To put it plainly, the SEC has stated that that statements made by a company, or anyone who could be considered as speaking for the company, must comply with all of the requirements and restrictions of the securities laws. That means that you must be truthful, complete and not misleading in any statements you make. You also have to comply with the requirements of Reg. FD, and if your blog or twitter feed doesn’t qualify as a broad based distribution method (and most probably do not) then you cannot use it to release material non-public information.

The second item to take into consideration in making social media comments about your company is plain old common sense. One way to test what you want to put in a blog or twitter post is to ask yourself, “Is this something I would be comfortable saying to a room full of equity analysts?” If not, then don’t put it out on the Internet where everyone can see it. This is not rocket science, but there seems to be a switch that gets flipped when some people get on the computer and start typing. People seem to think they can say anything and not be held to the consequences. Who can forget John Mackey, the CEO of Whole Foods making derogatory postings on a discussion board about a company Whole Foods later acquired? (As an aside, Mackey appears to have learned from his missteps as he now has a blog on the Whole Foods web site which gives you good insight into the way he thinks about his business.)

In the case in question, there are a number of statements Mr. Morphis made that are just plain dumb, and probably were reason enough to get him fired by a CEO and Board of Directors lacking in a sense of humor. One example was on March 6th when he said, “Dinner w/Board tonite. Used to be fun. Now one must be on guard every second." But the post that, in my view, he deserves to get fired for was made the following day when he wrote, "Board meeting. Good numbers=Happy Board." Given that the quarterly earnings were not released until March 13, it appears to me that he was making a comment on the upcoming quarterly earnings.  It violates both of the considerations I discuss above: it appears to disclose material non-public information in a selective manner, and it is something that even the most junior investor relations officer would have the common sense not to say. It is clearly, to misquote an old Brewer & Shipley song, one tweet over the line.

Read This Book - Winning Investors Over

To a large degree, investor relations exists in an academic research vacuum. It is hard to find good data on many of the issues IR practitioners spend their time on: guidance versus no guidance, how much information should be disclosed, how to be effective on conference calls, and the overall effectiveness of investor relations programs. Further, if you do go looking for the data, as I have done for my class at Rice, it’s buried in obscure academic journals and couched in dense academic verbiage. (If you are looking for a summary of some of the findings, you can find them on my July 7, 2008 and March 13, 2008 posts.) As a result, much of what investor relations people do is based upon common industry practices, hard learned experience and word of mouth, filtered through the particular corporate environment in which they operate. Hard data on whether or not these practices are effective is simply hard to find and so people go with their gut reaction and what they are comfortable with.

To a certain extent I think this is because effective investor relations covers a number of different disciplines, including finance, communication, marketing and law. Add to that effectiveness mix the need to be an expert on your company’s operations and industry and a comprehensive understanding of how the capital markets work, and you can start to understand why getting good comparisons on the difference between successful IR programs and run of the mill efforts is so difficult.

Recently however, I have run across a book that pulls together the research in the area of disclosure and investor relations activities and puts it into clear understandable language. (I’ve actually been reading the book for a while now, but I’m having trouble getting through it because I keep stopping to make notes to use in my investor relations class.) That book is “Winning Investors Over” by Baruch Lev, a professor at the Stern School of Business at NYU. It covers most of the issues that bedevil IR practitioners, discusses what the research data shows, and makes recommendations on courses of action. For example: Not sure what to do about guidance? Not only does this book show you what the research says, it also helps you put the decision process into a framework that helps you work through the issue. And he does this with issue after issue.

If you are an investor relations practitioner and you want your company’s investor relations and disclosure practices to be informed by the data, not just what everyone else does, you need to read this book. It is so far beyond what I have seen in other books about investor relations as to be in a class by itself. 

Moneyball for Investor Relations

I recently read Michael Lewis’ book Moneyball and was struck by some of the similarities between what it discusses and what commonly occurs in corporate investor relations. For those of you who may not have read the book or seen the movie, Moneyball is the story of Billy Beane, the general manager of the Oakland A’s baseball team who successfully positions his team to compete against teams with much larger payrolls than the Oakland A’s were able to afford. He does this by going against conventional wisdom and finding players that do not fit the establishment’s idea of what a professional ballplayer looks like but who contribute to winning in ways the establishment doesn’t value. In essence, the normal way of viewing these players allows their salaries to be mispriced in the marketplace and a general manager that appreciates this can assemble a winning team for considerably less money. (The football equivalent of this phenomena is Tim Tebow, who does not fit pro football’s concept of what a professional quarterback looks like or does. All he does is win yet the Denver Broncos seemingly couldn’t get rid of him fast enough.)

In investor relations, corporations are constantly applying conventional wisdom to their detriment, which in their case means that the value of their stock suffers. Take, for example, the following statement: “This is what the regulations require us to disclose, and therefore that’s all we are going to say”. This is what I call the regulatory mindset trap. The regulations describe the minimum disclosure requirements, but they don’t tell you to put it in context, or to make it intelligible. Anyone who has ever tried to parse through statements in annual reports dealing with deferred tax accounting or pension accounting can tell you that it is very difficult to make heads or tails of these sections without help from the company. In academic terms, when companies do this, they raise the cost of acquiring the information. This is because investors have to devote more resources towards understanding the information. Further, it also raises the specter of asymmetric information, that is, the information gap between what management knows and what it allows investors to know. Studies have shown that both increasing the cost of acquiring information and high information asymmetry will increase the cost of capital by lowering liquidity in the company’s shares.

Or consider the conventional wisdom that causes companies that take the position, “We simply report what we have done, and we leave it to the investors to figure out what our performance will look like in the future.” When you consider that the value of your company’s stock is equal to the sum of its future cash flows, discounted back to a present value (this is Finance 101), not discussing the future is obviously leaving off a critical piece of information. Investors will then make their own forecasts, whether a company helps them or not.  The forecasts then become harder to make and carry a greater degree of uncertainty without some input from the company. As a result, future values will be discounted to a greater degree, leading to lower stock prices.

So the investor relations thought for the week is that if you hear someone at your company say, “We can’t say that” or “We’ve never disclosed that”, question the conventional wisdom. Your stock could be mispriced simply because investors don’t have the right information needed to make an informed decision about the stock.

Just When You Thought It Was Safe To Go Back on the Call

Strange as it may seem, National Public Radio and Wall Street sell side research share a common business model – they both give the product away and hope you get paid later. The motivations are different; NPR is a not for profit entity while sell side research sits at the heart of profit driven capitalism, but NPR pledge drives and sell side marketing to get commissions directed their way are similar in many respects. Both occur long after the product has been delivered to the user with no obligation for the user to actually pay for it and both attempt to convince the user that they have been given a superior product.

The reason I bring this up is that occasionally NPR comes up with a story that actually has some bearing on corporate earnings and Wall Street, and they recently did so on February 2, 2012 with a piece entitled “Is That CEO Being Honest? Tone Of Voice May Tell A Lot”. You can find it at http://www.npr.org/blogs/thetwo-way/2012/02/02/146288038/is-that-ceo-being-honest-tone-of-voice-may-tell-a-lot.

In the story, NPR examines some software developed by an Israeli company based on research referred to as layered voice analysis. The software picks up on “vocal dissonance markers” that may indicate when the truth is being shaded, or when an executive is trying to avoid saying something that should be said in order to make an answer complete.

Of course, analysts on conference calls listen to tone and inflection all the time, so this of itself is not a news flash. The part of this story that makes it interesting is that the research shows that the analysts are much better at hearing the positive tones in a call than they are at hearing the cognitive dissonance in messages that are being shaded from complete truth. According to the radio story, part of this may be that most analysts stand to benefit more from positive recommendations than negative recommendations. Another part may be that most people are less likely to ascribe nefarious intent when a person sounds less than chipper. To this I will add another factor: most conference calls have taken on a very formulaic approach, and much of the time, corporate management sounds as if they are discussing their immanent root canal surgery with their dentist. Sounding unhappy to be on the call is par for the course and, therefore, it is hard to distinguish an unhappy tone from a less than honest tone. Conversely, any time management sounds happy, it really stands out and is easy to pick up on.

Faithful readers with long memories may recall that I wrote about similar research back in August 2010 in a post titled “Using Computers to Predict If a CEO is Lying”. In that case, researchers from Stanford Graduate School of Business took a look at word patterns during the Q & A sessions of earnings calls to help predict when company management was being deceitful. Now we have software that listens to voice tone that does the same thing. So maybe we are getting closer to the day when management will have no choice but to be completely honest with investors on earnings calls.

It could mark the death knell of the earnings conference call…

Where’s the Beef?

Way back in 1984, Wendy’s, the hamburger chain, ran a commercial that featured a little old lady, played by actress Clara Peller, and the tag line “Where’s the beef?” The commercial became an instant classic because it played to the common sense of the audience to look past marketing hype to try and find the substance of the product. You can find a video of the commercial here: http://www.youtube.com/watch?v=Ug75diEyiA0

I bring this up because I often feel the same way when I hear about the benefits of corporate restructuring programs. These programs are often announced to great fanfare by corporations when they take massive one-time write-downs. The benefits are then discussed in diminishing amounts as the ensuing years unfold and we are left to take the company’s word that they in fact achieved the benefits claimed. So I thought I would go back and look at an example of one of these programs to see if I could understand the savings claimed.

Here, for example, is Walgreens President, Greg Wasson, as quoted by StreetInsider.com on January 8, 2009:

"Our Rewiring effort is finding ways for Walgreens to be more effective and efficient so that our growth strategy can move forward"

In its entirety, Rewiring for Growth targets $1 billion in annual savings by fiscal 2011. The company will achieve savings through:

• strategic sourcing on indirect spend (all goods not for resale),

• reduction in overhead and labor,

• and the POWER project, which is designed to enhance patient-pharmacist interaction while reducing costs.

Walgreens expects to incur costs of $300-$400 million over FY09 and FY10 as it implements Rewiring for Growth. 50% of the project’s benefits are expected to accrue beginning in FY10, with the full $1 billion in targeted annual savings beginning in FY11.”

This sounds like great stuff. If Walgreens could take $1 billion out of its expenses, with 2011 sales of $72.184 billion, they should reduce their expense ratio by 1.38%, which presumably should go straight to the bottom line. So I went and looked at what has happened to expense ratios since 2008, the base year of the announced “Rewiring for Growth” program. When I looked at the S, G & A expense ratio for the company here’s what I found:

2008 (base year) 22.36%

2009 22.68%

2010 23.02%

2011 22.94%

In other words, not only has the expense ratio not gone down, it has gone up in two of the three years since the program was announced and the ratio is 58 basis points higher now than when they started. In fact, if Walgreens had just maintained the same expense ratio that it had in 2008 before the program began, expenses would have been $476.4 million lower than they were in 2011. So I have to ask: “Where’s the beef?” How can you have an expense reduction program that results in rising expense ratios?

In their 2011 Annual Report, Walgreens states way back on page 19: “We have realized total savings related to Rewiring for Growth of approximately $1.1 billion compared to our base year of 2008. Selling, general and administrative expenses realized total savings of $953 million, while cost of sales benefited by approximately $122 million.” If you go and look at some of the company presentations they go to great lengths to try and justify their calculations, but when I read it I find myself in a time warp back to the late 1990s where companies routinely issued press releases about “earnings without the bad stuff”. There must be a method to their calculations – but it’s a little too subtle for me and I always worry about how they decided what to leave in and what to take out. (And let’s not forget that they said they would be getting $1 billion per year savings by now, not over the life of the program.) I mean, they’ve got sophisticated accounting systems and I’m just one guy with a calculator, but I really would like to see it in the income statement numbers, because what they’re saying doesn’t make sense to me. It’s not a successful expense reduction program if you don’t lower expenses.

From an investor relations standpoint, this stuff certainly doesn’t help management’s credibility. Maybe this is just the way things are done, but it’s quit frustrating for your average investor. When I get frustrated, I tend to take it out with food, so I think I’ll go fix myself a hamburger… and find some real beef.

Practicing Safe Presentations

How many times have you been at a conference and seen a corporate investor presentation that begins something like this:

“Good morning. I’m Joe Terrific, CEO of Godzilla Industries, and I’m here to bring you up to date on all the great things we’re doing. (Pause while he moves rapidly from the title slide, past the safe harbor slide to the beginning slide describing the business.) Here at Godzilla Industries…”

In other words, the safe harbor statement slide is up on the screen fleetingly, but not referred to verbally. The thinking being that they’ve shown the disclaimer about forward-looking statements, all the investors in the room are sophisticated institutional investors and know that when a company makes projections and statements about the future things don’t always turn out the way the company thinks they will. The requirements of the Private Securities Litigation Act of 1995 have been met, right?

Well, maybe not.

A recent ruling by a federal trial court for the Western District of Washington has underlined the need for companies to make sure they verbally reference the safe harbor disclaimer. The case is In re Coinstar Securities Litigation, Case No. C11-133 MJP (W.D. Washington Oct. 6, 2011) and all practitioners of investor relations should take notice of it.

The case involved allegations that on various occasions the management of Coinstar made projections and statements about future expectations that did not come to fruition. As happens in these cases, the lawyers for Coinstar made a motion to dismiss the complaint. This is a motion made early in the proceedings that has the effect of cutting off the litigation before the really big legal bills start to pile up. It is done before pre-trial discovery takes place, which is when a plaintiff can drive a company to distraction by forcing it to produce thousands of pages of documents and produce members of management for time-consuming depositions. Once discovery starts, the chances of the plaintiff wringing a settlement out of the company go way up, as it is often cheaper to settle than to pay hefty lawyers fees for several years running while lawyers pore over boxcar loads of documents in the hope of turning up a smoking gun, with the Russian roulette of a jury trial lurking in the background.

In the Coinstar case, one of the allegations made in the complaint was that forward- looking statements made by company management at an investor conference were false or misleading. In making the allegation, the plaintiffs relied upon a transcript of the presentation, and because the transcript contained no reference to the cautionary language on the company’s presentation slides, the court ruled that for purposes of a motion to dismiss, they could not take notice of something that wasn’t in the record and therefore the lawsuit could proceed on those allegations.

This does not mean that Coinstar lost the lawsuit, but it does mean that the lawsuit can continue and move into the pretrial discovery phase, which is almost as bad as losing. Coinstar did not accompany their safe harbor slide with a simple statement such as, “Statements made in the course of today’s presentation may contain forward-looking information and actual results may differ materially from what we are presenting today. The slide you now see gives you more information on the assumptions and factors we consider in making those forward looking statements and where to go to get more information on our risk factors.” As a result, they have subjected themselves to, at a minimum, additional and unnecessary legal bills, and at worst, the potential of a large settlement or jury award.

So today’s lesson is, just because the safe harbor slide is in every presentation, and everyone has heard it dozens of times before, doesn’t mean that a trial judge will assume investors have heard about it. Practice safe presentations - always refer to the safe harbor statement and slide.