Risk & Compliance

Show Us the Cash!

Fixed-income investors are happy to receive earnings guidance, but what they really want is cash-flow information, and the more the better.
Kara NewmanJanuary 22, 2004

Much ink has been devoted to earnings guidance for equity investors, but what do debt investors want? Earnings per share is a nice-to-have, and some debt investors are happy with information about business trends and the general direction of future earnings. More than any other metric, however, fixed-income investors look to comprehensive information about cash flow.

Why is cash flow so important? First, because sustainable cash flows mean that a company is likely to make its interest payments, and therefore is less likely to default on its bonds and hurt its credit rating. Furthermore, explains Rob Feingold, managing director and fixed income portfolio manager at David L. Babson in Springfield, Massachusetts, compared with earnings per share, “free cash flow is not as volatile. [It’s] driven more by how much cash your business is generating, how well you manage your working capital, and how much you’re investing for future growth.”

Fixed-income investors are generally dissatisfied with the amount and quality of information that companies provide. According to a late 2002 survey of 285 U.K. bond analysts by Financial Dynamics, a London-based consulting firm, 52.7 percent are dissatisfied with the overall communications practices of issuers, and 53.8 percent are unhappy with the responsiveness of issuers to requests for information and the timeliness of their announcements of significant events. By and large, credit analysts feel that equity analysts receive preferential treatment from corporate investor-relations professionals.

This is not to suggest, however, that equity investors are overjoyed by corporate disclosure practices, either. In an October 2003 survey, members of the Association of Investment Management and Research — most of whose members are analysts or other investment professionals — gave public companies an average grade of “C+” for the overall quality of the financial and corporate information they disclose. (Of the 1,822 respondents, 46 percent said they analyze or invest in fixed-income securities at least part of the time, including 16 percent who said this is their primary focus.)

Companies Inclining Toward “Soft Guidance”

A growing number of companies are moving away from giving earnings-per-share guidance and toward giving a range of estimates or “soft guidance.” This might include qualitative statements about market conditions, trend information that may impact the company’s business, or industry-specific information.

A December 2003 survey of members of the National Investor Relations Institute — an association of corporate officers and investor relations consultants — found that 77 percent of companies provide some form of earnings guidance. Within this group, only 9 percent provide a specific EPS estimate, while 75 percent provide a range of estimates; 67 percent provide revenue guidance. Of the 23 percent of companies that do not provide earnings guidance, about 70 percent said they provide various trend information or other forms of soft guidance to help analysts arrive at their estimates.

Apparently, investment professionals support this burgeoning practice. In the AIMR survey, 69 percent of portfolio/fund managers and securities analysts believe the practice of giving earnings guidance increases “earnings management” — corporate manipulation of financial reports. On the other hand, only 26 percent believe that giving general trend and performance information, but not EPS forecasts or income targets, increases earnings management.

What Fixed-Income Investors Want

So what should companies provide to fixed-income investors? First and foremost, they want information about cash flow. This was the common thread among every fixed-income investor interviewed for this article.

“Net income is fine, but I really want to see what their cash flow looks like,” said a director of investment grade fixed income analysis at an asset management firm. “It is exceptionally helpful if the company can give me a free cash flow number as well.”

While earnings guidance regarding the earnings-per-share number has become a hot button among many equity analysts, fixed-income investors are less adamant about having this particular piece of information. In fact, many fixed-income analysts and investors say they calculate their own metrics and ratios anyway, and express a preference for information about the likely direction of a company’s business.

“My preference is directional guidance — what’s going on with business trends, margins, and so forth,” explains David L. Babson’s Feingold. “I don’t really care whether it’s 56 cents a share or 59 cents a share; that’s not important to me.”

However, this preference is not across the board; many fixed-income investors still expect EPS guidance. “I want a number; directional does not help me,” says the investment grade director. “I am suspicious of companies that are unwilling to give information. With less information, I am going to assume the worst.”

Likewise, a high-yield analyst at one bulge-bracket firm describes the EPS number as “a minimum” in terms of the information he wants to see, which includes operating revenue, operating income, and, of course, cash flow. “If a company does not give earnings guidance, like tech companies in the late ’90s, I think that it does not have a good understanding of its business,” he says.

Information on banking covenants also figures prominently on the wish lists of credit analysts. Although issuers are not legally obliged to provide these details, their absence makes it difficult for bond analysts and investors to assess the risk of an issue. Quips one fixed-income analyst, “What I really want is more complete information on bank covenants and not just the line that ‘we are not going to violate any.’ “

Other information sought by fixed-income analysts includes off-balance-sheet items and contingent/pension liabilities; breakdown of investment spending, such as maintenance and development capital expenditure; information on one-time charges related to recurring numbers; and revenue-per-unit figures. Luckily for fixed-income investors, much of this information dovetails with issuers’ growing inclination to provide soft guidance in lieu of forward-looking earnings per share.

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