Earnings Guidance Getting Conservative?

Two-of-three companies on Standard & Poor’s 500 roster have exceeded analysts’ per-share expectations consistently since the first quarter of 2004, suggesting companies are extremely conservative in their earnings guidance to analysts and then over-deliver on results. That’s according to a study by Chicago-based Parson Consulting of earnings-per-share projections and actual earnings results.

Noting that nearly one in four S&P 500 companies have beaten analysts’ expectations by more than 10 percent, Parson said the findings imply that companies have become more conservative in their earnings guidance following the passage of Sarbanes-Oxley.

Hicks

“Companies may be very conservative when projecting their earning causing them to under-promise and over-deliver,” said Toni Hicks, senior vice president of practices at Parson Consulting.

Parson examined public data for all of the available quarterly results of S&P 500 companies as of August 2005, focusing on the difference between EPS consensus estimates and actuals using data from Thomson Financial First Call and The Wall Street Journal.

“When we embarked on this [study], we were looking at the impact on reporting results of the Sarbanes-Oxley reforms” Hicks told Compliance Week. “Last year, one thing we discovered was that there was a great reduction in wide margin misses over all—across all industries, across geographies, companies were missing less on the wide margin in 2004.”

The rising percentage of wide-margin misses on the positive side—to 26.1 percent in the second quarter of 2005 from 20.6 percent in the year-ago third quarter—raises the question of whether companies are building padding into their financial systems to exceed expectations consistently, according to Parsons.

The report found that the percentage of companies that actually meet earnings expectations has fallen four consecutive quarters, to 13.3 percent in the second quarter of 2005 down from 16.8 percent a year earlier. The percentage of companies that have missed their projected EPS by more than 10 percent on the downside averages about 7.4 percent, with 8 percent missing the mark in the second quarter of 2005.

“We wanted to determine if companies are leveraging the intelligence they are gathering from their SOX compliance efforts to improve the accuracy of reporting their results,” said Hicks. “Whether they’re forecasting more accurately is still in question. But there are definitely more companies missing on the top side than on the bottom side.”

In isolation, during a single year, Hicks doesn't believe that the discrepancies are necessarily significant. But over multiple years, “investors want to invest in companies that execute the way they say they’re going to execute.” In other words, she says, companies shouldn’t have wild fluctuations in meeting their results. “As an investor, if a company is continually missing [earnings] on the high side, I wouldn’t necessarily think that they had a good handle on where their business is heading,” said Hicks.

While there’s been a lot of focus on how costly and time-consuming compliance with SOX has been, Hicks said, “The message here is, now is not the time to stop and take a breath: now is the time to take advantage of the work effort and the information you’ve gathered and turn it into a better operating business.”

Hicks suggested that companies move to more of a “virtual close process” and eliminate manual controls that slow down the process of sharing performance information.

King EPS

Thompson

The results of the Parson study didn’t surprise Louis Thompson, president and CEO of the National Investor Relations Institute.

“Companies learned well when the bubble burst in 2000 that they are severely punished by the market if they over-promised and underperformed,” Thompson said. “It comes as no surprise that companies want to be conservative so they can meet or beat [Wall Street] estimates. SOX didn’t provide any cure for this issue.”

“We’ve got a situation in the market today where EPS is king,” said Thompson. “It underscores the penchant in the marketplace for ‘short-termism’—an emphasis on quarterly results instead of on the long-term.”

Thompson says NIRI doesn’t have a position on earnings per share guidance. “It’s up to companies as to whether they provide it,” he says.

However, he noted that a survey earlier this year of 527 NIRI corporate members on current earnings guidance practices found a decline in the percentage of companies providing earnings guidance to 71 percent from 77 percent in December 2003.

That NIRI survey also found that the percentage of companies furnishing annualized guidance increased to 61 percent, from 38 percent in the previous survey, while the percentage that also provide quarterly guidance fell to 61 percent, down from 75 percent. The number of companies providing only quarterly guidance declined to 28 percent from 53 percent, while the number of companies that provide only annualized guidance rose to 28 percent from 16 percent.

The survey also found that 93 percent of companies providing guidance update that guidance to reflect a material change, up from 80 percent in 2003, which Thompson called, “good news, because that avoids the market surprise.”

“Companies that don’t put out EPS guidance can still put out a lot of guidance,” says Thompson. “As we see more companies move to the XBRL system, which allows companies to put in quantitative and qualitative measures, investors and analysts will have a better means for measuring companies’ performance.”

“The [Parson] study seems to suggest that companies ought to try to be closer to what they think actual results are going to be,” says Thompson. “But that assumes that companies know when they issue their guidance at the beginning of the quarter that they know what their results at the end of the quarter are going to be. That’s not a valid assumption in many cases.”

Jeffrey Diermeier, president and CEO of the CFA Institute, criticized the Parson report as “just the kind of useless information that leads the investing public to think investing is a game with a quarterly horizon.” He added, “Properly done research is of a longer term nature attempting to understand the fundamentals of a business for proper investment."