Earnings Guidance: Best Practices for IROs

In public company circles, few topics are as controversial as earnings guidance – the practice of quantifying and disclosing management’s expectations of future financial performance.

Many leading institutional investors, including JP Morgan’s Jamie Dimon and Warren Buffett, are dead set against the practice for leading to “an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability”, as they framed it in a Wall Street Journal editorial published in 2018. Detractors like these would argue that best practice is not to issue guidance at all.

However, some well-established companies in both Canada and the United States do publish guidance and stick by the practice as a valuable and complementary addition to their investor relations strategies.

In this issue of IR focus, we examine earnings guidance from the perspective of those who offer it, with a view to gaining insight into what information they provide, why, the cost/benefits of doing so and how IR teams participate in the practice.

First things first

The Ontario Securities Commission encourages issuers to provide forward-looking information “if they have a reasonable basis for doing so.” While discussions of known trends/uncertainties that are reasonably likely to affect the company’s business should be included in corporate disclosure materials (including material assumptions underlying forward-looking information and material risks to not achieving expected results), public companies do not have an obligation to forecast future revenues, income or loss.

Taking this into account, many companies produce what could be called soft or directional guidance. That is, they produce outlook statements conveying management’s expectations in a qualitative manner such as:

we expect growth to continue in the second quarter;
in the short run, expectations are for lower originations as higher mortgage rates continue to dampen housing market activity;
we expect gross margin to be slightly higher than our fourth quarter of 2022 gross margin; and
2023 capital expenditures will be in line with those in 2022.

In describing why his company provides such directional statements rather than quantitative guidance, one IRO offered that his management team is only comfortable with this level of “expectation setting. We recognize that investors crave forward-looking information but we’re just not comfortable putting numbers on the public record that can be either easily achieved, missed or derailed by economic factors outside our control. Our preference is to provide a very thorough explanation of our value drivers and business climate so analysts and shareholders can come up with their own short- and long-term forecasts grounded in a mutually understood reality.”

Regulators themselves are also skeptical of the reliability of projections too far into the future and recommend issuers limit their forecasts and outlooks to a period that can be reasonably foreseen – generally not more than one year.

Comfort in some numbers

Other companies will go a step further and produce partial guidance across selected quantitative measures – but notably not including EPS. Examples gathered by IR focus include observations such as:

in the short term, the Company expects non-cash working capital to remain above 10% (of annualized revenue);
over a three-year time frame, we expect to generate an increase in EBITDA margin of about 50 basis points;
we anticipate that over a one-year period we may lose approximately 4% to 6% of our aggregate annualized recurring revenues from the previous year in the ordinary course; and
in the fourth quarter, management expects the conversion of backlog to revenues to be in the 30% to 35% range.

Partial guidance can be helpful to issuers in managing investor expectations for certain key performance indicators but, said one IRO, it is issued by companies “disinclined to do all the work of the analyst community. If we give analysts certain quality inputs, they can come up with their own quality outputs.”

Going all the way

Then there are companies that produce full earnings guidance right down to the penny. A good example is Milwaukee-based Rockwell Automation. It states guidance for diluted and adjusted EPS along with sales growth including organic growth guidance distinct from acquisition growth.

Closer to home, Nutrien publishes full-year guidance for adjusted EBITDA and adjusted net earnings, as well as potash and nitrogen sales tonnage. EQB, known as Canada’s Challenger Bank, also sets annual guidance for measures including return on equity, diluted EPS growth, dividend growth, book value per share growth and capital ratio. Bombardier guides on metrics including revenues, adjusted EBITDA, adjusted EBIT, free cashflow and cashflow from operating activities.

These issuers are thought to be in the minority in Canada. In the United States, guidance became more common during the late 1990s after Congress explicitly protected issuers from liability for statements about their projected performance (see the Private Securities Litigation Reform Act of 1995).

A 2006 McKinsey & Company study of 4,000 companies with revenues above $500 million found that approximately 1,600 provided guidance “at least once in the years from 1994 to 2004.” Companies that discontinued guidance also grew in that period.

A study by FCLTGlobal in 2017 found that the share of S&P 500 companies issuing quarterly guidance declined from 36% in 2010 to 27.8% in 2017 and that among Euro Stoxx 300 companies, issuance of guidance “is near zero (0.7%).” The number of issuers that either withdrew guidance or discontinued it increased three years later at the outset of the COVID-19 pandemic.

Notwithstanding criticism from Dimon and Buffett, as well as BlackRock’s Larry Fink, who said, “Today’s culture of quarterly earnings hysteria is totally contrary to the long-term approach we need,” issuers that offer full guidance appear to do so for one or more of these reasons:

They have full confidence in their ability to forecast.
They say their investors and analysts are asking for it and that it will enhance disclosure practice.
They prefer to communicate their own specific expectations rather than letting outsiders set them and they want shareholders/analysts to use the same key financial metrics they do for assessing progress.
Due to the inclusion of hard numbers, it is a more precise way to express the company’s outlook than providing qualitative soft/directional statements and is seen as a better way of managing investor expectations, as well as analysts’ estimates.
Their businesses (and prospects) may not be well understood by analysts, their financial performance tends to be hard (for outsiders) to predict and these challenges are thought to lead to undeserved valuation discounts.
It provides additional company profile in the capital markets, which is thought to contribute to greater trading liquidity/reduce trading volatility.
It is a way for issuers to prove themselves (something that was posited in a 2006 CFA Institute report entitled “Breaking the Short-Term Cycle.”)
It will differentiate the company from peers.
If issuers are Canadian listed but targeting expansion of their U.S. investor base, it is seen as a way to improve shareholder/analyst interest south of the border.
If a Canadian issuer is dual listed (U.S. and Canada), and U.S. peers provide guidance, the company may feel it is a necessary practice.
Meeting/beating expectations creates credibility for management (although admittedly the opposite is also true).

Depending on whom you ask, some of these benefits may be more perceived than real. In a 2006 report, The Misguided Practice of Earnings Guidance, McKinsey & Company found “no evidence that it (guidance) affects valuation multiples, improves shareholder returns, or reduces share price volatility. The only significant effect we observed is an increase in trading volumes when companies start issuing guidance – an effect that would interest short-term investors who trade on the news of such announcements but should be of little concern to most managers, except in companies with illiquid stocks.” McKinsey also argued that “investors…don’t put as much weight on quarterly EPS guidance as executives believe they do.”

Similarly, the FLCTGlobal report entitled Moving beyond quarterly guidance refuted what it called six myths, one of which was “issuing quarterly guidance improves companies’ valuations.” Instead, its analysis of S&P 500 constituents found no “effect on valuation whatsoever.”

Determining what to disclose

As noted above, issuers provide different levels of guidance. Those providing partial quantitative guidance focus on deliverables that, as one IRO said, “are within our span of control or relatively easy to predict based on historical experience and well-established trends. Anything more than what we provide would be a financial bridge too far for our taste. That said, the KPIs we choose to guide on contribute directly to the quality of analyst modelling for revenue and a measure of cash use, so they are useful.”

IROs whose companies produce partial guidance find that analysts appreciate it. For example, one issuer interviewed for this article noted her company provided backlog conversion rate estimates (“please don’t call it guidance,” she said), as this allows analysts to project topline revenue in the ensuing quarter. Without the forward-looking information we provide, “analysts’ quarterly earnings estimates would be all over the map because orders in backlog each quarter don’t move at the same pace due to billing milestones and the varying size and complexity of each order. Analysts have no means of reliably estimating conversion because we aren’t about to disclose contractual terms on each order we receive. So we help the process along.”

Securities law does not distinguish between terms such as goals/targets, on the one hand, and guidance, on the other and, as noted above, regulators generally advise companies to limit their outlooks to a reasonable time frame. However, some companies will disclose long-range goals or multi-year targets for measures such as revenue, gross margin, or EPS. Empire Company is one. It helps investors to understand the impact of its ‘Project Horizon’ by stating that, within the project’s three-year time frame, it “expects to generate a compound average growth rate in EPS of approximately 13% and an increase in EBITDA margin of approximately 50 basis points, both excluding the full impact of the Cybersecurity Event and the one-time costs associated with the Grocery Gateway integration.” ATS Corporation, the automation company, has a standing target to achieve adjusted earnings from operations margin of 15% over the long term. Toromont Industries, the Caterpillar dealer, describes its goal of achieving 18% return on shareholders’ equity “over a business cycle.”

Each issuer has its own reasons for choosing the specific targets and time frames it discloses. In Empire’s case, the targets align with the completion of its Project Horizon.

One advantage of this approach is that financial progress in the measures chosen will not necessarily be realized every quarter or in a linear fashion. As one IRO said, “There are times that it takes time for projects and material improvements to gain traction. If we don’t put time frame goals on the public record, the analyst community could jump the gun and assume results will happen faster than is reasonable or faster than what we expect.”

As another IRO said: “Our CEO believes in the adage what gets measured gets managed. When we take on a significant project, we calculate investment returns and then measure ourselves against those targets. By offering longer-range objectives publicly, we are displaying a discipline that shareholders appreciate and make no mistake: we are appealing to our long-term owners. These are the people we care most about, not the day traders who are swayed by a quarterly beat.”

Beyond revenue or EPS guidance, what a company chooses to disclose will be unique to its business. For example, see Nutrien and its potash tonnage guidance, Bombardier and its annual airplane delivery guidance and EQB and its loan-growth guidance.

With escalating climate change risk, some companies are also adding net zero guidance/long-term timelines to their repertoire, at least in their sustainability reporting, a practice that may increase in future (and be integrated with financial guidance), given institutional interest.

That said, companies need to be very careful in publicly stating anything that could be deemed a stretch or aspiration goal. If such a goal is not met over the time frame envisioned, the issuer is expected to disclose why and how it expects to bridge the gap.

What do analysts expect?

It’s impossible to generalize about what every analyst wants from a public company when it comes to guidance. But one thing is universally true: analysts run their own forecast models and will take guidance into account when updating those models.

Said one IRO whose company provides full EPS guidance: “We know analysts will question our guidance rigorously not only to understand how we arrived at it but whether it’s realistic given their knowledge of the economy, our markets and our track record. If you asked them whether they quote/unquote rely on our guidance, they would say no. But we do know what we produce has value (to the analyst community) in shaving off any excessively optimistic or pessimistic estimates.”

Publicly, at least, most analysts will downplay the importance of company guidance but the IROs we spoke to have a slightly different take. Said one: “We find it (providing guidance) makes the entire exercise of analyst relations more effective and perhaps more transparent. We don’t need to do as much message management leading up to reporting because analysts know what we expect in dollar terms and how we arrived at our guidance. Interactions with analysts at quarter end tend to be more about reaffirmation. The guesswork for them and the behind-the-scenes nudging by us is reduced.”

This, of course, presumes that the guidance offered tends to mirror what a management team really expects as opposed to guidance that is stage-managed to always be exceeded.

Said one IRO: “We know that it’s better to meet or exceed earnings guidance than to underperform. But it’s part of our management culture to formulate guidance from our internal financial budgets. Our budgets are stress tested before finalization so there is a reasonable basis for the guidance we present. Perhaps not all companies (that produce guidance) share this philosophy, but we believe guidance will be treated not just with suspicion but with disdain by analysts if it is so obviously discounted by management to make it easy to achieve.”

Said another: “My experience is analysts will always listen to management guidance attentively while layering in their own perspective. By doing so, they can differentiate themselves (from other analysts) but not come out with estimates that make them outliers. Their motivation is to be as close as possible to actual results and they appreciate that management wants the same.”

Where does the IR function fit?

At its heart, setting guidance is a mathematical exercise that is performed in a company’s finance department. Before publicly producing guidance, however, IROs should:

explain the pros and cons of providing guidance to their management teams and remind management that providing meaningful, and potentially more frequent communications about strategy, market dynamics/growth opportunities and long-term value drivers can lessen the investment community’s reliance on earnings guidance;
have a view of what investors (existing and sought after) expect from the company in terms of guidance;
study the shareholder bases of peer companies that currently produce guidance to understand ownership makeup and ownership trends;
advise management on the guidance that would be most helpful to shareholders/analysts;
take part in discussions on guidance ranges that will be offered; and
seek to understand the math behind the numbers that their finance colleagues develop, since IR will be called upon to explain them.

The role of IR does not stop there. When guidance is issued, IROs spend time with analysts to explain management’s thinking, track changes in analysts’ estimates/expectations to understand why they were made and report the findings to the C-suite and Board of Directors. It is a very similar process for IR teams whose companies do not produce guidance.

Similarly, if guidance is exceeded, the IR team will need to explain why and prepare to manage (or contain) analyst expectations of future results.

When the bottom falls out

IR teams are also deeply involved in preparing management for situations where guidance is missed, something that is possible and perhaps even likely depending on the aggressiveness of management.

Said one IRO: “Missing consensus estimates is one thing but missing your own guidance is quite another. We are quite aware of our obligations to share a miss with the Street as soon as we know it and our team would work overtime in a situation like that to understand the reasons we fell short so we can explain them, as well as how we arrived at revised guidance for upcoming quarters.”

In situations like this, damage control would be a good term to use to describe what an issuer would need to focus on in the days following a guidance miss. Of course, that depends on how wide that miss was and the nature of the revised guidance. Ultimately, said one IRO: “We are guardians of corporate reputation. That means we need to be careful about sustaining management credibility through periods where we are seen to be underperforming our peers, our own guidance or analyst estimates. All three are bad but can happen. How a management team communicates externally when it underperforms and what it does after in communicating its story can be strongly influenced by what the IR team recommends. Be ready is my advice.”

Tips for producing guidance

From various interviews with IROs and reviews of literature, IR focus suggests a few tips for those who are thinking about setting guidance:

1.Think critically about the impact guidance might have on your company’s capital markets’ profile, trading and valuation, as well as its reputation and whether efforts to better communicate your company’s strategy/objectives (minus guidance) might achieve the same objectives at lower risk. Also remember that once offered, guidance cannot be easily switched off. Poor expectations of future performance is a bad reason for halting the practice.

2. Closely monitor business performance after guidance is offered to ensure your company is delivering to plan (or needs to update guidance) and plan ahead to contemplate how you will message a guidance miss and/or communicate the reason for withdrawing guidance.

3. Advocate that your company produce guidance ranges – because ranges are easier to achieve than absolutes – and that those ranges are calculated and presented using a consistent approach and format year to year, if possible. Using guidance ranges also reduces the need to update guidance during the period (provided management still believes results will fall within the range).

4. Make sure those ranges are reasonable in the context of your financial budgets and are not simply lowball estimates that will be ignored/discounted by analysts or require subsequent updating under law.

5. Scrutinize disclaimer language that should always appear with guidance to ensure shareholders understand the presumptions management used and the material risks involved in meeting guidance – recognizing that your legal team will hold the pen.

6. Think through the time frame for the guidance that is being offered – is it going to be annual (year over year), annual (from the end of the prior fiscal year) or something else – and how will seasonality, if any, be squared against guidance and quarterly progress toward meeting stated goals?

7. Actively participate in the development of your MD&A. Guidance-giving issuers have an obligation to update shareholders if guidance is no longer reasonably achievable. If guidance of a material nature is missed, they must also announce this by means of a press release, which could be required before the regular earnings release date.

8. Encourage internal discussion on how your company will safeguard and promote long-term value creation even as it strives to achieve short-term guidance and be prepared to defend your approach to your long-term owners. This includes those who might subscribe to Warren Buffett’s line of thinking when he said he had “observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced.” Hopefully, a well-structured executive compensation plan that incents the achievement of long-term strategic and value creation will be present to underpin your arguments.

The fundamentals of good IR don’t change because of guidance

While the fundamentals of good IR practice won’t change if you start offering guidance – including the ability to provide clear, consistent communication of corporate strategy and value drivers – there will be new dynamics and considerations to manage that will take your time and attention. Just ask IR teams whose companies missed guidance and found themselves in the crosshairs of law firms that were quick to respond by opening “investigations concerning possible violations of securities laws” – a favorite phrase of litigators.

Guidance is a controversial practice and, as an IRO, you would be well advised to have an informed perspective on the pros and cons for your company.

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