Reporting An Earnings Miss
Many public companies feel enormous pressure to meet or exceed quarterly consensus estimates on the belief that failing to do so will result in a loss of management credibility and a precipitous decline in market value.
If true, many management teams saw their credibility evaporate this past earnings season. A simple Bloomberg scan of 243 TSX-listed companies across energy, materials, industrial, consumer discretionary, consumer staples, health care, financials, info tech, telecom and utilities sectors showed that 56% fell short of earnings estimates and by a fairly wide margin. In aggregate, these companies missed estimates by 17.6%, dragged down by the energy sector’s 97.7% underperformance and a 64.1% underperformance by consumer discretionary stocks.
This widespread failure could be explained by external factors such as the 50% decline in the price of oil between November and early February and weak Christmas retail sales, but the reality is earnings misses occur all the time. What really happens when a company reports a miss and is there a way to cushion the blow?
Missing The Mark: The Street’s Reaction
To address the first question, a seven-year study by McKinsey & Company published in 2013 showed that for large U.S. companies “missing the consensus by one percent would lead to a share-price decrease of only two-tenths of one percent in the five days after the announcement [of financial results]. In other words, missing the consensus estimate by a penny or so just doesn’t matter.” Of course, tell that to the executives of eBay, which in 2005 missed earnings by one cent and suffered a 22% share price decline.
Unquestionably, a steeper earnings miss can have a bigger impact; one that can be magnified when a company chronically underperforms expectations, when underperformance occurs immediately following an IPO or secondary fundraising, or when a company is considered a bellwether for its industry.
While no company wants to disappoint shareholders, what should an IRO do when results are below estimates? First, identify exactly why results were lower than analysts expected. This requires understanding the set of assumptions that analysts used to arrive at their estimates. When the assumptions are faulty, the math around forecasts will be as well.
Pinpointing the root causes of the miss and being able to accurately communicate the reasons behind reported numbers will go a long way to protecting management credibility. Conversely, investor confidence is shaken when the CEO and CFO appear not to know why (or display adequate contrition for) weaker than anticipated results.
The Earnings Bridge
Good practice is to build what’s known as an earnings ‘bridge.’ Often presented as part of a quarterly earnings deck, the bridge visually helps investors understand variances (plus and minus) in performance. Variances may come from items such as higher input costs, delayed customer orders, or a wide variety of factors. In fact, it’s usually not just one item but many that result in underperformance. Using the bridge generally requires more disclosure than is normal for a company, but more disclosure, rather than less, is an absolute necessity in these circumstances.
Often in times of an earnings miss, companies will develop supplemental measures such as ‘Adjusted EBITDA’ to illustrate ‘operating’ performance before non-indicative items. This is fairly standard practice; however, in order to have resonance as a management performance measure, it needs to be used in more than one quarter and there must be consistency quarter-to-quarter in the non-indicative items that are eliminated to arrive at the adjustments. Companies also need to comply with the guidance in CSA Notice 52-306 Non-GAAP Financial Measures and Additional GAAP Measures.
A second best practice is to consider whether the miss is significant enough to warrant early release of financial results. It’s tough to make this call, but according to National Policy 51-201, Disclosure Standards, a significant increase or decrease in near-term earnings prospects, unexpected changes in financial results for any periods, shifts in financial circumstances (such as cash flow reductions and write-downs) and changes in the value of assets are all potentially material and therefore qualify for immediate disclosure.
So-called ‘going concern’ reporting is another matter and is explained in the April 2015 edition of IR leader.
If early disclosure is deemed unnecessary, it is nonetheless poor practice to delay information release until late in the quarterly cycle. Some TSX companies have been known to release bad results on the 45th day following quarter end: this deferral makes bad news worse and results in a further, if temporary, loss of goodwill toward management.
Similarly, releasing bad results when ‘no one is watching’ at 10:00 p.m. on a Friday evening is also credibility destroying and should be avoided. Even trying to escape attention by releasing slightly after market close is not a good idea, particularly since there is after-hours trading. Another ‘no-no’ is to attempt to bury bad news in the earnings release or report EPS without comment or explanation.
Instead, aim to disseminate well before the markets open (and open for pre-hours trading, which is easy when a company trades only in North America), clearly state the main causes for the results on page one of the news release and follow as quickly as practical with an analyst call. Leaving too much time between issuing the release and holding the conference call means more time for analysts and journalists to write reports without hearing management’s full side of the story.
What Does The Miss Mean to Your Outlook?
A third best practice in communicating bad results is to recalibrate your company’s outlook. Once quarterly results are released, analysts will immediately look to update their forecasts based on current results and revised assumptions. While it is tempting to be vague about the future so as not to create another credibility gap three months hence, this is the wrong approach. Instead, it is better to err on the side of more disclosure, rather than less. In particular, focus communications on actions that management is taking to improve earnings. Use the conference call to discuss the assumptions that management used to develop its outlook. If not part of supplemental disclosure, consider publishing period-end backlog figures and indicate expected book-to-bill ratios. Comment on the impact (if any) of the earnings miss on investment plans and timing, and generally your company’s ability to fund its strategies. And overall, do not fall into the trap of overpromising a speedy recovery. Perhaps it is human nature to paint every cloud with a silver lining, but when credibility is on the line, it is important to be realistically conservative when providing an outlook. This is particularly true of companies undergoing a turnaround.
Remember also that NI 51-102 Continuous Disclosure Obligations requires that companies disclose in their MD&A known trends or uncertainties that are reasonably likely to have an effect on the company’s business. If companies have disclosed material forward-looking information, then in subsequent MD&A or news releases they must discuss events and circumstances that have occurred during the relevant period that are reasonably likely to cause actual results to differ materially from that previous forward-looking information and to disclose the expected differences.
By including a detailed and measured outlook, some companies have found their earnings miss to be an (almost) non-event. Some have even found that their stock price increased following an earnings miss as investors recalibrate their outlooks to the upside. This is, of course, only a positive if future results mirror or exceed the past outlook given by management.
Once all is said and done, it is also worthwhile to go back and dissect communications that led up to consensus estimates. Typically, public companies may point out unrealistic assumptions during one-on-one discussions with an analyst. While it is ultimately up to the analysts to develop their own forecasts and a company can neither provide material undisclosed information selectively nor express comfort with estimates selectively, ‘talking an analyst down’ without tipping is an art form and clearly some management teams are better at it than others. IROs can play a role in preparing their management teams for these discussions and should sit in on calls with analysts to record discussions. In fact, as CIRI’s Guide to Developing an Investor Relations Program states, “the IR professional’s goal is to minimize surprises – both positive and negative” so that “…uncertainty is reduced and competitive valuations can be achieved and sustained.”
Missing consensus estimates once, or once in a while, is not the end of the world. Serial underperformers, however, face a much bigger problem and that can come from both equity and debt holders. In these cases, something more fundamental will have to change besides just providing more and better disclosure.
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