Earnings: To Guide Or Not To Guide

IN THE AGE OF SARBANES-OXLEY, you might be forgiven for thinking that by almost definition, making ample financial information available to the public is a good thing. But you'd be wrong. In one respect at least, companies and the audit committees that are increasingly in charge of financial disclosures are slowly but steadily abandoning a traditional staple of shareholder decision-making: frequent and regular guidance to analysts and investors about future earnings. Perhaps perversely, this eloquent silence could be one of the healthiest trends to hit the markets in decades.

According to the National Investor Relations Institute's annual survey of its corporate members' practices, a growing number of companies think less is more when it comes to earnings guidance (see table, right). In 2005, the percentage of respondents providing only annual guidance leaped to 43 percent, from 28 percent in 2004 and only 16 percent in 2003. Meanwhile, the number giving quarterly guidance (either exclusively or in addition to annual estimates) again fell sharply, to 52 percent, from 61 percent in 2004 and 75 percent in 2003. And for the third consecutive year, fewer companies reported giving any earnings guidance at all. "Companies, as a general rule, haven't seen that providing guidance yields a reward that justifies the risk," says Charles D. Maguire Jr., a partner at Denver-based law firm Holme Roberts & Owen. "The market tends to be really punitive if you don't make your quarterly guidance number."

Most audit committee charters spell out that reviewing earnings guidance issued by management is among the committee's responsibilities. Given the committee's oversight role in all market-facing activities, boards clearly have a stake in recommending that communications with analysts and investors about financial performance be as transparent as possible. But navigating the Securities and Exchange Commission rules regarding guidance can be tricky. And companies have seen millions' worth of market capitalization vaporize when performance didn't exactly match predictions.

So, rather than hazard a stock selloff—not to mention the occasional spurious class action—after missing their earnings per share estimate by even a penny, corporate leaders are more often deciding to give investors actual business news rather than magic numbers. As a result, the public may wind up with a better supply of what the SEC calls "material information," while companies can redirect their resources toward managing their business rather than managing earnings.

It's not hard to see why the practice of signaling even a range for future earnings has lost popularity ever since the Sage of Omaha himself spoke out against it more than five years ago. Companies embraced guidance in droves after 1995, when the Private Securities Litigation Reform Act let corporations issue forward-looking financial reports with a "safe harbor" provision protecting them from lawsuits if their predictions turned out to be wrong. In the wake of the dot-com bust, that safe harbor hasn't stopped investors from suing en masse when their stocks tank. Many such lawsuits are thrown out; the plaintiffs cannot often prove any intent to deceive. Still, with Sarbanes-Oxley holding CEOs and CFOs personally responsible for the veracity of financial statements, guesswork seems fraught with peril.

Critics of the guidance game charge that it forces companies to emphasize short-term results over long-term success. And in the accounting scandals that ultimately gave rise to SOX, pressure to meet or beat an earnings estimate was cited again and again by defendants. "Companies are really trying to get away from the quarterly focus on earnings," says Louis M. Thompson, NIRI's recently retired president and co-author of a soon-to-be-released white paper on how to recover from "short-termism."

Thompson says these companies are finding support where they least expected it: Wall Street. Aware that earnings guidance can easily be used to manipulate investor expectations, the very sell-side analysts who formerly insisted on frequent corporate guidance now speak out against it. Morgan Stanley's head of global equity research, Dennis Shea, has said the practice discourages analysts from coming to independent conclu- sions, since estimates that fall outside the so-called consensus range tend to be suppressed.

Candace Browning, Merrill Lynch's head of global securities, agrees. "It is very, very difficult for an analyst to disagree with the management that is providing guidance," she said during a Webcast hosted in April by Thompson after the NIRI survey came out. Last year, she testified to Congress that companies would serve investors better by dropping quarterly guidance.

These pronouncements are good news for companies sick of living by numbers. Many have feared they would lose analyst coverage—and hence liquidity—if they stopped handfeeding Wall Street the guidance it demanded.

But recent studies show that doesn't happen. Nor does discontinuing guidance lead to greater share volatility. An article in the March 2006 issue of The McKinsey Quarterly, "The Misguided Practice of Earnings Guidance," concludes that the costs to management of issuing and meeting frequent guidance far outweigh the perceived benefits. The authors pointed to Coca-Cola as a company that made the change the right way; in 2002, then-CFO Gary Fayard let it be known that Coke was reducing guidance because management wanted to spend more time on long-term goals. The stock never even quivered.

Companies that plan to continue their current guidance practices—and many do—should make sure they do their Reg FD homework. That SEC rule, for Fair Disclosure, prohibits any representative of a publicly traded company from sharing "material information" selectively. ("Representative" most definitely includes any director, whether or not he or she serves on the audit committee.) Shudders went through boardrooms last year when the commission fined Flowserve, a Texas-based pump and valve maker, $350,000 for affirming its earnings guidance at a private meeting, just a month after the company had filed a Form 10-Q with the same affirmation. Flowserve's CEO was personally docked $50,000 for answering an analyst's question at the meeting, and its IR director got a cease-and-desist order for letting his boss speak. The case marked the first time the SEC had ruled that simply confirming, rather than revising, earnings guidance amounted to "material" news.

In the wake of Flowserve, Holme Roberts & Owen counsels its clients to develop and follow a policy for communicating guidance. In heading into any private meeting with analysts, the firm says, senior management and board members alike should know the answers to the following questions and behave accordingly:

What was the date of the company's last earnings guidance? If it was more than a week, it would be wise not to confirm any previously issued guidance.

How many days are left in the period (quarter, fiscal year, etc.) for which previous earnings guidance was provided? If the period end is near, a confirmation could be viewed as a de facto announcement of results. Halfway through a quarter (for quarterly forecasts) or any significant time into the third quarter (for annual forecasts) are good rules of thumb for cutting off any private confirmations of prior guidance.

Was the prior guidance based on contingent events? If so, confirmation should be avoided, as it might allow the recipient to infer that the contingent event occurred.

Is there instability in your industry? If so, confirming guidance could communicate more than intended. For instance, if other companies in your industry are lowering their guidance as a result of poor market conditions, confirming your own guidance could suggest you are weathering the storm better than competitors. Selective disclosure of such a confirmation could be dangerous.

Has your company previously revised its earnings guidance for the period? If so, you should refrain from making any nonpublic disclosures regarding earnings.

Finally, Holme Roberts recommends that if the topic of earnings guidance comes up in a nonpublic forum, the company's investor relations and legal departments should be notified. If there is any doubt about whether material nonpublic information has been selectively disclosed, a Form 8-K should be filed as soon as possible.