Tuesday, July 10, 2007

The Quarterly Earnings Ogre-Creating Mouse Olympics

Here we are again in earnings season. Eddy Elfenbein at Crossing Wall Street took Moodys to task yesterday for its recent report that suggested an advantage of a company going private was that it was freed from quarterly earnings reports and hence, liberating to management. Eddy is so right...private equity investors frequently receive monthly operating and financial data.

But with all due respect (and I greatly respect Eddy's commentary) the real problem is not the frequency of the reporting, it is the guidance and the reliance on guidance by management, by analysts, and yes, by us, the investing public. All paranoia aside, earnings season is a setup for mouse olympics....keeping the hurdles low!! Find an expectation that you can beat, and that's where you set the bar. But like Pavlov's dog, if we keep reacting to quarterlies and quarterly guidance, the feedback mechanism only encourages managements to maintain this charade.

Most earnings guidance is complete and utter B.S. in my view. Get your mind out of the short-term earnings surprise clutter and noise and focus on long-term value creation.

Don't get me wrong....North American disclosures of quarterly earnings are far superior to many European jurisdictions that provide semi-annual reporting. But what should we be looking for from management?

It ain't earnings guidance.
What I want to know is how is management managing the business. What is the impact of competition and how do we stand in the marketplace? What are we doing about it? Justify the capital expenditures and tell me about the rate of return hurdles that justified them.

Although the creation of long-term company value is widely accepted as management’s primary responsibility, much research suggests that managing predominantly for short-term earnings expectations often impairs a manager’s ability to deliver such value to shareholders.

According to a survey (conducted on behalf of the CFA Institute) of more than 400 financial executives, 80 percent of the respondents indicated that they would decrease discretionary spending on such areas as research and development, advertising, maintenance, and hiring in order to meet short-term earnings targets and more than 50 percent said they would delay new projects, even if it meant sacrifices in value creation.In other words, satisfy the analysts and make sure that the accounting number is hit to meet the quarterly expectation. In other words, forget about long term value and working for the owners of the business.

Hitting the "number" by forgoing some value creating opportunities impairs long term value creation. The obsession with the short term number becomes destructive to the ultimate goal most of us should have, a stronger, more viable company that is value creating. An excessive short-term focus creates a disregard for long-term strategy and discourages investment.

Most of us are aware of Buffett's feeling about quarterly guidance...he doesn't, and a number of his portfolio companies have stopped as well. John Bogle ex-CEO of Vanguard expressed his views as well: “the role of management should not be beating abstract numeric estimates but improving the operations and long-term prospects of organizations.”

I believe that much of the effort expended by corporations in providing guidance is misleading and unproductive and creates an unhealthy short-term culture. To quote the CFA Institute study:

"Although there may be certain benefits to providing earnings guidance, the costs and negative consequences of the current focused, quarterly earnings guidance practices are significant, including (1) unproductive and wasted efforts by corporations in preparing such guidance, (2) neglect of long-term business growth in order to meet short-term expectations, (3) a “quarterly results” financial culture characterized by disproportionate reactions among internal and external groups to the downside and upside of earnings surprises, and (4) macro-incentives for companies to avoid earnings guidance pressure altogether by moving to the private markets. Corroborating research identifies the most significant costs of issuing guidance to be management time (which 53 percent of respondents identified as very costly), a focus on short-term earnings (42 percent), and employee time (35 percent). Additionally, earnings guidance contributes to an illusion of complete business predictability, a faulty premise for both companies and their investors. Recent evidence suggests that companies are indeed addressing the shortcomings of the current earnings guidance landscape. The trend is to shift from quarterly to annual guidance and, in some instances, to withholding guidance entirely. According to research conducted by the National Investor Relations Institute (NIRI), the number of companies providing quarterly guidance decreased from 75 percent in 2003 to 52 percent in 2006. The number of companies providing annual guidance has increased to 82 percent from 38 percent over the same period, and the percentage of companies that now provide only annual guidance is 43 percent."

What I think Moody's is saying is that going private gets a company out of producing quarterly guidance which is then subjected to the Wall Street process-distilling the complexities and nuances of a value creation strategy into a single number. That number, for the most part, is still enumerated by management as guidance and is shaded by Wall Street analysts. Performance is scrutinized very carefully by private equity investors, but it does not come down to a single sacred number.

The long term goal of value creation is what is sought, not an accounting number that Joe Kernen or Maria Bartiromo can rebuke or praise based on its fidelity to consensus. Information that provides insight into long term value creation is what private equity investors want and get and what all of us deserve.

I believe that better decision-making will come by having managements' quarterly discussions focus on strategic discussions, cash flow drivers, and more insightful disclosure. Operating data rather than financial data can provide higher quality information that is less subject to accounting manipulation. A lot of production data or sales data can be produced on a monthly basis.

It's tough to get over the sturm and drang of earnings surprise. It's tough to reject what analysts will spend hours composing as a quick and dirty first response to an earnings release. Private investors are getting the numbers that they deserve. The rest of us should too! And all of us should be insisting on getting answers to the right questions about value creation.

Disclaimer: I, my family, or clients have a current position in Berkshire Hathaway.


At 2:32 PM, Blogger Zach said...

Great post! I really enjoyed your insight.

I tend to think quarterly guidance has its place from time to time but agree with you that this guidance is missused. A company with a ver lumpy income stream may want to issue guidance for the next 4-8 quarters noting how contracts will be delivered upon so that a high or low quarterly number does not throw investors into thinking the long-term guidance is obsolete.

I wonder if the responsibility for most quarterly earnings mis-information lies more on the shoulders of investors than management. If institutional investors drive the stock price down or call for managment changes when quarterly numbers are missed while the long-term value remains strong, then we the owners of the companies are the ones determining the non-productive trends of concentrating on short-term goals.

Just a thought to consider. Again, thanks for the great post.



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