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Companies are trying to shift investors' focus from short-term results to long-term goals.
Joseph McCafferty, CFO Magazine
May 1, 2007
Warren Buffett may be the most celebrated stock picker of our time, but many investors ignore his advice. Instead of taking long-term positions in undervalued businesses, they fixate on short-term performance and clobber companies that miss quarterly earnings forecasts. That goes double for the aggressive hedge funds.
Corporate managers have long complained about the pressure to focus on the short term, but now, for the first time, critics and business groups are racing to their defense. The U.S. Chamber of Commerce recently called short-termism one of the biggest threats to America's competitiveness. "This focus on the short term is a huge problem," agrees William Donaldson, former chairman of the Securities and Exchange Commission. "With all the attention paid to quarterly performance, managers are taking their eyes off of long-term strategic goals."
The cure for the myopia? Stop giving quarterly earnings guidance, says Donaldson, the Chamber of Commerce, and others. "In the life of any public company, no three-month period is ever going to be that important," says David Chavern, the chamber's senior vice president and chief operating officer. The Conference Board has also called on companies to abandon quarterly guidance. And in March, the CFA Centre for Financial Market Integrity and the Business Roundtable Institute for Corporate Ethics proposed a standard template for quarterly earnings reports that would, in their view, obviate the need for earnings guidance.
Not everyone agrees that the focus on the quarter is such a big problem. Indeed, some observers reject the diagnosis altogether. "It's not a problem at all," declares Baruch Lev, a finance professor at New York University's Stern School of Business. Lev, along with University of Florida professors Joel Houston and Jennifer Tucker, recently published the results of a study showing that companies that ended quarterly guidance reaped almost no benefit from doing so.
Meanwhile, many companies are hesitant to give up issuing quarterly guidance. Some take advantage of the practice, using it to lowball earnings expectations. Most insist that guidance attracts analyst coverage and prevents nasty surprises during earnings releases. Small companies in particular find it valuable.
"At some companies that don't have an analyst following, the only way to let investors know what is going on [in between earnings releases] is to provide some earnings guidance," says Lou Thompson, former president of the National Investor Relations Institute (NIRI) and now a partner at Denver-based investor-relations consultancy Genesis Inc.
As the debate over guidance heats up, companies have already begun to change the way they communicate with shareholders. Some have abandoned quarterly guidance in favor of annual projections, or none at all. Others are seeking new ways to draw investors' attention to longer-term strategy and value creation, stressing longer-term goals and nonfinancial measures, and laying out three-to-five-year strategic plans.
Trouble in Toy Land
One of the first companies to stop issuing earnings guidance was Gillette, in 2001. The decision was urged by board member Warren Buffett, whose own Berkshire Hathaway Inc. had never practiced the quarterly ritual. Gillette's move came after the razor company missed its own earnings targets seven times in a year and a half — and took a hit to its stock price each time. The next year, Coca-Cola (where Buffett also sat on the board) and Intel also abandoned quarterly guidance, as did McDonald's in 2003.
It became a trend. By 2005 just 61 percent of companies were offering quarterly projections to the public, according to a NIRI study that year, and the number declined to 52 percent in 2006. Instead, companies have moved to annual guidance — 82 percent at recent count. Thompson says that few companies now give single-number guidance and that the performance ranges continue to widen.
A poster child for the problem with short-term focus could be toy maker Mattel Inc., which decided to discontinue earnings guidance in 2002 after a series of missteps. Indeed, CFO Kevin Farr says that short-term thinking was the primary factor behind the company's troubles. "We got on that treadmill where we set [near-term] performance goals that were very unrealistic, and [we] started doing things that didn't make sense," says Farr.
In 1999, Mattel acquired The Learning Co., a manufacturer of computer games and software located in Cambridge, Massachusetts, 3,000 miles from Mattel's El Segundo, California, headquarters. "It was a bad acquisition outside our core competency," says Farr. He says that quarterly guidance and the short-term focus that resulted were big factors in the company's disastrous move. Mattel sold The Learning Co. the very next year to turnaround firm Gores Technology Group for a share of its future earnings. Mattel posted a loss in 2000 of $431 million, mostly because of the acquisition, and eventually paid $122 million to settle shareholder lawsuits related to overly rosy projections of previous years. By 2000, Mattel's stock had declined to $10 (from a high of $45 in 1998), and CEO Jill Barad was forced to resign.
In 2002 Mattel swore off quarterly earnings guidance, says Farr, as a new management team worked to instill a long-term focus. The company now gives guidance only on a three-to-five-year outlook on a range of financial and nonfinancial goals.
Another change was a shift in the way the company views itself, and how it projects that view to others. Rather than benchmark itself against its smaller toy competitors in an industry full of fads and one-hit wonders, Mattel decided to compare itself to global consumer-products companies, which are typically more mature and show steady earnings growth. "We share many more characteristics with them," notes Farr. The move, he says, enables the company to better focus on creating value over the long term.
Today, Farr spends much more time talking about the business environment and the industry at large. Apparently, the emphasis on a longer horizon for value creation has paid off: the stock hit a seven-year high of $29 in April. "It's not what you say, it's what you deliver," says Farr.
New Companies Say No
A number of newly public companies are refusing right out of the gate to issue earnings guidance. The most famous example is Google, which went public in 2004. Less well known is Hanesbrands, which was spun off from Sara Lee Corp. last year and includes such brands as Hanes, Champion, and Bali. The company shuns bottom-line quarterly or annual guidance, releasing only broad percentage-range growth estimates as goals over three to five years. Currently, for example, Hanesbrands hopes to achieve annualized revenue growth of 1 to 3 percent, operating profit of 6 to 8 percent, and "double-digit" EPS growth over the next three to five years.
"We decided that we didn't want to worry if we were a penny long or a penny short [each quarter]," says CFO Lee Wyatt. He says the time the management team doesn't have to spend working on projections is time they can spend on the business. Wyatt, in fact, wants as little to do with investor relations as possible. That's not to say he thinks communicating with investors is unimportant. "We have a very capable IR person and we let him do his job," says Wyatt.
At first, analysts didn't like Hanesbrands's lack of guidance. "Early on, the conversations were pretty intense," says Brian Lantz, vice president of investor relations. But after a few quarters, Wall Street adjusted, he says. True, analysts' range of forecasts has probably been wider in the absence of the company's EPS guidance, but Hanesbrands's stock has not been correspondingly more volatile — indeed, its volatility has been lower than the market's, says Lantz. Although he cautions that the stock has been trading only since its spin-off last September, he attributes the company's early success to its consistency in communicating its long-term strategy.
Despite his advocacy of longer-term guidance, Wyatt believes the issue of short-termism may be overstated. "It's an issue, but I don't think it's a huge problem," he says. "I think investors want to be focused on long-term results. It's difficult for them because they receive quarterly results, so that's what they go by."
Another company that decided not to issue quarterly earnings guidance is former Enron subsidiary Portland General Electric. Since its 2006 stock issuance, the company has issued annual guidance that it updates every quarter. CFO Jim Piro says that while Portland General focuses on the long term — especially since the utility's shareholders tend to be very long-term-focused — it doesn't ignore what is happening over the short term. "Short-term results can reflect the ability of the company to execute on its strategy," says Piro. He communicates the effects that internal and external factors have on the business, helping investors separate out aberrations. This does not indicate a short-term focus, says Piro, but is rather "about providing more transparency around the business."
Look Who's Talking
Despite successes at companies like Mattel and Hanesbrands, renouncing quarterly earnings guidance isn't always a smooth ride. After giving up quarterly guidance in 2002, Coca-Cola temporarily broke from its policy during a rough patch in 2004 to give a range of estimates for two quarters that would be well below analysts' expectations.
The Stern School's Lev notes that companies that move away from quarterly guidance usually experience a significant decrease in analyst following. Worse, as Lev's survey indicates, companies that move away from earnings guidance face more stock-price volatility. As any day-trader will tell you, volatility is a short-term investor's dream.
Of the 222 companies in Houston, Lev, and Tucker's survey that halted quarterly earnings guidance between Q1 2002 and Q1 2005, nearly a third subsequently resumed giving such guidance. Perhaps somewhat embarrassing for proponents of long-termism, the survey found no evidence that guidance stoppers increased capital investments or research and development, or provided enhanced disclosures outside of EPS forecasts. Evidently, if the companies no longer talked the short-term talk, they didn't walk the long-term walk, either.
So when should companies give up earnings guidance? According to Lev, who sits firmly in the camp that more information is better than less, only when they aren't very good at telling the future. "If you are not better than others at forecasting, then don't bother," he says.
Joseph McCafferty is departments editor at CFO.
A History of Guidance
The practice of issuing earnings forecasts began in the early 1980s, a few years after the Securities and Exchange Commission's controversial 1978 decision to allow companies to include forward-looking projections, provided they were accompanied by appropriate cautionary language. By the late 1990s, nearly every public company was issuing some form of quarterly forecast; many issued a single-number earnings-per-share target. But not everyone was equally privy to the latest information: according to a 1994 National Investor Relations Institute study, two-thirds of investor-relations officers provided guidance on a selective basis, usually giving updates to the analysts they could count on for favorable ratings.
The result was what former SEC chairman Arthur Levitt once called a "game of winks and nods." Companies used earnings guidance to lower analyst estimates; when the actual numbers came in higher, their stock prices jumped. Meanwhile, analysts who claimed to have access to the real projections released "whisper numbers" to favored clients. Day-traders followed the game closely, looking to buy into companies they expected to beat the quarterly EPS number and shorting stocks they suspected could miss.
The game reached a fever pitch during the technology boom of the late 1990s. Companies that missed the consensus earnings estimates, even by just a penny, saw their stock price tumble. "The thinking was that if they couldn't come up with the penny to make the numbers, they must really be in trouble," says Lou Thompson, a partner at investor-relations consultancy Genesis Inc.
In 2000, after the stock market crashed, the SEC put a stop to the winks and nods by issuing Regulation Fair Disclosure, which requires companies to disseminate material nonpublic information, including earnings guidance, to all investors at the same time. The rule caused companies to put more care into their estimates and widen the range of guidance to avoid the constant public disclosure required to recalibrate their targets. — J.McC.