Quarterly Guidance Under Seige

♠ Posted by Emmanuel in , at 6/18/2007 01:39:00 AM
[UPDATE: The Aspen Principles have now been posted online.] This news is potentially big. Really big. As you all know, Wall Street engages in a quarterly game of beat-the-earnings-targets. Stock prices of firms that do are usually bolstered, while those that do not are punished. To this game's critics, it creates a short-term mentality of skimping on investment in the future to maximize on near-term reported earnings per share (EPS). Recent lackluster capital expenditures in the US despite healthy (reported) profits may reflect pathologies of this game. Looking back, I find it funny how firms were busy writing off things when the previous stock bubble burst while accounting frauds like Enron, WorldCom, Global Crossing, and Tyco were revealed. When the business cycle turns--as it inevitably does--accounting sleights of hand performed to meet earnings targets are often revealed.

The Financial Times now suggests that corporate executives, organized labor, and groups like the AARP are becoming fed up with this game of kowtowing to hedge funds and shortsighted investors:

An unprecedented coalition of large companies, pension funds, and trade unions will on Monday urge corporate America to scrap quarterly earnings guidance in an attempt to curtail the influence of hedge funds and other short-term investors.

The move, backed by leading corporate figures such as Jeff Kindler, chief executive of Pfizer, and Anne Mulcahy, his counterpart at Xerox, will increase pressure on companies and fund managers to focus on long-term objectives rather than short-term fixes.

The broad-based coalition, whose participants range from the Business Roundtable, which represents 160 leading US chief executives, to the AFL-CIO, the largest union federation, will also call for an overhaul in compensation practices to reward corporate and fund managers for long-term performance.

Monday’s publication of the new set of corporate principles – masterminded by the Aspen Institute, an influential not-for-profit group – underlines corporate America’s fear that the focus on quarterly results is hampering US companies’ long-term prospects and the country’s economic competitiveness...

The principles, which were also backed by PepsiCo, the Council of Institutional Investors and the five biggest audit firms [I'm surprised by the latter group coming on board], call on companies to “avoid both the provision of, and response to, estimates of quarterly earnings and other overly short-term financial targets”.

Instead, companies should talk to shareholders about their business strategy and their outlook over a number of years, according to the document, which has been seen by the Financial Times.

More than half of US companies offer quarterly earnings guidance and the percentage is higher among larger groups.

In private, many US chief executives say they have to provide their own quarterly earnings forecasts because analysts and investors demand them. Some express the fear that ending the practice would hit their companies’ share prices or that analysts would put out inaccurate forecasts.

Hedge funds and other short-term investors tend to like guidance because the discrepancies between actual and forecast earnings offers them lucrative trading opportunities.

However, corporate leaders and academics argue that the pressure to meet quarterly forecasts prompts companies to forgo long-term investments such as capital expenditure and research and development.

The principles say companies should look at a five-year horizon and urge both executives and fund managers to tie their compensation to long-term performance targets.

There's more from Bowne on an article detailing the growing backlash against providing quarterly EPS guidance and the challenges of discontinuing them:
A growing number of businesses are following the lead of companies such as Google and Berkshire Hathaway: they are moving away from publishing quarterly earnings guidance. Instead, they provide other data that reveal what they consider to be a more accurate picture of their finances. According to an annual study by the National Investor Relations Institute (NIRI), just two-thirds of US companies are providing traditional EPS guidance in 2006, compared with 71% a year earlier. Companies shun EPS guidance for a variety of reasons, Elizabeth Judd suggests. Some are wary of being wrong, particularly if short-term surprises such as bad weather or natural disasters wreak unexpected havoc. (To avoid missing the mark, 83% of the companies that provide guidance use a range for EPS; only 5% are still estimating a precise EPS point.) Others say increased awareness of earnings manipulation by unscrupulous managers has given investors a more jaded view of guidance announcements, even though one study shows that 40% to 50% of companies beat consensus earnings on a consistent basis.

In addition to re-thinking the way they provide guidance, companies are also taking a second look at the timing and frequency of their guidance. According to NIRI, the number of companies providing only annual guidance on earnings rose from 28% in 2005 to 43% in 2006. Updating investors as changes occur, regardless of a typical guidance timetable, is another strategy growing in popularity…

How discontinuing EPS guidance will impact analyst coverage remains unclear, the author observes. Companies that eschew the practice may not be sacrificing analyst coverage, because more and more analysts at larger research houses prefer doing their own research and drawing their own conclusions. However, at least one study has found that when a company ceases guidance, analyst coverage decreases and forecasts become less accurate. Companies contemplating a change in their EPS guidance policy should communicate the rationale clearly to investors, such as a desire to provide better information or to focus more on business matters. Explain the decision in a public forum, but to avoid information overload, one expert suggests, schedule discussions about longer-term strategy separately from earnings announcements.