This newsletter has made the case, more than once, that communications considerations should be factored into the policy-making process, but even we have never argued that communications needs—particularly the need to satisfy a single stakeholder group should drive corporate strategy. Yet that is precisely what appears to be happening in at least some boardrooms, where the need to meet quarterly earnings estimates is leading senior executives to focus more on meeting analyst expectations than on running their business for the long haul.
Concerns about the long-term impact of such an approach have led to increasingly louder calls for an end to the tyranny of quarterly earnings estimates. Last month, an unprecedented coalition of large companies, pension funds, and unions signed on to the Aspen Principles, developed under the auspices of the Aspen Institute, which include a pledge to eschew quarterly guidance. Two weeks later, the Committee for Economic Development released a report, Built to Last, which urged corporations to focus more on long-term performance measures.
Taken together, these two reports provide a call for corporate leaders to engage in what Financial Times columnist Stefan Stern describes as “more grown-up, substantial conversations with shareholders about the long-term aims of their businesses.” It’s a call that the majority of investor relations professionals wholeheartedly endorse.
Those same professionals are ambivalent, however, about whether companies can continue to provide quarterly earnings guidance and engage in those conversations at the same time. The former encourages a focus on a single metric, while the latter almost by definition requires an understanding of a range of metrics that combine to drive long-term success.
“Companies need to ask themselves what are the drivers of their growth,” says Larry Rand, a partner at New York-based corporate and financial communications firm Kekst and Company. “Then they need to set the standards by which they wish to be measured on the basis of those drivers.”
Most companies already have such standards and measure against them, using them as a basis for compensation and for the evaluation of senior management. But in too many cases, those metrics are for internal consumption only; externally, and on Wall Street in particular, those companies are being measured by a single number only.
“It has come down to a single metric,” says Rand, “and that is something that can be impacted by a number of factors beyond managers’ control, because there are so many macro-economic factors that can have an impact.”
But the problem is that many of the metrics by which corporations should be measuring their performance—including some non-financial metrics—do not lend themselves to quarterly measurement. Many can only be measured over the course of a full year, or even longer.
Says Rand, “Just because shareholders are focused on an immediate return, that doesn’t mean management has to work to that standard.”
Many CEOs obviously see it that way, and more and more have been speaking out on the issue. Two years ago, U.S. Chamber of Commerce chief executive Thomas Donahue told the Wall Street Analyst Forum, “CEO frustration with earnings expectations is widespread and rapidly growing. A lot of that frustration stems from the face that one or two cents of earnings per share in any quarter, especially for any public company that has taken years to build, doesn’t have any real meaning, even though Wall Street gives it a lot of meaning. We are talking about a small part of the past that rarely tells you much about the future.”
Companies that have moved away from providing earnings guidance include Gillette, Coca-Cola, McDonald’s, Mattel, and relatively recently Ford Motor Company, which announced its plans during a conference call with analysts and told them: “We cannot succeed over the long-run by focusing only on the short-term. We must be guided by our long-term goals of building brand, satisfying customers, developing strong products and accelerating innovations. Over time, we believe this approach will lead to sustainable profitability. You will be able to judge our results as we report our progress.”
The flip side of that coin involves companies that go out of their way to “smooth” their earnings, to use accounting tricks to ensure that they always meet expectations.
Says Rand: “You can always make your numbers. You can delay a payment, or you can cut back cut research and development or hold off on a new marketing effort, but when you do that you are running your business for investors, not running it for long-term objectives.”
The Aspen Principles marked the culmination of a two-year project led by The Aspen Institute
Corporate Values Strategy Group in collaboration with the Council of Institutional Investors and the Business Roundtable, an association of chief executive officers of U.S. companies with $4.5 trillion in annual revenues and more than 10 million employees. That project was prompted by concerns about the corrosive effect of short-term pressures on publicly traded companies and by the rising public sentiment against excessive executive compensation.
According to Judith Samuelson, executive director of The Aspen Institute Business and Society Program, “This is an important step forward in managing for the long term. We’ve built these principles on the foundation laid by many other organizations and individuals. What we have added to their efforts is the commitment of diverse stakeholders to work together to change business practices, investment practices and policy in support of long-term competitiveness.”
The Principles call for:
• Companies to stop providing quarterly earnings guidance to analysts, and to not respond to analyst estimates.
• Corporate boards to communicate with “long-term oriented investors” on senior executive compensation.
• Requiring senior executives to hold stock they are given for at least some period beyond their tenure with the company, thus tying them to the long-term growth of the company.
• Banning senior executives from hedging the risk of stock options of long-term oriented compensation.
• Providing for “clawbacks,” that involve recouping senior executive compensation awarded based on the achievement of performance targets that were subsequently slashed or wiped out by financial restatements.
The Committee for Economic Development, meanwhile, warned in its Built to Last report that an increasingly short-term focus by many business leaders is damaging the ability of public companies to deliver on long-term performance objectives.
“Decision making based primarily on short-term considerations damages the ability of public companies—and, therefore, of the U.S. economy—to sustain superior long-term performance,” according to former Securities & Exchange Commission chairman William Donaldson, now the chair of CED’s subcommittee on corporate governance. “Emphasis on quarterly earnings, compensation tied to earnings per share, shortened CEO tenures, and financial reports that fail adequately to inform about company performance impede the task of building long-term value.”
The report calls on boards of directors to address these problems by putting the long-term interests of the corporate entity at the forefront of their concerns. Specifically, it called on directors to:
• Support management’s development of comprehensive strategic plans with appropriate long-term objectives, and continually assess management’s performance vis-à-vis those objectives and interim milestones.
• Structure incentive compensation plans so that a significant portion of the income of the CEO and other top executives is tied to the achievement of well articulated longterm performance objectives in line with the corporate strategy.
• Insist that corporate reporting be redesigned to include useful non-financial indicators of value, such as those proposed by the Enhanced Business Reporting Consortium, and that such measures count internally for assessment of performance.
• Eliminate quarterly guidance on earnings per share. Such guidance encourages a focus on (and sometimes a distortion of) short-term financial results and attracts short-term, speculative trading rather than long-term investing.
There is widespread agreement among financial communications professionals that the focus on quarterly earnings guidance has created a short-term mindset, at least among some managers.
“Quarterly guidance has led to a vicious cycle for many companies, particularly younger, growth-oriented ones whose stock price is closely aligned with hitting their growth targets,” says Rich Torrenzano, chairman and chief executive of The Torrenzano Group and a former member of the management committee of the New York Stock Exchange. “The pressure of meeting quarterly targets has unfortunately resulted in companies and senior officers practicing unethical and sometimes criminal behavior to satisfy these numeric targets. We have seen the unfortunate outcomes with backdating options for large and small companies as the most recent example of the effect of ‘short-termism.’”
Torrenzano says several clients—acting on his firm’s advice—have discontinued providing quarterly guidance or have moved from quarterly to annual guidance. “With appropriate notice to the investment community, companies can transition successfully away from quarterly guidance without a major backlash from investors,” he says. “As far as clients who have discontinued providing guidance, there has been little or no impact on their credibility or stock price. All it takes is just getting used to and standing firmly by your decision.”
But most investor relations professionals believe some level of guidance is both appropriate and helpful. Kekst and Company’s Larry Rand, for example, says several of his firm’s clients have switched to annual guidance without any negative consequences.
“Earnings guidance can be used, or misused, in a number of ways,” says Richard Wolff, chief executive of Global Consulting Group, a corporate and financial communications unit of Huntsworth Group. “There are management teams that listen first to investors to find out what they want, and then try to drive their organizations to produce those results. This is definitely problematic because it focuses the entire company on benchmarks set by shareholders who have an imperfect view of the reality of the company and may have short-term interests that do not coincide with the real interests of the company’s development.
“On the other hand, if forecasts arise from an internal company process that provides a genuine window on future results, this can be useful to investors. Oftentimes, when done properly, guidance can talk down overly optimistic shareholders whose limited understanding of the market and company can lead them to very wrong conclusions.”
Wolff says his firm has seen some—“but a distinct minority”—clients discontinue guidance. “To manage this successfully, a company must become very transparent. If you are not going to provide guidance, you must give analysts sufficient detail so that they can create accurate forecasts. After all, misinformation or inaccurate information about a company only distorts the market valuation. So either provide accurate guidance or give the analysts the detailed information so they can do the job themselves.”
Others have increased the substance of the guidance they provide, with a greater emphasis on qualitative rather than quantitative benchmarks.
“In our view, the question is not whether to give guidance but what kind of guidance to give,” says Matthew Sherman, partner at New York financial communications specialist Joele Frank, Wilkinson Brimmer Katcher. “Guidance increases transparency and can help the investment community better understand a company’s business. Establishing—and meeting—benchmarks by which investors can measure success can also help management build credibility.
As for the specific guidance to be provided, “Every company is different. In determining guidance policies, we advise our clients to consider, for example, their ability to predict the business accurately, whether analysts/investors can model the business without guidance, peer practices and overall visibility. Whether the guidance is qualitative or quantitative in nature, establishing goals and being able to articulate a clear strategy to achieve them have always been key elements to any successful financial communications program.”
Steffan Williams, who heads Capitol/MS&L—the London-based financial communications unit of Manning Selvage & Lee—agrees. He says a growing number of his clients no longer provide earnings guidance, and even more provide guidance and continue to engage in more substantial conversations with their shareholders. As a result, he says, more investors see themselves as partners, and “their interests are increasingly aligned with those of managers.”
National Investor Relations Institute surveys have revealed two noteworthy trends. The first is a trend to annual guidance from quarterly guidance; the second is a trend away from managing expectations by providing specific quantitative or a likely range for earnings. Says Robert Berick, managing partner at Cleveland’s Dix & Eaton, “While there are some companies that enjoy fairly predictable earnings, many do not. Pretending that earnings are predictable when they aren’t tends to undermine a company’s credibility.
“So companies should not try to fit themselves into a mold if it’s not a good fit. Some companies continue because they feel it is expected of them—perhaps most others in their industry provide guidance—and they believe analysts want them to provide guidance. Or they fear that their stock price will become more volatile if they don’t provide earnings guidance, even though recent research suggests this is not the case.”
And many see no conflict between providing quarterly earnings guidance and holding grown-up conversations with shareholders. “In fact, accurate guidance should be based on grown up conversations,” says Wolff. “The problem is when managements says, ‘Shareholders want to see X percent earnings growth, so we have to deliver that number and we have to tell them that we will achieve it.’
“The right way to run a public company is to assess what your organization can deliver at its stage of development and to educate investors as to why those results should be acceptable. It’s a conversation with key investors, and it requires work and transparency.” If there’s a reason those conversations don’t take place as often as they should, it’s that “Most management teams just don’t want to be bothered; they’d rather take the easy way out.”
Torrenzano agrees: “Conversations with shareholders can be both intelligent and substantial provided that the ground rules are clear from the start,” he says. “However, some shareholders will push as hard as they can to gain an ‘information edge,’ and these are the conversations that turn into non-productive discourses, or less grown-up and less substantial, because they try and cross the line on disclosure.”
Recent regulatory reform has clearly been an issue for many large companies. In the wake of Regulation Fair Disclosure, which was adopted in August of 2000, and Sarbanes-Oxley, which was passed in response to Enron and other scandals in the early days of the 21st century, some executives clearly felt it was safer to say nothing at all—or at least as little as possible—rather than to risk saying something that could get them arrested.
Regulation FD was designed to level the information playing field between professional investors and “Main Street” shareholders, while Sarbanes-Oxley sought to improve the reliability of financial statements by holding senior executives personally responsible for their accuracy. Adding to the pressure created by those regulatory changes, in 2005 for the first the SEC fined a company (Flowserve Corporation) for confirming earnings guidance at a private meeting with investors—a case that also marked the first time charges had been brought against an investor relations manager under Regulation FD.
Regulation FD can act as a barrier to these kinds of “grown-up conversations,” says Berick, because “people worry about sharing material information without making it fully accessible to all. Liberal use of conference calls and webcasting can help meet the spirit of Reg FD.
“Companies can provide differential disclosure—more information to those that want it – as long as it isn’t material. Then analysts can put together what they know and form a mosaic that lets them predict future performance. But companies have to be very careful how they do this. In general, making the same information available to everyone at the same time is preferable: even required, if it is material information. But not all analysts or investors want the same amount of information or will do the work to put non-material information together to better understand a company’s prospects.”
“What we talk about has changed, because the markets have changed and are changing, and the amount of regulation has skyrocketed,” says Berick. “We are in a period of exuberant regulation and just keeping up with it all is a challenge.”
As a result, “compliance is more important than ever, because there are more regulations to comply with,” Berick says. “However, once policies and procedures are in place to ensure compliance with regulatory requirements, the underlying challenges of shaping and communicating messages remain the same as ever.”
If there is one thing all financial communications professionals agree on, it is that IR cannot add value to an organization if it is treated as a compliance function.
“We certainly talk to lawyers a lot more these days,” says Williams. “However, given that a huge percentage of a company’s valuation is based on perception and reputation, IR remains far more than an act of compliance, at least for those companies that are good at it.”
“IR is definitely not solely a compliance function,” says Wolff. “Complying with securities regulations is critical, but that is only a small part of IR consulting. The most important aspects of IR involve developing ‘grown up conversations’ with investors and potential investors within the difficult context of Sarbanes Oxley and short-term thinking on the part of much of the market. This strategic aspect of IR is the most valuable element to clients, and it is not easy to do.
Wolff agrees. “If you see IR as simply ‘compliance,’ rather than as developing the value proposition for a company, then you misunderstand IR completely,” he says. “You’re back to simply asking investors what they want, and artificially turning your organization on its head to give it to them. That’s a recipe for perhaps short-term success and certainly long-term disaster.”
“For many companies, investor relations at the practice level has always had an important compliance component,” says Torrenzano. “With new rules and regulations, today that compliance has expanded to the C-suite level, in addition to the formal strategic, performance and metric-based components. This has led to more information being exchanged, but perhaps not as much insight. We don’t practice that type of IR, and don’t accept clients that do.”
Rand notes that as companies move away from talking only about earnings per share, they find that most investors welcome the more substantial conversations that ensue.
“Most investors like that they are getting more information, that they have a greater understanding of the company. The discussion becomes a more intellectual discussion, more of a business discussion and less of a stock price discussion. It becomes the kind of discussion potential buyers have with management. In many cases, investors are surprised by the premium that buyers pay for companies. That premium is a result of buyers taking time to sit down and asking questions and holding a discussion about the fundamentals of that business.
“If companies held the same kind of discussions with their shareholders, there wouldn’t be that kind of gap between the market value and the value a buyer is prepared to buy.”