Capital Markets

Speaking of Earnings…

As the bank crisis filters down to U.S. units, investment-grade lending suffers.
Joseph McCaffertyOctober 1, 1997

As quarterly earnings announcements draw near, finance executives can safely predict at least one increase — in pulse rates. With Wall Street’s earnings targets for 1998 higher than ever and investors skittish about the course of a long-running bull market, companies that miss targets, even by small margins, face unpleasant consequences in the stock market. No wonder strategies for nudging targets downward are about as legion as cold remedies, and seldom more reliable.

“I do not think that companies or the investing public realize the impact these strategies have on stock prices,” says securities analyst Bill Milton, who follows the volatile computer and semiconductor industries for Brown Brothers Harriman & Co. Companies he covers are all over the map in their range of practices. “Some give very good guidance and some don’t communicate well,” he says. Others just don’t communicate at all.

A debate is brewing over how much, or even whether, companies should attempt to manage earnings expectations, and whether the strategy can really affect how the market reacts to earnings news. Then there is the delicate question of how much guidance on earnings companies should give. Say too much, and they could get hit with securities suits if things don’t go as planned. Say too little, and the volatility that comes from earnings surprises– especially negative ones–wreaks havoc on a company’s stock.

“We don’t give direct guidance to analysts; our business is too changeable,” says Motorola Inc. director of investor relations and corporate vice president Ed Gams, contending that having dozens of businesses around the world makes internal forecasting difficult. That leaves open the question of why companies as complex as IBM provide guidance, but then again, with a return on investment in excess of 30 percent a year for the past five years, Motorola lets its performance speak for itself. “It’s the analysts’ job to construct a model and reach their own conclusions,” says Gams.

The silent treatment can cause real headaches, though. With more than 1 billion shares outstanding, it definitely behooves Hewlett- Packard Co. to take every step to preserve its share price. Hewlett-Packard kept quiet last July as the third quarter of fiscal 1997 was ending. The news was largely good. Sales for the third quarter were up 15 percent versus the same quarter in 1996, and net income, at $617 million, or 58 cents a share, reflected a 45 percent improvement. The market, too, was cooking nicely the day that HP announced its results; the Dow Jones Industrial Average gained 108 points. But the giant manufacturer of office products and computer peripherals allowed analysts to draw their own conclusions, and they were expecting HP to earn 68 cents a share, not 58 cents. When actual results were announced, shares of HP slipped by $2.25 a share, erasing $2.4 billion of market capitalization.

Candor may have virtue, but its value is hard to discern. The Coca-Cola Co. took a candid approach on August 8, warning Wall Street that earnings for the third quarter would only “slightly exceed” 39 cents a share earned in the third quarter of 1996. In other words, Coke was telling Wall Street that the consensus, 44 cents a share, was too high, triggering speculation that the soft-drink giant would earn only 41 or 42 cents a share in the third quarter. Seeking to curtail volatility, Coke created uncertainty instead. Almost instantly, $12 billion fled from market capital, a decline of 7.2 percent. Whether Coke has fully inoculated Wall Street against an earnings disappointment remains to be seen when it announces quarterly results later this month.


Finance executives routinely wail that investors overreact when earnings don’t quite meet overheated expectations. “It’s crazy to think that if you miss by 2 cents you are going to take a big hit on your stock price,” says the CFO of a large computer-products company. This typical refrain, however, overlooks the mechanics of a market system.

Not every stock takes a beating when it misses expectations narrowly. When Sybase Inc. missed the analysts’ bull’s-eye by a 14 percent margin, its stock price actually increased by 4 percent. Fruit of the Loom Inc. enjoyed a similar boost. After reporting on July 23 that it earned 31 cents, not 37 cents, the stock price inched up 4.6 percent.

And of those that are hit, only some are clobbered. When Rubbermaid Inc., which does not comment on earnings except when it is time to disclose them, earned 25 cents for the second quarter, missing Wall Street’s target by 10.7 percent, its market capital may have dipped by 16.7 percent ($764 million). But don’t blame the market’s mood. The same day, July 17, General Public Utilities Corp. fell 10.8 percent short of its second-quarter earnings target, but market capital slipped by less than 3 percent.

How the market reacts has more to do with underlying long-term growth expectations– implicit in price/earnings ratios–than with corporate attempts at damage control. A hit to the stock price is more severe if it interrupts a consistent growth pattern, as is the case at Coke or Gillette Co., another steady earner that waved a warning flag about the third quarter. “Not only is [Coke] falling short of its implied promise to make the numbers, but management is warning about the difficult comparison for 1998,” analyst Jennifer Solomon wrote in a report on Coca- Cola for Salomon Brothers Inc.

When stocks are hard hit for a seemingly small hiccup, “it’s not an irrational reaction,” insists director of research Chuck Hill of Boston-based First Call Corp., a publisher of Wall Street earnings information. “It’s just free-market forces at work.” Stocks take such a large hit for two reasons. First, analysts lower estimates going forward. Many analysts believe the “cockroach” theory, that if there is one surprise, there are bound to be more. Second, says Hill, the P/E ratio is affected. “Investors lose some confidence that [the company] can deliver on what they have been talking about.” He says the uncertainty that a missed quarter creates multiplies the impact. “Noncyclical consumer companies, where earnings are more predictable, pay a bigger penalty for disappointment,” Hill observes. That’s why Rubbermaid took a drubbing in the stock market, while Consolidated Edison Co., which missed its earnings target for the same period by a margin three times larger, suffered no price erosion.

In Rubbermaid’s case, earnings per share not only fell short of analysts’ targets in the second quarter, they fell short of the company’s earnings in the first half of 1996 by almost 7 percent. The hissing sound company executives heard was not just a dip in earnings; it was the air rushing out as a lofty price/earnings ratio slid from 30 to 25. No such sound was audible at Con Edison, where the P/E ratio continued to hover at around 11, about half the average market P/E multiple.

Investor relations can try to temper Wall Street’s long-term growth expectations, but not without adverse effect on the price/earnings ratio, a proxy for growth expectations. Missing a quarterly earnings target by just 10 cents may sound like a meager cause for $2.4 billion to escape Hewlett-Packard’s market cap. But to the extent that stock prices are built on earnings expectations, which buttress price/earnings ratios, actual earnings cast a pall over HP’s future. Instead of an expected 25 percent growth rate, actual performance came in south of 20 percent. Try calculating the present value of $1,000 in 10 years discounted at both rates, and then ask who sounds irrational– nervous investors or executives crying foul?

There is substance to CFOs’ complaints, though, when shortfalls stem from such one- time glitches as high start-up costs for a product rollout or from a two-month delay in regulatory approval, experts report. Finance executives can do their companies some good by clarifying these setbacks. “When there is a logical explanation for a disappointment that doesn’t usually have long-lasting effects, you have to get that across,” observes Prof. Samuel L. Hayes of the Harvard Business School. “You need to preserve confidence in long-term expectations.”

But if business has taken a turn for the worse, preparing analysts for bad news might curb short-term volatility without affecting the long-term outcome. “Over a long period of time, it doesn’t make any difference,” says Hayes. In the long term, he adds, stock prices depend on revenue streams and cash flow, not investor relations.


That said, experts agree that cold remedies deserve a place in the corporate medicine cabinet on the chance that occasionally they’ll do some good. “Managing expectations does work to some degree,” says Michael Seely, president of Investor Access Corp., a New York­ based consulting firm specializing in shareholder value. “It can smooth the bumps.” That’s especially true for lesser-known growth companies, whose analysts often get carried away. “You don’t want the estimates to get away from you,” Seely warns. For 18 quarters through June, companies have beaten earnings expectations by wide margins, according to financial research firm I/B/E/S, in New York.

“One thing we have noticed is that when companies communicate more effectively, liquidity improves,” says Seely. “While it’s tough to quantify, it can result in a higher valuation, most conspicuously at small-cap companies.”

Others have noticed a similar link. Ray Ball, professor of business at the William E. Simon School of Business at the University of Rochester, says companies that communicate through conference calls, including those that comment on earnings, experience higher volume and more analyst coverage. “It reduces the cost to analysts of following you,” says Ball. He says that companies that can benefit the most from providing more guidance are those that are growing, raising capital, and have more extraordinary items in their financial statements.


When it comes to ongoing rapport with the Street, Amp Inc. gets top marks from Chuck Hill. “They have done a tremendous job over the years,” says Hill, who has worked as a securities analyst for several firms. “There are no surprises on announcement day.”

CFO Robert Ripp follows consensus numbers published by research firms like First Call and I/B/E/S, and keeps analysts posted on Amp’s progress toward them. “We have a long history of being very accessible in good times or bad,” says Ripp, who joined the Harrisburg, Pennsylvania-based maker of electronic connectors in 1994, as it was launching a difficult transition.

The $5.47 billion (in revenues) Amp also tries to keep expectations from putting too much heat on. So Amp calls analysts that it thinks are out in the stratosphere and simply tells them they are too high. “We’re candid about being conservative,” says Ripp. “Why would I want to point to left field and say we’re going to knock one out? I’d rather surprise them than disappoint them.”

But convincing analysts to adjust expectations downward can do more harm than good. “Rather than tell analysts that they’re too high or too low, companies should guide analysts by questioning the assumptions they use to arrive at a number. Otherwise, they risk selective disclosure or possible litigation,” says Louis Thompson, president and CEO of the National Investor Relations Institute (NIRI), in Vienna, Virginia. He says companies that make a habit of steering analysts so overtly incur an obligation to keep analysts, and the public at large, updated if something changes as the reporting period approaches. Once a company starts to comment, it risks litigation if it fails to pass along subsequent news that might hurt earnings.

A 1995 NIRI study found that 69 percent of respondents usually provide guidance to analysts on earnings estimates, mainly by questioning underlying assumptions in earnings models. “You want to guide them without giving them new material information,” says Thompson, suggesting a challenge for both parties. “You want them to derive a better estimate for themselves.” If that sounds fuzzy, NIRI’s Standards and Guidance for Disclosure is equally ambiguous: “Guidance from the SEC suggests that general discussions from which skilled analysts can extract pieces of a ‘jigsaw puzzle’ that would not be significant to the ordinary investor but are useful in constructing the analyst’s ultimate judgment, should be encouraged.”

The problem is that selective disclosure– which includes revealing material information to analysts but not to the rest of the public– and standards have left many CFOs and IR staff frustrated and confused. They want to provide analysts with as much guidance as possible without being held liable by plaintiffs’ attorneys if circumstances change unexpectedly.

“Its something we worry about all the time,” says Jerry Morris, chief financial officer of Diebold Inc. “And it’s something we hammer into our people at managers’ meetings.” Apart from making key employees aware of the dangers of selective disclosure, many find ways around the rules. CFOs are left using the “wink and a nod” practice–dropping hints during conference calls and using body language to make a point to analysts without going on the record. “They also use inflections in their voice or hand gestures to make things clearer to analysts,” says Ray Ball of the University of Rochester.


It’s a strange condition in corporate finance that executives who moan that their stock is too low often say it’s because Wall Street’s earnings expectations are too high. “A lot of companies lowball estimates,” says securities analyst Wendy Abramowitz of Argus Research Corp. “Microsoft has been doing that for a long time.” Indeed, Microsoft Corp. met or exceeded earnings targets in 43 of 44 quarters through last June. “They are always saying things like, ‘Earnings are slowing up,’” says Louis Ehrenkrantz, of investment management firm Ehrenkrantz King Nussbaum Inc., in New York City.

Microsoft executives bristle when accused of lowballing earnings estimates. “We have said for some time that our growth rates are going to slow,” says Carla Lewis, senior director, investor relations. “We don’t want [analysts] to get carried away about expectations that would be beyond a reasonable range of possibilities.” Never mind how hard it is to predict the growth of a company with new markets unfolding in front of it; Lewis credits the company’s steady predictability to “a lot of sharp analysts with a good understanding of the business.” There’s no hanky-panky, she insists. “The numbers are what they are: the result of actual business performance and the way we are required to report them according to GAAP.”

Like Microsoft, Compaq Computer Corp. has also been accused of playing the game, says Milton. “They lower expectations, then they coast through the year and beat the numbers.” But in Compaq’s circumstances, products and pricing change so often and so dramatically that an off quarter might be both severe and irrelevant–in other words, an excellent case for shaping expectations.


Diebold doesn’t lowball earnings estimates, but it does an awful lot of hand-holding with analysts. “If someone is out in left field with their model, we call them up and ask them about it,” says CFO Morris.

Because the Canton, Ohio-based maker of automated teller machines and other electronic equipment has few peers, Morris spends a lot of time directing analysts away from the wrong industry comparisons. He even refers to the need to “train” analysts.

Diebold’s special treatment of its analysts stems from a program that was started in the early 1990s to beef up investor relations. The company was suffering from volatile stock price, little analyst coverage, and a credibility problem among the analysts who did cover it. “Things were pretty bad,” admits Morris.


But no matter how much guidance some companies spoon out, analysts want more. “Very few [companies] fall into the range where they give very open guidance,” says Michael Caccese, of the Association for Investment Management and Research (AIMR), whose members include some 24,600 securities analysts. “From an analyst’s point of view, the more information the better,” Caccese says. “You can never give an analyst too much information.”

Tight-lipped policies drive some analysts crazy. “It certainly makes my job more difficult,” says Robert Wilkes, of Brown Brothers Harriman. First Call’s Hill doesn’t like it either. “There are some companies that didn’t tell us anything,” he says. “You’re out there flying blind.”

Not every analyst thinks companies need to provide more guidance. “I have no idea why companies are convinced it is good public relations to talk about earnings estimates,” says Ehrenkrantz. He thinks companies worry too much about Wall Street’s quarterly earnings targets. “It’s become an obsession,” he says. “Let the actuals speak for themselves. If the business is solid, then earnings will come.” Motorola’s Gams gives loss of long-term focus as a reason why Motorola refrains from guiding analysts and mutual fund managers who need investment gains every quarter to compete in their business.

“Whisper numbers” have added a puzzling new dimension to the debate over communicating with analysts. These are numbers investment firms don’t publish, but “whisper” to privileged clients. When Intel Corp. posted earnings last January of $2.13 per share that beat the consensus published by First Call, shares fell $5.125 in trading the next day. The reason, say analysts, is that whisper numbers had placed earnings as high as $2.20 per share and pushed the stock up in the days before earnings were reported. “They are causing some real anguish among companies,” says NIRI’s Thompson.

Not all unpublished numbers are rumors, says Caccese. Because analysts constantly revise assessments, it’s not uncommon to reveal numbers that have not been published. Those who do traffic in whisper numbers for the benefit of select clients cross a serious line. “If analysts are withholding information or lowballing in order to whisper another number, that would be an ethical violation of the standard,” Caccese declares.

Twice during the second quarter of 1997, Seagate Technology Inc. advised analysts to expect an earnings disappointment. The first time it announced that earnings would not meet the analysts’ consensus. “Ten days later, it was clear that the business had turned soft on us,” says a company official, prompting the second announcement. It’s not an ideal way to communicate with investors, he says, but it’s far better than letting the news dribble out as analysts change recommendations one at a time. “We wanted the world at large to hear it from us, not piecemeal from the analysts,” he grumbles.

When the dust settles, however, earnings’ preannouncements sound like more noise than action to Richard Pucci, executive vice president of I/B/E/S. “Bad news is still bad news, and the markets will react accordingly,” says Pucci. “Wall Street is not asleep at the wheel.”

It’s true that companies’ communication efforts don’t have a long-lasting impact on how the market interprets material information. But that doesn’t mean companies should button their lips. If they can bring some stability, even if it’s in the short term, then it’s worth it. “What we’re trying to do is erase as much uncertainty as we can that is related to inefficient information flow,” says Doug Wilburne, director of investor relations at Amp. CFO Ripp thinks being so open may have a more immediate impact. “It has brought Amp a lot of goodwill. There is the feeling that [investors] may be more forgiving if there is a bump in the road.”

What Analysts Really Want

By Mark J. Epstein and Krishna G. Palepu

Corporate executives often believe that financial analysts are just interested in next quarter’s earnings numbers, rather than paying attention to a company’s long-term strategy and management plans. As a result, managers often don’t pay adequate attention to communicating to the analysts. They see annual and quarterly reports merely as legal documents, not as communication vehicles.

To find out what analysts think of corporate communications, we surveyed 140 sell-side analysts that were recognized as leading the industry in research, stock-picking, and earnings estimates.

Our survey led to the following findings:

*More than 85 percent of the analysts surveyed indicate that they would like to receive more information than they currently receive on a company’s corporate strategy; and on the competitive strategy and key business risks of its individual lines of business.

*Analysts view management’s letter to shareholders and the management discussion and analysis in a company’s annual report as potentially very important. However, analysts feel that these sections currently do not provide adequate information on strategy and risks.

*Star analysts can often manage to get the information they seek through private contacts with management, or through conference calls and meetings. However, while 85 percent of the analysts surveyed feel that these informal channels work when a company is doing well, only 39 percent say that they receive adequate information when a company is doing poorly, or when its strategy is failing.

*Only 50 percent of the analysts believe that the current corporate communication is adequate to facilitate good corporate governance. Further, as many as 87 percent of the analysts say that boards of directors represent the interests of managers rather than investors.

What are the key implications of our findings for corporate executives? First, all-star managers should view corporate communications as more than a legal exercise involving financial disclosures. They should tailor a communications strategy to allow analysts to understand their company’s strategy, key value drivers, and the key measures (financial and nonfinancial) that track business success. Second, to gain credibility, managers should commit to communicate in good times and bad. Since analysts’ meetings are discretionary whereas annual reports are not, disclosure strategies involving annual reports are viewed by analysts as more binding. Thoughtful use of annual reports to communicate strategy and its success is, therefore, a must for blue-chip companies that want to maximize their share prices.

There are regular moves afoot to address analysts’ demands for better communication. Unless managers quickly and voluntarily respond to the perceived inadequacies in corporate communication, they may soon be forced to live by straitjacket accounting standards. Their best defense against inflexible standards is likely to be voluntary and credible expansion of their corporate disclosures.

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