Earnings guidance: Companies’ forecasts can do them as much harm as good
There have been arguments for and against the practice of guidance since slowly but steadily more and more cos are shying away from the practice.
Eleven years is a long time in the life of a habit. Long enough for observers to take it for granted. Long enough for them to also be enraged when the habit is broken, especially if it has served them well. That is exactly what happened in July 2012 when Infosys did not give a guidance for the July-September quarter, something it had been doing since 2001.
“Because of the environment, because of the events which are unfolding, we are not sure about the quarter-to-quarter decisions which the clients will make and that has an impact on our quarterly numbers…. At this point in time given the amount of facts which we know, we have decided not to give the quarterly guidance for the time being,” said Infosys chief executive and managing director SD Shibulal on a conference call with analysts after the results. This shocker came after the company lowered its dollar revenue growth guidance for 2012-13 to 5% from 8-10%.
Investors certainly did not take kindly to the news, as the stock received an 8% battering. They were hardly to blame since here was a company that not only stood out for giving quarterly guidance but also for consistently exceeding it. While the company had benefited immensely from it, now it was waking up to its downside.
Anirudha Dutta, former head of research at CLSA India, a brokerage, believes what Infosys did was uncalled for. “If they believe that guidance has a role in superior corporate governance, then given the uncertain environment, they could have continued giving a guidance within a larger band. A company can’t give guidance only when it suits itself,” he adds.
Shriram Subramanian, MD at Bangalore-based proxy advisory InGovern Research Services, concurs with him: “If you are adopting a practice like guidance, you might as well adopt it in bad times too. Everyone knew Infosys was going through a bad time, so why not continue giving guidance?” he asks.
READING THE TEA LEAVES
Guidance would come back to haunt it, as recently as in April this year. When the company guided for a 6-10% revenue growth in 2013-14, the stock plummeted over 21%. Clearly, the company that was as big a favourite of investors as any was drifting away from them. An Infosys spokesperson says the company’s philosophy of giving guidance remains consistent: “It is to share facts as we see them and to remove asymmetry of information between the external and internal world.” She did not specify if or when the company would resume its quarterly guidance.
While besides Infosys, among the IT biggies, Wipro and Nasdaq-listed Cognizant Technology Solutions give quarterly guidance, Tata Consultancy Services and HCL Technologies do not make projections. Outside of the IT sector, very few companies like Larsen & Toubro and Sun Pharmaceutical Industries provide guidance, which is annual in both their cases. This is contrary to the norm in the US where 44% of companies give financial guidance and only 8% don’t give either financial or nonfinancial guidance, according to a September 2012 study by the National Investor Relations Institute (Niri).
There have been arguments for and against the practice of guidance since slowly but steadily more and more big companies are shying away from the practice. Soon after he took charge as CEO of Unilever in January 2009, Paul Polman did away with earnings guidance.
Unilever joined the ranks of companies like Warren Buffett’s Berkshire Hathaway Inc and Google Inc. If not altogether scrap guidance, companies are turning to annual guidance. “Among Niri respondents who do not provide quarterly earnings guidance, nearly three quarters refrain to focus on long-term company performance,” says the study. At the height of the downturn in 2008-09, quarterly guidance by companies fell by a third, but has since recovered.
According to a US research paper titled “Is silence golden? An empirical analysis of firms that stop giving quarterly guidance”, firms are more likely to stop giving guidance if its managers are certain that they will have bad news in the future. While the paper adds that there is no evidence that stoppage of guidance increases the stock’s volatility or lowers analyst following, there is an increase in the variance of analyst forecasts and a drop in the accuracy of analyst forecasts.
Notable companies in the US that don’t give guidance:
* Google Inc
* Costco Wholesale Corp
* Berkshire Hathaway Inc
THE COCKROACH PROBLEM
Shivaram Rajgopal, professor of accounting at Emory University’s Goizueta Business School and also co-author of the paper, says quarterly guidance is like a treadmill, you can’t get off. “Missing earnings guidance is like having the ‘cockroach problem’. If you walk into a house and find a cockroach, you believe there are more hidden. Analysts believe the same when a company misses its guidance or stops guidance,” he adds.
R Shankar Raman, chief financial officer of Larsen & Toubro, India’s largest engineering and construction company, says it is with a lot of strain that the company gives annual guidance. “A guidance is not a commitment but markets take it as a commitment and hang organisations if they miss guidance. In times like this, giving guidance is like the meteorological department forecasting the weather,” he adds. L&T gives annual guidance on revenues, order inflows and margins in some major engineering and construction segments.
Sun Pharma, on the other hand, guides analysts on consolidated sales growth, capital expenditure and research and development spends. “Most international pharma companies and branded generic companies routinely share guidance. Hopefully it reduces irrational assumptions by investors and analysts,” says a company spokesperson.
The company in 2009-10 suspended a guidance it had shared with analysts because the US Food and Drug Administration had banned manufacturing at a Sun Pharma subsidiary’s plant in Detroit for alleged violation of norms. Sun Pharma’s peers Ranbaxy Laboratories and Cipla also give guidance.
Lev Baruch, professor of accounting and finance at New York University’s Stern School of Business, believes not every company should give guidance. “You should only if you can better predict than financial analysts. Most managers clearly know more than analysts,” he says adding that guidance helps companies steer investors to reality when they are too optimistic.
“The company cannot be sued if its guidance is wrong unless it has maliciously misguided the market,” Baruch adds.
There is another school of thought, however, which believes there is something fundamentally wrong with guidance. “If you want reliable information about a company’s profitability or the lack thereof, you shouldn’t ask the management because there is a conflict of interest,” says Saurabh Mukherjea, head of equities at Ambit Capital. He adds that corporate would be better doing away with guidance in all forms.
Dutta, formerly with CLSA, says: “When I started out as an analyst in the mid-1990s there was no guidance. What it does is make analysts lazy. It’s not the company’s job to give guidance.” Dutta adds that there is another reason to scrap guidance in India because here one analyst has more information about a company than others. In the US, fair disclosure to be singed by its guidance lately.
Wipro recently forecast negative to marginal revenue growth in April-June quarter, which caused its scrip to fall by 8%. Questions sent to Wipro remained unanswered. Dipen Shah, senior vice-president, Kotak Securities, believes guidance for IT companies used to make sense as most of their revenues come from overseas and it is difficult for analysts and investors to get information from different markets.
“But what is happening now is there is an increased uncertainty and companies are dealing with so many clients that it is becoming more difficult for them to forecast,” says Shah. He says Infosys did the right thing by stopping quarterly guidance. For a company like TCS which doesn’t give guidance, analysts use the projections of industry body Nasscom and the company’s past performance as yardsticks to make estimates.
Rajgopal believes there are alternatives to traditional quarterly guidance. “A company could switch to annual guidance or give non-financial indicators like Coca-Cola can say how many cases it hopes to sell instead of revenues and profits,” he says.
There are obviously benefits to giving guidance. “Companies that give guidance are followed by more analysts than those that do not,” observes Baruch. But, according to Rajgopal, guidance should not become an end in itself for a company. “It can’t be a case of the tail wagging the dog,” he adds.